M-SYSTEMS FLASH DISK PIONEERS LTD. AND ITS SUBSIDIARIES
INDEX TO FINANCIAL STATEMENTS
PAGE
-----
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM F-2
CONSOLIDATED BALANCE SHEETS F-3
CONSOLIDATED STATEMENTS OF OPERATIONS F-4
STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY F-5
CONSOLIDATED STATEMENTS OF CASH FLOWS F-6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS F-8
F-1
[ERNST & YOUNG GRAPHIC OMITTED]
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Shareholders of
M-SYSTEMS FLASH DISK PIONEERS LTD.
We have audited the accompanying consolidated balance sheets of M-Systems
Flash Disk Pioneers Ltd. ("the Company") and its subsidiaries as of December
31, 2003 and 2004, and the related consolidated statements of operations,
changes in shareholders' equity and cash flows for each of the three years in
the period ended December 31, 2004. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits. We did not audit the
2002 financial statements of a wholly-owned subsidiary, which statements
reflect total revenues constituting 26% of the related consolidated total.
Those statements were audited by other auditors whose report has been furnished
to us, and our opinion, insofar as it relates to the amounts and data included
for this subsidiary, is based solely on the report of the other auditors.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Company's
internal control over financial reporting. Accordingly, we express no such
opinion. An audit also includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits and the report of other auditors provide a reasonable basis for our
opinion.
In our opinion, based on our audits and, for 2002, the report of other
auditors, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of the
Company and its subsidiaries as of December 31, 2003 and 2004, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 2004, in conformity with United
States generally accepted accounting principles.
Tel-Aviv, Israel KOST FORER GABBAY & KASIERER
January 19, 2005 A Member of Ernst & Young Global
F-2
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
CONSOLIDATED BALANCE SHEETS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
DECEMBER 31,
-------------------------
2003 2004
------------ ------------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 25,218 $ 50,187
Short-term bank deposits 1,161 41,696
Short-term held-to-maturity marketable securities (Note 3) 7,356 56,871
Trade receivables (net of allowance for doubtful accounts - $246 in 2003 and
$216 in 2004) 19,722 41,503
Other accounts receivable and prepaid expenses 3,162 3,962
Inventories (Note 4) 45,857 56,160
--------- ---------
Total current assets 102,476 250,379
--------- ---------
LONG-TERM INVESTMENTS:
Severance pay funds 2,532 3,397
Long-term held-to-maturity marketable securities (Note 3) 46,072 25,959
Investment in a venture (Note 5) 350 8,988
Investments in other companies and long-term receivables (Note 6) 11,010 11,183
--------- ---------
Total long-term investments 59,964 49,527
--------- ---------
PROPERTY AND EQUIPMENT, NET (Note 7) 17,481 20,203
--------- ---------
OTHER INTANGIBLE ASSETS, NET (Note 8) 90 863
--------- ---------
GOODWILL (Note 9) 477 477
--------- ---------
Total assets $ 180,488 $ 321,449
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Trade payables $ 14,203 $ 19,488
Related party trade payables (Note 15) 3,582 6,027
Deferred revenues 11,920 4,625
Other accounts payable and accrued expenses (Note 10) 6,944 21,493
--------- ---------
Total current liabilities 36,649 51,633
--------- ---------
LONG-TERM LIABILITIES:
Accrued severance pay 3,190 4,263
Other long-term liabilities (Note 8) -- 488
--------- ---------
Total long-term liabilities 3,190 4,751
--------- ---------
MINORITY INTEREST IN A SUBSIDIARY 24 --
--------- ---------
COMMITMENTS AND CONTINGENT LIABILITIES (Note 11)
SHAREHOLDERS' EQUITY (Note 12):
Share capital:
Ordinary shares of NIS 0.001 par value: Authorized - 100,000,000 shares at
December 31, 2003 and 2004; Issued and outstanding - 29,082,615 shares
at December 31, 2003 and 35,508,648 shares at December 31, 2004 8 10
Additional paid-in capital 196,808 297,096
Accumulated deficit (56,191) (32,041)
--------- ---------
Total shareholders' equity 140,625 265,065
--------- ---------
Total liabilities and shareholders' equity $ 180,488 $ 321,449
========= =========
The accompanying notes are an integral part of the consolidated financial
statements.
F-3
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA
YEAR ENDED DECEMBER 31,
-------------------------------------------
2002 2003 2004
-------------- -------------- -------------
Revenues (Note 17):
Product sales $ 63,256 $ 123,801 $ 310,698
Other 1,561 6,253 36,853
----------- ----------- -----------
Total revenues 64,817 130,054 347,551
----------- ----------- -----------
Costs and expenses:
Cost of goods sold 44,415 93,114 264,799
Research and development, net (Note 16a) 11,974 14,714 24,834
Selling and marketing 12,547 19,419 31,077
General and administrative 4,000 4,852 6,771
----------- ----------- -----------
Total costs and expenses 72,936 132,099 327,481
----------- ----------- -----------
Operating income (loss) (8,119) (2,045) 20,070
Financial income, net (Note 16b) 2,619 2,711 3,897
Other income, net -- 131 183
----------- ----------- -----------
Income (loss) before minority interest in losses of a subsidiary (5,500) 797 24,150
Minority interest in losses of a subsidiary -- 117 --
----------- ----------- -----------
Net income (loss) $ (5,500) $ 914 $ 24,150
=========== =========== ===========
Basic net earnings (loss) per share (Note 13) $ (0.20) $ 0.03 $ 0.71
=========== =========== ===========
Diluted net earnings (loss) per share (Note 13) $ (0.20) $ 0.03 $ 0.66
=========== =========== ===========
Weighted average number of Ordinary Shares used in
computing basic net earnings (loss) per share 26,953,410 28,178,228 34,195,642
=========== =========== ===========
Weighted average number of Ordinary Shares used in
computing diluted net earnings (loss) per share 26,953,410 30,513,485 36,823,118
=========== =========== ===========
The accompanying notes are an integral part of the consolidated financial
statements.
F-4
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS
ADDITIONAL TOTAL
SHARE PAID-IN ACCUMULATED SHAREHOLDERS'
CAPITAL CAPITAL DEFICIT EQUITY
--------- ------------ ------------- --------------
Balance as of January 1, 2002 $ 8 $184,648 $ (51,605) $133,051
Exercise of share options, net *) -- 303 -- 303
Issuance of shares related to employee stock purchase
plan *) -- 436 -- 436
Net loss -- -- (5,500) (5,500)
----- -------- --------- --------
Balance as of December 31, 2002 8 185,387 (57,105) 128,290
Issuance of shares, net of $207 issuance expenses *) -- 7,898 -- 7,898
Exercise of share options, net *) -- 2,918 -- 2,918
Issuance of shares related to employee stock purchase
plan *) -- 605 -- 605
Net income -- -- 914 914
----- -------- --------- --------
Balance as of December 31, 2003 8 196,808 (56,191) 140,625
Issuance of shares, net of $9,160 of issuance expenses 2 95,363 -- 95,365
Exercise of share options, net *) -- 3,903 -- 3,903
Issuance of shares related to employee stock purchase
plan *) -- 1,022 -- 1,022
Net income -- -- 24,150 24,150
----- -------- --------- --------
Balance as of December 31, 2004 $ 10 $297,096 $ (32,041) $265,065
===== ======== ========= ========
*) Represents an amount lower than $ 1.
The accompanying notes are an integral part of the consolidated financial
statements.
F-5
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS
YEAR ENDED DECEMBER 31,
--------------------------------------------
2002 2003 2004
------------ ------------ --------------
Cash flows from operating activities:
Net income (loss) $ (5,500) $ 914 $ 24,150
Adjustments required to reconcile net income (loss) to net
cash used in operating activities:
Depreciation and amortization 2,234 2,480 2,885
Undistributed equity in earnings of a venture -- -- (8,638)
Accrued interest on short-term bank deposits (502) (121) (522)
Interest accrued and amortization of premium and
discount on held-to-maturity marketable securities 167 606 (2,393)
Gain on sale of available-for-sale marketable securities (70) -- --
Loss on sales of property and equipment 53
Gain on sale of investment in Taiwanese company -- (131) (236)
Accrued severance pay, net (80) 227 208
Minority interest in losses of subsidiary -- (117) (24)
Long-term lease deposits, net 7 (68) (151)
Decrease (increase) in trade receivables 205 (14,802) (21,781)
Increase in other accounts receivable and prepaid
expenses (903) (1,212) (869)
Increase in inventories (5,469) (28,757) (10,303)
Increase in trade payables 5,248 6,159 5,285
Increase in related party trade payables -- 3,582 2,445
Increase (decrease) in deferred revenues 1,840 7,161 (7,295)
Increase in other accounts payable and accrued
expenses 79 2,029 13,007
--------- --------- --------
Net cash used in operating activities (2,744) (22,050) (4,179)
--------- --------- --------
Cash flows from investing activities:
Investment in held-to-maturity marketable securities (30,955) (31,194) (52,122)
Purchase of property and equipment (1,292) (2,805) (5,425)
Loans to employees, net (76) (27) (4)
Issuance of shares to minority shareholder in a subsidiary -- 141 --
Proceeds from sale of available-for-sale marketable
securities 8,283 -- --
Proceeds from maturities of held-to-maturity marketable
securities 3,000 18,057 25,113
Proceeds from sales of property and equipment 33 24 14
Proceeds from sale of investment in Taiwanese company -- 150 287
Short-term bank deposits, net (22,862) 22,324 (40,013)
Investment in private companies (207) (656) --
Acquisition of a business (1) -- -- (534)
--------- --------- ----------
Net cash provided by (used in) investing activities (44,076) 6,014 (72,684)
--------- --------- ----------
The accompanying notes are an integral part of the consolidated financial
statements.
F-6
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS
YEAR ENDED DECEMBER 31,
---------------------------------------
2002 2003 2004
------------ ----------- ----------
Cash flows from financing activities:
Proceeds from issuance of share capital, net -- 7,898 96,858
Proceeds from exercise of share options, net 303 2,918 3,942
Proceeds from issuance of shares related to employee stock
purchase plan 436 605 1,032
--- ----- ------
Net cash provided by financing activities 739 11,421 101,832
--- ------ -------
Increase (decrease) in cash and cash equivalents (46,081) (4,615) 24,969
Cash and cash equivalents at the beginning of the year 75,914 29,833 25,218
------- ------ -------
Cash and cash equivalents at the end of the year $ 29,833 $ 25,218 $ 50,187
========= ======== ========
Non-cash financing activities:
Accrued issuance expenses $ -- $ -- $ 1,542
========= ======== ========
(1) Acquisition of a business:
YEAR ENDED
DECEMBER
31, 2004
-----------
Assets acquired and liabilities assumed on the acquisition date:
Intangible assets 1,022
Long-term liabilities (488)
-----
Cash paid $ 534
------
The accompanying notes are an integral part of the consolidated financial
statements.
F-7
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 1:- GENERAL
a. M-Systems Flash Disk Pioneers Ltd. (the "Company") designs,
develops and markets innovative flash data storage solutions for
digital consumer electronics markets. The Company primarily targets
two digital consumer electronics markets: the USB (universal serial
bus) flash drive market with the Company's DiskOnKey products and
the multimedia mobile handset market with the Company's Mobile
DiskOnChip product. The Company's DiskOnKey product is a personal,
portable, thumb-sized flash disk drive for the storage and transfer
of digital data files, including audio and video files and
pictures. The Company's Mobile DiskOnChip product is a set of
reliable, high-capacity, high performance and cost-effective
embedded memory solutions for data and code storage. The Company
also sells flash data storage products to the embedded systems
market. The Company's DiskOnChip for embedded systems provides the
functionality of a mechanical hard drive on a solid-state silicon
chip including for digital set-top boxes and thin client computers.
The Company's FFD (Fast Flash Disk) products provide a ruggedized
solid state flash disk product for industrial applications that
require reliable and high performance data storage.
As of December 31, 2004, the Company has wholly-owned subsidiaries
in the United States, Netherlands, Taiwan, China, U.K., Japan and
Israel, and several inactive subsidiaries.
b. The Company's flash memory based products require flash components,
which are currently supplied by Toshiba Corporation ("Toshiba") and
Samsung Electronics Co., Ltd. ("Samsung") or with respect to some
components, by only one of the two suppliers. The Company depends
on Toshiba and Samsung for flash memory components and any shortage
or disruption in its supply from these sources or achievement of
lower yield than expected will adversely affect the Company's
results of operations and financial condition. The Company expects
to depend upon Toshiba and Samsung for a significant portion of its
anticipated flash memory requirements. If either Toshiba or Samsung
fails to comply with its supply commitment to the Company or
downsizes its flash components fabrication business, or if either
Toshiba or Samsung terminates its supplier relationship with the
Company or supplies the Company with flash memory components with a
lower than customary yield, the Company's business, financial
condition and operating results will be adversely affected. In
addition, if those flash component suppliers do not continue to
invest in the required advancements in their flash memory
technology and flash memory products, the Company's business,
financial condition and operating results may suffer.
The Company depends on third parties to manufacture and supply
components for its products, including the capacitors, printed
circuit boards and the application specific integrated circuit
("ASIC") components used in the DiskOnKey and in some of the
DiskOnChip products. For some components, the Company relies on a
single source of supply. In particular, the Company has an
agreement with Atmel Sarl, its single source of supply for certain
ASIC components developed specifically for the DiskOnKey products
as well as a third party for some off-the-shelf ASIC components.
Because the Company depends on individual suppliers for certain
key components, and generally does not have a long-term supply
contract with its suppliers, it faces the risk of inadequate
component supply, price increases, late deliveries and poor
component quality, as suppliers may terminate their relationships
with the Company or pursue other relationships with the Company's
competitors.
F-8
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA
NOTE 1:- GENERAL (CONT.)
For information regarding the Company's principal markets and
major customers, see Note 17.
c. In July 2003, the Company announced a set of new agreements with
Toshiba that broadened its existing strategic relationship. The new
agreements consisted principally of a master purchase agreement for
the provision of flash components and Mobile DiskOnChip and
DiskOnChip products, a cross-license agreement, a development and
license agreement, agreements establishing a venture relating to
USB flash drives, and a share purchase agreement for the investment
in the Company's ordinary shares by Toshiba.
Under the master purchase agreement, Toshiba has improved the
overall terms under which the Company purchases from Toshiba raw
flash components and Mobile DiskOnChip and DiskOnChip products.
Under this agreement, the Company is required to make rolling
forecasts that are binding on the Company to varying extents, and
Toshiba is committed to supplying the Company with flash components
and Mobile DiskOnChip and DiskOnChip products in accordance with
the Company's forecasts. The agreement has a seven-year term.
The cross-licensing agreement with Toshiba provides Toshiba with a
license to all patents of the Company and provides the Company with
a license to specified patents of Toshiba.
In addition, the Company and Toshiba established, under a set of
agreements, a venture (the "Venture" ) designed to enable the
Company and Toshiba to benefit from a portion of each party's
respective sales of USB flash drives (see also Note 5).
Under the share purchase agreement, the Company issued 330,811
ordinary shares to Toshiba at fair market value, for total
consideration of $3,877 (net of issuance expenses in the amount of
$123), and granted Toshiba an option, which expired without being
exercised, to increase its stake in the Company to up to 4.99% of
the aggregate shares outstanding at the time of exercise,
d. In February 2004, the Company completed a secondary offering of its
Ordinary shares, which provided net proceeds for the Company of
approximately $95,365. In the offering, the Company issued
5,650,000 Ordinary shares, at a price of $18.5 per share.
e. On August 13, 2004, the Company entered into agreements with
SanDisk Corporation for the joint development, standardization and
promotion of a next-generation USB flash drive platform. In
connection with this collaboration, in December 2004, the parties
established U3 LLC, a Delaware limited liability company which is
equally held by both parties.
F-9
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION:
The consolidated financial statements have been prepared in accordance
with United States generally accepted accounting principles ("U.S.
GAAP").
USE OF ESTIMATES:
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates
and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from
those estimates.
FINANCIAL STATEMENTS IN U.S. DOLLARS:
Substantially all of the revenues of the Company and its subsidiaries
are generated in U.S. dollars ("dollars"). In addition, a substantial
portion of the Company's and its subsidiaries' costs is incurred in
dollars. Since management believes that the dollar is the primary
currency in the economic environment in which the Company and its
subsidiaries operate, the dollar is their functional and reporting
currency. Accordingly, amounts in currencies other than U.S dollars
have been translated as follows:
Monetary balances - at the exchange rate in effect on the balance
sheet date.
Revenues and costs -- at the exchange rates in effect as of the date
of recognition of the transactions.
All exchange gains and losses from the remeasurement mentioned above
are reflected in the statement of operations in financial expenses
(income), net.
PRINCIPLES OF CONSOLIDATION:
The consolidated financial statements include the accounts of the
Company and its subsidiaries ("the Group"). Intercompany balances and
transactions including profits from intercompany sales not yet
realized outside the Group, have been eliminated upon consolidation.
CASH EQUIVALENTS:
Cash equivalents include short-term, highly liquid investments that
are readily convertible to cash with original maturities of three
months or less.
SHORT-TERM BANK DEPOSITS:
Short-term bank deposits are deposits with maturities of more than
three months but less than one year. Short-term bank deposits are
presented at their cost, including accrued interest. The deposits are
in U.S. dollars and bear interest at an annual average rate of 1.89%.
DEBT SECURITIES:
The Company accounts for investments in debt securities in accordance
with Statement of Financial Accounting Standards No. 115 "Accounting
for Certain Investments in Debt and Equity Securities."
Management determines the appropriate classification of its
investments in marketable debt securities at the time of purchase and
reevaluates such determinations at each balance sheet date.
Debt securities are classified as held-to-maturity investments as the
Company has the positive intent and ability to hold the securities to
maturity. Such debt securities are stated at
F-10
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (CONT.)
amortized cost plus accrued interest. As of December 31, 2004 and
2003, the Company classified all its marketable debt securities as
held to maturity investments.
Amortization of premium and accretion of discounts, as well as
interest and decline in value judged to be other than temporary, are
included in financial income, net.
INVENTORIES:
Inventories are stated at the lower of cost or market value. Inventory
write-downs are provided to cover risks arising from slow-moving
items, excess inventories, technological obsolescence or market prices
lower than cost.
Cost is determined for all types of inventory using the moving average
cost method.
INVESTMENT IN A VENTURE:
The investment in the Venture is accounted for under the equity
method. Equity in the earnings of the Venture attributable to sales
between the Venture and the Company, but not realized through sales by
the Company to third parties, is eliminated.
The Company records the equity in earnings of the Venture attributable
to sales made by the Venture to the Company as a reduction in the
Company's cost of goods sold, as it represents inter-company profits
and a reduction to the cost of the products sold by the Venture to the
Company.
Equity in the earnings of the Venture less the portion recognized as
reduction of cost of goods sold is presented in the Company's
consolidated statement of operations as other revenues.
Management evaluates the investment in the Venture for evidence of an
other-than- temporary decline in value. When relevant factors indicate
a decline in value that is other than temporary, the Company will
record a provision for the decline in value. As of December 31, 2004,
no such decline in value has been indicated.
INVESTMENTS IN OTHER COMPANIES:
Investments in other companies are stated at cost, since the Company
does not have the ability to exercise significant influence over the
operating and financial policies of those companies.
Management evaluates investments in other companies for evidence of
declines in value, other than temporary declines. When relevant
factors indicate a decline in value that is other than temporary, the
Company records a provision for the decline in value. A judgmental
aspect of accounting for investments involves determining whether an
other-than-temporary decline in value of the investment has been
sustained. Such evaluation is dependent on the specific facts and
circumstances. Factors indicative of an other-than-temporary decline
include recurring operating losses, credit defaults and subsequent
rounds of financings at an amount below the cost basis of the
investment. This list is not all inclusive and management weighs all
quantitative and qualitative factors in determining if an
other-than-temporary decline in value of an investment has occurred.
As of December 31, 2004, no such decline in value has been indicated.
GOODWILL:
Effective January 1, 2002, the Company adopted the full provisions of
Statement of Financial Accounting Standards No. 142 "Goodwill and
Other Intangible Assets ("SFAS No. 142").
F-11
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (CONT.)
Under SFAS No. 142 goodwill is no longer amortized but instead is
tested for impairment at least annually (or more frequently if
impairment indicators arise).
SFAS No. 142 prescribes a two phase process for impairment testing of
goodwill. The first phase screens for impairment; while the second
phase (if necessary) measures impairment.
In the first phase of impairment testing, goodwill attributable to
each of the reporting units is tested for impairment by comparing the
fair value of each reporting unit with its carrying value. As of
December 31, 2004, no instances of impairment were found.
PROPERTY AND EQUIPMENT:
Property and equipment are stated at cost. Depreciation is calculated
by the straight-line method over the estimated useful lives of the
assets, at the following annual rates:
%
---------------------------
Building 4
Computers, manufacturing and peripheral
equipment 20 -- 50
Office furniture and equipment 6 -- 20
Motor vehicles 15
Leasehold improvements Over the term of the lease
INTANGIBLE ASSETS:
Intangible assets are presented at cost. The intangible assets
amortized over their useful lives, on the straight line basis for the
following periods:
WEIGHTED AVERAGE
AMORTIZATION PERIOD
IN YEARS
--------------------
Core technology 3
Patents and know-how 3
Other 5
IMPAIRMENT OF LONG-LIVED ASSETS:
The Company's and its subsidiaries' long-lived assets, including
identifiable intangibles assets, are reviewed for impairment in
accordance with Statement of Financial Accounting Standards No. 144
"Accounting for the Impairment or Disposal of Long-Lived Assets,"
whenever events or changes in circumstances indicate that the carrying
amount of an asset may not be recoverable. Recoverability of assets to
be held and used is measured by a comparison of the carrying amount of
an asset to the future undiscounted cash flows expected to be
generated by the asset. If an asset is considered to be impaired, the
impairment to be recognized is measured by the amount by which the
carrying amount of the asset exceeds its fair value. Assets to be
disposed of are reported at the lower of the carrying amount or fair
value less costs to sell. As of December 31, 2004, no impairment
losses have been identified.
INCOME TAXES:
The Company and its subsidiaries account for income taxes in
accordance with Statement of Financial Accounting Standards No. 109
"Accounting for Income Taxes" ("SFAS No. 109"). This statement
prescribes the use of the liability method whereby deferred tax asset
and
F-12
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (CONT.)
liability account balances are determined based on differences between
the financial reporting and tax bases of assets and liabilities and
are measured using enacted tax rates and laws that will be in effect
when the differences are expected to reverse. The Company and its
subsidiaries provide a valuation allowance, if necessary, to reduce
deferred tax assets to their estimated realizable value.
REVENUE RECOGNITION:
The Company and its subsidiaries generate most of their revenues from
selling their data storage products to end customers, distributors,
retailers and Original Equipment Manufacturers ("OEM").
Revenues from product sales are recognized in accordance with SEC
Staff Accounting Bulletin ("SAB") No. 104, "Revenue Recognition" when
delivery has occurred, persuasive evidence of an arrangement exists,
the vendor's fee is fixed or determinable, no further obligation
exists, and collectibility is probable.
Because of frequent sales price reductions and rapid technological
obsolescence in the industry, sales made to distributors and retailers
under agreements allowing price protection and/or a right of return
are deferred until the distributors or retailers sell the Company's
products to the end customers, or the right expires. In addition, when
introducing a new product, the Company defers revenues generated by
sales of such products until such time as the Company estimates the
acceptance of the product by the end customer to be reasonably
certain, since at the time of sale the Company does not have
sufficient experience to estimate the amount of returns for such
products.
Deferred revenues consist of amounts received from customers for which
revenues have not been recognized.
Cost of finished goods relating to unrecognized products sales are
presented as inventory until such time that these sales are
recognized.
Equity in earnings of the Venture, less the portion recognized as a
reduction in cost of goods sold, are presented in the statement of
operations as other revenues.
The Company receives royalties from licensing the right to use its
technology to third parties. The timing of revenue recognition is
dependent on the terms of each contract and on the timing of sales by
the licensees. The Company recognizes royalty revenues when final
reports of the licensee's sales covered by the license agreement are
received from the licensees. The Company recognizes revenues from
perpetual licenses for certain patents in consideration for fixed
periodic payments when the related payments become due.
RESEARCH AND DEVELOPMENT COSTS:
Research and development costs, net of grants received, are charged to
the statements of operations as incurred.
F-13
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (CONT.)
ROYALTY AND NON-ROYALTY BEARING GRANTS:
Royalty-bearing grants from the Office of the Chief Scientist ("OCS")
and from the Singapore-Israel Industrial Research and Development Fund
("SIIRD") for funding approved research and development projects are
recognized at the time the Company and its subsidiaries are entitled
to such grants, on the basis of the costs incurred. Such grants are
recorded as a deduction from research and development costs since when
received it is not probable that the grants will be repaid (see also
Notes 10 and 15a).
The Company received non-royalty-bearing grants from the Information
Society Technology Fund ("IST"). The grants are not required to be
repaid and are recognized at the time the Company is entitled to such
grants, on the basis of the costs incurred. These grants are recorded
as a deduction of research and development costs.
Grants from IST, OCS and SIIRD amounted to $212, $0, $63 in 2002,
respectively, $414, $177 and $84 in 2003, respectively and $111, $128
and $0 in 2004, respectively.
WARRANTY COSTS:
The Company provides warranties for periods between 12 and 60 months
at no extra charge. A provision is recorded for estimated warranty
costs based on the Company's experience. Warranty expenses for the
years ended December 31, 2002, 2003 and 2004 were approximately $272,
$166 and $234, respectively.
ADVERTISING EXPENSES:
Advertising expenses are charged to the statements of operations as
incurred. Advertising expenses for the years ended December 31, 2002,
2003 and 2004 were $132, $125 and $26, respectively.
CONCENTRATIONS OF CREDIT RISK:
Financial instruments that potentially subject the Company and its
subsidiaries to concentrations of credit risk consist principally of
cash and cash equivalents, short-term bank deposits, marketable
securities and trade receivables.
Cash and cash equivalents and short-term bank deposits are invested
mainly in U.S. dollars in deposits with major banks worldwide (mainly
in Israel, the United States, the Cayman Islands, England and France).
Such deposits may be in excess of insured limits and may not be
insured at all in some jurisdictions. However, management believes
that the financial institutions that hold the investments of the
Company and its subsidiaries are financially sound and, accordingly,
minimal credit risk exists with respect to these investments.
The trade receivables of the Company and its subsidiaries are derived
from sales to customers located primarily in the United States, the
Far East and Europe. The Company and its subsidiaries generally do not
require collateral; however, in certain circumstances, the Company and
its subsidiaries may require letters of credit, other collateral,
additional guarantees or advanced payments. The Company and its
subsidiaries perform ongoing credit evaluations of their customers and
insures its trade receivables under foreign trade risks insurance. To
date the Company has not experienced material losses. An allowance for
doubtful accounts is determined with respect to specific receivables
the collection of which may be doubtful.
F-14
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (CONT.)
Investments in marketable securities are conducted through investment
banks in France and the United States, and include investments in
government and corporate debentures. Corporate debentures are of
corporations with investment-grade ratings and credit exposure to any
given corporation is limited. Management believes that the financial
institutions that hold the Company's investments are financially sound
and that the portfolio is well diversified and, accordingly, minimal
credit risk exists with respect to these investments.
The Company and its subsidiaries have no significant off-balance-sheet
concentration of credit risk such as foreign exchange contracts,
option contracts or other foreign hedging arrangements.
ACCOUNTING FOR STOCK-BASED COMPENSATION:
The Company has elected to follow Accounting Principles Board Opinion
No. 25, "Accounting for Stock Issued to Employees," and FASB
Interpretation No. 44, "Accounting for Certain Transactions Involving
Stock Compensation," in accounting for its employee stock option
plans. According to APB 25, compensation expense is measured under the
intrinsic value method, whereby compensation expense is equal to the
excess, if any, of the quoted market price of the stock over the
exercise price at the grant date of the award."
The Company adopted the disclosure provisions of Statement of
Financial Accounting Standards No. 148 "Accounting for Stock-Based
Compensation" ("SFAS No. 148"), which amended certain provisions of
SFAS 123. The Company continues to apply the provisions of APB No. 25
in accounting for stock-based compensation.
The expenses related to stock-based employee compensation included in
the determination of net income (loss) for 2002, 2003 and 2004 is less
than that which would have been recognized if the fair value method
had been applied to all awards granted after the original effective
date of SFAS No. 123. If the Company and its subsidiaries had elected
to adopt the fair value recognition provisions of SFAS No. 123 as of
its original effective date, pro forma net income (loss) and pro forma
basic and diluted net income (loss) per share would be as follows:
F-15
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA
NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (CONT.)
YEAR ENDED DECEMBER 31,
--------------------------------------------
2002 2003 2004
-------------- -------------- --------------
Net income (loss) as reported $ (5,500) $ 914 $ 24,150
Deduct - stock-based compensation
expense determined under fair value
method for all awards 4,475 5,328 7,962
----------- ----------- -----------
Pro forma net income (loss) $ (9,975) $ (4,414) $ 16,188
=========== =========== ===========
Pro forma basic net earnings (loss) per
share $ (0.37) $ (0.16) $ 0.47
=========== =========== ===========
Pro forma diluted net earnings (loss) per
share $ (0.37) $ (0.16) $ 0.44
=========== =========== ===========
Basic net earnings (loss) per share, as
reported $ (0.20) $ 0.03 $ 0.71
=========== =========== ===========
Diluted net earnings (loss) per shares, as
reported $ (0.20) $ 0.03 $ 0.66
=========== =========== ===========
Weighted average number of Ordinary
Shares used in computing pro forma
Basic net earnings per share 26,953,410 28,178,228 34,195,642
=========== =========== ===========
Weighted average number of Ordinary
Shares used in computing pro forma
Diluted net earnings per share 26,953,410 30,513,485 36,427,381
=========== =========== ===========
For purposes of pro-forma disclosure, the estimated fair value of the
options is amortized to expenses over the options' vesting period,
which is four years on an accelerated basis.
The fair value of stock options was estimated at the date of grant
using a Black-Scholes option- pricing model with the following
weighted-average assumptions for 2002, 2003 and 2004:
2002 2003 2004
--------- --------- ---------
Risk-free Interest Rate 1.5% 1% 3%
Expected Dividend Yield 0% 0% 0%
Expected Volatility 62% 71% 55%
Expected Lives 3.25 3.25 3.25
F-16
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (CONT.)
SEVERANCE PAY:
The Company's liability for severance pay is calculated pursuant to
Israeli and Taiwanese severance pay laws as applicable to the relevant
employees, based on the most recent salary of the employees multiplied
by the number of years of employment, as of the balance sheet date.
Employees are entitled to one month's salary for each year of
employment or a portion thereof. The Company's liability for all of
its employees in Israel is fully covered by monthly deposits with
severance pay funds, insurance policies and an accrual. The value of
those policies is recorded as an asset in the Company's balance sheet.
The Company's liability for all of its employees in Taiwan is not
covered by deposits with severance pay funds or insurance policies,
but only by an accrual.
The deposited funds for the Company's Israeli employees include
profits accumulated up to the balance sheet date. The deposited funds
may be withdrawn only upon the fulfillment of the obligation pursuant
to Israeli severance pay law or labor agreements. The value of the
deposited funds is based on the cash surrender value of these
policies, and includes immaterial profits.
Severance expenses for the years ended December 31, 2002, 2003 and
2004 amounted to approximately $531, $1,067 and $1,300 respectively.
FAIR VALUE OF FINANCIAL INSTRUMENTS:
The carrying amounts of cash and cash equivalents, short-term bank
deposits, trade receivables and other accounts receivable, trade
payables and other accounts payable approximate their fair value due
to the short-term maturities of such instruments.
The fair value of marketable securities is disclosed in Note 3 and it
is based on quoted market prices of the securities.
It was not practical to estimate the fair value of the Company's
investments in the Venture and in the shares of non-public companies
because of the lack of quoted market prices and the inability to
estimate the fair value of each investment without incurring excessive
costs. The carrying amounts of these companies were $10,844 and
$19,431 at December 31, 2003 and 2004, respectively, and they
represent the original cost and in the case of the Venture include the
Company's equity in the earnings of the Venture since the date of
investment, net of distributions.
BASIC AND DILUTED NET EARNINGS (LOSS) PER SHARE:
Basic net earnings (loss) per share is computed based on the weighted
average number of Ordinary shares outstanding during each year.
Diluted net earnings per share is computed based on the weighted
average number of Ordinary shares and ordinary share equivalents
outstanding during each year.
The total weighted average number of outstanding options and warrants
excluded from the calculations of diluted net earnings (loss) per
share due to their anti-dilutive effect was 3,635,851, 346,052 and
766,190 for 2002, 2003 and 2004, respectively.
RECLASSIFICATION
Certain amounts from prior years have been reclassified to conform to
current period presentation.
F-17
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (CONT.)
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS:
In February 2004, the FASB issued the Emerging Issues Task Force
("EITF") Issue No. 03-1, "The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments" ("EITF 03-1").
This EITF was issued to determine the meaning of other-than-temporary
impairment and its application to investments in debt and equity
securities within the scope of SFAS No. 115. EITF 03-1 also applies to
investments in equity securities that are both outside SFAS No. 115's
scope and are not accounted for by the equity method, which are
defined as "cost method investments". The impairment measurement and
recognition guidance in EITF 03-1 is delayed until the final issuance
of FSP EITF 03-1-a. The disclosure requirements for cost method
investments are effective for annual reporting periods ending after
June 15, 2004. The Company does not expect that the adoption of the
provisions of EITF 03-1 will have a material effect on its financial
position or results of operation.
In November 2004, the FASB issued Statement of Financial Accounting
Standard No. 151, "Inventory Costs, an amendment of ARB No. 43,
Chapter 4." SFAS No. 151 amends Accounting Research Bulletin ("ARB")
No. 43, Chapter 4, to clarify that abnormal amounts of idle facility
expense, freight handling costs and wasted materials (spoilage) should
be recognized as current-period charges. In addition, SFAS 151
requires that allocation of fixed production overheads to the costs of
conversion be based on normal capacity of the production facilities.
SFAS No. 151 is effective for inventory costs incurred during fiscal
years beginning after June 15, 2005. The Company does not expect that
the adoption of SFAS No. 151 will have a material effect on its
financial position or results of operations
On December 16, 2004, the Financial Accounting Standards Board (FASB)
issued FASB Statement No. 123 (revised 2004), Share-Based Payment,
which is a revision of FASB Statement No. 123, Accounting for
Stock-Based Compensation. Statement 123(R) supersedes APB Opinion No.
25, Accounting for Stock Issued to Employees, and amends FASB
Statement No. 95, Statement of Cash Flows. Generally, the approach in
Statement 123(R) is similar to the approach described in Statement
123. However, Statement 123(R) requires all share-based payments to
employees, including grants of employee stock options, to be
recognized in the income statement based on their fair values. Pro
forma disclosure is no longer an alternative. Early adoption will be
permitted in periods in which financial statements have not yet been
issued. The Company expects to adopt Statement 123(R) on July 1, 2005
(the effective date).
Statement 123(R) permits public companies to adopt its requirements
using one of two methods:
A "modified prospective" method in which compensation cost is
recognized beginning with the effective date (a) based on the
requirements of Statement 123(R) for all share-based payments granted
after the effective date and (b) based on the requirements of
Statement 123 for all awards granted to employees prior to the
effective date of Statement 123(R) that remain unvested on the
effective date.
A "modified retrospective" method which includes the requirements of
the modified prospective method described above, but also permits
entities to restate based on the amounts previously recognized under
Statement 123 for purposes of pro forma disclosures either (a) all
prior periods presented or (b) prior interim periods of the year of
adoption.
The company plans to adopt Statement 123 using the
modified-prospective method.
F-18
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (CONT.)
As permitted by Statement 123, the company currently accounts for
share-based payments to employees using Opinion 25's intrinsic value
method and, as such, generally recognizes no compensation cost for
employee stock options. In addition, non-compensatory plans under APB
25 will be considered compensatory for FAS 123(R) purposes.
Accordingly, the adoption of Statement 123(R)'s fair value method will
have a significant impact on the Company result of operations,
although it will have no impact on the Company overall financial
position. The impact of adoption of Statement 123(R) cannot be
predicted at this time because it will depend on levels of share-based
payments granted in the future. However, had the Company adopted
Statement 123(R) in prior periods, the impact of that standard would
have approximated the impact of Statement 123 as described in the
disclosure of pro forma net income and earnings per share in Note 2 to
the consolidated financial statements.
NOTE 3:- DEBT SECURITIES
The following is a summary of held-to-maturity debt securities:
DECEMBER 31,
--------------------------------------------------------------------------------------------------
2003 2004
------------------------------------------------- ------------------------------------------------
ESTIMATED ESTIMATED
GROSS GROSS FAIR GROSS GROSS FAIR
AMORTIZED UNREALIZED UNREALIZED MARKET AMORTIZED UNREALIZED UNREALIZED MARKET
COST GAINS LOSSES VALUE COST GAINS LOSSES VALUE
----------- ------------ ------------ ----------- ----------- ------------ ------------ ----------
Government
debts $15,636 $ 334 $ (136) $15,834 $12,470 $148 $ (178) $12,440
Corporate debts 37,792 765 (355) 38,202 70,360 170 (350) 70,180
------- ------ ------ ------- ------- ---- ------ -------
$53,428 $1,099 $ (491) $54,036 $82,830 $318 $ (528) $82,620
======= ====== ====== ======= ======= ==== ====== =======
Aggregate maturities of held-to-maturity securities for years
subsequent to December 31, 2004 are:
AMORTIZED ESTIMATED FAIR
COST MARKET VALUE
----------- ---------------
2005 (short-term marketable securities) $56,871 $ 56,840
2006 8,203 8,355
2007 5,178 5,217
2008 1,072 1,066
2013 2,068 1,995
2014 1,008 985
2015 2,004 2,004
2018 5,421 5,188
2019 1,005 970
------- --------
$82,830 $ 82,620
======= ========
As of December 31, 2004, the Company holds investments in structured
notes in the amount of $12,527. The structured notes include mainly
inverse floaters and range accruals.
Range accruals are bonds where the coupon is paid only if a specified
interest rate stays within a pre-established range, otherwise the bond
pays 0%. Inverse floaters are bonds where the coupon varies in
accordance with changes in specified interest rates or indices (for
example, LIBOR).
F-19
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 3:- DEBT SECURITIES (CONT.)
During 2003 and 2004, several of the securities were redeemed for
consideration of $ 18,057 and $ 21,856, respectively.
NOTE 4:- INVENTORIES
DECEMBER 31,
----------------------
2003 2004
--------- ----------
Raw materials $ 2,314 $10,051
Work in progress 10,431 8,044
Finished goods 33,112 38,065
------- -------
$45,857 $56,160
======= =======
Finished goods include products for which revenues were not recognized
during the period in accordance with the Company's revenue recognition
policy (see also Note 2) and, to a lesser extent, inventory on
consignment to the Company's customers, in the aggregate amount of
$ 27,801 at December 31, 2003 and $ 22,593 at December 31, 2004.
NOTE 5:- INVESTMENT IN A VENTURE
a. Investment in Venture
DECEMBER 31,
------------------------
2003 2004
--------- ------------
Equity, net $ 350 $ 8,988
------ ---------
Total investment in Venture $ 350 $ 8,988
====== =========
Net equity as follows:
Investment in Venture as of purchase date $ 350 $ 350
Accumulated net earnings (*) -- 31,769
Dividend distribution -- (23,131)
------ ---------
$ 350 $ 8,988
====== =========
During the fourth quarter of 2003, the Company established a
venture with a strategic partner ("the Venture"), designed to
enable the Company and the partner to benefit from a portion of
each party's respective sales of USB flash drives. Upon
establishment of the Venture the Company and the partner each
invested $ 350 in the Venture. The Venture is jointly held and
equally controlled by the partner and the Company. Both the partner
and the Company have obligations to conduct a portion of their USB
flash drive business through the Venture (see also Notes 1 and 2).
The investment in the venture is accounted for under the equity
method.
(*) prior to inter-company profit elimination.
F-20
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 5:- INVESTMENT IN A VENTURE (CONT.)
b. Summary of the Venture financial information:
DECEMBER 31,
----------------------
2003 2004
--------- ----------
Current assets $9,131 $29,210
------ -------
Current Liabilities $8,431 $11,327
====== =======
Shareholders' equity $ 700 $17,883
====== =======
PERIOD FROM
NOVEMBER 1,
2003 TO YEAR ENDED
DECEMBER 31, DECEMBER 31,
2003 *) 2004
-------------- -------------
Revenues $4,440 $172,834
====== ========
Gross profit $ 899 $ 62,786
====== ========
Net income $ 862 $ 62,675
====== ========
*) The Venture commenced operations on November 1, 2003
NOTE 6:- LONG-TERM INVESTMENTS
DECEMBER 31,
-----------------------
2003 2004
---------- ----------
Investment in Saifun Semiconductors Ltd. (1) $10,000 $10,000
Investment in Taiwanese company (2) 494 443
Employee loans and lease deposits 516 740
------- -------
$11,010 $11,183
======= =======
(1) In October 2000, the Company purchased 586,080 of the
outstanding Preferred B shares of NIS 0.01 par value of Saifun
Semiconductors Ltd. ("Saifun") for $ 10,000. Saifun is a
privately held Israeli company engaged in providing advanced non
volatile memory solutions based on its NROM technology. Saifun's
founder, Chief Executive Officer and a director was, until
December 2002, a member of the Board of Directors of the
Company. As of December 31, 2004, the investment represents
approximately 2% of the outstanding shares of Saifun.
(2) During the first quarter of 2002, the Company signed a share
purchase agreement, as amended, with a Taiwanese company, with
the right to purchase 550,000 preferred shares TWD 10 par value
for $ 513.
In April 2002, the Company purchased 184,000 preferred shares, TWD
10 par value, of the Taiwanese company for $ 207.
In June 2003, the Company purchased 366,000 additional preferred
shares, TWD 10 par value of the Taiwanese company for $ 309. In
December 2003 and 2004, the Company sold 30,000 and 140,000 of its
shares in the Taiwanese company for $ 150 and $ 286 and recorded a
capital gain in the amounts of $ 131 and $ 236, respectively, which
is included in other income.
F-21
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 6:- LONG-TERM INVESTMENTS (CONT.)
As of December 31, 2004, the investment represents approximately 3%
of the outstanding shares of the Taiwanese company.
NOTE 7:- PROPERTY AND EQUIPMENT, NET
DECEMBER 31,
-----------------------
2003 2004
---------- ----------
Cost:
Land and building (1) $14,960 $15,754
Computers, manufacturing and peripheral equipment 8,312 11,020
Office furniture and equipment 1,616 1,735
Motor vehicles 124 193
Leasehold improvements 488 624
------- -------
25,500 29,326
Accumulated depreciation 8,019 9,123
------- -------
Depreciated cost (2) $17,481 $20,203
======= =======
(1) During 2004, the Company began the construction of its second
facility on the land acquired in 2001 located near the Company's
current facility in Kfar-Saba. Costs related to the construction
for the year ended December 31, 2004, were $520.
(2) Registration in the Company's name of land and building with a
depreciated cost of $13,490 and $13,220 as of December 31, 2003
and 2004, respectively, has not yet been completed (See Note
11).
a. For charges, see Note 11.
b. Depreciation expenses for the years ended December 31, 2002, 2003
and 2004, were $1,709, $2,056 and $2,636, respectively.
NOTE 8:- INTANGIBLE ASSETS, NET
DECEMBER 31,
---------------------
2003 2004
--------- ---------
Cost:
Core technology $1,243 $2,215
Patents, know-how and trade name 248 298
Other 252 252
------ ------
1,743 2,765
------ ------
Accumulated Amortization:
Core technology 1,243 1,432
Patents, know-how and trade name 248 258
Other 162 212
------ ------
1,653 1,902
------ ------
Amortized cost $ 90 $ 863
====== ======
F-22
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 8:- INTANGIBLE ASSETS, NET (CONT.)
a. In July 2004, the Company acquired the business and assets of
Seaside Software Corp. ("Seaside"). The acquisition provided the
Company with Seaside Software's enterprise application technology
and intellectual property. As consideration for the business
acquired the Company paid $ 534. In addition, the company is
required to make additional payments, based on sales associated
with the business acquired during the period commencing on July 1,
2004 and ending on June 30, 2009 ("contingent consideration").
The acquisition has been accounted for using the "purchase method"
of accounting as determined under Statement of Financial
Accounting Standard No. 141, "Business Combinations", and
accordingly, the purchase price of $ 534 was allocated according
to the estimated fair value of the assets acquired and liabilities
assumed.
The purchase price was allocated to technology in the amount of
$ 1,022, thus resulting in negative goodwill of $ 488. However,
since the acquisition involves contingent consideration in
accordance with the provisions of SFAS No. 141, the amount of
negative goodwill was recorded as long-term liability. Payments
made in the future in respect of contingent consideration, will be
reduced against the aforementioned liabilities.
b. Amortization expenses amounted to $ 525, $ 424 and $ 249 for the
years ended December 31, 2002, 2003 and 2004, respectively.
c. Following is the estimated amortization expenses in respect of
identifiable intangible assets for the years ended:
DECEMBER 31,
-------------
2005 $378
2006 341
2007 144
NOTE 9:- GOODWILL:
In June 1998, the Company established a subsidiary in Japan, M-Systems
Flash Disk Pioneers (Japan), Inc. ("MSJ"). The Company owned 67% of
this company. In June 2001, the Company exercised its option and
purchased all the remaining shares of MSJ held by the minority
shareholders for a total cash consideration of $ 235. The acquisition
was accounted for using the purchase method, resulting in goodwill of
$ 235.
The acquisition of the business and assets of Fortress, in September
2000, resulted in goodwill of $ 326 .
As of December 31, 2003 and 2004, the unamortized cost of the goodwill
from both acquisitions was $ 477.
F-23
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 10:- OTHER ACCOUNTS PAYABLE AND ACCRUED EXPENSES
DECEMBER 31,
----------------------
2003 2004
--------- ----------
Employees and payroll accruals $3,358 $10,902
Accrued expenses 2,620 8,356
Accrued royalty expenses 459 678
Provision for warranty 347 581
ESPP obligation 154 153
Other 6 823
------ -------
$6,944 $21,493
====== =======
NOTE 11:- COMMITMENTS AND CONTINGENT LIABILITIES
ROYALTY COMMITMENTS:
Under the Company's research and development agreements with the
Office of the Chief Scientist ("OCS") and Singapore-Israel Industrial
Research and Development ("SIIRD"), the Company is required to pay
royalties at the rate of 1.5%-5% of sales of products developed with
funds provided by the OCS and SIIRD, up to an amount equal to 150% of
the OCS and 100% of the SIIRD research and development grants
(dollar-linked) related to such projects. The obligation to pay these
royalties is contingent on actual sales of the products and in the
absence of such sales, no payment is required. Royalties payable with
respect to grants received under programs approved by the OCS after
January 1, 1999, are subject to interest on the U.S. dollar-linked
value of the total grants received at the annual rate of LIBOR
applicable to U.S. dollar deposits.
Expenses in respect of royalties relating to repayment of grants from
the OCS amounted to $ 0, $ 459 and $ 219 for the years ended December
31, 2002, 2003 and 2004, respectively. The royalties were recorded as
part of cost of goods sold.
As of December 31, 2004, the Company had an outstanding contingent
obligation to pay royalties of $ 678, in respect of these grants.
LEASE COMMITMENTS:
The Company's facilities, its subsidiaries facilities and its vehicles
are leased under several operating lease agreements, which expire on
various dates, the latest of which is in 2007.
Future minimum lease commitments under non-cancelable operating leases
are as follows:
YEAR ENDED DECEMBER 31,
-----------------------------
2005 2006 2007
-------- -------- -------
Facilities $ 688 $ 487 $188
Vehicles 1,888 1,480 656
------ ------ ----
Total $2,576 $1,967 $844
====== ====== ====
Facilities lease expenses for the years ended December 31, 2002, 2003 and 2004,
were approximately $ 456, $ 386 and $ 661, respectively.
Vehicles lease expenses for the years ended December 31, 2002, 2003 and 2004
were approximately $ 763, $ 1,169 and $ 1,516, respectively.
F-24
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA
NOTE 11:- COMMITMENTS AND CONTINGENT LIABILITIES
GUARANTEES:
The Company issued a guarantee in the amount of $139 to Tel Aviv
district court in connection with a litigation initiated by the
company .The Company issued a guarantee in the amount of $1,000 for
one of its suppliers.
CHARGES:
Land and the building are free and clear of all encumbrances except
for a mortgage over the land and a building securing a loan taken out
by the sellers of the property from Bank Leumi Le-Israel. The Company
has deposited in escrow on behalf of the seller the balance of the
loan required to be paid in order to remove the mortgage. Such funds
will be released to Bank Leumi Le-Israel upon the completion of the
registration of the land and the building in the name of the Company
at which time the mortgage will be removed.
LITIGATION:
In October 2003, Jaco Electronics Inc. (a distributor of the Company)
("Jaco") filed a claim against the Company's U.S. subsidiary. In this
action, the claimant alleged, among other things, fraud and
misappropriation in connection with Jaco's purchase of the assets of
Reptron Electronics Inc. (a former distributor of the Company). Jaco's
fraud and related claims arise out of alleged assurances by the
Company's U.S. subsidiary in connection with Jaco's purchase of the
assets of Reptron. Jaco's misappropriation claim arises out of the
alleged use of certain information from Jaco reports. The claimant
sought monetary damages in an amount of not less than $10,400, plus
punitive damages. The Company filed a motion to dismiss the complaint
on December 12, 2003. On August 18, 2004, the Court issued an order
granting M-Systems' motion to dismiss the complaint in its entirety.
On September 28, 2004, Jaco filed a notice of appeal and has six
months from the date of the notice to perfect its appeal. Jaco and
M-Systems are currently negotiating a settlement of the appeal
according to which the company will not incur any loss. Accordingly,
the company did not record any provision.
NOTE 12:- SHAREHOLDERS' EQUITY
The Ordinary shares of the Company are traded on the NASDAQ National
Market.
GENERAL:
The Ordinary shares entitle their holders to receive notice to
participate and vote in general meetings of the Company, the right to
share in distributions upon liquidation of the Company, and to receive
dividends, if declared.
In March 2000, the Company issued 4,735,000 Ordinary shares at $34.125
per share in consideration of net proceeds of approximately $148,226
in a public offering.
On December 31, 2002 investors exercised 623,378 warrants remaining
from warrants issued to them as part of a round of financing in 1999
into 406,140 shares, through a cashless exercise mechanism.
In May 2003, the Company entered into a Share Purchase Agreement with
a director, for the purchase by the director of 500,000 unregistered
Ordinary shares of the Company, at fair market value. In July 2003,
the shares were issued for $4,021 (net of issuance expenses of $84).
F-25
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA
NOTE 12:- SHAREHOLDERS' EQUITY (CONT.)
In August 2003, the Company issued 330,811 unregistered Ordinary
shares to Toshiba, at fair market value, for $ 3,877 (net of issuance
expenses of $ 123) and granted Toshiba an option, exercisable until
July 30, 2004, to increase its stake in the Company to up 4.99% of the
aggregate shares outstanding at the time of exercise. Toshiba did not
exercise the option prior to its expiration on July 30, 2004. (see
also Note 1).
In February 2004, the Company completed a secondary offering of its
Ordinary shares, which provided net proceeds for the Company of
approximately $95,365 (net of issuance expenses of approximately
$9,160). In the offering the Company issued 5,650,000 ordinary shares
at a price of $18.5 per share (see also Note 1).
STOCK OPTION PLANS:
a. Between 1993 and 2002, the Company implemented two Employee Stock
Option Plans, the Incentive and Restricted Stock Option Plan ("the
IRSO Plan") and the Employee Stock Option Plan ("the ESOP Plan")
for directors, officers, employees, consultants and contractors of
the Company and its subsidiaries. Options were granted at an
exercise price that was equal to the fair market value of the share
at the date of grant. These options vested over a period of four
years, 50% after two years and an additional 25% vest each year
thereafter. The IRSO Plan and ESOP Plan expired in 2003.
b. In November 2002, the Company approved a new option plan known as
the "2003 Stock Option and Restricted Stock Incentive Plan" (the
"2003 Plan"). Under the 2003 Plan, 5,000,000 options to purchase
Ordinary shares were reserved for grant to employees, officers,
directors, service providers and consultants of the Company and its
subsidiaries. On November 11, 2004, the Company's shareholders
resolved to increase the number of Ordinary shares reserved for
issuance under the 2003 Plan by an additional 3,000,000 Ordinary
shares. As of December 31, 2004, options to purchase 3,446,985
Ordinary shares remained available for future grant. The exercise
prices of options granted under the 2003 Plan are to be determined
by the Board of Directors at the time of grant. The options granted
expire no later than 10 years from the date of grant. The 2003 Plan
expires in 2013. Any options that are cancelled or forfeited before
expiration become available for future grant.
The options vest ratably over a period of four years, with the
first portion vesting not earlier than two years after the grant
of the option.
The options were granted at an exercise price that was equal to
the fair market value of the share at the date of grant.
c. The following is a summary of the Company's employees' and
directors' option activity under the IRSO, ESOP and 2003 Plan and
related information:
F-26
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA
NOTE 12:- SHAREHOLDERS' EQUITY (CONT.)
YEAR ENDED DECEMBER 31,
----------------------------------------------------------------------
2002 2003 2004
----------------------- ----------------------- ----------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
NUMBER EXERCISE NUMBER EXERCISE NUMBER EXERCISE
OF OPTIONS PRICE OF OPTIONS PRICE OF OPTIONS PRICE
------------ ---------- ------------ ---------- ------------ ---------
Options outstanding at
beginning of year 3,560,138 $ 6.37 3,813,654 $ 6.30 5,874,059 $ 8.81
Granted 855,166 $ 6.68 3,143,900 $ 10.64 1,896,180 $ 18.01
Exercised (154,250) $ 1.96 (683,095) $ 4.31 (700,950) $ 5.63
Forfeited (447,400) $ 9.04 (400,400) $ 6.86 (530,714) $ 11.69
--------- --------- ---------
Options outstanding at
end of year 3,813,654 $ 6.30 5,874,059 $ 8.81 6,538,575 $ 11.59
========= ====== ========= ======= ========= =======
Options exercisable at end
of year 1,213,003 $ 5.47 1,449,926 $ 6.50 1,439,631 $ 7.36
========= ====== ========= ======= ========= =======
Weighted average fair
value of options granted
during the year, at grant
date $ 2.92 $ 5.27 $ 10.89
====== ======= =======
The options outstanding as of December 31, 2004, under the IRSO
ESOP and 2003 Plans have been separated into ranges of exercise
prices as follows:
WEIGHTED
OPTIONS WEIGHTED OPTIONS AVERAGE
OUTSTANDING AVERAGE WEIGHTED EXERCISABLE EXERCISE
RANGE OF AS OF REMAINING AVERAGE AS OF PRICE OF
EXERCISE DECEMBER 31, CONTRACTUAL EXERCISE DECEMBER 31, OPTIONS
PRICE 2004 LIFE (YEARS) PRICE 2004 EXERCISABLE
- ----------------- -------------- -------------- ---------- -------------- ------------
$ 1.75-2.75 326,958 3.41 $ 1.93 326,958 $ 1.93
$ 3.75-5.30 448,991 6.87 4.43 269,145 4.34
$ 5.41-6.20 1,895,335 7.68 5.55 298,510 6.04
$ 7.02-8.75 465,691 7.36 7.32 177,183 7.21
$ 10.10-12.75 380,985 6.95 12.3 232,235 12.27
$ 14.02-16.25 839,415 9.35 15.27 15,000 16.25
$ 17.70-18.00 871,400 8.98 17.7 3,500 18.0
$ 19.0-19.90 1,255,400 9.73 19.84 62,700 19.50
$ 24.50-25.00 54,400 5.55 24.59 54,400 24.66
--------- -------
6,538,575 8.11 $ 11.59 1,439,631 $ 7.36
========= ==== ======= ========= ======
All options were granted at exercise prices that were equal to the
market prices at the date of grant and, therefore, no compensation
expenses were charged against income in respect of the
aforementioned plans in the years ended December 31, 2002, 2003
and 2004.
EMPLOYEE STOCK PURCHASE PLAN ("ESPP"):
During 2001, the Company adopted its Global and U.S. ESPP (the
"Stock Purchase Plans"). The Stock Purchase Plans provide eligible
employees with the opportunity to
F-27
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA
NOTE 12:- SHAREHOLDERS' EQUITY (CONT.)
purchase up to 550,000 Ordinary shares under the Global ESPP and
200,000 Ordinary shares under the U.S. ESPP. Under the plans'
terms, employees may purchase shares through periodic deductions
of 1% - 10% of their salary. The number of shares to be issued in
return for amounts deducted in a six-month period (the "Offering
Period") will be determined at the end of the Offering Period and
will be equal to the lower of 85% of the closing bid of the
Company's shares on the Nasdaq National Market on the first day or
the last day of the Offering Period. During 2002, 2003 and 2004,
the Company issued 64,592, 83,348 and 75,083 Ordinary shares,
respectively, to eligible employees at average prices of $ 6.85,
$ 7.31 and $ 19.00 per share, respectively.
As of December 31, 2004, 508,664 Ordinary shares are available for
future issuances under the Stock Purchase Plan.
DIVIDENDS:
In the event that cash dividends are declared in the future, such
dividends will be paid in NIS or in foreign currency subject to
any statutory limitations. The Company does not intend to pay cash
dividends in the foreseeable future. The Company has decided not
to declare dividends out of tax-exempt earnings.
NOTE 13:- NET EARNINGS (LOSS) PER SHARE
The following table sets forth the computation of historical basic and
diluted net earnings (loss) per share:
YEAR ENDED DECEMBER 31,
----------------------------------------------
2002 2003 2004
-------------- ------------- -------------
Numerator:
Numerator for basic and diluted
net earnings (loss) per share -
income (loss) available to
Ordinary shareholders $ (5,500) $ 914 $ 24,150
Denominator:
Denominator for basic net earnings
(loss) per share 26,953,410 28,178,228 34,195,642
----------- ---------- ----------
Effect of dilutive securities:
Employee stock options and
stock purchase plan -- 2,335,257 2,627,476
----------- ---------- ----------
Denominator for diluted net
earnings (loss) per share 26,953,410 30,513,485 36,823,118
=========== ========== ==========
In 2002, 2003 and 2004, options and warrants in the amount of
3,635,851, 346,052 and 766,190, respectively, were excluded from the
computation of diluted earnings (loss) per share due to their
anti-dilutive effect.
F-28
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 14:- INCOME TAXES
TAX BENEFITS UNDER THE LAW FOR THE ENCOURAGEMENT OF CAPITAL
INVESTMENTS, 1959 (THE "CAPITAL INVESTMENT LAW"):
Most of the Company's production facilities have been granted
"Approved Enterprise" status under the Capital Investments Law
currently under six separate investment programs. Pursuant to the
Capital Investments Law, the Company has elected the "alternative
benefits" track and has waived Government grants in return for a tax
exemption.
The Company is also a "foreign investors' company", as defined by the
Capital Investments Law, and, as such, is entitled to a 10-year period
of benefits and may be entitled to reduced tax rates of between 10%
and 25% (based on the percentage of foreign ownership in each taxable
year).
For the Company's six investment programs, the tax benefits are as
follows: Income derived from investment programs, that commenced
operations prior to or during 1996 is tax exempt for the first four
years of the 10-year tax benefit period, and is entitled to a reduced
tax rate of 20% during the remaining benefit period. Income derived
from investment programs that commenced operations after 1996, is tax
exempt for the first two years of the 10-year tax benefit period, and
is entitled to a reduced tax rate of 10%-25% during the remaining
benefit period. The period of benefits for all these investment
programs has not yet commenced, since the Company has not yet reported
taxable income.
The period of tax benefits detailed above is subject to time limits of
the earlier of 12 years from commencement of production, or 14 years
from receiving the approval. Accordingly, the period of benefits
relating to all investment programs will expire in the years 2005
through 2012.
In connection with the purchase of Fortress, the Company established a
research and development facility in Omer, Israel, at the site of
Fortress' facilities. Income derived from the Omer facility is tax
exempt for a 10-year period. The Company reached an agreement with the
Israeli tax authorities and the Investment Center on the percentage of
revenues which are deemed attributable to the facility in Omer.
The Company manufactures part of its products outside of Israel, using
foreign contract manufacturers. This may effect the tax benefits to
which the Company is entitled. The Company is currently negotiating
this matter with the Israeli tax authorities and the Investment
Center.
The entitlement to the above benefits is conditional upon the Company
fulfilling the conditions stipulated by the Capital Investments Law,
regulations published thereunder and the instruments of approval for
the specific investments in "approved enterprises". In the event of
failure to comply with these conditions, the benefits may be canceled
and the Company may be required to refund the amount of the benefits,
in whole or in part, including interest.
In the event of a distribution of such tax-exempt income including,
among other things, a cash dividend, the Company will be required to
pay tax at the rate of 10%-25% on the amount distributed. In addition,
these dividends will be subject to a 15% withholding tax.
The Company's Board of Directors has determined that such tax-exempt
income will not be distributed as dividends. Accordingly, no deferred
taxes have been provided on income attributable to the Company's
"Approved Enterprise".
F-29
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 14:- INCOME TAXES (CONT.)
The Capital Investments Law also grants entitlement to claim
accelerated depreciation on equipment used by the "Approved
Enterprise" during the first five tax years.
If the Company derives income from sources other than an "Approved
Enterprise", such income will be taxable at the regular corporate tax
rate of 35% in 2004 and 34%, 32%, 30% in 2005, 2006, 2007,
respectively.
TAX BENEFITS UNDER THE LAW FOR THE ENCOURAGEMENT OF INDUSTRY (TAXES),
1969:
The Company and its Israeli subsidiary currently qualify as an
"industrial company" under the above law and, as such, are entitled to
certain tax benefits, mainly accelerated depreciation of machinery,
equipment and building, and the right to claim public issuance
expenses and amortization of patents and other intangible property
rights as a deduction for tax purposes.
TAXABLE INCOME UNDER THE INFLATIONARY INCOME TAX (INFLATIONARY
ADJUSTMENTS) LAW, 1985:
Results of the Company and its Israeli subsidiary for tax purposes are
measured and reflected in real terms in accordance with the changes in
the Israeli Consumer Price Index (the "CPI"). As explained in Note 2,
the financial statements are presented in U.S. dollars. The difference
between the rate of change in Israeli CPI and the rate of change in
the NIS/U.S. dollar exchange rate causes a difference between taxable
income or loss and the income or loss before taxes reflected in the
financial statements. In accordance with paragraph 9(f) of SFAS No.
109, the Company has not provided deferred income taxes on temporary
differences resulting from change in exchange rates and indexing for
tax purposes.
DEFERRED INCOME TAXES:
Deferred income taxes reflect the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for
financial reporting purposes and the amounts used for income tax
purposes. Significant components of the Company's deferred tax assets
are as follows:
DECEMBER 31,
-------------------------
2003 2004
----------- -----------
Deferred tax assets:
Net operating loss carryforward of subsidiaries $ 4,761 $ 4,738
Reserve and allowances 929 655
-------- --------
Total deferred tax asset before valuation allowance 5,690 5,393
Valuation allowance (5,690) (5,393)
-------- --------
Net deferred tax asset $ -- $ --
======== ========
As of December 31, 2004, the Company's subsidiaries have provided
valuation allowances of $ 5,393 in respect of deferred tax assets
resulting from tax loss carryforwards and other temporary differences.
The net change in the valuation allowance in 2004 amounted to a
decrease of $ 297 Management currently believes that since the
Company's subsidiaries have a history of losses it is more likely than
not that the deferred tax regarding the loss carryforward and other
temporary differences will not be realized in the foreseeable future.
F-30
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 14:- INCOME TAXES (CONT.)
INCOME (LOSS) BEFORE MINORITY INTEREST CONSISTS OF THE FOLLOWING:
YEAR ENDED DECEMBER 31,
-------------------------------------
2002 2003 2004
------------ --------- ----------
Domestic $ (1,509) $ 956 $22,675
Foreign (3,991) (159) 1,475
-------- ------ -------
$ (5,500) $ 797 $24,150
======== ====== =======
NET OPERATING LOSS CARRYFORWARD:
The Company and its Israeli subsidiary have accumulated losses for
Israeli income tax purposes as of December 31, 2004, in the amount of
approximately $ 30,000. These losses may be carried forward (linked to
the Israeli CPI) and offset against taxable income in the future for
an indefinite period. The Company expects that during the period these
tax losses are utilized, its income would be substantially tax-exempt.
Accordingly, there will be no tax benefit available from such losses
and no deferred income taxes have been included in these consolidated
financial statements.
As of December 31, 2004, M-Systems, Inc. had U.S. federal net
operating loss carryforwards of approximately $ 11,023 that can be
carried forward and offset against taxable income. These loss
carryforwards expire during the years 2009 to 2023. Utilization of
U.S. net operating losses may be subject to substantial annual
limitations due to the "change in ownership" provisions of the
Internal Revenue Code of 1986 and similar state law provisions. The
annual limitations may result in the expiration of net operating
losses before utilization.
As of December 31, 2004, M-Systems Taiwan and M-Systems Japan had net
operating loss carryforwards of approximately $ 2,470 and $ 1,548,
respectively, which can be carried forward and offset against taxable
income during the years 2005 to 2007.
RECONCILIATION OF THE THEORETICAL TAX EXPENSE (BENEFIT) TO THE ACTUAL
TAX EXPENSE (BENEFIT):
The main reconciling items of the statutory tax rate of the Company
(2002,2003 -36%, 2004-35%) to the effective tax rate (0%) are tax
exempt income due to approved enterprise status in the Company,
valuation allowance provided for deferred tax assets (in 2002 and
2003) and reversal of valuation allowance in 2004.
F-31
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 15:- RELATED PARTY TRANSACTIONS
The balances and transactions with related parties were as follows
(for additional information see Note 1c and Note 5):
DECEMBER 31,
---------------------
2003 2004
--------- ---------
a. Balances with related party:-
Trade Payables - Venture $3,582 $ 6,027
====== =======
YEAR ENDED DECEMBER 31,
------------------------
2003 2004
------- --------
b. Transactions with related party:-
Equity in the earnings of the Venture $ -- $22,233
======= ========
Purchases from the Venture (1) $4,440 $73,448
======= ========
Sales of components to the Venture (2) $ 798 $ 9,796
======= ========
(1) After elimination of the Company's share in the profits
resulting to the Venture from these transactions.
(2) Sales of components to the Venture are not recognized as
revenues but are instead offset against the purchase of such
components.
NOTE 16:- SELECTED STATMENTS OF OPERATIONS DATA
YEAR ENDED DECEMBER 31,
------------------------------------
2002 2003 2004
---------- ---------- ----------
a. Research and development expenses, net:
Total expenses $12,249 $15,389 $25,073
Less - grants and participations 275 675 239
------- ------- -------
$11,974 $14,714 $24,834
======= ======= =======
b. Financial income, net:
Financial income:
Interest on marketable securities, net $ 1,391 $ 1,928 $ 2,458
Interest on bank deposits 1,164 511 1,051
Gain on sale of available-for-sale
marketable securities 70 -- --
Foreign currency translation
differences 157 453 392
Other 117 196 189
------- ------- -------
2,899 3,088 4,090
------- ------- -------
Financial expenses:
Foreign currency translation
differences, net 174 206 39
Bank commissions 74 101 99
Other 32 70 55
------- ------- -------
280 377 193
------- ------- -------
Financial income, net $ 2,619 $ 2,711 $ 3,897
======= ======= =======
F-32
M-SYSTEMS FLASH DISK PIONEERS LTD.
AND ITS SUBISIDARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS, EXCEPT SHARE DATA
NOTE 17:- CUSTOMERS AND GEOGRAPHIC INFORMATION
The Company applies Statement of Financial Accounting Standards No.
131 "Disclosures about Segments of an Enterprise and Related
Information" ("SFAS No. 131").The Company manages its business on a
basis of one reportable segment. See Note 1 for a description of the
Company's business. Total revenues are attributed to geographic areas
based on the location of customers.
The following presents total revenues and long-lived assets as of and
for the years ended December 31, 2002, 2003 and 2004 according to
geographic locations:
2002 2003 2004
----------------------- ----------------------- ----------------------
TOTAL LONG-LIVED TOTAL LONG-LIVED TOTAL LONG-LIVED
REVENUES ASSETS REVENUES ASSETS REVENUES ASSETS
---------- ------------ ---------- ------------ ---------- -----------
Israel (*) $ 1,678 $16,923 $ 2,955 $17,652 $ 24,994 $20,154
United States 17,248 117 41,021 96 109,235 130
Europe 10,605 4 21,031 1 47,942 --
Taiwan 8,282 100 22,623 116 53,534 299
Japan 22,177 76 26,014 78 56,054 71
China 2,167 15 6,816 15 32,769 26
Far East (excluding Taiwan,
Japan and China) 2,660 -- 9,594 -- 23,023 --
------- ------- -------- ------- -------- -------
$64,817 $17,235 $130,054 $17,958 $347,551 $20,680
======= ======= ======== ======= ======== =======
(*) Includes equity in the earnings of the Venture in the amount of
$ 22,233 for the year ended December 31, 2004.
Total revenues from external customers are divided as follows:
YEAR ENDED DECEMBER 31,
-------------------------------------
2002 2003 2004
---------- ---------- -----------
USB Flash Drive $26,810 $ 79,358 $228,218
Multimedia mobile handsets 3,613 17,356 69,772
Embedded Systems 31,679 30,727 46,698
Other 2,715 2,613 2,863
------- -------- --------
$64,817 $130,054 $347,551
======= ======== ========
Major customers data as a percentage of total revenues:
YEAR ENDED DECEMBER 31,
-------------------------
2002 2003 2004
------ ------ -------
Customer A 15% 16% 14%
Customer B 10% 3% -%
Customer C --% 1% 11%
- - - - - - - -
F-33
[ERNST & YOUNG GRAPHIC OMITTED]
o KOST FORER GABBAY & KASIERER
o 3 Aminadav St. o Phone: 972-3-6232525
Tel-Aviv 67067, Israel Fax: 972-3-5622555
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Partners of
TWINSYS DATA STORAGE LIMITED PARTNERSHIP
We have audited the accompanying statements of assets, liabilities and
partners' capital of Twinsys Data Storage Limited Partnership (the
"Partnership") as of December 31, 2003 and 2004, and the related statements of
income, changes in partners' capital and cash flows for the period from
November 1, 2003 to December 31, 2003 and for the year ended December 31, 2004.
These financial statements are the responsibility of the Partnership's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Company's
internal control over financial reporting. Accordingly, we express no such
opinion. An audit also includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of the Partnership as of
December 31, 2003 and 2004, and the results of its operations and it's cash
flows for the period from November 1, 2003 to December 31, 2003, and for the
year ended December 31, 2004, in conformity with United States generally
accepted accounting principles.
Tel-Aviv, Israel KOST FORER GABBAY & KASIERER
January 19, 2005 A Member of Ernst & Young Global
F-34
TWINSYS DATA STORAGE LIMITED PARTNERSHIP
STATEMENTS OF ASSETS, LIABILITIES AND PARTNERS' CAPITAL
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS
DECEMBER 31,
-----------------------
2003 2004
---------- ----------
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 699 $ 6,324
Related parties - trade receivables 4,441 29,008
Other accounts receivable 7 1,578
Inventories (Note 3) 4,825 4,646
------- -------
Total assets $ 9,972 $41,556
======= =======
LIABILITIES AND PARTNERS' CAPITAL
CURRENT LIABILITIES:
Related Parties - trade payables $ 7,618 $12,346
Trade payables 792 11,235
Accrued distribution payable to partners 862 92
------- -------
Total liabilities 9,272 23,673
======= =======
PARTNERS' CAPITAL (Note 4):
Accumulated contributions 700 700
Retained earnings -- 17,183
------- -------
Total partners' capital 700 17,883
------- -------
Total liabilities and partners' capital $ 9,972 $41,556
======= =======
The accompanying notes are an integral part of the financial statements.
F-35
TWINSYS DATA STORAGE LIMITED PARTNERSHIP
STATEMENTS OF INCOME
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS
PERIOD FROM
NOVEMBER 1, 2003 TO YEAR ENDED
DECEMBER 31, 2003 *) DECEMBER 31, 2004
---------------------- ------------------
Revenues from related parties $ 4,440 $172,834
Cost of revenues **) 3,541 110,048
------- --------
Gross profit 899 62,786
------- --------
Operating expenses:
General, administrative and other expenses 37 133
------- --------
Operating income 862 62,653
------- --------
Financial income -- 22
------- --------
Net income $ 862 $ 62,675
======= ========
*) The Partnership commenced operations on November 1, 2003.
**) Includes purchases from related parties in the amount of $7,575 and
$82,936 in the period from November 1, 2003 to December 31, 2003 and for
the year ended December 31, 2004 respectively.
The accompanying notes are an integral part of the financial statements.
F-36
TWINSYS DATA STORAGE LIMITED PARTNERSHIP
STATEMENTS OF CHANGES IN PARTNERS' CAPITAL
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS
LIMITED GENERAL
PARTNERS PARTNER TOTAL
------------ --------- ------------
ACCUMULATED CONTRIBUTIONS:
Balance as of November 1, 2003 *) $ -- $ -- $ --
Capital contributions during 2003 699 1 700
--------- ----- ---------
Balance as of December 31, 2003 and December 31, 2004 699 1 700
--------- ----- ---------
RETAINED EARNINGS:
Balance as of November 1, 2003 *) -- -- --
Net income 860 2 862
Accrued distribution to partners (860) (2) (862)
--------- ------- ---------
Balance as of December 31, 2003 -- -- --
Net income 62,550 125 62,675
Cash distributions to partners in cash (45,400) -- (45,400)
Accrued distribution to partners (92) (92)
--------- ------ ---------
Balance as of December 31, 2004 17,150 33 17,183
--------- ------ ---------
Total partners' capital as of December 31, 2004 $ 17,849 $ 34 $ 17,883
========= ====== =========
*) The Partnership commenced operations on November 1, 2003.
The accompanying notes are an integral part of the financial statements.
F-37
TWINSYS DATA STORAGE LIMITED PARTNERSHIP
STATEMENTS OF CASH FLOWS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS
PERIOD FROM
NOVEMBER 1, 2003 YEAR ENDED
TO DECEMBER 31, DECEMBER 31,
2003*) 2004
------------------ -------------
Cash flows from operating activities:
Net income $ 862 $ 62,675
Adjustments to reconcile net income for the period to net cash
used in operating activities:
Increase in other accounts receivable (6) (1,572)
Decrease (increase) in inventories (4,825) 179
Increase in related parties-trade receivables (4,441) (24,567)
Increase in related Parties-trade payables 7,618 4,728
Increase in trade payables 792 10,443
--------- ---------
Net cash provided by operating activities -- 51,886
--------- ---------
Cash flows from financing activities:
Distribution to partners -- (46,262)
Capital contributions 699 1
--------- ---------
Net cash provided by (used in) financing activities 699 (46,261)
--------- ---------
Increase in cash and cash equivalents 699 5,625
--------- ---------
Cash and cash equivalents at the beginning of the period -- 699
Cash and cash equivalent at the end of the period $ 699 $ 6,324
========= =========
Non-cash activities:
Receivables on account of capital contribution $ 1 $ --
--------- ---------
Accrued distribution to partners $ 862 $ 92
========= =========
*) The partnership commenced operations on November 1, 2003.
The accompanying notes are an integral part of the financial statements.
F-38
TWINSYS DATA STORAGE LIMITED PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS
NOTE 1:- GENERAL
a. Twinsys Data Storage Limited Partnership (the "Partnership"), was
formed in Israel on July 30, 2003, by Twinsys Ltd., an Israeli
corporation ("the General Partner"), M-Systems Flash Disk Pioneers
Ltd., an Israeli corporation, and First Flash Ltd., an Israeli
corporation wholly owned by Toshiba Corporation ("the Partners"),
in accordance with the Israeli Partnership Ordinance. The
Partnership commenced operations on November 1, 2003.
The General Partner and the Partners respective percentage
interests are:
49.9% of the Partnership' assets, liabilities, revenues and costs
will be attributable to each of the Partners and the remaining 0.2%
of the Partnership's assets, liabilities, revenues and costs will
be allocated to the General Partner.
The Partnership shall be terminated on July 30, 2013, unless sooner
terminated or extended by the express written agreement of all of
the Partners.
b. The Partnership is designed to enable the Partners to benefit from
a portion of each party's respective sales of USB flash drives.
Each of the Limited Partners invested an initial amount of $ 350 in
the Partnership. The Partners have obligations to conduct a portion
of their USB flash drive business through the Partnership, and thus
each will receive a percentage of the income attributable to the
portion of sales of the USB flash drives generated by the other
party through the Partnership.
NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES
The Partnership's financial statements have been prepared in
accordance with accounting principles generally accepted in the United
States ("U.S. GAAP").
USE OF ESTIMATES:
The preparation of financial statements in conformity with generally
accepted accounting principles requires the management to make
estimates and assumptions that affect the amounts reported in the
financial statements and accompanying notes. Actual results could
differ from those estimates.
FINANCIAL STATEMENTS IN U.S. DOLLARS:
Substantially all of the revenues of the Partnership are generated in
U.S. dollars ("dollars"). In addition, a substantial portion of the
Partnership's costs is incurred in dollars. Therefore, management
believes that the dollar is the primary currency in the economic
environment in which the Partnership operates, and accordingly the
dollar is the functional and reporting currency of the partnership.
Monetary accounts maintained in currencies other than the dollar and
transactions in currencies other than the dollar are remeasured into
U.S. dollars, in accordance with Statement of Financial Accounting
Standards No. 52, "Foreign Currency Translation" ("SFAS No. 52"). All
transaction gains and losses from the remeasurement are reflected in
the statement of income.
CASH EQUIVALENTS:
Cash equivalents are short-term, highly liquid investments that are
readily convertible into cash, with original maturities of three
months or less.
INVENTORIES:
Inventories are stated at the lower of cost or market value. Inventory
cost is determined using the moving average cost method.
F-39
TWINSYS DATA STORAGE LIMITED PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS
NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES (CONT.)
TAXES ON INCOME:
No provision has been made for income taxes in the accompanying
financial statements since the partnership is not subject to taxation
as the partners are taxed on the partnership's income.
REVENUE RECOGNITION:
The Partnership generates its revenues from selling its data storage
products to the Partners.
Revenues from product sales are recognized in accordance with Staff
Accounting Bulletin No. 104, "Revenue Recognition in Financial
Statements" ("SAB No. 104"), when delivery has occurred, persuasive
evidence of an arrangement exists, the vendor's fee is fixed or
determinable, no further obligation exists, and collectibility is
probable.
Warranty obligations are incurred by a partner. Therefore the
partnership does not provide a provision for warranties
CONCENTRATIONS OF CREDIT RISK:
Financial instruments that potentially subject the Partnership to
concentrations of credit risk consist principally of cash and cash
equivalents and receivables.
Cash and cash equivalents are invested with major banks in Israel.
Management believes that the financial institutions that hold the
investments of the Partnership are financially sound and, accordingly,
minimal credit risk exists with respect to these investments.
Trade receivables consist only of trade receivables from related
parties which are financially sound entities. Accordingly, minimal
credit risk exists in respect of these receivables.
The Partnership has no off-balance-sheet concentration of credit risk
such as foreign exchange contracts, option contracts or other foreign
hedging arrangements.
FAIR VALUE OF FINANCIAL INSTRUMENTS:
The carrying amounts of cash and cash equivalents, trade receivables,
other accounts receivable, and trade payables approximate their fair
value due to the short-term maturities of such instruments.
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS:
In November 2004, the FASB issued Statement of Financial Accounting
Standard No. 151, "Inventory Costs, an amendment of ARB No. 43,
Chapter 4.". SFAS No. 151 amends Accounting Research Bulletin ("ARB")
No. 43, Chapter 4, to clarify that abnormal amounts of idle facility
expense, freight handling costs and wasted materials (spoilage) should
be recognized as current-period charges. In addition, SFAS 151
requires that allocation of fixed production overheads to the costs of
conversion be based on normal capacity of the production facilities.
SAFS No. 151 is effective for inventory costs incurred during fiscal
years beginning after June 15, 2005. The partnership does not expect
that the adoption of SFAS No. 151 will have a material effect on its
financial position or results of operations.
RECLASSIFICATION:
Certain 2003 figures have been reclassified to conform to the 2004
presentation.
F-40
TWINSYS DATA STORAGE LIMITED PARTNERSHIP
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
U.S. DOLLARS IN THOUSANDS
NOTE 3:- INVENTORIES
DECEMBER 31, DECEMBER 31,
2003 2004
-------------- -------------
Raw materials $3,643 $4,253
Work in progress 1,182 393
------ ------
$4,825 $4,646
====== ======
Majority of raw materials are purchased from the Partners.
NOTE 4:- PARTNERS' CAPITAL
a. Partners contributions:
As of December 31, 2003, each of the Limited Partners invested an
initial amount of approximately $ 350 in the Partnership.
b. Distributions:
In accordance with the Partnership agreements, within ninety (90)
days after the end of the second and forth quarter of each fiscal
year of the Partnership, and subject to the Israeli Partnership
Ordinance and other applicable laws, the Partnership shall
distribute its available cash (if any) to the Partners. Any
distribution of cash and other property by the Partnership shall be
made in accordance with the Partners' respective percentage
interests.
- - - - - - - -
F-41
