EXHIBIT 99.2
OPERATING AND FINANCIAL REVIEW AND PROSPECTS
YOU SHOULD READ THE FOLLOWING DISCUSSION AND ANALYSIS IN CONJUNCTION WITH OUR
INTERIM CONSOLIDATED FINANCIAL STATEMENTS AND NOTES THERETO INCLUDED ELSEWHERE
IN THIS CURRENT REPORT ON FORM 6-K. THIS "OPERATING AND FINANCIAL REVIEW AND
PROSPECTS" SECTION CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND
UNCERTAINTIES. OUR ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED
IN THESE FORWARD-LOOKING STATEMENTS.
OVERVIEW
We design, develop and market innovative flash data storage solutions for
digital consumer electronics markets. We primarily target two digital consumer
electronics markets: the USB flash drive market with our mDrive products and the
mobile handset market with our mDOC products. We also sell flash data storage
products targeted at the embedded systems market, including our mModule and mSSD
products.
BELOW ARE SOME OF THE HIGHLIGHTS AND TRENDS AFFECTING OUR BUSINESS SINCE THE
BEGINNING OF 2005:
REVENUE GROWTH - Because the markets that our products address grew rapidly, our
revenues have grown significantly over the past few years. Our revenues in 2005
grew by 47.6% in comparison to 2004 and our revenues in the six-month period
ended June 30, 2006, grew by 79.6% in comparison to the same period in 2005. In
particular, our sales to the USB flash drive market grew by 42.3%, from $172.2
million in the six month period ended June 30, 2005, to $245.0 million in the
six month period ended June 30, 2006, and our sales to the mobile handset and
portable devices market grew by 223.5% from $42.0 million in the six month
period ended June 30, 2005, to $135.9 million in the six month period ended June
30, 2006.
Our revenue growth since the beginning of 2005 was attributable in large part to
significant growth in unit sales of both our mDrive and mDOC products, as both
the USB flash drive and mobile handset markets experienced strong end-user
demand. Although the average selling prices per megabyte for our products have
declined in recent years, the average selling prices per unit of our mDrive and
mDOC products decreased at a lower rate, because consumers purchased products
with higher density storage. This revenue growth has placed a strain on our
operational, logistical and managerial resources.
To support our revenue growth, we have expanded our work force from
approximately 689 employees at June 30, 2005, to approximately 822 employees at
December 31, 2005, and approximately 843 employees at June 30, 2006.
SEASONALITY. In 2005, we experienced stronger demand for our mDOC products in
the second half of the fiscal year, and for our mDrive products in the fourth
quarter of the fiscal year, in each case due to end-of-year holiday purchases.
MERGER AGREEMENT. On July 30, 2006, we entered into an Agreement and Plan of
Merger with SanDisk Corporation ("SanDisk") and Project Desert Ltd., a
wholly-owned subsidiary of SanDisk ("MergerSub"), pursuant to which, and subject
to the terms and conditions set forth in the agreement, (i) MergerSub will merge
with and into our company and our company will become a wholly-owned subsidiary
of SanDisk and, (ii) at the effective time of the merger, each of our
outstanding ordinary shares will be converted into the right to receive 0.76368
of a share of SanDisk common stock.
Consummation of the proposed merger is subject to closing conditions, including
(among others) receipt of the requisite vote of our shareholders in favor of the
merger, Israeli court approval and requisite regulatory approvals and expiration
of requisite waiting periods under antitrust laws.
Each party has certain rights to terminate the merger agreement. If the merger
agreement is terminated under certain circumstances (including if it is
terminated by us in order to accept a superior acquisition proposal), we have
agreed to pay SanDisk a termination fee of $74.0 million. If the merger
agreement is terminated under certain circumstances as a result of not receiving
antitrust approvals, we will have the option of requiring SanDisk to purchase
from us ordinary shares equal to up to 9.9% of the number of ordinary shares
outstanding on the date of termination of the merger agreement, at a price per
share equal to the greater of (i) $38.15 and (ii) the average closing price of
our ordinary shares on the Nasdaq Stock Market for the five consecutive trading
days ending on the date of such termination.
RESTATEMENT OF CONSOLIDATED FINANCIAL INFORMATION.
1. CONSOLIDATION OF THE VENTURE
In 2003, we and Toshiba entered into a venture (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's results in our financial statements.
..
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. 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.
2. STOCK- BASED COMPENSATION
On June 1, 2006, we announced the commencement, at our own initiative, of an
internal review of prior stock option grants. Our Board of Directors
subsequently appointed a special committee (the "Special Committee") to conduct
this review. A description of the internal review, including the findings of the
Special Committee, is set forth in our annual report on Form 20-F for the year
ended December 31, 2005, filed with the Securities and Exchange Commission on
July 17, 2006, (the "Annual Report").
Based on the Special Committee's findings, we concluded that for accounting
purposes the actual measurement dates of certain past stock option grants
differed from the previously determined measurement dates for these grants.
Because the closing market prices of our ordinary shares as of the corrected
measurement dates were generally higher than the relevant option exercise
prices, we determined that we should have recognized non-cash stock-based
compensation expense and related tax adjustments which were not previously
accounted for in our previously issued financial statements. Accordingly, as
disclosed in the Annual Report, we have restated our consolidated financial
statements as of December 31, 2004 and 2005, and for each of the years in the
three-year period ended December 31, 2005, and certain financial information as
of December 31, 2003 and as of and for the years ended December 31, 1999, 2000,
2001 and 2002. We have also revised previously issued financial information as
of and for the quarter ended March 31, 2006.
Consequently, we have rested our previously issued financial statements for the
six months ended June 30, 2005. The effect of these two restatement adjustments
on our net income for the six-month period ended June 30, 2005, is a reduction
of $2.1 million in our net income previously reported for such period.
The cumulative effect of these two restatement adjustments on our retained
earning as of January 1, 2006 is a reduction of $18.8 million.
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The effects of these two restatement adjustments on the Company's interim
consolidated financial statements for the six-month period ended June 30, 2005
are summarized below:
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ADJUSTMENT
ADJUSTMENT FOR STOCK
AS FOR -BASED
PREVIOUSLY CONSOLIDATION COMPENSATION
REPORTED OF VENTURE EXPENSE AS RESTATED
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UNAUDITED
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Revenues $ 201,611 $ 37,019 $ - $ 238,630
Costs and expense:
Costs of goods sold 151,888 20,865 94 172,847
Research and development, net 16,979 - 470 17,449
Selling and marketing 15,856 - 1,208 17,064
General and administrative 6,006 166 328 6,500
Total costs and expenses 190,729 21,031 2,100 213,860
Operating income 10,882 15,988 (2,100) 24,770
Financial income, net 4,478 72 - 4,550
Income before taxes on income 15,360 16,060 (2,100) 29,320
Income after taxes on income 15,360 16,060 (2,100) 29,320
Minority interest in earnings of a
subsidiary - (16,060) - (16,060)
Net income 13,741 - (2,100) 11,641
Basic earnings per share 0.38 - ( 0.06) 0.32
Diluted earnings per share 0.35 - ( 0.05) 0.30
Weighted average number of shares used in 40,089,242 (314,377) 39,774,865
computing diluted earnings per share -
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TERMINATION OF SAMSUNG AGREEMENT - We recently terminated our strategic
agreement with Samsung, which term was until December 31, 2007. As a result of
this termination, we will no longer be entitled to committed manufacturing
capacity and favorable pricing terms from Samsung under the agreement or to
receive license fees from Samsung. Samsung will no longer hold a license to our
patents, effective from the termination date. Consequently, we will likely need
to purchase flash components from alternate sources and may encounter
difficulties in purchasing additional flash components, or be required to
purchase flash components from alternate sources at higher relative prices. The
company has received a letter from Samsung according to which Samsung disputes
the termination of the agreement.
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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.
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SIX MONTHS ENDED JUNE 30,
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2006 2005*)
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Revenues 100.0% 100.0%
Costs and expenses:
Cost of goods sold 78.2% 72.4%
Research and development, net 5.7% 7.3%
Selling and marketing 6.4% 7.2%
General and administrative 3.3% 2.7%
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Total costs and expenses 93.6% 89.6%
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Operating income 6.4% 10.4%
Financial income, net 0.7% 1.9%
Other income, net 0.3% -
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Income before taxes on income 7.4% 12.3%
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Taxes on income 0.6% -
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Income after taxes on income 6.8% 12.3%
Equity losses of an affiliate 0.6% 0.7%
Minority interest in earnings of subsidiaries 4.2% 6.7%
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Net income 2.0% 4.9%
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*) As restated
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The following table sets forth, for the periods indicated, our revenues by end
markets (in thousands):
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SIX MONTHS ENDED JUNE 30,
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2006 2005
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Revenues
USB flash drive market 245,040 172,178
Mobile handset and portable devices market 135,857 41,996
Embedded systems market 46,166 23,808
Other 1,540 648
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Total. 428,603 238,630
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SIX MONTHS ENDED JUNE 30, 2006, COMPARED TO SIX MONTHS ENDED JUNE 30, 2005
REVENUES - Revenues for the six months ended June 30, 2006, increased by $190.0
million, or 79.6%, to $428.6 million from $238.6 million for the six months
ended June 30, 2005. Revenues derived from the USB flash drive market increased
by $72.9 million, or 42.3%, to $245.0 million, revenues derived from the mobile
handset and portable devices market increased by $93.9 million, or 223.5%, to
$135.9 million and revenues derived from the embedded systems market increased
by $22.4 million, or 93.9%, to $46.2 million.
COST OF GOODS SOLD - Our cost of goods sold for the six months ended June 30,
2006, increased by $162.3 million to $335.2 million, an increase of 93.9% from
cost of goods sold of $172.8 million for the six months ended June 30, 2005. Our
costs of goods sold as a percentage of total revenues increased from 72.4% for
the six months ended June 30, 2005, to 78.2% for the six months ended June 30,
2006, due to (i) pricing pressures resulting from increasing competition and
(ii) a decrease in the gross margins of the Venture.
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RESEARCH AND DEVELOPMENT EXPENSES, NET - Our gross research and development
expenses for the six months ended June 30, 2006, increased by $6.9 million to
$24.5 million, an increase of 39.0% from gross research and development expenses
of $17.6 million for the six months ended June 30, 2005. Our net research and
development expenses for the six months ended June 30, 2006, increased by $6.9
million to $24.3 million, an increase of 39.2% from net research and development
expenses of $17.4 for the six months ended June 30, 2005. The increase in our
gross research and development expenses is attributable to an increase in our
investment in the development of new products and technologies, and the
enhancement of existing products.
As a percentage of revenues, our net research and development expenses decreased
to 5.7% for the six months ended June 30, 2006, from 7.3% for the six months
ended June 30, 2005. During the six months ended June 30, 2006, we recognized
$152,000 and $63,000 of research and development grants from Magneton and
Britech, respectively, compared to $0 and $172,000 of research and development
grants we recognized during the six months ended June 30, 2005.
SELLING AND MARKETING EXPENSES - Selling and marketing expenses for the six
months ended June 30, 2006, increased by $10.5 million, or 61.7%, to $27.6
million from $17.1 million for the six months ended June 30, 2005. Our selling
and marketing expenses are only partially affected by an increase in our product
sales, due to the fact that the direct expenses related to actual sales are
limited. The increase in our sales and marketing expenses was attributable
mainly to (i) an increase of our marketing activities in the USB flash drive
market and (ii) increases in sales and marketing personnel in order to support
our substantial revenue growth. As a percentage of revenues, our selling and
marketing expenses decreased to 6.4% for the six months ended June 30, 2006,
from 7.2% for the six months ended June 30, 2005.
GENERAL AND ADMINISTRATIVE EXPENSES - General and administrative expenses for
the six months ended June 30, 2006 increased by $7.7 million, or 118.0%, to
$14.2 million from $6.5 million for the six months ended June 30, 2005. This
increase was attributable mainly to expanding our operations in order to support
our substantial growth, principally increases in personnel, legal and accounting
expenses as well as expenses attributable to the internal review of prior stock
option grants described above and to the previously contemplated securities
offering. As a percentage of revenues, our general and administrative expenses
remained unchanged.
FINANCIAL INCOME, NET - Financial income, net for the six months ended June 30,
2006, decreased by $1.7 million to $2.9 million from $4.6 million for the six
months ended June 30, 2005. The decrease was attributable to the lower aggregate
amount of our cash, cash equivalents, bank deposits and marketable securities
held by us during the six months ended June 30, 2006, compared to the six months
ended June 30, 2005.
OTHER INCOME - In 2006, we realized a gain from the sale of a portion of our
shares of a Taiwanese company, in the amount of $1.2 million.
EQUITY IN LOSSES OF AN AFFILIATE - Equity in losses of an affiliate represents
our share in the losses incurred by U3 LLC, a partnership established by us and
Sandisk to develop a unified standard for the development of software
applications for USB flash drives, which commenced operations at the beginning
of 2005. The equity in losses of an affiliate for the period ended June 30,
2006, increased by $ 0.9 million to $2.5 million from $1.6 million for the six
months ended June 30, 2005. The increase was attributable to the increased
marketing activity of the U3 standard.
MINORITY INTEREST - Minority interest in earnings of consolidated subsidiary was
$17.6 million in the six months ended June 30, 2006, compared to $16.1 million
in the six months ended June 30, 2005. Minority interest in the earnings of our
consolidated subsidiary represents the proportional share of Toshiba in the
earnings of the Venture, a variable interest entity consolidated in accordance
with FIN 46R.
INCOME TAXES - Income taxes for the six months ended June 30, 2006, amounted to
$2.5 million, which consisted of $2.2 million of current income taxes and $0.3
million of deferred tax income. Income taxes in 2006 are mainly attributable to
our wholly-owned Spanish subsidiary, Microelectronica Espanola S.A.U. ("MEE"),
which we acquired in November 2005, which is subject to a 35% tax rate, to
recent changes in Israeli tax law which apply a 31% tax rate to financial
income, to the sale of available for sales equity securities, and to our
wholly-owned Taiwanese subsidiary, which is subject to 25% tax rate.
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Due to our utilization of net operating loss carryforwards and to our not being
liable for taxes with respect to the share of the Venture's earnings
attributable to Toshiba, as well as various tax reduction programs established
by the Israeli government to encourage investment in Israel, we did not incur
any income tax expenses in Israel in 2005.
NET INCOME - For the six months ended June 30, 2006, we recognized net income of
$8.8 million, representing 2.0% of total revenues, compared to a net income of
$11.6 million for the six months ended June 30, 2005, representing 4.9% of total
revenues. The decrease of net income as a percentage of the total revenues was
attributable principally to lower margins realized on revenues, higher general
and administrative expenses and higher taxes during the six months ended June
30, 2006.
LIQUIDITY AND CAPITAL RESOURCES
Through June 30, 2006, we funded our operations primarily from cash from
operations and previous issuances and sales of ordinary shares and convertible
senior notes. Our cash flow from operating activity for the six months ended
June 30, 2006, amounted to $43.8 million. In March 2005 we completed an offering
of convertible senior notes which provided net proceeds of $72.8 million. We
believe that our cash, cash equivalents, bank deposits, marketable securities
and cash generated from operations will be sufficient to fund our anticipated
working capital needs for the next twelve months.
As of June 30, 2006, our cash, cash equivalents, bank deposits and marketable
securities were $179.0 million ($51.3 million of this amount being comprised of
long-term marketable securities) compared to $186.3 million as of December 31,
2005. The decrease results mainly from the purchase of equipment placed at
Hynix.
We had indebtedness of $71.4 million as of June 30, 2006, attributable
exclusively to the convertible senior notes issued by us in March 2005.
Our trade receivables decreased to $106.1 million at June 30, 2006, from $131.9
million at December 31, 2005, which reflects decrease in our sales from $222.4
million in the quarter ended December 31, 2005 to $209.5 million in the quarter
ended June 30, 2006.
Our inventories increased from $76.3 million at December 31, 2005, to $84.1
million at June 30, 2006. The main reason for the increase is build up of
inventory for the mobile handset market.
OPERATING ACTIVITIES
Net cash provided by operating activities for the six months ended June 30,
2006, was $43.8 million as compared to $60.8 million of net cash provided by
operating activities for the six months ended June 30, 2005. The decrease in
cash provided by operating activities was primarily attributable to the decrease
in our accounts payable.
INVESTING ACTIVITIES
Net cash used in investing activities for the six months ended June 30, 2006,
was $53.8 million as compared to $97.6 million of net cash used in investing
activities for the six months ended June 30, 2005. The decrease was primarily
attributable to lower investments in marketable securities, which was partially
offset by the investment in equipment under the purchase agreement with Hynix.
For the six months ended June 30, 2006, the aggregate amount of capital
expenditures was $9.3 million. These expenditures were principally for the
construction of our second facility in Kfar-Saba and for the purchases of
computer hardware and software. In addition, during the six months ended June
30, 2006, we purchased $ 35.4 million of equipment which we placed in Hynix's
facilities under the terms of our agreement with Hynix.
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FINANCING ACTIVITIES
Net cash used in financing activities during the six months ended June 30, 2006,
was $2.9 million as compared to net cash provided by financing activities of
$58.7 million during the six months ended June 30, 2005. The significantly
higher amount of net cash provided by financing activities during the six months
ended June 30, 2005, was primarily attributable to our issuance in 2005 of
convertible senior notes, which provided net proceeds of $72.8.
We expect to use cash in the near future to fund working capital and increased
selling and marketing and research and development expenses. We currently have
no commitments or plans for the acquisition of any business, product line or
technology, or for any material expenditures or investments. Under our merger
agreement with SanDisk, we are required to obtain SanDisk's prior written
consent for, among other things, the acquisition of any business, joint venture,
strategic partnership or similar alliance as well as for certain capital
expenditures.
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