Form 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 (Mark one) X Quarterly report pursuant to Section 13 or 15(d) of the Securities - ------------ Exchange Act of 1934 for the quarterly period ended September 30, 1996 OR Transition report pursuant to Section 13 or 15(d) of the Securities - ------------ Exchange Act of 1934 for the transition period from ________ to ________ Commission File Number 0-26734 SanDisk Corporation (Exact name of registrant as specified in its charter) Delaware 77-0191793 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 140 Caspian Court, Sunnyvale, California 94089 (Address of principal executive offices) (Zip code) (408) 542-0500 (Registrant's telephone number, including area code) 3270 Jay Street, Santa Clara, California, 95054 (Former name, former address, and former fiscal year, if changed since last report.) 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 the number of shares outstanding of each of the issuer's classes of common stock as of September 30, 1996 Common Stock, $.01 par value 22,269,016 ---------------------------- ---------- Class Number of shares SanDisk Corporation Index PART I. FINANCIAL INFORMATION Page No. Item 1. Condensed Consolidated Financial Statements: Condensed Consolidated Balance Sheets September 30, 1996 and December 31, 1995................... 3 Condensed Consolidated Statements of Operations Three and nine months ended September 30, 1996 and 1995.... 4 Condensed Consolidated Statement of Cash Flows Nine months ended September 30, 1996 and 1995.............. 5 Notes to Condensed Consolidated Financial Statements........... 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................................. 8 PART II. OTHER INFORMATION Item 1. Legal Proceedings............................................. 19 Item 2. Changes in Securities......................................... 19 Item 3. Defaults upon Senior Securities............................... 19 Item 4. Submission of Matters to a Vote of Security Holders........... 19 Item 5. Other Information............................................. 19 Item 6. Exhibits and Reports on Form 8-K.............................. 20 Signatures.................................................... 22 Page 2 PART I. FINANCIAL INFORMATION SanDisk Corporation Condensed Consolidated Balance Sheets (In thousands) ASSETS September 30, December 31, 1996 1995 (unaudited) Current Assets: Cash and cash equivalents $ 26,301 $ 27,255 Short-term investments 48,904 41,140 Accounts receivable, net 9,835 8,428 Inventories, net 9,117 10,411 Prepaid expenses and other current assets 724 534 --------- -------- Total current assets 94,881 87,768 Property and equipment, net 8,638 4,254 Deposits and other assets 347 125 --------- -------- Total Assets $ 103,866 $ 92,147 ========= ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable $ 8,655 $ 9,053 Accrued payroll and related expenses 2,804 1,946 Accrued warranty 668 917 Other accrued liabilities 2,416 1,847 Deferred revenue 6,046 5,905 Current obligations under capital leases 0 98 --------- -------- Total current liabilities 20,589 19,766 Stockholders' Equity: Common stock 98,149 97,294 Accumulated deficit (14,872) (24,913) --------- -------- Total stockholders' equity 83,277 72,381 Total Liabilities and --------- -------- Stockholders' Equity $ 103,866 $ 92,147 ========= ======== The accompanying notes are an integral part of these condensed consolidated financial statements. Page 3 SanDisk Corporation Condensed Consolidated Statements of Operations (In thousands, except per share data; unaudited) Three months ended Nine months ended September 30, September 30, 1996 1995 1996 1995 ------- ------- ------- ------- Revenues $26,048 $16,886 $71,349 $43,593 Cost of sales 15,759 10,048 43,538 24,748 ------- ------- ------- ------- Gross profits 10,289 6,838 27,811 18,845 Operating expenses: Research and development 2,735 2,192 7,280 6,019 Sales and marketing 2,161 1,691 6,467 4,816 General and administrative 2,279 950 5,580 2,546 ------- ------- ------- ------- Total operating expenses 7,175 4,833 19,327 13,381 Operating income 3,114 2,005 8,484 5,464 Interest and other income, net 799 373 2,320 1,120 ------- ------- ------- ------- Income before taxes 3,913 2,378 10,804 6,584 Provision for income taxes 270 81 702 261 ======= ======= ======= ======= Net income $ 3,643 $ 2,297 $10,102 $ 6,323 ======= ======= ======= ======= Primary net income per share $ 0.15 $ 0.38 $ 0.42 $ 1.11 ======= ======= ======= ======= Fully diluted net income per share $ 0.15 $ 0.11 $ 0.42 $ 0.31 ======= ======= ======= ======= Shares used in computing primary net income per share 24,268 5,968 24,204 5,695 ======= ======= ======= ======= Shares used in computing fully diluted net income per share 24,268 20,530 24,204 20,193 ======= ======= ======= ======= The accompanying notes are an integral part of these condensed consolidated financial statements. Page 4 SanDisk Corporation Condensed Consolidated Statements of Cash Flows (In thousands; unaudited) Nine Months ended September 30, 1996 1995 -------- -------- Cash flows from operating activities: Net income $ 10,102 $ 6,323 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 1,641 1,165 Accounts receivable, net (1,407) (3,834) Inventory 1,294 (2,645) Prepaids and other assets (412) (864) Accounts payable (398) 4,368 Accrued payroll and related expenses 858 861 Accrued warranty (249) 196 Other accrued liabilities 569 1,096 Deferred revenue 141 738 -------- -------- Total adjustments 2,037 1,081 -------- -------- Net cash provided by operating activities 12,139 7,404 Cash flows from investing activities: Purchases of short term investments (34,520) (17,267) Proceeds from sale of short term investments 26,695 8,108 Acquisition of capital equipment (6,025) (3,000) -------- -------- Net cash used in investing activities (13,850) (12,159) Cash flows from financing activities: Principal payments under capital leases (98) (435) Sale of convertible preferred stock -- 6,215 Sale of common stock, net of repurchases 855 82 -------- -------- Net cash provided by financing activities 757 5,862 -------- -------- Net increase (decrease) in cash and cash equivalents (954) 1,107 Cash and cash equivalents at beginning of period 27,255 11,109 ======== ======== Cash and cash equivalents at end of period $ 26,301 $ 12,216 ======== ======== The accompanying notes are an integral part of these condensed consolidated financial statements. Page 5 SanDisk Corporation Notes to Condensed Consolidated Financial Statements 1. These interim condensed consolidated financial statements are unaudited but reflect, in the opinion of management, all normal recurring adjustments necessary to present fairly the financial position of SanDisk Corporation and Subsidiaries (the "Company") as of September 30, 1996, including the results of operations for the three and nine month periods ended September 30, 1996 and 1995 and cash flows for the nine month periods ended September 30, 1996 and 1995. Because all the disclosures required by generally accepted accounting principles are not included, these interim condensed consolidated financial statements should be read in conjunction with the audited financial statements and notes thereto in the Company's annual report on Form 10-K as of, and for the year ended December 31, 1995. The year-end condensed consolidated balance sheet data as of December 31, 1995 was derived from the audited financial statements, but does not include all disclosures required by generally accepted accounting principles. The results of operations for the three and nine month periods ended September 30, 1996 and the statement of cash flows for the nine months ended September 30, 1996 are not necessarily indicative of results of operations and cash flows for any future period. 2. The Company's fiscal year ends on the Sunday closest to December 31, and each fiscal quarter ends on the Sunday closest to March 31, June 30, and September 30. The third fiscal quarter of 1996 and 1995 ended on September 29, 1996 and October 1, 1995, respectively. Fiscal year 1995 ended on December 31, 1995. For ease of presentation, the accompanying financial statements have been shown as ending on the last day of the calendar month. 3. The components of inventory consist of the following: September 30, December 31, 1996 1995 ------- ------- (In thousands) Raw materials $ 2,670 $ 2,753 Work-in-process 5,491 6,921 Finished goods 956 737 ------- ------- $ 9,117 $10,411 ======= ======= 4. Primary net income per share applicable to common stockholders is computed using the weighted average number of shares of common stock outstanding. Common equivalent shares from Series C convertible preferred stock (using the if-converted method) and from stock options and warrants (using the treasury stock method or modified treasury stock method where applicable) have been included in the computation when dilutive. Pursuant to the Securities and Exchange Commission Staff Accounting Bulletins, common and common equivalent (common stock options and Series G preferred stock) shares issued by the Company at prices below the initial public offering price during the twelve-month period prior to the offering have been included in the calculation as if they were outstanding for all periods presented regardless of whether they are dilutive (using the treasury stock method and the initial public offering price). The Company completed its initial public offering in November, 1995. Fully diluted earnings per share is calculated using net income and the shares used in the primary calculation, as well as other dilutive preferred stock (Series A, B, D, E, and F) which is not deemed to be a common stock equivalent for purposes of the primary earnings per share calculation. 5. Samsung Electronics Company Ltd. filed a complaint against the Company in the Northern District of California in October 1995 accusing the Company of infringing two Samsung patents, seeking declaratory relief with respect to five Company patents and alleging unspecified damages for certain other related claims. The Company has received opinions from its patent counsel that, based on information currently known, the Company's products do not infringe one of these Samsung patents and that, based on certain assumptions as to how Samsung would claim infringement, the particular patent claim in the other Samsung patent is invalid and that the Company's products do not infringe any of the other claims of such patent. Nonetheless, the Company anticipates that Samsung will continue to pursue litigation with respect to such claims. SanDisk filed its answer to Samsung's complaint in March 1996. At that time, SanDisk asserted a number of counterclaims based on the Company's belief that Samsung infringes three SanDisk patents. On January 11, 1996, the Company filed a complaint against Samsung with the United States International Trade Commission alleging that Samsung and its U.S. subsidiary, are importing and selling products that infringe two of the Company's patents. By its complaint, the Company seeks a judgment by the International Trade Commission that Samsung is infringing the Company's patents and an order precluding Samsung from importing those infringing products into the United States. The U.S. International Trade Commission completed its hearings on this matter in October 1996. A decision is expected in the first half of 1997. The Company intends to vigorously enforce its patents against Samsung, but there can be no assurance that these efforts will be successful. Litigation frequently involves substantial expenditures and can require significant management attention, even if the Company ultimately prevails. In addition, the results of any litigation matters are inherently uncertain. Accordingly, there can be no assurance that any of the foregoing matters, or any future litigation, will not have a material adverse effect on the Company's business, financial condition and results of operations. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis may contain forward looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding expected possible price competition, future sales mix (product and channel), average selling prices, inventory levels, gross margins and the company's customer base. Such statements are subject to certain risks and uncertainties, including those discussed below and in the Company's Form 10-K for the year ended December 31, 1995 under the heading "Risk Factors", that could cause actual results to differ materially from those projected. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The Company undertakes no obligation to update these forward looking statements to reflect events or circumstances occurring after the date hereof. Results of Operations Revenues. Revenues for the third quarter of fiscal 1996 increased 54% to $26.0 million compared to $16.9 million for the same period of the previous year. The increase for the three month period ended September 30, 1996 was primarily due to increased sales of Chipset and CompactFlash(TM) products. Unit sales of FlashDisk products for the third quarter of 1996 increased 39% compared to the same period of 1995, however, revenues from FlashDisk products declined slightly due to lower average selling prices. Unit sales of all products for the third quarter of 1996 increased 97% compared to the third quarter of 1995. This growth in unit volume was offset by a decrease in average selling prices of approximately 30%. Revenues for the first nine months of fiscal 1996 increased 64% to $71.3 million compared to $43.6 million for the same period in 1995. The increase in revenues for the nine month period ended September 30, 1996 was primarily due to increased sales of the Company's Chipset, CompactFlash(TM) and FlashDisk products. For the first nine months of 1996, unit volumes increased 140% and average selling prices declined 37% compared to the same period in 1995. Revenues for the three and nine month periods ended September 30, 1996 also included royalties from a patent cross-license agreement that was entered into during the fourth quarter of 1995. Approximately 24% of revenues in the third quarter and 19% of revenues for the nine month period ended September 30, 1996 was related to applications destined for consumers (such as digital cameras). There is no assurance that sales into the consumer products market will continue to represent a significant portion of the Company's revenues, particularly on a quarter to quarter basis. Many of the consumer products that incorporate SanDisk's flash memory are new and the success of these products is still uncertain. As the consumer markets develop, competition is expected to increase, which could cause lower average selling prices and decreased gross margins on units shipped into these markets. In addition to the consumer market, the Company sells products to the industrial, highly portable computing and telecommunications markets. The mix of sales to these key markets varies from quarter to quarter and may vary in the future. Export sales represented 61% of revenues in the third quarter of 1996 and 54% of revenues for the nine months ended September 30, 1996 compared with 48% and 54%, respectively, for the same periods of the previous year. The Company's top ten customers accounted for 72% of total revenues for the third quarter of 1996 compared with 79% in the third quarter of 1995. The Company expects sales of its products to a limited number of customers to continue to account for a substantial portion of its revenues for the foreseeable future. Order visibility weakened during the third quarter of 1996. SanDisk's OEM customers in the emerging consumer markets are still experiencing difficulty gauging the initial market demand for their new products. The Company is also experiencing a shift in its customer order profile. The current market situation of ready availability, coupled with rapid price declines of semiconductor memories, have led customers to expect ever shorter lead-times. Consequently, the turns component of the Company's quarterly business is increasing. To adapt to these evolving market conditions, the Company shifted to more in-house manufacturing in the third quarter to reduce costs and lead times and to position itself to respond quickly to changes in customer demand. The current limited visibility of orders could continue for the next several quarters. Gross Profits. In the third quarter of 1996, gross profits increased 50% to $10.3 million, or 39.5% of revenues, compared to $6.8 million, or 40.5% of revenues, for the same period of the previous year. Gross profits for the nine month period ended September 30, 1996 increased 48% to $27.8 million, or 39.0% of revenues from $18.8 million, or 43.2% of revenues for the comparable period of 1995. SanDisk completed its transition from 16Mbit to 32Mbit technology during the third quarter of 1996. For the three and nine month periods ended September 30, 1996, 32Mbit products accounted for approximately 86% and 75%, respectively, of the Company's unit shipments. Product gross margins declined in 1996 due to lower average selling prices. Revenues from patent cross-license royalties partially offset the lower product gross margins in 1996. The Company expects price competition to increase in the future, which is likely to result in decreased average selling prices and may result in lower gross margins. Operating Expenses. Research and development, sales and marketing, and general and administrative expenses increased by $2.3 million, or 48%, during the third quarter of 1996 and by $5.9 million, or 44%, for the nine month period ended September 30, 1996 compared to the same periods of 1995. Operating expenses declined as a percentage of revenues to 28% from 29% for the three months ended September 30, 1996 and to 27% from 31% for the nine months ended September 30, 1996 compared to the same periods in 1995. Salaries and payroll related expenses increased for the three and nine month periods ended September 30, 1996 due to higher headcount in all organizations compared to the same periods of the previous fiscal year. Legal fees related to the defense of SanDisk's patents were significant in the third quarter of 1996. The Company spent approximately $1.0 million on patent related litigation during the quarter. A substantial portion of these expenses related to the SanDisk's ITC complaint against Samsung Electronics Company. The ITC completed its hearings in this matter in early October 1996. See Note 5 to the Company's financial statements contained in Item 1 of this report. Increased professional fees associated with investor relations activities also contributed to the increases in general and administrative expenses. Interest and Other Income, Net. Interest and other income, net, increased $426,000 for the three months ended September 30, 1996 and $1.2 million for the nine months ended September 30, 1996 compared to the same periods of 1995. This was primarily due to increased investment balances associated with the proceeds of SanDisk's initial public offering. Provision for Income Taxes. The Company recorded a provision for income taxes at a 6.5% effective tax rate for the first nine months of 1996 compared to a 4% effective tax rate for the same period of 1995. The Company anticipates that its effective tax rate will continue to increase over the next several quarters, but will be less than the statutory rate due to the utilization of net operating loss and tax credit carryforwards. Liquidity and Capital Resources As of September 30, 1996, the Company had working capital of $74.3 million, which included $26.3 million in cash and cash equivalents and $48.9 million in short term investments. The Company also has a line of credit with a commercial bank under which it can borrow up to $10 million. The line of credit expires in July 1997. As of September 30, 1996, the Company had $6.2 million committed under the line of credit facility for standby letters of credit. Operating activities provided $12.1 million of cash during the first nine months of 1996. The increase was primarily due to net income of $10.1 million and a decline in inventory of $1.3 million which were partially offset by an increase in accounts receivable of $1.4 million. Cash used in investing activities was $13.8 million for the nine months ended September 30, 1996 which included net purchases of short term investments of $7.8 million. Capital equipment additions of $6.0 million included leasehold improvements on SanDisk's new Sunnyvale headquarters facility, purchase of the surface mount production line and the construction of test equipment for production of 32Mbit products. During the third quarter of 1996, the Company's net inventory decreased due to shorter manufacturing cycle times and revaluation of the inventory to reflect the lower costs. The Company anticipates net inventory to increase in the fourth quarter, in line with the Company's strategy to establish a strategic buffer inventory of critical or sole-sourced components. Depending on the demand for the Company's products, the Company may decide to make substantial investments in manufacturing capacity to support its business in the future. Management believes the existing cash and cash equivalents, and short term investments will be sufficient to meet the Company's currently anticipated working capital and capital expenditure requirements for the next twelve months. Impact of Currency Exchange Rates The Company currently purchases wafers from Matsushita under purchase contracts denominated in yen. A portion of the Company's revenues are also denominated in yen. Foreign exchange exposures arising from the Company's yen denominated commitments and related accounts payable are offset to the extent the Company has yen denominated accounts receivable and cash balances. To the extent such foreign exchange exposures are not offset, the Company enters into foreign exchange forward contracts to hedge against changes in foreign currency exchange rates. At September 30, 1996, there were no forward contracts outstanding. Future exchange rate fluctuations could have a material adverse effect on the Company's business, financial condition and results of operations. Risk Factors Fluctuations in Operating Results. SanDisk's operating results are subject to quarterly and annual fluctuations due to a variety of factors. The Company has very limited visibility with respect to anticipated operating results for any given quarter, even during the quarter in question. In addition, the Company is requesting customers to qualify its new products based on the 32Mbit wafers produced by LG Semicon (formerly Goldstar Electron). Any delays in customer qualifications or product acceptance could negatively impact revenues during the next several quarters. Other factors affecting the Company's operating results include volume of product sales, availability of foundry capacity, the timing of significant orders, competitive pricing pressures, the ability of the Company to match supply with demand or to accurately forecast future inventory levels, fluctuations in product costs, fluctuation in manufacturing yields, manufacturing utilization, changes in product and customer mix, changes in the channels through which the Company's products are distributed, timing of new product announcements and introductions by the Company and its competitors, quality of the Company's products, increased research and development expenses associated with new product introductions, exchange rate fluctuations and market acceptance of new or enhanced versions of the Company's products. In addition, the Company expects to continue to increase its operating expenses in connection with the hiring of additional personnel and the development of new applications. If the Company does not achieve increased levels of revenues commensurate with these increased levels of operating expenses, the Company's business, financial condition and results of operations will be materially adversely affected. All of these factors are difficult to forecast and these or other factors can materially affect the Company's quarterly or annual operating results. Order visibility weakened during the third quarter of 1996. SanDisk's OEM customers in the emerging consumer markets are still experiencing difficulty gauging the initial market demand for their new products. The Company is also experiencing a shift in its customer order profile. The current market situation of ready availability, coupled with rapid price declines of semiconductor memories, have led customers to expect ever shorter lead-times. Consequently, the turns component of the Company's quarterly business is increasing. To adapt to these evolving market conditions, the Company shifted to more in-house manufacturing in the third quarter to reduce costs and lead times and to position itself to respond quickly to changes in customer demand. The current limited visibility of orders could continue for the next several quarters. Due to the emerging nature of the Company's markets and certain planned product transitions, it is difficult for the Company to forecast future inventory levels required to meet customer demand. As a result of both contractual obligations and manufacturing cycle time, the Company is required to order wafers from its foundries approximately six months in advance of the ultimate shipment of its products. Under the Company's wafer supply agreements, there are limits on the number of wafers the Company can order and the Company's ability to change that quantity is restricted. Accordingly, the Company's ability to react to significant fluctuations in demand for its products is limited. As a result, the Company is not able to match its purchases of wafers to specific customer orders and therefore, the Company may take provisions for potential excess inventory purchased prior to the receipt of customer orders. These provisions decrease gross margins in the quarter reported and can result in significant fluctuations in gross margins on a quarter to quarter basis. As demand for the Company's products has increased and its manufacturing cycle time has decreased over the past 12 months, the Company's ability to respond to changes in customer demand has improved. However, there can be no assurance that future gross margin volatility will not reoccur as a result of the Company's inability to match supply with demand or for other reasons. During the first and second calendar quarters of 1996, the price of dynamic random access memory (DRAM) decreased dramatically, in some cases by 75%. All DRAM suppliers were adversely impacted, including the Company's two Flash foundry suppliers, which now have excess capacity of foundry wafers that can be made available to the Company at reduced prices. Such reduced wafer prices should help the Company to accelerate its cost reduction efforts. However, because SanDisk values its inventory on a lower of cost or market basis, these cost reductions may have an adverse effect on the Company's gross margins and results of operations in the fourth quarter of 1996 and the first quarter of 1997 as the Company's inventory is written down to reflect the lower wafer costs. Due to the highly competitive nature of the DRAM business, there can be no assurance that wafer costs will remain low or that increased capacities will remain available. Dependence on Third Party Foundries. All of the Company's products require silicon wafers, which are currently supplied by Matsushita in Japan and LG Semicon in Korea, which was qualified as a second foundry source in late 1995. The Company is dependent on Matsushita and LG Semicon to produce wafers of acceptable quality and with acceptable manufacturing yields, to deliver those wafers to the Company on a timely basis and to allocate to the Company a portion of their foundry capacity sufficient to meet the Company's needs. On occasion, the Company has experienced difficulties in each of these areas. The loss or reduction of capacity from Matsushita and LG Semicon or the inability to qualify or receive the anticipated level of capacity from Matsushita and LG Semicon could have a material adverse effect on the Company's business, financial condition and results of operations. Each time a new foundry is brought into operation, it typically requires several months before acceptable quality and manufacturing yields are achieved. There can be no assurance that Matsushita and LG Semicon will be able to maintain acceptable yields or that they will continue to deliver sufficient quantities of wafers on a timely basis. Under the Company's wafer supply agreements with Matsushita and LG Semicon, the Company is obligated monthly to provide a rolling forecast of anticipated purchase orders. Except in limited circumstances and subject to acceptance by the foundries, the estimates for the first three months of each forecast constitute a binding commitment and the estimates for the remaining months may not increase or decrease by more than a certain percentage from the previous month's forecast. This limits the Company's ability to react to any significant fluctuations in demand for its products. To the extent the Company inaccurately forecasts the number of wafers required, it may have either a shortage or an excess supply of wafers, either of which could have a material adverse effect on the Company's business, financial condition and results of operations. The wafer supply agreements with Matsushita and LG Semicon each include a target number of wafers to be delivered per month that is substantially higher than the level of supply from either foundry as of September 30, 1996. To the extent the Company is unable to obtain scheduled quantities of wafers from Matsushita or LG Semicon with planned yields, the Company's business, financial condition and results of operations could be negatively impacted. The Company has entered into a joint development agreement with NEC for the development of future generations of semiconductor devices to be used in the manufacture of the Company's products. However, there can be no assurance that future generations of the semiconductor devices will be successfully developed or, if developed, that a wafer supply agreement will be entered into with NEC. Because the lead time to qualify a new foundry is approximately 18 to 24 months, in the event that the Company and NEC do enter into a wafer supply agreement, the Company could not expect to receive volume shipments from NEC until 1998 at the earliest. Due to the unpredictable nature of the new markets for the Company's products, the Company may periodically experience shortages in the future. Because of the lengthy lead times required to qualify a new foundry, there is no readily available alternative source of supply. The inability of the Company to obtain expanded foundry capacity, to qualify other wafer manufacturers or to correctly forecast the number of wafers required from its current suppliers, as well as any inability to obtain timely and adequate deliveries from the Company's current or future suppliers or any other circumstance that would require the Company to seek alternative sources of supply, could delay shipments of the Company's products and could have a material adverse effect on the Company's business, financial condition and results of operations. SanDisk has received recent indications from its foundries that additional capacity is available. Finished goods inventory levels increased during the first nine months of 1996 and the Company is now quoting average delivery times of two to six weeks. There can be no assurance, however, that this situation will continue. Risks Associated with Transitioning to New Products and Processes. Successive generations of the Company's products incorporate semiconductor devices with greater memory capacity per chip. In addition, the Company is continually involved in joint development with its foundries to produce semiconductor devices based upon smaller geometry manufacturing processes. Both the development of higher capacity semiconductor devices and the implementation of smaller geometry manufacturing processes are important determinants of the Company's ability to decrease the cost per megabyte of its flash data storage products. The utilization of semiconductor devices with greater memory capacity and the design and implementation of new semiconductor manufacturing processes can entail a number of problems, including lower yields associated with semiconductor device production, problems associated with design and manufacture of products to incorporate such devices, and production delays. There can be no assurance that such devices or processes will be successfully developed by the Company. For example, the Company discovered and successfully corrected a design flaw in its new Flash ChipSet product in the fourth quarter of 1995. As a result of delays in supplying this product to a major customer, this customer canceled approximately $500,000 of product orders that were scheduled for delivery in the fourth quarter of 1995. The Company shipped the majority of its backlog scheduled for this customer during the fourth quarter of 1995 and no additional order cancellations were received. However, there can be no assurance that the Company will not experience similar problems in the future that could have a material adverse effect on the Company's business, financial condition and results of operations. During the first quarter of 1996, the Company began receiving 32Mbit devices from LG Semicon and began the qualification of this process, which it completed in October 1996. During the third quarter of 1996, the Company began production of the 32Mbit devices at LG Semicon. High density flash memory, such as the 32Mbit, is a complex technology requiring tight manufacturing controls and effective test screens. The production ramp up period for a flash device at a new foundry is particularly prone to problems which can impact both reliability and yields exposing the Company to increased manufacturing costs. Any problems experienced by the Company in its current or future transitions to higher capacity memory devices or to new semiconductor manufacturing processes could have a material adverse effect on the Company's business, financial condition and results of operations. The Company's 32Mbit devices are designed to work only in conjunction with a new integrated microcontroller developed by the Company in cooperation with Motorola Inc. ("Motorola"). Qualification of the Motorola microcontroller was completed during the fourth quarter of 1995. The transition to 32Mbit devices exposes the Company to risks related to the ability to obtain sufficient quantities of 32Mbit wafers and integrated microcontrollers on a timely basis. Such factors are difficult to forecast and may have a material adverse effect on the Company's business, financial condition and results of operations. Manufacturing Yields. The fabrication of the Company's products is a complex and precise process requiring wafers that are produced in a highly controlled and clean environment. Semiconductor companies supplying the Company with wafers periodically have experienced problems in achieving acceptable wafer manufacturing yields. Semiconductor manufacturing yields are a function both of design technology, which is developed by the Company, and process technology, which is typically proprietary to the foundry. Because low yields may result from either design or process technology failures, yield problems may not be effectively determined or improved until an actual product exists that can be analyzed and tested to recognize process sensitivities in relation to the design rules that are used. As a result, yield problems may not be identified until well into the production process and would require cooperation by and communication between the Company and the foundry for resolution. This risk is increased due to the fact that the Company receives its wafers from independent offshore foundries, increasing the effort and time required to identify, communicate and resolve manufacturing yield problems. At the end of the third quarter of 1996, the Company experienced manufacturing related difficulties at both of its wafer foundries suppliers, which resulted in reductions in effective yields of between 5% and 10%. The Company and its foundries identified the issues and corrective steps are being implemented. There can be no assurance that the Company's foundries will achieve or maintain acceptable manufacturing yields in the future. The inability of the Company to achieve planned yields from its foundries could have a material adverse effect on the Company's business, financial condition and results of operations. Dependence on Key and Sole Source Suppliers. The majority of the memory components of the Company's products are assembled by Alphatec in Manteca, California. The majority of the controller sub-assemblies for the Company's products are assembled by ATI in Milpitas, California. In the third quarter of 1996, the Company stopped using GSS Array in Thailand and Anam in Korea and installed its own surface mount line in its new Sunnyvale facility. The Company expects to do a substantial portion of its assembly on this new line. The remainder will be done by other third party subcontractors. Unexpected costs or delays in bringing the surface mount line to full production capability could adversely affect the Company's results from operations in the fourth quarter of 1996. The Company also has no long term agreement with Alphatec. As a result of this reliance on third party subcontractors for assembly of a portion its products, the Company cannot directly control product delivery schedules, which could lead to product shortages or quality assurance problems that could increase the costs of manufacture or assembly of the Company's products. Any problems associated with the delivery, quality or cost of the Company's products could have a material adverse effect on the Company's business, financial condition and results of operations. The Company purchases several key components from sole or single source vendors for which alternative sources are not currently available. Even where alternative vendors are available, a significant amount of time would be required to qualify an additional vendor in the case of certain of the Company's other components. The Company does not maintain long-term supply agreements with any of these vendors. The inability to develop alternative sources for these single or sole source components or to obtain sufficient quantities of these components could result in delays or reductions in product shipments which could adversely affect the Company's business, financial condition and results of operations. For example, the Company relies on Motorola as the sole source of microcontrollers, which are critical components in the Company's products. The sole source risk associated with microcontrollers from Motorola is heightened during transitions from one generation of microcontrollers to the next given the lack of safety stock available during these transitions. In the event Motorola were to stop shipment of microcontrollers for any reason, the time to design and qualify an alternative source would be approximately nine to twelve months. The Company's reliance on Motorola as its sole source of microcontrollers exposes the Company to interruptions of supply that could have a material adverse effect on the Company's business, financial condition and results of operations. The Company is continuing to identify and establish second sources for its key single and sole source component vendors as sales volumes increase. Patents, Proprietary Rights and Related Litigation. The Company relies on a combination of patents, mask work protection, trademarks, copyright and trade secret laws, confidentiality procedures and licensing arrangements to protect its intellectual property rights. There can be no assurance that there will not be any disputes regarding the Company's intellectual property rights. Specifically, there can be no assurance that any patents held by the Company will not be invalidated, that patents will be issued for any of the Company's pending applications or that any claims allowed from existing or pending patents will be of sufficient scope or strength or be issued in the primary countries where the Company's products can be sold to provide meaningful protection or any commercial advantage to the Company. Additionally, competitors of the Company may be able to design around the Company's patents. From time to time the Company has been notified and its foundries may in the future be notified, of claims that they may be infringing patents or other intellectual property rights owned by third parties. If it is necessary or desirable, the Company may seek licenses under such patents or intellectual property rights. However, there can be no assurance that licenses will be offered or that the terms of any offered licenses will be acceptable to the Company. The failure to obtain a license from a third party for technology used by the Company could cause the Company to incur substantial liabilities and to suspend the manufacture of products or the use by the Company's foundries of processes requiring the technology, or to expend substantial resources redesigning its products to eliminate the infringement. There can be no assurance that the Company would be successful in redesigning its products or that such licenses would be available under reasonable terms, and any such development or license could require expenditures by the Company of substantial time and other resources. The Company has notified IBM Microelectronics, Samsung Electronics Company Ltd. ("Samsung") and Toshiba Corporation ("Toshiba") that the Company believes certain of their existing or announced products infringe certain of the Company's patents. In addition, from time to time, the Company has entered into discussions with other companies regarding potential cross-license agreements for the Company's patents. In response to the Company's allegations of infringement of five of the Company's patents, Samsung has filed a complaint in October 1995 accusing the Company of infringing two of its patents, seeking declaratory relief with respect to these five Company patents and alleging unspecified damages for certain other related claims. As written, the complaint potentially implicates products that comprise substantially all of the Company's revenues for 1995. The Company has received opinions from its Patent Counsel that, based on information currently known, the Company's products do not infringe one of these Samsung patents and that, based on certain assumptions as to how Samsung would claim infringement, the particular patent claim in the other Samsung patent that Samsung has accused the Company of infringing is invalid and that the Company's products do not infringe any of the other claims of such patent. Nonetheless, the Company anticipates that Samsung will continue to pursue litigation with respect to these claims. SanDisk filed its answer to Samsung's complaint in March 1996. At that time, SanDisk asserted a number of counterclaims based on Samsung's alleged infringement of three SanDisk patents. On January 11, 1996, the Company filed a complaint against Samsung with the United States International Trade Commission alleging that Samsung and its U.S. sales arm, are importing and selling products that infringe two of the Company's patents. By its Complaint, the Company seeks a judgment by the International Trade Commission that Samsung is infringing the Company's patents and an order precluding Samsung from importing those infringing products into the United States. The U.S. International Trade Commission completed its hearing on this matter in October 1996. A decision is expected in the first half of 1997. The Company intends to vigorously enforce its patents against Samsung, but there can be no assurance that these efforts will be successful. As is common in the industry, the Company agrees to indemnify certain of its suppliers and customers for alleged patent infringement. The scope of such indemnity varies, but may, in some instances, include indemnification for damages and expenses, including attorneys fees. The Company may from time to time be engaged in litigation as a result of such indemnification obligations. For example, in 1995 one of the Company's customers with which the Company has an indemnification obligation was served with a complaint alleging patent infringement with respect to a product manufactured by the Company. Although the Company has received an opinion from its Patent Counsel that, based on certain assumptions as to how the plaintiff would claim infringement, the Company's products do not infringe any valid claim under this patent, the Company anticipates that the plaintiff will continue to pursue this litigation. Third party claims for patent infringement are excluded from coverage under the Company's insurance policies. There can be no assurance that the Company's obligation to indemnify this customer, or any future obligation to indemnify its customers or suppliers, will not have a material adverse effect on the Company's business, financial condition and results of operations. If any third party patents are deemed to be valid and infringed by the Company's products, the Company would be required to obtain a license to the patents or to redesign its products to eliminate the infringement. Such a redesign effort, if possible, could result in substantial delays in marketing its products and in significant costs. There can be no assurance that the Company could successfully design around the technology in question or that it could obtain a license to the infringed patents on reasonable terms, or at all. The Company's inability to design around a valid patent or to obtain a license on reasonable terms could have a material adverse effect on the Company's business, financial condition and results of operations. To preserve its intellectual property rights, the Company believes it may be necessary to initiate litigation with one or more third parties, including but not limited to those the Company has notified of possible patent infringement. In addition, one or more of these parties may bring suit against the Company. Any litigation, whether as a plaintiff or as a defendant, would likely result in significant expense to the Company and divert the efforts of the Company's technical and management personnel, whether or not such litigation is ultimately determined in favor of the Company. In the event of an adverse result in any such litigation, the Company could be required to pay substantial damages, cease the manufacture, use and sale of infringing products, expend significant resources to develop non-infringing technology, discontinue the use of certain processes or obtain licenses to the infringing technology. In addition to litigation, the Company may need to license some or all of its patent portfolio to be able to obtain cross-licenses to the patents of others. In October 1995, the Company entered into a cross-license agreement with Intel Corporation ("Intel"). There can be no assurance that any other licenses will be available on commercially reasonable terms, or at all. Moreover, any such cross-licenses could result in more rapid and intense competition for the Company's products, by much larger and better financed competitors. Any such limitations on the Company's ability to market its products, or delays and costs associated with redesigning its products, or payments of license fees or licenses of Company rights to others could have a material adverse effect on the Company's business, financial condition and results of operations. Litigation frequently involves substantial expenditures and can require significant management attention, even if the Company ultimately prevails. Legal fees associated with the Samsung ITC hearings were approximately $1.0 million in both the second and third quarters of 1996. While these expenses are expected to decline in the fourth quarter of 1996, they will remain significant. In addition, the results of any litigation matters are inherently uncertain. Accordingly, there can be no assurance that any of the foregoing matters, or any future litigation, will not have a material adverse effect on the Company's business, financial condition and results of operations. Competition. The flash data storage markets in which the Company competes are characterized by rapid technological change, evolving industry standards, declining average selling prices and rapid product obsolescence. The Company's competitors include many large domestic and international companies that have greater access to foundry capacity, substantially greater financial, technical, marketing and other resources, broader product lines and longer standing relationships with customers than the Company. The Company expects competition to increase in the future from existing competitors and from other companies that may enter the Company's existing or future markets with similar or alternative data storage solutions that may be less costly or provide additional features. In addition, competition will increase to the extent that the Company determines to license its patents to certain of its competitors in order to gain licenses to their patents. For example, in October 1995, the Company entered into a patent cross-license agreement with Intel pursuant to which each party is entitled to manufacture and sell products that incorporate technology covered by their respective patents related to flash memory devices. Increased competition could have a material adverse effect on the Company's business, financial condition and results of operations. The Company recently settled patent infringement issues relating to features embodied in M-Systems' TFFS and FTL technology. Subsequent to the M-System's settlement, the PCMCIA standards committee adopted FTL technology as part of the PCMCIA standard, which enables flash file system software to operate with linear flash cards. Intel has announced the Miniature Card and Toshiba announced the Solid-State Floppy Disk Card (SSFDC). Both products are aimed at the mass storage market for consumer applications, such as digital filmless cameras. The Company expects these products to compete against its CompactFlash (TM) product. A manufacturer of digital cameras wishing to design any one of these three alternatives as removable "digital film" will eliminate the other two from use in their product, since all three are mechanically and electronically incompatible with each other. Competition to win the initial design-in is therefore expected to be fierce. Due to the high price sensitivity in the market for consumer products, aggressive price competition is expected for these applications. Such competition may result in lower gross margins in future quarters, should the relative percentage of sales of CompactFlash(TM) products increase. In the third quarter of 1996, the Company experienced strong competition from Toshiba's SSFDC 2 Mbyte product. The Company also believes that Samsung has begun shipment of competing 32Mbit NAND flash products. Dependence on Emerging Markets and New Products. The Company's success depends to a significant extent upon the development of emerging and new applications and markets for flash data storage systems, as well as on its ability to introduce commercially attractive and competitively priced new products on a timely basis and to reduce production costs of existing products. There can be no assurance that new applications or markets for flash data storage will develop as expected by the Company or that prospective customers developing products for any such markets will design the Company's products into their products and successfully introduce such products. In addition, there can be no assurance that the Company's new products, including its CompactFlash(TM) or Flash ChipSet products, will achieve market acceptance. The failure of new applications or markets to develop or the failure of new markets to be receptive to the Company's products could have a material adverse effect on the Company's business, financial condition and results of operations. The Company believes that continued significant expenditures for research and development will be required in the future. In particular, the Company intends to develop new products with increased memory capacity at lower prices, which the Company believes will be essential to its ability to remain competitive. There can be no assurance that these products will be successfully developed or will achieve market acceptance, or that the Company will be successful in identifying new product opportunities and develop and bring new products to market in a timely manner, or that products or technologies developed by others will not render the Company's products or technologies obsolete or noncompetitive. The failure of any of the Company's new product development efforts or lack of market acceptance of such products would have a material adverse effect on the Company's business, financial condition and results of operations. Development of Double Density Flash. On November 6, 1996, the Company announced its first 64Mbit products based on double density flash ("D2 flash") technology, a new flash system designed to store two bits in each flash memory cell. The Company believes that D2 flash will be important to the Company's ability to increase the capacity and decrease the cost of certain of its products, maintain its competitive advantage, broaden its target markets and attract strategic partners. The Company does not expect to generate significant revenues from sales of 64Mbit products in the first half of 1997. The implementation of D2 flash in a production environment is currently planned for the second half of 1997 and will be highly complex. There can be no assurance that reliable and cost effective D2 flash products can be manufactured reliably in commercial volumes and with yields sufficient to result in a lower cost per megabyte. Furthermore, flash data storage products designed with D2 flash will initially exhibit approximately one quarter of the performance of the Company's existing products when writing data into memory. This may preclude their use in certain applications. The failure of the Company to successfully manufacture D2 flash devices could have a material adverse effect on the Company's business, financial condition and results of operations. Customer Concentration. A limited number of customers historically have accounted for a substantial portion of the Company's revenues. The Company expects that sales of its products to a limited number of customers will continue to account for a substantial portion of its revenues for the foreseeable future. Sales to the Company's customers are generally made pursuant to standard purchase orders rather than long-term contracts. The Company has also experienced significant changes in the composition of its major customer base from year to year and expects this variability to continue as certain customers increase or decrease their purchases of the Company's products as a result of fluctuations in market demand for such customers' products. Under a joint cooperation agreement signed in January 1993, Seagate has the option to market the Company's products beginning in 1997. During the third quarter of 1996, this option was extended for two years. Under the amended agreement, beginning in 1999, if Seagate exercises its option to market the Company's products, the Company and Seagate will coordinate their efforts so that approximately one-third of the Company's worldwide net revenues would be generated from sales of the Company's flash products through Seagate. International Operations. All of the Company's wafers are, and for the foreseeable future will be, produced by foreign foundries. Because the Company currently purchases the majority of its flash wafers in Japanese Yen at a set price, fluctuations in currencies could materially adversely affect the Company's business, financial condition and results of operations. Due to its reliance on export sales and its dependence on foundries outside the United States, the Company is subject to the risks of conducting business internationally, including foreign government regulation and general geopolitical risks such as political and economic instability, potential hostilities and changes in diplomatic and trade relationships. In addition, since most of the Company's international sales are denominated in U.S. dollars, the Company's products may be less competitive in countries with currencies declining in value against the dollar. Manufacturing and sales of the Company's products may also be materially adversely affected by factors such as unexpected changes in, or imposition of, regulatory requirements, tariffs, import and export restrictions and other barriers and restrictions, longer payment cycles, greater difficulty in accounts receivable collection, potentially adverse tax consequences, the burdens of complying with a variety of foreign laws and other factors beyond the Company's control. In addition, the laws of certain foreign countries in which the Company's products are or may be developed, manufactured or sold, including various countries in Asia, may not protect the Company's intellectual property rights to the same extent as do the laws of the United States and thus make piracy of the Company's products a more likely possibility. There can be no assurance that these factors will not have a material adverse effect on the Company's business, financial condition or results of operations. Possible Volatility of Stock Price. The Company believes that future announcements concerning the Company, its competitors or its principal customers, including technological innovations, new product introductions, governmental regulations, litigation or changes in earnings estimated by analysts, may cause the market price of the Common Stock to fluctuate substantially. In addition, an aggregate of approximately 18,185,920 shares of Common Stock became eligible for sale in May 1996 after the expiration of lock-up agreements. Sales of substantial amounts of the Company's outstanding Common Stock in the public market could materially adversely affect the market price of the Common Stock. Further, in recent years the stock market has experienced extreme price and volume fluctuations that have particularly affected the market prices of equity securities of many high technology companies and that often have been unrelated or disproportionate to the operating performance of such companies. These fluctuations as well as general economic, political and market conditions such as recessions or international currency fluctuations, may materially adversely affect the market price of the Common Stock. PART II. OTHER INFORMATION Item 1. Legal Proceedings The information required by this item is set forth in Note 5 of the Condensed Consolidated Financial Statements on page 7 of this Form 10-Q for the quarterly period ended September 30, 1996, and is hereby incorporated by reference. Item 2. Changes in Securities None Item 3. Defaults upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Page 19 Item 6. Exhibits and Reports on Form 8-K A. Exhibits Exhibit Number Exhibit Title 3.1* Certificate of Incorporation of the Registrant, as amended to date. 3.2* Form of Amended and Restated Certificate of Incorporation of the Registrant 3.3* Bylaws of the Registrant, as amended. 3.4* Form of Amended and Restated Bylaws of the Registrant 4.1* Reference is made to Exhibits 3.1, 3.2, 3.3 and 3.4. 4.3* Amended and Restated Registration Rights Agreement, among the Registrant and the investors and founders named therein, dated March 3, 1995. 4.4* Amendment No. 1 to the Stock Purchase Agreements among the Registrant and the holders of Series A, B and D Preferred Stock, and certain holders of Series E Preferred Stock, dated January 15, 1993. 4.5* Series F Preferred Stock Purchase Agreement between Seagate Technology, Inc. and the Registrant, dated January 15, 1993. 4.6* Amendment Agreement between Seagate Technology, Inc. and the Registrant, dated August 23, 1995. 4.7* Form of Stock Purchase Agreement between the Registrant and Seagate Technology, Inc. 9.1* Amended and Restated Voting Agreement, among the Registrant and the investors named therein, dated March 3, 1995. 10.1* Form of Indemnification Agreement entered into between the Registrant and its directors and officers. 10.2*+ Foundry Agreement between Matsushita Electronics Corporation, Matsushita Electronic Industrial Co., Ltd. and the Registrant, dated May 20, 1992. 10.3*+ Amendment No. 1 to MEC/SunDisk Foundry Agreement, between Matsushita Electronics Corporation, Matsushita Electronic Industrial Co., Ltd. and the Registrant, dated April 17, 1995. 10.4*+ Foundry Agreement between Goldstar Electron Co., Ltd. and the Registrant, dated October 13, 1993. 10.5*+ Amendment No. 1 to the Foundry Agreement between Goldstar Electron Co., Ltd. and the Registrant, dated May 10, 1994. 10.6*+ SanDisk/Goldstar Technical Collaboration Agreement between Goldstar Electron Co., Ltd. and the Registrant, dated March 25, 1994. 10.7*+ Joint Development Agreement between NEC Corporation and the Registrant, dated June 20, 1994. 10.8*+ Joint Cooperation Agreement between the Registrant and Seagate Technology, Inc., dated January 15, 1993. 10.9*+ Amendment and Termination Agreement between the Registrant and Seagate Technology, Inc., dated October 28, 1994. 10.10* License Agreement between the Registrant and Dr. Eli Harari, dated September 6, 1988 10.11* Lease Agreement between the Registrant and A&P Family Investments, dated June 24, 1991, as amended on February 26, 1992, January 31, 1994, January 30, 1995 and April 7, 1995. 10.12* Business Loan Agreement between the Registrant and Silicon Valley Bank, dated July 31, 1992, as modified February 8, 1995 and July 27, 1995. 10.13* 1989 Stock Benefit Plan. 10.14* 1995 Stock Option Plan. 10.15* Employee Stock Purchase Plan. 10.16* 1995 Non-Employee Directors Stock Option Plan. 10.17* Patent Cross License Agreement between the Registrant and Intel Corporation, dated October 12, 1995. 10.18** Lease Agreement between the Registrant and G.F. Properties, dated March 1, 1996. 10.19# Business loan agreement between the Registrant and Union Bank of California, dated July 3, 1996. 11.1 Computation of Earnings Per Share (three and nine months ended September 30, 1996). 21.1* Subsidiaries of the Registrant. 27.1 Financial Data Schedule for nine months ended September 30, 1996 (In EDGAR format only) <FN> - ---------- * Previously filed as an Exhibit to the Registrant's Registration Statement on Form S-1 (No. 33-96298). ** Previously filed as an Exhibit to the Registrant's 1995 Annual Report on Form 10-K. # Previously filed as an Exhibit to the Registrant's Form 10-Q for the quarter ended June 30, 1996. + Confidential treatment granted as to certain portions of these exhibits. </FN> B. Reports on Form 8-K No reports on Form 8-K were filed during the quarter ended September 30, 1996. Page 21 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. SanDisk Corporation (Registrant) By: /s/ Cindy L. Burgdorf --------------------------- Cindy L. Burgdorf Chief Financial Officer, Senior Vice President, Finance and Administration and Secretary DATED: November 13, 1996 Page 22