Commission File No. 1-11712
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 20-F/A
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004
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M-SYSTEMS FLASH DISK PIONEERS LTD.
(Exact name of Registrant as specified in its charter and
translation of Registrant's name into English)
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Israel
(Jurisdiction of incorporation or organization)
7 Atir Yeda St., Kfar Saba, Israel 44425
(Address of principal executive offices)
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Securities registered or to be registered pursuant to Section 12(b) of the Act:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
------------------- -----------------------------------------
N/A N/A
Securities registered or to be registered pursuant to Section 12(g) of the Act:
ORDINARY SHARES, NOMINAL VALUE 0.001 NEW ISRAELI SHEKEL PER SHARE
(Title of Class)
Securities for which there is a reporting obligation pursuant to Section 15(d)
of the Act:
NONE
(Title of Class)
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Indicate the number of outstanding shares of each of the issuer's classes of
capital or common stock as of the close of the period covered by the annual
report:
35,508,598
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days:
Yes [X] No [_]
Indicate by check mark which financial statements the registrant has elected to
follow:
Item 17 [_] Item 18 [X]
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EXPLANATORY NOTE
M-Systems Flash Disk Pioneers Ltd. ("M-Systems" or the "Company") is filing this
Form 20-F/A to amend Items 3, 4, 5, 15, 18 and 19 of its Annual Report on Form
20-F for the year ended December 31, 2004, which was filed on May 27, 2005 (the
"Original Report"). In 2003, the Company established a joint venture with
Toshiba, known as Twinsys Data Storage Limited Partnership, which is designed,
among other things, to enable each party to benefit from a portion of the other
party's respective sales of USB flash drives (the "Venture"). The Venture
commenced its activities in November 2003, and has been accounted for under the
equity method by the Company. The Company previously concluded that it was not
the primary beneficiary of the Venture under Financial Accounting Standard Board
Interpretation No. 46R ("FIN 46R"), which has been effective as of January 1,
2004, and, as a result, continued to account for its investment in the Venture
from inception using the equity method.
In connection with a review of the Original Report by the staff of the U.S.
Securities and Exchange Commission, the Company has reconsidered the manner in
which FIN 46R applies to the Venture. The Company has now concluded that it is
the primary beneficiary of the Venture and, therefore, that consolidation of the
Venture is required effective from January 1, 2004. Accordingly, the Company is
filing this Form 20-F/A to (i) restate its financial statements for the year
ended December 31, 2004 and (ii) revise the other information set forth in the
Original Report to reflect the consolidation of the Venture effective from
January 1, 2004. The consolidation of the Venture in the Company's financial
statements does not affect the Company's previously reported net income,
shareholders' equity or earnings per share. See note 1f to the Company's
financial statements included in this Form 20-F/A for a summary of the effects
of the restatement on the Company's previously issued financial statements
contained in the Original Report.
This Form 20-F/A does not otherwise revise, amend or update the information
(including any forward-looking statements) included in, or exhibits to, the
Original Report or reflect any events that have occurred after the Original
Report was filed on May 27, 2005.
PRELIMINARY NOTE
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THIS ANNUAL REPORT CONTAINS HISTORICAL INFORMATION AND FORWARD-LOOKING
STATEMENTS. STATEMENTS LOOKING FORWARD IN TIME ARE INCLUDED IN THIS ANNUAL
REPORT PURSUANT TO THE "SAFE HARBOR" PROVISION OF THE PRIVATE SECURITIES
LITIGATION REFORM ACT OF 1995. THEY INVOLVE KNOWN AND UNKNOWN RISKS AND
UNCERTAINTIES THAT MAY CAUSE OUR ACTUAL RESULTS IN FUTURE PERIODS TO BE
MATERIALLY DIFFERENT FROM ANY FUTURE PERFORMANCE SUGGESTED HEREIN, INCLUDING ALL
OF THE RISKS AND UNCERTAINTIES DISCUSSED BELOW IN ITEM 3.D "RISK FACTORS" AND
ELSEWHERE IN THIS REPORT. FURTHERMORE, WE OPERATE IN AN INDUSTRY SECTOR WHERE
SECURITIES VALUES MAY BE VOLATILE AND MAY BE INFLUENCED BY ECONOMIC AND OTHER
FACTORS BEYOND THE COMPANY'S CONTROL. FUTURE EVENTS AND ACTUAL RESULTS COULD
DIFFER MATERIALLY FROM THOSE SET FORTH IN, CONTEMPLATED BY OR UNDERLYING THE
FORWARD-LOOKING STATEMENTS AND THUS RELIANCE SHOULD NOT BE PLACED ON THESE
FORWARD-LOOKING STATEMENTS, WHICH ARE APPLICABLE ONLY AS OF THE DATE HEREOF. IN
THE CONTEXT OF THE FORWARD-LOOKING INFORMATION PROVIDED IN THIS ANNUAL REPORT
AND IN OTHER REPORTS, PLEASE REFER TO THE DISCUSSIONS OF RISK FACTORS DETAILED
IN, AS WELL AS THE OTHER INFORMATION CONTAINED IN, THIS ANNUAL REPORT AND OUR
OTHER FILINGS WITH THE SECURITIES AND EXCHANGE COMMISSION.
WE URGE YOU TO CONSIDER THAT STATEMENTS THAT USE THE TERMS "BELIEVE," "DO NOT
BELIEVE," "EXPECT," "PLAN," "INTEND," "ESTIMATE," "ANTICIPATE," "PROJECT" AND
SIMILAR EXPRESSIONS ARE INTENDED TO IDENTIFY FORWARD-LOOKING STATEMENTS. THESE
STATEMENTS REFLECT OUR CURRENT VIEWS WITH RESPECT TO FUTURE EVENTS AND ARE BASED
ON ASSUMPTIONS AND ARE SUBJECT TO RISKS AND UNCERTAINTIES.
EXCEPT AS REQUIRED BY APPLICABLE LAW, INCLUDING THE SECURITIES LAWS OF THE
UNITED STATES, WE DO NOT INTEND TO UPDATE OR REVISE ANY FORWARD-LOOKING
STATEMENTS, WHETHER AS A RESULT OF NEW INFORMATION, FUTURE EVENTS OR OTHERWISE
AND WE DISCLAIM ANY OBLIGATION TO PUBLICLY REVISE ANY SUCH STATEMENTS TO REFLECT
ANY CHANGE IN EXPECTATIONS OR IN EVENTS, CONDITIONS, OR CIRCUMSTANCES ON WHICH
ANY SUCH STATEMENTS MAY BE BASED.
2
INDEX
PART ONE
Item 1. Identity of Directors, Senior Management and Advisors - NOT APPLICABLE
Item 2. Offer Statistics and Expected Timetable - NOT APPLICABLE
Item 3. Key Information
Item 4. Information on the Company
Item 5. Operating and Financial Review and Prospects
Item 6. Directors, Senior Management and Employees
Item 7. Major Shareholders and Related Party Transactions
Item 8. Financial Information
Item 9. The Offer and Listing
Item 10. Additional Information
Item 11. Quantitative and Qualitative Disclosures About Market Risk
Item 12. Description of Securities Other Than Equity Securities- NOT APPLICABLE
PART TWO
Item 13. Defaults, Dividend Arrearages and Delinquencies - NOT APPLICABLE
Item 14. Material Modifications to the Rights of Security Holders and Use of
Proceeds - NOT APPLICABLE
Item 15. Controls and Procedures
Item 16. [Reserved]
Item 16A. Audit Committee Financial Expert
Item 16B. Code of Ethics
Item 16C. Principal Accountant Fees and Services
Item 16D. Exemptions from the Listing Standards for Audit Committees
Item 16E. Purchases of Equity Securities by the Issuer and Affiliated Purchasers
PART THREE
Item 17. Financial Statements - NOT APPLICABLE
Item 18. Financial Statements
Item 19. Exhibits
EXHIBIT INDEX
SIGNATURES
3
PART I
Unless the context otherwise requires, all references in this annual report to
"M-Systems", "we", "our", "us" and the "Company" refer to M-Systems Flash Disk
Pioneers Ltd. and its consolidated subsidiaries. References to "dollars" or $
are to United States dollars.
All references herein to "Ordinary Shares" shall refer to our Ordinary Shares,
nominal value 0.001 New Israeli Shekel per share.
ITEM 1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISORS
- - NOT APPLICABLE
ITEM 2. OFFER STATISTICS AND EXPECTED TIMETABLE
- - NOT APPLICABLE
4
ITEM 3. KEY INFORMATION
A. SELECTED FINANCIAL DATA
The following summary selected consolidated financial data was derived from our
audited Consolidated Financial Statements, which have been prepared in
accordance with accounting principles generally accepted in the United States.
Commencing with our 2004 results, we adopted a new presentation method for our
consolidated statement of operations. See "Item 5A: Operating Results" in the
paragraph titled "Overview" for further description.
As discussed in Note 1f to the Consolidated Financial Statements contained in
Item 18 of this Report, the Consolidated Financial Statements at December 31,
2004 and for the year then ended have been restated for the matters set forth
therein.
This data should be read in conjunction with, and are qualified in their
entirety by, our audited Consolidated Financial Statements and notes thereto,
which are presented elsewhere herein and by reference to "Item 5: Operating and
Financial Review and Prospects."
SUMMARY CONSOLIDATED FINANCIAL INFORMATION
YEAR ENDED DECEMBER 31,
-----------------------------------------------------------------------
2000 2001 2002 2003 2004
(RESTATED)
------------ ------------ ------------ ------------ -------------
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
STATEMENT OF OPERATIONS DATA:
Revenues................................................... 92,589 44,678 64,817 130,054 416,560
------------ ------------ ------------ ------------ -------------
Costs and expenses:
Cost of goods sold...................................... 64,281 60,573 44,415 93,114 303,320
Research and development, net.......................... 7,364 13,290 11,974 14,714 24,834
Selling and marketing................................... 11,535 12,122 12,547 19,419 31,077
General and administrative.............................. 2,809 3,913 4,000 4,852 6,904
In-process research and development write off........... 6,215 -- -- -- --
------------ ------------ ------------ ------------ -------------
Total costs and expenses................................... 92,204 89,898 72,936 132,099 366,135
------------ ------------ ------------ ------------ -------------
Operating income (loss).................................... 385 (45,220) (8,119) (2,045) 50,425
Financial income,net....................................... 5,875 4,628 2,619 2,711 3,920
Other income (expenses),net................................ -- (1,193) -- 131 183
------------ ------------ ------------ ------------ -------------
Income (loss) before minority interest in losses
(earnings) of subsidiaries................................. 6,260 (41,785) (5,500) 797 54,528
Minority interest in losses (earnings) of subsidiaries..... 19 -- -- 117 (30,378)
------------ ------------
Net income (loss).......................................... $ 6,279 $ (41,785) $ (5,500) $ 914 $ 24,150
============ ============ ============ ============ =============
Basic net earnings (loss) per share........................ $ (0.25) $ (1.56) $ (0.20) $ 0.03 $ 0.71
============ ============ ============ ============ =============
Diluted net earnings (loss) per share...................... $ (0.22) $ (1.56) $ (0.20) $ 0.03 $ 0.66
============ ============ ============ ============ =============
Number of shares used in computing basic net
earnings (loss) per share.................................. 25,368,286 26,715,683 26,953,410 28,178,228 34,195,642
Number of shares used in computing diluted net
earnings (loss) per share.................................. 28,040,611 26,715,683 26,953,410 30,513,485 36,823,118
5
SUMMARY CONSOLIDATED FINANCIAL INFORMATION (CONT.)
YEAR ENDED DECEMBER 31,
-----------------------------------------------------------------------
2000 2001 2002 2003 2004
(RESTATED)
------------ ------------ ------------ ------------ -------------
(IN THOUSANDS)
BALANCE SHEET DATA:
Cash, cash equivalents, short-term bank deposits,
short term and long term marketable securities............. $ 120,476 $ 97,236 $ 94,094 $ 79,807 $ 181,038
Working capital............................................ 155,694 87,264 70,297 65,827 215,331
Total assets............................................... 185,251 145,451 148,202 180,488 343,488
Shareholders' equity....................................... 172,799 133,051 128,290 140,625 265,065
B. CAPITALIZATION AND INDEBTEDNESS
- - NOT APPLICABLE
C. REASONS FOR THE OFFER AND USE OF PROCEEDS
- - NOT APPLICABLE
6
D. RISK FACTORS
You should carefully consider the risks described below and in the documents we
have incorporated by reference into this annual report before making an
investment decision. The risks described below and in the documents we have
incorporated by reference into this prospectus are not the only ones facing our
Company. Our business, financial condition or results of operations could be
materially adversely affected by any of these risks. The trading price of our
Ordinary Shares could decline due to any of these risks, and you may lose all or
part of your investment.
RISKS RELATED TO OUR BUSINESS AND PRODUCTS
WE HAVE A HISTORY OF LOSSES AND WE MAY INCUR ADDITIONAL LOSSES IN THE FUTURE.
We have a history of losses. Other than in 2000, 2003 and 2004, in which we were
profitable on an annual basis, we have incurred losses in each of our last ten
years of operation. While we had net income in 2003, we had an operating loss in
that year of $ 2.0 million. As of December 31, 2004, we had an accumulated
deficit of approximately $ 32 million. We cannot assure you that we will be able
to maintain our profitability.
OUR QUARTERLY OPERATING RESULTS HAVE FLUCTUATED SIGNIFICANTLY IN THE PAST AND
MAY FLUCTUATE SIGNIFICANTLY IN THE FUTURE, WHICH MAY ADVERSELY AFFECT THE PRICE
OF OUR SECURITIES.
Our quarterly operating results have fluctuated significantly in the past and we
expect that they will continue to fluctuate in the future. This fluctuation
might cause our quarterly operating results in future periods to be below the
expectations of securities analysts and investors. If that occurs, the market
price of our securities could be materially and adversely affected.
OUR RELATIVE MIX OF PRODUCTS VARIES QUARTERLY, WHICH CAN NEGATIVELY AFFECT OUR
GROSS MARGINS AND PROFITABILITY.
Our product mix varies quarterly, which affects our overall gross margins and
profitability. Each of our products has different associated gross margins,
which vary quarterly based on market dynamics, competition, our average selling
prices and our cost of materials. To the extent the percentage of our revenues
derived from lower margin products increases in any given period, our overall
gross margins will decline for that period. Currently, sales of our DiskOnKey
product to the universal serial bus, or USB, flash drive market carry lower
margins than our other products. Consequently, an increase in the percentage of
revenues deriving from sales of DiskOnKey products could decrease our margins,
adversely affecting our profitability. Revenues derived from our non-product
revenue sources - specifically license fees and royalties - carry no associated
cost of goods sold. Consequently, if our non-product revenues decrease as a
percentage of our total revenues, our gross margins and profitability could be
adversely affected. Depending on the relative mix of sales of our products and
the relative contribution our product and non-product revenues, our gross
margins could fluctuate significantly from quarter to quarter and may be
negatively affected in any given quarter.
7
WE TARGET HIGH GROWTH MARKETS, WHICH CAN EXPERIENCE INTENSE COMPETITION, LEADING
TO REDUCED MARGINS AND DECREASED PROFITABILITY.
Fast growing markets frequently attract competition, including from large U.S.
and international companies, which can lead to loss of market share, increased
pricing pressures and compression of margins. We target markets that have
enjoyed substantial growth and may continue to experience fast growth. In
particular, the USB flash drive market has experienced significant growth, which
has attracted numerous competitors, leading to aggressive price competition and
low margins. As a result, our revenues from sales to the USB flash drive market
currently have the lowest associated margins among our product revenues.
Similarly, the multimedia mobile handset market has experienced significant
growth and become increasingly competitive, which may lead to pricing pressure
and margin compression. To the extent we continue to target fast growing
markets, we are likely to experience significant competition and pricing
pressures, which may lead to loss of market share and loss of revenues, which
could negatively affect our profitability.
WE ARE DEPENDENT ON DISKONKEY AND MOBILE DISKONCHIP FOR THE VAST MAJORITY OF OUR
SALES. AS A RESULT, OUR BUSINESS WILL SUFFER IF DEMAND FOR EITHER OF THESE
PRODUCTS DECLINES.
The vast majority of our revenues are generated by sales of DiskOnKey and Mobile
DiskOnChip. If demand for either of these products declines and we cannot
develop new products to offset this decline, or if the new products that we
develop are not successful in the market, our sales would decline. Any
significant decrease in the sales of our DiskOnKey or Mobile DiskOnChip products
would have a material adverse effect on our business, financial condition and
results of operations.
DEMAND FOR INCREASINGLY HIGHER CAPACITY DATA STORAGE MAY DECLINE, WHICH COULD
CAUSE OUR SALES TO DECLINE.
Our target markets have recently enjoyed significant growth, driven in part by
the decline in prices for flash memory components, which in turn has enabled us
to offer higher capacity storage at lower prices. A portion of the growth in our
sales to the USB flash drive market is attributable to consumers replacing their
existing personal data storage medium with higher capacity data storage, as the
prices for higher capacity storage decline. Similarly, a portion of the growth
in our sales to the multimedia mobile handset is attributable to consumers
demanding applications in handsets that require high capacity data storage, such
as embedded digital cameras and MP3 playback functionality. However, the demand
for increasingly higher capacity storage may diminish as consumers achieve
sufficient capacity for their data storage applications. In lieu of upgrading to
higher data storage capacities, consumers may opt to buy lower capacity data
storage products at lower prices, or entirely forego replacing their existing
high capacity data storage medium or device. To the extent consumer demand for
higher capacity data storage declines, our sales could decline, which could have
an adverse affect on our business and results of operations.
THE AMOUNT OF LICENSE FEES AND ROYALTIES PAYABLE TO US FROM THIRD PARTIES VARIES
QUARTERLY AND MAY DECLINE IN THE FUTURE, WHICH WOULD ADVERSELY AFFECT OUR GROSS
MARGINS AND RESULTS OF OPERATIONS.
The license fees and royalties payable to us from our patent cross license and
other agreements with third parties, such as Samsung Electronics Co., Ltd. and
Toshiba Corporation, are often variable and can fluctuate from period to period
making it difficult to predict our license fees and royalty revenues. Our
intellectual property strategy includes licensing our patents and technology to
third parties. Under these arrangements, we earn license fees and royalties on
individually negotiated terms. Our income from license fees and royalties can
fluctuate significantly from quarter to quarter as a portion of this income
comes from royalties based on actual sales by our licensees. As a result, our
license and royalty revenues have fluctuated in the past and are likely to
continue to fluctuate in the future. Given that license and royalty revenues
have no associated cost of goods sold, our gross margins and net income are
likely to fluctuate more with changes in license and royalty revenues than with
changes in product revenues. In addition, our license and royalty revenues may
decline in the future as our existing license agreements expire or caps are
reached, which could adversely affect our results of operations.
8
THE OPERATING RESULTS OF OUR VENTURE WITH TOSHIBA MAY VARY QUARTERLY AND MAY
DECLINE IN THE FUTURE, WHICH CAN ADVERSELY AFFECT OUR REVENUES, GROSS MARGINS
AND RESULTS OF OPERATIONS.
In the USB flash market, we generate a portion of our revenues through the
Venture (as further described under Item 4.B below "Business Overview" in the
paragraph titled "Toshiba"). The Venture is designed, among other things, to
enable us and Toshiba to benefit from a portion of each party's respective sales
of USB flash drives. We consolidate the results of the Venture, although we
reflect in our net income only our proportional share of the net income of the
Venture. Our revenues, gross margins and operating income derived from the
Venture are dependent upon various factors, including the sales of USB flash
drives from the Venture to Toshiba, Toshiba's sales of USB flash drives to its
customers, and the Venture's cost of purchasing flash memory components from
Toshiba These factors could fluctuate significantly from quarter to quarter,
which could adversely affect our revenues, gross margins and operating income
and make it difficult to predict them.
OUR OPERATING RESULTS WILL BE ADVERSELY AFFECTED BY A DECLINE IN SALES MADE BY
THE VENTURE TO TOSHIBA.
We consolidate the results of the Venture. A portion of the revenues of the
Venture, which historically has represented approximately half of the revenues
of the Venture, are attributable to sales made by the Venture to Toshiba.
Toshiba purchases USB flash drives from the Venture and sells them to its
customers. We have no control over Toshiba's sales to its customers, which can
vary from quarter to quarter, and we have no visibility into the expected demand
of Toshiba's customers. Moreover, Toshiba may purchase USB flash drives from
sources other than the Venture. Our revenues and operating results will
fluctuate depending upon the amount of sales made by the Venture to Toshiba in
any given period. To the extent sales by the Venture to Toshiba decline, our
revenues and operating results will be adversely affected.
OUR REVENUES AND GROSS MARGINS HAVE BEEN, AND IN THE FUTURE MAY BE, ADVERSELY
AFFECTED BY VOLATILITY IN THE MARKET PRICE OR IN THE AVAILABILITY OF FLASH
MEMORY COMPONENTS.
For most of our products, we rely to a significant extent on the purchase of
flash memory components, or custom made products incorporating flash components,
from third party manufacturers. As a result, we are exposed to the risks
associated with the ongoing volatility in the price of flash components. For
example, prices of these components increased in the second half of 2003 due to
industry-wide shortages in supply, and declined in 2004 due to excess supply in
the market.
If the price of flash components declines, the value of our inventory will fall
and we may be compelled to write-down the value of our inventory, which may
result in a significant decrease in our gross margins. In addition, we may need
to reduce significantly our selling prices, which may result in a decline in our
revenues and gross margins. For example, during the first half of 2001, flash
component prices decreased significantly due to both the worldwide economic
slowdown and the excess supply of flash components. This price decrease caused
our revenues to decline significantly and required us to write-down $ 30.2
million of our inventory in the first half of 2001. Moreover, we expect the
number of suppliers of flash components to increase in the near term, which
could increase the supply of flash memory components in the market and reduce
the market prices of these components.
Alternatively, if the market price for flash components increases (for example,
as a result of increased demand for any reason or due to flash memory supply
constraints), we may be unable to pass these price increases on to our customers
and, consequently, our gross margins would decline. If flash component prices
increase in the future, our gross margins could suffer, or we may not be able to
sell our products at a profit, resulting in a loss of revenues and market share
or in net losses.
In addition, in the past, there have been constraints in supply of flash
components. If these supply constraints were to recur, our suppliers may not
allocate to us sufficient flash memory components to enable us to meet the
orders of all our customers, forcing us to decline orders or shift product
orders to the following quarter. Irrespective of the movement in flash component
pricing, to the extent we are not able to obtain sufficient supply of flash
components, our results of operations would be adversely affected.
9
THERE IS SEASONALITY IN OUR BUSINESS, WHICH MAY LEAD TO FLUCTUATIONS IN OUR
PRODUCT SALES AND COULD ADVERSELY AFFECT OUR SALES IN THE FIRST HALF OF THE
FISCAL YEAR.
Sales of our DiskOnKey and Mobile DiskOnChip products may be subject to
seasonality arising from the seasonal purchasing patterns of consumer end-users.
We have recently experienced strong demand for our Mobile DiskOnChip products in
the second half of 2004, and for our DiskOnKey product in the fourth quarter of
2004, in each case due to end-of-year holiday demand. We expect demand in the
first half of 2005 to be weaker, due in part to the strong sales during the 2004
holiday season, which would adversely affect our product sales and profitability
in the first half of 2005.
EXCESS OR OBSOLETE INVENTORY COULD ADVERSELY AFFECT OUR GROSS MARGINS.
We may accumulate a higher level of inventory of raw materials, including flash
components, and finished goods than we need due to various reasons including:
o an anticipation of a shortage in components;
o unrealized sales forecasts;
o long-term commitments to our suppliers for certain components without
a back-to-back commitment from our customers to purchase finished
products;
o consignment sales to some of our customers;
o cancellation of orders from customers; and
o an anticipation of an increase in prices.
In the event that we maintain a higher level of inventory than we need, certain
components or products, if warehoused for too long, may be devalued due to a
decrease in the market value of flash components, or rendered obsolete, which
might cause us to incur an inventory write-off. Any devaluation or write-off of
inventory would have an adverse effect on our business and results of
operations.
CONSIGNMENT SALES REQUIRE US TO SUPPLY OUR PRODUCTS TO OUR CUSTOMERS IN ADVANCE
OF SALES, WHICH COULD ADVERSELY AFFECT OUR BUSINESS AND RESULTS OF OPERATIONS.
Under some of our customer agreements, we deliver finished goods inventory to
our customers in distribution hubs, where the inventory is held on consignment.
We are obligated to supply in advance based on our customer's forecasts, but the
customer is not obligated to purchase the product until it removes the product
from the hub and takes title to the product, which it may do at its discretion.
The time lag between our delivery and the customer taking title may be as long
as weeks or months. To the extent the price for those products drops during that
time lag, our customers enjoy the lower prices. In an environment of rapidly
declining prices for flash components and corresponding declines in prices for
our products, we are exposed to the risk that our margins and profitability will
be adversely affected by extended time lags between delivery and transfer of
title on our consignment sales. If time lags on our consignment sales lengthen
and product prices drop, our business and results of operations could be
adversely affected.
IF WE CONTINUE TO GROW, OUR GROWTH MAY STRAIN OUR OPERATIONS INFRASTRUCTURE AND
OUR SUPPLY CHAIN.
In recent years, our revenues have grown significantly in response to increased
customer demand. If this growth continues, it may strain our operations
infrastructure and supply chain. To meet this growth, we substantially increased
our employee base during 2003 and 2004, from approximately 330 employees on
January 1, 2003 to approximately 513 employees on December 31, 2004. If our
growth continues, we will have to continue hiring additional employees. The
hiring of new employees requires the allocation of resources for the training
and management of the employees, and the integration of the employees into our
existing staff. We also will need to identify and manage additional third party
subcontractors to accommodate the growth. In addition, our logistical
infrastructure, systems, procedures and controls may not be adequate to support
our anticipated growth, which could adversely affect our business, financial
condition and results of operations.
10
WE DEPEND ON OUR KEY PERSONNEL, INCLUDING OUR EXECUTIVE OFFICERS, THE LOSS OF
WHOM COULD DISRUPT OUR BUSINESS.
Our success greatly depends on the continued contributions of our senior
management and other key research and development, sales, finance, marketing and
operations personnel, including Mr. Dov Moran, our Chairman, President and Chief
Executive Officer. We cannot assure you that we will be successful in retaining
our key personnel. Any loss of the services of these key personnel could
adversely affect our business, at least until a suitable replacement is
identified, hired and acclimated.
WE WILL NOT BE ABLE TO SUSTAIN CONTINUED GROWTH UNLESS WE ARE SUCCESSFUL IN
ATTRACTING AND RETAINING ADDITIONAL QUALIFIED PERSONNEL.
The success of our business depends on our ability to attract and retain highly
qualified management, technical, finance, and sales and marketing personnel. In
particular, we require highly qualified technical personnel who are capable of
developing technologies and products and providing the technical support
required by our customers. Further, to the extent we continue to experience
rapid growth, we will need management personnel who can effectively manage that
growth as well as ensure that our organization adapts effectively to that
growth. Individuals who possess these qualifications are in high demand, and we
may not be successful in attracting, integrating and retaining them when and as
needed in the various geographic regions in which we operate. In the past, we
have from time to time experienced difficulty hiring the necessary engineering
and sales and marketing personnel to support our growth.
OUR BUSINESS DEPENDS SIGNIFICANTLY UPON SALES OF PRODUCTS IN THE CONSUMER
MARKET. THIS MARKET IS EXTREMELY COMPETITIVE AND IS HIGHLY SUSCEPTIBLE TO
FLUCTUATIONS IN DEMAND.
Our DiskOnKey and Mobile DiskOnChip products are designed for consumer
electronic applications. The consumer market is intensely competitive and price
sensitive. Sales of consumer electronic products have historically been
dependent upon discretionary spending by consumers. Consumers may defer or alter
purchasing decisions based on economic conditions or other factors, and
accordingly could reduce demand for our products, or products of our customers
which incorporate our products. Softening consumer demand for consumer
electronic products has in the past caused a decline in the demand for our
products. As a result, there is uncertainty with respect to our expected
revenues, and delays or reductions in consumer spending on electronics and
related products could adversely affect our revenues and operating results.
WE DEPEND ON THE ABILITY OF ORIGINAL EQUIPMENT MANUFACTURERS, OR OEMS, AND
CONSUMER ELECTRONICS COMPANIES WHO PURCHASE OUR PRODUCTS TO ACHIEVE BROAD MARKET
ACCEPTANCE FOR THEIR PRODUCTS. IF THESE OEMS AND CONSUMER ELECTRONICS COMPANIES
DO NOT SUCCEED IN SELLING THEIR PRODUCTS, THIS WILL REDUCE DEMAND FOR OUR
PRODUCTS AND OUR REVENUES WILL BE ADVERSELY AFFECTED.
Our customers are primarily OEMs and consumer electronics companies who
repackage or resell our products under their own private label to consumers or
incorporate our products into their own products, which are then sold to
consumers. We are dependent upon the success of our customers and the broad
market acceptance of their products. To the extent that consumers choose to
purchase USB flash drives, or multimedia mobile handsets, from competitors of
our customers, our revenues and operating results will be adversely affected.
WE MAY INCREASE OUR DIRECT SALES EFFORTS, WHICH COULD INCREASE OUR COSTS AND
ADVERSELY AFFECT OUR RESULTS OF OPERATIONS.
In addition to selling our products to OEMs, we may consider in the future
pursuing a direct sales strategy that provides us greater access to retailers
and end-users. To the extent we increase our direct sales, we will be exposed to
additional risks, including potentially losing OEM customers who view our direct
sales efforts as competitive, as well as risks inherent to direct sales efforts,
such as increased sales and marketing expenditures, having to provide price
protection or rebates to retailers, and more frequent and rapid selling price
declines. If these risks materialize, they could adversely affect our results of
operations.
11
UNDETECTED HARDWARE AND SOFTWARE ERRORS OR DEFECTS MAY INCREASE OUR COSTS AND
IMPAIR THE MARKET ACCEPTANCE OF OUR PRODUCTS.
Our products may contain undetected errors or defects. These could result either
from errors or defects in software, components or products designed or
manufactured by or for us that we fail to detect, or errors or defects in
components supplied by third parties. Some of our customers integrate our
products into their applications together with products they acquire from other
vendors. As a result, when problems occur in an application, it may be difficult
to identify the component that caused the problem. Regardless of the source of
these errors or defects, we will need to divert the attention of engineering
personnel from our product development and support efforts to address the
detection of the errors or defects. These errors or defects could cause us to
incur warranty or repair costs, liability claims or lags or delays. We could be
forced to recall products that were already sold into the market by our
customers. Our insurance policies may not provide sufficient protection should a
claim be asserted against us. Moreover, the occurrence of errors or defects,
whether caused by our products or the products of another vendor, may
significantly harm our relations with customers, or result in the loss of
customers, injure our reputation and impair market acceptance of our products.
WE MAY MAKE INVESTMENTS IN COMPANIES OR TECHNOLOGIES, WHICH MAY DISTRACT OUR
MANAGEMENT AND DISRUPT OR OTHERWISE HARM OUR BUSINESS, AND MAY PROVE TO BE
UNSUCCESSFUL.
One of our strategies is to make investments in complementary businesses,
technologies or products if appropriate opportunities arise. We have made
several investments in companies or assets of companies in the past and we may
in the future invest in additional businesses, products or technologies. These
investments could disrupt our ongoing business, distract our management and
employees, increase our expenses and adversely affect our results of operations.
In addition, any investment in another company will be subject to the risks
faced by that company. To the extent that any company in which we invested in
the past or any company in which we invest in the future thereafter loses value
or does not succeed, we may lose part or all of our investment. We may also have
to write down the value of our investment in our financial statements to the
extent that the carrying value of an investment exceeds its fair market value.
WE MAY MAKE ACQUISITIONS THAT RESULT IN DIFFICULTIES IN INTEGRATING THE
OPERATIONS, PERSONNEL AND PRODUCTS OF THE ACQUIRED COMPANIES OR RESULT IN
SIGNIFICANT CHARGES OR OTHERWISE ADVERSELY AFFECT OUR RESULTS OF OPERATIONS.
We may grow our business through acquisitions of companies, products or
technologies that allow us to expand our existing product offerings or sales
channels or enhance our technological capabilities. We cannot assure you that we
will be able to identify suitable acquisition candidates in the future, or if we
do identify suitable candidates that we will be able to make the acquisitions on
commercially acceptable terms or at all. If we acquire another company, we could
encounter difficulty integrating that company's personnel, operations,
technology and products into our own. The key personnel of the acquired company
may decide not to work for us. These difficulties could disrupt our ongoing
business, distract our management and employees, increase our expenses and
adversely affect our results of operations. We may incur indebtedness or issue
equity securities or securities convertible into equity to pay for any future
acquisitions, which could be dilutive to our existing shareholders.
Alternatively, acquisitions made entirely or partially for cash may reduce our
cash reserves. Furthermore, acquisitions may require one-time charges and can
result in increased debt or contingent liabilities, adverse tax consequences,
amortization of intangible assets or impairment of goodwill, any of which could
negatively impact our results of operations.
IF WE FAIL TO MANAGE OUR INVENTORY EFFICIENTLY, OUR GROSS MARGINS COULD BE
ADVERSELY AFFECTED.
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 Mobile DiskOnChip
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
surplus inventory, we might be required to write down the value of the inventory
as flash component prices drop, adversely affecting our gross margins and
results of operation.
12
THE USB FLASH DRIVE MARKET IS CHARACTERIZED BY HIGH VOLATILITY OF DEMAND, MAKING
IT DIFFICULT FOR US TO PLAN OUR OPERATIONS.
The USB flash drive market is characterized by highly volatile demand, making it
difficult for us to plan our inventory levels, production plans and operations.
For example, our USB flash drive customers expect us to fill orders on a
short-term basis, often in as little as two weeks. Our suppliers of raw
materials for these products, particularly flash components, require us to place
orders months in advance. We must make commitments to our suppliers in advance
of receiving orders from our customers based upon our forecast of expected
customer demand. Similarly, our internal production plans and resource
allocation are based upon our forecast of expected customer demand. Due to the
volatility of demand, we risk over- or under-estimating customer demand in any
given period. If we maintain inventory levels or increase production in
anticipation of orders that do not materialize, our profitability will decline.
Alternatively, if we do not maintain sufficient inventory levels or do not
commit sufficient production or other resources to meet actual demand, we risk
losing customers to other manufacturers who can supply sufficient product to our
customers. Losing customers could adversely affect our revenues and our
long-term profitability.
WE CUSTOMIZE OUR MOBILE DISKONCHIP PRODUCT TO MEET OUR CUSTOMERS' DESIGN
REQUIREMENTS, EXPOSING US TO THE RISK OF OBSOLETE INVENTORY AND LOWER GROSS
MARGINS.
Our Mobile DiskOnChip is incorporated into the design of our customers'
multimedia mobile handsets. We often customize our product by combining the
Mobile DiskOnChip with other memory chips in a single compact package. After a
design win, our customers provide us with forecasts of their anticipated
requirements, based on which we produce customized products in anticipation of
the customer purchasing our product for the new handset design. However, the
customer is not obligated to purchase our product until it places purchase
orders with us, and may decide, prior to placing orders, not to commercialize
the handset design or to order less than initially forecasted, thereby rendering
our inventory of customized products or a portion thereof obsolete, as the
customized product may not be marketable for other handset designs. Obsolete
inventory will reduce our gross margins and could adversely affect our
profitability.
SALES TO A SMALL NUMBER OF CUSTOMERS REPRESENT A SIGNIFICANT PORTION OF OUR
REVENUES. IF WE WERE TO LOSE ANY OF OUR SIGNIFICANT CUSTOMERS, OR IF WE
EXPERIENCE A REDUCTION IN DEMAND FROM THEM, OUR REVENUES AND OPERATING RESULTS
WOULD SUFFER.
More than half of our revenues come from a small number of customers.
Specifically, sales to our top three customers accounted for approximately 34%
of our revenues in 2002, 30% in 2003 and 38% in 2004, and sales to our top 10
customers accounted for approximately 56% of our revenues in 2002, 55% in 2003
and 64% in 2004. In addition, in 2004, sales to two of our customers each
represented more than 10% of revenues. If we were to lose any of our significant
customers or experience any material reduction in orders from these customers,
our revenues and operating results would suffer. Because the substantial
majority of our sales are made by means of standard purchase orders rather than
long-term commitments, we cannot assure you that these customers will continue
to purchase quantities of our products at current levels, or at all. In
particular, due to the nature of the market for our DiskOnKey products, a
customer can, with relatively little effort and investment, move from our
product to a product of a competitor. This, combined with the relative ease with
which our customers may terminate their business relationship with us, may cause
a severe reduction in sales of our DiskOnKey products over a very short period
of time. We expect our operating results for at least the next several years to
continue to depend on sales to a relatively small number of customers.
13
OUR MOBILE DISKONCHIP PRODUCTS TARGET A SMALL NUMBER OF POTENTIAL CUSTOMERS. IF
THESE CUSTOMERS DECLINE TO PURCHASE OUR PRODUCTS, WE WOULD HAVE A LIMITED
MARKET, IF ANY, FOR SALE OF THESE PRODUCTS, WHICH COULD ADVERSELY AFFECT OUR
GROSS MARGINS AND RESULTS OF OPERATION.
In the multimedia mobile handset market, we manufacture a limited number of
versions of our Mobile DiskOnChip products to accommodate the handset design
parameters of a small number of potential large customers. After attaining a
design win, due to the size of these customers and their sales forecasts for the
handset that will incorporate our product, we are often required to build a
meaningful inventory position in these products in advance of any orders. The
customer, however, has no obligation to buy our products until it places an
order. To the extent any of these customers decline to purchase the version we
designed for them because the handset design is not commercialized or is
discontinued, we would be left with inventory that would have a limited market,
if any, for sale. This could require us to devalue or write-off the inventory,
which would adversely affect our gross margins and results of operation.
INCREASED EXPENSE LEVELS AND SIGNIFICANT FIXED COSTS WILL HARM OUR BUSINESS IF
OUR REVENUES DO NOT GROW.
We have significant fixed costs and we cannot readily reduce these expenses over
the short term. We expect our operating expenses to increase due primarily to
planned increases in sales and marketing and research and development activities
to support our growth plan. If our revenues do not increase proportionately to
our operating expenses, or if revenues decrease or do not meet expectations for
a particular period, and we are not able to reduce our expenses in the short
term, or at all, our business, financial condition and results of operations
will be adversely affected.
WE WILL BE REQUIRED TO RECORD A COMPENSATION EXPENSE IN CONNECTION WITH STOCK
OPTION GRANTS AND, AS A RESULT, OUR PROFITABILITY MAY BE REDUCED SIGNIFICANTLY.
The Financial Accounting Standards Board (``FASB'') has recently issued an
accounting standard that will require that the fair value of all equity-based
awards granted to employees be recognized in the statement of operations as a
compensation expense, beginning in the first quarter of 2006. The various
methods for determining the fair value of stock options are based on, among
other things, the volatility of the underlying stock. The impact of the adoption
of this standard cannot be predicted at this time because it will depend also on
levels of share-based compensation granted in the future. Had we adopted this
standard in prior periods, however, the impact would have had a material adverse
effect on our profitability. The adoption of this standard could materially
adversely affect our profitability in the future. Such adoption could also limit
our ability to continue to use stock options as an incentive and retention tool,
which could, in turn, hurt our ability to recruit employees and retain existing
employees.
THE ABSENCE OF DIVIDENDS COULD REDUCE THE ATTRACTIVENESS OF OUR ORDINARY SHARES
TO INVESTORS.
We have never paid any dividends on our Ordinary Shares and have no plans to pay
any such dividends in the foreseeable future. Our current policy is to retain
all funds and earnings for use in the operation and expansion of our business.
As a result, our Ordinary Shares may be less attractive to certain investors
than the stock of dividend-paying companies.
14
OUR STOCK PRICE HAS BEEN, AND MAY CONTINUE TO BE, VOLATILE FOR VARIOUS REASONS,
INCLUDING THE VOLATILITY AND DOWNTURN IN SHARE PRICES FOR TECHNOLOGY COMPANIES
GENERALLY AND COMPANIES IN OUR INDUSTRY SPECIFICALLY.
The market price of our stock has fluctuated significantly in the past and is
likely to continue to fluctuate in the future. For example, between January 1,
2002 and April 30, 2005, our closing stock price fluctuated from a low of $ 4.91
to a high of $ 26.06. We believe that these fluctuations will continue as a
result of, among other things, the factors discussed herein and as a result of
announcements by us, our competitors or third parties (such as industry and
research analysts) regarding our business, the business of our competitors, our
markets, technological innovations, or changes in earnings estimates. In
addition, in recent years the stock market has experienced significant price and
volume fluctuations and the market prices of the securities of high technology
companies have been especially volatile, often for reasons outside the control
of these companies. These fluctuations, as well as general economic, political
and market conditions, including certain conditions related to the State of
Israel, may have an adverse effect on our stock price. In the past, securities
class action litigation has often been brought against companies following
periods of volatility in the market price of their securities. We may be the
target of similar litigation in the future. Securities litigation could result
in substantial costs and divert our management's attention and resources, which
could cause serious harm to our business.
In addition, the price of our Ordinary Shares could be affected by possible
sales of our Ordinary Shares by investors who view the Convertible Notes as a
more attractive means of equity participation in the Company and by hedging or
arbitrage trading activity that may develop involving our Ordinary Shares.
RISKS RELATED TO DEVELOPMENT AND MARKETING OF NEW PRODUCTS
WE WILL NOT BE ABLE TO GROW UNLESS OUR TARGET MARKETS CONTINUE TO GROW AND WE
ARE ABLE TO MEET THE CHANGING NEEDS OF THESE MARKETS.
Sales to the multimedia mobile handset market accounted for approximately $ 69.8
million of our revenues in 2004, an increase of 302% as compared to 2003. Sales
to the multimedia mobile handset market are directly related to the demand for
multimedia mobile handsets. We cannot assure you that this market will grow,
that our data storage solutions for multimedia mobile handsets will continue to
achieve market acceptance, that demand for these products will grow or that our
products will be included in the multimedia mobile handsets that achieve broader
market acceptance. Most multimedia mobile handsets currently do not use or need
embedded high capacity data storage and we cannot assure you that the
requirement for embedded high capacity data storage in that market will grow or
that handset manufacturers and OEMs will select Mobile DiskOnChip as their
solution for embedded data storage. If sales of multimedia mobile handsets do
not grow as anticipated, or if Mobile DiskOnChip is not designed into leading
multimedia mobile handsets, then sales of our Mobile DiskOnChip products will
decrease or will not grow as anticipated, which could adversely affect our
results of operations.
Sales to the USB flash drive market accounted for approximately $ 297.2 million
of our revenues in 2004, an increase of 275% as compared to 2003. We cannot
assure you that this market will continue to grow or that our products will be
accepted as the preferred solution by OEMs, consumer electronics companies and
consumer end-users. If demand for USB flash drives does not continue to grow as
anticipated, or the DiskOnKey is not chosen by the relevant OEMs, consumer
electronic companies and consumer end-users as their preferred solution, then
sales of our DiskOnKey products will decrease or will not grow as anticipated,
which could adversely affect our results of operations.
15
OUR BUSINESS WILL BE HARMED IF WE FAIL TO ANTICIPATE NEW TECHNOLOGICAL CHANGES
OR TO INTRODUCE NEW PRODUCTS IN A TIMELY MANNER.
The market for our products is characterized by rapidly changing technology and
evolving industry standards. The introduction of products embodying new
technology and the emergence of new industry standards could render our existing
products obsolete and unmarketable. For example, our USB flash drive products,
which accounted for 71% of our revenues in 2004, were only introduced in 2000.
Although we design our products to fit and match certain market standard
interfaces, some of these interfaces may change over a relatively short period,
which may cause our then existing products to become obsolete while possibly
enabling competing products. Our ability to anticipate changes in technology and
industry standards and interfaces, and to successfully develop and introduce new
and enhanced products on a timely basis, will be a critical factor in our
ability to grow and to remain competitive. In addition, the anticipated
development schedules for high technology companies are inherently difficult to
predict and are subject to change as a result of shifting priorities in response
to customers' requirements and product introductions from competitors. Our
inability, for technological or other reasons, to develop products and product
enhancements that are technologically competitive, responsive to customer needs
or competitively priced would adversely affect our business, financial condition
and results of operations.
WE CANNOT ASSURE YOU THAT ANY NEW PRODUCTS WE DEVELOP WILL BE COMMERCIALLY
SUCCESSFUL.
We continually seek to develop new products. For example, in October 2004, we
announced our intention to develop the MegaSIM card module, a universal
subscriber identification management (SIM) card that incorporates high capacity
embedded data storage. We expect this product to be commercially available in
the second half of 2005. It will take time for new products to be accepted and
for significant sales to be generated from them, if this happens at all. We
cannot assure you that any new products we develop will be commercially
successful. To the extent our new products do not enjoy market acceptance, we
may not be able to recoup our research and development and sales and marketing
expenditures on the product.
IN TRANSITIONING TO NEW TECHNOLOGIES AND PROCESSES, WE FACE DESIGN AND
PRODUCTION RISKS THAT MAY CAUSE SIGNIFICANT PRODUCT DELAYS THAT COULD HARM OUR
BUSINESS.
The flash memory market continues to enjoy successively higher memory capacities
at lower costs per megabyte due to the implementation over time of more advanced
technologies and manufacturing processes. In addition, other components used in
our products, such as ASICs (application specific integrated circuits), continue
to achieve technological advances, and must be replaced or upgraded from time to
time in order for us to remain competitive. Our success depends on our ability
to continuously redesign our products to integrate with the latest flash memory
technologies and manufacturing processes and other new components. The
transition to new technologies and processes is highly complex and requires new
designs, components, testing and qualification processes. We cannot assure you
that we will be able to timely adapt our products to new emerging technologies
or offer such new products at competitive prices, or that we will not suffer
from design and quality issues in connection with the transition to new
technologies. We cannot assure you that we, along with our suppliers and
subcontractors, will successfully develop and bring into full production with
acceptable yields and reliability products based on these technologies and
processes, or that any development or production ramp-up will be completed in a
timely or cost-effective manner. If we are not successful in adapting to new
technologies or if our transition to these new technologies is too slow or too
costly, our business, financial condition and results of operations could
suffer.
16
RISKS RELATED TO THIRD PARTY MANUFACTURERS, SUPPLIERS AND SUBCONTRACTORS
WE DEPEND ON TOSHIBA AND SAMSUNG FOR FLASH MEMORY COMPONENTS. ANY SHORTAGE OR
DISRUPTION IN OUR SUPPLY FROM THESE SOURCES OR ACHIEVEMENT OF LOWER YIELD THAN
EXPECTED WILL ADVERSELY AFFECT OUR RESULTS.
Our flash memory based products require flash memory components, which are
currently supplied by Toshiba and Samsung, or with respect to some components,
by only one of the two suppliers. We have secured commitments from both Toshiba
and Samsung to provide us with a specified portion of their respective flash
component manufacturing capacity. We expect that we will depend upon Toshiba and
Samsung for a significant portion of our anticipated flash memory requirements
for the foreseeable future. In the past, our suppliers have, at times, been
unable or unwilling to meet our supply needs, which has adversely affected our
operating results. If either Toshiba or Samsung fails to comply with its supply
commitment to us, in terms of volumes and/or pricing of flash components, or
closes down or downsizes its flash components fabrication business, our
business, financial condition and operating results will be adversely affected.
In addition, if either Toshiba or Samsung terminates its supply relationship
with us at any time, our business, financial condition and operating results
will be adversely affected. In the event that we are supplied by Toshiba or
Samsung with flash memory components with a lower than customary yield, our
operating results and our ability to supply products to our customers will be
adversely affected. Any disruption in supply from these sources due to natural
disaster, power failure, labor unrest or other causes, could significantly harm
our business, financial condition and results of operations. In addition, if our
flash suppliers do not continue to invest in the necessary advancements to their
flash memory technology and flash memory products, our business, financial
condition and operating results may suffer.
WE DEPEND ON TOSHIBA AS A SINGLE SOURCE FOR MULTI-LEVEL CELL FLASH COMPONENTS,
WHICH ARE LESS COSTLY THAN STANDARD FLASH COMPONENTS. ANY REDUCTION OR
DISRUPTION IN OUR RECEIPT OF THESE COMPONENTS FROM TOSHIBA WILL NEGATIVELY
AFFECT OUR GROSS MARGINS AND PROFITABILITY.
At present, Toshiba is our sole supplier of multi-level cell (MLC) flash
components, which are less costly per megabyte than standard flash components.
If Toshiba were to:
o breach its obligations under its agreements with us;
o close down or downsize its flash fabrication business;
o experience manufacturing or yield problems or delays for any reason,
including difficulty in obtaining sufficient raw materials, work
stoppages, excessive demand for its manufacturing capacity or other
causes;
o increase its prices to us for MLC flash components,
we would be required to use standard flash components in lieu of MLC components,
which would decrease our gross margins and adversely affect our profitability.
In addition, if Toshiba were restricted from supplying its products to us due to
any legal restraints imposed upon it as a result of its current litigation with
Lexar Media Inc., our gross margins and profitability could be similarly
adversely effected.
17
DIFFICULTY IN ESTIMATING SUPPLY REQUIREMENTS MAY CAUSE US TO OVERESTIMATE OUR
REQUIREMENTS AND BUILD EXCESS INVENTORIES, OR UNDERESTIMATE OUR REQUIREMENTS AND
HAVE A SHORTAGE OF SUPPLY, EITHER OF WHICH WILL HARM OUR FINANCIAL RESULTS.
Under the terms of our agreements with Toshiba and Samsung, we are obligated to
provide advance rolling forecasts of anticipated requirements for components
that we use to manufacture our products. Because a significant portion of our
products is sold into the consumer market, it is difficult to accurately
forecast future sales. In addition, sales visibility remains limited because a
substantial majority of our quarterly sales are from orders received and
fulfilled in the same quarter, which makes accurate forecasting difficult.
Generally, the estimates for the first few months of each rolling forecast we
provide to Toshiba and Samsung are binding commitments and cannot be cancelled
and the estimates for the remaining months of the forecast may only be changed
by a certain percentage from the previous month's forecast. This limits our
ability to react to fluctuations in demand for our products. If we underestimate
our needs when we place orders, we may be unable to meet our customers' demands,
and we could lose revenues and market share to our competitors. Alternatively,
if we overestimate our need for products, we could increase our inventory
levels, which could result in reduced gross margins as well as obsolete
inventory and a corresponding write-down of that inventory. Either of these
situations could have a material adverse effect on our business, financial
condition and operating results.
IF OUR FLASH MEMORY SUPPLIERS ARE UNABLE TO PROVIDE US WITH SUFFICIENT
QUANTITIES OF FLASH MEMORY IN A TIMELY MANNER AT COMPETITIVE PRICES, WE WOULD
HAVE TO SEEK ALTERNATE SUPPLIERS, WHICH MAY NOT BE AVAILABLE, AND THIS WOULD
ADVERSELY AFFECT OUR RESULTS.
If we are unable to obtain sufficient quantities of flash memory from Toshiba
and Samsung at competitive prices, or if Toshiba or Samsung are unable or
unwilling to timely satisfy our requirements on competitive terms, and other
flash memory suppliers do not meet our additional capacity requirements in a
timely manner and at competitive prices, we would not be able to manufacture and
deliver flash memory products to satisfy our customers' requirements. If we are
unable to satisfy the requirements of our customers or supply them in the
volumes they request, they will likely reduce future orders or eliminate us as a
supplier. Our reputation would likely also be harmed and we may not be able to
replace any lost business with new customers. Even if we are able to obtain
flash memory in sufficient volumes and on schedules that permit us to satisfy
our delivery requirements, we cannot assure you that the prices charged by these
suppliers will enable us to compete effectively in our market. If we are unable
to obtain flash memory at competitive prices, our margins would decline unless
we could raise the prices of our products in a commensurate manner or offset the
cost increases elsewhere. The existing competitive conditions may not permit us
to do so, which would adversely impact our gross margins and operating results.
WE DEPEND ON TOSHIBA AS A SINGLE SOURCE TO MANUFACTURE MOST OF OUR DISKONCHIP
PRODUCTS, AND WE EXPECT TO REMAIN DEPENDENT ON TOSHIBA AS A SINGLE SOURCE FOR
FUTURE DISKONCHIP PRODUCTS. ANY DELAY OR DISRUPTION IN OUR RECEIPT OF THESE
PRODUCTS FROM TOSHIBA WILL ADVERSELY AFFECT OUR RESULTS.
At present, Toshiba is our sole manufacturer of most of our DiskOnChip products,
including our Mobile DiskOnChip products. In addition, we are working with
Toshiba on the joint development of future DiskOnChip products, for which they
will be the sole source of supply as well. For our DiskOnChip products, Toshiba
not only supplies the flash components but also manufactures and assembles the
finished product. If Toshiba were to:
o breach its obligations under its agreements with us;
o close down or downsize its flash business;
o experience manufacturing problems or delays for any reason, including
difficulty in obtaining sufficient raw materials, work stoppages,
excessive demand for its manufacturing capacity or other causes;
o for any other reason be unable to sell us DiskOnChip products at
competitive prices,
18
we may be unable to fill our customers' orders for these products in a timely
fashion or at all or unable to offer these products at competitive prices, which
would result in lost sales and significantly lower revenues. In addition, having
a single source for the Mobile DiskOnChip might deter the larger mobile handset
vendors from accepting our Mobile DiskOnChip product line as the data storage
solution for their handsets, which would similarly result in lost sales and
affect the acceptance of our product in the relevant market. We are seeking to
develop with other manufacturers products that will be comparable to the
DiskOnChip although possessing different features and capacity. This will
require additional hardware and software development, and we cannot assure you
that we will be successful in developing such comparable products or that such
other manufacturers will succeed in delivering products which are of similar
cost, quality and functionality.
In addition, if Toshiba were restricted from supplying its products to us due to
any legal restraints imposed upon it as a result of its current litigation with
Lexar Media Inc., we may similarly be unable to fill our customers' orders for
these products in a timely fashion or at all or unable to offer these products
at competitive prices.
WE DEPEND ON A LIMITED NUMBER OF THIRD PARTY SUBCONTRACTORS TO MANUFACTURE AND
ASSEMBLE OUR DISKONKEY PRODUCTS, AND ANY DELAY OR DISRUPTION IN THE SUPPLY OF
THESE PRODUCTS WILL ADVERSELY AFFECT OUR RESULTS.
We are dependent on a limited number of third party subcontractors. The
substantial majority of our DiskOnKey products are manufactured and assembled by
Global Brands Manufacturing Limited, or GBM, and to a lesser extent by Celestica
Italia S.r.l. Any significant problems that occur at our subcontractors, and
specifically with GBM, our principal subcontractor, or their failure to perform
at the level we expect, could lead to product shortages or quality assurance
problems, either of which could increase the manufacturing costs of our products
and have adverse effects on our operating results. If any of our subcontractors
are unable or unwilling to continue to manufacture, assemble and deliver
products of acceptable quality, at acceptable costs and in a timely manner, due
to conditions in their respective countries or otherwise, our future results
might be adversely affected. Specifically, if GBM was unable or unwilling to
continue to act as our subcontractor, we would not be able to switch our
production to Celestica or another subcontractor without significant advance
notice, which could adversely affect our ability to supply DiskOnKey products to
our customers. While we are planning to qualify an additional subcontractor, we
cannot assure you that we will be successful in agreeing to terms with any such
subcontractor, or that we will be able to timely switch our production to any
such subcontractor should any of the other subcontractors be unable or unwilling
to continue working with us. In addition, we do not have long-term contracts
with our subcontractors. As a result, these subcontractors may terminate their
relationships with us at any time, generally upon advance notice. In either
case, we would be required to qualify new subcontractors, which could take as
much as six months or longer, as well as result in unforeseen operations
problems, and our results may be adversely affected.
WE DEPEND ON THIRD PARTIES FOR THE SUPPLY AND QUALITY OF COMPONENTS REQUIRED FOR
THE MANUFACTURE OF OUR PRODUCTS, AND ANY DELAY OR DISRUPTION IN THE SUPPLY OF
THESE PRODUCTS WILL ADVERSELY AFFECT OUR RESULTS.
We depend on third parties to manufacture and supply components for our
products, including the capacitors, printed circuit boards and the ASIC
components used in our DiskOnKey and in some of our DiskOnChip products. For
some components, we rely on a single source of supply, such as Atmel Sarl which
supplies us with certain ASIC components developed specifically for our
DiskOnKey products, as well as a third party for some off-the-shelf ASIC
components. Because we depend on single suppliers for certain key components,
and do not have a long-term supply contract with our suppliers, we face the risk
of inadequate component supply, price increases, late deliveries and poor
component quality, as any supplier may terminate their relationships with us or
pursue other relationships with our competitors. If we were to lose our
relationship with these suppliers, the lead time required to qualify new
suppliers could be as long as six months. Also, if we lose our single suppliers
or these suppliers are otherwise unable to satisfy our volume and delivery
schedule requirements, it may be difficult to locate any suppliers who have the
ability to develop, manufacture and deliver the specialized components we need
for our products in the desired lead times and quality.
Our component suppliers are often operating at peak capacity. At times, the
demand for components used in our products has exceeded available supply, and
suppliers have raised prices and/or been forced to allocate limited resources
among competing purchasers. On certain occasions we have been unable to obtain
adequate supplies of certain components, which has resulted in delayed or lost
sales of our products. In other cases, we have been required to keep unusually
large component inventories in order to avoid shortages. We cannot assure you
that shortages will not occur in the future.
19
Furthermore, if we experience quality problems from any of our component
suppliers, it could take us a significant amount of time to identify the problem
as associated with a particular component, ascertain whether this is as a result
of a design or a manufacturing flaw and either correct the problem and, if
possible, replace the components or find an alternate source of supply. Any such
quality problem or delay could, in addition to causing us lost sales,
detrimentally affect our reputation in the market and cause us to incur
additional costs as a result of the recall and replacement of affected products.
IF WE ARE NOT SUCCESSFUL IN DEVELOPING RELATIONSHIPS WITH SUPPLIERS OF MEMORY
COMPONENTS THAT UTILIZE NEW MEMORY TECHNOLOGIES, OUR BUSINESS COULD BE ADVERSELY
AFFECTED.
The market for memory components is characterized by rapidly changing
technology. Several semiconductor manufacturers are currently developing new
memory technologies that would supplement or compete with existing flash memory
technologies and other memory components. If these new memory technologies gain
widespread market acceptance and we are not successful in developing
relationships with the suppliers of these new memory technologies and memory
components or we are unable to develop products based on these new technologies,
our business could be adversely affected.
LOSS OF OR DAMAGE TO INVENTORY HELD BY OUR SUBCONTRACTORS OR OEM CUSTOMERS COULD
DAMAGE OUR RELATIONSHIPS WITH OUR CUSTOMERS AND HARM OUR BUSINESS.
Some of our inventory is held directly by our third party subcontractors or our
OEM customer's warehouse facilities and is outside of our physical control. We
may be exposed to additional risks relating to this inventory, including loss of
or damage to the inventory. In the event that inventory held by our third party
subcontractors or OEM customers or that is on consignment with our customers is
damaged and we are unable to timely replace that inventory, we may not be able
to meet our customers' orders which would harm our business, financial condition
and results of operations.
OUR BUSINESS WILL BE HARMED IF OPERATING SYSTEM VENDORS DO NOT CONTINUE TO
SUPPORT OUR SOFTWARE AND INCLUDE OUR SOFTWARE WITH THEIR OPERATING SYSTEMS.
Our marketing strategy for DiskOnChip relies on our software being included in
major operating systems. These operating systems are constantly being updated.
If we are unable to maintain or obtain the support of major operating systems
for our products, if the developers and distributors of major operating systems
choose to support a competing product instead of our own or support other
competing solutions together with our solution, or if other operating systems
that do not include our software achieve market acceptance, this could adversely
impact sales and accordingly have a material adverse effect on our business,
financial condition and results of operations.
RISKS RELATED TO COMPETITION
WE SELL OUR PRODUCTS IN A HIGHLY COMPETITIVE INDUSTRY, OFTEN IN COMPETITION WITH
LARGER COMPANIES WITH SUBSTANTIALLY GREATER RESOURCES. OUR FAILURE TO COMPETE
EFFECTIVELY COULD HURT OUR BUSINESS.
The markets in which we compete are characterized by intense competition, rapid
technological changes, evolving industry standards, declining average selling
prices and rapid product obsolescence. Our Mobile DiskOnChip, DiskOnKey and
other products compete with other flash data storage devices, standard flash
components, hard drives and alternative data storage technologies. Our
competitors include many large U.S. and international companies that have
substantially greater financial, technical, marketing, logistical infrastructure
and support and other resources, greater access to component fabrication
capacity, broader product lines and longer-standing relationships with customers
than us. These factors may limit our ability to compete effectively with them.
We expect competition to increase in the future from existing competitors and
from other companies, including flash manufacturers, that may enter our existing
or future markets with similar or alternative data storage solutions that may be
less costly or provide additional features.
20
DiskOnKey. Our DiskOnKey product competes with other USB-compatible flash data
storage devices, removable magnetic media, removable optical media, flash cards,
MP3 players and other removable storage media. Our competitors in this market
currently consist of U.S. and international companies, as well as numerous
computer and computer-based peripherals manufacturers or hardware manufacturers,
many of whom are located in the Far East where costs tend to be lower. Many of
these competitors are vying for and attaining market share on the basis of
aggressive pricing or marketing campaigns. In addition, we also currently
experience and expect to continue to experience competition from large U.S.
and/or international companies (including flash manufacturers such as Toshiba
and Samsung) that have substantially greater resources, greater access to
component fabrication capacity, often at substantially lower costs, broader
product lines and longer-standing relationships with customers than we do. In
particular, flash manufacturers have a significant cost advantage over us, which
they could exploit to our detriment if they decided to compete more aggressively
in our markets, leading to substantial pricing pressures, which would adversely
affect our income.
Mobile DiskOnChip. Our Mobile DiskOnChip products compete with other flash and
flash-based memory solutions, including those offered by flash manufacturers.
These competitors have an advantage over us in that they have substantially
greater financial, sales, technical, marketing, logistical infrastructure and
support and other resources, greater access to component fabrication capacity at
substantially lower costs, broader product lines and longer-standing
relationships with customers than we do. In particular, flash manufacturers have
a significant cost advantage over us, which they can exploit to our detriment if
they decided to compete more aggressively in our markets. Since these
competitors also own their own fabrication facilities, they would also have more
effective control over supply. In addition, some manufacturers of multimedia
mobile handsets are using or plan to use multi-chip packaging which integrates
flash and other memory chips. Some of our competitors already manufacture, in
addition to flash, other memory chips, and may therefore have a competitive
advantage over us with respect to time to market and costs for products
incorporating multi-chip packaging. These factors could lead to substantial
pricing pressures, which would adversely affect our income.
OUR DATA STORAGE PRODUCTS COMPETE WITH OTHER PRODUCTS OFFERING SIMILAR
FUNCTIONALITY, WHICH COULD ENJOY GREATER MARKET ACCEPTANCE AND CAUSE THE SALE OF
OUR PRODUCTS TO DECLINE.
Our products are targeted at the personal data storage market. There are
numerous technologies and products that have been designed for the personal data
storage market, including removable magnetic media, removable optical media,
flash cards, flash-based MP3 players and other removable storage media. Many of
these products are substitute products, providing essentially the same data
storage functionality. To the extent any of these competing technologies or any
technologies developed in the future enjoy greater market acceptance than our
products, the market for our products may contract and our sales would decline,
which could adversely affect our results of operations. For example, sales of
high capacity MP3 players have recently enjoyed significant growth. If MP3
manufacturers were to market high capacity MP3 players for data storage as well
as music storage or consumers were to use their MP3 players to store digital
data files in addition to music, this could diminish the demand for USB flash
drives in general and our DiskOnKey in particular.
WE MAY BE UNABLE TO MAINTAIN MARKET SHARE DUE TO PRICE COMPETITION OR SUPPLY
CONSTRAINTS, WHICH WOULD REDUCE OUR POTENTIAL REVENUES AND PROFITABILITY.
The market for flash memory products is currently undergoing a period of surplus
supply, but we cannot predict if this condition will continue and, if it does,
for how long. During periods of excess supply in the market for our flash memory
products, we may lose market share to competitors who aggressively lower their
prices. We have in the past experienced, and may in the future experience,
severe price competition for our products, which adversely impacts our product
gross margins and overall profitability. Conversely, under conditions of tight
flash memory supply, we may be unable to meet customer demand and maintain our
market share. Our future growth rate depends in part on our ability to obtain
sufficient flash memory components and other components to meet demand. If we
are unable to do so in a timely manner, we may lose market share to our
competitors.
21
WE FACE COMPETITION IN OUR TARGET MARKETS FROM SOME OF OUR BUSINESS PARTNERS AND
THEIR CUSTOMERS, DUE TO OUR LICENSE AGREEMENTS WITH OUR PARTNERS.
We have entered into license agreements with several of our business partners,
including Toshiba and Samsung. Under these agreements, these parties and, in
some circumstances their customers, may manufacture and sell products that
incorporate technology covered by our patents which compete with our DiskOnKey
and DiskOnChip products. In particular, pursuant to our agreements with Toshiba,
Toshiba markets and sells the Mobile DiskOnChip products to customers under
Toshiba's trademark. In addition, Toshiba has begun to market and sell USB flash
drives which compete with our DiskOnKey products. Toshiba also has the right to
directly market products that we may jointly develop in the future. Similarly,
Samsung markets and sells products that compete with our Mobile DiskOnChip and
DiskOnKey products. In addition, we have agreed not to pursue any action for
infringement of our patents against any customer of Samsung which manufactures
flash data storage devices that incorporate both flash components and
controllers provided by Samsung. Any current or future agreements to license our
patents to our partners and competitors, may increase competition and may
adversely impact our revenues.
RISKS RELATED TO OUR INTELLECTUAL PROPERTY
OUR BUSINESS COULD SUFFER IF THIRD PARTIES INFRINGE UPON OUR PROPRIETARY
TECHNOLOGY, AND OUR PATENTS AND PROPRIETARY TECHNOLOGY MAY NOT AFFORD US
SUFFICIENT PROTECTION FROM SUCH INFRINGEMENT.
Our success is dependent upon our proprietary technology. As of April 30, 2005,
we had 37 U.S. patents and several foreign patents relating to our technology
and products. We also had, as of such date, 97 applications for patents pending
in the U.S. We currently rely on a combination of patent, trade secret,
copyright and trademark law, together with non-disclosure agreements, to
establish and protect the proprietary rights and technology used in our
products. However, these methods may not afford complete protection and we
cannot assure you that:
o any of our existing patents will not be invalidated;
o patents will be issued for any of our pending applications;
o any claims allowed from existing or pending patents will have
sufficient scope or strength;
o our patents will be issued in the primary countries where our products
are sold in order to protect our rights and potential commercial
advantage; or
o our competitors will not be able to design their products around our
patents or independently develop our trade secrets and know-how.
WE MAY BE INVOLVED IN LITIGATION REGARDING OUR INTELLECTUAL PROPERTY RIGHTS,
WHICH WOULD BE COSTLY AND WOULD DIVERT THE EFFORTS OF OUR KEY TECHNICAL AND
MANAGEMENT PERSONNEL.
Given the developing nature of our markets and the related intellectual
property, we cannot assure you that some of our competitors will not infringe
our intellectual property rights, and thereby force us to incur substantial
costs if we choose to defend our rights. Litigation involving intellectual
property can become complex and extend for a protracted time and is often very
expensive. We are currently involved in several opposition and/or revocation
procedures where we have opposed third party patents in various jurisdictions
(China, UK and Taiwan). Intellectual property claims, whether or not
meritorious, may result in the expenditure of significant financial resources,
injunctions against us or the imposition of damages that we must pay and would
also divert the efforts and attention of some of our key management and
technical personnel. If we bring an intellectual property infringement action
and are not successful, our competitors would be able to use similar technology
to compete with us. Moreover, the defendant in such an action may successfully
assert a counterclaim that our patents are invalid or unenforceable.
22
OUR PRODUCTS MAY INFRINGE ON THE INTELLECTUAL PROPERTY RIGHTS OF OTHERS AND THIS
COULD REQUIRE US TO PAY DAMAGES AND FORCE US TO STOP MANUFACTURING OR SELLING
CERTAIN OF OUR PRODUCTS.
Third parties may assert against us infringement claims or claims that we have
violated their patent or infringed their copyright, trademark or other
proprietary right. We currently are involved in one legal action in Singapore in
connection with the allegation of our infringement of the intellectual property
rights of a third party. Oppositions to our patent applications have been filed
by third parties in Taiwan, Australia and Israel. An infringement claim, even if
not meritorious, could result in the expenditure of significant financial and
managerial resources by us. An adverse determination of any infringement claim
could subject us to significant liabilities to third parties, could require us
to seek licenses from third parties or expend significant resources to develop
non-infringing technology and could prevent us from manufacturing, selling or
using certain of our products. Any of these developments could have a material
adverse effect on our business, financial condition or results of operations.
WE MAY BE UNABLE TO LICENSE INTELLECTUAL PROPERTY TO OR FROM THIRD PARTIES AS
NEEDED.
We may desire or be required to obtain licenses from others in order to further
develop, produce and market commercially viable products. We may also need to
license some of our intellectual property to others in order to enable us to
obtain cross-licenses to third-party patents. We cannot assure you that we will
be able to obtain any required licenses on commercially reasonable terms, if at
all, that the patents underlying those licenses will be valid and enforceable or
that the technology underlying those licenses will remain proprietary in nature.
If we do obtain licenses from third parties, we may be required to pay license
fees or royalty payments. In addition, if we are unable to obtain a license that
is necessary to the manufacture of our products, we could be required to suspend
the manufacture of products. We cannot assure you that we would be successful in
redesigning our products or that the necessary licenses will be available under
reasonable terms, or that our existing licensees will renew their licenses upon
expiration, or that we will be successful in signing new licenses in the future.
WE MAY NEED TO INDEMNIFY THIRD PARTIES FOR INFRINGEMENT CLAIMS RELATED TO OUR
INTELLECTUAL PROPERTY.
We historically have agreed to indemnify distributors, partners and customers
for alleged patent infringement claims in connection with our technology or
products. The scope of this indemnity varies, but may, in some instances,
include indemnification for damages and expenses, including attorneys' fees. We
may periodically engage in litigation as a result of these indemnification
obligations. Our insurance policies exclude coverage for third-party claims for
patent infringement. Any future obligation to indemnify our distributors,
partners and customers could adversely affect our business, financial condition
or results of operations.
RISKS RELATED TO OUR INDEBTEDNESS
OUR INDEBTEDNESS AND DEBT SERVICE OBLIGATIONS HAVE INCREASED FOLLOWING THE
ISSUANCE OF OUR CONVERTIBLE SENIOR NOTES, AND THIS MAY ADVERSELY AFFECT OUR CASH
FLOW, CASH POSITION AND STOCK PRICE.
In March, 2005, we issued $ 75,000,000 in aggregate amount of Convertible Senior
Notes (as further described under Item 4.B below "Business Overview" in the
paragraph titled "Recent Developments" under the heading "Convertible Note
Offering"). We intend to fulfill our debt service obligations from our existing
cash, investments and operations and that of M-Systems Finance Inc., our wholly
owned subsidiary that issued the Convertible Notes. In the future, if M-Systems
Finance and M-Systems are unable to generate cash or raise additional cash
financings sufficient to meet these obligations and need to use existing cash or
liquidate investments in order to fund these obligations, we may have to delay
or curtail research, development and commercialization programs.
Our indebtedness could have significant additional negative consequences,
including, without limitation:
o requiring the dedication of a portion of our expected cash flow to
service our indebtedness, thereby reducing the amount of our expected
cash flow available for other purposes, including funding our research
and development programs and other capital expenditures;
o increasing our vulnerability to general adverse economic conditions;
23
o limiting our ability to obtain additional financing; and
o placing us at a possible competitive disadvantage to less leveraged
competitors and competitors that have better access to capital
resources.
CONVERSION OF THE CONVERTIBLE NOTES WOULD DILUTE THE OWNERSHIP INTEREST OF OUR
EXISTING SHAREHOLDERS.
The conversion of some or all of the Convertible Notes would dilute the
ownership interests of our existing shareholders. Any sales in the public market
of our Ordinary Shares issuable upon such conversion could adversely affect the
prevailing market prices of our Ordinary Shares. In addition, the existence of
the Convertible Notes may encourage short selling by market participants because
the conversion of the Convertible Notes could depress the price of our Ordinary
Shares.
THE FUNDAMENTAL CHANGE PROVISION OF THE INDENTURE GOVERNING THE CONVERTIBLE
NOTES MAY DETER POTENTIAL ACQUIRERS AND WILL RESTRICT OUR ABILITY TO EFFECT
CERTAIN TYPES OF RECAPITALIZATION TRANSACTIONS.
Under the indenture governing the Convertible Notes, we are required to offer to
purchase all of the outstanding Convertible Notes for cash upon the occurrence
of certain fundamental changes. This provision could have the effect of making
it more difficult for a third party to acquire, or of discouraging a third party
from attempting to acquire, our company. For example, only in certain
circumstances could a potential acquirer issue a combination of stock and cash
in exchange for all of our outstanding Ordinary Shares without triggering the
fundamental change provision. In addition, this fundamental change provision
will limit our ability to effect certain types of recapitalization structures.
M-SYSTEMS OR M-SYSTEMS FINANCE MAY NOT HAVE THE ABILITY TO PURCHASE THE
CONVERTIBLE NOTES FOR CASH IF REQUIRED TO DO SO BY HOLDERS ON MARCH 15, 2010,
MARCH 15, 2015, MARCH 15, 2020, MARCH 15, 2025 OR MARCH 15, 2030 OR UPON THE
OCCURRENCE OF A FUNDAMENTAL CHANGE.
On March 15, 2010, March 15, 2015, March 15, 2020, March 15, 2025 and March 15,
2030, or upon the occurrence of a fundamental change under the indenture
governing the Convertible Notes, each holder of Convertible Notes may require
M-Systems or M-Systems Finance to purchase for cash all or a portion of such
holder's Convertible Notes at a price equal to 100% of the principal amount,
plus accrued and unpaid interest, if any, on such Convertible Notes up to but
excluding the date of purchase. We cannot assure you that we would have
sufficient financial resources to purchase the Convertible Notes for cash. This
repurchase requirement may also delay or make it harder for others to obtain
control of us.
RISKS RELATED TO OUR ISRAELI AND INTERNATIONAL OPERATIONS
CONDITIONS IN ISRAEL MAY ADVERSELY AFFECT OUR OPERATIONS AND MAY LIMIT OUR
ABILITY TO PRODUCE AND SELL OUR PRODUCTS.
We are incorporated under Israeli law and our principal offices and research and
development facilities and some of our manufacturing facilities are located in
Israel. Political, economic and military conditions in Israel directly affect
our operations. Since the establishment of the State of Israel in 1948, a number
of armed conflicts have taken place between Israel and its Arab neighbors and a
state of hostility, varying in degree and intensity, has led to security and
economic problems for Israel. We could be adversely affected by any major
hostilities involving Israel, the interruption or curtailment of trade between
Israel and its trading partners, a significant increase in inflation, or a
significant downturn in the economic or financial condition of Israel. From
October 2000 until recently, there was an increase in violence between Israel
and the Palestinians, primarily but not exclusively in the West Bank and Gaza
Strip. There can be no assurance that the recent relative calm and renewed
discussions with Palestinian representatives will continue. Ongoing and revived
hostilities with the Palestinians or Arab countries might require more
widespread military reserve service by some of our employees, which could have a
material adverse effect on our business. In addition, several Arab and Muslim
countries still restrict business with Israeli companies. We could be adversely
affected by restrictive laws or policies directed towards Israel or Israeli
businesses.
24
Generally, all male adult citizens and permanent residents of Israel under the
age of 45 can, unless exempt, be called up and obligated to perform active
military reserve duty for as many as 36 days annually (beyond this age, they may
be called up and obligated to take part in military training for as many as 13
days annually). Additionally, all Israeli residents of this age are subject to
being called to active duty at any time under emergency circumstances. Many of
our officers and employees are currently obligated to perform annual reserve
duty. Although we have operated effectively under these requirements since we
began operations, we cannot assess the full impact of these requirements on our
workforce or business if political and military conditions should change, and we
cannot predict the effect on us of any expansion or reduction of these
obligations.
THE GOVERNMENT PROGRAMS AND TAX BENEFITS THAT WE CURRENTLY RECEIVE REQUIRE US TO
MEET SEVERAL CONDITIONS AND MAY BE TERMINATED OR REDUCED IN THE FUTURE, WHICH
WOULD INCREASE OUR COSTS AND TAXES.
We benefit from certain government programs and tax benefits, particularly as a
result of tax exemptions and reductions resulting from the approved enterprise
status of our manufacturing facilities in Israel. To be eligible for these
programs and tax benefits, we must continue to meet conditions, including making
specified investments in property and equipment and financing a percentage of
investments with share capital. If we fail to meet such conditions in the
future, the tax benefits would be canceled and we could be required to refund
the tax benefits already received, together with an adjustment based on the
Israeli consumer price index and an interest factor. These programs and tax
benefits may not be continued in the future at their current levels or at any
level. The Israeli government has reduced the benefits available under some of
these programs in recent years, and Israeli governmental authorities have
indicated that the government may further reduce or eliminate some of these
benefits in the future. The termination or reduction of existing programs and
tax benefits could increase our expenses, thereby reducing our profits or
increasing our losses. In addition, the law and regulations prescribing the
benefits provide an expiration date for the grant of new benefits. The
expiration date has been extended several times in the past. The expiration date
currently in effect is December 31, 2007, and no new benefits will be granted
after that date unless the expiration date is extended again. There can be no
assurance that new benefits will be available after December 31, 2007, or that
existing benefits will be continued in the future at their current levels or at
any level.
The government grants we have received for research and development expenditures
limit our ability to manufacture products and transfer technologies outside of
Israel and require us to satisfy specified conditions. If we fail to satisfy
these conditions, we may be required to refund grants previously received
together with interest and penalties.
In connection with research and development grants received from the Office of
the Chief Scientist of Israel, or the OCS, we must pay royalties to the OCS on
the revenue derived from the sale of products, technologies and services
developed with the grant from the OCS. The terms of the OCS grants and the law
pursuant to which grants are made may impair our ability to manufacture products
or transfer technologies developed using OCS grants outside of Israel. The
transfer to a non-Israeli entity of technology developed with OCS funding,
including pursuant to a merger or similar transaction, and the transfer of
rights related to the manufacture of more than ten percent of a product
developed with OCS funding are subject to approval by an OCS committee and to
various conditions, including payment by us to the OCS of a percentage of the
consideration paid to us or our shareholders in the transaction in which the
technology is transferred. In connection with a merger or similar transaction,
the amount payable would be a fraction of the consideration equal to the
relative amount invested by the OCS in the development of the relevant
technology compared to the total investment in our company, net of financial
assets that we have at the time of the transaction, but in no event less than
the amount of the grant. In addition, in the event that the committee believes
that the consideration to be paid in a transaction requiring payment to the OCS
pursuant to the provisions of the law described above does not reflect the true
value of the technology or the company being acquired, it may determine an
alternate value to be used as the basis for calculating the requisite payments.
These restrictions may impair our ability to enter into agreements for those
products or technologies, without OCS approval. We cannot be certain that any
approval of the OCS will be obtained on terms that are acceptable to us, or at
all. Furthermore, in the event that we undertake a transaction involving the
transfer to a non-Israeli entity of technology developed with OCS funding
pursuant to a merger or similar transaction, the consideration available to our
shareholders may be reduced by the amounts we are required to pay to the OCS.
25
In connection with our grant applications, we have made certain representations,
including information provided in periodical performance reports, and we have
committed to certain performance-based covenants. The funding from the OCS is
subject to the accuracy of these representations and covenants and to our
compliance with the conditions and restrictions imposed by the OCS. If we fail
to comply with any of these conditions or restrictions, we could be required to
repay any grants previously received, together with an adjustment based on the
Israeli consumer price index and an interest factor in addition to certain other
penalties. In addition, if we fail to comply with any of these conditions or
restrictions, we would likely be ineligible to receive OCS grants in the future.
The inability to receive these grants would result in an increase in our
research and development expenses.
IT MAY BE DIFFICULT TO ENFORCE A U.S. JUDGMENT AGAINST US OR OUR OFFICERS AND
DIRECTORS OR TO ASSERT U.S. SECURITIES LAW CLAIMS IN ISRAEL.
We are incorporated in Israel. All of the directors and officers of M-Systems
reside outside of the United States. Service of process on them may be difficult
to effect in the United States. Furthermore, because a substantial portion of
the assets of M-Systems are located in Israel, any judgment obtained in the
United States against us or any of our directors and officers may not be
collectible within the United States.
An Israeli court may declare a judgment rendered by a foreign court in a civil
matter, including judgments awarding monetary or other damages in non-civil
matters, enforceable if it finds that:
1. the judgment was rendered by a court which was, according to Israeli
law, competent to render it;
2. the judgment is no longer appealable;
3. the obligation in the judgment is enforceable according to the rules
relating to the enforceability of judgments in Israel and the
substance of the judgment is not contrary to public policy in Israel;
and
4. the judgment can be executed in the state in which it was given.
A foreign judgment will not be declared enforceable by Israeli courts if it was
given in a state, the laws of which do not provide for the enforcement of
judgments of Israeli courts (subject to exceptional cases) or if its enforcement
is likely to prejudice the sovereignty or security of Israel. An Israeli court
also will not declare a foreign judgment enforceable if it is proven to the
Israeli court that:
1. the judgment was obtained by fraud;
2. there was no due process;
3. the judgment was given by a court not competent to render it according
to the laws of private international law in Israel;
4. the judgment conflicts with another judgment that was given in the
same matter between the same parties and which is still valid; or
5. at the time the action was brought to the foreign court a claim in the
same matter and between the same parties was pending before a court or
tribunal in Israel.
Israeli courts may refuse to hear a claim based on a violation of U.S.
securities laws because Israel is not the most appropriate forum to bring such a
claim. In addition, even if an Israeli court agrees to hear a claim, it may
determine that Israeli law and not U.S. law is applicable to the claim. If U.S.
law is found to be applicable, the content of applicable U.S. law must be proved
as a fact that can be a time-consuming and costly process. Certain matters of
procedure will also be governed by Israeli law. Additionally, there is doubt as
to the enforceability of civil liabilities under the Securities Act and the
Securities Exchange Act in original actions instituted in Israel.
Similarly, the directors of M-Systems Finance reside outside the United States,
and all or a significant portion of the assets of such persons may be, and
substantially all of the assets of M-Systems Finance are, located outside the
United States. As a result, it may not be possible to effect service of process
within the United States upon such persons or to enforce against M-Systems
Finance or such persons judgments obtained in United States courts predicated
upon the civil liability provisions of the federal securities laws of the United
States.
26
The United States and the Cayman Islands do not currently have a treaty between
them providing for reciprocal recognition and enforcement of judgments in civil
and commercial matters. Therefore, a final judgment for the payment of money
rendered by any federal or state court in the United States based on civil
liability, whether or not predicated solely upon the federal securities laws of
the United States, would not be directly enforceable in the Cayman Islands.
If the party in whose favor such a final judgment is rendered brings a new suit
in a competent court in the Cayman Islands, that party may submit to the Cayman
Islands court the final judgment that has been rendered in the United States.
Since the laws of the State of New York have been chosen to govern the
Convertible Notes, M-Systems Finance has submitted to the jurisdiction of the
State or federal courts sitting in the State of New York in connection with
disputes relating to the Convertible Notes. The holders, by acquiring the
Convertible Notes, have voluntarily accepted such choice of law and choice of
forum. A judgment obtained in any such court will be considered and recognized
by the competent courts of the Cayman Islands, and such courts would grant a
judgment that would be enforceable in the Cayman Islands generally, without any
re-examination of the merits of the original judgment where the judgment is
final and in respect of which the foreign court had jurisdiction over the
defendant according to Cayman Islands conflict of law rules and which is
conclusive, for a liquidated sum not in respect of penalties or taxes or a fine
or similar fiscal or revenue obligations, and which was neither obtained in a
manner, nor is of a kind enforcement of which is contrary to natural justice or
the public policy of the Cayman Islands.
UNDER CURRENT ISRAELI LAW, WE MAY NOT BE ABLE TO ENFORCE COVENANTS NOT TO
COMPETE AND THEREFORE MAY BE UNABLE TO PREVENT OUR COMPETITORS FROM BENEFITING
FROM THE EXPERTISE OF SOME OF OUR FORMER EMPLOYEES.
We currently have non-competition clauses in the employment agreements of nearly
all of our employees. The provisions of such clauses prohibit our employees, if
they cease working for us, from directly competing with us or working for our
competitors. Recently, Israeli courts have required employers, seeking to
enforce non-compete undertakings against former employees, to demonstrate that
the competitive activities of the former employee will cause harm to one of a
limited number of material interests of the employer recognized by the courts
(for example, the confidentiality of certain commercial information or a
company's intellectual property). In the event that any of our employees chooses
to work for one of our competitors and we could not demonstrate to the court
that we would be harmed, we may be unable to prevent our competitors from
benefiting from the expertise of our former employees obtained from us.
OUR OPERATIONS MAY BE ADVERSELY AFFECTED BY FLUCTUATIONS IN CURRENCY EXCHANGE
RATES, INCLUDING BY THE APPRECIATION OF ISRAELI CURRENCY AGAINST THE U.S.
DOLLAR.
We price our products primarily in U.S. Dollars. If the Euro, Japanese Yen, New
Taiwanese (NT) dollar or other currencies in regions in which we sell our
products weaken relative to the U.S. Dollar, our products may be relatively more
expensive in these regions, which could result in a decrease in our sales. Also,
in the event that any of our customers require that our products be quoted and
sold in currencies other than the U.S. Dollar, we may receive income in such
other currencies and as a result, our results will be impacted by fluctuations
in the currencies relative to the U.S. Dollar.
In addition, certain of our expenses are in, or are linked to, currencies other
than the U.S. Dollar, principally the New Israeli Shekel (NIS), the NT dollar
and the Japanese Yen. This exposes us to potentially increased operational costs
as well as increased costs for certain of our products as a result of currency
fluctuations.
A substantial portion of the cost of our Israeli operations, mainly personnel
and facility-related, is incurred in NIS. We bear the risk that the NIS, after
adjustment for inflation in Israel, will appreciate in relation to the dollar.
In that event, the dollar cost of our operations in Israel will increase and our
dollar-measured results of operations will be adversely affected. In 2001 and
2002, the inflation adjusted NIS devalued against the dollar, which lowered the
dollar cost of our Israeli operations. In 2003, the inflation adjusted NIS
appreciated against the dollar, which raised the dollar cost of our Israeli
operations. In 2004, however, the inflation adjusted NIS did not appreciate
against the dollar significantly. We cannot predict whether in the future the
NIS will appreciate against the dollar or vice versa. We cannot assure you that
we will not be materially adversely affected if the NIS appreciates against the
dollar in the future.
27
TERRORIST ATTACKS AND GOVERNMENT RESPONSES THERETO AND WARS MAY HAVE AN ADVERSE
EFFECT ON ALL ASPECTS OF OUR BUSINESS.
The terrorist attacks in the U.S., U.S. military responses to these attacks, the
ongoing hostilities in Iraq and threats of war and acts of terrorism in Europe
and elsewhere and the related decline in consumer confidence and continued
economic weakness have had a negative impact on consumer retail demand and our
business. Any escalation in these events or similar future events may disrupt
our worldwide operations or those of our customers and suppliers and may
adversely affect the availability of materials needed to manufacture our
products or the means to transport those materials to manufacturing facilities
and finished products to customers. In addition, these events have had and may
continue to have an adverse impact on the U.S. and world economy in general and
consumer confidence and spending in particular, which could harm our sales.
OUR U.S. INVESTORS COULD SUFFER SIGNIFICANT ADVERSE TAX CONSEQUENCES IF WE ARE
CHARACTERIZED AS A PASSIVE FOREIGN INVESTMENT COMPANY.
We would be a passive foreign investment company ("PFIC") for U.S. federal
income tax purposes if (i) 75% or more of our gross income in a taxable year
including our pro rata share of the gross income of any company treated as a
corporation for U.S. federal income tax purposes, U.S. or foreign, in which we
are considered to own, directly or indirectly, 25% or more of the shares by
value, is passive income, or (ii) at least 50% of our assets in a taxable year,
averaged quarterly over the year and ordinarily determined based on fair market
value and including our pro rata share of the assets of any company treated as a
corporation for U.S. federal income tax purposes, U.S. or foreign, in which we
are considered to own, directly or indirectly, 25% or more of the shares by
value, produce, or are held for the production of passive income. Passive income
includes, among other items, interest, dividends, royalties, rents and
annuities, and amounts derived by the investment of funds raised in this and
other offerings. If we are or become a PFIC, or if the U.S. Internal Revenue
Service, or IRS, subsequently successfully asserts that we are, were or became a
PFIC at some point, many of our shareholders will be subject to potentially
substantial adverse tax consequences, including:
o Taxation at the highest ordinary income tax rates in effect during the
holding period on some distributions on our Ordinary Shares, and on
gain from the sale or other disposition of our Ordinary Shares;
o Paying interest on taxes allocable to prior periods; and
o No increase in the tax basis of our Ordinary Shares to fair market
value at the date of the holder's death.
We believe that we were not a PFIC for 2004 and do not anticipate becoming a
PFIC in the future. Our belief is based, in part, on our market capitalization
and our plans for spending the proceeds of this and future offerings. However,
the tests for determining PFIC status are applied annually and it is difficult
to make an accurate prediction of future income and assets that are relevant to
this determination. Accordingly, we cannot assure you that we will not be
treated as a PFIC in future years.
28
CERTAIN PROVISIONS OF ISRAELI LAW AND OUR ARTICLES OF ASSOCIATION MAY DELAY,
PREVENT OR MAKE DIFFICULT A MERGER WITH OR AN ACQUISITION OF US, WHICH COULD
PREVENT A CHANGE OF CONTROL AND THEREFORE DEPRESS THE PRICE OF OUR SHARES.
Provisions of Israeli law may delay, prevent or make undesirable a merger or an
acquisition of all or a significant portion of our shares or assets. Israeli
corporate law regulates acquisitions of shares through tender offers and
mergers, requires special approvals for transactions involving significant
shareholders and regulates other matters that may be relevant to these types of
transactions. These provisions of Israeli law could have the effect of delaying
or preventing a change in control and may make it more difficult for a third
party to acquire us, even if doing so would be beneficial to our shareholders.
These provisions may limit the price that investors may be willing to pay in the
future for our Ordinary Shares. In addition, our Articles of Association contain
provisions that could make it more difficult for a third party to acquire
control of us, even if that change would be beneficial to our shareholders.
Specifically, our Articles of Association provide that any merger or significant
acquisition involving us requires the approval of 75% of the voting power of our
shareholders present at a meeting, in person or by proxy, and voting on the
transaction. This provision of our Articles of Association can only be amended
by the same supermajority shareholder vote required for approval of a merger or
acquisition transaction. Furthermore, Israeli tax considerations may make
potential transactions undesirable to us or to some of our shareholders. See
"Description of Share Capital."
29
ITEM 4. INFORMATION ON THE COMPANY
A. HISTORY AND DEVELOPMENT OF THE COMPANY
Our commercial and legal name is M-Systems Flash Disk Pioneers Ltd. We are a
company organized under the laws of the State of Israel and are subject to the
Companies Law. We were incorporated on November 10th, 1982 and began operation
in 1989. Our principal offices are located at 7 Atir Yeda St., Kfar Saba 44425,
Israel and our telephone number is +972-9-764-5000. Our U.S. agent is our
subsidiary, M-Systems, Inc., located at 555 N. Mathilda Avenue, Suite 220,
Sunnyvale, CA 94085, and its telephone number is (408) 470-4440.
In April 2001, we signed an agreement for the purchase of the building in which
our headquarters' executive offices, research, development and manufacturing
facilities are located. As part of the agreement, we also purchased a vacant lot
adjacent to our offices, upon which in December 2004 we began construction of
our second office facility. The aggregate consideration for these purchases was
approximately $ 10.5 million, which we financed ourselves. Some of the
consideration has been placed in an escrow fund pending the receipt by the
sellers of these properties of various permits and third party approvals. In
addition to the consideration paid for the building and the adjacent lot, we
invested an additional $ 4.7 million in developing and renovating the facility.
In February 2004, we completed a secondary offering of our Ordinary Shares,
which provided net proceeds for the company of approximately $ 95.0 million.
On March 23, 2005, we completed an offering of our Convertible Notes which
provided net proceeds for us of approximately $ 72.75 million (as further
described under Item 4.B below "Business Overview" in the paragraph titled
"Recent Developments" under the heading "Convertible Note Offering").
B. BUSINESS OVERVIEW
OUR BUSINESS
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 DiskOnKey products, and
the multimedia mobile handset market with our Mobile DiskOnChip products. We
also sell data storage products to the embedded systems market, including for
digital set-top boxes and thin client computers. We have recently enjoyed
significant revenue growth, growing from revenues of $ 130.1 million in 2003 to
revenues of $ 416.6 million in 2004, an increase of 220%.
We pioneered the USB flash drive concept with our DiskOnKey products, a
personal, portable, thumb-sized flash disk drive for the storage and transfer of
digital data files, including audio and video files and pictures, between PCs,
laptops and other USB-enabled devices.
We target the multimedia mobile handset market with our Mobile DiskOnChip
products, a set of reliable, high-capacity, high performance and cost-effective
embedded memory solutions for data and code storage. Leveraging our expertise in
the management and optimization of flash memory, we have developed our Mobile
DiskOnChip products to respond to this increasing demand by providing a high
capacity flash memory solution for multimedia mobile handsets, enabling high
reliability, high speed and low power consumption.
We also sell flash data storage products to the embedded systems market,
including for digital set-top boxes and thin client computers. Our DiskOnChip
for embedded systems provides the functionality of a mechanical hard drive on a
solid-state silicon chip. Our FFD (Fast Flash Disk) products provide a rugged
solid state flash disk product for embedded systems applications that require
reliable and high performance data storage.
30
In addition to our existing product lines, we recently announced plans to
introduce our MegaSIM card module, a high capacity data storage solution
designed for universal subscriber identification modules, or SIM cards, that are
used in mobile handsets for GSM and WCDMA cellular networks. We source the flash
memory components used in our products principally from Toshiba and Samsung,
each of whom has committed to provide us with a specified portion of its flash
components manufacturing capacity. We believe that these capacity commitments
will satisfy a substantial portion of our anticipated near-term flash memory
component needs.
OUR PRINCIPAL MARKETS
We focus primarily on two digital consumer electronics markets: the USB flash
drive market, into which we sell our DiskOnKey product, and the multimedia
mobile handset market, into which we sell our Mobile DiskOnChip products. We
also sell flash data storage products targeted at the embedded systems market,
including our DiskOnChip and FFD products.
USB FLASH DRIVES -
USB flash drives provide an innovative solution for removable data storage,
allowing a user to conveniently store and carry data and to easily transfer data
between PCs or similar devices with a USB port. USB flash drives have the
following attributes:
o High Capacity Combined with a Compact, Portable Form Factor: USB flash
drives are thumb-sized, able to fit on a key chain, and are available
in capacities ranging from 64 megabytes to 2 gigabytes of memory.
o Ease of Use: USB flash drives are "plug-and-play" devices that are
simple to use. USB flash drives are automatically recognized when
plugged into a computer with current versions of popular operating
systems, requiring no installation of additional equipment, an adaptor
or a software driver.
o Universal Interface/Portability: USB flash drives provide users with a
compelling alternative to conventional removable storage media by
leveraging the ubiquitous USB interface, which is a standard accessory
in PCs sold in recent years.
Due to the high capacity, ease of use and portability of USB flash drives,
consumers are increasingly using USB flash drives for personal data storage. Our
revenues from the USB flash drive market have grown from $ 79.4 million in 2003
to $ 297.2 million in 2004.
MULTIMEDIA MOBILE HANDSETS -
The market for multimedia mobile handsets has recently enjoyed significant
growth. As mobile handset manufacturers increasingly design handsets with
embedded digital cameras and personal digital assistant, or PDA, and MP3
functionality, there is an increasing demand for embedded memory in mobile
handsets which offer the following:
o Higher Capacity: Today's multimedia handsets require greater storage
capacity for the more sophisticated operating systems as well as
pictures, multimedia messages, video clips, audio recordings and MP3
files and other types of data-rich content. In many cases,
new-generation handsets are required to include as much as 1 gigabyte
of memory capacity to accommodate the multi-media rich content.
o Higher Performance: In order to accommodate the growing demand for
high capacity data storage as well as read/write functionality,
multimedia mobile handset manufacturers are increasingly seeking to
provide higher read/write speeds with memory components that occupy
less space and consume less power.
o Lower Cost Per Byte: Data-centric applications require higher density
memory solutions that provide high capacity with a small footprint at
a lower cost per memory byte than the currently most widely used
memory solutions in voice-centric handsets.
Consequently, mobile handset manufacturers are increasingly choosing to design
their multimedia mobile handsets using embedded flash memory that enable higher
reliability, higher speed and lower power consumption than existing memory
solutions. Our revenues from the multimedia mobile handset market have grown
from $ 17.4 million in 2003 to $ 69.8 million in 2004.
31
OUR PRODUCTS
In order to address the market opportunity for USB flash drives and flash data
storage solutions for multimedia mobile handsets and other high capacity
data-centric memory applications, we have focused primarily on the following
product offerings:
DiskOnKey
Our DiskOnKey enables easy storage and transfer of digital data files, including
audio and video files and pictures, between PCs, laptops and other USB-enabled
devices. DiskOnKey is available in a range of capacities, from 64 megabytes to 2
gigabytes of memory. Our DiskOnKey products have the following product
attributes:
o High Performance: We believe that our DiskOnKey leads the USB flash
drive market in performance.
o Intellectual Property Rights: We hold a number of patents relating to
the use of flash memory devices that connect using a USB interface. We
believe that this provides us with a competitive advantage and is an
important factor considered by our customers in selecting our products
over products of our competitors.
o Flash Independent Design: Due to the flexibility of its design,
DiskOnKey is compatible with flash components from multiple suppliers,
including our current suppliers, Toshiba and Samsung, and can be
adapted to be compatible with flash components from additional
suppliers that may enter the flash memory component market in the
future. This allows us to seek additional sources of flash components
for our DiskOnKey products to reduce our dependence on any specific
flash component supplier.
Our strategy is to sell our DiskOnKey through major original equipment
manufacturers (OEMs) and consumer electronics companies, leveraging their market
position and brand strength to achieve wide market penetration. We sell our
DiskOnKey through leading consumer electronics companies worldwide, such as IBM,
I-O Data. Kingston, Memorex and Verbatim, leveraging their international market
position and brand strength to achieve wide market penetration.
Mobile DiskOnChip
Our Mobile DiskOnChip products consist of a set of reliable, high-capacity,
high-performance and cost-effective embedded memory solutions for data and code
storage for multimedia mobile handsets. Our Mobile DiskOnChip products provide
multimedia mobile handset manufacturers with an attractive solution due to the
following product attributes:
o High Density: Through our relationship with Toshiba, we have access to
multi-level cell (MLC) flash memory technology which we believe allows
us to offer a higher density solution than competing solutions in the
market, practically doubling the capacity of our Mobile DiskOnChip
solutions without meaningfully increasing the size of the chip. We
currently offer our Mobile DiskOnChip in capacities from 32 megabytes
to 1 gigabytes.
o Cost-Effective, Improved Performance and Optimized Reliability: By
combining our patented TrueFFS flash management software with an
embedded controller, we have been able to optimize the reliability and
improve the performance of high-density flash memory. This allows us
to use high-density flash memory, traditionally limited to data
storage, for code storage as well. As a result, we are able to provide
mobile handset manufacturers with a less expensive, integrated memory
solution for both code and data storage, while maintaining high
performance and reliability.
o Compact Size: Our monolithic, or single die, design, available in the
vast majority of our Mobile DiskOnChip products, combines a controller
and flash memory within a single silicon die. Compact size is
particularly important to multimedia mobile handset manufacturers that
increasingly are seeking to provide increased product functionality
using components that occupy less space.
32
Our Mobile DiskOnChip already has numerous design wins, including design wins
with four of the five leading handset manufacturers, as well as with leading PDA
manufacturers, and has been designed into many multimedia mobile handsets,
including handsets produced by leading handset manufacturers such as LG,
Motorola, Samsung and Sony Ericsson, as well as into PDAs produced by leading
PDA manufacturers such as Hewlett Packard and PalmOne. Our strategy is to
penetrate the mobile handset market by acquiring additional design wins for our
Mobile DiskOnChip in multimedia and other high-end mobile handsets and PDAs.
EMBEDDED PRODUCTS
Our DiskOnChip family is comprised of various compact and light-weight flash
disk products (at a form factor of either a chip or module) which are optimized
for applications which are relatively small and/or need relatively small data
storage capacities. Our FFD products are available in much higher data storage
capacities, come in standard hard-drive sizes and interfaces, and are designed
to provide extremely high reliability, ruggedness and durability under the
harshest environmental and other conditions.
NEW PRODUCTS
In addition to our existing product lines, we recently announced plans to
introduce our MegaSIM card module, a high capacity data storage solution
designed for universal subscriber identification modules, or SIM cards, that are
used in mobile handsets for GSM and WCDMA cellular networks. Our MegaSIM module
is designed to enable the integration in a SIM card of secure, high capacity
flash-based storage, with densities ranging between 16 to 256 megabytes,
combining the functionality of a standard SIM card with high capacity memory.
MegaSIM is designed to provide cellular network operators secure SIM cards with
embedded high capacity data storage, enabling them to offer their subscribers a
variety of advanced mobile services, such as MP3 and video downloading and
picture storage. We currently anticipate commercial availability of our initial
MegaSIM module in the second half of 2005. We cannot assure you that we will
meet our product introduction schedule for MegaSIM, or that our MegaSIM module
will be commercially successful when introduced.
MARKETING CHANNELS
We market and sell the DiskOnKey primarily to OEMs and consumer electronics
companies who repackage or resell our products under private label to consumers
or incorporate our products into their own products, which are then sold to
consumers.
We market our other products through a combination of our own sales managers;
independent local sales representatives that sell our products on our behalf;
and independent distributors that purchase our products for resale to their
customers. Our sales managers are compensated based on a salary and a bonus
dependent in part on sales levels. The independent local sales representatives
receive commissions for their product sales. We continually seek to strengthen
each of our sales channels, including by engaging new representatives and
distributors and providing them with extensive training and support with respect
to our products and technologies. Our technical engineers are an integral part
of the sales process and provide customers with technical information and
support regarding our products and their integration with the customers'
applications.
We maintain local sales offices in Sunnyvale, California; Raleigh, North
Carolina; Saddle Brook, New Jersey, Tokyo, Japan, Taipei, Taiwan, Beijing,
China, Shenzhen, China, Seoul, Korea and Kfar Saba, Israel.
RELATIONSHIP WITH TOSHIBA AND SAMSUNG
TOSHIBA
On July 29, 2003, we announced a set of new agreements with Toshiba which
broadened our relationship with Toshiba. The new agreements consisted
principally of:
o a master purchase agreement for the provision of flash components and
Mobile DiskOnChip and DiskOnChip products,
o a cross-license agreement,
33
o a development and license agreement,
o agreements establishing the Venture relating to USB flash drives, and
o a share purchase agreement for the investment in our Ordinary Shares
by Toshiba.
Under the master purchase agreement, Toshiba has improved the overall terms
under which we purchase from Toshiba raw flash components and Mobile DiskOnChip
and DiskOnChip products. Under this agreement, we are required to make rolling
forecasts that are binding on us to varying extents, and Toshiba is committed to
supply us with flash components and Mobile DiskOnChip and DiskOnChip products in
accordance with our forecasts. The agreement has a seven-year term.
The cross-license agreement between us grants a non-exclusive, worldwide,
royalty-free and fully paid license to Toshiba with respect to all of our
patents, and to us with respect to certain of Toshiba's patents. In each case,
the term of the license runs through the expiration of the last to expire
licensed patent. We expect Toshiba to utilize our intellectual property related
to USB flash drives to develop and sell a USB flash drive that will compete with
our DiskOnKey.
The development and license agreement provides for the development of new Mobile
DiskOnChip and DiskOnChip products and restates the provisions of our previous
development and license agreements relating to earlier versions of our Mobile
DiskOnChip and DiskOnChip products. Under this agreement, which terminates in
2018 except for certain provisions related to development which terminate in
2010, we licensed certain of our intellectual property to Toshiba for the
production and sale of the jointly developed products in exchange for royalties.
We also entered into various agreements with Toshiba, under which we began to
operate in November 2003, pursuant to which we established the Venture designed
to enable us and Toshiba to benefit from a portion of each party's respective
sales of USB flash drives. Both we and Toshiba have obligations each to conduct
a portion of its USB flash drive business through the Venture. Under the
agreements, Toshiba has committed to provide us with a specified portion of its
flash component manufacturing capacity for the portion of our USB flash drive
business that we conduct through the Venture. In addition, we and Toshiba will
each receive a percentage of the income attributable to the portion of sales of
USB flash drives generated by the other party through the Venture. In 2005, we
entered into additional agreements which reduced to writing the terms under
which the companies have been engaging since the commencement of the Venture's
operation in November 2003. The new agreements consisted principally of:
o a NAND supply agreement, and
o a product supply agreement for the supply of products.
Under the NAND supply agreement, Toshiba has committed to supply a specified
portion of its NAND capacity to the Venture. The Venture is required to make
rolling forecasts that are binding to varying extents and Toshiba has committed
to supply the forecasted NAND requirements. The agreement is in effect for as
long as the Venture between the companies is in place.
The product supply agreement sets out the terms under which both Toshiba and we
purchase products from the Venture. Under the product supply agreement, the
Venture is to sell products only to Toshiba and us pursuant to rolling forecasts
which we and Toshiba are required to make and which are binding to varying
extents. The agreement is in effect for as long as the Venture between the
companies is in place.
Under the share purchase agreement, Toshiba invested $ 4.0 million in our
Company, acquiring 330,811 Ordinary Shares. In addition, Toshiba had the option
until July 30, 2004 to increase its stake in our Company to up to 4.99% of the
aggregate shares outstanding at the time of exercise. Toshiba did not exercise
its option and it has expired. Under the share purchase agreement, if Toshiba's
holdings of our Ordinary Shares exceed 7% of our outstanding shares, Toshiba has
the right to request us to use our commercially reasonable efforts to have a
representative of Toshiba nominated to our board of directors as a director or
observer.
34
SAMSUNG
On December 31, 2003, we entered into a Strategic Agreement with Samsung which
broadened our relationship with Samsung. Under this agreement, Samsung agreed to
provide us with a specified portion of its raw flash component manufacturing
capacity available to third parties at more favorable pricing terms compared to
our previous arrangement. The agreement is effective for a period of four years.
As part of the agreement, we granted Samsung a license to all of our patents for
any products produced by Samsung until the expiration of the last to expire
licensed patent. We also agreed not to pursue any action for infringement of our
patents against any customer of Samsung in connection with the manufacture of
flash data storage devices, provided that the customer uses both flash
components and controllers sourced from Samsung. In exchange for the license,
Samsung agreed to pay us a fixed stream of payments throughout the term of the
agreement. Samsung currently markets and sells products that compete with our
Mobile DiskOnChip and DiskOnKey products.
SOURCES OF SUPPLY
We purchase our supplies from various sources. All of our products are flash
memory based and require flash memory components, which are currently supplied
by Toshiba and Samsung, or with respect to some components, by only one of the
two suppliers. We have commitments from both Toshiba and Samsung to provide us
with a specified portion of their respective flash component manufacturing
capacity. We expect that we will depend upon Toshiba and Samsung for a
significant portion of our anticipated flash memory requirements. Our policy is
to have more than one supplier for all of our parts wherever feasible. However,
Toshiba is currently the sole manufacturer of most of our DiskOnChip products,
including our Mobile DiskOnChip products. In addition, we are working with
Toshiba on the joint development of future DiskOnChip products, for which they
will be the sole source of supply as well. We have also entered into development
and supply agreements with Atmel under which, Atmel develops, manufactures, and
supplies us with certain ASIC components developed specifically for our
DiskOnKey products, as well as a third party for other off-the-shelf ASIC
components.
If Toshiba, Samsung, Atmel or any of our other suppliers fails to provide parts
or services in a timely manner and we are unable to secure an alternate supply
of comparable price and quality in a timely manner, our results of operations
could be adversely affected (see the discussion in Item 3.D "Risk Factors -
Risks Related to Third Party Manufacturers, Suppliers and Subcontractors").
At times, we have experienced difficulties in securing adequate supplies of
certain components for our products, which has resulted in delayed or lost
sales. In an effort to mitigate supply shortages, we at times have maintained a
larger inventory of certain components than we would otherwise maintain if the
availability of adequate supplies were more certain.
SEASONALITY
Sales of our DiskOnKey and Mobile DiskOnChip products may be subject to
seasonality arising from the seasonal purchasing patterns of consumer end-users.
Although in the past we have not experienced seasonality in relation to these
products, due to the significant initial growth of their respective markets, as
the markets have matured, we have begun, and anticipate that we will continue,
to experience seasonality, with stronger results in the fourth quarter for the
DiskOnKey products and in the second half of the year for Mobile DiskOnChip
products, in each case due to end-of-year holiday demand. Additionally, we
anticipate that future sales of our new MegaSIM products will be subject to
seasonal patterns similar to our Mobile DiskOnChip products.
35
REVENUE BREAKDOWN
Our revenues are derived mainly from the sales to the USB flash drive,
multimedia mobile handset and embedded systems markets. The following table
describes, for the periods indicated, the percentage of revenues represented by
each of the items on our consolidated statements of operations:
YEAR ENDED DECEMBER 31,
---------------------------------------
2002 2003 2004
(RESTATED)
---------------------------------------
USB Flash Drives 41% 61% 71%
Multimedia Mobile Handset 6 13 17
Embedded Systems 49 24 11
Others 4 2 1
-------- -------- --------
Total 100% 100% 100%
The following table summarizes the revenues from our products and services by
country, stated as a percentage of total revenues for the periods indicated:
Country YEAR ENDED DECEMBER 31,
---------------------------------------
2002 2003 2004
(RESTATED)
---------------------------------------
Israel 3% 2% 1%
United States 27 32 26
Europe 16 16 11
Taiwan 13 17 13
Japan 34 20 35
China 3 5 8
Far East (excluding Taiwan, Japan and China) 4 8 6
-------- -------- --------
Total 100% 100% 100%
RECENT DEVELOPMENTS
SANDISK COLLABORATION
In August, 2004, we entered into agreements with SanDisk Corporation for the
joint development, standardization and promotion of a next-generation USB flash
drive platform. The agreements contain certain patent cross-license provisions
in connection with the USB flash drive technology and an option to license
certain other patents which are not covered by such cross-license. In connection
with this collaboration, in December 2004, we and SanDisk formed U3 to develop a
unified standard for the development of software applications for USB flash
drives. U3 intends to provide software developers with software development
tools to create applications that will be accessible from all USB flash drives
designed based on the new standard.
CONVERTIBLE NOTE OFFERING
In March, 2005 we completed an offering of $ 75 million aggregate principal
amount of 1% Convertible Senior Notes due 2035. The Convertible Notes will be
convertible into Ordinary Shares at an initial conversion price of approximately
$ 28.46 per Ordinary Share. The Convertible Notes were offered only to qualified
institutional buyers and non-U.S. persons. The issuer of the Convertible Notes
was M-Systems Finance, a wholly owned subsidiary of M-Systems, whose obligations
in respect of the Convertible Notes are unconditionally guaranteed by M-Systems.
Holders of the Convertible Notes will have the ability to require us to
repurchase the Convertible Notes for cash on March 15, 2010 and at specified
times thereafter, at a repurchase price equal to 100% of the unpaid principal
amount of the Convertible Notes plus accrued and unpaid interest to, but
excluding, the purchase date.
36
The Convertible Note Offering was made in a transaction exempt from the
registration requirements of the Securities Act of 1933, as amended (the
"Securities Act"). However, we have agreed to register the Convertible Notes
under the Securities Act and intend to file with the SEC a shelf registration
statement covering the guarantee, the resales by holders of Convertible Notes
and the ordinary shares issuable upon conversion of the Convertible Notes. If
the registration statement is not filed or has not become effective within the
time periods set forth in the Convertible Note Offering, M-Systems Finance will
be required to pay additional cash amounts to holders of the Convertible Notes.
C. STRUCTURE
The following table lists our subsidiaries, their country of organization and
our ownership percentage in each.
NAME COUNTRY OF ORGANIZATION OWNERSHIP
---- ----------------------- ---------
M-Systems, Inc. U.S. 100%
M-Systems Finance Inc. Cayman Islands 100%
M-Systems (Cayman) Limited. Cayman Islands 100%
P.P.S. von Koppen Pensioen B.V. Netherlands 100%
M-Systems Asia Ltd. Taiwan 100%
M-Systems Flash Disk Pioneers (Japan), Inc.
Japan 100%
M-Systems UK Ltd. United Kingdom 100%
M-Systems China Shenzhen Ltd. China 100%
M-Systems B.V. The Netherlands 100%
TwinSys Ltd. * Israel 50.1%
TwinSys Data Storage L.P. * Israel 50%
U3 LLC U.S. 50%
* Established together with a partner as an Israeli corporation to serve
as the General Partner of TwinSys Data Storage L.P., which is a
limited partnership established by the Company and such partner.
D. PROPERTY, PLANTS AND EQUIPMENT
Our headquarters' executive offices, research, development and manufacturing
facilities are currently located in a building of approximately 75,000 square
feet at 7 Atir Yeda St., Kfar Saba 44425, Israel, which we own. We also own an
adjacent vacant plot of 117,000 square feet on which, in December, 2004, we
began construction of our second office facility. We own the building and the
property free and clear of all encumbrances except for a mortgage taken out by
the sellers from Bank Leumi. The outstanding balance of that mortgage on our
building and property is covered in full by escrowed funds to be delivered to
the sellers only upon the receipt of various necessary permits and third party
approvals, at which point the escrowed funds are to be released for the purpose
of paying off the mortgage and removing the lien. In addition, we lease office
space of approximately 5,500 square feet for a research and development facility
in Omer, Israel, approximately 24,000 square feet for additional offices in
Raanana, Israel and approximately 10,000 square feet for additional offices
adjacent to our headquarters in Kfar Saba.
We also lease office space for our sales offices in Sunnyvale, California;
Raleigh, North Carolina; Saddle Brook, New Jersey; Tokyo, Japan, Taipei, Taiwan,
Beijing, China and Shenzhen, China., Seoul, Korea The leases for these sales
offices are not material to our operations.
37
ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS -
YOU SHOULD READ THE FOLLOWING DISCUSSION AND ANALYSIS IN CONJUNCTION WITH ITEM 3
"SELECTED FINANCIAL DATA" AND OUR CONSOLIDATED FINANCIAL STATEMENTS AND NOTES
THERETO INCLUDED ELSEWHERE IN THIS ANNUAL REPORT. 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 AS A RESULT OF CERTAIN FACTORS
INCLUDING, BUT NOT LIMITED TO, THOSE SET FORTH UNDER THE CAPTION "RISK FACTORS"
AND ELSEWHERE IN THIS REPORT.
A. OPERATING RESULTS
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 DiskOnKey product and
the multimedia mobile handset market with our Mobile DiskOnChip products. We
also sell flash data storage products targeted at the embedded systems market,
including our DiskOnChip and FFD products.
In 2003, we and Toshiba entered into the Venture, which is 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. We previously accounted for our investment in the
Venture from its inception under the equity method. On December 24, 2003, the
Financial Accounting Standard Board ("FASB") issued FASB Interpretation No. 46R,
"Accounting for Variable Interest Entities" ("FIN 46R"), which is applicable for
financial statements issued for reporting periods ending after March 15, 2004.
We considered the provisions of FIN 46R in our fiscal 2004 financial statements
and made the determination that the Venture was a variable interest entity under
FIN 46R. At that time, we also determined that we were not the primary
beneficiary of the Venture under FIN 46R and, therefore, we did not consolidate
the Venture.
In connection with a review of our 2004 annual report on Form 20-F by the staff
of the U.S. Securities and Exchange Commission, we reconsidered the manner in
which FIN 46R applies to the Venture and concluded that we are the primary
beneficiary of the Venture and, therefore, we are required to consolidate the
Venture in our financial statements. We have restated our financial statements
to consolidate the Venture from the beginning of 2004. The impact of this
restatement on our consolidated statement of operations for year ended December
31, 2004 is to increase revenues by $69.0 million, from $347.6 million to $416.6
million, to increase gross margins from 23.8% to 27.2%, and to increase
operating income by $30.3 million, from $20.1 million to $50.4 million. Since we
previously accounted for the Venture using the equity method, consolidation of
the Venture does not affect our previously reported net income, shareholders'
equity or earnings per share. The increase in revenues and operating income is
entirely attributable to sales of USB flash drives made by the Venture to
Toshiba, and is also reflected in an increase in our geographic sales in Japan.
In addition, the impact on our balance sheet as of December 31, 2004 is to
increase total assets by $22.0 million and current liabilities by $14.4 million
and to reflect a minority interest of $7.6 million. This Item 5 - "Operating and
Financial Review and Prospects" - gives effect to the restatement.
38
Consolidated balance sheet as of December 31, 2004:
AS PREVIOUSLY AS
REPORTED RESTATED
------------- -----------
US DOLLARS IN THOUSANDS
----------------------------
Cash and cash equivalents $ 50,187 $ 56,511
Trade receivables 41,503 61,373
Other accounts receivable and prepaid expenses 3,962 5,540
Inventories 56,160 59,415
Total current assets 250,379 281,406
Investment in a Venture 8,988 -
Total long-term investments 49,527 40,539
Total assets 321,449 343,488
Trade payables 19,488 39,957
Related party trade payables 6,027 -
Total current liabilities 51,633 66,075
Minority interest in subsidiaries - 7,597
Total liabilities and shareholders' equity 321,449 343,488
Consolidated statements of operations for the year ended December 31, 2004:
AS PREVIOUSLY AS
REPORTED RESTATED
------------- -----------
US DOLLARS IN THOUSANDS
----------------------------
Revenues 347,551 416,560
Cost of goods sold 264,799 303,320
General and administrative expenses 6,771 6,904
Total costs and expenses 327,481 366,135
Operating income 20,070 50,425
Financial income, net 3,897 3,920
Income before minority interest in earnings of a subsidiary 24,150 54,528
Minority interest in earnings of a subsidiary - (30,378)
BELOW ARE SOME OF THE HIGHLIGHTS AND TRENDS AFFECTING OUR BUSINESS SINCE THE
BEGINNING OF 2004:
REVENUE GROWTH - Because the markets that our products address grew rapidly, our
revenues have grown significantly over the past few years. In 2003, our revenues
grew by 101% in comparison to 2002, and our revenues in 2004 grew by 220% in
comparison to 2003. In particular, our sales to the USB flash drive market grew
by 275%, from $ 79.4 million in 2003 to $ 297.2 million in 2004, and our sales
to the mobile multimedia handset market grew by 302%, from $ 17.4 million in
2003 to $ 69.8 million in 2004. We expect our revenues to continue to grow in
2005, though at a significantly slower rate.
39
Revenue growth in 2004 was attributable in large part to significant growth in
unit sales of both our DiskOnKey and Mobile DiskOnChip products, as both the USB
flash drive and multimedia mobile handset markets experienced strong end-user
demand. Sales to the USB flash drive market in 2004 include sales made by the
Venture to Toshiba. While the average selling prices per megabyte for our
products have declined in recent years, the average selling price per unit for
our DiskOnKey and Mobile DiskOnChip products remained relatively stable, as a
result of consumers purchasing products with higher capacity storage due to
declining prices.
Such revenue growth has placed and is expected to continue to place a strain on
our operational, logistical and managerial resources. We have expanded our work
force from approximately 330 employees at January 1, 2003 to approximately 513
employees at December 31, 2004. We cannot assure you that our logistical
infrastructure, systems, procedures and controls will be adequate to support our
anticipated growth.
SEASONALITY - In 2004, we experienced stronger demand for our Mobile DiskOnChip
products in the second half of the fiscal year, and for our DiskOnKey product in
the fourth quarter, in each case due to end-of-year holiday demand. We expect,
however, that demand in the first half of 2005 will be weaker, due in part to
the strong sales during the 2004 holiday season, which would adversely affect
our product sales and profitability in the first half of 2005. 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.
MEGASIM PRODUCT - In October 2004, we announced plans to introduce our MegaSIM
card module, a high capacity data storage solution designed for universal
subscriber identification modules, or SIM cards, that are used in all mobile
handsets for GSM and WCDMA cellular networks. Our MegaSIM module is designed to
enable the integration in a SIM card of secure, high capacity flash-based
storage, with densities ranging between 16 to 256 megabytes. MegaSIM is designed
to combine the functionality of a standard SIM card with high capacity memory.
We currently anticipate commercial availability of our initial MegaSIM module in
the second half of 2005. We cannot assure you that we will meet our product
introduction schedule for MegaSIM, or that our MegaSIM module will be
commercially successful when introduced.
SANDISK COLLABORATION - In August 2004, we entered into agreements with SanDisk
for the joint development, standardization and promotion of a next-generation
USB flash drive platform. The agreements contain certain patent cross-license
provisions in connection with the USB flash drive technology and an option to
license certain other patents which are not covered by such cross-license. In
connection with this collaboration, in December 2004, we and SanDisk formed U3
LLC to develop a unified standard for the development of software applications
for USB flash drives. U3 intends to provide software developers with software
development tools to create applications that will be accessible from all USB
flash drives designed based on the new standard. We cannot assure you that
software developers will be interested in creating these applications or that,
to the extent applications are developed based on the platform, that these
applications will be commercially successful.
NEW PRESENTATION METHOD FOR OUR CONSOLIDATED STATEMENT OF OPERATIONS -
Commencing with our 2004 results, we adopted a new presentation method for our
consolidated statement of operations, since a portion of our revenues is
generated from sources other than product sales, specifically license fees and
royalties from licensing our intellectual property rights to third parties,
which have no associated cost of goods sold. As a result, our historical
presentation in our statement of operations of gross profit, derived by
subtracting cost of goods sold from revenues, is no longer a meaningful measure
of our business. Under the new presentation method, we group cost of goods sold
with our operating expenses and have eliminated the presentation of gross profit
from our statement of operations.
40
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 DiskOnKey, Mobile
DiskOnChip, DiskOnChip and FFD 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 DiskOnKey product, the multimedia mobile handset
market, into which we sell our Mobile DiskOnChip products, and the embedded
systems market, into which we sell our DiskOnChip and FFD products. For the year
ended December 31, 2004, we derived approximately 71% of our revenues from the
USB flash drive market, approximately 17% of our revenues from the multimedia
mobile handset market and approximately 12% 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, 2003 and 2004, our top 10 customers accounted for 55%
and 64% of our revenues, respectively. In 2004, two customers separately
accounted for greater than 10% of our total revenues. We expect that sales to a
limited number of customers will continue to account for a substantial portion
of our revenues for at least the next several years.
In 2004, Asia accounted for 61% of our revenues, the United States accounted for
26% of our revenues, Europe accounted for 12% of our revenues and Israel
accounted for 1% of our revenues. We expect to continue to generate a
significant portion of our revenues from Asia, in part due to the fact that many
of our Mobile DiskOnChip customers are handset manufacturers located in Asia, as
well as from the United States, the largest market for our DiskOnKey products.
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:
. 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.
. 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.
41
. 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 Mobile DiskOnChip
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.
. Product pricing environment. Our DiskOnKey and Mobile DiskOnChip
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.
. 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 DiskOnKey product 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
DiskOnKey could increase our costs of goods sold as a percentage of
revenues, negatively affecting our profitability.
. 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.
We currently expect our cost of goods sold as a percentage of revenues to show a
modest decrease in 2005 relative to 2004, based on our expectations of the
overall impact of the various factors described above. However, we cannot assure
you that these factors will indeed contribute as expected to our cost of goods
sold. To the extent any factor described above or any other factor has a
different effect than we currently anticipate, our cost of goods sold as a
percentage of revenues could increase and our operating margins could be
adversely affected.
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, and the Information Society Technology Fund, or IST. 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 2004, 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
MegaSIM module targeted at the multimedia mobile handset market.
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 2004, as a result of the
growth in our revenues and the expected growth potential for both the DiskOnKey
and the Mobile DiskOnChip 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.
42
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 related 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.
MINORITY INTEREST - In the USB flash drive market, we and Toshiba entered into
the Venture, which is 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 FIN 46R we
are considered the primary beneficiary and therefore consolidate the results of
the Venture in our financial statements. Minority interest represents Toshiba's
proportional interest in the 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,
2002 2003 2004
Revenues................................................................ 100.0% 100.0% 100.0%
Costs and expenses:
Cost of goods sold................................................... 68.5% 71.6% 72.8%
Research and development,net......................................... 18.5% 11.4% 6.0%
Selling and marketing................................................ 19.3% 14.9% 7.5%
General and administrative........................................... 6.2% 3.7% 1.6%
Total costs and expenses................................................ 112.5% 101.6% 87.9%
Operating income (loss)................................................. (12.5%) (1.6%) 12.1%
Financial income,net.................................................... 4.0% 2.1% 1.0%
Other income, net....................................................... 0.0% 0.1% 0.0%
Income (loss) before minority interest in losses (earnings)
of subsidiaries......................................................... (8.5%) 0.6% 13.0%
Minority interest in losses (earnings) of subsidiaries.................. 0.0% 0.1% (7.3%)
Net income (loss)....................................................... (8.5%) 0.7% 5.8%
The following table sets forth, for the periods indicated, our revenues by end
markets (in thousands):
YEAR ENDED DECEMBER 31,
2002 2003 2004
Revenues:
USB flash drive market............................................... $ 26,810 $ 79,358 $ 297,227
Multimedia mobile handset market..................................... 3,613 17,356 69,772
Embedded systems market.............................................. 31,679 30,727 46,698
Other................................................................ 2,715 2,613 2,863
----------- ----------- -----------
Total................................................................... $ 64,817 $ 130,054 $ 416,560
43
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
$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 1.7% 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 a 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.
We expect that we will incur little to no income taxes on a consolidated basis
during 2005.
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. Year Ended December 31, 2003 Compared to Year Ended
December 31, 2002.
44
YEAR ENDED DECEMBER 31, 2003 COMPARED TO YEAR ENDED DECEMBER 31, 2002
REVENUES. - Revenues for the year ended December 31, 2003 increased by $ 65.2
million, or 101%, to $ 130.1 million from $ 64.8 million for the year ended
December 31, 2002. Revenues derived from the USB flash drive market increased by
$ 52.5 million, or 196%, to $ 79.4 million, revenues derived from the multimedia
mobile handset market increased by $ 13.7 million, or 380%, to $ 17.4 million
and revenues derived from the embedded systems market decreased by $ 1.0
million, or 3%, to $ 30.7 million. Total product sales increased by $ 60.5
million, or 96%, to $ 123.8 million and other revenues, consisting of license
fees and royalties, increased by $ 4.7 million, or 301%, to $ 6.3 million.
COST OF GOODS SOLD. - Our cost of goods sold for the year ended December 31,
2003 increased by $ 48.7 million to $ 93.1 million, an increase of 110% from
cost of goods sold of $ 44.4 million for the year ended December 31, 2002. Our
costs of goods sold as a percentage of total revenues increased from 68.5% for
the year ended December 31, 2002 to 71.6% for the year ended December 31, 2003,
due to an increase in the price of flash components as a result of a shortage in
the supply of flash memory components and due to pricing pressures resulting
from increasing competition. This increase was partially offset by an increase
in our revenues from license fees and royalties for which no related costs of
goods sold exists.
RESEARCH AND DEVELOPMENT EXPENSES, NET. - Our gross research and development
expenses for the year ended December 31, 2003 increased by $ 3.2 million to $
15.4 million, an increase of 25.6% from gross research and development expenses
of $ 12.2 million for the year ended December 31, 2002. Our net research and
development expenses for the year ended December 31, 2003 increased by $ 2.7
million to $ 14.7 million, an increase of 22.9% from net research and
development expenses of $ 12.0 million for the year ended December 31, 2002. The
increase in our gross research and development expenses is attributable to our
decision to increase our investments in the development of new products. As a
percentage of revenues, our net research and development expenses decreased to
11.3% for the year ended December 31, 2003 from 18.5% for the year ended
December 31, 2002. During the year ended December 31, 2003, we recognized $
84,000, $ 414,000, and $ 177,000 of research and development grants from SIIRD,
IST and OCS, respectively, compared to $ 63,000 and $ 212,000 of research and
development grants we recognized from SIIRD and IST, respectively, during the
year ended December 31, 2002.
SELLING AND MARKETING EXPENSES. - Selling and marketing expenses for the year
ended December 31, 2003 increased by $ 6.9 million, or 55%, to $ 19.4 million
from $ 12.5 million for the year ended December 31, 2002, due to increased
expenditures on broadening our sales channels, increased sales and marketing
personnel and increased marketing activity for existing and new opportunities.
As a percentage of revenues, our selling and marketing expenses decreased to
14.9% for the year ended December 31, 2003 from 19.4% for the year ended
December 31, 2002.
GENERAL AND ADMINISTRATIVE EXPENSES. - General and administrative expenses for
the year ended December 31, 2003 increased by $ 0.9 million, or 21%, to $ 4.9
million from $ 4.0 million for the year ended December 31, 2002. This increase
is attributable mainly to expenses associated with an intellectual property
litigation matter, which was settled in the third quarter of 2003. As a
percentage of revenues, our general and administrative expenses decreased to
3.7% for the year ended December 31, 2003 from 6.2% for the year ended December
31, 2002.
FINANCIAL INCOME, NET. - Financial income, net for the year ended December 31,
2003 increased slightly by $ 0.1 million to $ 2.7 million from $ 2.6 million for
the year ended December 31, 2002.
MINORITY INTEREST IN LOSSES OF SUBSIDIARY. - In 2003, we established a
subsidiary, SmartCaps Ltd., to create applications for our DiskOnKey. The OCS
invested in SmartCaps, and held a minority interest in the subsidiary's equity.
During 2003, we reported minority interest in the losses of SmartCaps of $
117,000. In 2004, SmartCaps ceased operations.
NET INCOME (LOSS). - For the year ended December 31, 2003, we recognized net
income of $ 0.9 million compared to a net loss of $ 5.5 million for the year
ended December 31, 2002.
45
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.
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.
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 our products to the end
customers, or the 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.
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 the sales are recognized.
We receive royalties from licensing the right to use our 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. We recognize
royalty revenues when final reports of the licensee's sales covered by the
license agreement are received from the licensees. Revenues from the grant
of perpetual licenses for certain patents in consideration for fixed
periodic payments are recognized when the related payments become due.
INVENTORY VALUATION - 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 reserves
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.
46
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.
INVESTMENTS IN OTHER COMPANIES - 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
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 the equity method of accounting is
appropriate. 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 a majority of the outstanding voting
interests of an entity in which we have invested, generally we 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 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.
LEASE COMMITMENTS
Our facilities in Omer and Raanana, Israel, our subsidiaries' facilities and our
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 (in millions of dollars):
YEAR ENDED DECEMBER 31,
2005 2006 2007
Facilities.................... $ 0.7 $ 0.5 $ 0.2
Vehicles...................... 1.9 1.5 0.7
Total......................... $ 2.6 $ 2.0 $ 0.9
Facilities lease expenses for the years ended December 31, 2003 and 2004, were
approximately $ 0.4 million and $ 0.7 million, respectively. Vehicle lease
expenses for the years ended December 31, 2003 and 2004 were approximately $ 1.2
million and $ 1.5 million, respectively.
47
ROYALTY COMMITMENTS
Under our research and development agreements with the OCS and SIIRD, we are
required to pay royalties at the rate of 1.5% to 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. As of December 31, 2004, we had
outstanding contingent obligations to pay royalties of $ 0.7 million in respect
of these various grants.
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, 32% for the 2006 tax year and
30% for the 2007 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. Most 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. 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
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.
We manufacture part of our products outside of Israel, using foreign contract
manufacturers. This might affect the tax benefits to which we are entitled. We
are currently negotiating this matter with the Israeli tax authorities and the
investment center. We do not believe that the outcome of these negotiations,
even if adverse, will have a material impact on us in 2005.
We cannot be sure that approved enterprise programs will continue to be
available, or that we will continue to qualify for benefits under such 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. In the event that we do not comply with these conditions, in whole or in
part, we may be required to refund the amount of the benefits, indexed to the
Israeli consumer price index ("CPI"), with interest.
For the years ended December 31, 2002 and 2003, we incurred losses for tax
purposes. Accordingly, we did not provide for taxes on income in the reported
periods. Although we had gains in 2004, we did not provide for taxes on income
because of our net operating losses.
48
We and our Israeli subsidiary have accumulated losses for Israeli income tax
purposes as of December 31, 2004, in the amount of approximately $ 30.0 million.
These losses may be carried forward (linked to the Israeli CPI) and offset
against taxable income in the future for an indefinite period. We expect that
until these tax losses are utilized in full, 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, we had U.S. federal net operating loss carryforwards of
approximately $ 11.0 million 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 $ 2.5 million and $ 1.5 million,
respectively, which can be carried forward and offset against taxable income
during the years 2005 to 2007.
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.
B. LIQUIDITY AND CAPITAL RESOURCES
Through December 31, 2004, we have funded our operations primarily through the
sales of our Ordinary Shares, cash from operations and, to a lesser extent,
government grants to support our selling and marketing and research and
development efforts. We completed our initial public offering in March 1993.
Since then, we have raised $ 328.95 million in the aggregate through public
offerings and private placements of our ordinary shares, including a secondary
offering of our ordinary shares in February 2004 which raised net proceeds of
approximately $ 95.4 million and a convertible note offering in March 2005 which
provided net proceeds of approximately $ 72.8 million. Although the growth in
our revenues creates greater working capital needs, the growth in revenues has
been accompanied by a growth in profits and positive cash flow and we believe
that we will be able to fund our working capital needs in 2005 from cash
generated from operations.
As of December 31, 2004, our cash, cash equivalents, bank deposits and
marketable securities were $ 181.0 million ($ 26.0 million of this amount being
comprised of long-term marketable securities). In addition, we recently
completed the Convertible Note Offering which provided net proceeds to us of
approximately $ 72.8 million (as further described under Item 4.B above
"Business Overview" in the paragraph titled "Recent Developments" under the
heading "Convertible Note Offering"). We believe that our cash, cash
equivalents, bank deposits and marketable securities will be sufficient to fund
our anticipated working capital needs and planned capital expenditures for the
next twelve months.
We had no indebtedness as of December 31, 2004, and other than the indebtedness
we assumed under the Convertible Note Offering, we had no indebtedness as of
April 30, 2005.
49
Net cash provided by operating activities for the year ended December 31, 2004
was $ 27.8 million, as compared to $ 22.0 million net cash used in operating
activities for the year ended December 31, 2003. The change from negative to
positive cash flow from operating activities in 2004 as compared to 2003 was
primarily attributable to (i) our achieving net income of $ 24.2 million in 2004
compared with $ 0.9 million of net income in 2003, and (ii) contribution of the
proportional share of our partner in the Venture to our operating cash flows,
which we consolidated commencing on January 1, 2004, in the amount of $30.4
million.
Our trade receivables increased to $ 61.4 million at December 31, 2004 from $
19.7 million at December 31, 2003. This increase reflects our increased sales in
2004. We expect trade receivables to continue to increase as our sales grow.
Our inventories increased from $ 45.9 million at December 31, 2003 to $ 59.4
million at December 31, 2004, in order to meet increasing market demand. Our
inventory of finished goods increased from $ 33.1 million at December 31, 2003
to $ 36.7 million at December 31, 2004. However, the portion of our finished
goods 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 collectively decreased from
$ 27.8 million to $ 21.2 million over this same period. See also "-Critical
Accounting Policies and Estimates-Revenue Recognition." We expect that our
inventory levels will continue to be at higher than historical levels as our
revenues continue to grow.
Net cash used in investing activities for the year ended December 31, 2004 was $
75.9 million, as compared to net cash provided by investing activities of $ 6.0
million for the year ended December 31, 2003. This increase in net cash used in
investing activities was primarily attributable to our investment in marketable
securities of the proceeds of our secondary equity offering in February 2004.
Similarly, net cash provided by financing activities increased to $ 78.7 million
in 2004, primarily due to the secondary equity offering.
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.
Notwithstanding, we currently intend to use the net proceeds from the sale of
the Convertible Notes for general corporate purposes outside of Israel. However,
we currently have no commitments for any specific acquisitions, expenditures or
investments. We cannot assure you that the uses will not be different.
For the year ended December 31, 2004, the aggregate amount of our capital
expenditures was $ 5.4 million. These expenditures were principally for the
purchases of computer hardware and software and facilities improvements.
C. RESEARCH AND DEVELOPMENT, PATENTS AND LICENSES, ETC.
GOVERNMENT OF ISRAEL SUPPORT PROGRAMS
RESEARCH AND DEVELOPMENT OVERVIEW AND INTERNAL PROGRAM
We have devoted significant resources to research and development activities
with respect to our core flash data storage technology. We have emphasized the
development of our technology, the enhancement of existing products and the
development of new products, generally in response to the rapidly evolving
markets for High-End Mobile Devices, Embedded Devices, military systems and
network infrastructure equipment and other embedded systems. In addition, we
emphasize the development and addition of new features to our products, such as
security and access control.
Our gross research and development expenses during 2002, 2003 and 2004 were $
12.2 million, $ 15.4 million and $ 25.1 million, respectively. A small portion
of our revenues during those years was funded through grants from OCS, SIIRD and
IST, as discussed below.
50
RESEARCH AND DEVELOPMENT GRANTS
We participate in programs offered by the OCS, SIIRD and IST that support
research and development activities. We received or accrued participation from
OCS, SIIRD and IST of $ 128,000, $ 0 and $ 111,000, respectively, in 2004, $
177,000, $ 84,000 and $ 414,000, respectively, in 2003, and $ 0, $ 63,000 and $
212,000 respectively in 2002. Our OCS grants related to the development of a
compact IDE interface flash disk, our SIIRD grants related to the development of
LPC flash disk and our IST grants related to the development of secure mobile
payment on chip (SM-PAYSOC).
D. TREND INFORMATION
Please see the discussion of significant recent trends in our business,
including trends in our revenues, cost of goods sold, research and development
expenses, net, selling and marketing expenses and net income (loss), in "Item
5A: Operating Results - Overview."
E. OFF-BALANCE SHEET ARRANGEMENTS
We are not party to any material off-balance sheet arrangements.
F. TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS
Payments due by Period (US$ in thousands)
CONTRACTUAL OBLIGATIONS AS OF LESS THAN 1 MORE THAN 5
DECEMBER 31, 2004 TOTAL YEAR 1-3 YEARS 3-5 YEARS YEARS
- ----------------------------- ----------- ------------ ------------- ------------- -------------
Operating leases(1) $ 2,576 $ 2,811 $ ---
$ 5,387 $ ---
Purchase obligations(2) 84,766 84,766 --- --- ---
Accrued severance pay 4,263 --- --- --- 4,263
---------- ---------- ---------- ---------- ----------
Total $ 94,416 $ 87,342 $ 2,811 $ --- $ 4,263
(1) Includes leases for facilities and vehicle leases for Israeli
employees
(2) Covers material goods and services under issued purchase orders and
further includes material purchase commitments under applicable
binding forecasts.
51
ITEM 6. DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES
A. DIRECTORS AND SENIOR MANAGEMENT
The following table sets forth certain information regarding our directors and
executive officers as of May 10, 2005:
NAME AGE POSITION
- ---- --- --------
Dov Moran 49 President, CEO and Chairman of the Board of Directors
Aryeh Mergi 43 Executive Vice President of Business Development; Director
Ronit Maor 34 CFO and Corporate Secretary
Dana Gross 38 Chief Marketing Officer; Director
Itsik Onfus 43 Director
Yair Shoham 51 Director
Dr. Hans Wagner 75 Director
Yossi Ben Shalom 49 Director
Zehava Simon 46 Director
The background of each of our directors, executive officers and key employees is
as follows:
Dov Moran. Mr. Moran is a founder of M-Systems and has been a director and
President, Chief Executive Officer and Chairman of the Board of Directors of
M-Systems since 1989. Mr. Moran has also been a director and chairman of the
board of directors of our U.S. subsidiary, M-Systems Inc. ("MSU"), since 1992.
From 1984 to 1989, Mr. Moran was an independent consultant in the computer
industry. Prior thereto, Mr. Moran served in the Israeli Navy for seven years
and was director of its microprocessors department. Mr. Moran received a B.Sc.
in Computers and Electronic Engineering (with honors) from the Technion, Israel
Institute of Technology, in Haifa, Israel in 1977.
Aryeh Mergi. Mr. Mergi is a founder of M-Systems and has been a director of
M-Systems since 1989 and a director of MSU since 1992. Mr. Mergi has been our
Executive Vice President of Business Development of the Company since 2000. From
1995 to 2000, he served as Executive Vice President of Sales and Marketing. From
1989 to 1995, he served as Vice President of Research and Development. Mr. Mergi
also serves of the board of directors of WideMed Ltd., of which he is a founder,
since May 2000, and of Kidin, a company founded by his wife, since 1999. Mr.
Mergi received a B.Sc. in Electronic Engineering (with honors) from the
Technion, Israel Institute of Technology, in Haifa, Israel in 1988.
52
Ronit Maor. Ms. Maor has been Chief Financial Officer since May 1997. Ms. Maor
joined us as Planning and Control Manager in March 1996 and was promoted to Vice
President of Planning and Control in February 1997. Prior thereto, Ms. Maor was
a project manager at Tefen, an industrial engineering consulting company. She
received her B.Sc. in Industrial Management Engineering (with honors) from
Tel-Aviv University in 1995.
Dana Gross. Ms. Gross, a director of the Company since September 2000, joined
the Company in July 1992 as Vice President of Operations and has served in
various management positions, including, among others, as Chief Financial
Officer and President of MSU. Currently, she serves as the Company's Chief
Marketing Officer since July, 2002. Ms. Gross also serves on the board of
directors of AudioCodes Ltd. (Nasdaq: AUDC), since June, 2000, and of PowerDsine
Ltd. (Nasdaq: PDSN), since September, 2004. Ms. Gross received a B.Sc. in
Industrial Management Engineering (with honors) from Tel-Aviv University in 1992
and an M.B.A. degree from San Jose State University in 1997.
Itsik Onfus. - Mr. Onfus has served as a director of M-Systems since August,
2003. Since the consolidation of all SAP entities in Israel in the beginning of
2005, Mr. Onfus serves as the Vice President Finance of the consolidated
corporation - SAP Labs Israel. From July, 2002, Mr. Onfus served as the Director
of Finance at Sap Portals Israel Ltd. From 1995 to 2002, Mr. Onfus served as the
Chief Financial Officer of a number of start-up companies in their incubation
stage, including, among others, VDOnet Corporation Ltd., TI ISRAEL (formerly
Butterfly V.L.S.I Ltd.), CallManage Inc., Voquette, RFWaves Ltd., Envara Ltd.
and IXI Mobile. From 1990 to 1995, Mr. Onfus filled the positions of Controller,
Corporate Controller and, prior to its purchase by Elbit, Chief Financial
Officer of Fibronics Ltd., prior to which, from 1986 to 1990, Mr. Onfus worked
as a CPA for the accounting firm of Goren, Ben Yaakov. During his studies, Mr.
Onfus worked both as an assistant professor in the Economics department of the
Hebrew University, Jerusalem, and as a research assistant, in the Research
Department of the Bank of Israel. Mr. Onfus received his B.A. degree in
Economics and Accounting from the Hebrew University, Jerusalem in 1990. Mr.
Onfus qualifies as an independent director under applicable Nasdaq rules and was
elected to the Board of Directors as an External Director under the applicable
provisions of the Companies Law.
Yair Shoham. Mr. Shoham has served as a director of M-Systems since 1996. Since
June 1999, Mr. Shoham has been general partner with Genesis Partners, a large
Israel-based venture capital fund. From 1997 to 1999, Mr. Shoham was the Vice
President for Business Development of Butterfly VLSI Ltd., and from January 1996
to December 1996 he was the Vice President for Business Development of VDOnet
Corporation Ltd. From January 1994 to December 1995, Mr. Shoham was a partner at
the law firm of Goldfarb, Levy, Eran & Co., Tel-Aviv, Israel. Mr. Shoham
received his B.A. degree from Haifa University in Israel in 1982 and a J.D.
degree from Loyola University of Chicago School of Law in 1985. Mr. Shoham
qualifies as an independent director under applicable Nasdaq rules and was
elected to the Board of Directors as an External Director under the applicable
provisions of the Companies Law.
Dr. Hans Wagner. Dr. Wagner has served as a director of M-Systems since
November, 2002. Dr. Wagner is currently a Senior Partner of Omega Partners Ltd.,
a telecommunications consultancy firm, of which he was a founder in 1977. Dr.
Wagner also founded and serves as a director of Ozone Ltd., a manufacturer of
recycling devices founded in 1996, and of Pelikon Ltd., a developer and
manufacturer of electro-luminescent displays founded in 2000. From 1995 to 2000,
Dr. Wagner served as a strategic advisor to the management of Ericsson Mobile
LM. From 1984 to 1992, Dr. Wagner was a founder and served as chairman of
Technophone, a mobile telephone manufacturer which was then the worldwide number
three in sales prior to its acquisition by Nokia. From 1973 to 1977, Dr. Wagner
served as the Assistant Secretary General of the UNDP. From 1969 to 1973, Dr.
Wagner served as the CEO of SONAB AB, Sweden's second largest communication
equipment manufacturer. From 1963 to 1969, Dr. Wagner served as the COO of
Incentive AB, Sweden's largest technical conglomerate. Dr. Wagner holds a
Masters degree in Chemical Engineering, an MBA degree from the Stockholm School
of Economics and a Ph.D. from the Massachusetts Institute of Technology. Dr.
Wagner qualifies as an independent director under applicable Nasdaq rules.
Yossi Ben Shalom. Mr. Ben Shalom has served as a director of the Company since
January, 2003. Mr. Ben Shalom is a co-founder of DBSI Investments Ltd. Before
establishing DBSI Investments, Mr. Ben-Shalom had been Executive Vice President
and Chief Financial Officer of Koor Industries Ltd. (KOR: Nasdaq) from 1998
through 2000. Before that, Mr. Ben-Shalom served as Chief Financial Officer of
Tadiran Ltd. Mr. Ben Shalom is serving as an active chairman in Nexus Telocation
(Nasdaq: NXUSF.OB) and in Cimatron (Nasdaq :CIMT). Mr. Ben Shalom holds a BA in
Economics and an MA in Business Management from Tel Aviv University. Mr. Ben
Shalom qualifies as an independent director under applicable Nasdaq rules.
53
Zehava Simon. Ms. Simon joined our Board in May 2005. Since 2002, Ms. Simon has
served as Chief Executive Officer of BMC Software Israel, Ltd. after having
served in various positions at BMC from 2000 to 2002. Prior to her joining BMC,
Ms. Simon served as CFO & Operations manager for Intel's Israeli subsidiaries.
Ms. Simon received her B.A degree from the Hebrew University, Jerusalem in 1981,
an M.Sc. in Business Management degree from the joint program of Boston
University/Ben Gurion University in 1991 and an LLB from the Interdisciplinary
Center, Herzliya in 2003. Ms. Simon qualifies as an independent director under
applicable Nasdaq rules.
B. COMPENSATION
The aggregate compensation paid by us and our subsidiaries to all persons who
served in the capacity of director and executive officer for the year ended
December 31, 2004 (9 persons of which 1 no longer serves in such capacity) was
approximately $ 553,000, which includes approximately $ 28,000 set aside or
accrued to provide pension, retirement or similar benefits, but does not include
amounts expended by us for automobiles made available to our officers, expenses
(including business travel, professional and business association dues and
expenses) reimbursed to officers and other fringe benefits commonly reimbursed
or paid by companies in Israel. The Company does not pay directors' fees to its
directors.
During fiscal 2004, all persons who served in the capacity of director and
executive officer for the year ended December 31, 2004 (9 persons of which 1 no
longer serves in such capacity), were granted options to purchase a total of
335,000 Ordinary Shares at an average price of $ 15.32 per share, with vesting
terms of 2-4 years. All options were granted pursuant to our then current share
option and incentive plans (see in Item 6.E below the paragraph titled "Share
Option Plans and recent changes in Israeli law").
C. BOARD PRACTICES
TERMS OF OFFICE
Directors are elected by an ordinary resolution at the Annual General Meeting of
our shareholders. All directors of the Company, other than "External directors
under the Companies Law (see in this Item 6.C below the paragraph titled
"External Directors") who serve for a period of three years after their
election, serve until the next Annual General Meeting, unless their offices are
vacated earlier under any relevant provision of our Articles of Association.
We have entered into employment agreements with all of our executive officers
similar in form to the agreements entered into with all of our other employees.
These agreements are subject to termination by either party, with or without
cause, in most cases on either 30 or 60 days' notice, depending on the
agreement. Under these agreements with our Israeli executive officers, we and
the employee each contribute a percentage of the salary of the employee to a
fund known as "Managers' Insurance." This fund provides a combination of savings
plan, insurance and severance pay benefits to the employee, giving the employee
a lump sum of payment upon retirement and securing severance pay, if legally
entitled, upon termination of employment. Each employee who agrees to
participate contributes an amount equal to 5% of his or her salary and we
contribute between 13.3% and 15.8% of his or her salary. Israeli law generally
requires severance pay, which may be funded by Managers' Insurance, upon the
retirement or death of an employee or termination of employment without due
cause. These agreements all contain provisions standard for a company in our
industry regarding non competition, confidentiality of information and
assignment of inventions. The enforceability of covenants not to compete is
limited in Israel.
54
ALTERNATE DIRECTORS
Our Articles of Association provide that a director may appoint, by written
notice to us, any individual to serve as an alternate director so long as such
individual does not already serve as a director or an alternate director. Any
alternate director will have all of the rights and obligations of the director
appointing him or her, except the power to appoint an alternate (unless the
instrument appointing him or her provides otherwise) and the right to
remuneration. The alternate director may not act at any meeting at which the
director appointing him or her is present. Unless the appointing director limits
the time period or scope of any such appointment, the appointment will be
effective for all purposes and for an indefinite time, but will expire upon the
expiration of the appointing director's term. Currently, no alternate directors
have been appointed.
EXTERNAL DIRECTORS
Under the Companies Law, companies incorporated under the laws of Israel whose
shares have been offered to the public in or outside of Israel are required to
appoint at least two external directors. This law provides that a person may not
be appointed as an external director if the person or the person's relative,
partner, employer or any entity under the person's control, has, as of the date
of the person's appointment to serve as external director, or had, during the
two years preceding that date, any affiliation with the company or any entity
controlling, controlled by or under common control with the company. The term
"affiliation" includes:
o an employment relationship;
o a business or professional relationship maintained on a regular basis;
o control; and
o service as an office holder.
No person may serve as an external director if the person's position or other
business activities create, or may create, a conflict of interest with the
person's responsibilities as an external director or may otherwise interfere
with the person's ability to serve as an out external side director.
External directors are to be elected by a majority vote at a shareholders'
meeting, provided that either:
1. at least one-third of the shares of non-controlling shareholders voted
at the meeting, vote in favor of election of the director; or
2. the total number of shares of non-controlling shareholders voted
against the election of the director does not exceed one percent of
the aggregate voting rights in the company.
The initial term of an external director will be three years and may be extended
for an additional three years. Each committee of a company's board of directors
will be required to include at least one external director and the audit
committee of a company's board of directors is required to include both the
external directors. We have appointed Yair Shoham and Itsik Onfus as external
directors pursuant to the Companies Law.
An external director is entitled to compensation as provided in regulations to
be adopted under the Companies Law and is otherwise prohibited from receiving
any other compensation, directly or indirectly, in connection with service
provided as an external director.
Under recent amendments to the Companies Law, at least one of the external
directors serving on a company's board of directors is required to have
"financial expertise" and the other external director or directors are required
to have "professional expertise." The definition of each of these terms is to be
determined under relevant regulations, which have not yet been published.
55
INDEPENDENT DIRECTORS
Our Ordinary Shares are listed for quotation on The Nasdaq National Market and
thus we are subject to the rules of The Nasdaq National Market applicable to
quoted companies as well as to the applicable provisions of the Sarbanes-Oxley
Act of 2002 and the rules and regulations thereunder. Under the rules, we are
required to appoint a minimum of three (3) Independent Directors. The
independence standard under the rules excludes any person who is a current
employee of the Company or who has been an employee of the Company for a certain
period of time as well as the immediate family members of an executive officer
of the Company. Messrs. Onfus, Shoham, Ben-Shalom and Dr. Wagner serve as
Independent Directors and meet the independence standard of the above rules.
AUDIT COMMITTEE
Under the Companies Law, the board of directors of any publicly traded company
must appoint an audit committee, comprised of at least three directors including
all of the external directors but excluding: (a) the chairman of the board of
directors; (b) any controlling shareholder or relative of a controlling
shareholder; or (c) any director employed by the company or who provides
services to the company on a regular basis. Under the Nasdaq rules, we are
required to have at least three independent directors on the audit committee. In
addition, Nasdaq requires that the members of the audit committee (a) not have
any relationship to the company that may interfere with the exercise of their
independence, and (b) must be financially literate.
The roles of our audit committee under the Companies Law include identifying
irregularities in the management of the Company's business and approving related
party transactions as required by law. The responsibilities of the audit
committee under the Nasdaq rules include, among other things, evaluating the
independence of a company's outside auditors.
In addition to such functions as the audit committee may have under the
Companies Law or under the Nasdaq rules, the primary purpose of our audit
committee is to assist the board of directors in fulfilling its responsibility
to oversee management's conduct of the financial reporting process, the systems
of internal accounting and financial controls and the annual independent audit
of the Company's financial statements. The audit committee reviews with
management and our outside auditors the audited financial statements included in
our Annual Report on Form 20-F and our interim quarterly financial results
included on Form 6-K.
The audit committee must observe the independence of our outside auditors and
has the authority and responsibility to nominate for shareholder approval,
evaluate and, where appropriate, replace our outside auditors.
In discharging its oversight role, our audit committee is empowered to
investigate any matter brought to its attention with full access to all books,
records, facilities and personnel of the Company and the power to retain outside
counsel, auditors or other experts for this purpose.
Our audit committee currently consists of Yossi Ben Shalom, Itsik Onfus and Yair
Shoham.
FINANCIAL EXPERT
Under Sarbanes-Oxley, one of the Audit Committee members must have accounting or
related financial management expertise. Our Board of Directors has recognized
Mr. Ben Shalom, based on all of the requirements set forth in the applicable
rules and regulations, as our "financial expert" and we believe that we are in
compliance with this requirement.
INTERNAL AUDITOR
Under the Companies Law, the board of directors of a public company must appoint
an internal auditor, nominated by its audit committee. The role of the internal
auditor is to examine, among other matters, whether the Company's actions comply
with the law and orderly business procedure. Under the Companies Law, the
internal auditor may be an employee of the Company but not an office holder, an
affiliate, or a relative of an office holder or affiliate, and he may not be the
Company's independent accountant or its representative. We have appointed an
internal auditor in accordance with the requirements of the Companies Law.
56
D. EMPLOYEES
As of December 31, 2002, 2003 and 2004, we had 288, 362 and 513 employees,
respectively, of which for 2004, such number includes 76 employees in
administration and finance, 158 in sales and marketing, 190 in research and
development and 89 in operations. Of these 513 employees, 403 were based in
Israel, 44 in the United States and 66 in other countries.
We are subject to Israeli labor laws and regulations with respect to our Israeli
employees. These laws principally concern matters such as paid annual vacation,
paid sick days, length of the workday and work week, minimum wages, pay for
overtime, insurance for work-related accidents, severance pay and other
conditions of employment.
Furthermore, by order of the Israeli Ministry of Labor and Welfare, we and our
Israeli employees are subject to provision of the collective bargaining
agreements between the Histadrut, the General Federation of Labor in Israel and
the Coordination Bureau of Economic Organizations, including the Industrialists
Associations. These provisions principally concern cost of living increases,
recreation pay and other conditions of employment. We believe that the benefits
and working conditions that we provide to our employees are above the required
minimum. Our employees are not represented by a labor union. We have written
employment contracts with virtually all of our employees and we believe that our
relations with our employees are satisfactory.
E. SHARE OWNERSHIP
As of April 30, 2005, the aggregate number of our Ordinary Shares beneficially
owned by our directors and executive officers as a group was 3,746,745, and
includes options to purchase up to 365,125 Ordinary Shares which are exercisable
or will become exercisable within 60 days of April 30, 2005. The weighted
average exercise price of these options was $ 6.00 per share.
Other than those individual directors and executive officers listed in the table
below, all of our directors and executive officers listed in Item 6.B above
beneficially own less than one percent of our Ordinary Shares as of April 30,
2005.
ORDINARY SHARES
BENEFICIALLY OWNED
NAME NUMBER PERCENT
- ----------- ---------- ---------
Dov Moran 2,263,542 6.29%
Aryeh Mergi 665,878 1.85%
Hans Wagner 613,700 1.70%
SHARE OPTION PLANS AND RECENT CHANGES IN ISRAELI LAW
The Company previously had two incentive share option plans in place, the
Incentive and Restricted Share Option Plan (the "IRSO Plan") and the Section 102
Share Option Plan (the "102 Plan" and, together with the IRSO Plan, the "Old
Plans"). The respective term of each of the Old Plans expired on February 15th,
2003.
In replacement of the Old Plans and in lieu of recent revisions (the "Tax
Reform") to the Israeli Income Tax Ordinance (New Version) 1961 (the "Tax
Ordinance") requiring the adoption of certain adjustments concerning the
issuance of share options to Israeli employees, the Company adopted, by way of a
resolution of the Board of Directors on November 5th, 2002 and a resolution of
the shareholders of the Company on December 17th, 2002, its new omnibus 2003
Stock Option and Restricted Stock Incentive Plan (the "New 2003 Plan").
Following is a brief review of each of the Old Plans, of the New 2003 Plan and
of the Tax Reform:
57
INCENTIVE AND RESTRICTED SHARE OPTION PLAN
Under the IRSO Plan, we were authorized to grant options for up to 3,000,000
Ordinary Shares to our employees, directors and consultants. The exercise price
per share for an incentive share option could not be less than the market value
of the Ordinary Shares on the date the option was granted. Incentive options
granted under the IRSO Plan in accordance with the terms thereof were intended
to qualify as incentive stock options under Section 422 of the U.S. Internal
Revenue Code of 1986, as amended (the "Code"). Any options that were cancelled
or forfeited before expiration became available for future grant under the IRSO
Plan. The IRSO Plan expired on February 15th, 2003.
SECTION 102 SHARE OPTION PLAN
Under the 102 Plan, we were authorized to grant options to purchase an aggregate
of 4,000,000 Ordinary Shares to our Israeli employees. The exercise prices of
options granted under the 102 Plan were determined by our Board of Directors at
the time of the grant, and such granted options usually expire no later than ten
years from the date of grant. Any options that were cancelled or forfeited
before expiration became available for future grant under the 102 Plan. The 102
Plan expired on February 15th, 2003.
Prior to the revision of the Tax Ordinance, pursuant to Section 102 thereof and
the rules promulgated thereunder (including the requirement that the options
and/or the resulting shares be deposited with a trustee for at least two years),
the tax on the benefit arising to the employee from the grant and exercise of
options as well as from the allotment of Ordinary Shares under these options is
deferred until the transfer of the options and/or Ordinary Shares to the
employee's name or upon the sale of those options and/or Ordinary Shares. We
will be allowed to claim as an expense for tax purposes the amounts credited to
the employees as a benefit upon sale of the shares allotted under the 102 Plan
at a price exceeding the exercise price, when the related capital gains tax is
payable by the employee.
THE NEW 2003 PLAN
Under the New 2003 Plan, the Company has reserved eight million (8,000,000)
Ordinary Shares for the granting of awards to the employees, officers,
directors, service providers and consultants of the Company and of any
subsidiary of the Company. Of this amount, five million Ordinary Shares were
reserved for issuance with the adoption of the New 2003 Plan by the shareholders
of the Company on the December 17, 2003 Annual General Meeting of Shareholders
and the number of Ordinary Shares reserved for issuance was increased by an
additional 3,000,000 Ordinary Shares following approval by the shareholders of
the Company on November 11, 2004. The New 2003 Plan is intended to enable the
Company to issue awards under varying tax regimes, including without limitation
(i) pursuant and subject to the provisions of the Tax Ordinance; (ii) incentive
stock options within the meaning of Section 422 of the Code; (iii) nonqualified
stock options; (iv) shares of restricted stock; and (v) other share-based
awards. Apart from issuance under the relevant tax regimes in the State of
Israel and the United States of America, the New 2003 Plan contemplates
issuances of awards in other jurisdictions, with respect to which the Board of
Directors is empowered to make the requisite adjustments in the New 2003 Plan
and set forth the relevant conditions in the Company's agreement with the
grantee in order to comply with the requirements of the tax regimes in any such
jurisdictions.
Awards may be granted pursuant to the New 2003 Plan from time to time within a
period of ten (10) years from the date the New 2003 Plan was adopted by the
Board of Directors. The exercise prices of options granted under the New 2003
Plan is to be determined, subject to applicable law, by the Board of Directors
at the time of the grant, and such granted options usually expire no later than
ten years from the date of grant. Any of the Ordinary Shares reserved under the
New 2003 Plan, which may remain unsold and which are not subject to outstanding
options at the termination of the New 2003 Plan, shall cease to be reserved for
the purpose of the New 2003 Plan. If any outstanding award under the New 2003
Plan should, for any reason, expire, be canceled or be forfeited without having
been exercised in full, the Ordinary Shares allocable to the unexercised,
canceled or terminated portion of such award shall (unless the New 2003 Plan
shall have been terminated) become available for subsequent grants of awards
under the New 2003 Plan.
58
AGGREGATE AMOUNTS OF OUTSTANDING OPTIONS
As of April 30, 2005, under the Old Plans and the New 2003 Plan we had, in the
aggregate, outstanding options for 6,162,445 Ordinary Shares at an average
exercise price of $ 12.25 per Ordinary Share, and with expiration dates ranging
from August, 2003 to March, 2014.
REVISIONS TO THE TAX ORDINANCE
The Tax Reform created a new tax structure for taxing stock or stock options
that the Company grants to its Israeli employees, while the existing tax
structure will continue to apply to the issuance of options to external service
providers and to the controlling owners of the Company, who are not considered
to be `employees' of the Company for the purposes of Section 102 of the Tax
Ordinance. As a general rule, a company can choose to issue options or shares
through a trustee or without a trustee. If such company chooses the trustee
track, it must further opt for either the `ordinary income track' or the
`capital gains track' and this decision is then binding on the company and on
all similarly situated office-holders for the subsequent two years.
We have chosen to issue shares and options through a trustee, who has been
authorized by the tax authorities in accordance with and for the period set by
law and, as a result, neither the issuance of shares or options to those of our
eligible employees, nor the exercise by such employees of their options, will be
taxable. The tax will be imposed only when the shares are sold by the trustee or
transferred to the employee, whichever is earlier. We have notified the tax
authorities of our opting for the `capital gains track' in accordance with the
requirements of the Tax Ordinance.
As a result of our choosing the `capital gains track,' in the event that the
trustee holds the shares until the end of the required holding period, which is
at least 2 years from the end of the tax year in which the shares or options
were issued to the trustee, the value of the benefit to the employee will be
considered to be capital gain and he or she will be taxed at a rate of 25%. In
addition, we will not be able to deduct expenses for tax purposes. As our
Ordinary Shares are registered on a stock exchange, a part of the profit that
reflects the value of the benefit to the date of issuance will be considered as
ordinary income by the employee and we will be able to deduct this as a salary
expense, with the balance being deemed as capital gains and taxable at 25% which
we will not be able to deduct as an expense. Had we chosen the `ordinary income
(employment income) track', the employee would have been considered as having
received employment income in an amount equal to the benefit (consideration at
date of sale, less share option exercise price and expenses from the purchase
and sale). We would then have been entitled to deduct as a salary expense, the
same amount as the employee would have received in income. The required holding
period by the trustee under the `ordinary income (employment income) track' is
one year from the end of the tax year in which the options or shares were issued
to the employee.
THE EMPLOYEE STOCK PURCHASE PLAN -- GLOBAL NON-U.S. (THE "GLOBAL ESPP PLAN");
AND THE EMPLOYEE STOCK PURCHASE PLAN -- U.S. (THE "U.S. ESPP PLAN")
The purpose of the ESPP plans is to enable our employees to purchase M-Systems'
shares through accumulated payroll deductions. The Global ESPP plan is available
to all of our non-U.S. employees. The U.S. ESPP plan is available to our U.S.
employees and contains certain provisions intended to qualify the U.S. ESPP plan
as an "employee stock purchase plan" under Section 423 of the Code.
The terms of our ESPP plans (both Global and U.S.) provide that any of our
employees (with certain restrictions in the U.S. ESPP Plan), if he or she so
chooses, can elect before any "Offering Period" to have any whole percentage
between 1% and 10% deducted from his salary and allocated to buy M-Systems
shares. An "Offering Period" is a six-month period, with a new Offering Period
beginning on May 15 and November 15 each year (unless changed by the Board of
Directors). The price of the shares purchased by the employee -- i.e., the
number of shares that he will receive in return for the amounts deducted from
his salary over the six-month 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
for of M-Systems' shares on (1) the first day of the Offering Period; or (2) the
last day of the Offering Period.
Under the Global ESPP plan, we may sell up to 550,000 shares to our employees.
Under the U.S. ESPP plan, we may sell up to 200,000 shares to our employees.
The ESPP plans expire in 2011 unless earlier terminated by our Board of
Directors.
59
ITEM 7. MAJOR SHAREHOLDERS AND INTERESTED PARTY TRANSACTIONS
A. MAJOR SHAREHOLDERS
The following table sets forth the number of Ordinary Shares owned beneficially
by all shareholders known to us to own beneficially more than 5% of the
outstanding Ordinary Shares on April 30, 2005.
ORDINARY SHARES
BENEFICIALLY OWNED
NAME NUMBER PERCENT
- --------------------------------------------------------------- --------- ---------
Dov Moran 2,263,542 6.29%
RS Investment Management Co. LLC (1)(2) 2,882,235 8.00%
Federated Investors, Inc. (Asset Management) (2) 1,882,400 5.23%
All directors and executive officers as a group (8 persons) (3) 3,746,745 10.41%
The following table lists the significant changes in the percentage ownership
held by any major shareholders during the past three years:
NAME OF SIGNIFICANT SHAREHOLDER EFFECT OF CHANGE YEAR OF CHANGE
- ------------------------------------------------- ------------------------------------- ----------------
Federated Investors, Inc. (Asset Management) (2) increased its shareholdings beyond 5% 2004
Fidelity Investments (2) increased its shareholdings beyond 5% 2003
decreased its shareholdings beneath 5% 2004
Viking Global Investors LP (2) increased its shareholdings beyond 5% 2004
decreased its shareholdings beneath 5% 2004
(1) Based on information contained in the most recently filed Report of
Form 13-G. In such form filed by RS Investment Management Co. LLC, it
is the general partner of RS Investment Management, L.P. and the
majority shareholder of RS Investment Management, Inc. G. Randall
Hecht is the chief executive officer and a control person of RS
Investment Management Co. LLC, RS Investment Management, L.P., and RS
Investment Management, Inc. RS Investment Management, L.P. is a
registered investment adviser and the investment adviser to RS
Emerging Growth Fund, a registered investment company.
(2) Numbers and percentages are based on information provided to the
Company from outside sources. We are unable to give accurate
percentages of each entity's holdings.
(3) Also includes options granted to such directors and executive officers
of the Company, which are exercisable within 60 days of April 30,
2005.
Our shareholders do not have different voting rights.
As of April 30, 2005, our Ordinary Shares were held by approximately 76 holders
of record. Based on a review of the information provided to us by our transfer
agent, 62 holders of record, holding approximately 91.43% of our outstanding
Ordinary Shares, were residents of the United States.
60
B. RELATED PARTY TRANSACTIONS
On May 1st, 2003, we entered into a Share Purchase Agreement with Dr. Hans
Wagner, a member of our Board of Directors, according to which Dr. Wagner
purchased 500,000 of our Ordinary Shares, at a purchase price per share of $
8.21, for an aggregate investment amount of $ 4,105,000. This transaction was
approved by our Audit Committee and Board of Directors, in the absence of Dr.
Wagner, in accordance with the provisions of the Companies Law governing
approval of related party transactions.
INSURANCE. We have obtained directors and officers liability insurance for the
benefit of our office holders and intend to continue and obtain such insurance
and pay all premiums thereunder to the fullest extent permitted by the Companies
Law. Under the Companies Law, an Israeli company may not exempt an office holder
from liability for a breach of his duty of loyalty, but may exempt in advance an
office holder from his liability to the company, in whole or in part, for a
breach of his duty of care.
Our Articles of Association provide that, subject to the provisions of the
Companies Law, we may enter into a contract for the insurance of the liability
of any of our office holders for acts which he or she performed in his or her
capacity as an office holder in relation to:
o a breach of his/her duty of care to us or to another person;
o a breach of his/her duty of loyalty to us, provided that the office
holder acted in good faith and had reasonable cause to assume that
his/her act would not prejudice our interests; or
o a financial liability imposed upon him/her in favor of another person.
INDEMNIFICATION OF OFFICE HOLDERS. Our Articles of Association provide that we
may indemnify an office holder against:
o a financial liability imposed on him/her in favor of another person by
any judgment, including a settlement or an arbitrator's award approved
by a court concerning an act performed in his/her capacity as an
office holder;
o reasonable litigation expenses, including attorneys' fees, expended by
the office holder or charged to him/her by a court in proceedings we
institute against him/her, instituted on our behalf, or instituted by
another person, in each case relating to an act performed in his/her
capacity as an office holder; and
o reasonable litigation expenses relating to an act performed in his/her
capacity as an office holder, including attorneys' fees, expended by
the office holder or charged to him/her by a court in a criminal
proceeding from which he/she was acquitted, or a criminal proceeding
in which he/she was convicted for a criminal offense that does not
require proof of intent.
Our Articles of Association also include:
o authorization to undertake, in advance, to indemnify an office holder,
provided that the undertaking is limited to specified events which the
board of directors believes are anticipated and limited in amount
determined by the board of directors to be reasonable under the
circumstances; and
o authorization to indemnify retroactively an office holder.
We have agreed to indemnify our office holders under indemnification agreements
with each office holder, to the maximum extent permitted under the Companies
Law.
61
C. INTEREST OF EXPERT AND COUNSEL
- - NOT APPLICABLE
ITEM 8. FINANCIAL INFORMATION
A. CONSOLIDATED STATEMENTS AND OTHER FINANCIAL INFORMATION
Our consolidated audited financial statements are included in this annual report
in "Item 18: Financial Statements."
LEGAL PROCEEDINGS
Other than the litigation set forth below, we are not involved in any legal
proceedings that we believe, individually or in the aggregate, will have a
material adverse effect on the Company:
TREK
M-Systems and a number of its distributors in Singapore are in litigation with
Trek Technology (Singapore) Pte Ltd. a company registered in Singapore ("Trek").
In April 2002, Trek received a patent in Singapore for a "Portable Data Storage
Device". Trek immediately issued `Cease and Desist' letters to several
companies, including M-Systems' distributors in Singapore alleging that
M-Systems' DiskOnKey product infringed its patent. M-Systems asked Trek to
withdraw its letters and was refused. Consequently, On May 17th, 2002 M-Systems
filed a lawsuit against Trek for groundless threats and on May 20th, 2002 Trek
filed a lawsuit against M-Systems' distributors (and later M-Systems itself) for
patent infringement. M-Systems is under a contractual obligation to indemnify
these distributors and we represent them in the pending litigation.
The trial was held in mid-2004. On May 12, 2005, the High Court ruled in favor
of Trek in respect of its application to amend its patent and in respect of its
claim for patent infringement against us and our distributors in Singapore. The
High Court also dismissed our claim against Trek for making groundless threats
of patent infringement as well as our counterclaim to invalidate the Trek
patent. We have one month from May 12, 2005 to file a notice of appeal
indicating that we intend to appeal. As of May 12, 2005, we already have an
appeal pending against an earlier procedural decision of the High Court which
wasn't addressed yet.
The amount of damages to be awarded to Trek, both for legal costs and
compensatory damages will be determined by the Court. Our current estimation,
which is based upon the information available to us, is that the amount of the
damage award will not have a material adverse impact on our financial condition
or results of operations. As of December 31, 2004, no accrual has been made in
respect of the abovementioned litigation since we had not deemed it probable
that we would incur any loss.
62
JACO
In October 2003, a distributor of ours Jaco Electronics Inc., or Jaco, filed a
claim against our 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 ours). Jaco's
fraud and related claims arise out of alleged assurances by our 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
$ 10,400,000, plus punitive damages. We filed a motion to dismiss the complaint
on or about December 12, 2003. On August 18, 2004, the Court issued an order
granting our motion to dismiss the complaint in its entirety. On September 28,
2004, Jaco filed a notice of appeal which must be perfected by May 27, 2005. We
and Jaco are currently negotiating a settlement of the appeal according to which
we will not incur any loss in respect to such litigation. Accordingly, no
accrual has been made in respect thereto.
DIVIDEND DISTRIBUTION POLICY
We have never declared or paid any cash dividends on our Ordinary Shares and we
do not intend to pay cash dividends on our Ordinary Shares in the foreseeable
future. We currently intend to retain all future earnings to finance operations
and to expand our business.
Under the provisions of our Articles of Association, the declaration of any
final cash dividends in respect of any fiscal period requires shareholder
approval, which may reduce but not increase such dividend from the amount
proposed by our board of directors; provided that any failure by the
shareholders to approve a final dividend will not affect any interim dividend
which has been paid. Payments of dividends may be subject to withholding and
other taxes.
If we declare cash dividends, they could be taxable to the recipient. Because we
have received benefits under the Investment Law (see item 10.E below the
paragraph titled "Law for the Encouragement of Capital Investments, 1959"),
payment of cash dividends during the exemption period granted under the
Investment Law will subject that portion of our income derived from the
`approved enterprise' status granted to us under the Investment Law, to Israeli
taxes to which the income would not otherwise be subject. We have decided to
reinvest permanently the amount of tax-exempt income derived from our approved
enterprises and not to distribute such income as dividends. In the event that we
decide to pay a cash dividend from income that is tax exempt, we would be liable
for corporate tax on the amount distributed at the rate of 20%. Cash dividends
may be paid by an Israeli company only out of retained earnings as calculated
under Israeli law.
B. SIGNIFICANT CHANGES
- - NOT APPLICABLE
63
ITEM 9. THE OFFER AND LISTING
A. OFFER AND LISTING DETAILS
4. The following table lists the high and low last reported sales prices on
Nasdaq for the periods indicated:
YEARLY FIGURES
--------------
High Low
-----------------------
2000:* $ 44.25 $ 11.94
2001: $ 16.56 $ 3.92
2002: $ 12.59 $ 4.95
2003 $ 22.49 $ 5.20
2004 $ 23.15 $ 11.50
QUARTERLY FIGURES
-----------------
2003: High Low
-----------------------
First Quarter $ 8.25 $ 5.20
Second Quarter $ 11.72 $ 6.00
Third Quarter $ 17.61 $ 11.43
Fourth Quarter $ 22.49 $ 15.73
2004:
First Quarter $ 22.00 $ 16.86
Second Quarter $ 23.15 $ 13.55
Third Quarter $ 16.50 $ 11.50
Fourth Quarter $ 19.99 $ 13.85
2005:
First Quarter $ 26.06 $ 18.65
MONTHLY FIGURES
---------------
2004-2005: High Low
Most Recent 6 months: -----------------------
November 2004 $ 16.85 $ 13.85
December 2004 $ 19.99 $ 16.45
January 2005 $ 20.97 $ 18.65
February 2005 $ 24.73 $ 20.4
March 2005 $ 26.06 $ 21.54
April 2005 $ 23.54 $ 19.45
* We effected a two-for-one stock split in September 2000. Accordingly,
the share price information for 2000 is adjusted to reflect such stock
split.
On April 29, 2005, the last reported sale price of our Ordinary Shares was $
18.95 per share. There is currently no trading market for our Ordinary Shares
outside the United States.
64
B. PLAN OF DISTRIBUTION
- - NOT APPLICABLE
C. MARKETS
Our Ordinary Shares were quoted on The Nasdaq Small-Cap Market under the symbol
"FLSHF" from our initial public offering in March 1993 through our secondary
public offering in August 1996. Since August 8, 1996, our Ordinary Shares have
been quoted on The Nasdaq National Market. On March 24, 1999, our ticker symbol
was changed to "FLSH."
D. SELLING SHAREHOLDERS
- - NOT APPLICABLE
E. DILUTION
- - NOT APPLICABLE
F. EXPENSES OF ISSUE
- - NOT APPLICABLE
65
ITEM 10. ADDITIONAL INFORMATION
A. SHARE CAPITAL
- - NOT APPLICABLE
B. MEMORANDUM AND ARTICLES OF ASSOCIATION
OBJECTS AND PURPOSES
The objects and purposes of our Company appear in our Memorandum of Association
and include taking all actions permissible under applicable laws.
APPROVAL OF SPECIFIED RELATED PARTY TRANSACTIONS
The Companies Law imposes a duty of care and a duty of loyalty on all of a
company's office holders as defined below, including directors and executive
officers. The duty of care requires an office holder to act with the level of
care that a reasonable office holder in the same position would have acted under
the same circumstances. The duty of loyalty generally requires an office holder
to act in good faith and for the good of the company. An "office holder" as
defined in the Companies Law is a director, a general manager, a chief executive
officer, a deputy general manager, a vice general manager, other managers
directly subordinate to the general manager and any person who fills one of the
above positions without regard to title.
The Companies Law requires that an office holder of a company promptly disclose
any personal interest that he may have and all related material information
known to him, in connection with any existing or proposed transaction by the
company. Once an office holder complies with these disclosure requirements, the
board of directors may approve a transaction between the company and the office
holder, or a third party in which an office holder has a personal interest,
unless the articles of association provide otherwise. A transaction that is
adverse to the company's interest cannot be approved. If the transaction is an
extraordinary transaction under the Companies Law, then, in addition to any
approval stipulated by the articles of association, it also requires audit
committee approval before board approval and, in specified circumstances,
subsequent shareholder approval. Any transaction between a company and one of
its directors relating to the conditions of the director's service, including in
relation to exculpation, insurance or indemnification, or in relation to the
terms of the director's service in any other capacity requires audit committee
approval before board approval and subsequent shareholder approval.
The Companies Law also provides that a director with an interest in an
extraordinary transaction brought before the board of directors or the audit
committee for its approval may not vote on the approval and may not be present
for the discussion of the issue. However, this rule would not apply if a
majority of the directors or a majority of the members of the audit committee
also possessed an interest in the transaction.
Under our Articles of Association, our Board of Directors may exercise all
powers and take all actions that are not required under law or under our
Articles of Association to be exercised or taken by our shareholders, including
the power to borrow money for the purposes of our Company.
Our directors are not subject to any age limit requirement, nor are they
disqualified from serving on the Board of Directors because of a failure to own
certain amount of our shares.
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RIGHTS, PREFERENCES AND RESTRICTIONS ON SHARES
Our Articles of Association authorize one class of shares, which are our
Ordinary Shares. We may declare a dividend to be paid to the holders of our
Ordinary Shares and allocated among them in proportion to the sums paid up or
credited as paid up on account of the nominal value of their respective
shareholdings, without taking into account any premium paid for the shares. Our
Board of Directors may declare dividends only out of retained earnings, or
earnings derived over the two most recent fiscal years, whichever is higher. Our
Articles of Association provide that our Board of Directors may propose a final
dividend in respect of any fiscal period but that such dividend shall be payable
only after approved by our shareholders. All unclaimed dividends may be invested
or otherwise used by the Board of Directors for our benefit until those
dividends are claimed. In the event an unclaimed dividend is claimed, only the
principal amount of the dividend will be paid to the person entitled to the
dividend.
If we liquidate, after satisfying liabilities to creditors and subject to the
rights of holders of shares, if any, with any special rights upon winding up,
our assets will be distributed to the holders of Ordinary Shares in proportion
to their holdings.
Holders of Ordinary Shares have one vote for each - paid-up Ordinary Share held
of record on all matters submitted to a vote of our shareholders. These voting
rights may be affected by the grant of any special voting rights to the holders
of a class of shares with preferential rights that may be authorized in the
future.
Our Articles of Association provide that directors are elected by an ordinary
resolution of a general meeting of our shareholders. Our Ordinary Shares do not
have cumulative voting rights in the election of directors. Accordingly, the
holders of Ordinary Shares representing more than 50% of the voting power in our
Company have the power to elect all directors.
We may, subject to the applicable provisions of the Companies Law, issue
redeemable shares and subsequently redeem them. In addition, our Board of
Directors may make calls for upon shareholders in respect of any sum that has
not been paid up in respect of any shares held by those shareholders.
Under the Companies Law, the disclosure requirements that apply to an office
holder also apply to a controlling shareholder of a public company. A
controlling shareholder includes a shareholder that holds 25% or more of the
voting rights in a public company if no other shareholder owns more than 50% of
the voting rights in the company. Extraordinary transactions with a controlling
shareholder or in which a controlling shareholder has a personal interest, and
the terms of compensation of a controlling shareholder who is an office holder,
require the approval of the audit committee, the board of directors and the
shareholders of the company. The shareholder approval requires that: (a) the
majority of shares voted at the meeting, including at least one third of the
shares of disinterested shareholders voted at the meeting, vote in favor of the
transaction; or (b) the total number of shares of disinterested shareholders
voted against the transaction does not exceed one percent of the aggregate
voting rights in the company.
The Companies Law also requires a shareholder to act in good faith towards a
company in which he holds shares and towards other shareholders and to refrain
from abusing his power in the company, including in connection with voting at a
shareholders' meeting on:
o Any amendment to the Articles of Association;
o An increase in the company's authorized capital;
o A merger; or
o Approval of some of the acts and transactions that require shareholder
approval.
A shareholder has the general duty to refrain from depriving other shareholders
of their rights. Any controlling shareholder, any shareholder that knows that it
possesses the power to determine the outcome of a shareholder vote and any
shareholder that, under the provisions of the articles of association, has the
power to appoint an office holder in the company, is under a duty to act in
fairness towards the company. The Companies Law does not describe the substance
of this duty, except to state that the remedies generally available upon a
breach of contract will apply also in the event of a breach of the duty to act
with fairness.
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MODIFICATIONS OF SHARE RIGHTS
Under our Articles of Association, the rights attached to any class may be
varied by adoption of the necessary amendment of the Company's Articles of
Association, provided that the holders of shares of the affected class approve
the change by a class meeting in which the holders of at least 75% of the
shareholders present at the meeting, in person or by proxy, and voting on the
issue approve the change. Our Articles of Association differ from the Companies
Law in this respect, as under the law changes in the rights of shareholders
require the consent of at least 50% of the voting power of the affected class
represented at the meeting and voting on the change. Our Articles of Association
require for quorum at a meeting of a particular class of shares the presence of
two shareholders holding at least 25% of the voting power of that class. Our
Articles of Association - may be amended by majority of the voting power of our
Company represented at a shareholders meeting and voting thereon, except that
the provisions of our Articles of Association relating to mergers and
acquisitions can only be amended by a vote of 75% of the voting power of our
Company represented at a meeting and voting thereon.
SHAREHOLDERS MEETINGS AND RESOLUTIONS
We are required to hold an annual general meeting of our shareholders once every
calendar year, but no later than 15 months after the date of the previous annual
general meeting. All meetings other than the annual general meeting of
shareholders are referred to as extraordinary general meetings. Our Board of
Directors may call extraordinary general meetings whenever it sees fit, at such
time and place, within or without the State of Israel, as it may be determined.
In addition, the Companies Law provides that the board of directors of a public
company is required to convene an extraordinary meeting upon the request of (a)
any two directors of the company or one quarter of the company's board of
directors or (b) one or more shareholders holding, in the aggregate, (i) five
percent of the outstanding shares of the company and one percent of the voting
power in the company or (ii) five percent of the voting power in the company.
The quorum required by our Articles of Association for a meeting of shareholders
consists of at least two shareholders present in person or by proxy who hold or
represent between them at least 25% of the voting power in our Company. This
percentage requirement complies with the Companies Law; however, it differs from
the Nasdaq requirement of 33%. Nasdaq rules enable foreign private issuers, such
as ourselves, to comply with the law of our jurisdiction of incorporation in
place of certain Nasdaq listing requirement. A meeting adjourned for lack of
quorum is adjourned to the same day in the following week at the same time and
place or any time and place as the chairman of the meeting decides. At such
reconvened meeting, the required quorum consists of any two shareholders present
in person or by proxy.
Our Articles of Association enable our Board of Directors to fix a record date
to allow us to determine the shareholders entitled to notice of, or to vote at,
any general meeting of our shareholders. The record date may not be more than 40
days, or any longer period permitted under the Companies Law, nor less than 4
days before the date of the meeting. Each shareholder of record as of the record
date determined by the Board of Directors may vote the shares then held by that
shareholder unless all calls and other sums then payable by the shareholder in
respect of its shares have not been paid.
LIMITATION ON OWNERSHIP OF SECURITIES
The ownership and voting of our Ordinary Shares by non-residents of Israel are
not restricted in any way by our Articles of Association or by the laws of the
State of Israel, except for shareholders who are subjects of countries which are
enemies of the State of Israel.
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MERGERS AND ACQUISITIONS; ANTI-TAKEOVER PROVISIONS
The Companies Law includes provisions allowing corporate mergers. These
provisions require that the board of directors of each company that is party to
the merger approve the transaction. In addition, the shareholders of each
company must approve the merger. Our Articles of Association require approval of
a merger or acquisition by a vote of the 75% of our Company's voting power,
present and voting on the proposed merger at a shareholders' meeting. In
determining whether the requisite majority has approved the merger, shares held
by the other party to the merger or by any person holding at least 25% of such
other party are excluded from the vote. The Companies Law does not require court
approval of a merger other than in specified situations. However, upon the
request of a creditor of either party to the proposed merger, a court may delay
or prevent the merger if it concludes that there exists a reasonable concern
that as a result of the merger, the surviving company will be unable to satisfy
the obligations of any of the parties of the merger to their creditors.
A merger may not be completed until at least 50 days have passed from the time
that a merger proposal was filed with the Israeli Registrar of Companies and 30
days have passed from the shareholders' approval of the merger in each of the
merging companies.
The Companies Law also provides that the acquisition of shares in a public
company on the open market (i.e., from other shareholders of the company) must
be made by means of a tender offer if, as a result of the acquisition, the
purchaser would become a 25% shareholder of the company. The rule does not apply
if there already is another 25% shareholder of the company. Similarly, the law
provides that an acquisition of shares in a public company must be made by means
of a tender offer if, as a result of the acquisition, the purchaser would become
a 45% shareholder of the company, unless there already is another 45%
shareholder of the company.
If, following any acquisition of shares, the purchaser would hold 90% or more of
the shares of the company that acquisition must be made by means of a tender
offer for all of the target company's shares. An acquirer who wishes to
eliminate all minority shareholders must do so by means of a tender offer and
acquire 95% of all shares not held by or for the benefit of the acquirer prior
to the acquisition. However, in the event that the tender offer to acquire that
95% is not successful, the acquirer may not acquire tendered shares if by doing
so the acquirer would own more than 90% of the shares of the target company.
CHANGES IN CAPITAL
Our Articles of Association enable us to increase or reduce our share capital.
Any such changes are subject to the provisions of the Companies Law and must be
approved by a resolution passed by a majority of the voting power of our Company
present, in person or by proxy, at a general meeting and voting on such change
in the capital. In addition, certain transactions, which have the effect of
reducing capital, such as the declaration and payment of dividends under certain
conditions and the issuance of shares for less than their nominal value, require
a resolution of the Board of Directors and court approval.
MATERIAL CONTRACTS
On July 29, 2003, we announced a set of new agreements with Toshiba which
broadened our relationship with Toshiba (see Item 4.B above the paragraph titled
"Relationship with Toshiba and Samsung").
On December 31, 2003, we entered into a Strategic Agreement with Samsung which
broadened our relationship with Samsung (see Item 4.B above the paragraph titled
"Relationship with Toshiba and Samsung").
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On March 23, 2005, we completed an offering of our Convertible Notes which
provided net proceeds for us of approximately $ 72.75 million (as further
described under Item 4.B above "Business Overview" in the paragraph titled
"Recent Developments" under the heading "Convertible Note Offering"). The
interest rate, conversion rate and offering price were pursuant to the Purchase
Agreement between M-Systems Finance, M-Systems and the initial purchasers of the
Convertible Notes and the Senior Indenture between M-Systems Finance, M-Systems
and The Bank of New York Trust Company, N.A., as trustee. .The Purchase
Agreement provides that obligations of M-Systems Finance under the Purchase
Agreement are unconditionally guaranteed by M-Systems. M-Systems Finance issued
the notes under the Senior Indenture. The terms for registering the Convertible
Notes and the ordinary shares issuable upon conversion of the Convertible Notes
with the SEC are covered by the Registration Rights Agreement.
Other than the agreements referred to above, in the past two years we have not
entered into any material contracts other than contracts entered into in the
ordinary course of our business.
D. EXCHANGE CONTROLS
Holders of Ordinary Shares are able to convert dividends and liquidation
distributions into freely repatriable non-Israeli currencies at the rate of
exchange prevailing at the time of repatriation, pursuant to a general permit
issued by the Controller of Foreign Exchange at the Bank of Israel under the
Currency Control Law, 1978, provided that Israeli income tax has been withheld
by us with respect to such amounts.
Our Ordinary Shares may be freely held and traded pursuant to the General Permit
and the Currency Control Law. The ownership or voting of Ordinary Shares by
non-residents of Israel, except with respect to citizens of countries that are
in a state of war with Israel, are not restricted in any way by our Memorandum
of Association or Articles of Association or by the laws of the State of Israel.
E. TAXATION
The following is a summary of the current tax structure applicable to companies
in Israel, with special reference to its effect on us. The following also
contains a discussion of certain Israeli Government programs benefiting us. To
the extent that the discussion is based on new tax legislation that has not been
subject to judicial or administrative interpretation, there can be no assurance
that the views expressed in the discussion will be accepted by the tax
authorities in question. The discussion is not intended, and should not be
construed, as legal or professional tax advice and is not exhaustive of all
possible tax considerations.
GENERAL CORPORATE TAX STRUCTURE
Israeli companies are subject to corporate tax. The corporate tax rate was
reduced, in July 2004, from 36% to 35% for the 2004 tax year, 34% for the 2005
tax year, 32% for the 2006 tax year and 30% for the 2007 tax year and
thereafter. However, the effective rate of tax of a company that derives income
from an `approved enterprise' (as referred to below) may be considerably lower
(see in this Item 10.E below the paragraph titled "Law for the Encouragement of
Capital Investments, 1959").
TAX REFORM
On January 1, 2003, the Law for Amendment of the Income Tax Ordinance (Amendment
No. 132), 5762-2002, known as the `Tax Reform', came into effect.
The Tax Reform, aimed at broadening the categories of taxable income and
reducing the tax rates imposed on employment income, introduced the following,
among other things:
o Reduction of the tax rate levied on capital gains (other than gains
deriving from the sale of listed securities) derived after January 1,
2003, to a general rate of 25% for both individuals and corporations.
Regarding assets acquired prior to January 1, 2003, the reduced tax
rate will apply to a proportionate part of the gain, in accordance
with the holding periods of the asset, before or after January 1,
2003, on a linear basis;
o Imposition of Israeli tax on all income of Israeli residents,
individuals and corporations, regardless of the territorial source of
income, including income derived from passive sources such as
interest, dividends and royalties;
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o Introduction of controlled foreign corporation (CFC) rules into the
Israeli tax structure. Generally, under such rules, an Israeli
resident who holds, directly or indirectly, 10% or more of the rights
in a foreign corporation whose shares are not publicly traded (or
which has offered less than 30% of its shares or any rights to its
shares to the public), in which more than 50% of the rights are held
directly or indirectly by Israeli residents, and a majority of whose
income in a tax year is considered passive income, will be liable for
tax on the portion of such income attributed to his holdings in such
corporation, as if such income were distributed to him as a dividend;
o Imposition of capital gains tax on capital gains realized by Israeli
individuals as of January 1, 2003, from the sale of shares of publicly
traded companies on the Tel Aviv Stock Exchange and from the sale of
shares of publicly traded Israeli companies on certain other stock
exchanges (such gain was previously exempt from capital gains tax in
Israel in certain cases). For information with respect to the
applicability of Israeli capital gains taxes on the sale of our
Ordinary Shares, see "Capital Gains Taxes on Sales of our Ordinary
Shares" below;
o Introduction of a new regime for the taxation of shares and options
issued to employees and officers (including directors); and
o Introduction of tax at a rate of 25% on dividends paid by one Israeli
company to another (which are generally not subject to tax), if the
source of such dividend is income that was derived outside of Israel.
LAW FOR THE ENCOURAGEMENT OF INDUSTRY (TAXES), 1969
We currently qualify as an "industrial company" under the Law for the
Encouragement of Industry (Taxes), 1969 (the "Industry Encouragement Law"). A
company qualifies as an "industrial company" if it is resident in Israel and at
least 90% of its income in a given tax year, determined in NIS (other than
income from certain types of loans, capital gains, interest and dividends), is
derived from industrial enterprises owned by that company. An "industrial
enterprise" is defined as an enterprise whose major activity in a particular tax
year is industrial manufacturing activity. See Note 12 to our Consolidated
Financial Statements.
Under the Industry Encouragement Law, an industrial company is entitled to
deduct the purchase price of patents and certain other intangible property
rights (other than goodwill) over a period of eight years, beginning with the
year in which such rights were first used.
An industrial company may be eligible for special depreciation rates for
machinery, equipment and buildings. These rates differ based on various factors,
including the date of commencement of operation and the number of work shifts.
An industrial company owning an `approved enterprise' may choose between such
special depreciation rates and the depreciation rates available to `approved
enterprises'.
Qualification as an industrial company under the Industry Encouragement Law is
not conditioned upon the receipt of prior approval from any Israel government
authority. No assurance can be given that we will continue to qualify as an
industrial company or that we will, in the future, be able to take advantage of
any tax benefits available to industrial companies.
LAW FOR THE ENCOURAGEMENT OF CAPITAL INVESTMENTS, 1959
The Investment Law provides that a capital investment in eligible facilities
may, upon application to the Investment Center, be designated as an `approved
enterprise'. Each certificate of approval for an `approved enterprise' relates
to a specific investment program delineated both by its financial scope,
including its capital resources, and by its physical characteristics, e.g., the
equipment to be purchased and utilized pursuant to the program. The tax benefits
derived from any such certificate of approval relate only to taxable income
attributable to the specific `approved enterprise'. If a company has more than
one approval, its effective tax rate is the result of a weighted combination of
the applicable rates. Income derived from activity that is not integral to the
activity of the enterprise should not be divided between the different
enterprises and should not enjoy tax benefits.
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Most of our current production facilities have been granted the status of an
`approved enterprise' under the Investment Law, in six separate investment
programs. Under the Investment Law, we have chosen the "alternative benefits"
option and have waived Government grants in return for a tax exemption. These
programs provide us with the tax benefits described below. Under the terms of
our `approved enterprise' programs, our income from `approved enterprises' will
be tax exempt for periods of 2-4 years (except with respect to income from our
Omer facility, which will be tax-exempt for 10 years), commencing with the year
in which we first earn taxable income from the relevant `approved enterprise',
and is subject to a reduced tax rate for an additional period of up to a total
of ten years from when the tax exemption began. The reduced tax rate is imposed
at a rate of between 10% and 25%, depending on the percentage of M-Systems'
shares held by non-Israelis during that remaining period (the more shares held
by non-Israelis, the lower the tax rate). The tax benefits periods described
above will end upon the earlier of (a) 12 years from the year of commencement of
production, or (b) 14 years from the year of approval of `approved enterprise'
status).
A company that has elected the alternative package of benefits, like we have,
and that subsequently pays dividend out of income derived from the `approved
enterprise' during the tax exemption period, will be subject to tax in respect
of the amount distributed (including the tax thereon) at the rate that would
have been applicable had it not elected the alternative package of benefits
(generally 10%-25%, depending on the extent of foreign shareholders holding our
Ordinary Shares). The dividend recipient is taxed at the reduced rate applicable
to dividends from `approved enterprises' (15%), if the dividend is distributed
during the tax exemption period or within 12 years thereafter.
The Investment Law also provides that an `approved enterprise' is entitled to
accelerated tax depreciation on property and equipment included in an approved
investment program.
Any future applications we make to the Investment Center will be reviewed
separately, and decisions as to whether or not to approve such applications will
be based, among other things, on the then prevailing criteria set forth in the
Investment Law, on the specific objectives we set forth in such applications and
on certain financial criteria. Accordingly, there can be no assurance that any
such applications will be approved. In addition, the benefits available to an
`approved enterprise' are conditional upon our fulfilling certain conditions
stipulated in the Investment Law and its regulations and the criteria set forth
in the specific certificate of approval, as described below. If we were to
violate those conditions, in whole or in part, we would be required to refund
the amount of tax benefits, with the addition of the CPI linkage adjustment and
interest. We believe that our `approved enterprises' operate in substantial
compliance with all of these conditions and criteria.
As of December 31, 2004, we generated a total of approximately $ 35 million of
net operating loss carryforwards in Israel. These Israeli net operating loss
carryforwards have no expiration date. The tax benefits granted to an `approved
enterprise' are not available to us with respect to the income of our
subsidiaries. The actual amount of the benefits associated with the `approved
enterprise' program will depend upon a number of factors, including whether
these tax incentives are renewed or if the tax authorities successfully
challenge the manner in which profits are recognized among our subsidiaries or
within specified tax jurisdictions.
In March 2005, the government of Israel passed an amendment to the Investment
Law in which it revised the criteria for investments qualified to receive tax
benefits as an approved enterprise. No assurance can be given that we will, in
the future, be eligible to receive additional tax benefits under this law.
TAXATION UNDER INFLATIONARY CONDITIONS
The Income Tax (Inflationary Adjustments) Law, 1985 (the "Inflationary
Adjustments Law"), was designed to neutralize the erosion of capital investments
in business and to prevent tax benefits resulting from deduction of inflationary
expenses. This law applies a supplementary set of inflationary adjustments to
the normal taxable profits computed under regular historical cost principles.
The Inflationary Adjustments Law introduced a special tax adjustment for the
preservation of equity based on changes in the Israeli CPI, whereby certain
corporate assets are classified broadly into fixed (inflation-resistant) assets
and non-fixed assets. Where a corporation's equity exceeds the depreciated cost
of fixed assets, a tax deduction that takes into account the effect of the
annual rate of inflation on such excess is allowed (up to a ceiling of 70% of
taxable income for companies in any single year, with the unused portion carried
forward on a linked basis, without limit). If the depreciated cost of fixed
assets exceeds shareholders' equity, then such excess, multiplied by the annual
inflation rate, is added to taxable income.
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Under the Inflationary Adjustments Law, results for tax purposes are measured in
real terms, in accordance with changes in the Israeli CPI. We are taxed under
this law. The discrepancy between the change in (1) the Israeli CPI and (2) the
exchange rate of Israeli currency in relation to the dollar, may in future
periods cause significant differences between taxable income and the income
measured in dollars as reflected by our financial statements (which are measured
in dollars). In addition, subject to certain limitations, depreciation of fixed
assets and losses carried forward are adjusted for inflation on the basis of
changes in the Israeli CPI.
WITHHOLDING AND CAPITAL GAINS TAXES APPLICABLE TO NON-ISRAELI SHAREHOLDERS
The State of Israel imposes income tax on nonresidents of Israel on income
accrued or derived from sources in Israel. These sources of income include
passive income such as dividends, royalties and interest, as well as non-passive
income from services rendered in Israel. We are required to withhold income tax
at the rate of 25%, or 15% for dividends of income generated by an `approved
enterprise', on all distributions of dividends other than bonus shares (stock
dividends), unless a different rate is provided in a treaty between Israel and
the shareholder's country of residence. Under the income tax treaty between the
United States and Israel, the maximum tax on dividends paid to a holder of
Ordinary Shares who is a U.S. resident (as defined in the treaty) is 25%.
CAPITAL GAINS TAXES ON SALES OF OUR ORDINARY SHARES
Israeli law imposes a capital gains tax on the sale of securities and other
capital assets. In general, the capital gains tax rate on the sale of
publicly-traded securities of an Israeli company is 15% for gains accrued after
December 31, 2002. However, non-residents of Israel, who do not maintain a
permanent establishment within Israel, are exempt from Israeli capital gains tax
on the sale of our shares.
A nonresident of Israel who receives interest, dividend or royalty income
derived from or accrued in Israel, from which tax was withheld at the source, is
generally exempted from the duty to file tax returns in Israel with respect to
such income, provided such income was not derived from a business conducted in
Israel by the taxpayer and the taxpayer has no other taxable sources of income
in Israel.
Israel Presently has no estate or gift tax.
UNITED STATES FEDERAL INCOME TAX CONSIDERATIONS
The following discussion describes the material United States federal income tax
consequences to a holder of our Ordinary Shares, referred to for purposes of
this discussion as a "U.S. Holder", that is:
o A citizen or resident of the United States;
o A corporation created or organized in or under the laws of the United
States or of any state thereof;
o An estate, the income of which is includible in gross income for
United States federal income tax purposes regardless of its source; or
o A trust, if a court within the United States is able to exercise
primary supervision over the administration of the trust and one or
more U.S. persons have the authority to control all substantial
decisions of the trust.
This summary does not purport to be a comprehensive description of all of the
tax considerations that may be relevant to each person's decision to purchase
Ordinary Shares. This summary considers only U.S. Holders that will own Ordinary
Shares as capital assets.
This discussion does not address all aspects of United States federal income
taxation that may be relevant to any particular shareholder based on such
shareholder's individual circumstances. In particular, this discussion does not
address the potential application of the alternative minimum tax or United
States federal income tax consequences to U.S. Holders that are subject to
special treatment, including:
o Taxpayers who are broker-dealers or insurance companies;
o Taxpayers who have elected mark-to-market accounting;
o Tax-exempt organizations;
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o Financial institutions or "financial services entities";
o Taxpayers who hold Ordinary Shares as part of a straddle, "hedge,"
"Constructive sale transaction," "conversion transaction" or other
integrated transaction;
o Taxpayers who own directly, indirectly or by attribution at least 10%
of our voting power; and
o Taxpayers whose functional currency is not the U.S. dollar.
In addition, this discussion does not address any aspect of state, local or
non-United States tax laws.
Additionally, this discussion does not consider the tax treatment of
partnerships or persons who hold Ordinary Shares through a partnership or other
pass-through entity or the possible application of United States federal gift or
estate tax.
INDIVIDUAL HOLDERS ARE ADVISED TO CONSULT WITH THEIR OWN TAX ADVISOR WITH
RESPECT TO THE SPECIFIC TAX CONSEQUENCES TO THEM OF PURCHASING, HOLDING OR
DISPOSING OF OUR ORDINARY SHARES.
TAXATION OF ORDINARY SHARES
TAXATION OF DIVIDENDS PAID ON ORDINARY SHARES
Except as provided under the paragraph below titled "Tax Consequences of Passive
Foreign Investment Company (PFIC) Status," a U.S. Holder will be required to
include in gross income as ordinary income the amount of any distribution paid
on Ordinary Shares, including the amount of foreign taxes, if any, withheld from
the amount paid, on the date the distribution is received to the extent the
distribution is paid out of our current or accumulated earnings and profits as
determined for United States federal income tax purposes. Distributions in
excess of such earnings and profits will be applied against and will reduce the
U.S. Holder's basis in the Ordinary Shares and, to the extent in excess of such
basis, will be treated as gain from the sale or exchange of a capital asset. We
do not intend to calculate our earnings for U.S. Federal Income Tax purposes.
Therefore, a U.S. Holder should expect that a distribution will generally be
treated as a dividend even if that distribution would otherwise be treated as a
non-taxable return of capital under the rules set forth above.
Distributions of current or accumulated earnings and profits paid in foreign
currency to a U.S. Holder will be includible in the income of a U.S. Holder in a
U.S. dollar amount calculated by reference to the exchange rate on the day the
distributions received. A U.S. Holder that receives a foreign currency
distribution and converts the foreign currency into U.S. dollars subsequent to
receipt will have foreign exchange gain or loss based on any appreciation or
depreciation in the value of the foreign currency against the U.S. dollar, which
will generally be U.S. source ordinary income or loss.
U.S. Holders will have the option of claiming the amount of any Israeli income
taxes withheld at source either as a deduction from gross income or as a
dollar-for-dollar credit against their United States federal income tax
liability. Individuals who do not claim itemized deductions, but instead utilize
the standard deduction, may not claim a deduction for the amount of the Israeli
income taxes withheld, but such amount may be claimed as a credit against the
individual's United States federal income tax liability. The amount of foreign
income taxes that may be claimed as a credit in any year is subject to complex
limitations and restrictions, which must be determined on an individual basis by
each shareholder. These limitations include, among others, rules that limit
foreign tax credits allowable with respect to specific classes of income to the
United States federal income taxes otherwise payable with respect to each such
class of income. The total amount of allowable foreign tax credits in any year
cannot exceed regular U.S. tax liability for the year attributable to foreign
source taxable income. A U.S. Holder will be denied a foreign tax credit with
respect to Israeli income tax withheld from dividends received on the Ordinary
Shares to the extent such U.S. Holder has not held the Ordinary Shares for at
least 16 days of the 31-day period beginning on the date which is 15 days before
the ex-dividend date or to the extent such U.S. Holder is under an obligation to
make related payments with respect to substantially similar or related property.
Any days during which a U.S. Holder has substantially diminished its risk of
loss on the Ordinary Shares are not counted toward meeting the 16-day holding
period required by the statute. In addition, distributions of current or
accumulated earnings and profits will be foreign source passive income for
United States foreign tax credit purposes and will not qualify for the dividends
received deduction available to corporations.
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The maximum Federal U.S. Income Tax rate on certain qualified dividends paid to
non-corporate U.S. Holders through 2008 is 15%. This reduced rate will generally
not apply, however, to dividends paid by us if we are treated as a passive
foreign investment company in the year the dividends are paid or in the prior
year or if certain holding period or other requirements are not met (see
discussion in the paragraph below titled "Tax Consequences of Passive Foreign
Investment Company (PFIC) Status"). U.S. Holders are urged to consult their own
tax advisors regarding the U.S. Federal Income Tax rate that will be applicable
to their receipt of any dividends paid with respect to Ordinary Shares.
TAXATION OF THE DISPOSITION OF ORDINARY SHARES
Except as provided under the paragraph below titled "Tax Consequences of Passive
Foreign Investment Company (PFIC) Status," upon the sale, exchange or other
disposition of our Ordinary Shares, a U.S. Holder will recognize capital gain or
loss in an amount equal to the difference between such U.S. Holder's basis in
the Ordinary Shares, which is usually the cost of such shares, and the amount
realized on the disposition. If, as anticipated, the Ordinary Shares are
publicly traded, a disposition of shares will be considered to occur on the
"trade date," regardless of the holder's method of accounting. Capital gain from
the sale, exchange or other disposition of Ordinary Shares held more than one
year is long-term capital gain and is eligible for a maximum 15% rate of
taxation for non-corporate holders. The deductibility of a capital loss
recognized on the sale, exchange or other disposition of Ordinary Shares is
subject to limitations. Gain or loss recognized by a U.S. Holder on a sale,
exchange or other disposition of Ordinary Shares generally will be treated as
United States source income or loss for United States foreign tax credit
purposes.
INFORMATION REPORTING AND BACKUP WITHHOLDING
Dividend payments made within the United States with respect to the Ordinary
Shares and proceeds from the sale, exchange or redemption of Ordinary Shares may
be subject to information reporting to the Internal Revenue Service ("IRS") and
possible U.S. backup withholding. Backup withholding will not apply, however, to
a U.S. Holder who furnishes a correct taxpayer identification number and makes
any other required certification or who is otherwise exempt from backup
withholding. Generally, a U.S. Holder will provide such certification on IRS
Form W-9 (Request for Taxpayer Identification Number and Certification).
Amounts withheld under the backup withholding rules may be credited against a
U.S. Holder's tax liability, and a U.S. Holder may obtain a refund of any excess
amount withheld under the backup withholding rules by timely filing the
appropriate claim for refund with the IRS.
TAX CONSEQUENCES OF PASSIVE FOREIGN INVESTMENT COMPANY (PFIC) STATUS
We will be deemed a passive foreign investment company, or PFIC, if 75% or more
of our gross income in a taxable year, including our pro rata share of the gross
income of any company, U.S. or foreign, in which we are considered to own 25% or
more of the shares by value, is passive income. Alternatively, we will be deemed
to be a PFIC if at least 50% of our assets in a taxable year, averaged over the
year and ordinarily determined based on fair market value and including our pro
rata share of the assets of any company in which we are considered to own 25% or
more of the shares by value, are held for the production of, or produce, passive
income. Passive income includes, among other things, amounts derived by reason
of the temporary investment of funds raised in offerings of our Ordinary Shares.
If we were a PFIC, and a U.S. Holder did not make an election to treat us as a
"qualified electing fund" (as described below):
o Excess distributions by us to a U.S. Holder would be taxed in a
special way. "Excess distributions" are amounts received by a U.S.
Holder with respect to our stock in any taxable year that exceed 125%
of the average distributions received by such U.S. Holder from us in
the shorter of either the three previous years or such U.S. Holder's
holding period for Ordinary Shares before the present taxable year.
Excess distributions must be allocated ratably to each day that a U.S
Holder has held our stock. A U.S. Holder must include amounts
allocated to the current taxable year in its gross income as ordinary
income for that year. A U.S. Holder must pay tax on amounts allocated
to each prior taxable year in which we were a PFIC at the highest rate
in effect for that year on ordinary income and the tax is subject to
an interest charge at the rate applicable to deficiencies for income
tax.
75
o The entire amount of gain realized by a U.S. Holder upon the sale or
other disposition of Ordinary Shares will also be treated as an excess
distribution and will be subject to tax as described above.
o The tax basis in shares of our stock that were acquired from a
decedent who was a U.S. Holder would not receive a step-up to fair
market value as of the date of the decedent's death but would instead
be equal to the decedent's basis, if lower than fair market value.
The special PFIC rules described above will not apply to a U.S. Holder if the
U.S. Holder makes an election to treat us as a `qualified electing fund' ("QEF")
in the first taxable year in which the U.S. Holder owns Ordinary Shares and if
we comply with certain reporting requirements. Instead, a shareholder of a
qualified electing fund is required for each taxable year to include in income a
pro rata share or the ordinary earnings of the qualified electing fund as
ordinary income and a pro rata share or the net capital gain of the qualified
electing fund as long-term capital gain, subject to a separate election to defer
payment of taxes, which deferral is subject to an interest charge.
The QEF election is made on a shareholder-by-shareholder basis and can be
revoked only with the consent of the Internal Revenue Service, or IRS. A
shareholder makes a QEF election by attaching a completed IRS Form 8621,
including the PFIC annual information statement, to a timely filed United States
federal income tax return and by filing such form with the IRS Service Center in
Philadelphia, Pennsylvania. Even if a QEF election is not made, a shareholder in
a PFIC who is a U.S. person must file a completed IRS Form 8621 every year.
A U.S. Holder of PFIC stock which is marketable stock (e.g. regularly traded on
Nasdaq) publicly traded could, instead of making a QEF election, elect to mark
the stock to market annually, recognizing as ordinary income or loss each year
an amount equal to the difference as of the close of the taxable year between
the fair market value of the PFIC stock and the U.S. Holder's adjusted tax basis
in the PFIC stock. Losses would be allowed only to the extent or net
mark-to-market gain previously included by the U.S. Holder under the election
for prior taxable years. If the mark-to-market election were made, then the
rules set forth above would not apply for periods covered by the election.
We reasonably believe that we were not a PFIC for 2004. We base our belief that
we were not a PFIC in 2002 on a tax valuation made by an independent "big 4"
U.S. accounting firm for the fiscal year 2001 and further calculations that we
have made in comparison to such tax valuation and the facts set forth in such
tax valuation with respect to 2002 and 2003. However, we did not obtain any new
tax valuation with respect to either 2002, 2003 or 2004. There can be no
assurance, however, that the IRS will not determine that we are a PFIC.
Furthermore, the tests for determining PFIC status are applied annually and it
is difficult to make accurate predictions of future income and assets, which are
relevant to this determination. Accordingly, we cannot assure you that we will
not be treated as a PFIC in any of 2001, 2002, 2003, 2004 or in future years.
U.S. Holders who hold Ordinary Shares during a period when we are a PFIC will be
subject to the foregoing rules, even if we cease to be a PFIC, subject to
certain exceptions for U.S. Holders who made a QEF election. U.S. Holders are
urged to consult their tax advisors about the PFIC rules, including as to the
advisability of choosing to make a QEF election, a "protective" QEF election, or
an election to mark the shares to market annually.
F. DIVIDENDS AND PAYING AGENTS
- - NOT APPLICABLE
G. STATEMENT BY EXPERTS
- - NOT APPLICABLE
76
H. DOCUMENTS ON DISPLAY
All documents referenced herein concerning us are archived at our principal
offices located at:
7 Atir Yeda St.,
Kfar Saba, Israel.
I. SUBSIDIARY INFORMATION
- - NOT APPLICABLE
77
ITEM 11. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to a variety of risks, including changes in foreign currency
exchange rates, changes in interest rates and weak economic conditions in
foreign markets. However, we do not use derivative financial instruments in our
investment portfolio to hedge foreign currency, interest rate or other types of
market risks.
INTEREST RATE RISK
Our exposure to interest rate risk relates primarily to our short term deposits
and investments. The majority of our cash is held in U.S. dollars and bears
interest at various rates. These deposits are placed with high quality U.S. and
European banks. Approximately half of our cash is currently invested in bonds,
auction securities and structure bonds featuring credit ratings of A or higher.
FOREIGN CURRENCY EXCHANGE AND INFLATION RISK
Most of our revenues generated and costs incurred outside of the United States
are generally denominated in dollar currencies. Costs not effectively
denominated in United States dollars are translated to United States dollars,
when recorded, at the prevailing exchange rates for the purposes of our
financial statements. Consequently, fluctuations in the rates of exchange
between the dollar and non-dollar currencies will affect our results of
operations. An increase in the value of a particular currency relative to the
dollar will increase the dollar reporting value for transactions in that
particular currency, and a decrease in the value of that currency relative to
the dollar will decrease the dollar reporting value for those transactions. This
effect on the dollar reporting value for transactions is generally only
partially offset by the impact that currency fluctuations may have on costs. We
do not generally engage in currency hedging transactions to offset the risks
associated with variations in currency exchange rates. Consequently, significant
foreign currency fluctuations and other foreign exchange risks may have a
material adverse effect on our business, financial condition and results of
operations. Since our revenues are generated in United States dollars and
currencies other than NIS, and a substantial portion of our expenses is incurred
and will continue to be incurred in NIS, we are exposed to risk by the amount
that the rate of inflation in Israel exceeds the rate of devaluation of the NIS
in relation to the dollar and other currencies or if the timing of the
devaluation lags behind inflation in Israel.
ITEM 12. DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES
- - NOT APPLICABLE
78
PART II
ITEM 13. DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES
- - NOT APPLICABLE
ITEM 14. MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF
PROCEEDS
- - NOT APPLICABLE
ITEM 15. CONTROLS AND PROCEDURES
(a) Disclosure Controls and Procedures - The Company's management evaluated,
with the participation of the Company's principal executive and principal
financial officers, the effectiveness of the Company's disclosure controls and
procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934, as amended (the "Exchange Act")), as of December 31, 2004.
Based on their evaluation, the Company's principal executive and principal
financial officers concluded that the Company's disclosure controls and
procedures were effective as of December 31, 2004.
(b) - NOT YET APPLICABLE
(c) - NOT YET APPLICABLE
(d) Changes in Internal Control Over Financial Reporting - There has been no
change in the Company's internal control over financial reporting (as defined in
Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during 2003,
that has materially affected, or is reasonably likely to materially affect, the
Company's internal control over financial reporting.
ITEM 16. [Reserved]
ITEM 16A. AUDIT COMMITTEE FINANCIAL EXPERT
Our Board of Directors has determined that we have at least one audit committee
financial expert, Mr. Yossi Ben Shalom (See in Item 6.A "Directors and Senior
Management" synopsis of Mr. Ben Shalom's biography).
79
ITEM 16B. CODE OF ETHICS
We have adopted a written code of ethics that applies to all of our employees,
including our principal executive officer, principal financial officer and
principal accounting officer.
You may request a copy of our code of ethics, at no cost, by writing to or
telephoning us as follows:
M-Systems Flash Disk Pioneers Ltd.
7 Atir Yeda St., Kfar Saba
Israel 44425
Attn. Legal Department
Telephone: (972)-9-764-5000
ITEM 16C. PRINCIPAL ACCOUNTANT FEES AND SERVICES
During each of the last two fiscal years, Kost, Forer, Gabbay & Kasierer, a
member of Ernst and Young Global, has acted as the Company's independent
auditors.
AUDIT FEES
Ernst & Young billed the Company $ 376,502 for audit services for fiscal 2004.
Ernst & Young billed the Company $ 121,464 for audit services for fiscal 2003.
TAX FEES
Ernst & Young billed the Company $ 94,478 for tax services, including fees
associated with tax compliance services, tax planning services and other tax
consulting services for fiscal 2004. Ernst & Young billed the Company $ 75,254
for tax services in fiscal 2003.
ALL OTHER FEES
We did not pay Ernst & Young for any fees other than the Audit Fees and Tax Fees
described above for fiscal 2004 and 2003.
PRE-APPROVAL POLICIES FOR NON-AUDIT SERVICES
Prior to the engagement of Ernst & Young each year, the engagement is approved
by the Audit Committee of the Board of Directors and by vote of the Company's
shareholders at the Company's Annual General Meeting of Shareholders. The
Company's Audit Committee has also adopted its own rules of procedure. The Audit
Committee's rules of procedure provide for a process with respect to the prior
approval of all services, including non-audit services, to be performed by the
independent auditors for the Company. In fiscal 2004, the Company's Audit
Committee approved all of the services provided by Ernst & Young.
80
ITEM 16D. EXEMPTION FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES
- - NOT APPLICABLE
ITEM 16E. PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS
On February 23, 2005, the District Court of Tel-Aviv - Jaffa approved the
Company's request to repurchase its shares which are traded on Nasdaq for an
aggregate sum that will not exceed $ 30 million. The Company has not made a
final decision as to whether it will, in fact, repurchase any of its shares.
81
PART III
ITEM 17. FINANCIAL STATEMENTS
- - NOT APPLICABLE
ITEM 18. FINANCIAL STATEMENTS
See Consolidated Financial Statements, attached to this annual report as Exhibit
15(a).4.
82
ITEM 19. EXHIBITS
1.1 + M-Systems' Memorandum of Association, as amended
1.2 ++ M-Systems' Articles of Association, as amended
4(a).1 +++ Form of Warrant for Purchase of Ordinary Shares, dated
July 23, 1999
4(a).2 ++ Purchase Agreement made as of September 17, 2000 between
Fortress U&T Ltd. and M-Systems Flash Disk Pioneers Ltd.
4(a).4 * Development and Supply Agreement dated April 18, 2001 by
!! and between Atmel Rousset, Atmel Sarl, and M-Systems
Flash Disk Pioneers Ltd.
4(a).5 ** Master Purchase Agreement dated August 10, 1998 by and
!! between Toshiba America Electronic Components, Inc. and
M-Systems, Inc.
4(a).6 * Amendment to the Master Purchase Agreement dated August
23, 2002 by and between Toshiba America Electronic
Components, Inc. and M-Systems, Inc., as entered into by
and between Toshiba Corporation and M-Systems Flash Disk
Pioneers Ltd.
4(a).7 ** Development and License Agreement dated June 25, 2002 by
!! and between Toshiba Corporation and M-Systems Flash
Disk Pioneers Ltd.
4(a).8 *** Patent License Agreement dated July 15, 2003 by and
!! between Toshiba Corporation and M-Systems Flash Disk
Pioneers Ltd.
4(a).9 *** Ordinary Shares Purchase Agreement dated July 15, 2003 by
!! and between Toshiba Corporation and M-Systems Flash Disk
Pioneers Ltd.
4(a).10 *** New Master Purchase Agreement dated July 15, 2003 by and
!! between Toshiba Corporation and M-Systems Flash Disk
Pioneers Ltd.
4(a).11 *** XDOC Development and License Agreement dated July 15, 2003
!! by and between Toshiba Corporation and M-Systems Flash
Disk Pioneers Ltd.
4(a).12 *** Strategic Agreement dated December 31, 2003 by and between
!! Samsung Electronics Co., Ltd., and M-Systems Flash Disk
Pioneers Ltd.
4(a).13 !! Standard Nand Supply Agreement dated as of October 1, 2003
by and between Toshiba Corporation and [a third party]
4(a).14 !! Product Supply Agreement dated as of October 1, 2003 by
and between Toshiba Corporation and M-Systems Flash Disk
Pioneers Ltd. and [a third party]
4(a).15 **** Purchase Agreement dated March 17, 2005 by and between
M-Systems Finance Inc., M-Systems Flash Disk Pointers Ltd.
and the initial purchasers of the notes, as defined
therein, represented by Citigroup Global Markets Inc.
4(a).16 **** Registration Rights Agreement dated March 23, 2005 by and
between M-Systems Finance Inc., M-Systems Flash Disk
Pointers Ltd. and the initial purchasers of the notes, as
defined therein, represented by Citigroup Global Markets
Inc.
4(a).17 **** Senior Indenture dated March 23, 2005 by and between
M-Systems Finance Inc., M-Systems Flash Disk Pointers Ltd.
and The Bank of New York Trust Company, N.A.
4(b)(i) ++++ Share Purchase Agreement dated May 1st, 2003, by and
between M-Systems Flash Disk Pioneers Ltd. And Dr. Hans
Wagner
83
ITEM 19. EXHIBITS (CONT.)
8 **** List of M-Systems' Subsidiaries and where they are
incorporated
12.1 Certificate of Chief Executive Officer pursuant to Rule
13a-14(a)/Rule 15d-14(a)
12.2 Certificate of Chief Financial Officer pursuant to Rule
13a-14(a)/Rule 15d-14(a)
13(a).1 Certification of Chief Executive Officer pursuant to 18
U.S.C. Section 1350
13(a).2 Certification of Chief Financial Officer pursuant to 18
U.S.C. Section 1350
15(a).1 Consent of Kost Forer Gabbay & Kasierer (formerly Kost
Forer & Gabbay)
15(a).3 Consent of BDO Seidman, LLP
15(a).4 Consolidated Financial Statements
+ Previously filed as an exhibit to our Registration
Statement on Form F-1, File No. 33-55838, and incorporated
by reference herein.
++ Previously filed as an exhibit to our Annual Report on
Form 20-F for the fiscal year ended December 31, 2000, and
incorporated by reference herein.
+++ Previously filed as an exhibit to our Registration
Statement on Form F-1, File No. 333-11450, and
incorporated by reference herein.
++++ Previously filed as an exhibit to our original Annual
Report on Form 20-F for the fiscal year ended December 31,
2002, and incorporated by reference herein.
* Previously filed as an exhibit to our Annual Report on
Form 20-F/A Amendment No. 2 for the fiscal year ended
December 31, 2002, File No. 001-11712 and incorporated by
reference herein.
** Previously filed as an exhibit to our Annual Report on
Form 20-F/A Amendment No. 3 for the fiscal year ended
December 31, 2002, File No. 001-11712 and incorporated by
reference herein.
*** Previously filed as an exhibit to our Annual Report on
Form 20-F for the fiscal year ended December 31, 2003, and
incorporated by reference herein.
**** Previously filed as an exhibit to our Annual Report on
Form 20-F for the fiscal year ended December 31, 2004, and
incorporated by reference herein.
!! Portions of the agreement and/or exhibits have been
omitted pursuant to a request for confidential treatment
provided to the SEC.
84
SIGNATURES
Pursuant to the requirements of Section 12 of the Securities Exchange Act of
1934, M-Systems hereby certifies that it meets all of the requirements for
filing on Form 20-F/A, and that it has duly caused and authorized the
undersigned to sign this Annual Report on its behalf on the 20th day of April,
2006.
M-SYSTEMS FLASH DISK PIONEERS LTD.
By: /s/ Dov Moran
-----------------------------------------
Dov Moran,
President and Chief Executive Officer
85