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 March 31, 1999
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)
N/A
(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 March 31, 1999
Common Stock, $0.001 par value 26,865,588
------------------------------ ----------
Class Number of shares
SanDisk Corporation
Index
PART I. FINANCIAL INFORMATION
Page No.
Item 1. Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets
March 31, 1999 and December 31, 1998........................... 3
Condensed Consolidated Statements of Income
Three months ended March 31, 1999 and 1998..................... 4
Condensed Consolidated Statements of Cash Flows
Three months ended March 31, 1999 and 1998..................... 5
Notes to Condensed Consolidated Financial Statements............... 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations...................................... 9
Item 3. Quantitative and Qualitative Disclosures About Market Risk.........24
PART II. OTHER INFORMATION
Item 1. Legal Proceedings................................................. 25
Item 2. Changes in Securities............................................. 25
Item 3. Defaults upon Senior Securities................................... 25
Item 4. Submission of Matters to a Vote of Security Holders............... 25
Item 5. Other Information................................................. 25
Item 6. Exhibits and Reports on Form 8-K.................................. 26
Signatures........................................................ 28
Page 2
PART I. FINANCIAL INFORMATION
SanDisk Corporation
Condensed Consolidated Balance Sheets
(In thousands)
ASSETS March 31, 1999 December 31, 1998*
-------------- ---------------
(unaudited)
Current Assets:
Cash and cash equivalents $ 15,430 $ 15,384
Short-term investments 129,562 119,074
Accounts receivable, net 23,509 20,400
Inventories 8,066 8,922
Deferred tax assets 15,900 15,900
Prepaid expenses and other current assets 3,371 6,694
---------------- ----------------
Total current assets 195,838 186,374
Property and equipment, net 18,921 17,542
Investment in foundry 51,208 51,208
Deposits and other assets 620 617
---------------- ----------------
Total Assets $ 266,587 $ 255,741
================ ================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable $ 15,521 $ 6,938
Accrued payroll and related expenses 4,772 3,768
Other accrued liabilities 11,876 9,745
Deferred revenue 21,034 27,452
---------------- ----------------
Total current liabilities 53,203 47,903
Stockholders' Equity:
Common stock 187,595 186,120
Retained earnings 25,789 21,718
---------------- ----------------
Total stockholders' equity 213,384 207,838
Total Liabilities and
---------------- ----------------
Stockholders' Equity $ 266,587 $ 255,741
================ ================
The accompanying notes are an integral part of these condensed consolidated
financial statements.
* Information derived from the audited Consolidated Financial Statements.
Page 3
SanDisk Corporation
Condensed Consolidated Statements of Income
(In thousands, except per share data; unaudited)
Three months ended
March 31,
1999 1998
---------- ----------
Revenues:
Product $ 35,926 $ 25,426
License and royalty 8,210 8,676
---------- ----------
Total revenues 44,136 34,102
Cost of sales 26,509 17,772
---------- ----------
Gross profits 17,627 16,330
Operating expenses:
Research and development 5,212 4,331
Sales and marketing 5,173 3,951
General and administrative 2,394 2,044
---------- ----------
Total operating expenses 12,779 10,326
Operating income 4,848 6,004
Interest and other income, net 1,604 1,339
---------- ----------
Income before taxes 6,452 7,343
Provision for income taxes 2,129 2,640
---------- ----------
Net income $ 4,323 $ 4,703
========== ==========
Net income per share
Basic $ 0.16 $ 0.18
Diluted $ 0.15 $ 0.17
Shares used in computing
net income per share
Basic 26,767 26,019
Diluted 29,314 28,022
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)
Three months ended
March 31,
1999 1998
-------- --------
Cash flows from operating activities:
Net income $ 4,323 $ 4,703
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation 1,657 1,351
Accounts receivable, net (3,109) 785
Inventory 856 (4,788)
Prepaid expenses and other assets 3,320 401
Accounts payable 8,583 (8,793)
Accrued payroll and related expenses 1,004 (1,147)
Other accrued liabilities 2,131 2,074
Deferred revenue (6,418) (1,427)
-------- --------
Total adjustments 8,024 (11,544)
-------- --------
Net cash provided by (used in) operating activities 12,347 (6,841)
Cash flows from investing activities:
Purchases of short term investments (45,127) (48,984)
Proceeds from sale of short term investments 34,387 46,284
Acquisition of capital equipment (3,036) (1,825)
-------- --------
Net cash used in investing activities (13,776) (4,525)
Cash flows from financing activities:
Sale of common stock 1,475 1,120
-------- --------
Net cash provided by financing activities 1,475 1,120
-------- --------
Net increase (decrease) in cash and cash equivalents 46 (10,246)
Cash and cash equivalents at beginning of period 15,384 20,888
-------- --------
Cash and cash equivalents at end of period $ 15,430 $ 10,642
======== ========
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 its subsidiaries (the "Company") as of March 31, 1999,
and the results of operations and cash flows for the three month periods
ended March 31, 1999 and 1998. 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/A as of, and for the year ended December 31,
1998. The condensed consolidated balance sheet data as of December 31,
1998 was derived from the audited financial statements.
The results of operations and cash flows for the three month period ended
March 31, 1999 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 first fiscal quarter of 1999 and 1998 ended on March
28, 1999 and March 29, 1998, respectively. Fiscal year 1998 ended on
December 27, 1998. For ease of presentation, the accompanying financial
statements have been shown as ending on the last day of the calendar
month.
3. The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements
and accompanying notes. Actual results could differ from those estimates.
4. The components of inventory consist of the following:
March 31, December 31,
1999 1998
---------- ----------
(In thousands)
Raw materials $ 2,094 $ 2,710
Work-in-process 3,876 3,818
Finished goods 2,096 2,394
---------- ----------
$ 8,066 $ 8,922
========== ==========
5. The following table sets forth the computation of basic and diluted earnings
per share:
Page 6
Three months ended
March 31,
1999 1998
------- -------
(In thousands, except
per share amounts)
Numerator:
Numerator for basic and diluted
net income per share - net income $ 4,323 $ 4,703
======= =======
Denominator for basic net income per share:
Weighted average common shares 26,767 26,019
------- -------
Shares used in computing basic net income
per share 26,767 26,019
======= =======
Basic net income per share $ 0.16 $ 0.18
======= =======
Denominator for diluted net income per share:
Weighted average common shares 26,767 26,019
Employee stock options and warrants
to purchase common stock 2,547 2,003
------- -------
Shares used in computing diluted net income
per share 29,314 28,022
======= =======
Diluted net income per share $ 0.15 $ 0.17
======= =======
For the three month periods ending March 31, 1999 and 1998, options to
purchase 10,753 and 150,706 shares of common stock, respectively, have
been excluded from the earnings per share calculation, as their effect is
antidilutive.
6. 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, or
others, may bring suit against the Company.
In March 1998, the Company filed a complaint in federal court against
Lexar Media, Inc. ("Lexar") for infringement of a fundamental flashdisk
patent. Lexar has disputed the Company's claim of patent infringement,
claimed SanDisk's patent is invalid or unenforceable and asserted various
counterclaims including unfair competition, violation of the Lanham Act,
patent misuse, interference with prospective economic advantage, trade
defamation and fraud. SanDisk has denied each of Lexar's counterclaims.
In July 1998, the federal district court denied Lexar's request to have
the case dismissed on the grounds the Company failed to perform an
adequate prefiling investigation. Discovery in the Lexar suit commenced
in August 1998. On February 22, 1999, the Federal District Court
considered arguments and papers submitted by the parties regarding the
scope and proper interpretation of the asserted claims in SanDisk's
patent at issue in the Lexar suit. On March 4, 1999, the Federal District
Court issued its ruling on the proper construction of the claim terms in
SanDisk's patent. A trial date has not yet been set. The Company intends
to vigorously enforce its patents, but there can be no assurance that
these efforts will be successful.
From time to time 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
Page 7
to time be engaged in litigation as a result of such indemnification
obligations. Third party claims for patent infringement are excluded from
coverage under the Company's insurance policies. There can be no
assurance that any future obligation to indemnify the Company's customers
or suppliers, will not have a material adverse effect on the Company's
business, financial condition and results of operations.
Any litigation, whether as a plaintiff or as a defendant, will 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 or obtain licenses to the infringing
technology, or discontinue the use of certain processes. 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.
7. The Company has a credit agreement (the Agreement) with a bank, which was
renewed in July 1998. Under the provisions of the Agreement, which
expires in July 1999, the Company may borrow up to $10.0 million on a
revolving line of credit at the bank's prime interest rate. Amounts under
the revolving line of credit can be applied to the issuance of letters of
credit up to the full amount of the credit line. At March 31, 1999, $1.0
million of letters of credit were outstanding. In addition, under the
Agreement, the Company also has a $15.0 million foreign exchange contract
line under which the Company may enter into foreign exchange contracts.
As of March 31, 1999, $4.5 million was outstanding under the foreign
exchange contract portion of the line. The Agreement contains covenants
that require the Company to maintain certain financial ratios and levels
of net worth. The Agreement prohibits the payment of cash dividends to
stockholders.
8. Certain of the Company's purchase commitments and balance sheet accounts
are denominated in Japanese Yen. The Company enters into foreign exchange
contracts to hedge against changes in foreign currency exchange rates.
The effects of movements in currency exchange rates on these instruments
are recognized when the related operating revenues and expenses are
recognized. The impact of movements in currency exchange rates on foreign
exchange contracts substantially mitigates the related impact on the
underlying items hedged.
9. Accumulated other comprehensive income presented in the accompanying
balance sheet consists of the accumulated unrealized gains and loses on
available-for-sale marketable securities, net of the related tax effects,
for all periods presented.
Three months ended
March 31,
1999 1998
--------- --------
(In thousands)
Net income $ 4,323 $ 4,703
Unrealized gain (loss) on
available-for-sale securities (252) 125
--------- --------
Comprehensive income $ 4,071 $ 4,828
========= ========
Accumulated other comprehensive income was $219,000 and $168,000 at March
31, 1999 and 1998, respectively.
Page 8
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Certain statements in this discussion and analysis are forward looking
statements based on current expectations, and entail various risks and
uncertainties that could cause actual results to differ materially from those
expressed in such forward looking statements. Such risks and uncertainties are
discussed below and in the Company's Form 10-K/A for the year ended December 31,
1998 under the heading "Factors That May Affect Future Results." 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. The following discussion should be read in conjunction
with the Company's consolidated financial statements and the notes thereto.
Overview
The Company was founded in 1988 to develop and market flash data storage
systems. The Company sells its products to the consumer electronics and
industrial/communications markets. During 1998, the percentage of the Company's
product sales attributable to the consumer electronics market, particularly
sales of CompactFlash for use in digital camera applications, increased
substantially. This increase in sales to the consumer market resulted in a shift
to lower capacity products, which typically have lower average selling prices
and gross margins than higher capacity products. In addition, these products are
frequently sold into the retail channel, which usually has shorter customer
order lead-times than the other channels used by the Company, thereby decreasing
the Company's ability to accurately forecast future production needs. Subject to
market acceptance of its CompactFlash products, the Company believes these
products will continue to represent a majority of the Company's sales as the
popularity of consumer applications, including digital cameras, increases. The
percentage of sales attributable to orders received and fulfilled in the same
quarter has increased over time and, in response, the Company is continuing to
work to shorten its manufacturing cycle times.
The Company's operating results are affected by a number of factors
including the volume of product sales, the timing of significant orders,
competitive pricing pressures, the ability of the Company to match supply with
demand, changes in product and customer mix, market acceptance of new or
enhanced versions of the Company's products, 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, the timing
of license and royalty revenues, fluctuations in product costs, availability of
foundry capacity, variations in manufacturing cycle times, fluctuations in
manufacturing yields and manufacturing utilization, increased research and
development expenses, and exchange rate fluctuations. In addition, as the
proportion of the Company's products sold for use in consumer electronics
applications continues to increase, the Company's revenues may become subject to
seasonal declines in the first quarter of each year. See "Factors That May
Affect Future Results - Our Operating Results May Fluctuate Significantly" and
"There is Seasonality in Our Business."
Beginning in late 1995, the Company adopted a strategy of licensing its
flash technology, including its patent portfolio, to selected third party
manufacturers of flash products. To date, the Company has entered into patent
cross-license agreements with six companies, and it intends to pursue
opportunities to enter into additional licenses. The Company's current license
agreements provide for the payment of license fees, royalties, or a combination
thereof, to the Company. The timing and amount of these payments can vary
substantially from quarter to quarter, depending on the terms of each agreement
and, in some cases, the timing of sales of products by the other parties. As a
result, license and royalty revenues have fluctuated significantly in the past
and are likely to continue to fluctuate in the future. Given the relatively high
gross margins associated with license and royalty revenues, gross margins and
net income are likely to fluctuate more with changes in license and royalty
revenues than with changes in product revenues.
SanDisk markets its products using a combination of its direct sales
organization, distributors, manufacturers' representatives, private label
partners, OEMs and retailers. The Company expects that sales
Page 9
through the retail channel will continue to comprise an increasing share of
total revenues in the future, and that a substantial portion of its sales into
the retail channel will be made to participants that will have the right to
return unsold products. The Company does not recognize revenues from these sales
until the products are sold to the end customers.
Historically, a majority of the Company's sales have been to a limited
number of customers. The Company expects that sales of its products to a limited
number of customers will continue to account for a substantial portion of its
product revenues for the foreseeable future. The Company has also experienced
significant changes in the composition of its customer base from year to year
and expects this pattern to continue as market demand for such customers'
products fluctuates. The loss of, or significant reduction in purchases by major
customers, could have a material adverse effect on the Company's business,
financial condition and results of operations. See "Factors That May Affect
Future Results - Sales to a Small Number of Customers Represent a Significant
Portion of Our Revenues."
Due to the emerging nature of the Company's target markets and certain
planned product transitions, the Company has had difficulty forecasting future
inventory levels required to meet customer demand. As a result of both
contractual obligations and manufacturing cycle times, the Company has been
required to order wafers from its foundries several 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 has not been able to match its purchases of
wafers to specific customer orders and therefore the Company has from time to
time taken write downs for potential excess inventory purchased prior to the
receipt of customer orders. For example, in the second quarter of 1998, the
Company's product gross margins declined to 12% from 30% in the previous quarter
due in part to a write down of this inventory to reflect inventory at net
realizable value. These adjustments decrease gross margins in the quarter
reported and have resulted, and could in the future result, in fluctuations in
gross margins on a quarter to quarter basis. See "Factors That May Affect Future
Results - Our Operating Results May Fluctuate Significantly."
Export sales are an important part of the Company's business. In 1998,
product sales to Japan declined 19% from the prior year, due in part to the
Asian economic crisis. While a majority of the Company's revenues from sales to
Japan and other Asian countries are derived from OEM customers who plan to
export a portion of their products to countries outside of Asia, the Asian
economic crisis may continue to adversely effect the Company's revenues to the
extent that demand for the Company's products in Asia declines. Given the recent
economic conditions in Asia and the weakness of many Asian currencies relative
to the United States dollar, the Company's products may be relatively more
expensive in Asia, which could result in a decrease in the Company's sales in
that region. The Company may also experience pressure on its gross margins as a
result of increased price competition from Asian competitors. While most of the
Company's sales are denominated in U.S. Dollars, the Company invoices certain
Japanese customers in Japanese Yen. Exchange rate fluctuations can therefore
affect the Company's business, financial condition and results of operations.
See "Factors That May Affect Future Results - We Face Risks Associated with
International Operations."
For the foreseeable future, the Company expects to realize a significant
portion of its revenues from recently introduced and new products. Typically new
products initially have lower gross margins than more mature products because
the manufacturing yields are lower at the start of manufacturing each successive
product generation. In addition, manufacturing yields are generally lower at the
start of manufacturing any new product. To remain competitive, the Company is
focusing on a number of programs to lower its manufacturing costs, including
development of future generations of double density ("D2") flash and advanced
technology wafers. There can be no assurance that such products or processes
will be successfully developed by the Company or that development of such
processes will lower manufacturing costs. In addition, the Company anticipates
that price competition will increase in the future, which could result in
decreased average selling prices and lower gross margins. See "Factors That May
Affect Future Results -We Must Achieve Acceptable Wafer Manufacturing Yields."
Page 10
Year 2000 Readiness Disclosure
The Company is aware of problems associated with computer systems as
the Year 2000 approaches. Year 2000 problems are the result of common computer
programming techniques that result in systems that do not function properly when
manipulating dates later than December 31, 1999. The issue is complex and wide
ranging. The problem may affect transaction processing computer applications
used by the Company for accounting, distribution, manufacturing, planning and
communications. The problem may also affect embedded systems such as building
security systems, machine controllers and production test equipment. Year 2000
problems with these systems may affect the ability or efficiency with which the
Company can perform many significant functions, including but not limited to:
order processing and fulfillment, material planning, product assembly, product
test, invoicing and financial reporting. While there can be no guarantee of
unaffected operation, the completed implementation of the Company's new
Management Information System, and the completed assessment of its embedded
systems indicates limited exposure in these areas. The Year 2000 problem may
also affect the computer systems of the Company's suppliers and customers,
potentially disrupting their operations. Year 2000 problems with the Company's
business partners may impact the Company's sources of supply and demand.
Year 2000 Readiness. The Company has a Year 2000 Risk Management
program to assess the impact of the Year 2000 issue on the Company, and to
coordinate remediation activities. The Company completed the evaluation of its
products for Year 2000 compliance in the third quarter of 1998. The Company's
FlashDisk, FlashDrive, Flash ChipSet, CompactFlash, MultiMediaCard, and
ImageMate product lines do not perform date related processing and do not
contain real time clock circuitry and therefore, are Year 2000 ready. The
Company's storage and connectivity products are used as components in a variety
of host systems. The firmware, operating system and application software of
these host systems are designed and manufactured by others. The Company makes no
claim with regard to the Year 2000 readiness of host systems designed by others
in which the Company's products are used. Independent system designers make
derivative works from the SanDisk Host Developer's Toolkit ("Toolkit") source
code product. Sample date related subroutines and data structures are included
in the Toolkit for use by system designers. Designers modify the sample routines
in order to fit the specific requirements of their host operating system. The
designer is responsible for the formatting and processing logic associated with
the date values that pass through the Toolkit subsystem and for the Year 2000
readiness of the systems in which the Toolkit is used. The Company makes no
claims with regard to the Year 2000 readiness of host firmware and operating
systems designed by others that contain derivative works of the Toolkit.
The Year 2000 remediation of the Company's transaction processing
systems was completed with the installation and testing of the Company's new
management information system in the fourth quarter of 1998. The new system is a
commercially available, fully integrated MRP II (Materials Requirement Planning
and Accounting system) software application. This system is used for Accounting,
Order Processing, Planning, Inventory Control, Shop Floor Control and
Distribution.
The Company's assessment and remediation of Year 2000 problems in
tertiary business information systems is on-going. Well over 90% of the
Company's investment in desktop PC hardware is known to be Year 2000 compliant,
and proven remediation solutions have been identified for the remaining 10%. The
majority of the software used on these systems and network servers are recent
versions of vendor supported, commercially available products. Upgrading these
applications as Year 2000 compliant patches are released by the respective
vendors has not been a significant burden on the Company and is expected to be
completed before the end of 1999.
The Company's assessment of Year 2000 problems in computer systems used
for facilities control, machine control and manufacturing testing is complete,
and remediation is on-going. The most significant Year 2000 issue in this area
has been found to be related to older wafer test equipment. This
Page 11
equipment is not expected to be in use in the year 2000. The Company is phasing
in new Year 2000 compliant wafer test equipment in conjunction with the
introduction of new generations of flash memory.
The Company's assessment of Year 2000 risks related to suppliers,
customers and other third parties is ongoing. Inquiries have been made of all
critical suppliers and an assessment of their Year 2000 readiness is in
progress. The Company expects to utilize the completed assessment as the basis
for strategic decisions regarding alternate material sourcing and/or increasing
inventory safety stocks by the end of the second quarter of 1999. SanDisk will
also contact its significant customers regarding their Year 2000 readiness in
order to understand the potential for any disruptions in their ordering
patterns. Completion of this review will depend on the responsiveness of the
Company's vendors and customers, over which the Company has no control.
Year 2000 Risk Management Program Costs. The cost of the Year 2000
project related to upgrading the Company's core management information system
was approximately $1.0 million, $400,000 of which was related to the purchase of
software and hardware which was capitalized by the Company. In the first quarter
of 1999, the Company spent approximately $100,000 for application software
upgrades. The Company estimates it will cost an additional $150,000 to upgrade
remaining non-compliant application software and to replace non-compliant
personal computer systems. The Company would have incurred the majority of these
costs, in spite of Year 2000 issues, due to the need to upgrade its management
information system, application software and personal computers to support the
Company's growth. The Company's Year 2000 remediation projects will be funded
from operating cash flows. No material projects have been deferred in order to
complete the Company's Year 2000 assessment and remediation project. The
additional expenses related to the management of the Year 2000 compliance
program and completing the assessment of the Company's internal and external
risks are not expected to be material to the Company's quarterly operating
results.
The costs and time schedule for the Year 2000 problem abatement are
based on management's best estimates for the remediation of Year 2000 problems
uncovered to date. These estimates were derived utilizing numerous assumptions,
including that the most significant Year 2000 risks have already been
identified, that certain resources will continue to be available, that third
party plans will be fulfilled and other factors. However, there can be no
guarantee that these estimates will be achieved or that the anticipated time
schedule will be met and actual results could differ materially from those
anticipated.
Contingency Plans. Specific contingency plans for systems that pose
significant risk to on-going operations are being developed under the auspices
of the Company's Year 2000 Risk Management program. Should previously undetected
Year 2000 problems be found in other systems, these systems will either be
upgraded, replaced, turned off, or operated in place with manual procedures to
compensate for their deficiencies. While the Company believes that these
alternative plans would be adequate to meet the Company's needs without
materially impacting its operations, there can be no assurance that such
alternatives would be successful or that the Company's results of operations
would not be materially adversely affected by the delays and inefficiencies
inherent in conducting operations in this manner.
Risks Related to Year 2000 Readiness. Success of the Company's Year
2000 compliance effort depends, in part, on the success of its key suppliers and
customers in dealing with their Year 2000 issues. The Company does not have any
control over the remediation efforts of its key suppliers and customers and
cannot fully determine the extent to which they have resolved their Year 2000
compliance issues. The Company currently purchases several critical components
from single or sole source vendors. While this issue is being carefully managed,
disruptions in the supply of components from any of these sole source suppliers
due to Year 2000 issues, could cause delays in the Company's fulfillment of
customer orders which could result in reduced or lost revenues. Furthermore, the
Company's sales have historically been to a limited number of customers. Any
disruption in the purchasing patterns of these customers or potential customers
due to Year 2000 issues could cause a decline in the Company's revenues. There
can be no assurance that the Company and its key suppliers and customers will
identify and remediate all significant Year 2000 problems on a timely basis.
Furthermore, there can be no assurance that the Company's
Page 12
insurance will cover losses from business interruptions arising from Year 2000
problems of the Company or its suppliers. Year 2000 compliance problems of the
Company's key suppliers and customers could adversely affect the Company's,
business, financial condition and results of operations.
The foregoing statements regarding the Company's Year 2000 readiness
are based upon management's best estimates at the present time, which were
derived utilizing assumptions regarding future events, including the continued
availability of certain resources, third party modification plans and other
factors. There can be no guarantee that these estimates will be achieved and
actual results could differ materially from those anticipated. Specific factors
that might cause such material differences include, but are not limited to, the
availability and cost of personnel trained in this area, the ability to locate
and correct all relevant computer codes, the nature and amount of programming
required to upgrade or replace each of the affected programs, the rate and
magnitude of related labor and consulting costs and the success of the Company's
external customers and suppliers in addressing the Year 2000 issue. The
Company's evaluation is on-going and it expects that new and different
information will become available to it as the evaluation continues.
Consequently, there is no guarantee that all material elements will be Year 2000
ready in time.
Results of Operations
Product Revenues. SanDisk's product revenues were $35.9 million in the first
quarter of 1999, up $10.5 million or 41% from the first quarter of 1998. During
the three months ended March 31, 1999, units shipped increased 144%. The largest
increase in unit volumes came from sales of CompactFlash products, which
represented approximately 76% of units shipped and 60% of product revenues
compared to 68% of units shipped and 45% of product revenues for the first
quarter of 1998. Average selling prices declined 44% in the first quarter of
1999 compared to the same period of the prior year, partially due to a shift in
product mix to CompactFlash, Flash ChipSet and MultiMediaCard products which
have lower capacities and average selling prices than the Company's FlashDisk
products. The Company anticipates that lower capacity products will continue to
represent a significant portion of its sales as consumer applications such as
digital cameras become more popular. Sales of these lower capacity products
generally have lower average selling prices and gross margins than higher
capacity products. The mix of products sold varies from quarter to quarter and
may vary in the future, affecting the Company's overall average selling prices
and gross margins.
The Company continues to experience limited bookings visibility as customers
continue to expect short lead-times, particularly in the growing retail
component of the Company's business. A majority of the Company's anticipated
second quarter revenues, which are projected to slightly exceed the level
achieved in the first quarter, continue to be turns business with orders
received and fulfilled in the same quarter. Due to a number of factors described
herein and in "Factors That May Affect Future Results," the Company's ability to
adjust its operating expenses is limited in the short term. As a result, if
product revenues are lower than anticipated, the Company's results of operations
will be adversely affected.
Export sales represented 42% of product revenue for the first quarter of
1999 compared with 46% for the same period of the previous year. The Company
expects international sales to continue to represent a significant portion of
its product revenues. In the first quarter of 1999, the Company's top ten
customers represented approximately 61% of product revenue with the top two
customers representing a combined 31% of product revenues. Sales to the top 10
customers represented approximately 72% of product revenues in the first quarter
of 1998. The Company expects that sales to a limited number of customers will
continue to represent a substantial portion of its revenues for the foreseeable
future.
License and Royalty Revenues. The Company currently earns patent license
fees and royalties under six cross-license agreements with Hitachi Ltd.
("Hitachi"), Intel Corporation ("Intel"), Samsung Electronics Company Ltd.
("Samsung"), Sharp Electronics Corporation ("Sharp"), Silicon Storage
Technology, Inc.
Page 13
("SST") and Toshiba Corporation ("Toshiba"). License and royalty revenues from
patent cross-license agreements were $8.2 million in the first quarter of 1999,
down from $8.7 million in the same period of the previous year due primarily to
the timing of royalties earned under the various agreements. Revenues from
licenses and royalties decreased to 19% of total revenues in the first quarter
of 1999 from 25% in the first quarter of 1998.
Gross Profits. In the first quarter of 1999, gross profits were $17.6
million, or 40% of total revenues compared to $16.3 million, or 48% of total
revenues in the same period of 1998. Product gross margins decreased to 26% of
product revenues from 30% in the first quarter of 1998 due primarily to a
decline in average selling prices.
Competition remains strong and product gross margins are expected to remain
under pressure due to declining average selling prices. The Company is currently
working on a number of cost reduction programs to strengthen product gross
margins in 1999, including the transition of manufacturing operations for high
volume products offshore. However, there can be no assurance that the Company
will be successful in these efforts. Also, increased competition may negatively
affect gross margins in 1999.
During the first quarter of 1999, the Company began shipping customer
samples of its CompactFlash and FlashDisk products utilizing its new 128Mbit
flash chip. This design is currently undergoing final internal qualification,
with full volume production expected to begin in the second quarter of 1999. The
128Mbit flash chip has a lower manufacturing cost per megabyte and is expected
to contribute to improved product gross margins in the second half of 1999. The
initial production period of each new generation of flash technology is subject
to many risks and uncertainties as described in "Factors That May Affect Future
Results - We Face Risk in Transitioning to New Processes and Products." There
can be no assurance that the Company will successfully complete the internal and
customer qualifications of the 128Mbit flash chips in a timely manner, or that
it will realize the expected cost reductions in the second half of 1999.
In addition, in the second quarter of 1999, the Company will be moving the
high volume production of its CompactFlash cards to Celestica in South China and
the production of its MultiMediaCard products to Siliconware Precision
Industries Co. Ltd. and Siliconware Corporation in Taiwan. The Company expects
to incur some start up costs related to these ventures in the second quarter of
1999, but expects these investments to reduce future product costs and greatly
expand production capacity in the second half of the year. There are many risk
and uncertainties involved with the transfer of production to these
subcontractors as discussed in "Factors That May Affect Future Results - We Face
Risks Associated with Our International Operations and -- We Depend on Our
Suppliers and Third Party Subcontractors." Failure to successfully manage the
transition could result in excess and/or obsolete inventory or lower of cost or
market valuation adjustments due to potential duplication of certain inventory
build plans. There can be no assurance that the Company will realize the
expected product cost reductions or that these reductions will be large enough
to offset future average selling price declines due to increased competition.
Research and Development. Research and development expenses consist
principally of salaries and payroll related expenses for design and development
engineers, prototype supplies and contract services. Research and development
expenses were $5.2 million in the first quarter of 1999, up $0.9 million or 20%
from $4.3 million in the same period of 1998. The increase was primarily due to
increased salary and related expenses and higher nonrecurring engineering and
project related expenses. Research and development expenses represented 12% of
total revenues in the first quarter of 1999 compared to 13% in the first quarter
of 1998. The Company expects research and development expenses to continue to
increase in absolute dollars to support the development and introduction of new
generations of flash data storage products.
Sales and Marketing. Sales and marketing expenses include salaries, sales
commissions, benefits and travel expenses for the Company's sales, marketing,
customer service and applications engineering personnel. These expenses also
include other selling and marketing expenses, such as independent manufacturer's
representative commissions, advertising and tradeshow expenses. Sales and
marketing
Page 14
expenses were $5.2 million in the first quarter of 1999 up $1.2 million or 31%
from $4.0 million in the first quarter of 1998. The increase was primarily due
to increased salary and related expenses, higher commissions and increased
marketing expenses. Sales and marketing expenses represented approximately 12%
of total revenues in the first quarters of both 1999 and 1998. The Company
expects sales and marketing expenses to increase as sales of its products grow
and as it continues to develop the retail channel for its products.
General and Administrative. General and administrative expenses include the
cost of the Company's finance, information systems, human resources, shareholder
relations, legal and administrative functions. General and administrative
expenses were $2.4 million in the first quarter of 1999, up $0.4 million or 17%
from $2.0 million in the first quarter of 1998. The increase was primarily due
to increased salary and related expenses and higher legal fees as a result of
patent litigation related to the Lexar suit. General and administrative expenses
represented 5% of total revenues in the first quarter of 1999 compared to 6% for
the first quarter of 1998. The Company expects general and administrative
expenses to increase as the general and administrative functions grow to support
the overall growth of the Company. General and administrative expenses could
also increase substantially in the future if the Company continues to pursue
litigation to defend its patent portfolio. See "Factors That May Affect Future
Results - Risks Associated with Patents, Proprietary Rights and Related
Litigation."
Interest and Other Income, Net. Interest and other income, net, was $1.6
million in the first quarter of 1999 compared to $1.3 million in the first
quarter of 1999. The increase in 1998 was primarily due to foreign currency
transaction gains.
Provision for Income Taxes. The Company recorded a provision for income
taxes at a 33% effective tax rate for the first three months of 1999 compared to
a 36% effective tax rate for the same period of 1998. The lower effective tax
rate in 1999 reflects greater benefits from federal and state tax credits.
Liquidity and Capital Resources
As of March 31, 1999, the Company had working capital of $142.6 million,
which included $15.4 million in cash and cash equivalents and $129.6 million in
short-term investments. The Company has a line of credit facility with a
commercial bank under which it can borrow up to $10.0 million at the bank's
prime rate. This line of credit facility expires in July 1999. As of March 31,
1999, the Company had $1.0 million committed under the line of credit facility
for standby letters of credit. The facility contains covenants that require the
Company to maintain certain financial ratios and levels of net worth, and
prohibits the payment of cash dividends to stockholders. The Company is
currently in compliance with all covenants in the line of credit agreement. The
Company intends to either renew its line of credit or negotiate a new line of
credit upon the expiration of its current line.
Operating activities provided $12.3 million of cash in the first quarter of
1999 primarily from net income, an increase in accounts payable of $8.6 million
and a reduction in prepaids and other assets of $3.3 million. These were
partially offset by a decrease in deferred revenue of $6.4 million and an
increase in accounts receivable of $3.1 million.
Net cash used in investing activities of $13.8 million in the first quarter
of 1999 consisted of net purchases of investments of $10.7 million and capital
equipment purchases and leasehold improvements of $3.0 million. In the first
quarter of 1999, cash provided by financing activities of $1.5 million came
primarily from the sale of common stock through the Company's stock option and
employee stock purchase plans.
Depending on the future demand for the Company's products, the Company may
decide to make additional investments, which could be substantial, in assembly
and test manufacturing equipment or foundry capacity to support its business in
the future. Management believes the existing cash and cash
Page 15
equivalents, short-term investments and available line of credit 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
A portion of the Company's revenues are denominated in Japanese Yen. The
Company enters into foreign exchange forward contracts to hedge against changes
in foreign currency exchange rates. At March 31, 1999, one forward contract with
a notional amount of $4.5 million was outstanding. Future exchange rate
fluctuations could have a material adverse effect on the Company's business,
financial condition and results of operations.
Factors That May Affect Future Results
Our business, financial condition and results of operations could be
impacted by a number of factors including the risk factors listed below.
Our Operating Results May Fluctuate Significantly
Our quarterly and annual operating results have fluctuated
significantly in the past and we expect that they will continue to fluctuate in
the future. This fluctuation is a result of a variety of factors, including the
following:
o Unpredictable demand for our products
o Decline in our average selling prices due to competitive pricing pressures
o Seasonality in sales of our products for consumer electronics applications
o Changes in product and customer mix
o Market acceptance of new or enhanced versions of our products
o Changes in our distribution channels
o Timing of license and royalty revenue recognition
o Fluctuations in product costs, particularly due to fluctuations in
manufacturing yields and utilization
o Availability of foundry capacity
o Variations in manufacturing cycle times
o Increased research and development expenses
o Exchange rate fluctuations
o Changes in general economic conditions, in particular the economic
recession in Japan
o Obsolescence of unsold inventory
When we order silicon wafers from our foundries, we have to estimate
the number of silicon wafers needed to fill product orders several months into
the future. If we overestimate this number, we build excess inventories which
adversely affects our gross margins and operating results. For example, in the
second quarter of 1998, our product gross margins declined to 12% from 30% in
the previous quarter due in part to a write down of this inventory to reflect
inventory at net realizable value. Because our largest volume product,
CompactFlash, is sold into an emerging consumer market, it is very difficult to
accurately forecast future sales. If sales fall below our forecast, our
operating results could be adversely affected if we are unable to reduce our
operating expenses. More than 50% of our quarterly sales are from orders
received and fulfilled in the same quarter (turns business). In addition, our
product order backlog may fluctuate substantially from quarter to quarter.
Due to anticipated growth, we increased our expense levels in 1998 and
in the first quarter of 1999. Operating expenses are expected to continue to
increase as a result of the need to hire additional personnel to support
expected growth in sales unit volumes, marketing and sales efforts and research
and development activities. These expenses cannot be readily scaled back over
the short term. If revenue does
Page 16
not increase proportionately to operating expenses, or if revenues decrease or
do not meet expectations for a particular period, our business, financial
condition and results of operations will be adversely affected.
Product mix varies quarterly, which affects our overall average selling
prices and gross margins. Our CompactFlash products, which currently represent
the majority of our product revenues, have lower average selling prices and
gross margins than our higher capacity FlashDisk and FlashDrive products. We
believe that sales of CompactFlash products may become an even more significant
percentage of our product revenues as consumer applications, such as digital
cameras, become more popular. Dependence on CompactFlash sales, together with
lower pricing caused by increased competition, caused average selling prices to
decline 28% during 1998. Average selling prices declined 24% in the first
quarter of 1999 compared to the fourth quarter of 1998, partially due to a shift
in product mix to CompactFlash, Flash ChipSet and MultiMediaCard products which
have lower capacities and average selling prices than the Company's FlashDisk
products. This trend is expected to continue.
Our intellectual property strategy is to cross-license our patents to
other manufacturers of flash products. Under such arrangements, we earn license
fees and royalties on individually negotiated terms. The timing of revenue
recognition from these payments is dependent on the terms of each contract and
on the timing of product shipments by the third parties. This may cause license
and royalty revenue to fluctuate significantly from quarter to quarter. Because
this revenue has higher gross margins than product revenue, gross margins and
net income fluctuate more with changes in license and royalty revenue than with
changes in product revenue.
Our Business Depends Upon Consumer Products
In 1998 and the first quarter of 1999, we received more product revenue
and shipped more units of products destined for consumer electronics
applications, principally digital cameras, than for any other applications. We
believe that these products will encounter intense competition and be more price
sensitive than products sold into our other target markets. In addition, we must
spend more on marketing and promotion in consumer markets to establish brand
name recognition and preference.
A significant portion of sales to the consumer electronics market is
made through distributors and to retailers. Sales through these channels
typically include rights to return unsold inventory. As a result, revenue is not
recognized until after the product has been sold to the end user. If our retail
customers are not successful in this market, there could be substantial product
returns, which may cause harm to our business, financial condition and results
of operations.
Our Business Depends on Emerging Markets and New Products
In order for demand for our products to grow, the markets for new
products that use CompactFlash and the MultiMediaCard, such as smart phones and
MP3 portable music players, must develop and grow. If sales of these products do
not grow, our product revenues and profit margins could level off or decline. To
remain competitive, we intend to develop new products with increased memory
capacity at a lower cost per megabyte. The success of this new product strategy
will depend upon, among other things, the following:
o Our ability to successfully develop new products with higher memory
capacities at a lower cost per megabyte;
o The development of new applications or markets for our flash data storage
products; o The extent to which prospective customers design our products
into their products and successfully introduce their products;
o The extent to which our products or technologies become obsolete or
noncompetitive due to products or technologies developed by others.
Page 17
If our new applications or target markets fail to develop, or if our
products are not accepted by the market, our business, financial condition and
results of operations could suffer.
There Is Seasonality In Our Business
Sales of our products, in particular the sale of CompactFlash Products,
in the consumer electronics applications market are subject to seasonality. As a
result, product sales are impacted by seasonal purchasing patterns with higher
sales generally occurring in the second half of each year as compared to the
first half of each such year. In addition, in the past we have experienced a
decrease in orders in the first quarter from our Japanese OEM customers
primarily due to the fact that most customers in Japan operate on a fiscal year
ending in March and prefer to delay purchases until the beginning of their next
fiscal year. For example, our product revenues were 24% lower in the first
quarter of 1998 than in the fourth quarter of 1997, mostly due to these seasonal
factors and the Asian economic crisis. However, we did not experience such
seasonality in the first quarter of 1999.
Our Markets Are Highly Competitive
We compete in an industry characterized by intense competition, rapid
technological changes, evolving industry standards, declining average selling
prices and rapid product obsolescence. Our 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. Our primary competitors include flash chip producers such as Advanced
Micro Devices, Inc., Atmel Corporation, Hitachi Ltd., Intel Corporation, Micron
Technology, Inc., Mitsubishi Electronic Corporation, Samsung Electronics Company
Ltd., Sharp Electronics Corporation and Toshiba Corporation. Other competitors
include companies using data storage techniques such as socket flash, linear
flash and system flash components, as well as package or card assemblers such as
Lexar Media, Inc., M-Systems, Inc., Simple Technology Inc., SMART Modular
Technologies, Inc., Sony Corporation, Kingston Technology Company, TDK
Corporation, Matsushita Battery, Inc. and Viking Components, Inc., which combine
controllers and flash memory chips developed by others into flash storage cards.
Approximately 25 companies have been certified by the CompactFlash Association
to manufacture and sell their own brand of CompactFlash. We believe that other
manufacturers will enter the CompactFlash market in the future.
In addition, competing products have been introduced that promote
industry standards that are different from our CompactFlash product, including
Toshiba's Smart Media (Solid-State Floppy Disk Card), Sony Corporation's Memory
Stick, Panasonic's recently introduced Mega Storage cards and M-Systems'
Diskonchip(TM) for embedded storage applications. Each competing standard is
mechanically and electronically incompatible with CompactFlash. If a
manufacturer of digital cameras or other consumer electronic devices designs-in
one of these alternative competing standards, CompactFlash will be eliminated
from use in that product.
In November 1997, Iomega Corporation announced its Clik drive, a
miniaturized, mechanical, removable disk drive, and claims that it will compete
directly with our flash card products. In September 1998, IBM introduced the
microdrive, a rotating disk drive in a type II CompactFlash format. Initially,
this product will compete directly with our type II CompactFlash memory cards,
when we introduce these products in 1999, for use in high end professional
digital cameras. In October 1998, M-Systems introduced their Diskonchip 2000
product which is expected to compete against our Flash ChipSet products in
embedded storage applications.
According to independent industry analysts, Sony's Mavica digital
camera captured a considerable portion of the United States market for digital
cameras in 1998. The Mavica uses a standard floppy disk to store digital images
and therefore uses no CompactFlash (or any other flash) cards. Our sales
prospects for CompactFlash cards will be adversely impacted if the Mavica market
share continues at a high level into the future. Also, our MultiMediaCard
products are expected to face stiff competition from
Page 18
Toshiba's SmartMedia flash cards and Sony's flash Memory Stick. Although the
Memory Stick is proprietary to Sony, if it is adopted and achieves widespread
use in future products, sales of our MultiMediaCard and CompactFlash products
may decline.
We also face competition from products based on multilevel cell flash
technology such as Intel's 64Mbit flash chip and Hitachi's anticipated
introduction of their 256Mbit flash chip. These products compete with our D2
multilevel cell flash technology. Multilevel cell flash is a technological
innovation that allows each flash memory cell to store two bits of information
instead of the traditional single bit stored by the industry standard flash
technology.
Furthermore, we expect to face competition from existing companies and
from other companies that may enter our existing or future markets that have
similar or alternative data storage solutions which may be less costly or
provide additional features. Price is an important competitive factor in the
market for consumer products. Increased price competition could lower gross
margins if our average selling prices decrease faster than costs and could also
result in lost sales.
We have entered into patent cross-license agreements with Hitachi,
Intel, Samsung, Sharp, SST and Toshiba. Under these agreements, each party may
manufacture and sell products that incorporate technology covered by the other
party's patents related to flash memory devices. As we continue to license our
patents to certain competitors, competition will increase and may cause harm to
our business, financial condition and results of operations.
Other competitive factors include:
o Product cost, availability and performance
o Adequate foundry capacity
o Efficiency of production
o Timing of our new product announcements or introductions
o Successful protection of our intellectual property rights
o General market and economic conditions
Our Average Sales Prices Have Declined
In 1998, the average unit selling prices of our products declined 28%
compared to 1997. In the first quarter of 1999, the average unit selling prices
of our products declined 24% compared to the fourth quarter of 1998. Because
flash data storage markets are characterized by intense competition, we expect
that pricing pressures from our customers and competitors may increase. This
will likely result in a further decline in average sales prices for our
products. We believe that we can offset declining average sales prices by
achieving manufacturing cost reductions and developing new products that
incorporate advanced features and can be sold at higher average gross margins.
However, if we are unable to achieve such cost reductions or remain price
competitive, this could result in lost sales, declining gross margins, and as a
result, our business, financial condition and results of operations could
suffer.
From time to time, the semiconductor industry has experienced a
significant downturn and is currently beginning to recover from one of its most
severe down cycles. During most of 1998, the semiconductor industry experienced
significant production over capacity. This "buyers market" put margin pressures
on all flash memory suppliers. We believe product gross margins will remain
under pressure in the first half of 1999 until the more favorable cost structure
of our 128Mbit flash chip design begins to have a favorable impact on the cost
per megabyte of our products.
We Face Risks Associated with Our International Operations
Our sales are primarily denominated in United States dollars. As a
result, if the value of the US dollar increases relative to foreign currencies,
our products could become less competitive in international
Page 19
markets. For example, our products are relatively more expensive in Asia because
of the recent economic conditions in Asia and the weakness of many Asian
currencies relative to the US dollar. This resulted in a decrease in our sales
in that region in 1998. In fiscal 1998, sales to Japan declined to 31.6% of
total product sales from 38.1% in 1997. This was primarily due to the Japanese
economic crisis and market recession. In the first quarter of 1999, sales to
Japan represented 27.6% of product revenue compared to 35.0% for the same period
of 1998. If the current market conditions in Japan do not improve, or if they
decline further, our results of operations may suffer.
Currently, all of our wafers are produced by foundries located outside
the United States and the majority are purchased in United States dollars.
Because we currently invoice certain customers in Japanese Yen, fluctuations in
currencies could adversely affect our business, financial condition and results
of operations. Our international business activities could also be limited or
disrupted by any of the following:
o The need to comply with foreign government regulation;
o General geopolitical risks such as political and economic instability,
potential hostilities and changes in diplomatic and trade relationships;
o Imposition of regulatory requirements, tariffs, import and export
restrictions, and other barriers and restrictions;
o Longer payment cycles and greater difficulty in accounts receivable
collection;
o Potentially adverse tax consequences;
o Less protection of our intellectual property rights;
o Delays in product shipments due to local customs restrictions.
In the second quarter of 1999, we will begin using third-party
subcontractors in China and Taiwan for the assembly and testing of our
components. As a result, our business could be harmed by the effect of
political, economic, legal and other uncertainties in China. Under its current
leadership, the Chinese government has been pursuing economic reform policies,
including the encouragement of foreign trade and investment and greater economic
decentralization. The Chinese government may not continue to pursue such
policies and, even if it continued, such policies may not be successful. The
Chinese government may significantly alter these policies from time to time. In
addition, China does not currently have a comprehensive and highly developed
system of laws, particularly with respect to the protection of intellectual
property rights. As a result, enforcement of existing and future laws and
contracts is uncertain, and the implementation and interpretation of such laws
may be inconsistent, which could lead to piracy and degradation of the Company's
intellectual property protection among other things.
Sales to a Small Number of Customers Represent a Significant Portion of
Our Revenues
More than half of our revenue comes from a small number of customers.
For example, sales to the Company's top 10 customers accounted for approximately
59%, 67%, and 71%, respectively, of the Company's product revenues for 1998,
1997, and 1996. In the first quarter of 1999, the Company's top 10 customers
represented approximately 61% of product revenue. If we were to lose any of
these customers or experience any material reduction in orders from these
customers, our revenues and operating results would suffer. Our sales are
generally made by standard purchase orders rather than long-term contracts. In
addition, the composition of our major customer base changes from year to year
as the market demand for our customers' products change.
We Depend on Third Party Foundries for Silicon Wafers
All of our products require silicon wafers. We rely on United Silicon
Corporation ("USC") and United Semiconductor Incorporated ("USIC") in Taiwan for
supplying our silicon wafers. We depend on our foundries to (1) allocate a
portion of their foundry capacity to our needs, (2) produce acceptable quality
wafers with acceptable manufacturing yields and (3) deliver our wafers on a
timely basis at a competitive
Page 20
price. If our foundries are unable to satisfy these requirements, our business,
financial condition and operating results may suffer.
Under the wafer supply agreements with our foundries, we are obligated
to provide monthly rolling forecasts for our anticipated wafer purchases.
Generally, the estimates for the first three months of each forecast are binding
commitments. The estimates for the remaining months 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 and could cause us to have
excess inventory. In addition, if we are unable to obtain scheduled quantities
of wafers with acceptable price and yields from any foundry, our business,
financial condition and results of operations could be adversely affected.
We Depend on Our Suppliers and Third Party Subcontractors
We rely on our vendors, some of which are sole source suppliers, for
several of our critical components. We do not have long-term supply agreements
with any of these vendors. Our business, financial condition and operating
results could be harmed by delays or reductions in shipments if we are unable to
develop alternative sources or to obtain sufficient quantities of these
components. For example, we rely on Motorola, Inc. and NEC to supply certain
designs of critical microcontrollers.
We also rely on third-party subcontractors to assemble, and sometimes
test the memory components for our products. We have no long-term contracts with
these subcontractors and cannot directly control product delivery schedules.
This could lead to product shortages or quality assurance problems which could
increase the manufacturing costs of our products and have adverse effects on our
operating results.
During the second and third quarters of 1999, we plan to transfer the
majority of wafer test, packaged memory final test, card assembly and card test
to subcontractors in Taiwan and China. This increased reliance on subcontractors
is expected to reduce the cost of such operations and give us access to
increased production capacity. During the transition period, we will continue
full operations at our Sunnyvale production facility while simultaneously
transferring test equipment and training personnel of our subcontractors. Any
significant problems in this complex transfer of operations may result in a
disruption of production and a shortage of product to meet customer demand in
the second and third quarters of 1999.
We Face Risk in Transitioning to New Processes and Products
Successive generations of our products incorporate semiconductor
devices with greater memory capacity per chip. We are continually involved in
joint development efforts with our foundries to produce semiconductor devices
based upon smaller geometry manufacturing processes. Two important factors that
enable us to decrease the costs per megabyte of our flash data storage products
are the development of higher capacity semiconductor devices and the
implementation of smaller geometry manufacturing processes. A number of
challenges exist in achieving a lower cost per megabyte, including (1) lower
yields often associated with the early production of new semiconductor devices,
(2) problems with design and manufacturing of products that will incorporate
these devices and (3) production delays. Because our products are complex, we
periodically experience significant delays in the development and volume
production ramp up of our products. Similar delays could occur in the future and
could harm our business, financial condition and results of operations.
We have developed new products based on D2 flash technology, a new
flash architecture designed to store two bits in each flash memory cell. We
believe that the 256Mbit D2 flash design currently in advanced development, will
help us increase the capacity and decrease the costs of certain products,
enabling us to maintain our competitive advantage and broaden our target
markets. High density flash memory, such as D2 flash, is a complex technology
that requires tight manufacturing controls and effective test screens. Problems
from the shift to volume production for new flash products could impact both
Page 21
reliability and yields and result in increased manufacturing costs. We may not
be able to manufacture reliable and cost effective D2 flash products in
commercial volumes and with yields sufficient to result in lower costs per
megabyte. Furthermore, D2 flash technology needs significantly improved write
speed so that it can be usefully applied to market applications such as digital
cameras. Although the 256Mbit design is intended to meet the improved write
speed requirements, it is possible that we may not be able to achieve the target
write speed in our future D2 products.
The MultiMediaCard product family is expected to undergo a rapid
production ramp during the second and third quarters of 1999. During the startup
phase, it is expected that production yields may be lower than expected, thereby
adversely impacting MultiMediaCard product availability as well as increasing
manufacturing costs and reducing product margins for this product family.
We Must Achieve Acceptable Wafer Manufacturing Yields
The fabrication of our products requires wafers to be produced in a
highly controlled and clean environment. Semiconductor companies that supply our
wafers sometimes have experienced problems achieving acceptable wafer
manufacturing yields. Semiconductor manufacturing yields are a function of both
our design technology and the foundry's manufacturing process technology. Low
yields may result from design errors or manufacturing failures. Yield problems
may not be determined or improved until an actual product is made and can be
tested. As a result, yield problems may not be identified until the wafers are
well into the production process. The risks associated with yields are even
greater because we rely on independent offshore foundries for our wafers which
increases the effort and time required to identify, communicate and resolve
manufacturing yield problems. If the foundries cannot achieve the planned
yields, it could negatively affect our business, financial condition and results
of operations.
Risks Associated with Patents, Proprietary Rights and Related Litigation
We rely on a combination of patents, trademarks, copyright and trade
secret laws, confidentiality procedures and licensing arrangements to protect
our intellectual property rights. In the past, we have been involved in
significant disputes regarding our intellectual property rights and claims that
we may be infringing third parties' intellectual property rights. We expect that
we may be involved in similar disputes in the future. We cannot assure you (1)
that any of our patents will not be invalidated, (2) that patents will be issued
for any of our pending applications, (3) that any claims allowed from existing
or pending patents will have sufficient scope or strength or (4) that our
patents will be issued in the primary countries where our products are sold in
order to protect our rights and potential commercial advantage. In addition, our
competitors may be able to design around our patents.
From time to time, it may be necessary to initiate litigation against
third parties to preserve our intellectual property rights. These parties could
in turn bring suit against us. Such a situation occurred in March of 1998. We
filed a complaint in federal court against Lexar for infringement of a
fundamental flash disk patent. Lexar disputed this claim and asserted that our
patent was invalid or unenforceable, as well as asserting various counterclaims
including unfair competition, violation of the Lanham Act, patent misuse,
interference with prospective economic advantage, trade defamation and fraud. We
have denied all of these counterclaims. In July 1998, the federal district court
denied Lexar's request to have the case dismissed. Discovery in this suit began
in August 1998. On February 22, 1999, the Federal District Court considered
arguments and papers submitted by the parties regarding the scope and proper
interpretation of the asserted claims in SanDisk's patent at issue in the Lexar
suit. On March 4, 1999, the Federal District Court issued its ruling on the
proper construction of the claim terms in SanDisk's patent. A trial date has not
yet been set.
We intend to vigorously enforce our patents but we cannot be sure that
our efforts will be successful. If we were to have an adverse result in any such
litigation, we 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
Page 22
to the infringing technology. Any litigation is likely to result in significant
expense to us, as well as divert the efforts of our technical and management
personnel.
If we decide to incorporate third party technology into our products or
if we are found to infringe on others' intellectual property, we could be
required to license intellectual property from a third party. 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. Currently, we have patent
cross-license agreements with Hitachi, Intel, Samsung, Sharp, SST and Toshiba
and we are in discussions with other companies regarding potential cross-license
agreements. We cannot be certain that licenses will be offered when we need
them, or that the terms offered will be acceptable. 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 or stop our foundries from using processes that may infringe the rights
of third parties. We cannot assure you that we would be successful in
redesigning our products or that the necessary licenses will be available under
reasonable terms.
We have historically agreed to indemnify various 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 attorney's fees. We may periodically engage in litigation as a result
of these indemnification obligations. We are not currently engaged in any such
indemnification proceedings. Our insurance policies exclude coverage for third
party claims for patent infringement. Any future obligation to indemnify our
customers or suppliers could have a negative affect on our business, financial
condition or results of operations.
Our Rapid Growth May Strain Our Operations
We have periodically experienced rapid growth, which has placed, and
continues to place, a significant strain on our personnel and other resources.
To accommodate this growth, we must continue to implement and improve our
operational, financial and management information systems, as well as hire,
train, motivate and manage our employees. We have had difficulty in the past
hiring the necessary engineering, sales and marketing personnel to support our
growth. In addition, we must make a significant investment in our existing
internal information management systems to support increased manufacturing, as
well as accounting and other management related functions. Our systems,
procedures and controls may not be adequate to support our rapid growth, which
could in turn negatively affect our business, financial condition and results of
operations.
We Depend Upon Certain Key Personnel
Our success greatly depends on the continued contributions of our
senior management and other key research and development, sales, marketing and
operations personnel, including Dr. Eli Harari, the founder, President and Chief
Executive Officer. Our success will also depend on our ability to recruit
additional highly skilled personnel. We cannot assure you that we will be
successful in hiring or retaining such key personnel, or that any of our key
personnel will remain employed with us.
Our Stock Price May Be Volatile
The market price of our stock has fluctuated in the past and is likely
to fluctuate in the future. For example, in the twelve month period ending March
31, 1999, our stock price fluctuated from a low of $5.125 to a high of $37.00.
We believe that such fluctuations could continue as a result of future
announcements concerning us, our competitors or principal customers regarding
technological innovations, new product introductions, governmental regulations,
litigation or changes in earnings estimates by analysts. 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 the particular
companies. These fluctuations as well as
Page 23
general economic, political and market conditions may have an adverse affect on
the market price of our Common Stock.
Year 2000 Issues May Harm Our Business
Many existing computer systems and applications may not function
properly when using dates beyond December 31, 1999. We have established a Year
2000 Risk Management program to assess the impact that the Year 2000 issue may
have on our business. Based on our assessment to date, all of our flash memory
and connectivity products are Year 2000 compliant. Other Year 2000 issues that
we face include:
o Assessment and remediation of the tertiary business information systems
o Assessment and remediation of the computer systems used for facilities
control, machine control and manufacturing testing
o Year 2000 compliance of our key suppliers and customers
Our estimated total costs for Year 2000 compliance issues are not expected to
have a material adverse affect on our business. However, the failure of our key
suppliers and customers to take proper remedial efforts could harm our business,
financial condition and results of operations. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations-Year 2000 Readiness
Disclosure."
We Have Anti-Takeover Provisions
We have taken a number of actions that could have the effect of
discouraging a takeover attempt. For example, we have adopted a Shareholder
Rights Plan that would cause substantial dilution to a stockholder who attempts
to acquire us on terms not approved by our Board of Directors. In addition, our
Certificate of Incorporation grants the Board of Directors the authority to fix
the rights, preferences and privileges of and issue up to 4,000,000 shares of
Preferred Stock without stockholder action. Although we have no present
intention to issue shares of Preferred Stock, such an issuance could have the
effect of making it more difficult and less attractive for a third party to
acquire a majority of our outstanding voting stock. Preferred Stock may also
have other rights, including economic rights senior to the Common Stock that
could have a material adverse effect on the market value of the Common Stock. In
addition, we are subject to the anti-takeover provisions of Section 203 of the
Delaware General Corporation Law. This section provides that a corporation shall
not engage in any business combination with any interested stockholder during
the three-year period following the time that such stockholder becomes an
interested stockholder. This provision could have the effect of delaying or
preventing a change of control of SanDisk.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Please refer to the Company's form 10-K/A for the year ended December
31, 1998.
Page 24
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
The information required by this item is set forth in Note 6 of the
Notes to the Condensed Consolidated Financial Statements on pages 7 and 8 and
under "Factors That May Affect Future Results - Risks Associated with Patents,
Proprietary Rights and Related Litigation" on pages 22 and 23 of this Form 10-Q
for the quarterly period ended March 31, 1999, and is incorporated herein 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 25
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.2
3.2 Form of Amended and Restated Certificate of Incorporation of the
Registrant.2
3.3 Bylaws of the Registrant, as amended.2
3.4 Form of Amended and Restated Bylaws of the Registrant 2
3.5 Certificate of Designation for the Series A Junior Participating
Preferred Stock, as filed with the Delaware Secretary of State on April
24, 1997.4
4.1 Reference is made to Exhibits 3.1, 3.2, 3.3 and 3.4.2
4.3 Amended and Restated Registration Rights Agreement, among the
Registrant and the investors and founders named therein, dated March 3,
1995.2
4.5 Series F Preferred Stock Purchase Agreement between Seagate Technology,
Inc. and the Registrant, dated January 15, 1993.2
4.8 Rights Agreement, dated as of April 18, 1997, between the Company and
Harris Trust and Savings Bank.4
4.9 First Amendment to Rights Agreement dated October 22, 1999, between
Harris Trust and the Registrant.11
9.1 Amended and Restated Voting Agreement, among the Registrant and the
investors named therein, dated March 3, 1995.2
10.10 License Agreement between the Registrant and Dr. Eli Harari, dated
September 6, 1988.2
10.13 1989 Stock Benefit Plan.2
10.14 1995 Stock Option Plan.2
10.15 Employee Stock Purchase Plan.2
10.16 1995 Non-Employee Directors Stock Option Plan.2
10.18 Lease Agreement between the Registrant and G.F. Properties, dated March
1, 1996.3
10.21 Amendment to Lease Agreement between the Registrant and G.F.
Properties, dated April 3, 1997.5
10.23 Foundry Venture Agreement between the Registrant and United
Microelectronics Corporation, dated June 27, 1997.1, 6
10.24 Written Assurances Re: Foundry Venture Agreement between the Registrant
and United Microelectronics Corporation, dated September 13, 1995.1, 6
10.25 Side Letter between Registrant and United Microelectronics Corporation,
dated May 28, 1997.1, 6
10.27 Clarification letter with regards to Foundry Venture Agreement between
the Registrant and United Microelectronics Corporation dated October
24, 1997.7
10.28 Lease Agreement between the Registrant and G.F. Properties, dated June
10, 1998.8
10.29 Trade Finance Agreement between the Registrant and Union Bank of
California, dated July 15, 1998.9
10.30 1995 Stock Option Plan Amended and Restated as of December 17, 1998.
10.31 1995 Non-Employee Directors Stock Option Plan Amended and Restated as
of December 17, 1998.
10.32 1995 Employee Stock Purchase Plan Amended and Restated as of December
17, 1998.
21.1 Subsidiaries of the Registrant.10
23.1 Consent of Ernst & Young, LLP, Independent Auditors. 10
27.1 Financial Data Schedule for the quarter ended March 31, 1999. (In EDGAR
format only)
- ----------
1. Confidential treatment granted as to certain portions of these
exhibits.
2. Previously filed as an Exhibit to the Registrant's Registration
Statement on Form S-1 (No. 33-96298).
Page 26
3. Previously filed as an Exhibit to the Registrant's 1995 Annual Report
on Form 10-K.
4. Previously filed as an Exhibit to the Registrant's Current Report on
Form 8-K/A dated April 18, 1997.
5. Previously filed as an Exhibit to the Registrant's Form 10-Q for the
quarter ended June 30, 1997.
6. Previously filed as an Exhibit to the Registrant's Current Report on
form 8-K dated October 16, 1997.
7. Previously filed as an Exhibit to the Registrant's Form 10-Q for the
quarter ended September 30, 1997.
8. Previously filed as an Exhibit to the Registrant's Form 10-Q for the
quarter ended June 30, 1998.
9. Previously filed as an Exhibit to the Registrant's Form 10-Q for the
quarter ended September 30, 1998.
10. Previously filed as an Exhibit to the Registrant's Annual Report on
Form 10-K.
11. Previously filed as an Exhibit to the Registrant's Current Report on
Form 8-K dated January 1, 1999.
B. Reports on Form 8-K
During the quarter ended March 31, 1999, the Company filed a current
report on Form 8-K dated January 8, 1999, reporting the amendment to its
shareholders' rights agreement.
Page 27
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: May 11, 1999
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