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
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Exchange Act of 1934
For the quarterly period ended March 31, 2001
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
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SanDisk Corporation
(Exact name of registrant as specified in its charter)
Delaware 77-0191793
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
140 Caspian Court, Sunnyvale, California 94089
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(Address of principal executive offices) (Zip code)
(408) 542-0500
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(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 _______
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Indicate the number of shares outstanding of each of the issuer's classes of
common stock as of March 31, 2001
Common Stock, $0.001 par value 67,973,928
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Class Number of shares
SanDisk Corporation
Index
PART I. FINANCIAL INFORMATION
Page No.
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Item 1. Condensed Consolidated Financial Statements:
Condensed Consolidated Balance Sheets
March 31, 2001 and December 31, 2000................................ 3
Condensed Consolidated Statements of Operations
Three months ended March 31, 2001 and 2000.......................... 4
Condensed Consolidated Statements of Cash Flows
Three months ended March 31, 2001 and 2000.......................... 5
Notes to Condensed Consolidated Financial Statements.................. 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations........................................... 10
Item 3. Quantitative and Qualitative Disclosures About Market Risk............ 29
PART II. OTHER INFORMATION
Item 1. Legal Proceedings..................................................... 30
Item 2. Changes in Securities................................................. 30
Item 3. Defaults upon Senior Securities....................................... 30
Item 4. Submission of Matters to a Vote of Security Holders................... 30
Item 5. Other Information..................................................... 30
Item 6. Exhibits and Reports on Form 8-K...................................... 30
Signatures............................................................ 33
Page 2
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
SANDISK CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
March 31, December 31,
----------- ------------
2001 2000*
----------- ------------
(unaudited)
ASSETS
Current Assets:
Cash and cash equivalents $ 77,487 $ 106,277
Short-term investments 228,954 260,462
Investment in UMC 143,851 112,854
Accounts receivable, net 71,059 104,617
Inventories 83,682 96,600
Deferred tax assets 5,637 7,066
Prepaid expenses and other current assets 17,324 9,431
----------- ------------
Total current assets 627,994 697,307
Property and equipment, net 43,794 41,095
Investment in UMC 71,925 197,688
Investment in joint ventures 150,334 134,730
Investment in equity securities 23,340 7,200
Deposits and other assets 24,483 29,887
----------- ------------
Total Assets $941,870 $1,107,907
=========== ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable $ 71,070 $ 67,112
Accrued payroll and related expenses 8,430 16,215
Income taxes payable 5,800 16,427
Other accrued liabilities 21,166 20,863
Deferred revenue 33,389 50,740
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Total current liabilities 139,855 171,357
Deferred tax liability 21,268 70,000
Other liabilities 5,657 3,492
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Total Liabilities 166,780 244,849
Stockholders' Equity:
Common stock 571,155 567,001
Retained earnings 203,367 346,469
Accumulated other comprehensive income (loss) 568 (50,412)
----------- ------------
Total stockholders' equity 775,090 863,058
Total Liabilities and
Stockholders' Equity $941,870 $1,107,907
=========== ============
______________
* Information derived from the audited Consolidated Financial Statements.
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
March 31,
-------------------------
2001 2000
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Revenues:
Product $ 88,083 $ 97,249
License and royalty 13,244 12,120
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Total revenues 101,327 109,369
Cost of sales 118,780 67,758
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Gross profits (losses) (17,453) 41,611
Operating expenses:
Research and development 16,353 8,769
Sales and marketing 10,218 10,544
General and administrative 4,279 4,747
----------- ----------
Total operating expenses 30,850 24,060
Operating income (loss) (48,303) 17,551
Equity in income of joint ventures, net of equity in losses of joint ventures 634 --
Interest income 4,075 5,618
Gain (loss) on investment in foundry (179,981) 344,168
Other income (expense), net (1,783) 434
----------- ----------
Income (loss) before taxes (225,358) 367,771
Provision for (benefit from) income taxes (82,256) 148,500
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Net income (loss) $(143,102) $219,271
=========== ==========
Net income (loss) per share
Basic $ (2.11) $ 3.32
Diluted $ (2.11) $ 3.00
Shares used in computing net income per share
Basic 67,814 66,095
Diluted 67,814 73,015
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,
-----------------------------
2001 2000
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Cash flows from operating activities:
Net income (loss) $(143,102) $ 219,271
Adjustments to reconcile net income (loss) to net cash provided by operating
activities:
Depreciation 4,489 3,546
Deferred taxes (81,538) 138,437
Loss (Gain) on investment in foundry 179,981 (344,168)
Equity in income of joint ventures (634) --
Loss on write down of fixed assets 1,887 --
Changes in operating assets and liabilities:
Accounts receivable, net 33,558 (26,451)
Inventories 12,918 448
Prepaid expenses and other assets (2,489) (3,559)
Accounts payable 3,958 613
Accrued payroll and related expenses (7,785) (1,351)
Income taxes payable (10,627) 5,873
Other accrued liabilities 303 3,952
Deferred revenue (17,351) 3,558
Other non-current liabilities 2,165 --
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Total adjustments 118,835 (219,102)
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Net cash provided by (used in) operating activities (24,267) 169
Cash flows from investing activities:
Purchases of short term investments (49,737) (114,631)
Proceeds from sale of short term investments 81,245 73,453
Investment in equity securities (16,140) --
Investment in joint ventures (14,970) --
Acquisition of capital equipment (9,075) (3,676)
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Net cash used in investing activities (8,677) (44,854)
Cash flows from financing activities:
Sale of common stock 4,154 6,073
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Net cash provided by financing activities 4,154 6,073
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Net decrease in cash and cash equivalents (28,790) (38,612)
Cash and cash equivalents at beginning of period 106,277 146,170
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Cash and cash equivalents at end of period $ 77,487 $ 107,558
========= =========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
Page5
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, 2001, and the results of
operations and cash flows for the three month periods ended March 31, 2001 and
2000. Because all the disclosures required by accounting principles generally
accepted in the United States 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, 2000. The condensed
consolidated balance sheet data as of December 31, 2000 was derived from the
audited financial statements.
The Company's results of operations and cash flows for the three month
periods ended March 31, 2001 and 2000 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 2001 and 2000 ended on April 1, 2001
and April 2, 2000, respectively. Fiscal year 2001 is 52 weeks long and ends on
December 30, 2001. Fiscal year 2000 was 52 weeks long and ended on December 31,
2000. 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 accounting
principles generally accepted in the United States 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,
2001 2000
--------- ------------
(in thousands)
Raw materials............................ $ 44,824 $ 33,092
Work-in-process.......................... 11,950 53,921
Finished goods........................... 26,908 9,587
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$ 83,682 $ 96,600
========= ==========
6
5. The following table sets forth the computation of basic and diluted
earnings per share:
Three Months Ended
March 31,
---------------------------------
2001 2000
--------------- -------------
(in thousands), except for per
share amounts
Numerator:
Numerator for basic and diluted net income per
share--net income (loss) $(143,102) $219,271
=============== =============
Denominator for basic net income per share:
Weighted average common shares 67,814 66,095
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Basic net income (loss) per share $ (2.11) $ 3.32
=============== =============
Denominator for diluted net income per share:
Weighted average common shares 67,814 66,095
Employee stock options and warrants to purchase
common stock --- 6,920
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Shares used in computing diluted net income per share 67,814 73,015
--------------- -------------
Diluted net income (loss) per share $ (2.11) $ 3.00
=============== =============
For the three-month periods ended March 31, 2001 and 2000, options to
purchase 8,558,000 and 82,000 shares of common stock, respectively, have be
excluded from the earnings per share calculation, as their effect is
antidilutive.
6. The Company relies on a combination of patents, trademarks, copyright
trade secret laws, confidentiality procedures and licensing arrangements to
protect its intellectual property rights. There can be no assurance that the
will not be any disputes regarding the Company's intellectual property right
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
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
commercial advantage to the Company. Additionally, competitors of the Company
may be able to design around the Company's patents.
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.
On March 21, 2000, Mitsubishi Denki Co. Ltd. (Mitsubishi Electric) filed a
complaint in Tokyo District Court against SanDisk K.K., SanDisk's wholly owned
subsidiary in Japan. The complaint alleges that SanDisk K.K., based in Yokohama,
Japan, infringes on three Mitsubishi Japanese patents, which are related
primarily to the mechanical construction of memory cards. In the complaint,
Mitsubishi asked the court for a preliminary injunction halting the sale of
SanDisk CompactFlash and flash ATA memory cards in Japan. Mitsubishi has since
dropped two of the patents from the suit. The Company and SanDisk K.K. are
vigorously defending against Mitsubishi's remaining claims and believe they have
meritorious defenses.
Compaq Corporation has opposed in several countries, including the United
States, our attempting to register CompactFlash as a trademark. We do not
believe that our failure to obtain registration for the CompactFlash mark will
materially harm our business.
7
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.
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 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.
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.
7. Certain of the Company's balance sheet accounts and purchase commitments
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. In
the first quarter of 2001, the Company had a net foreign currency transaction
loss of $1.8 million, compared to a gain of $0.5 million in the first quarter of
2000, primarily due to translation adjustments on its Japanese Yen based assets.
On January 1, 2001, the Company adopted Statement of Financial Accounting
Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging
Activities." The standard requires that all derivatives be recorded on the
balance sheet at fair value and establishes criteria for designation and
effectiveness of hedging relationships. The cumulative effect of adopting SFAS
133 as of January 1, 2001 was not material to the Company's consolidated
financial statements.
The Company is exposed to foreign currency exchange rate risk inherent in
forecasted sales, cost of sales, and assets and liabilities denominated in
currencies other than the U.S. dollar. The Company is also exposed to interest
rate risk inherent in its debt and investment portfolios. The Company's risk
management strategy provides for the use of derivative financial instruments,
including foreign exchange forward contracts, to hedge certain foreign currency
exposures. The Company's intent is to offset gains and losses that occur on the
underlying exposures, with gains and losses on the derivative contracts hedging
these exposures. The Company does not enter into any speculative positions with
regard to derivative instruments. The Company enters into foreign exchange
contracts to hedge against exposure to changes in foreign currency exchange
rates, only when natural offsets can not be achieved. Such contracts are
designated at inception to the related foreign currency exposures being hedged,
which include sales by subsidiaries, and assets and liabilities that are
denominated in currencies other than the U.S. dollar. The Company's foreign
currency hedges generally mature within six months.
The Company records all derivatives on the balance sheet at fair value. For
derivative instruments that are designated and qualify as cash flow hedges, the
effective portion of the gain or loss on the derivative instrument is recorded
in accumulated other comprehensive income as a separate component of
stockholders' equity and reclassified into earnings in the period during which
the hedged transaction affects earnings. For derivative instruments that are
designated and qualify as fair value hedges, the gain or loss on the derivative
instrument, as well as the offsetting gain or loss on the hedged item
attributable to the hedged risk, are recognized in earnings in the current
period. For derivative instruments not designated as hedging instruments,
changes in their fair values are recognized in earnings in the current period.
For foreign currency forward contracts, hedge effectiveness is measured by
comparing the cumulative change in the hedged contract with the cumulative
change in the hedged item, both of which are based on forward rates. To the
extent that the critical terms of the hedged item and the derivative are not
identical, hedge ineffectiveness is
8
reported in earnings immediately. The Company estimates the fair values on
derivatives based on quoted market prices or pricing models using current market
rates.
The Company reports hedge ineffectiveness from foreign currency derivatives
for both options and forward contracts in other income or expense. Hedge
ineffectiveness was not material in the first quarter of fiscal 2001. The
effective portion of all derivatives is reported in the same financial statement
line item as the changes in the hedged item.
At March 31, 2001, the Company had $31.2 million in foreign-denominated
accounts payable and open purchase orders designated as cash flow hedges or fair
value hedges against foreign denominated cash holding and accounts receivable.
The Company estimates the fair values on derivatives based on quoted market
prices or pricing models using current market rates. At March 31, 2001, the
Company had approximately $1.1 million of unrealized losses on derivative
instruments, net of taxes, in accumulated other comprehensive income.
8. Accumulated other comprehensive income (loss) presented in the
accompanying balance sheet consists of the accumulated unrealized gains and
losses on available-for-sale marketable securities, net of the related tax
effects, for all periods presented.
Three Months Ended
March 31,
--------------------------
2001 2000
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(in thousands)
Net income (loss) $(143,102) $219,271
Unrealized gain on available-for-sale securities: 370 9,807
----------- ------------
Comprehensive income (loss) $(142,732) $229,078
=========== ============
Accumulated other comprehensive income (loss) was $0.6 million and $(50.4)
million at March 31, 2001 and December 31, 2000, respectively. The balance at
December 31, 2000 included unrealized losses on UMC and SmartDisk of $50.2
million and $0.4 million, respectively. Each of these losses was marked to
market through the income statement in the first quarter of 2001, as each of
their declines in value were believed to be other than temporary.
9. In January 2001, the Company invested the final $15 million of its $150
million commitment in cash in FlashVision, L.L.C., our joint venture with
Toshiba for the development and manufacture of 512 megabit and 1 gigabit flash
memory chips and Secure Digital Card controllers. On January 26, 2001, the
Company guaranteed the first $20 million in equipment lease lines to equip
Toshiba's Dominion Semiconductor manufacturing clean room with advanced wafer
processing equipment. A total of $215 million will be guaranteed by the Company.
The Company accounts for this investment under the equity method, and recorded
$894,000 as equity in income of joint ventures in the first quarter of 2001.
10. On January 3, 2000, the USIC foundry in Taiwan, one of our major
suppliers of semiconductor wafers, was merged into UMC. The Company had invested
$51.2 million in USIC. In exchange for its USIC shares, the Company received 111
million UMC shares. These shares were valued at approximately $396 million at
the time of the merger, resulting in a pretax gain of $344.2 million ($203.9
million after-tax) in the first quarter of 2000. Trading restrictions expired on
one-half of the shares on July 3, 2000, and the remaining shares become
available for sale over a two-year period beginning in January 2002.
Due to the current weakness in the semiconductor industry, the value of the
Company's UMC shares declined to $215.8 million as of March 31, 2001. The
downturn in the semiconductor industry, and the economy in general, appears to
be more severe than previously anticipated, and there is a great deal of
uncertainty regarding when the semiconductor industry will recover from this
down cycle. Because of the continued downturn in the economy, the Company
believed that the decline in the market value of its investment in UMC as of
March 31,
9
2001, was other than temporary as defined by accounting principles generally
accepted in the United States. In the first quarter of 2001, the Company
recorded a loss in other income and expense on this other than temporary decline
in value of $179.6 million, or $114.0 million after taxes. This loss is included
in other income and expense. If the value of the Company's UMC shares declines
further, it may be required to record additional losses. In addition, in future
periods, the Company may recognize a gain or loss if it sells its UMC shares due
to fluctuations in the market value of UMC's stock.
11. On July 4, 2000, SanDisk entered into a share purchase agreement to make
a $75 million investment in Tower Semiconductor, or Tower, in Israel,
representing approximately 10% ownership of Tower. On January 26, 2001, Tower
satisfied the closing conditions of the share purchase agreement, and the
Company transferred the first $20 million of its investment from an escrow
account to purchase 866,551 shares ordinary shares and obtain $8.8 million in
pre-paid wafer credits. On March 1, 2001, the Company paid Tower an additional
$11.0 million upon its completion of milestone one, to purchase 366,690 ordinary
shares and obtain $6.1 million prepaid wafer credits. Additional contributions
will take the form of mandatory warrant exercises for ordinary shares at an
exercise price of $30.00 per share if other milestones are met. The warrants
will expire five years from the date of grant, and in the event the key
milestones are not achieved, the exercise of these warrants will not be
mandatory. We expect first wafer production to commence at the new fabrication
facility in late 2002.
12. On August 9, 2000, SanDisk entered into a joint venture, DigitalPortal
Inc., or DPI, with Photo-Me International, or PMI, for the manufacture,
installation, marketing, and maintenance of self-service, digital photo printing
labs, or kiosks, bearing the SanDisk brand name in locations in the U.S. and
Canada. Under the agreement, SanDisk and PMI will each make an initial
investment of $4.0 million and secure lease financing for the purchase of the
kiosks. The total value of the lease financing will depend on the number of
kiosks deployed by the joint venture. The Company estimates that it will
guarantee equipment lease arrangements of approximately $40.0 million over the
first two years of the agreement. PMI will manufacture the kiosks for the joint
venture and will install and maintain the kiosks under contract with the joint
venture. The Company expects the first kiosks to be deployed in pilot programs
in select retail stores in the United States starting in the third quarter of
2001. The Company accounts for this investment under the equity method, and
recorded a loss of $260,000 as equity in loss of joint venture in the first
quarter of 2001.
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 under Section 21E of the Securities and Exchange Act of 1934, as
amended based on current our expectations, and entail various significant risks
and uncertainties that could cause our actual results to differ materially from
those expressed in such forward looking statements. Such risks and uncertainties
are discussed below and in our Form 10-K for the year ended December 31, 2000
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. We undertake 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 our
consolidated financial statements and the notes thereto.
Overview
SanDisk was founded in 1988 to develop and market flash data storage systems.
We sell our products to the consumer electronics and industrial/communications
markets. In the first three months of fiscal 2001, approximately 72% of our
product sales were attributable to the consumer electronics market, particularly
sales of CompactFlash and MultiMediaCard products for use in digital cameras and
portable music devices. Our CompactFlash products have lower average selling
prices and gross margins than our higher capacity FlashDisk and FlashDrive
products. In addition, a substantial portion of our CompactFlash and
MultiMediaCard products are sold into the retail channel, which usually has
shorter customer order lead-times than our other channels. A majority of our
sales to the retail channel are turns business, with orders received and
fulfilled in the same quarter, thereby decreasing our ability to accurately
forecast future production needs. We believe sales to the consumer market will
continue to represent a
10
majority of our sales, and increase as a percentage of sales in future years, as
the popularity of consumer applications, including digital cameras, increases.
Our operating results are affected by a number of factors including the
volume of product sales, competitive pricing pressures, availability of foundry
capacity, our ability to match supply with demand, low order visibility,
variations in manufacturing cycle times, fluctuations in manufacturing yields
and manufacturing utilization, the timing of significant orders, changes in
product and customer mix, market acceptance of new or enhanced versions of our
products, changes in the channels through which our products are distributed,
timing of new product announcements and introductions by us and our competitors,
the timing of license and royalty revenues, fluctuations in product costs,
increased research and development expenses, weak worldwide economic conditions
and uncertainty, and exchange rate fluctuations. We have experienced seasonality
in the past, and as the proportion of our products sold for use in consumer
electronics applications increases, our revenues may become subject to more
pronounced seasonal declines in the first quarter of each year. See "Factors
That May Affect Future Results--Our Operating Results May Fluctuate
Significantly Which May Adversely Affect Our Stock Price" and "--There is
Seasonality in Our Business."
Beginning in late 1995, we adopted a strategy of licensing our flash
technology, including our patent portfolio, to third-party manufacturers of
flash products. To date, we have entered into patent cross-license agreements
with several companies, and intend to pursue opportunities to enter into
additional licenses. Under our current license agreements, licensees pay us
license fees, royalties, or a combination thereof. In some cases, the
compensation to us may be partially in the form of guaranteed access to flash
memory manufacturing capacity from the licensee. The timing and amount of
royalty payments and the recognition of license fees 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.
We market our products using a direct sales organization, distributors,
manufacturers' representatives, private label partners, OEMs and retailers. We
expect that sales through the retail channel will comprise an increasing share
of our product revenues in the future, and that a substantial portion of our
sales into the retail channel will be made to participants that will have the
right to return unsold products. Our policy is to defer recognition of revenues
from these sales to the retail and distribution channels until the products are
sold to the end customers.
Historically, a majority of our sales have been to a limited number of
customers. We expect that sales of our products to a limited number of customers
will continue to account for a substantial portion of our product revenues for
the foreseeable future. We have also experienced significant changes in the
composition of our customer base from year to year and expect this pattern to
continue as market demand for our customers' products fluctuates. The loss of,
or significant reduction in purchases by any of our major customers, could have
a material adverse effect on our 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".
All of our products require silicon wafers, the majority of which are
currently manufactured for us by UMC in Taiwan. Industry-wide demand for
semiconductors increased significantly in 1999 and the first nine months of
2000, due to increased demand in the consumer electronics and cellular phone
markets. This increased demand caused supply constraints for most of 2000.
Semiconductor manufacturers, including UMC and Toshiba added new advanced wafer
fab capacity during 2000. This additional capacity, along with slowing economic
conditions experienced late in the fourth quarter of 2000 and into 2001, has
resulted in excess supply and intense pricing pressure. If industry-wide demand
for our products continues to be below the industry-wide available supply, our
product prices could decrease further causing our revenues and profits to
continue to decline significantly. Under our wafer supply agreements, there are
limits on the number of wafers we can order and our ability to change that
quantity, either up or down, is restricted. Accordingly, our ability to react to
significant fluctuations in demand for our products is limited. If customer
demand
11
exceeds our forecasts, we may be unable to obtain an adequate supply of wafers
to fill customer orders, which could result in lost sales and lower revenues. If
we are unable to obtain adequate quantities of flash memory wafers with
acceptable prices and yields from our current and future wafer foundries, our
business, financial condition and results of operations could be harmed. See
"Factors That May Affect Future Results--Our Operating Results May Fluctuate
Significantly."
In the first quarter of 2001, we have taken an inventory charge of $45.3
million, reflecting lower market pricing and the write off of excess and
obsolete inventories, and we may be forced to write down inventories again if
the current deterioration in market demand for our products continues and our
inventory levels continue to exceed customer orders. In addition, we may have to
write down our inventories if continued pricing pressure results in a net
realizable value that is lower than our cost, or if part of the inventory
becomes obsolete. Due to the market demand for our products changing so rapidly,
we ended the first quarter of 2001 with significant amounts of excess inventory.
Although we are working to reduce this inventory in line with the current level
of business, we are obligated to honor existing purchase orders that we have
placed with our suppliers. Furthermore, to assure favorable future business
relations with our major suppliers, we may choose not to shut down their
production of our products. In the case of FlashVision manufacturing at Dominion
in Virginia, both Toshiba and SanDisk are obligated to purchase their share of
the production output, which may make it more difficult for us to reduce our
inventory.
Excess inventory not only ties up our cash, but also can result in
substantial losses if such inventory, or large portions thereof, has to be
revalued due to lower market pricing or product obsolescence. These inventory
adjustments decrease gross margins and have resulted in, and could in the future
result in, fluctuations in gross margins and net earnings in the quarter in
which they occur. The inventory charge of $45.3 million in the first quarter of
2001 represented 51% of product revenues, resulting in a decrease of gross
margins from positive 17% to negative 35%.
Export sales are an important part of our business. Our international sales
are impacted by changes in economic conditions in our international markets.
Economic conditions in our international markets, including Asia and the
European Union, may adversely affect our revenues to the extent that demand for
our products in these regions declines. Given the recent adverse economic
conditions in Asia and the European Union and the weakness of the Euro, Yen and
other currencies relative to the United States Dollar, our products may be
relatively more expensive in these regions, which could result in a decrease of
our sales in these regions. While most of our sales are denominated in U.S.
Dollars, we invoice certain Japanese customers in Japanese Yen and are subject
to exchange rate fluctuations on these transactions, which could affect our
business, financial condition and results of operations. See "Factors That May
Affect Future Results--Our international operations make us vulnerable to
changing conditions and currency fluctuations."
For the foreseeable future, we expect to realize a significant portion of our
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 product at a new foundry. To remain competitive, we
are focusing on a number of programs to lower manufacturing costs, including
development of future generations of flash memory. There can be no assurance
that we will successfully develop such products or processes or that development
of such processes will lower manufacturing costs. If the current industry-wide
and worldwide economic slowdown continues for the rest of fiscal 2001, we may be
unable to efficiently utilize the NAND flash wafer production from FlashVision,
which would force us to amortize the fixed costs of the fabrication facility
over a reduced wafer output, making these wafers significantly more expensive.
The output of Nand flash wafers from Flashvision is expected to increase
substantially in the second half of 2001, which will result in a corresponding
increase of our Nand inventory if the market conditions for the sale of our
products do not improve materially in the second half. See "Factors That May
Affect Future Results--We Must Achieve Acceptable Manufacturing Yields."
Results of Operations
Product Revenues. Our product revenues were $88.1 million in the first
quarter of 2001, down $9.2 million or 9% from the first quarter of 2000. During
the first quarter of 2001, total flash memory product units sold increased
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approximately 18% over the first quarter of 2000. The largest increase came from
sales of CompactFlash products. CompactFlash products represented 53% of product
revenues and MultiMediaCards 15% of product revenues for the first quarter of
2001, compared to 50% and 15%, respectively, in the first quarter of 2000. The
average selling price per megabyte of memory shipped declined 27% in the first
quarter of 2001 when compared to the first quarter of 2000 due primarily to
competitive pricing pressures driven by excess supply in the market. Average
unit selling prices for memory products decreased by 9% due to the decline per
megabyte, partially offset by an increase in the average megabytes per unit.
Product revenues were down $66.6 million or 43% from the fourth quarter of
2000, and total units sold declined 23%, as we experienced significantly
weakened market conditions and weak overall economic conditions. The average
selling price per megabyte of memory declined by 13% for the quarter, primarily
due to competitive pricing pressures driven by the excess supply in the market.
Compared to the fourth quarter of 2000, average unit selling prices for memory
products decreased 15% from quarter to quarter. Total revenues for the first
quarter of 2001 were down $76.3 million or 43% compared to $177.7 million in the
fourth quarter of 2000.
Due to the rapid deterioration of market conditions and lack of visibility,
which began late in the fourth quarter of 2000 and continued into in the first
quarter of 2001, we have had difficulty predicting customer demand. Customer
demand for the first quarter was significantly below our previous forecasts.
Anticipated demand for 2001 is significantly below our previous forecasts. We
expect second quarter 2001 product revenues to be approximately unchanged from
our first quarter 2001 product revenues, and for average selling prices to
continue to decline significantly due to competition.
Sales to the consumer market represented approximately 72% of product
revenues in the first quarter of 2001, with sales to the
telecommunications/industrial market accounting for the remaining 28%. This
compares to 70% for the consumer market and 30% for the
telecommunications/industrial market in the first quarter of 2000. Sales to the
retail channel represented 38% of product revenues in the first quarter of 2001,
compared to 26% in the first quarter of 2000. Our mix of products sold varies
from quarter to quarter and will continue to vary in the future, affecting our
overall average selling prices and gross margins.
Export sales represented 57% of our product revenues in the first quarter of
2001, compared to 50% in the first quarter of 2000 and 50% in the fourth quarter
of 2000. We expect international sales to continue to represent a significant
portion of our product revenues. In the first quarter of 2001, our top ten
customers represented approximately 64% of our product revenues compared to 52%
in the first quarter of 2000 and 51% in the fourth quarter of 2000. In the first
quarter of 2001, sales to one customer exceeded 10% of product sales, and there
were two customers that each represented more than 10% of product sales in the
first quarter of 2000. We expect that sales to a limited number of customers
will continue to represent a substantial portion of our product revenues for the
foreseeable future.
License and Royalty Revenues. We currently earn patent license fees and
royalties under several cross-license agreements. License and royalty revenues
from patent cross-license agreements were $13.2 million in the first quarter of
2001, up from $12.1 million in the first quarter of 2000 due primarily to
recognition of royalty revenues related to the Lexar settlement in the fourth
quarter of 2000. Revenues from licenses and royalties increased to 13% of total
revenues in the first quarter of 2001 from 11% in the first quarter of 2000. Our
revenues from patent license and royalties fluctuate quarterly based on the
timing of revenue recognition under our various agreements.
License and royalty revenue for the first quarter of 2001 was down $9.7
million or 42% from the fourth quarter of 2000 primarily due to lower royalty
revenues resulting from the overall weak market conditions for our entire market
segment which resulted in lower royalty bearing sales by our licensees. We
expect license and royalty revenues to be approximately $10.0 million in the
second quarter of 2001.
Gross Profits. In the first quarter of 2001, gross profits were negative
$17.5 million, or negative 17% of total revenues compared to positive $41.6
million, or 38% of total revenues in first quarter of 2000. Product gross margin
decreased to negative 35% of product revenues in the first quarter of 2001 from
positive 30% in the first quarter of 2000 and positive 34% in the fourth quarter
of 2000. The decrease included a $45.3 million inventory charge reflecting
substantially lower market pricing, reduced demand for our products, and the
write off of excess and obsolete inventory components. Excluding this inventory
charge, our product gross margin was 17%. Our product
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gross margins were also adversely affected by the significant decreases in
average selling prices per unit and megabyte in the first quarter of 2001, which
we expect to continue at least through the second quarter.
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 $16.4 million in the first quarter of 2001, up $7.6 million or 86%
from $8.8 million in the first quarter of 2000. This increase was primarily due
to increased salary and related expenses associated with additional personnel,
increased project expenses to support the development of new generations of
flash data storage products including the 512 megabit and 1 gigabit flash memory
co-development with Toshiba, and increased depreciation and amortization
expenses. Research and development expenses represented 16% of total revenues in
the first quarter of 2001 compared to 8% in the first quarter of 2000. We
expect our research and development expenses to continue to increase in future
quarters to support the development and introduction of new generations of flash
data storage products, including the joint venture with Toshiba and the
development of advanced controller chips.
Sales and Marketing. Sales and marketing expenses include salaries, sales
commissions, benefits and travel expenses for our 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 expenses were $10.2 million in the first quarter of 2001, down $0.3
million or 3% from $10.5 million in the first quarter of 2000. This decrease was
primarily due to decreased variable compensation and selling expenses related to
reduced revenue levels, offset by increased salary and related expenses
associated with additional personnel. Sales and marketing expenses represented
approximately 10% of total revenues in the first quarters of 2001 and 2000. We
expect sales and marketing expenses to continue to increase, as we continue to
develop the retail channel and brand awareness for our products and as we
increase our marketing activities for our Secure Digital Card products.
General and Administrative. General and administrative expenses include the
cost of our finance, information systems, human resources, stockholder
relations, legal and administrative functions. General and administrative
expenses were $4.3 million in the first quarter of 2001, down approximately 10%
from $4.7 million in the first quarter of 2000. This decrease was primarily due
to lower legal fees, offset by increased salary and related expenses associated
with additional personnel. General and administrative expenses represented 4% of
total revenues in the first quarters of 2001 and 2000. General and
administrative expenses could increase substantially in the future if we
continue to pursue litigation to defend our patent portfolio. In addition, we
expect general and administrative expenses to continue to increase as our
general and administrative functions grow to support our overall growth and our
investments in infrastructure.
Given the current market conditions, we have instituted strict expense
control measures. These measures in the first quarter of 2001 included a
reduction in our work force and cuts in discretionary spending. However, we are
continuing to invest in research and development of advanced technologies and
future products.
Equity in Income of Joint Ventures. In the first quarter of 2001, equity in
income of joint ventures of $634,000 included our share of interest income, net
of expenses, from our FlashVision joint venture and expenses from our
DigitalPortal joint venture.
Interest Income. Interest income was $4.1 million in the first quarter of
2001 compared to $5.6 million in the first quarter of 2000. The decrease is a
result of our lower cash and investment balances, as a result of investments in
Tower and FlashVision, as well as cash used in operations. We expect interest
income to decrease in the second quarter of 2001 as we continue to invest in the
Tower foundry investment and DigitalPortal Inc and make internal capital
acquisitions.
Loss on Investment in Foundry. As discussed in footnote 9 of the financial
statements included in this report, the market value of our investment in UMC
has declined significantly. On January 3, 2000, the date we exchanged our USIC
shares for UMC shares, our investment was worth $395.4 million. At that time,
we recorded a pretax gain of $344.2 million on our original investment of $51.2
million. Due to the current weakness in the semiconductor industry, the value
of our UMC shares declined to $215.8 million on March 31, 2001. The downturn in
the semiconductor industry, and the economy in general, appears to be more
severe than previously anticipated, and there is a great deal of uncertainty
regarding when the semiconductor industry will recover from this down cycle.
14
Because of the continued downturn in the economy, we believe that the decline in
the market value of our investment in UMC as of March 31, 2001, was other than
temporary as defined by accounting principles generally accepted in the United
States. In the first quarter of 2001, we recorded a loss in other income and
expense on this other than temporary decline in value of $179.6 million, or
$114.0 million after taxes. If the value of our UMC shares declines further, we
may be required to record an additional loss. In addition, in future periods, we
may recognize a gain or loss if we sell our UMC shares due to fluctuations in
the market value of UMC's stock. Also included on this line is an loss on our
investment in SmartDisk for $382,000, as its decline in value was also
determined to be other than temporary.
Other Income (Expenses), Net. Other expense, net was $1.8 million in the
first quarter of 2001 compared to other income, net, of $434,000 in the first
quarter of 2000. The expense in the first quarter was primarily due to foreign
exchange losses on our Japanese Yen denominated assets.
Provision for Income Taxes. In the first quarter of 2001, our blended
effective tax rate benefit was 36.5%, compared to an effective tax rate expense
of 36% in the first quarter of 2000. The larger benefit percentage was a result
of the higher rate on the UMC investment loss.
Liquidity and Capital Resources
As of March 31, 2001, we had working capital of $488.1 million, which
included $77.5 million in cash and cash equivalents and $229.0 million in short-
term investments, excluding our investment in UMC. Operating activities used
$24.3 million of cash in the first quarter of 2001 primarily due to the net loss
and cash used by decreases in taxes payable and deferred revenues, which were
partially offset by cash provided by a decline in accounts receivable of $33.6
million and inventory of $12.9 million.
Net cash used in investing activities in the first quarter of 2001 of $8.7
million included our additional investment in the FlashVision foundry joint
venture of $15.0 million, our investment in Tower of $16.1 million, net of
prepaid wafer credits of $14.9 million, and capital equipment purchases of $9.1
million, which were partially offset by net proceeds of short term investments
of $31.5 million. In the first quarter of 2000, cash used by investing
activities of $44.9 million was primarily due the net purchases of short term
investments. In the first quarters of both 2001 and 2000, cash provided by
financing activities was primarily due to the sale of common stock through our
stock option and employee stock purchase plans.
On January 3, 2000, the USIC foundry was merged into UMC. We had invested
$51.2 million in USIC. In exchange for its USIC shares, we received 111 million
UMC shares. These shares were valued at approximately $396 million at the time
of the merger, resulting in a pretax gain of $344.2 million ($203.9 million
after-tax) in the first quarter of 2000. Trading restrictions expired on one-
half of the shares on July 3, 2000, and the remaining shares become available
for sale over a two-year period beginning in January 2002. Due to the current
weakness in the semiconductor industry, the value of our UMC shares declined to
$215.8 million on March 31, 2001. The downturn in the semiconductor industry,
and the economy in general, appears to be more severe than previously
anticipated, and there is a great deal of uncertainty regarding when the
semiconductor industry will recover from this down cycle. Because of the
continued downturn in the economy, we believed that the decline in the market
value of our investment in UMC as of March 31, 2001, was other than temporary as
defined by accounting principles generally accepted in the United States. In the
first quarter of 2001, we recorded a loss in other income and expense on this
other than temporary decline in value of $179.6 million, or $114.0 million after
taxes. This loss is included in other income and expense. If the value of our
UMC shares declines further, we may be required to record an additional loss. In
addition, in future periods, we may recognize a gain or loss if we sell our UMC
shares due to fluctuations in the market value of UMC's stock.
In January 2001, we invested the final $15 million of $150 million in cash in
FlashVision LLC, our joint venture with Toshiba for the development and
manufacture of 512 megabit and 1 gigabit flash memory chips and Secure Digital
Card controllers. On January 26, 2001, we guaranteed $20 million in equipment
lease lines to equip Toshiba's Dominion Semiconductor manufacturing clean room
with advanced wafer processing equipment, and a total of $215 million will be
guaranteed by us. We account for this investment under the equity method, and
recorded equity in income of joint ventures of $894,000 in the first quarter of
2001, which included interest income, net of operating expenses.
15
On July 4, 2000, we entered into a share purchase agreement to make a $75
million investment in Tower Semiconductor, or Tower, in Israel, representing
approximately 10% ownership of Tower. On January 26, 2001, Tower satisfied the
closing conditions of the share purchase agreement, and we transferred the first
$20.0 million of this investment from an escrow account to purchase 866,551
shares ordinary shares and obtain $8.8 million in pre-paid wafer credits. On
March 1, 2001, we paid Tower $11.0 million upon its completion of milestone one,
to purchase 366,690 ordinary shares and obtain $6.1 million prepaid wafer
credits. Additional contributions will take the form of mandatory warrant
exercises for ordinary shares at an exercise price of $30.00 per share if other
milestones are met. The warrants will expire five years from the date of grant,
and in the event the key milestones are not achieved, the exercise of these
warrants will not be mandatory. We expect first wafer production to commence
at the new fabrication facility in late 2002.
On August 9, 2000, we entered into a joint venture, DigitalPortal Inc., or
DPI, with Photo-Me International, or PMI, for the manufacture, installation,
marketing and maintenance of self-service, digital photo printing labs, or
kiosks, bearing the SanDisk brand name in locations in the U.S. and Canada.
Under the agreement, we and PMI each own 50% of DPI and will each make an
initial investment of $4.0 million and secure lease financing for the purchase
of the kiosks. The total value of the lease financing will depend on the number
of kiosks deployed by the joint venture. We estimate that, as part of this joint
venture, we will guarantee equipment lease arrangements of approximately $40.0
million over the first two years of the agreement. PMI will manufacture the
kiosks for the joint venture and will install and maintain the kiosks under
contract with the joint venture. We expect the first kiosks to be deployed in
pilot programs in select retail stores in the United States starting in the
third quarter of 2001. We account for this investment under the equity method,
and recorded a loss of $260,000 as equity in loss of joint venture in the first
quarter of 2001.
We may make additional investments, which could be substantial, in assembly
and test manufacturing equipment or foundry capacity to support our business in
the future. We believe our existing cash and cash equivalents and short-term
investments along with the planned capital equipment lease arrangements
currently in negotiation related to our FlashVision, L.L.C. and Digital Portal,
Inc. joint ventures will be sufficient to meet our currently anticipated working
capital, capital equipment expenditure and joint venture and Tower foundry
investment requirements, for at least the next twelve months.
Impact of Currency Exchange Rates
A portion of our revenues are denominated in Japanese yen. We enter into
foreign exchange forward contracts to hedge against changes in foreign currency
exchange rates. Future exchange rate fluctuations could have a material adverse
effect on our business, financial condition and results of operations.
Factors That May Affect Future Results
Our operating results may fluctuate significantly, which may adversely affect
our stock price.
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:
. unpredictable demand for our products;
. decline in the average selling prices of our products due to competitive
pricing pressures;
. seasonality in sales of our products;
. excess capacity of flash memory from our competitors and our own new flash
wafer capacity;
. difficulty of forecasting and management of inventory levels; in
particular, building a large inventory of unsold product due to non-
cancelable contractual obligations to purchase materials such as flash
wafers, controllers, printed circuit boards and discrete components;
16
. expenses related to obsolescence or devaluation of unsold inventory, or
reserves necessary to protect us against future write-offs of such unsold
inventory;
. adverse changes in product and customer mix;
. slower than anticipated market acceptance of new or enhanced versions of
our products;
. competing flash memory card standards which displace the standards used in
our products;
. changes in our distribution channels;
. timing of license and royalty revenue;
. fluctuations in product costs, particularly due to fluctuations in
manufacturing yields and utilization;
. availability of sufficient silicon wafer foundry capacity to meet customer
demand;
. shortages of components such as capacitors and printed circuit boards
required for the manufacturing of our products;
. significant yield losses which could affect our ability to fulfill
customer orders and could increase our costs;
. manufacturing flaws affecting the reliability, functionality or
performance of our products which could increase our product costs, reduce
demand for our products or require product recalls;
. increased research and development expenses;
. exchange rate fluctuations, particularly the U.S. dollar to Japanese yen
exchange rate;
. changes in general economic conditions, particularly in Japan and the
European Union;
. natural disasters affecting the countries in which we conduct our
business, particularly Taiwan, Japan and the United States;
Difficulty of estimating silicon wafer needs
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 will build excess inventories, which
could harm our gross margins and operating results. Bookings visibility declined
significantly late in the fourth quarter of 2000, and remains low in 2001 due to
the current economic uncertainty in our markets. On the other hand, if we
underestimate the number of silicon wafers needed to fill product orders, we may
be unable to obtain an adequate supply of wafers, which could harm our product
revenues. Because our largest volume products, CompactFlash and MultiMediaCard,
are sold into emerging consumer markets, it has been difficult to accurately
forecast future sales. A substantial majority of our quarterly sales have
historically been from orders received and fulfilled in the same quarter, which
makes accurate forecasting very difficult. In addition, our product order
backlog may fluctuate substantially from quarter to quarter.
Anticipated growth in expense levels
We significantly increased our expense levels in 2000 to support our growth.
We may need to hire additional personnel or increase our operating expenses in
2001 to support our sales and marketing efforts and research and development
activities, including our joint venture with Toshiba providing for the
development of 512 megabit and 1 gigabit flash memory chips. We have significant
fixed costs and we cannot readily reduce these expenses over the short term. If
our revenues do not increase proportionately to our operating expenses, or if
revenues decrease or do not meet expectations for a particular period, such as
we are forecasting for the second quarter of 2001, our business, financial
condition and results of operations will be harmed.
Variability of average selling prices and gross margins
Our product mix varies quarterly, which affects our overall average selling
prices and gross margins. Our CompactFlash and MultiMediaCard products, which
currently represent the majority of our product revenues, have
17
lower average selling prices and gross margins than our higher capacity
FlashDisk and FlashDrive products. We believe that sales of CompactFlash and
MultiMediaCard products will continue to represent a significant percentage of
our product revenues as consumer applications, such as digital cameras and
digital music players, become more popular. In fiscal 2000, average selling
prices per megabyte decreased 22% compared to fiscal 1999, reflecting the Flash
memory supply shortages that prevailed during the first nine months of the year,
which helped to keep selling prices in 2000 more stable than in 1999. Due to
recent increases in flash memory foundry capacity and the economic slow-down in
the first quarter of 2001, we expect that the decline in our average selling
prices in 2001 will be more severe than in 2000. We experienced a 13% decline in
our average selling price per megabyte of memory shipped when comparing the
first quarter of 2001 to the fourth quarter of 2000. If we cannot reduce our
product manufacturing costs in 2001 to offset these reduced prices, our gross
margins and net profitability will suffer.
Variability of license fees and royalties
Our intellectual property strategy consists of cross-licensing our patents to
other manufacturers of flash products. Under these 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. Our income from patent
licenses and royalties can fluctuate significantly from quarter to quarter. A
substantial portion of this income comes from royalties based on the actual
sales by our licensees. Given the current market outlook for 2001, sales of
licensed flash products by our licensees may be substantially lower than the
corresponding sales in recent quarters, which may cause a substantial drop in
our royalty revenues. Because these revenues have higher gross margins than
product revenues, gross margins and net income fluctuate significantly with
changes in license and royalty revenues.
Continuing declines in our average sales prices may result in declines in our
gross margins.
In 2000, the average price per megabyte shipped declined 22% compared to
1999, and we experienced a 13% decline when comparing the first quarter of 2001
to the fourth quarter of 2000. Flash data storage markets are intensely
competitive and accordingly, price reductions for our products are necessary to
meet consumer price points. Due to recent increases in flash memory foundry
capacity and the worldwide economic slow-down in the first quarter of 2001, we
expect that further price declines for our products in the next several quarters
could be significant. If we cannot reduce our product manufacturing costs in
2001 to offset these reduced prices, our gross margins and net profitability
will suffer.
Our selling prices may be affected by excess capacity in the market for flash
memory products.
In the first nine months of 2000, industry-wide demand for flash memory
products exceeded the available supply, driven by an explosion in the growth of
cellular phones and the accelerating shift in consumer electronics from analog
to digital devices. Flash memory suppliers, including SanDisk, responded to this
strong demand by significantly increasing investments in new advanced flash
memory production capacity. This has led to a significant increase in worldwide
flash memory supply at a time when customer demand has decreased significantly,
causing excess supply in the markets for our products and significant declines
in average selling prices. If this situation continues throughout 2001, we
expect that price declines for our products could be significant on an
annualized basis. If we cannot reduce our product manufacturing costs in 2001 to
offset these reduced prices, our gross margins and net profitability will
suffer.
Our business depends upon consumer products.
In 2000, and the first quarter of 2001, we continued to receive more product
revenue and ship more units of products for consumer electronics applications,
principally digital cameras, compared to other applications. The consumer market
is intensely competitive and is more price sensitive than our other target
markets. In addition, we must spend more on marketing and promotion in consumer
markets to establish brand name recognition and drive demand.
A significant portion of our 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, we do not recognize
revenue until after the product has been sold through to the end user. If our
distributors and retailers are
18
not successful in this market, there could be substantial product returns, which
would harm our business, financial condition and results of operations.
There is seasonality in our business.
Sales of our products, in particular the sale of CompactFlash and
MultiMediaCard products, in the consumer electronics market may be subject to
seasonality. As a result, product sales may be impacted by seasonal purchasing
patterns with higher sales generally occurring in the second half of each year.
In addition, in the past we have experienced a decrease in orders in the first
quarter from our Japanese OEM customers primarily because 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. Although we did not experience
seasonality in 2000, we cannot assure you that we will not experience
seasonality in 2001 or future years.
In transitioning to new processes and products, we face production and market
acceptance risks.
General
Successive generations of our products have incorporated semiconductor
devices with greater memory capacity per chip. Two important factors have
enabled us to decrease the cost per megabyte of our flash data storage products:
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:
. lower yields often experienced in the early production of new
semiconductor devices;
. manufacturing flaws with new processes including manufacturing processes
at our subcontractors which may be extremely complex;
. problems with design and manufacturing of products that will incorporate
these devices; and
. 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.
D2 flash technology
We have developed new products based on D2 flash technology, a flash
architecture designed to store two bits in each flash memory cell. High density
flash memory, such as D2 flash, is a complex technology that requires strict
manufacturing controls and effective test screens. Problems encountered in the
shift to volume production for new flash products could impact both reliability
and yields, and result in increased manufacturing costs and reduced product
availability. We may not be able to manufacture future generations of our D2
products with yields sufficient to result in lower costs per megabyte. If we are
unable to bring future generations of high density flash memory into full
production as quickly as planned or if we experience unplanned yield or
reliability problems, our revenues and gross margins will decline.
Secure Digital Card products
SanDisk, along with Matsushita and Toshiba, jointly developed and will
promote the Secure Digital Card. The Secure Digital Card is an enhanced version
of our MultiMediaCard that incorporates advanced security and copyright
protection features required by the emerging markets for the electronic
distribution of music, video and other copyrighted works. We began shipping our
Secure Digital Card products in the first quarter of 2001, and expect to begin
high-volume production in the first half of 2001.
The Secure Digital Card incorporates a number of new features, including SDMI
compliant security and copy protection, a mechanical write protect switch and a
high data transfer rate. We have never before built products incorporating these
features. Any problems or delays in establishing production capabilities or
ramping up production volumes of our Secure Digital Card products could result
in lost sales or increased manufacturing costs in 2001 and beyond. In addition,
we cannot be sure that manufacturers of consumer electronic products will
develop
19
new products that use the Secure Digital Card or that content providers such as
music studios will agree to distribute their copyrighted content for storage on
Secure Digital Cards. For example, in 2000 the major U.S. based content
providers have had significant success in U.S. courts in their litigation with
Napster.Com and MP3.Com, and this may have slowed down the widespread
distribution of digital music on the internet. Although the Secure Digital Card
is designed specifically to address the copy protection rights of the content
providers, there can be no assurance that these content providers will find
these measures sufficient or will agree to support them. Furthermore, there is
no assurance that consumers will widely adopt Secure Digital Cards, as they only
operate with copyrighted content. Conversely, broad acceptance of our Secure
Digital Card by consumers may reduce demand for our MultiMediaCard and
CompactFlash card products. See "--The success of our business depends on
emerging markets and new products."
We are transitioning our technology to NAND based products
The transition to NAND based products is very complex, and requires good
execution from our manufacturing, technology, quality, marketing, and customer
support staffs. If the current soft market conditions continue through the
second half of this year, or if we are unable for any reason to achieve customer
acceptance of our card products built with these NAND flash chips, we will
experience a significant increase in our inventory, as we are contractually
obligated to purchase half of FlashVision's NAND wafer production output. This
may result in write offs and have a material adverse effect on our business,
results of operations and financial condition.
Coincidentally, with our ramping up of NAND flash wafer production through
the FlashVision joint venture, we began to reduce our purchases of NOR flash
wafers from UMC, and are limiting our flash wafers production from three wafer
fabs to one fab. At the same time, we began to increase our purchase of
controller wafers from UMC. Despite the significantly reduced level of business
at UMC, our business relationship with UMC remains good. However, if market
conditions improve significantly, there can be no assurances that we will be
able to contract for the same amount of capacity we have used in the past.
We depend on third party foundries for silicon wafers.
All of our products require silicon wafers. We rely on UMC in Taiwan and
Toshiba in Yokkaichi, Japan to supply the majority of our silicon wafers. We
depend on UMC to allocate a portion of its capacity to meet our needs, produce
acceptable quality wafers with acceptable manufacturing yields and deliver our
wafers on a timely basis at a competitive price. If UMC is unable to satisfy
these requirements, our business, financial condition and operating results may
suffer. Any disruption in supply from UMC due to natural disaster, power failure
or other causes could significantly harm our business, financial condition and
results of operations.
Under the terms of our wafer supply agreements with UMC, we are obligated to
provide a rolling forecast of anticipated purchase orders for the next six
calendar months. 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. For
example, if customer demand falls below our forecast and we are unable to
reschedule or cancel our wafer orders, we may end up with excess wafer
inventories, which could result in higher operating expenses and reduced gross
margins. Conversely, if customer demand exceeds our forecasts, we may be unable
to obtain an adequate supply of wafers to fill customer orders, which could
result in dissatisfied customers, lost sales and lower revenues. In addition, in
February 2000, we entered into a capacity and reservation deposit agreement with
UMC. To reserve additional foundry capacity under this agreement, we paid UMC a
reservation deposit. This deposit will be refunded to us on a quarterly basis,
over the agreement term, if we purchase the full wafer capacity reserved for us.
We may forfeit part of our deposit if we are unable to utilize our reserved
capacity within four quarters of the end of the agreement term. 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 harmed.
Our investment in new flash memory wafer production may result in increased
expenses and fluctuations in operating results.
On June 30, 2000, we closed a transaction with Toshiba providing for the
joint development and manufacture of 512 megabit and 1 gigabit flash memory
chips and Secure Digital Card controllers. As a part of this transaction,
20
we and Toshiba formed and contributed initial funding to FlashVision LLC, a
joint venture to equip and operate a silicon wafer manufacturing line at
Dominion Semiconductor in Virginia. In January 2001, we invested the final $15
million of $150 million in cash. On January 26, 2001, we guaranteed $20 million
in equipment lease lines to equip Toshiba's Dominion Semiconductor manufacturing
clean room with advanced wafer processing equipment, and a total of $215 million
will be guaranteed. We will use the new production capacity at Dominion to
manufacture primarily NAND flash memory wafers with minimum lithographic feature
size of 0.16 micron initially, moving to 0.13 micron in the future. Such minimum
feature sizes are considered today to be among the most advanced for mass
production of silicon wafers and have never been used for the high volume
manufacture of flash memory chips. Therefore, it is difficult to predict how
long it will take to equip and commence production at the new facility and
achieve adequate yields, reliable operation, and economically attractive product
costs based on our new designs. We have not operated our own wafer fabrication
facility in the past and therefore we rely on Toshiba to address these
challenges. With our investments in the Dominion facility, we are now exposed to
the adverse financial impact of any delays or manufacturing problems associated
with the wafer production line. Any problems or delays in commencing production
at the new Dominion facility could adversely impact our operating results in
2001 and beyond.
We expect to incur substantial start up expenses related to the hiring and
training of manufacturing personnel, facilitizing the clean room and installing
equipment. During the ramp-up period, currently expected to begin in the middle
of 2001, equipment depreciation begins and line operating expenses increase
substantially. While the wafer output is still relatively low, the cost of
wafers from the Dominion facility is expected to be significantly higher than
the cost of wafers from our other suppliers. This may negatively impact our
overall product gross margins until flash wafer output from Dominion reaches an
optimum level, which may never occur. Under our agreement with Toshiba, we are
committed to purchase 50% of the output from the Dominion facility. We will
incur startup costs and pay our share of ongoing operating activities even if we
do not utilize our full share of the Dominion output. Should customer demand for
NAND flash products be less than our available supply, we may suffer from
reduced revenues and increased expenses, and increased inventory of unsold NAND
flash wafers, which could adversely affect our operating results. We cannot
assure you that we or Toshiba will be able to secure sufficient funding to
support this manufacturing line. Furthermore, in order for us to sell NAND based
CompactFlash, MultiMediaCards and Secure Digital Cards, we will have to develop
new controllers, printed circuit boards and test algorithms because the
architecture of NAND flash is significantly different from our current NOR flash
designs. Any technical difficulties or delays in the development of these
elements could prevent us from taking advantage of the available NAND output and
could adversely affect our results of operations.
On July 4, 2000, we entered into a share purchase agreement to make a $75
million investment in Tower Semiconductor, or Tower, in Israel, representing
approximately 10% ownership of Tower. On January 26, 2001, Tower satisfied the
closing conditions of the share purchase agreement, and we transferred the first
$20 million of this investment from an escrow account to purchase 866,551 shares
ordinary shares and obtain $8.8 million in pre-paid wafer credits. On March 1,
2001, we paid Tower $11 million upon its completion of milestone one, to
purchase 366,690 ordinary shares and obtain $6.1 million prepaid wafer credits.
Additional contributions will take the form of mandatory warrant exercises for
ordinary shares at an exercise price of $30.00 per share if other milestones are
met. The warrants will expire five years from the date of grant, and in the
event the key milestones are not achieved, the exercise of these warrants will
not be mandatory. We expect first wafer production to commence at the new
fabrication facility in late 2002.
The success of 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, the MultiMediaCard, and Secure Digital Card such as
portable digital music players and smart phones, must develop and grow. If sales
of these products do not grow, our revenues and profit margins could level off
or decline.
Because we sell our products for use in many new applications, it is
difficult to forecast demand. During the third quarter of 2000, the U.S. Courts
ruled against Napster.Com and MP3.Com in two cases involving unlicensed
distribution of copyrighted digital music over the Internet. This action is
being carefully studied by the original equipment manufacturers, or OEMs, who
have been developing MP3 players using Flash memory cards such as our
MultiMediaCards for storage of music. If these OEMs reduce their production of
digital music players in response to these recent court decisions or other
factors, demand for our products will decrease. In addition, we believe that
21
these OEMs may redesign their platforms to work with our Secure Digital Card,
which we began shipping in the first quarter of 2001. Accordingly, we may
experience a drop in demand from our MultiMediaCard customers before the new
anticipated demand for our Secure Digital Card materializes.
Secure Digital Card products
As part of our June 2000 collaboration with Toshiba and Matsushita Electric
Industrial Co. Ltd., we have jointly developed the Secure Digital Card, an
enhanced version of our MultiMediaCard, which incorporates advanced security
and copyright protection features required by the emerging markets for the
electronic distribution of music, video and other copyrighted works. We began
shipping our Secure Digital Card products in 32 and 64 megabyte capacities in
the first quarter of 2001. The Secure Digital Card is slightly thicker and uses
a different interface than our MultiMediaCard. Because of these differences, the
Secure Digital Card will not work in current products that include a
MultiMediaCard slot. In order for the market for our Secure Digital Card to
develop, manufacturers of digital audio/video and portable computing products
must include a Secure Digital Card compatible slot in their products and acquire
a license to the security algorithms. If OEMs do not incorporate Secure Digital
Card slots in their products or do not buy our Secure Digital Cards, our
business, financial condition and results of operations may be harmed. In
addition, consumers may postpone or altogether forego buying products that
utilize our MultiMediaCard in anticipation of new products such as MP3 players
and digital camcorders that will incorporate the Secure Digital Card. If this
occurs, sales of our MultiMediaCard products may be harmed. The main competition
for the Secure Digital Card is expected to come from the Sony Memory Stick. Sony
has substantially greater financial and other resources than we do and extensive
marketing and sales channels and brand recognition. We cannot assure you that
our Secure Digital Card will be successful in the face of such competition.
In addition, the market for portable digital music players is very new and it
is uncertain how quickly consumer demand for these players will grow. If this
market does not grow as quickly as anticipated or our customers are not
successful in selling their portable digital music players to consumers, our
revenues could be adversely affected. In addition, it is often the case with new
consumer markets that after an initial period of new market formation and
initial acceptance by early adopters, the market enters a period of slow growth
as standards emerge and infrastructure develops. In the event that this occurs
in the portable digital music player market or other emerging markets, sales of
our products would be harmed.
The success of our new product strategy will depend upon, among other things,
the following:
. our ability to successfully develop new products with higher memory
capacities and enhanced features at a lower cost per megabyte;
. the development of new applications or markets for our flash data storage
products;
. the adoption by the major content providers of the copy protection
features offered by our Secure Digital Card products;
. the extent to which prospective customers design our products into their
products and successfully introduce their products; and
. the extent to which our products or technologies become obsolete or
noncompetitive due to products or technologies developed by others.
512 megabit and 1 gigabit flash memory card products
On June 30, 2000, we closed a transaction with Toshiba providing for the
joint development and manufacture of 512 megabit and 1 gigabit flash memory
chips and Secure Digital Card controllers. As part of this venture, we and
Toshiba plan to employ Toshiba's 0.16 micron and future 0.13 micron NAND flash
integrated circuit manufacturing technology and SanDisk's multilevel cell flash
and controller system technology. During the third quarter of 2000, we announced
with Toshiba the completion of the joint development of the 512 Megabit NAND
flash chip employing Toshiba's .16 micron manufacturing process technology. We
expect cards employing the 512 megabit technology to be shipped in significant
quantities in the second half of 2001, and cards employing the 1 gigabit
technology to be shipped in 2002. The development of 512 megabit and 1 gigabit
flash memory chips and Secure Digital Card controllers is expected to be complex
and incorporates SanDisk and Toshiba technology that is still under development.
We cannot assure you that we and Toshiba will successfully develop and bring
into full
22
production with acceptable yields and reliability these new products or the
underlying technology, or that any development or production ramp will be
completed in a timely or cost-effective manner. If we are not successful in any
of the above, our business, financial condition and results of operations could
suffer.
We may be unable to maintain market share.
During periods of excess supply in the market for our flash memory products,
such as we are experiencing in the first half of 2001, we may lose market share
to competitors who aggressively lower their prices. Conversely, under
conditions of tight flash memory supply, we may be unable to increase our
production volumes at a sufficiently rapid rate so as to maintain our market
share. Ultimately, our growth rate depends on our ability to obtain sufficient
flash memory wafers and other components to meet demand. If we are unable to do
so in a timely manner, we may lose market share to our competitors.
Our international operations make us vulnerable to changing conditions and
currency fluctuations.
Political risks
Currently, the majority of our flash memory wafers are produced by UMC in
Taiwan. We also use a third-party subcontractor in Taiwan for the assembly and
testing of our MultiMediaCard products. We may therefore be affected by the
political, economic and military conditions in Taiwan. Taiwan is currently
engaged in various political disputes with China and in the past both countries
have conducted military exercises in or near the other's territorial waters and
airspace. The Taiwanese and Chinese governments may escalate these disputes,
resulting in an economic embargo, a disruption in shipping routes or even
military hostilities. This could harm our business by interrupting or delaying
the production or shipment of flash memory wafers or MultiMediaCard products by
our Taiwanese foundries and subcontractor. See "-- We depend on our suppliers
and third party subcontractors."
We use a third-party subcontractor in China for the assembly and testing of
our CompactFlash products. 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 these policies and, even if it does continue, these policies may not be
successful. The Chinese government may also significantly alter these policies
from time to time. In addition, China does not currently have a comprehensive
and highly developed legal system, 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. Such inconsistency could lead to piracy and
degradation of our intellectual property protection.
Although we do not believe the current political unrest in Israel represents
a major security problem for Tower since Migdal Haemek, Israel is in a secure
geographic location, the unrest may expand and even if it remains at current
levels, could cause scheduling delays. We cannot assure you that the Tower
facility will be completed or will begin production as scheduled, or that the
processes needed to fabricate our wafers will be qualified at the new facility.
Moreover, we cannot assure you that this new facility will be able to achieve
acceptable yields or deliver sufficient quantities of wafers on a timely basis
at a competitive price.
In addition, while the political unrest has not yet posed a direct security
risk to our engineering design center in Israel, it may cause unforeseen delays
in the development of our products.
Economic risks
We price our products primarily in U.S. dollars. Given the recent economic
conditions in Asia and the European Union and the weakness of the Euro, Yen and
other currencies relative to the United States dollar, our products may be
relatively more expensive in these regions, which could result in a decrease in
our sales. While most of our sales are denominated in U.S. Dollars, we invoice
certain Japanese customers in Japanese Yen and are subject to exchange rate
fluctuations on these transactions which could harm our business, financial
condition and results of operations.
General risks
23
Our international business activities could also be limited or disrupted by
any of the following factors:
. the need to comply with foreign government regulation;
. general geopolitical risks such as political and economic instability,
potential hostilities and changes in diplomatic and trade relationships;
. natural disasters affecting the countries in which we conduct our
business, such as the earthquake experienced in Taiwan in 1999;
. imposition of regulatory requirements, tariffs, import and export
restrictions and other barriers and restrictions, particularly in China;
. longer payment cycles and greater difficulty in accounts receivable
collection, particularly as we increase our sales through the retail
distribution channel, and general business conditions deteriorate;
. Adverse tax rules and regulations;
. weak protection of our intellectual property rights; and
. delays in product shipments due to local customs restrictions.
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 some
of these vendors. Our business, financial condition and operating results could
be significantly harmed by delays or reductions in shipments if we are unable to
develop alternative sources or obtain sufficient quantities of these components.
For example, we rely on UMC for the majority of our flash memory wafers. NEC has
traditionally supplied 100% of certain designs of our microcontrollers. During
the second quarter, we expect to commence production of other controller designs
at UMC.
We also rely on third-party subcontractors for a substantial portion of wafer
testing, packaged memory final testing, card assembly and card testing,
including Silicon Precision Industries Co., Ltd. in Taiwan, Celestica, Inc. in
China, and Amkor, in the Philippines. These three subcontractors will also be
assembling and testing a majority of our mature, high-volume products. We began
transferring portions of our testing and assembly operations to these
subcontractors in the second half of 1999 and are still continuing this
transition. We will continue operations at our Sunnyvale production facility
for new products and special customer requirements. However, we do not have
sufficient duplicative production testing equipment at Sunnyvale and at our
subcontractors. Any problems in this complex transition may result in a
disruption of production and a shortage of product to meet customer demand. We
have no long-term contracts with these subcontractors and cannot directly
control product delivery schedules. Any significant problems that occur at our
subcontractors, or their failure to perform at the level we expect 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. Furthermore, we are moving to turnkey manufacturing with some of our
subcontract suppliers, which may reduce our visibility and control of their
inventories of purchased parts necessary to build our products.
Our markets are highly competitive.
Flash memory manufacturers and memory card assemblers
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 advanced wafer
foundry capacity, substantially greater financial, technical, marketing and
other resources, broader product lines and longer standing relationships with
customers.
24
Our primary competitors include companies that develop and manufacture
storage flash chips, such as Hitachi, Samsung, Micron Technology and Toshiba. In
addition, we compete with companies that manufacture other forms of flash memory
and companies that purchase flash memory components and assemble memory cards.
Companies that manufacture socket flash, linear flash and components include
Advanced Micro Devices, Atmel, Intel, Macronix, Mitsubishi, Fujitsu, Sharp
Electronics and ST Microelectronics. Companies that combine controllers and
flash memory chips developed by others into flash storage cards include Lexar
Media, M-Systems, Pretec, Simple Technology, Sony Corporation, Kingston
Technology, Panasonic, Silicon Storage Technology, TDK Corporation, Matsushita
Battery, Delkin Devices, Inc., Feiya Technology Corporation, Dane-Elec
Manufacturing, Silicon Tek, Infineon Technologies and Viking Components.
In addition, many companies have been certified by the CompactFlash
Association to manufacture and sell their own brand of CompactFlash. We believe
additional manufacturers will enter the CompactFlash market in the future.
We have announced an agreement with Matsushita and Toshiba to jointly
develop and promote a next generation flash memory card called the Secure
Digital Card. Under this agreement, Secure Digital Card royalty-bearing licenses
will be granted to other flash memory card manufacturers, which will increase
the competition for our Secure Digital Card, CompactFlash and MultiMediaCard
products. In addition, Matsushita and Toshiba have commenced selling Secure
Digital Cards that will compete directly with our products. While other flash
card manufacturers will be required to pay the SD Association license fees and
royalties which will be shared between Matsushita, Toshiba and SanDisk, there
will be no royalties or license fees payable among the three companies for their
respective sales of the Secure Digital Card. Thus, we will forfeit potential
royalty income from Secure Digital Card sales by Matsushita and Toshiba.
In addition, we and Toshiba will each separately market and sell any 512
megabit and 1 gigabit flash memory chips and Secure Digital Card controllers
developed and manufactured under our relationship. Accordingly, we will compete
directly with Toshiba for sales of these advanced chips and controllers.
We have entered into patent cross-license agreements with several of our
leading competitors including Hitachi, Lexar, Samsung, Toshiba, Intel, SST,
Sharp, SmartDisk and TDK. 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 of our competitors, competition will increase and may harm our business,
financial condition and results of operations. Currently, we are engaged in
licensing discussions with several of our competitors. There can be no assurance
that we will be successful in concluding licensing agreements under terms which
are favorable to us.
Alternative storage media
Competing products have been introduced that promote industry standards
that are different from our CompactFlash and MultiMediaCard products including
Toshiba's SmartMedia, Sony Corporation's Memory Stick, Sony's standard floppy
disk used for digital storage in its Mavica digital cameras, Panasonic's Mega
Storage cards, Iomega's Clik drive, a miniaturized, mechanical, removable disk
drive, M-Systems' Diskonchip for embedded storage applications and the Secure
MultiMediaCard from Hitachi and Infineon. Each competing standard is
mechanically and electronically incompatible with CompactFlash and
MultiMediaCard. If a manufacturer of digital cameras or other consumer
electronic devices designs in one of these alternative competing standards,
CompactFlash or MultiMediaCard will be eliminated from use in that product.
IBM's microdrive, a rotating disk drive in a Type II CompactFlash format
competes directly with our Type II CompactFlash memory cards for use in high-end
professional digital cameras. M-Systems' Diskonchip 2000 Millennium product
competes against our Flash ChipSet products in embedded storage applications
such as set top boxes and networking appliances.
According to independent industry analysts, Sony's Mavica digital camera
captured a considerable portion of the U.S. market for digital cameras from 1998
to 2000. 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 have been adversely impacted by the success of the
Mavica. Recently, Sony has shifted its focus to the use of its flash Memory
Stick in its latest digital camera models.
25
Our MultiMediaCard products also have faced significant competition from
Toshiba's SmartMedia flash cards and we expect to face similarly significant
competition from Sony's Memory Stick. Sony has licensed its proprietary Memory
Stick to other companies. If it is adopted and achieves widespread use in future
products, sales of our MultiMediaCard and CompactFlash products may decline.
Recently, Hitachi, Infineon, Sanyo and Fujitsu have proposed their Secure
MultiMediaCard which provides the copy protection function that is included in
our Secure Digital Card. Should this initiative gain industry wide acceptance,
it may reduce the widespread adoption of the Secure Digital Card.
In the first quarter of 2000, Sanyo announced that it is developing a
miniature magneto-optical storage device for use in future digital cameras,
music players and camcorders. There can be no assurance that this device will
not be adopted by some of our OEM customers.
Alternative flash technologies
We also face competition from products based on multilevel cell flash
technology from Intel and Hitachi. 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 competitors 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. For example, Infineon has formed a joint venture
with Saifun, an Israeli startup company, to develop a proprietary flash memory
technology which will be targeted at low cost data storage applications. 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 our costs and could also result in lost sales.
Sales to a small number of customers represent a significant portion of our
revenues.
Approximately one-half of our revenues came from a small number of
customers in fiscal 2000 and 1999. For example, sales to our top 10 customers
accounted for approximately 64% of our product revenues in the first quarter of
2001, and 52% in the first quarter of 2000. In the first quarter of 2001, sales
to one customer exceeded 10% of product sales, and there were two customers that
each represented more than 10% of product sales in the first quarter of 2000. If
we were to lose one of our major customers or experience any material reduction
in orders from any of 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
changes.
Our multiple sales channels may compete for a limited number of customer sales.
Web based sales of our products today represent a small but growing portion
of our overall sales. Sales on the Internet tend to undercut traditional
distribution channels and may dramatically change the way our consumer products
are purchased in future years. We cannot assure you that we will successfully
develop the Internet sales channel or successfully manage the inherent conflict
between the Internet and our traditional sales channels.
We must achieve acceptable wafer manufacturing yields.
The fabrication of our products requires wafers to be produced in a highly
controlled and ultra 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 exclusively on independent offshore foundries for our
wafers which increases the effort and time required to identify, communicate and
resolve manufacturing yield
26
problems. If the foundries cannot achieve planned yields, we will experience
higher costs and reduced product availability, which could harm our business,
financial condition and results of operations.
In addition, we cannot assure you that the Dominion fabrication facility we
are co-developing with Toshiba, will produce satisfactory quantities of wafers
with acceptable prices, reliability and yields. Any failure in this regard could
materially harm our business, financial condition and results of operations. In
addition, the construction and operation of this line will cause us to incur
significant expense and may result in the diversion of resources from other
important areas of our business. In addition, we have no experience in operating
a wafer manufacturing line and we intend to rely on the existing manufacturing
organization at the Dominion facility. This organization will be trained in NAND
flash manufacturing by Toshiba, but we cannot assure you that they will be
successful in manufacturing these advanced NAND flash products on a cost-
effective basis or at all.
Risks associated with patents, proprietary rights and related litigation.
General
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 that:
. any of our existing patents will not be invalidated;
. patents will be issued for any of our pending applications;
. any claims allowed from existing or pending patents will have
sufficient scope or strength;
. our patents will be issued in the primary countries where our products
are sold in order to protect our rights and potential commercial
advantage; or
. any of our products may infringe on the patents of other companies.
In addition, our competitors may be able to design their products around
our patents.
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
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 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. For example, our recent Litigation with
Lexar lasted for two and one-half years and resulted in cumulative litigation
expenses of approximately $6.0 million.
Cross-licenses and indemnification obligations
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 several companies, including Hitachi, Intel, Lexar, Samsung,
Sharp, SST, SmartDisk, TDK 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 wafer suppliers 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.
27
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 harm our business, financial condition or results
of operations.
Litigation risks associated with our intellectual property
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. On March 21, 2000, Mitsubishi Denki Co. Ltd.
(Mitsubishi Electric) filed a complaint in Tokyo District Court against SanDisk
K.K., our wholly owned subsidiary in Japan. The complaint alleges that SanDisk
K.K., based in Yokohama, Japan, infringes on three Mitsubishi Japanese patents.
The Mitsubishi patents in question are #JP2099342, #JP2129071 and #JP2138047,
which are related primarily to the mechanical construction of memory cards. In
the complaint, Mitsubishi asked the court for a preliminary injunction halting
the sale of SanDisk CompactFlash and flash ATA memory cards in Japan. Mitsubishi
has since dropped patents #JP2129071 and #JP2138047 from the suit. We and
SanDisk K.K. are vigorously defending against Mitsubishi's remaining claims.
Our rapid growth may strain our operations.
We have experienced rapid growth, which has placed a significant strain on
our personnel and other resources. To accommodate future growth, we must
continue to hire, train, motivate and manage our employees. We have experienced
difficulty 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 rapid growth,
which could in turn harm our business, financial condition and results of
operations.
California energy crisis
In recent months, California has been experiencing a shortage of energy
supply. This shortage is expected to continue throughout 2001 and possibly into
future years. Although the majority of our product assembly and testing is done
outside of California, we may experience some hardship due to rolling blackouts
and the need for reduced power consumption, as well as increased power costs.
Our success depends on key personnel, including our executive officers, the loss
of whom could disrupt our business.
Our success greatly depends on the continued contributions of our senior
management and other key research and development, sales, marketing and
operations personnel, including Dr. Eli Harari, our 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.
Anti-takeover provisions in our charter documents, stockholder rights plan and
in Delaware law could prevent or delay a change in control and, as a result,
negatively impact our stockholders.
We have taken a number of actions that could have the effect of
discouraging a takeover attempt. For example, we have adopted a stockholder
rights plan that would cause substantial dilution to a stockholder, and
substantially increase the cost paid by a stockholder, who attempts to acquire
us on terms not approved by our board of directors. This could prevent us from
being acquired. 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 our
28
common stock that could have a material adverse effect on the market value of
our 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.
Our stock price has been, and may continue to be, volatile.
The market price of our stock has fluctuated significantly in the past and
is likely to continue to fluctuate in the future. For example, in the 12 months
ending March 31, 2001 our stock price fluctuated significantly from a low of
$18.63 to a high of $126.50. We believe that such fluctuations will 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 general economic, political and market conditions may have an adverse
affect on the market price of our common stock.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Please refer to the Company's Form 10-K for the year ended December 31,
2000.
29
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 to 8 and under
"Factors That May Affect Future Results - Risks Associated with Patents,
Proprietary Rights and Related Litigation" on pages 26 to 27 of this report, 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
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),(13)
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)
10.15 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
30
Exhibit
Number Exhibit Title
------ -------------
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.(12)
10.31 1995 Non-Employee Directors Stock Option Plan Amended and
Restated as of December 17, 1998.(12)
10.32 1995 Employee Stock Purchase Plan Amended and Restated as of
December 17, 1998. (12)
10.33 Master Agreement, dated as of May 9, 2000, by and among the
Registrant, Toshiba Corporation and Semiconductor North America,
Inc.(13),(+)
10.34 Operating Agreement dated as of May 9, 2000, by and between the
Registrant and Semiconductor North America, Inc.(13)
10.35 Common R&D and Participation Agreement, dated as of May 9, 2000,
by and between the Registrant and Toshiba Corporation.(13),(+)
10.36 Product Development Agreement, dated as of May 9, 2000, by and
between the Registrant and Toshiba Corporation.(13),(+)
10.37 Share Purchase Agreement, dated as of July 4, 2000, by and
between the Registrant and Tower Semiconductor Ltd.(14)
10.38 Escrow Agreement, dated as of August 14, 2000, by and between the
Registrant, Tower Semiconductor Ltd. and Union bank of
California, N.A.(14)
10.39 Additional Purchase Obligation Agreement, dated as of July 4,
2000, by and between the Registrant and Tower Semiconductor
Ltd.(14)
10.40 Shareholders Agreement, dated as of July 4, 2000, by and between
the Registrant and the Israel Corporation.(14)
10.41 Definitive Agreement to Form Vending Business, dated August 7,
2000, by and between the Registrant and Photo-Me International,
Plc.(14),(+)
10.42 Non-Solicitation Agreement, dated August 7, 2000, by and between
the Registrant, DigitalPortal Inc. and Photo-Me International,
Plc.(14),(+)
10.43 Exclusive Product Purchase Agreement, dated as of August 7, 2000,
by and between Photo-Me, International Plc., and DigitalPortal
Inc. (14),(+)
10.44 Stockholders' Agreement, dated as of August 7, 2000, by and among
the Registrant, DigitalPortal Inc. and Photo-Me, International,
Plc.(14),(+)
10.45 Bylaws of DigitalPortal Inc.(14),(+)
10.46 Registration Rights Agreement, dated as of January 18, 2001, by
and between Registrant, The Israel Corporation, Alliance
Semiconductor Ltd., Macronix International Co., Ltd. and Quick
Logic Corporation (15)
10.47 Consolidated Shareholders Agreement, dated as of January 18,
2001, by and among Registrant, The Israel Corporation, Alliance
Semiconductor Ltd. And Macronix International Co., Ltd. (15)
10.48 Appendix 1 to FlashVision L.L.C. 2000 lease financing agreement
between FlashVision L.L.C. Corporation to ABN AMRO Bank N.V.
(16), (++)
10.49 Master Lease agreement between FlashVision L.L.C. Corporation to
ABN AMRO Bank N.V. (16), (++)
10.50 Guarantee, dated as of December 27, 2000 from SanDisk Corporation
to ABN AMRO Bank N.V., related to FlashVision L.L.C. 2000 lease
financing. (16), (++)
21.1 Subsidiaries of the Registrant. (10)
______________
* Filed herewith.
31
+ Confidential treatment has been granted for certain portions thereof.
++ Confidential treatment has been requested for certain portions thereof.
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).
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.
12. Previously filed as an Exhibit to the Registrant's Form 10-Q for the
quarter ended March 31, 1999.
13. Previously filed as an Exhibit to the Registrant's Form 10-Q for the
quarter ended June 30, 2000.
14. Previously filed as an Exhibit to the Registrant's Form 10-Q for the
quarter ended September 30, 2000.
15. Previously filed as an Exhibit to the Registrant's Schedule 13(d) dated
January 26, 2001.
16. Previously filed as an Exhibit to the Registrant's 2000 Annual Report on
Form 10-K.
B. Reports on Form 8-K
None
32
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)
Dated: May 8, 2001 By: /s/ Frank Calderoni
----------------------------------------
Frank A. Calderoni
Senior Vice President,
Finance and Administration and
Chief Financial Officer
(On behalf of the Registrant and as
Principal Financial Officer.)
33