EXHIBIT 99.3
OPERATING AND FINANCIAL REVIEW AND PROSPECTS
YOU SHOULD READ THE FOLLOWING DISCUSSION AND ANALYSIS IN CONJUNCTION WITH OUR
CONSOLIDATED FINANCIAL STATEMENTS AND NOTES THERETO INCLUDED ELSEWHERE IN THIS
CURRENT REPORT ON FORM 6-K. THIS "OPERATING AND FINANCIAL REVIEW AND PROSPECTS"
SECTION CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND
UNCERTAINTIES. OUR ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED
IN THESE FORWARD-LOOKING STATEMENTS.
OVERVIEW
We design, develop and market innovative flash data storage solutions for
digital consumer electronics markets. We primarily target two digital consumer
electronics markets: the USB flash drive market with our M-Drive products and
the mobile handset market with our M-DOC products. We also sell flash data
storage products targeted at the embedded systems market, including our M-Module
and M-SSD products.
BELOW ARE SOME OF THE HIGHLIGHTS AND TRENDS AFFECTING OUR BUSINESS SINCE THE
BEGINNING OF 2005:
Revenue Growth - Because the markets that our products address grew rapidly, our
revenues have grown significantly over the past few years. In 2004, our revenues
grew by 220% in comparison to 2003, and our revenues in 2005 grew by 48% in
comparison to 2004. In particular, our sales to the USB flash drive market grew
by 40%, from $297.2 million in 2004 to $415.4 million in 2005, and our sales to
the mobile handset and portable devices market grew by 100% from $69.8 million
in 2004 to $139.8 million in 2005.
Revenue growth in 2005 was attributable in large part to significant growth in
unit sales of both our M-Drive and M-DOC products, as both the USB flash drive
and mobile handset markets experienced strong end-user demand. The average
selling prices per megabyte for our products have declined in recent years.
However, the average selling prices per unit for our M-Drive and M-DOC decreased
at a significantly lower rate than the average selling prices per megabyte, as a
result of consumers purchasing products with higher density storage.
This revenue growth has placed and is expected to continue to place a strain on
our operational, logistical and managerial resources. To support our revenue
growth, we have expanded our work force from approximately 352 employees at
January 1, 2004 to approximately 822 employees at December 31, 2005.
Seasonality - In 2005, we experienced stronger demand for our M-DOC products in
the second half of the fiscal year, and for our M-Drive products in the fourth
quarter, in each case due to end-of-year holiday demand. We expect, however,
that demand in the first half of 2006 will be weaker, due in part to the strong
sales during the 2005 holiday season, which will adversely affect our product
sales and profitability in the first half of 2006. We anticipate that we will
experience seasonal declines in our sales in the first half of future fiscal
years when compared to the fourth quarter of the preceding year.
Acquisition of Microelectronica Espanola - On November 14, 2005, we acquired all
the outstanding shares of Microelectronica Espanola S.A.U. ("MEE"), a European
SIM card vendor. The purchase price for the shares of MEE (net of working
capital of $34.5 million) was $40.5 million. We acquired MEE in order to gain a
strategic foothold in the SIM card market and realize the synergies achievable
by combining MEE's technology, customer relationships and established reputation
with our products and expertise in storage solutions to accelerate the
development and commercialization of our MegaSIM product. Through the
acquisition, we obtained the technology, know-how and manufacturing capabilities
to manufacture SIM cards which, combined with MEE's strong customer
relationships with some of the leading mobile network operators in Europe and
Latin America and its recognized status as a secure, approved manufacturer and
supplier of SIM cards, will facilitate the adoption of our MegaSIM product by
mobile network operators.
In connection with the acquisition, we wrote-off $2.5 million of acquired
in-process research and development during the fourth quarter of 2005. In
addition, we acquired intangible assets valued at $11.0 million, which will be
amortized on a straight-line basis over their estimated useful lives of 5-10
years. We expect to record $1.1 million (net of the related tax liability) in
amortization expenses during 2006 relating to the acquisition. As part of the
acquisition, we also recorded goodwill of $27.4 million.
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Strategic Relationship with Hynix
In August 2005, we entered into cooperation agreements with Hynix in
order to secure guaranteed capacity and favorable purchasing terms for flash
memory components from Hynix. The principal terms of the agreements are:
o our purchase of approximately $100 million of equipment to be placed
at Hynix's manufacturing facility, in return for guaranteed capacity
and favorable purchasing terms from Hynix;
o the joint development of an embedded flash drive for the mobile
handset market;
o the receipt by us of credits of up to $100 million in the aggregate
(the purchase price for the purchased equipment) on products that we
purchase from Hynix over the six year term of the agreement, subject
to certain conditions; and
o Hynix's commitment to purchase the equipment from us upon
termination or expiration of the agreement for a purchase price
equal to the un-credited portion of the equipment purchase price,
subject to certain conditions.
The purchased equipment will be operated and maintained by Hynix and our receipt
of credits and any other rights under the agreement are not affected by Hynix's
utilization of the equipment. We do not have any purchase commitments under the
agreement; however, if we fail to purchase a minimum agreed-upon amount of
products, we may relinquish a portion of the proportional credit arising out of
the amount paid for the equipment.
We have recognized the amount invested in the equipment as deferred purchase
credits, which will be amortized over the six year term of the agreement on the
straight line method, as an addition to the future cost of the products we
purchase from Hynix, subject to certain conditions.
As of December 31, 2005, we had completed the purchase and placement in Hynix's
facilities of $71.5 million in equipment under the terms of our agreement, which
was recognized as deferred purchase credits. We have substantially completed our
equipment obligations under the agreement during the first quarter of 2006. We
expect to begin to receive credits on products we purchase from Hynix commencing
in the first half of 2006.
U3 - In December 2004, we and SanDisk Corporation ("SanDisk") formed U3 LLC
("U3") to develop a unified standard for the development of software
applications for USB flash drives. U3 provides software developers a unified
standard applications platform that enables software developers to create
standardized applications that will be recognized and interoperable with all U3
enabled USB flash drives. During 2005, we recorded $3.1 million equity in losses
of an affiliate representing our share in the losses incurred by U3, which
commenced operations at the beginning of 2005. In 2005, we introduced our
M-Drive U3 Smart Drive, the first USB flash drive with a standardized
applications platform, based on the standard developed by U3. We commenced sales
of U3 Smart Drives in the third quarter of 2005, and expect U3 Smart Drives to
represent an increasing portion of our USB flash drive sales.
Termination of Samsung Agreement - We recently terminated our strategic
agreement with Samsung, which was to have been effective until December 31,
2007. As a result of this termination, we will no longer be entitled to
committed manufacturing capacity and favorable pricing terms from Samsung under
the agreement or to receive license fees from Samsung. Samsung will no longer
hold a license to our patents, effective from the termination date.
Consequently, we will likely need to source flash components from alternate
sources and may encounter difficulties in sourcing additional flash components,
or be required to source flash components from alternate sources at higher
relative prices.
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THE FOLLOWING IS A BRIEF DESCRIPTION OF CERTAIN OF THE LINE ITEMS INCLUDED IN
OUR FINANCIAL STATEMENTS AS WELL AS TREND INFORMATION REGARDING THOSE LINE
ITEMS:
Revenues - We categorize revenues based both on the manner in which we generate
our revenues and on the end markets from which we generate our revenues. We
generate revenues from the sale of our products, primarily our M-Drive, M-DOC,
M-Module and M-SSD products, and from license fees and royalties received for
licensing our technology to third parties. These revenues are generated from
sales into three principal end markets: the USB flash drive market, into which
we sell our M-Drive products, the mobile handset and portable devices market,
into which we sell our M-DOC products, and the embedded systems market, into
which we sell our M-Module and M-SSD products. For the year ended December 31,
2005, we derived approximately 68% of our revenues from the USB flash drive
market, approximately 23% of our revenues from the mobile handset and portable
devices market and approximately 9% of our revenues from the embedded systems
market.
Revenues from licensing our technology to third parties are derived from our
license agreements, under which, in exchange for granting the licenses, we
receive, among other things, license fees and royalties. Given that these
revenues have no associated cost of goods sold, our operating profit and net
income are more sensitive to fluctuations in these revenues than to changes in
product sales.
A majority of our sales have been to a limited number of customers. For the
years ended December 31, 2004 and 2005, our top 10 customers accounted for 64%
and 62% of our revenues, respectively. In 2005, each of two customers accounted
for greater than 10% of our total revenues (or 26% in the aggregate). We expect
that sales to a limited number of customers will continue to account for a
substantial portion of our revenues for the next several years.
In 2005, Asia accounted for 42% of our revenues, the United States accounted for
36% of our revenues, and Europe and Israel accounted for 17% of our revenues and
other regions accounted for 5% of our revenues. We expect to continue to
generate a significant portion of our revenues from the United States, the
largest market for our M-Drive products. We also expect to continue to generate
a significant portion of our revenues from Asia, since many of our M-DOC
customers are handset manufacturers located in Asia, and a significant portion
of the sales of the Venture are to Toshiba in Japan.
Cost of Goods Sold - Our cost of goods sold consists primarily of the cost of
flash memory components, ASIC components and manufacturing costs (including
costs of subcontractors that manufacture our products), and salaries and related
personnel expenses for those engaged in the manufacture of our products. Cost of
flash memory components accounts for the substantial majority of our cost of
goods sold. Our cost of goods sold as a percentage of revenues is impacted by a
number of factors, including the following factors:
o Cost of flash components. In the event that our cost for flash
components increases, we may be unable to pass these cost increases on
to our customers, and consequently our cost of goods sold as a
percentage of revenues could rise and our profitability could be
adversely affected. Conversely, if the market price for flash
components decreases, we may be required to write down the value of our
existing inventory, thereby increasing our cost of goods sold as a
percentage of revenues.
o Access to lower cost flash components. We strive to have the
technological ability and commercial access to use in our products
lower cost flash components based on more advanced technology, such as
multi-level cell (MLC) flash technology. The higher the portion that
such lower cost flash components represent of our total flash
components usage, the lower our cost of goods sold as a percentage of
revenues.
o Efficient inventory management. The dynamic pricing environment for
flash components requires that we manage our inventory in an efficient
manner. Under our supply agreements, we are committed to provide
binding purchase forecasts for flash components and M-DOC at lead times
longer than those that our customers provide us for their product
orders. This requires us to purchase inventory based on forecasted
demand in advance of customer orders. If we overestimate customer
demand, leaving us with excess inventory, we might be required to write
down the value of the inventory as flash component prices drop, causing
our cost of goods sold as a percentage of revenues to increase.
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o Product pricing environment. Our M-Drive and M-DOC products are
designed for consumer electronics applications. The consumer market is
intensely competitive and is price-sensitive. Softening demand for our
products targeted at these markets or aggressive pricing strategies of
our competitors may cause market prices to decrease. To the extent that
market prices in these consumer electronics markets decrease rapidly,
we may be forced to lower our selling prices at a faster rate than the
decrease in the cost of flash components that we purchase, which could
cause our cost of goods sold as a percentage of revenues to rise and
our profitability to be adversely affected.
o Product mix. Each of our products has different associated gross
margins, which varies quarterly based on market dynamics, competition,
our average selling prices and our cost of materials. Our product mix
varies quarterly, which affects our overall gross margins and
profitability. Therefore, when the percentage of our revenues derived
from lower margin products increases in any given period, our cost of
goods sold as a percentage of revenues will increase for that period.
Currently, sales of our M-Drive products to the USB flash drive market
carry lower gross margins than our other products. Consequently, an
increase in the percentage of revenues from sales of M-Drive could
increase our costs of goods sold as a percentage of revenues,
negatively affecting our profitability.
o Supply mix. During 2005, we purchased flash components from various
suppliers. Each of our agreements with these suppliers has different
capacity commitments and pricing terms. The capacity to which we are
entitled under each agreement is generally fixed within any given
period. Subject to our contractual purchase commitments, we strive to
optimize our purchases from our suppliers by first purchasing
components from the supplier that offers us the best relative pricing
terms, until we exhaust the quantity available to us from that
supplier at those terms, and then purchasing from the supplier that
offers us the next best pricing terms. As a result, incremental
increases in sales in a given period will generally be sourced from a
supplier that offers us less attractive pricing terms than our average
pricing terms for sales previously made during that period, thereby
increasing our cost of good sold as percentage of revenues. We
recently terminated our agreement with Samsung, resulting in our
relinquishing our rights to committed capacity and favorable pricing
terms from Samsung. To the extent we are required to source flash
components from alternate sources at higher relative prices, our costs
of goods sold as a percentage of revenues will increase, which would
negatively affect our profitability.
o Percentage of revenues derived from license fees and royalties. Given
that revenues from licensing our technology have no associated cost of
goods sold, our overall profitability is more sensitive to changes in
our license fees and royalties than to changes in product sales. A
decline in the percentage of revenues generated from licenses during
any given period could increase our costs of goods sold as a percentage
of revenues, negatively affecting our profitability. For example, in
light of our recent decision to terminate our agreement with Samsung,
we will no longer be entitled to receive license fees from Samsung
under this agreement, which could negatively affect our profitability.
Research and Development Expenses, Net - Research and development expenses
consist primarily of salaries and related personnel expenses and subcontractor
costs related to the design, development and testing of new products and
technologies and product enhancements. Research and development expenses are
presented net of participations received or accrued from the Office of the Chief
Scientist, or OCS, the Singapore-Israel Industrial Research and Development
Fund, or SIIRD, The Information Society Technology Fund, or IST, and The Britech
Foundation Limited, or Britech. All research and development costs are expensed
as incurred. We believe that continued investment in research and development is
critical to attaining our strategic objectives. During 2005, as a result of the
growth in our revenues and the expected growth potential for both our existing
products and products and technologies in development, we expanded our
investments in research and development. We expect research and development
expenses to increase in the future as we continue to enhance existing products
and develop new products and product lines to address existing and potential
markets, including our new M-SIM MegaSIM product targeted at the mobile handset
market.
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Selling and Marketing Expenses - Selling and marketing expenses consist
primarily of salaries, commissions and related personnel expenses for those
engaged in the sale and marketing of our products (including commissions payable
to our independent sales representatives), as well as related trade shows and
promotional and public relations expenses. During 2005, as a result of the
growth in our revenues and the expected growth potential for the M-Drive, M-DOC
and M-SIM MegaSIM products, we expanded our selling and marketing activities and
invested in broadening our sales channels to target additional geographic and
end markets. We expect our selling and marketing expenses to increase in the
future as we continue to expand our sales and marketing activities.
General and Administrative Expenses - General and administrative expenses
consist primarily of salaries and related personnel expenses for executive,
accounting, finance, legal and litigation, human resources, administrative and
network and information systems personnel, facilities maintenance, professional
fees and other general corporate expenses. As we add personnel and incur
additional costs in response to the growth of our business, we expect that
general and administrative expenses will also increase.
Financial Income, Net - Financial income, net consists primarily of interest
earned on marketable securities and bank deposits, gains or losses from the sale
of marketable securities and foreign currency translation differences resulting
from the translation of monetary balance sheet items denominated in non-dollar
currencies, net of interest paid on our convertible senior notes.
Equity in Losses of an Affiliate - We and SanDisk formed U3, a joint venture 50%
owned by each of us. Equity in losses of an affiliate represents our share in
the losses incurred by U3, which commenced operations in the beginning of 2005.
Minority Interest - In the USB flash drive market, we and Toshiba entered into a
venture (the "Venture") designed, among other things, to enable us and Toshiba
to benefit from a portion of each party's respective sales of USB flash drives.
The Venture is jointly owned and equally controlled by us and Toshiba. The
Venture is a variable interest entity and under the relevant guidelines of
Financial Accounting Standards Board Interpretation No. 46R, "Accounting for
Variable Interest Entities" ("FIN 46R") we are considered the primary
beneficiary and therefore consolidate the results of the Venture into our
financial statements. Minority interest represents Toshiba's proportional
interest in the net earnings of the Venture.
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, the percentage of
revenues represented by certain items reflected in our consolidated statements
of operations.
YEAR ENDED DECEMBER 31,
-------------------------------------
2003 2004 2005
------ ------ ------
Revenues................................................. 100.0% 100.0% 100%
Costs and expenses:
Cost of goods
sold.................................................. 71.6% 72.8% 75.2%
Research and development, net......................... 11.4% 6.0% 6.0%
Selling and
marketing............................................. 14.9% 7.5% 5.4%
General and
administrative........................................ 3.7% 1.6% 2.0%
In-process research and development write-off......... - - 0.4%
------ ------ ------
Total costs and expenses................................. 101.6% 87.9% 89.0%
------ ------ ------
Operating income (loss).................................. (1.6%) 12.1% 11.0%
Financial income, net.................................... 2.1% 1.0% 1.4%
Other income, net........................................ 0.1% *) 1.0%
------ ------ ------
Income before taxes on income............................ 0.6% 13.1% 13.4%
------ ------ ------
Taxes on income.......................................... - - *)
------ ------ ------
Income after taxes on income............................. 0.6% 13.1% 13.4%
------ ------ ------
Equity losses of an affiliate ........................... - - (0.5%)
Minority interest in losses (earnings) of subsidiaries... 0.1% (7.3%) (4.3%)
Net income............................................... 0.7% 5.8% 8.6%
*) Represents a percentage lower than 1%.
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The following table sets forth, for the periods indicated, our revenues by end
markets (in thousands):
YEAR ENDED DECEMBER 31,
---------------------------------------
2003 2004 2005
---- ---- ----
$130,054 $416,560 $614,983
======== ======== ========
Revenues:
USB flash drive
market............................................... $79,358 $297,227 $415,380
Mobile handset and portable devices
market....................... 17,356 69,772 139,802
Embedded systems
market............................................... 30,727 46,698 58,147
Other................................................ 2,613 2,863 1,654
-------- -------- --------
Total................................................... $130,054 $416,560 $614,983
======== ======== ========
YEAR ENDED DECEMBER 31, 2005 COMPARED TO YEAR ENDED DECEMBER 31, 2004
Revenues - Revenues for the year ended December 31, 2005 increased by $198.4
million, or 48%, to $615.0 million from $416.6 million for the year ended
December 31, 2004. Revenues derived from the USB flash drive market increased by
$118.2 million, or 40%, to $415.4 million, revenues derived from the mobile
handset and portable devices market increased by $70.0 million, or 100%, to
$139.8 million and revenues derived from the embedded systems market increased
by $11.4 million, or 25%, to $58.1 million. In November 2005, we entered the SIM
card market through the acquisition of MEE. Revenues derived from the SIM card
market for 2005 were $5.2 million. Revenue growth in 2005 was attributable in
large part to significant growth in unit sales of both our M-Drive and M-DOC
products, as both the USB flash drive and mobile handset markets experienced
strong end-user demand.
Cost of Goods Sold - Our cost of goods sold for the year ended December 31, 2005
increased by $158.9 million to $462.2 million, an increase of 52% from cost of
goods sold of $303.3 million for the year ended December 31, 2004. Our costs of
goods sold as a percentage of total revenues increased from 72.8% for the year
ended December 31, 2004 to 75.2% for the year ended December 31, 2005, due to
pricing pressures resulting from increasing competition, and as a result of a
decrease in the gross margins of the Venture.
Research and Development Expenses, Net - In the last year, we have shifted
resources to research and development activities from selling and marketing
activities in an effort to increase our investment in the technology that we
believe will fuel our future growth. Our gross research and development expenses
for the year ended December 31, 2005 increased by $12.9 million to $38.0
million, an increase of 51.5% from gross research and development expenses of
$25.1 million for the year ended December 31, 2004. Our net research and
development expenses for the year ended December 31, 2005 increased by $12.6
million to $37.5 million, an increase of 51% from net research and development
expenses of $24.8 million for the year ended December 31, 2004. As a percentage
of revenues, our net research and development expenses remained unchanged.
During the year ended December 31, 2005, we recognized $331,000 and $188,000 of
research and development grants from Britech and IST, respectively, compared to
$111,000 and $128,000 of research and development grants we recognized from IST
and OCS, respectively, during the year ended December 31, 2004. The increase in
our gross research and development expenses is attributable to an increase in
our investments in the development of new products and the enhancement of
existing products.
Selling and Marketing Expenses - Selling and marketing expenses for the year
ended December 31, 2005 increased by $2.4 million, or 9.0%, to $33.5 million
from $31.1 million for the year ended December 31, 2004. The modest increase was
the result of our decision to shift resources from selling and marketing
activities to increase our investment in research and development activities. In
addition, our principal marketing activities in the USB flash drive market were
primarily pursued through an affiliate (U3), which we include as equity in
losses of an affiliate. Our selling and marketing expenses are only partially
affected by an increase in our product sales, due to the fact that the direct
expenses related to actual sales are limited. As a percentage of revenues, our
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selling and marketing expenses decreased to 5.4% for the year ended December 31,
2005 from 7.5% for the year ended December 31, 2004.
General and Administrative Expenses - General and administrative expenses for
the year ended December 31, 2005 increased by $5.2 million, or 76%, to $12.1
million from $6.9 million for the year ended December 31, 2004. This increase is
attributable mainly to expanding our operations in order to support our
substantial growth in 2005, principally increases in personnel, legal and
accounting expenses as well as one time expenses associated with an intellectual
property litigation matter. As a percentage of revenues, our general and
administrative expenses increased to 2.0% for the year ended December 31, 2005
from 1.6% for the year ended December 31, 2004.
In Process R&D Write-off - In 2005, we realized a one-time charge of $2.5
million due to a write-off of in-process research and development in connection
with our acquisition of MEE.
Financial Income, Net - Financial income, net for the year ended December 31,
2005 increased by $4.8 million to $8.7 million from $3.9 million for the year
ended December 31, 2004 due primarily to our increased cash balance during 2005,
as a result of the proceeds raised from our $75 million convertible senior notes
offering in March 2005, as well as in an increase in market interest rates.
Financial income, net in 2005 also includes a one-time gain of $1.4 million
recognized from the expiration of an option granted to the initial purchasers of
the convertible senior notes.
Other Income - In 2005, we realized a gain from the sale of our shares of Saifun
Semiconductors Ltd., an Israeli company, in the amount of $5.4 million and a
gain from the sale of a portion of our shares of a Taiwanese company in the
amount of $841,000.
Equity in Losses of an Affiliate - Equity in losses of an affiliate represent
our share in the losses incurred by U3. The equity in losses of an affiliate for
the period ended December 31, 2005 was $3.1 million.
Minority Interest - Minority interest in earnings of consolidated subsidiary was
$26.2 million in 2005 compared to $30.4 million in 2004. Minority interest in
the earnings of our consolidated subsidiary represents the proportional share of
Toshiba in the earnings of the Venture, a variable interest entity consolidated
in accordance with FIN 46R.
Income Taxes - Income taxes in 2005 amounted to $156,000, which consisted of
$396,000 of current income taxes offset by $240,000 of deferred tax income.
Income taxes in 2005 are mainly attributable to MEE, which we acquired in
November 2005. Due to our utilization of net operating loss carryforwards and to
our not being liable for taxes on the share of the Venture's earnings
attributable to Toshiba, as well as various tax reduction programs established
by the Israeli government to encourage investment in Israel, we did not incur
any income tax expenses in Israel in 2005.
Net Income - For the year ended December 31, 2005, we recognized net income of
$52.6 million, representing 8.6% of total revenues, compared to a net income of
$24.2 million for the year ended December 31, 2004, representing 5.8% of total
revenues due to the reasons stated above.
YEAR ENDED DECEMBER 31, 2004 COMPARED TO YEAR ENDED DECEMBER 31, 2003
Revenues - Revenues for the year ended December 31, 2004 increased by $286.5
million, or 220%, to $416.6 million from $130.1 million for the year ended
December 31, 2003. Revenues derived from the USB flash drive market increased by
$217.9 million, or 275%, to $297.2 million, revenues derived from the mobile
handset and portable devices market increased by $52.4 million, or 302%, to
$69.8 million, and revenues derived from the embedded systems market increased
by $16.0 million, or 52%, to $46.7 million. Sales to the USB flash drive market
in 2004 include sales made by the Venture to Toshiba.
Cost of Goods Sold. - Our cost of goods sold for the year ended December 31,
2004 increased by $210.2 million to $303.3 million, an increase of 226% from
cost of goods sold of $93.1 million for the year ended December 31, 2003. Our
cost of goods sold as a percentage of total revenues increased from 71.6% for
the year ended December 31, 2003 to 72.8% for the year ended December 31, 2004,
primarily due to competitive pricing pressures.
Research and Development Expenses, Net. - Our gross research and development
expenses for the year ended December 31, 2004 increased by $9.7 million to $25.1
million, an increase of 62.9% from gross research and development expenses of
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$15.4 million for the year ended December 31, 2003. Our net research and
development expenses for the year ended December 31, 2004 increased by $10.1
million to $24.8 million, an increase of 68.8% from net research and development
expenses of $14.7 million for the year ended December 31, 2003. The increase in
our gross research and development expenses is attributable to our increase in
investments in the development of new products and the enhancement of existing
products. As a percentage of revenues, our net research and development expenses
decreased to 6.0% for the year ended December 31, 2004 from 11.4% for the year
ended December 31, 2003. During the year ended December 31, 2004, we recognized
$111,000 and $128,000 of research and development grants from IST and OCS,
respectively, compared to $84,000, $414,000 and $177,000 of research and
development grants we recognized from SIIRD, IST and OCS, respectively, during
the year ended December 31, 2003.
Selling and Marketing Expenses. - Selling and marketing expenses for the year
ended December 31, 2004 increased by $11.7 million, or 60%, to $31.1 million
from $19.4 million for the year ended December 31, 2003, due to increased
expenditures on broadening our sales channels to target additional geographic
and end markets, increased sales and marketing personnel and increased marketing
activity for existing and new opportunities, including our MegaSIM product. As a
percentage of revenues, our selling and marketing expenses decreased to 7.5% for
the year ended December 31, 2004 from 14.9% for the year ended December 31,
2003.
General and Administrative Expenses. - General and administrative expenses for
the year ended December 31, 2004 increased by $2.0 million, or 39.6%, to $6.9
million from $4.9 million for the year ended December 31, 2003. This increase
was attributable to our expanding operations to accommodate our substantial
growth in 2004, principally an increase in salaries, legal and accounting
expenses, rent expense and insurance premiums to accommodate our growing
operations and larger employee base. As a percentage of revenues, our general
and administrative expenses decreased to 1.6% for the year ended December 31,
2004 from 3.7% for the year ended December 31, 2003.
Financial Income, Net. - Financial income, net for the year ended December 31,
2004 increased by $1.2 million to $3.9 million from $2.7 million for the year
ended December 31, 2003, due primarily to our increased cash balance in 2004
resulting from our secondary equity offering in February 2004.
Minority interest - Minority interest in earnings of a consolidated subsidiary
was $30.4 million in 2004 compared to minority interest in losses of a
consolidated subsidiary of $0.1 million in 2003. Minority interest in the
earnings of the consolidated subsidiary in 2004 represents the proportional
share of earnings of the Venture attributable to Toshiba. Minority interest in
losses of a consolidated subsidiary in 2003 represents 20.5% of the proportional
losses of SmartCaps Ltd., a subsidiary that we established together with the
State of Israel, through the OCS.
Income Taxes. - Due to our carryforward of net operating losses as well as
various programs established by the Israeli government to encourage investment
in Israel, under which we enjoy tax holidays and reduced tax rates in Israel, we
did not incur any income tax expenses in 2003 and 2004 on a consolidated basis.
Net Income (Loss). - For the year ended December 31, 2004, we recognized net
income of $24.2 million compared to net income of $0.9 million for the year
ended December 31, 2003.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our discussion and analysis of our financial condition and results of operations
are based upon our consolidated financial statements, which have been prepared
in accordance with accounting principles generally accepted in the U.S. The
preparation of these financial statements requires us to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues and
expenses, and related disclosure of contingent liabilities. On an on-going
basis, we evaluate our estimates, including those related to product returns,
bad debts, inventories, investments, income taxes, warranty obligations, and
contingencies and litigation. We base our estimates on historical experience and
on various other assumptions that we believe are reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different
assumptions or conditions.
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We believe the following critical accounting policies affect our significant
judgments and estimates used in the preparation of our consolidated financial
statements:
REVENUE RECOGNITION - We generate most of our revenues from selling our
flash data storage products to end customers, distributors, retailers and
OEMs.
We recognize revenues from product sales in accordance with SEC Staff
Accounting Bulletin ("SAB") No. 104, "Revenue Recognition" when the earning
process is complete, 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
earlier of sale by distributors or retailers of our products to the end
customers or their return right expires. In addition, when introducing a
new product, we defer revenues generated by sales of such products until
such time as we estimate the acceptance of the product by the end customer
to be reasonably certain, since at the time of sale we do not have
sufficient experience to estimate the amount of returns for such products.
We exercise judgment and use estimates in connection with the determination
of the amount of product revenues to be recognized in each accounting
period.
ALLOWANCES FOR DOUBTFUL ACCOUNTS - We perform ongoing credit evaluations of
our customers' financial condition and we require collateral as we deem
necessary. We maintain allowances for doubtful accounts for estimated
losses resulting from the inability of our customers to make payments. In
judging the adequacy of the allowance for doubtful accounts, we consider
multiple factors including the aging of our receivables, historical bad
debt experience and the general economic environment. Management applies
considerable judgment in assessing the realization of receivables,
including assessing the probability of collection and the current credit
worthiness of each customer. If the financial condition of our customers
were to deteriorate, resulting in an impairment of their ability to make
payments, additional allowances may be required.
INVENTORY VALUATION - Inventories are stated at the lower of cost or
market. Our policy for valuation of inventory and commitments to purchase
inventory, including the determination of obsolete or excess inventory,
requires us to perform a detailed assessment of inventory at each balance
sheet date which includes a review of, among other factors, an estimate of
future demand for products within specific time horizons, valuation of
existing inventory, as well as product life-cycle and product development
plans. The estimates of future demand that we use in the valuation of
inventory are the basis for the revenue forecast, which is also consistent
with our short-term manufacturing plan. Inventory write-downs are also
provided to cover risks arising from slow moving items. We write down our
inventory for estimated obsolescence or unmarketable inventory equal to the
difference between the cost of inventory and the market value based upon
assumptions about future demand, market conditions, and, specifically,
prices of flash components. Our inventory impairment charges permanently
establish a new cost basis and are not subsequently reversed to income even
if circumstances later suggest that increased carrying amounts are
recoverable. Rather these amounts reverse into income only if, as and when
the inventory is sold. If our estimates regarding consumer demand are
inaccurate or changes in technology affect demand for certain products in
an unforeseen manner, we may be exposed to losses or gains in excess of our
established inventory write-down that could be material.
WARRANTIES - We provide for the estimated cost of product warranties at the
time revenue is recognized. The products we sell are covered by a warranty
for periods ranging from one year to five years. We accrue a warranty
reserve for estimated costs to provide warranty services. Our estimate of
costs to service the warranty obligations is based on historical experience
and expectation of future conditions. To the extent we experience increased
warranty claim activity or increased costs associated with servicing those
claims, our warranty accrual will increase, resulting in decreased gross
profits.
ACCOUNTING FOR INVESTMENTS - We evaluate whether entities in which we have
invested are variable interest entities within the meaning of FIN 46R. If
an entity is a variable interest entity, then we determine whether we are
the primary beneficiary of that entity by reference to our contractual and
business arrangements. Assessment of whether an entity is a variable
interest entity for purposes of FIN 46R and the determination of the
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primary beneficiary of such entity requires judgment and careful analysis
of all relevant facts and circumstances, including determining whether
other parties are related parties solely for the purposes of FIN 46R.
With respect to equity investments, we review the degree of control that
our investment and other arrangements give us over the entity in which we
have invested in order to confirm that these conclusions are correct.
Generally, after considering all factors, if we hold equity interests
representing less than 20% of the outstanding voting interests of an entity
in which we have invested, we use the cost method of accounting. If we hold
at least 20% but less than 50% of the outstanding voting interests of an
entity in which we have invested, we generally use the equity method of
accounting.
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, we record a
provision for the decline which results in a capital loss. Depending on the
amount of any such decline, a capital loss may have a material adverse
impact on our financial condition or results of operations. A judgmental
aspect of accounting for investments involves determining whether
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 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 other-than-temporary decline in value of an investment has
occurred. As of December 31, 2005, no such decline in value has been
indicated.
DEFERRED TAX ASSET - We provide a valuation allowance against deferred tax
assets if it is more likely than not that such an amount will not be
realized. In evaluating our ability to recover our deferred tax assets, in
full or in part, we consider all available positive and negative evidence
including our past operating results, the existence of cumulative losses in
the most recent fiscal years and our forecast of future taxable income on a
jurisdiction by jurisdiction basis. In determining future taxable income,
we are responsible for assumptions utilized, including the amount of
Israeli and international pre-tax operating income, the reversal of
temporary differences and the implementation of feasible and prudent tax
planning strategies. These assumptions require significant judgment about
the forecasts of future taxable income and are consistent with the plans
and estimates we use to manage the underlying businesses. At December 31,
2005, we carried a valuation allowance on our deferred tax assets of $4.7
million based on our expectation that it is more likely than not that our
subsidiaries will be able to utilize these losses prior to their
expiration.
ACQUIRED INTANGIBLES AND GOODWILL - Under SFAS No. 142, "Goodwill and Other
Intangible Assets," goodwill is not amortized but is subject to an annual
impairment test based upon its estimated fair value in accordance with SFAS
No. 142. We conduct an annual test for impairment of goodwill as of
September 30 of each year. The goodwill impairment test compares the
carrying value of our reporting units with the fair value at that date. We
determine fair value using a discounted cash flow analysis. This type of
analysis requires us to make assumptions and estimates regarding industry
economic factors and the profitability of future business strategies. It is
our policy to conduct impairment testing based upon our current business
strategy in light of present industry and economic conditions, as well as
future expectations. In assessing the recoverability of our goodwill, we
may be required to make assumptions regarding estimated future cash flows
and other factors to determine the fair value of the respective assets.
This process is subjective and requires judgment at many points throughout
the analysis. If our estimates or their related assumptions change in
subsequent periods, or if actual cash flows are below our estimates, we may
be required to record impairment charges for these assets.
In addition, we test for impairment periodically whenever events or
circumstances occur subsequent to our annual impairment tests that indicate
that the asset may be impaired. Indicators we consider important which
could trigger an impairment include, but are not limited to, significant
underperformance relative to historical or projected future operating
results, significant changes in the manner of use of the acquired assets or
the strategy for our overall business, significant negative industry or
economic trends, or a significant decline in our stock price for a
sustained period.
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Intangible assets arising on acquisition are capitalized and amortized to
the income statement over the period during which benefits are expected to
accrue. Where events and circumstances are present which indicate that the
carrying value may not be recoverable, we recognize an impairment loss.
Such impairment loss is measured by comparing the recoverable amount of the
asset with its carrying value. The determination of the value of such
intangible assets requires management to make assumptions regarding
estimated future cash flows and other factors to determine the fair value
of the respective assets. If these estimates or the related assumptions
change in the future, we could be required to record impairment charges.
CONTINGENCIES - We are involved in legal proceedings and other claims from
time to time. We are required to assess the likelihood of any adverse
judgments or outcomes to these proceedings, as well as potential ranges of
probable losses. A determination of the amount of reserves required, if
any, for any contingencies is made after careful analysis of each
individual claim. The required reserves may change due to future
developments in each matter or changes in approach, such as a change in the
settlement strategy in dealing with any contingencies, which may result in
higher net loss. If actual results are not consistent with our assumptions
and judgments, we may be exposed to gains or losses that could be material.
ROYALTY COMMITMENTS
Under our research and development agreements with Britech, we are required to
pay royalties at the rate of 2%-5% of sales of products developed with funds
provided by the Britech, up to an amount equal to 150% of the research and
development grants 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.
During 2005, we reached a settlement agreement with the OCS under which we paid
a total of $544,000 in respect of grants received from this institution. The
SIIRD project which started during 2004 failed, accordingly, the contingent
obligation in respect of these institutions ceased to exist
TAXATION
The general Israeli corporate tax rate was reduced in July 2004 from 36% to 35%
for the 2004 tax year, 34% for the 2005 tax year, and starting January 1, 2006,
the corporate tax rate was reduced to 31% for the 2006 tax year, 29% for the
2007 tax year, 27% for the 2008 tax year, 26% for the 2009 tax year and 25% for
the 2010 tax year and thereafter. However, the effective rate of tax of a
company that derives income from an approved enterprise may be considerably
lower than those rates. All of our production facilities have been granted
approved enterprise status under six separate programs pursuant to Israel's Law
for the Encouragement of Capital Investments, 1959, or the Capital Investments
Law. The primary tax benefits resulting from such status are described below.
During 2000, we purchased the assets of Fortress U&T Ltd., which had a facility
that had been granted approved enterprise status. In 2000, we initiated a
research and development facility in Omer, Israel, at the site of Fortress'
facilities. Income derived from our Omer facility is tax exempt for a 10-year
period, commencing in the year in which we first recognize Israeli taxable
income from that facility. However, the tax-exempt period will end no later than
the earlier of 12 years from the commencement of production, or 14 years from
receipt of the approval for the Omer approved enterprise. We have an agreement
with the Israeli tax authorities and the investment center as to the percentage
of our revenues which are deemed attributable to the facility in Omer.
In addition, income which is not attributable to our Omer facility and which is
derived from our approved enterprises 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 subject to a reduced tax rate during the rest of the period.
Income which is not attributable to the Omer facility and which is derived from
our approved enterprises that commenced operations after 1996 is tax exempt for
the first two years of the 10-year tax benefit period, and is subject to a
reduced tax rate during the rest of the period. The reduced tax rate is imposed
at a rate of between 10% and 25%, depending on the percentage of our Ordinary
Shares held by non-Israelis in that remaining period (the more of our Ordinary
Shares held by non-Israelis, the lower the tax rate). The tax benefit periods
for each respective approved enterprise will commence in the year in which we
first recognize Israeli taxable income from such approved enterprise, and will
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end no later than the earlier of 12 years from the commencement of production,
or 14 years from receipt of the approval for such approved enterprise.
Accordingly, the period relating to these approved enterprises will expire
between 2005 and 2012. The tax benefit periods for these approved enterprises
have not yet commenced except for the first program.
On April 1, 2005, an amendment to the Capital Investments Law came into effect
(the "Amendment") and has significantly changed the provisions of the Capital
Investments Law. The Amendment limits the scope of enterprises which may be
approved by the Investment Center by setting criteria for the approval of a
facility as a Privileged Enterprise, such as provisions generally requiring that
at least 25% of the Privileged Enterprise's income will be derived from export.
Additionally, the Amendment enacted major changes in the manner in which tax
benefits are awarded under the Capital Investments Law so that companies no
longer require Investment Center approval in order to qualify for tax benefits.
However, the Capital Investments Law provides that terms and benefits included
in any certificate of approval already granted will remain subject to the
provisions of the law as they were on the date of such approval. Therefore, our
existing Approved Enterprise will generally not be subject to the provisions of
the Amendment. As a result of the Amendment, tax-exempt income generated under
the provisions of the new law, will subject us to taxes upon distribution or
liquidation and we may be required to record deferred tax liability with respect
to such tax-exempt income. As of December 31, 2005, we did not generate income
under the provision of the new law.
We cannot be sure that approved enterprise programs will continue to be
available, or that we will continue to qualify for benefits under these
programs. In addition, the benefits available to an approved enterprise are
conditional upon the fulfillment of certain conditions stipulated in the
relevant laws and regulations and the criteria set forth in the certificate of
approval issued to us. We and our Israeli subsidiary have accumulated losses for
Israeli income tax purposes as of December 31, 2005, in the amount of $ 7.0
million. We expect to utilize these losses to offset income in 2006 and to have
taxable income in Israel with an effective tax rate of 0%. As of December 31,
2005, our U.S. subsidiary had net operating loss carryforwards for federal
income tax purposes of $10.9 million which expire beginning in the year 2012. It
also has net operating loss carryforwards for state tax purposes of $3.3 million
which expire beginning in the year 2010. 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, 2005, M-Systems China and M-Systems Japan had net operating
loss carryforward of $213,000 and $906,000, respectively, which can be carried
forward and offset against taxable income during the years 2006 to 2008.
INFLATION
Most of our sales are made in dollars, and most of our expenses are incurred in
dollars or New Israeli Shekels. We have not been materially affected by changes
in the rate of inflation in Israel. Inflation in the United States and our other
markets has not had a material effect on our results of operations.
LIQUIDITY AND CAPITAL RESOURCES
Through December 31, 2005, we have funded our operations primarily through the
sales of our Ordinary Shares, the issuance of convertible senior notes by our
subsidiary in March 2005, cash from operations and, to a lesser extent,
government grants to support our selling and marketing and research and
development efforts. Since our initial public offering, we have raised $329.0
million in the aggregate through public offerings and private placements of our
Ordinary Shares and convertible senior notes, including a secondary offering of
our Ordinary Shares in February 2004, which raised net proceeds of $95.4
million, and an offering of convertible senior notes in March 2005 which
provided net proceeds of $72.8 million. Our growth in revenues in 2005 created
greater working capital needs. We funded our working capital needs from cash
generated from operations due to the growth in profits and positive cash flow
that we experienced in 2005. We believe that our cash, cash equivalents, bank
deposits, marketable securities and cash generated from operations will be
sufficient to fund our anticipated working capital needs for the next twelve
months.
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As of December 31, 2005, our cash, cash equivalents, bank deposits and
marketable securities were $186.3 million ($87.4 million of this amount being
comprised of long-term marketable securities) compared to $181.0 million as of
December 31, 2004. This slight increase is mainly a result of our operating cash
flows, our offering of convertible senior notes, which provided net proceeds to
us of $72.8 million, less the recent purchase of equipment placed at Hynix and
the acquisition of MEE.
We had indebtedness of $71.4 million as of December 31, 2005, arising
exclusively from the indebtedness we incurred through our offering of
convertible senior notes in March 2005.
Our trade receivables increased to $131.9 million at December 31, 2005 from
$61.4 million at December 31, 2004, which increase reflects our increased sales
in the fourth quarter of 2005. We expect trade receivables to continue to
increase as our sales grow.
Our inventories increased from $59.4 million at December 31, 2004 to $76.3
million at December 31, 2005. The portion of our inventory that represents our
product sales for which revenues were not recognized during the period in
accordance with our revenue recognition policy, as well as inventory on
consignment to our customers, decreased from $21.9 million to $21.2 million over
this period. In 2005, we managed our inventory to allow us to hold lower levels
of inventory than in prior periods, in part due to our decision in the first
half of 2005 to reduce our inventory levels in order to reduce our exposure to
potential devaluations of on-hand inventory. As a result, notwithstanding the
significant increase in our revenues in 2005, we have maintained lower levels of
inventory as a percentage of revenues during 2005, in comparison to prior
periods. We do not believe that this reduction in inventory levels on a relative
basis has had a material effect on our liquidity needs.
As of December 31, 2005, we had an outstanding obligation of $36.2 million due
for the purchase of equipment to be placed at Hynix's premises under our
agreement with Hynix.
Operating Activities
Net cash provided by operating activities for the year ended December 31, 2005
was $63.6 million as compared to $27.8 million net cash provided by operating
activities for the year ended December 31, 2004. The increase in cash provided
by operating activities was primarily attributable to our increase in net income
to $52.6 million in 2005 from $24.2 million in 2004 and an increase in accounts
payable offset in part by an increase in accounts receivable.
Investing Activities
Net cash used in investing for the year ended December 31, 2005 was $94.2
million as compared to $75.9 million for the year ended December 31, 2004. The
increase was primarily attributable to our investments in marketable securities,
the acquisition of MEE and the investment in equipment related to our agreement
with Hynix.
Financing Activities
Net cash provided by financing activities for the year ended December 31, 2005
was $45.8 million as compared to $78.7 million for the year ended December 31,
2004. The decrease was primarily attributable to our issuance in 2005 of
convertible senior notes, which provided net proceeds of $72.8 million as
compared to the public offering that we completed in 2004, which provided net
proceeds of $96.9 million, and a cash distribution to the minority shareholder
of the Venture in the amount of $36.0 million in 2005 compared to $23.1 million
in 2004.
We expect that our uses of cash in the near future will be to fund working
capital and increases in selling and marketing expenditures and research and
development expenditures as well as for potential strategic acquisitions of, or
investments in, related businesses, product lines and technologies. However, we
currently have no commitments for any specific acquisitions, expenditures or
investments. We cannot assure you that the uses will not be different.
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For the year ended December 31, 2005, the aggregate amount of our capital
expenditures was $10.2 million. These expenditures were principally for the
construction of our second facility in Kfar-Saba and for the purchases of
computer hardware and software. In addition, during 2005 we purchased $63.8
million of equipment which we placed in Hynix's facilities under the terms of
our agreement with Hynix.
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