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
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Securities Exchange Act of 1934
For the quarterly period ended September 30, 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
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(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
capital stock as of September 30, 2001
Common Stock, $0.001 par value 68,288,730
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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
September 30, 2001 and December 31, 2000 .................. 3
Condensed Consolidated Statements of Operations
Three and nine months ended September 30, 2001 and 2000 ... 4
Condensed Consolidated Statements of Cash Flows
Nine months ended September 30, 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 ................................. 11
Item 3. Quantitative and Qualitative Disclosures About Market Risk .... 32
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ............................................. 33
Item 2. Changes in Securities ......................................... 33
Item 3. Defaults upon Senior Securities ............................... 34
Item 4. Submission of Matters to a Vote of Security Holders ........... 34
Item 5. Other Information ............................................. 34
Item 6. Exhibits and Reports on Form 8-K .............................. 34
Signatures .................................................... 37
Page 2
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
SANDISK CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
September 30, December 31,
2001 2000*
---- -----
(unaudited)
ASSETS
Current Assets:
Cash and cash equivalents $ 45,876 $ 106,277
Short-term investments 225,466 260,462
Investment in UMC 93,565 112,854
Accounts receivable, net 41,892 104,617
Inventories 39,846 96,600
Deferred tax assets 10,934 7,066
Prepaid expenses and other current assets 15,371 9,431
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Total current assets 472,950 697,307
Property and equipment, net 36,596 41,095
Investment in UMC 25,990 197,688
Investment in FlashVision 151,769 134,730
Investment in equity securities and joint venture 29,763 7,200
Deposits and other assets 7,766 29,887
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Total Assets $ 724,834 $ 1,107,907
============= ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable $ 48,350 $ 67,112
Accrued payroll and related expenses 7,035 16,215
Income taxes payable 5,379 16,427
Other accrued liabilities 45,759 20,863
Deferred revenue 16,987 50,740
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Total current liabilities 123,510 171,357
Deferred tax liability 2,506 70,000
Other liabilities - 3,492
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Total Liabilities 126,016 244,849
Stockholders' Equity:
Common stock 575,115 567,001
Retained earnings 22,897 346,469
Accumulated other comprehensive income (loss) 806 (50,412)
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Total stockholders' equity 598,818 863,058
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Total Liabilities and Stockholders' Equity $ 724,834 $ 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 Nine months ended
September 30, September 30,
------------------------------------------------
2001 2000 2001 2000
---- ---- ---- ----
Revenues:
Product $ 57,305 $ 151,816 $ 233,503 $ 371,638
License and royalty 8,582 19,023 40,859 52,519
--------- --------- --------- ---------
Total revenues 65,887 170,839 274,362 424,157
Cost of sales 89,426 101,874 314,958 254,146
--------- --------- --------- ---------
Gross profits (losses) (23,539) 68,965 (40,596) 170,011
Operating expenses:
Research and development 14,660 13,018 45,231 32,838
Sales and marketing 10,664 12,505 31,415 34,568
General and administrative 4,000 7,907 12,574 18,667
Restructuring charge 8,510 - 8,510 -
--------- --------- --------- ---------
Total operating expenses 37,834 33,430 97,730 86,073
Operating income (loss) (61,373) 35,535 (138,326) 83,938
Activity related to equity in interest in
joint ventures 794 - 1,301 -
Interest income 2,616 5,855 9,770 17,291
Gain (loss) on investment in foundries (116,370) - (296,351) 344,168
Other income (expense), net (514) (438) (2,516) 661
--------- --------- --------- ---------
Income (loss) before taxes (174,847) 40,952 (426,122) 446,058
Provision for (benefit from) income taxes (4,371) 15,349 (102,550) 176,916
--------- --------- --------- ---------
Net income (loss) $(170,476) $ 25,603 $(323,572) $ 269,142
========= ========= ========= =========
Net income (loss) per share
Basic $ (2.50) $ 0.38 $ (4.75) $ 4.04
Diluted $ (2.50) $ 0.35 $ (4.75) $ 3.70
Shares used in computing net income (loss)
per share
Basic 68,289 67,142 68,064 66,685
Diluted 68,289 72,638 68,064 72,817
The accompanying notes are an integral part of these condensed consolidated
financial statements.
Page 4
SANDISK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands, Unaudited)
Nine Months Ended
September 30,
-----------------------------------
2001 2000
-----------------------------------
Cash flows from operating activities:
Net income (loss) $(323,572) $ 269,142
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization 16,095 11,691
Deferred income taxes (120,267) 138,435
Loss (gain) on investment in foundries 296,351 (344,168)
Activity related to equity interest in joint ventures (1,301) --
Non-cash portion of restructuring charge 6,383 --
Loss on write down/disposal of fixed assets 6,555 858
Changes in operating assets and liabilities:
Accounts receivable, net 62,725 (81,127)
Inventories 56,754 (31,644)
Prepaid expenses and other assets 10,723 (4,085)
Accounts payable (18,762) 34,386
Accrued payroll and related expenses (9,180) 7,262
Income taxes payable (11,048) 12,900
Other accrued liabilities 18,514 10,236
Deferred revenue (33,753) 12,494
Other non-current liabilities (3,490) 1,859
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Total adjustments 276,299 (230,903)
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Net cash provided by (used in) operating activities (47,273) 38,239
Cash flows from investing activities:
Purchases of short term investments (219,014) (288,389)
Maturities and proceeds from sales of short term investments 255,206 341,279
Investment in equity securities (22,526) (20,000)
Investment in joint venture (16,757) (36,926)
Acquisition of capital equipment (18,151) (19,026)
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Net cash used in investing activities (21,242) (23,062)
Cash flows from financing activities:
Sale of common stock 8,114 10,914
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Net cash provided by financing activities 8,114 10,914
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Net increase (decrease) in cash and cash equivalents (60,401) 26,091
Cash and cash equivalents at beginning of period 106,277 146,170
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Cash and cash equivalents at end of period $ 45,876 $ 172,261
========= =========
The accompanying notes are an integral part of these condensed consolidated
financial statements.
Page 5
SANDISK CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
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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 September 30, 2001, and the results of
operations for the three and nine month periods ended September 30, 2001 and
2000 and cash flows for the nine month periods ended September 30, 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 for the three and nine month periods
ended September 30, 2001 and 2000 and its cash flows for the nine month periods
ended September 30, 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 third fiscal quarter of 2001 and 2000 ended on September 30,
2001 and October 1, 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.
In the third quarter of fiscal 2001, the Company recorded inventory
charges of $16.1 and startup costs related to its FlashVision joint venture
foundry of $8.5 million. In the first nine months of 2001, charges totaled
$100.6 million. These charges reflect substantially lower market pricing,
reduced demand for the Company's products, startup costs related its our
FlashVision joint venture foundry and the write off of excess and obsolete
inventory components and equipment. These charges reflect the Company's best
estimation of the current value of inventory and assets, based on market
pricing, customer demand, and future usability.
4. The components of inventories consist of the following:
September 30, December 31,
2001 2000
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(In thousands)
Raw materials .............................. $ 6,260 $ 33,092
Work-in-process ............................ 21,147 53,921
Finished goods ............................. 12,439 9,587
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$ 39,846 $ 96,600
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6
5. Restructuring charge: In the third quarter of 2001, the Company adopted
a plan to transfer all of its card assembly and test manufacturing operations
from its Sunnyvale location to offshore subcontractors. As a result the Company
recorded a restructuring charge of $8.5 million, which includes a workforce
reduction cost of $1.1 million, equipment write-off charges of $6.4 million and
lease commitments of $1.0 million on a vacated warehouse facility.
Workforce Reduction: In the third quarter of 2001, the Company announced
a plan to reduce its workforce by a total of 193 employees through involuntary
employee separations from October 2001 through January 2002. The Company
recorded a charge of $1.1 million for employee separations in the third quarter
of 2001.
Abandonment of Excess Equipment: As a part of its plan to transfer all
card assembly and test manufacturing operations to offshore subcontractors, the
Company abandoned excess equipment and recorded a charge of $6.4 million in the
third quarter of fiscal 2001.
Abandonment of Excess Leased Facilities: The Company is attempting to
sublease one warehouse building in San Jose, California. Given the current real
estate market condition in the San Jose area, the Company does not expect to be
able to sublease this building before the end of 2003 and as a result, the
Company has recorded a charge of $1.0 million in the third quarter of 2001.
Remaining Payout: Cash expenditures related to the workforce reduction
will be paid in the fourth quarter of 2001 and the first quarter of 2002.
Amounts related to the abandonment of excess leased facilities will be paid as
the lease payments are due in 2002 and 2003.
Savings: The Company believes that the savings resulting from the
restructuring activity will contribute to a reduction in manufacturing and
operating expense levels by approximately $11.8 million in fiscal 2002.
The following table reflects the total restructuring charge:
Workforce Lease
Equipment Reduction Commitments Total
--------- --------- ----------- -----
(in thousands)
Restructuring Charge $ 6,383 $ 1,094 $ 1,033 $8,510
Write off and write downs -- -- -- --
Cash charges/adjustments -- -- -- --
--------- --------- ----------- ------
Reserve balance, September 30, 2001 $ 6,383 $ 1,094 $ 1,033 $8,510
========= ========= =========== ======
6. The following table sets forth the computation of basic and diluted
earnings per share:
Three months ended Nine months ended
September 30, September 30,
-------------------------- --------------------------
2001 2000 2001 2000
--------- --------- --------- ---------
(In thousands, except for per share amounts)
Numerator:
Numerator for basic and diluted net income (loss)
per share - net income (loss) $(170,476) $ 25,603 $(323,572) $ 269,142
========= ========= ========= =========
Denominator for basic net income (loss) per share:
Weighted average common shares 68,289 67,142 68,064 66,685
========= ========= ========= =========
Basic net income (loss) per share $ (2.50) $ 0.38 $ (4.75) $ 4.04
========= ========= ========= =========
Denominator for diluted net income per share:
Weighted average common shares 68,289 67,142 68,064 66,685
Employee stock options and warrants
to purchase common stock - 5,496 - 6,132
--------- --------- --------- ---------
Shares used in computing diluted net income
per share 68,289 72,638 68,064 72,817
========= ========= ========= =========
7
Diluted net income per share $ (2.50) $ 0.35 $ (4.75) $ 3.70
======== ======= ======== ======
For the three months ended September 30, 2001 and 2000, options to purchase
5,144,214 and 468,063 shares of common stock, respectively, have been excluded
from the earnings per share calculation, as their effect is antidilutive. For
the nine months ended September 30, 2001 and 2000, options to purchase 4,252,670
and 263,266 shares of common stock, respectively, have been excluded from the
earnings per share calculation, as their effect is antidilutive.
7. The Company relies on a combination of patents, trademarks, copyright
and trade secret laws, confidentiality procedures and licensing arrangements to
protect its intellectual property rights. There can be no assurance that there
will not be any disputes regarding the Company's intellectual property rights.
Specifically, there can be no assurance that any patents held by the Company
will not be invalidated or that others will not be granted rights under the
Company's patents, that patents will be issued for any of the Company's pending
applications or that any claims allowed from existing or pending patents will be
of sufficient scope or strength or be issued in the primary countries where the
Company's products can be sold to provide meaningful protection or any
commercial advantage to the Company. Additionally, competitors of the Company
may be able to design around the Company's patents.
To preserve its intellectual property rights, the Company believes it may
be necessary to initiate litigation with one or more third parties, including
but not limited to those the Company has notified of possible patent
infringement. In addition, one or more of these parties may bring suit against
the Company. Any litigation, whether as a plaintiff or as a defendant, would
likely result in significant expense to the Company and divert the efforts of
the Company's technical and management personnel, whether or not such litigation
is ultimately determined in favor of the Company.
In the event of an adverse result in any such litigation, the Company could
be required to pay substantial damages, cease the manufacture, use and sale of
infringing products, expend significant resources to develop non-infringing
technology 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. See Part II, Item 1 for
further discussion of litigation which the Company is currently involved in.
8. 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
8
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 cannot 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.
All derivatives are recorded at fair market value on the balance sheet,
classified in other assets. 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 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 nine months 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 September 30, 2001, the Company had $18.9 million in Japanese
Yen-denominated accounts payable and open purchase orders designated as cash
flow hedges or fair value hedges against Japanese Yen-denominated cash holdings
and accounts receivable. The Company estimates the fair values of derivatives
based on quoted market prices or pricing models using current market rates. At
September 30, 2001, the Company had one forward contract to sell Yen in the
amount of $9.4 million. There was no unrealized loss on derivative instruments
as of September 30, 2001.
For the three month periods ended September 30, 2001 and 2000,, the Company
had net foreign currency transaction losses of $0.5 million. In the nine months
ended September 30, 2001, the Company had a net foreign currency transaction
loss of $2.4 million, compared to a gain of $0.6 million in the nine months
ended September 30, 2000. These amounts are primarily due to translation
adjustments on Japanese Yen-based assets.
In June 2001, the Financial Accounting Standards Board issued Statements of
Financial Accounting Standards No. 141, Business Combinations, and No. 142,
Goodwill and Other Intangible Assets, effective for fiscal years beginning after
December 15, 2001. Under the new rules, goodwill and intangible assets deemed to
have indefinite lives will no longer be amortized but will be subject to annual
impairment tests in accordance with the Statements. Other intangible assets will
continue to be amortized over their useful lives.
The Company will apply the new rules on accounting for goodwill and other
intangible assets beginning in the first quarter of 2002. Application of the
nonamortization provisions of the Statement is not expected to have a
significant impact on our financial position at transition. During 2002, the
Company will perform the first of the required impairment tests of goodwill and
indefinite lived intangible assets as of January 1, 2002 and has not yet
determined what the effect of these tests will be on the earnings and financial
position of the Company.
9
9. 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, including the short-term
portion of the Company's investment in UMC, net of the related tax effects, for
all periods presented.
Three months ended Nine months ended
September 30, September 30,
----------------------- -----------------------
2001 2000 2001 2000
---- ---- ---- ----
(In thousands) (In thousands)
Net income (loss) $(170,476) $ 25,603 $(323,572) $ 269,142
Unrealized gain (loss) on available-for-sale securities 16,506 (29,604) 51,777 (55,356)
Gain from stock dividend received -- -- -- 36,606
--------- --------- --------- ---------
Comprehensive income (loss) $(153,970) $ (4,001) $(271,795) $ 250,392
========= ========= ========= =========
Accumulated other comprehensive income (loss) was $0.8 million and ($50.4)
million at September 30, 2001 and December 31, 2000, respectively. The balance
at December 31, 2000 included unrealized losses on UMC of $50.3 million,
respectively.
10. In January 2001, the Company invested the final $15 million of its $150
million cash commitment in FlashVision, L.L.C., its joint venture with Toshiba
for the development and manufacture of 512 megabit and 1 gigabit flash memory
chips and Secure Digital Card controllers. The Company will guarantee one-half
of all FlashVision lease amounts up to a maximum of $215 million. In the first
nine months of 2001, draw downs totaling $121.9 million were made on the
equipment lease lines guaranteed by the Company to equip FlashVision's
manufacturing clean room with advanced wafer processing equipment. An additional
draw down of $25.0 million was completed in early October 2001. Under the terms
of the FlashVision lease agreements, the Company as guarantor is subject to
certain financial covenants. The Company obtained a compliance waiver for the
third quarter of 2001 and negotiated an amendment to the lease agreement which
includes a modification of the covenant requirements and requires the Company to
pledge cash and equity securities up to the full value of the outstanding
guaranteed lease commitments beginning in the fourth quarter of 2001. In the
event that the Company fails to comply with the revised covenants or the Company
or FlashVision otherwise breach the agreements and are unable to obtain a
compliance waiver, the Company may be required to repay the guaranteed amounts
outstanding under the lease agreement, which would adversely impact its
financial condition. The Company accounts for its investment in FlashVision
using the equity method, and recorded $995,000 as its share of the equity in
income of joint ventures in the third quarter of 2001, and total income of $2.1
million in the first nine months of 2001.
11. Due to the continued weakness in the semiconductor industry, the
value of the Company's investment in UMC had declined to $119.6 million at
September 30, 2001.It was determined that the decline in the market value of the
investment in UMC was other than temporary, as defined by generally accepted
accounting principles and a loss of $96.2 million, or $93.8 million net of tax
benefit, was recorded in accordance with Statement of Financial Accounting
Standards Number 115. This loss was included in loss on investment in foundry in
the third quarter of 2001. For the nine months ended September 30, 2001, the
total loss recognized based on the other than temporary decline in the value of
the UMC investment was $275.8 million or $207.8 net of tax. If the fair value of
the UMC shares declines further, it may be necessary to record additional
losses. In addition, in future periods, there may be a gain or loss, due to
fluctuations in the market value of UMC's stock, if the UMC shares are sold.
12. On July 4, 2000, SanDisk entered into a share purchase agreement to
make a $75.0 million investment in Tower Semiconductor, or Tower, in Israel,
representing approximately 10% ownership of Tower. The investment is subject to
the completion of certain milestones. During the first nine months of 2001,
Tower satisfied the closing conditions of the share purchase agreement and
completed the first two milestones. Under the terms of the agreement, the
Company invested $42.0 million to purchase 1,599,931 ordinary shares and obtain
wafer credits of $21.4 million. In September 2001, the Company agreed to convert
75% of its wafer credits to equity at a price of $12.75 per share and received
an additional 1,284,007 ordinary shares. Due to the decline in the value of
Tower's common stock, the Company recorded a loss of $5.4 million on this
exchange in the third quarter of 2001.
10
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.
Due to the continued weakness in the semiconductor industry, the value of
the Company's Tower investment and remaining wafer credits had declined to $22.6
million on September 30, 2001. It was determined that this decline was other
than temporary, as defined by generally accepted accounting principles and a
loss of $14.0 million was recorded in the third quarter of 2001. The loss on the
other than temporary decline in value and the loss on exchange of wafer credits
totaling $19.4 million, or $18.9 million net of tax benefit, were included in
loss on investment in foundry in the third quarter of 2001. Tower's completion
of the wafer foundry facility is dependent on its ability to obtain additional
financing for the foundry construction from equity and other sources and the
release of grants and approvals for changes in grant programs from the Israel
government's Investment Center. If Tower is unable to complete foundry
construction in a timely manner or successfully complete the development and
transfer of advanced CMOS process technologies and ramp-up of production, the
value of our investment in Tower will decline and we may be unable to obtain the
wafers needed to manufacture our products, which would harm our results of
operations. In addition, the value of our investment in Tower may be adversely
affected by a further deterioration of conditions in the market for foundry
manufacturing services and the market for semiconductor products generally. If
the fair value of the Tower investment declines further, it may be necessary to
record additional losses.
13. 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. During the first nine months of 2001, the Company invested $2.0
million in DPI. 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 $15.0 million in 2001
and 2002. 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 fourth quarter of 2001. The Company
accounts for this investment under the equity method, and recorded a loss of
$201,000 as its share of the equity in loss of joint venture in the third
quarter of 2001 and a total loss of $769,000 in the first nine months of 2001.
14. In September 2001, the Company signed an agreement with Sony
Corporation involving their Memory Stick card format. Under the agreement Sony
will supply the Company a portion of their Memory Stick output for resale under
the SanDisk brand name. Sony has also agreed to purchase a portion of their NAND
memory chip requirements from SanDisk provided that the Company meets market
competitive pricing for these components. In addition, the two companies agreed
to co-develop and co-own the specifications for the next generation Memory
Stick. Each company will have rights to manufacture and sell this new generation
Memory Stick. The Company cannot assure you that this new business will generate
substantial revenues or gross margin contributions for us. Consumers may prefer
to purchase the Sony brand Memory Stick over our SanDisk brand Memory Stick.
Furthermore, the second generation Memory Stick is still in the early stages of
development and is not expected to generate significant sales before 2003 at the
earliest. The Company cannot assure you that the second generation Memory Stick
will achieve commercial success in the marketplace when it is introduced.
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
Certain statements in this report are forward-looking statements under
Section 21E of the Securities and Exchange Act of 1934, as amended, based on our
current 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. Forward-looking statements in this report are
identified by words such as "believes," "anticipates," "expects," "intends,"
"may," "will" and other similar expressions. However, these words are not the
only way we identify forward-looking statements. In addition, any statements,
which refer to expectations, projections or other characterizations of future
events or circumstances are forward-looking statements. Such risks and
uncertainties are discussed below and in our Form 10-K for the year ended
December 31, 2000 and our various quarterly reports on form 10-Q 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.
11
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 nine months of fiscal 2001,
approximately 80% of our product sales were derived from 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, MultiMediaCard, Secure Digital card and SmartMedia card
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
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, our ability to match
supply with demand, excess supply from competition which may lead to lower
pricing and excess inventory, low order visibility, availability of foundry
capacity, 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 continue to comprise an
increasing share of our product revenues in the future, and that a substantial
and increasing 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".
12
All of our Flash memory card products require silicon wafers, the majority
of which are currently supplied by Toshiba from its Yokkaichi wafer fab in Japan
and through our FlashVision joint venture in Virginia, as well as UMC in Taiwan.
Semiconductor manufacturers, including UMC and Toshiba, as well as competitors
such as Samsung, 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 through the first nine months of 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 will likely decrease further causing our revenues and gross
margins 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 falls below our forecast and we are unable to reschedule or
cancel our orders for wafers or other long lead-time items such as controller
chips or printed circuit boards, we will end up with excess inventories, which
could result in higher operating expenses and reduced gross margins. 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 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.
During the startup and production ramp at the FlashVision fabrication facility,
while the unit output is still relatively low compared to the fixed expenses, we
expect our gross margins to be adversely impacted .See "Factors That May Affect
Future Results--Our Operating Results May Fluctuate Significantly."
In the third quarter of 2001, we recorded inventory charges of $16.1
million and startup costs related to our FlashVision joint venture foundry of
$8.5 million. In the first nine months of 2001, inventory charges totaled $100.6
million. These charges reflect substantially lower market pricing, reduced
demand for our products, startup costs related to our FlashVision joint venture
foundry and the write off of excess and obsolete inventory components and
equipment. 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 the inventory becomes obsolete. We
believe our current level of inventory is in line with the anticipated level of
near-term business. However, we are obligated to honor existing purchase orders
that we have placed with our suppliers, which may increase our inventory levels
if demand does not increase. 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 uses our cash, but can also 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 our gross margins and net earnings in the quarter in which they
occur. The total write downs to inventories and write offs of tooling and
equipment of $100.6 million in the first nine months of 2001 represented 43% of
product revenues, resulting in a decrease of product gross margins from positive
8% to negative 35%.
Export sales are an important part of our business. 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, such as
13
FlashVision. 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 and beyond, 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 and
reduce gross margins. We expect that the output of NAND flash wafers from
FlashVision will increase substantially in the fourth quarter 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 fourth
quarter. See "Factors That May Affect Future Results--We Must Achieve Acceptable
Manufacturing Yields."
Results of Operations
Product Revenues. Our product revenues were $57.3 million in the third
quarter of 2001, down $94.5 million or 62% from the third quarter of 2000.
Product revenues were $233.5 million in the first nine months of 2001, down
$138.1 million or 37% from the first nine months of 2000. During the third
quarter of 2001, total flash memory product units shipped decreased
approximately 50% over the third quarter of 2000, and for first nine months of
2001 unit shipments decreased 14% compared to the first nine months of 2000. In
the third quarter of 2001, the decrease in product revenues resulted from lower
sales of our MultiMediaCard, CompactFlash and Flash Chipset products primarily
due to lower sales to our OEM customers. For the first nine months of 2001, the
decrease in product revenues resulted from lower unit sales of our
MultiMediaCard and Flash Chipset products and lower average selling prices.
CompactFlash products represented 55% of product revenues and MultiMediaCards
10% of product revenues for the first nine months of 2001, compared to 46% and
22%, respectively, in the first nine months of 2000. Our FlashDisk products
represented 11% of product revenues in the first nine months of 2001 compared to
15% for the same period of the prior year.
The average selling price per megabyte of memory shipped declined 34% in
the third quarter of 2001 compared to the second quarter of 2001, due primarily
to competitive pricing pressures driven by excess supply in the market. Due to
the intense price competition experienced throughout 2001, our average selling
price per megabyte declined 59% in the first nine months of 2001. The decline in
average selling price per megabyte was partially offset by an increase in the
average megabytes per unit associated with an increase in sales of higher
capacity cards particularly in the retail channel. The 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.
Product revenues in the third quarter of 2001 declined $30.8 million or 35%
compared to the second quarter of 2001. The decline was primarily due to a 34%
decrease in the average selling price per megabyte for our products due to the
continuing competitive pricing pressures resulting from excess supply in the
market for flash memory products. Total units shipped decreased 30% primarily
due to a decline in sales to our OEM customers. However, total megabytes sold
increased 17% due to a shift to higher capacity cards particularly in the retail
channel.
Sales to the consumer market represented approximately 80% of product
revenues, while the telecommunications/ industrial market made up the remaining
20% in the first nine months of 2001. This compares to approximately 77% and
23%, respectively, in the first nine months of 2000. Sales to the retail channel
represented 67% and 47% of product revenues in the third quarter and first nine
months of 2001, compared to 25% and 26% for the same periods of the prior year.
Export sales represented 42% and 52% of our product revenues in the third
quarter and first nine months of 2001, compared to 56% and 54% in the third
quarter and first nine months of 2000. We expect international sales to continue
to represent a significant portion of our product revenues.
Our top ten customers represented approximately 52% and 54% of our product
revenues in the third quarter and first nine months of 2001, compared to 56% and
54% in the same periods of 2000. In the first nine months of 2001, sales to one
customer totaled 12% of product revenue, and there was no customer that
represented more than 10% of product sales in the first nine months 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.
14
License and Royalty Revenues. We earn patent license fees and royalties
under several cross-license agreements. License and royalty revenues from patent
cross-license agreements were $8.6 million and $40.9 million in the third
quarter and first nine months of 2001, compared to $19.0 million and $52.5
million in the same periods of 2000. The decrease in 2001 was primarily due to
lower royalty bearing sales by our licensees due to weak market conditions.
Revenues from licenses and royalties increased to 15% of total revenues in the
first nine months of 2001 from 12% in the first nine months of 2000. Our
revenues from patent license and royalties fluctuate quarterly based on the
timing of revenue recognition under our various agreements.
Gross Profits. In the third quarter and first nine months of 2001, gross
profits were negative $23.5 million, or negative 36% of total revenues, and
negative $40.6 million, or negative 15% of total revenues, compared to positive
$69.0 million, or 40% of total revenues, and positive $170.0 million, or 40% of
total revenues, in the same periods of 2000. In the third quarter and first nine
months of 2001, product gross margins were negative 56% and negative 35% of
product revenues, compared to positive 33% and positive 32% the same periods of
2000. Cost of sales in the third quarter of 2001 included inventory charges
totaling $16.1 million and startup costs related to our FlashVision joint
venture foundry of $8.5 million, and the first nine months of 2001 included
charges totaling $100.6 million. These charges reflect substantially lower
market pricing, reduced demand for our products, startup costs related to our
FlashVision joint venture foundry, and the write off of excess and obsolete
inventory components and equipment. Excluding these charges, our product gross
margin for the third quarter and first nine months of 2001 would have been
negative 13% and positive 8%, respectively. Our product gross margins were also
adversely affected by the 59% decrease in average selling prices per megabyte
experienced in the first nine months of 2001.
Operating Expenses. Given current market conditions, we have instituted
strict expense control measures. These measures in the first nine months of 2001
included a reduction in our work force in the first quarter of 2001 and cuts in
discretionary spending. In the third quarter of 2001 we announced a plan to
implement a second reduction in our work force, a company wide temporary salary
reduction and holiday week company shutdown in the fourth quarter of 2001. After
the fourth quarter workforce reduction, we will have less than 600 full-time and
temporary employees down from approximately 1,000 at the beginning of 2001.
However, we are continuing to invest in research and development of advanced
technologies and future products.
Research and Development Expenses. 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 $14.7 million in the third quarter of 2001, up $1.6
million or 13% from $13.0 million in the third quarter of 2000. In the first
nine months of 2001, research and development expenses were $45.2 million, up
$12.4 million or 38% from $32.8 million in the first nine months of 2000. These
increases were primarily due to 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 22% and 16% of total revenues in the third quarter and first nine
months of 2001, compared to 8% in the each of the same periods 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 our joint venture with Toshiba and the
development of advanced controller chips.
Sales and Marketing Expenses. 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
manufacturers representative commissions, advertising and tradeshow expenses.
Sales and marketing expenses were $10.7 million in the third quarter of 2001,
down $1.8 million or 15% from $12.5 million in the third quarter of 2000. In the
first nine months of 2001, sales and marketing expenses were $31.4 million, down
$3.2 million or 9% from $34.6 million in the first nine months of 2000. These
decreases were primarily due to decreased variable compensation and selling
expenses related to reduced revenue levels, which were partially offset by
higher marketing expenses related to the increase in revenue in our retail
channel as a percentage of total product revenues. Sales and marketing expenses
represented approximately 16% and 11% of total revenues in the third quarter and
first nine months of 2001, compared to 7% and 8% for each of the same periods of
2000. We expect sales and marketing expenses to increase, as we continue to
develop our retail channel and brand awareness for our products and as we
increase our marketing activities for our Secure Digital Card products.
15
General and Administrative Expenses. 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 $4.0 million in the third quarter of 2001, down
$3.9 million or 49% from $7.9 million in the third quarter of 2000. In the first
nine months of 2001, general and administrative expenses were $12.6 million,
down $6.1 million or 33% from $18.7 million in the first nine months of 2000.
These decreases were primarily due to a decline in legal fees and lower
allowance for doubtful account expense related to lower revenues and accounts
receivable balances. General and administrative expenses represented 6% and 4.5%
of total revenues in the third quarter and first nine months of 2001 compared to
4.6% and 4.4% for the same periods of 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 expected growth and our
investments in infrastructure.
Restructuring Charges. In the third quarter of 2001, we adopted a plan to
transfer all of our card assembly and test manufacturing operations from our
Sunnyvale location to offshore subcontractors. As a result we recorded a
restructuring charge of $8.5 million, which includes workforce reduction cost of
$1.1 million, equipment write-off charges of $1.0 million and lease commitments
of $6.4 million on a vacated warehouse facility. See Note 5 of Notes to
Condensed Consolidated Financial Statements.
In the third quarter of 2001, we announced a plan to reduce our workforce
by a total of 144 employees through involuntary employee separations from
October 2001 through January 2002 and recorded a charge of $1.1 million for
employee separations in the third quarter of 2001.
As a part of our plan to transfer all card assembly and test
manufacturing operations to offshore subcontractors, we abandoned excess
equipment and recorded a charge of $6.4 million in the third quarter of fiscal
2001.
We are attempting to sublease one warehouse building in San Jose,
California. Given the current real estate market condition in the San Jose area,
we do not expect to be able to sublease this building before the end of 2003 and
as a result, we have recorded a charge of $1.0 million in the third quarter of
2001.
Cash expenditures related to the workforce reduction will be paid in the
fourth quarter of 2001 and the first quarter of 2002. Amounts related to the
abandonment of excess leased facilities will be paid as the lease payments are
due in 2002 and 2003. We believe that the savings resulting from the
restructuring activity will contribute to a reduction in manufacturing and
operating expense levels by approximately $11.8 million in fiscal 2002.
Equity in Income of Joint Ventures. In the third quarter and first nine
months of 2001, equity in income of joint ventures of $0.8 million and $1.3
million included our share of interest income, net of expenses, from our
FlashVision joint venture and losses from our DigitalPortal joint venture. As
FlashVision utilizes cash to fund its perations in future quarters, its interest
income will decrease. DPI's losses are expected to increase substantially as
operations are ramped up.
Interest Income. Interest income was $2.6 million and $9.8 million in the
third quarter and first nine months of 2001 compared to $5.9 million and $17.3
million in the same periods of 2000. The decreases are a result of our lower
cash and investment balances, resulting from our investments in Tower and
FlashVision, as well as cash used in operations, and the lower interest rates in
2001 when compared to 2000. We expect interest income to decrease in the fourth
quarter of 2001 as cash balances will decrease due to the utilization of cash to
fund operating activities and internal capital acquisitions and investments due
to the transition from NOR to NAND technology.
Loss on Investment in Foundry. As discussed in footnote 11 and 12 of the
financial statements included in this report, the market value of our
investments in UMC and Tower Semiconductor have declined significantly.
Due to the continued weakness in the semiconductor industry, the
value of the Company's investment in UMC had declined to $119.6 million at
September 30, 2001. It was determined that the decline in the market value of
the investment in UMC was other than temporary, as defined by generally accepted
accounting principles and a loss of $96.2 million, or $93.8 million net of
taxes, was recorded in accordance with Statement of Financial Accounting
Standards Number 115. This loss was included loss on investment in foundry in
the third quarter of
16
2001. For the nine months ended September 30, 2001 the total loss recognized
based on the other than temporary decline in the value of the UMC investment was
$275.8 million or $207.8 million net of tax. If the fair value of our UMC
investment declines further, it may be necessary to record additional losses. In
addition, in future periods, there may be a gain or loss, due to fluctuations in
the market value of UMC's stock, if the UMC shares are sold.
Due to the continued weakness in the semiconductor industry, the value of
our Tower investment and wafer credits had declined to $22.5 million on
September 30, 2001. It was determined that this decline was other than
temporary, as defined by generally accepted accounting principles and a loss of
$14.0 million was recognized. In addition, we recorded a loss of $5.4 million on
our exchange of 75% of our Tower wafer credits for 1,284,007 ordinary shares at
$12.75 per share. These losses totaling $19.4 million, or $18.9 million net of
tax benefit, were recorded in loss on foundry investment in the third quarter of
2001. If the fair value of our Tower investment declines further, it may be
necessary to record additional losses.
Other Income (Expense), Net. Other expense, net was $0.5 million and $2.5
million in the third quarter and first nine months of 2001 compared to other
expense, net of $0.4 million and other income, net of $0.7 million in the same
periods of 2000. The expense in 2001 was primarily due to foreign exchange
losses on our Japanese Yen denominated assets, compared to gains on Japanese Yen
denominated assets in 2000.
Provision for Income Taxes. Our effective income tax benefit rate was
2.5% for the third quarter and 24.0% for the first nine months of 2001, as
compared with a provision rate of 37.5% and 39.7% for the same periods in 2000.
The change in the third quarter 2001 effective rate primarily reflects the
impact of the UMC and Tower write-downs on our net operating loss carrybacks,
and our projected inability to fully benefit from our net cumulative operating
losses experienced in 2001.
Liquidity and Capital Resources
As of September 30, 2001, we had working capital of $350.0 million, which
included $47.3 million in cash and cash equivalents and $226.4 million in
short-term investments, excluding our investment in UMC. Operating activities
used $46.9 million of cash in the first nine months of 2001 primarily due to our
net loss, a relief of future tax obligations of $120.3 million, a decrease in
accounts payable of $18.8 million and a decrease in deferred revenue of $33.8
million. These were partially offset by cash provided by a decline in accounts
receivable of $62.7 million and a reduction in inventories of $56.8 million,
reflecting the reduced value. In the first nine months of 2000, operating
activities provided $38.2 million of cash, primarily from net income, an
increase in future tax obligations of $138.4 million and an increase in accounts
payable of $34.4 million, which was partially offset by an increase in accounts
receivable of $81.1 million, due to increased revenues, and an increase in
inventories of $31.6 million.
Net cash used in investing activities in the first nine months of 2001 of
$21.2 million, included our investments in Tower of $20.4 million, our
additional investment in the FlashVision foundry joint venture of $15.0 million,
investments in DPI of $2.0 million, and capital equipment purchases of $18.2
million, which were partially offset by net proceeds from short term investments
of $36.2 million. In the first nine months of 2000, investing activities used
$23.1 million due to an investment in FlashVision of $36.9, and investment in
Tower Semiconductor of $20.0 million and capital equipment purchases of $19.0
million, offset by net proceeds of short term investments of $52.9 million. In
the first nine months of both 2001 and 2000, cash provided by financing
activities of $8.1 million and $10.9 million 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 our USIC shares, we received 111 million
UMC shares. These shares were valued at approximately $396.0 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
decline in UMC's stock price from the continued weakness in the semiconductor
industry, the value of the Company's investment in UMC had declined to $119.6
million at September 30, 2001. It was determined that the decline in the market
value of the investment in UMC was other than temporary, as defined by generally
accepted accounting principles and a loss of $96.2 million, or $93.8 million net
of taxes, was recorded in accordance with Statement of Financial Accounting
17
Standards Number 115. This loss was included in loss on investment in foundry in
the third quarter of 2001. For the nine months ended September 30, 2001 the
total loss recognized based on the other than temporary decline in the value of
our UMC investment was $275.8 million or $207.8 net of tax. If the fair value of
our UMC investment declines further, it may be necessary to record additional
losses. In addition, in future periods, there may be a gain or loss, due to
fluctuations in the market value of UMC's stock, if the UMC shares are sold.
In January 2001, we invested the final $15 million of our $150 million
cash commitment 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. In addition, we will guarantee one-half of all
FlashVision lease amounts up to a maximum of $215 million. In the first nine
months of 2001, draw downs totaling $121.9 million were made on the equipment
lease lines guaranteed by us to equip FlashVision's manufacturing clean room
with advanced wafer processing equipment. An additional draw down of $25.0
million was completed in early October 2001. Under the terms of the FlashVision
lease agreements, we as guarantor are subject to certain financial covenants. We
obtained a compliance waiver for the third quarter and negotiated an amendment
to the lease agreement which includes a modification of the covenant
requirements and requires us to pledge cash and equity securities up to the full
value of the outstanding guaranteed lease commitments beginning in the fourth
quarter of 2001. In the event that we fail to comply with the revised covenants
or we or FlashVision otherwise breach the agreements and are unable to obtain a
compliance waiver, we may be required to repay the guaranteed amounts
outstanding under the lease agreement, which would adversely impact our
financial condition.
On July 4, 2000, we entered into a share purchase agreement to make a
$75.0 million investment in Tower Semiconductor, or Tower, in Israel,
representing approximately 10% ownership of Tower. The investment is subject to
the completion of certain milestones. During the first nine months of 2001,
Tower satisfied the closing conditions of the share purchase agreement and
completed the first two milestones. Under the terms of the agreement, we
invested $42.0 million to purchase 1,599,931 ordinary shares and obtain wafer
credits of $21.4 million. In September 2001, we agreed to convert 75% of our
wafer credits to equity at a price of $12.75 per share and received an
additional 1,284,007 ordinary shares. Due to the decline in the value of Tower's
common stock, we recorded a loss of $5.4 million on this exchange in the third
quarter of 2001. 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. Due to the continued
weakness in the semiconductor industry, the value of our Tower investment and
remaining wafer credits had declined to $22.6 million on September 30, 2001. It
was determined that this decline was other than temporary, as defined by
generally accepted accounting principles and a loss of $14.0 million was
recorded in the third quarter of 2001. Tower's completion of the wafer foundry
facility is dependant on its ability to obtain additional financing for the
foundry construction from equity and other sources and the release of grants and
approvals for changes in grant programs from the Israel government's Investment
Center. If Tower is unable to complete foundry construction in a timely manner
or successfully complete the development and transfer of advanced CMOS process
technologies and ramp-up of production, the value of our investment in Tower
will decline and we may be unable to obtain the wafers needed to manufacture our
products, which would harm our results of operations. In addition, the value of
our investment in Tower may be adversely affected by a further deterioration of
conditions in the market for foundry manufacturing services and the market for
semiconductor products generally. If the fair value of the Tower investment
declines further, it may be necessary to record additional losses.
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, SanDisk and PMI will each make an initial investment of
$4.0 million and secure lease financing for the purchase of the kiosks. During
the first nine months of 2001 we invested $2.0 million in DPI. The total value
of the lease financing will depend on the number of kiosks deployed by the joint
venture. We estimate that we will guarantee equipment lease arrangements of
approximately $15.0 million in 2001 and 2002. PMI will manufacture the kiosks
for the joint venture and will install and maintain the kiosks under contract
with the joint venture. We expects the first kiosks to be deployed in pilot
programs in select retail stores in the United States starting in the fourth
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 capital equipment lease arrangements
related to our FlashVision, L.L.C. joint venture and the planned equipment lease
arrangements related to our Digital Portal, Inc. joint venture will be
sufficient to meet our currently anticipated working capital, capital equipment
expenditures, 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.
18
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 or declining 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, which may cause an acceleration in the decline
in our average selling prices;
. 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;
. 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;
. fluctuations in our 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;
. reduced sales to our retail customers if consumer confidence
continues to be adversely impacted by the September 11 terrorist
attacks and subsequent events.
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. 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, MultiMediaCard and
Secure
19
Digital Card, are sold into emerging consumer markets, it has been
difficult to accurately forecast future sales. In addition, 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. A substantial
majority of our quarterly sales are currently, and have historically been, from
orders received and fulfilled in the same quarter, which makes accurate
forecasting very difficult. 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 in certain business areas or
increase our operating expenses in the future 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, 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, MultiMediaCard and Secure
Digital Card products, which currently represent the majority of our product
revenues, have lower average selling prices and gross margins than our higher
capacity FlashDisk and FlashDrive products. We believe that sales of
CompactFlash, MultiMediaCard and Secure Digital Card 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. Due to continued oversupply in flash memory foundry
capacity throughout 2001 and the economic slow-down in 2001, the decline in our
average selling prices has been much more severe than in 2000. We have already
experienced a 59% decline in our average selling price per megabyte of memory
shipped in the first nine months of 2001. If we cannot reduce our product
manufacturing costs in future periods to offset further price reductions, our
gross margins and net profitability will suffer.
In the fourth quarter we expect to commence retail sales of Memory Stick
cards supplied to us under an OEM supply and purchase agreement with Sony
Corporation. We cannot assure you that the gross margins on the sale of Memory
Stick products will be comparable to the gross margins from the sale of our
other products.
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 the fourth
quarter of 2001 and beyond, 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 our product revenues, gross margins and
net income fluctuate significantly with changes in license and royalty revenues.
We receive royalty revenue reports from certain of our licensees twice a year,
and record all revenues one quarter in arrears. We align estimates to actual
reported royalty revenues when reports are received.
Continuing declines in our average sales prices may result in declines in our
gross margins.
In 2000, our average price per megabyte shipped declined 22% compared to
1999, and we have experienced a 59% decline in the first nine months of 2001.
Flash data storage markets are intensely competitive, and price reductions for
our products are necessary to meet consumer price points. Due to recent
increases in flash memory
20
foundry capacity and the worldwide economic slow-down in 2001, we expect that
price declines for our products in the next several quarters could be
significant. If we cannot reduce our product manufacturing costs in the future
periods 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 which currently exceeds customer demand, causing excess
supply in the markets for our products and significant declines in average
selling prices. If this situation continues throughout the fourth quarter of
2001 and beyond, price declines for our products could be significant. If we
cannot reduce our product manufacturing costs to offset these reduced prices,
our gross margins and net profitability will suffer.
Our business depends upon consumer products.
In 2000, and the first nine months 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 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,
MultiMediaCard, Secure Digital card Smartmedia card and Memory Stick 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 the future.
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, which may result in delays or product
recalls; and
. production delays.
21
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 and Nand MLC flash technology
We have developed new products based on D2 NOR 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. As we transition from NOR to NAND technology, we expect to develop
NAND MLC (Multi Level Cell) products which are the D2 NOR equivalents, and which
will allow each NAND memory cell to store two data bits in place of one bit.
NAND MLC technology is highly complex and has never been successfully
commercialized. We may not be able to manufacture future generations of NAND MLC
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 jointly
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. 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 will likely reduce demand for our
MultiMediaCard and CompactFlash card products. See "--The success of our
business depends on emerging markets and new products."
Memory Stick Products
In September 2001 we signed an agreement with Sony Corporation involving
their Memory Stick card format. Under the agreement Sony will supply us a
portion of their Memory Stick output for us to resell under the SanDisk brand
name. Sony has also agreed to purchase a portion of their NAND memory chip
requirements from us provided that we meet market competitive pricing for these
components. In addition, the two companies agreed to co- develop and co-own the
specifications for the next generation Memory Stick. Each company will have all
rights to manufacture and sell this new generation Memory Stick. We cannot
assure you that this new business will generate substantial revenues or gross
margin contributions for us. Consumers may prefer to purchase the Sony brand
Memory Stick over our SanDisk brand Memory Stick. Furthermore, the second
generation Memory Stick is still in the early stages of development and is not
expected to generate significant sales before 2003 at the earliest. We cannot
assure you that the second generation Memory Stick will achieve commercial
success in the marketplace when it is introduced.
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 sales and
customer support staffs. If the current soft market conditions continue through
the fourth quarter of this year and beyond, 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 inventory write offs and have a material adverse
effect on our business, results of operations and financial condition.
22
In connection with our ramping up of NAND flash wafer production through
the FlashVision joint venture, we expect to complete final purchases of NOR
flash wafers from UMC in the fourth quarter of 2001. In the third quarter of
2001, we began to purchase controller wafers from UMC and are continuing
development of advanced flash memory technology at the 0.15 micron technology
design rules.
We depend on third party foundries for silicon wafers.
All of our flash memory card products require silicon wafers, the majority
of which are currently supplied by Toshiba's wafer fab at Yokkaichi, Japan and
through our FlashVision joint venture in Virginia, as well as UMC in Taiwan. If
Toshiba, Flashvision and UMC are uncompetitive or are unable to satisfy these
requirements, our business, financial condition and operating results may
suffer. Any disruption in supply from these sources 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 Toshiba, Flashvision
and 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, 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. To date, we have invested a total of $150 million in
cash, and have guaranteed $147 million in equipment lease lines to equip
Toshiba's Dominion Semiconductor manufacturing clean room with advanced wafer
processing equipment. We will guarantee a total of up to $215 million in
equipment lease lines. 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. 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, although we expect significant forward progress in the
fourth quarter of 2001. 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 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, which began late in the second quarter of
2001, equipment depreciation began and line-operating expenses increased
substantially. While the wafer output is still relatively low, the cost of
wafers from the Dominion Virginia fab facility is significantly higher than the
cost of wafers from our other suppliers. This will negatively impact our overall
product gross margins until the flash wafer output from Dominion reach a more
optimum level. Under our agreement with Toshiba, we are committed to
23
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. In order for us to
sell NAND based CompactFlash, MultiMediaCards and Secure Digital Cards, we have
been developing 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 $75.0
million investment in Tower Semiconductor, or Tower, in Israel, representing
approximately 10% ownership of Tower. The investment is subject to the
completion of certain milestones. During the first nine months of 2001, Tower
satisfied the closing conditions of the share purchase agreement and completed
the first two milestones. Under the terms of the agreement, we invested $42.0
million to purchase 1,599,931 ordinary shares and obtain wafer credits of $21.4
million. In September 2001, we agreed to convert 75% of our wafer credits to
equity at a price of $12.75 per share and received an additional 1,284,007
ordinary shares. Due to the decline in the value of Tower's common stock, we
recorded a loss of $5.4 million on this exchange in the third quarter of 2001.
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. Due to the continued weakness in the
semiconductor industry, the value of our Tower investment and remaining wafer
credits had declined to $22.6 million on September 30, 2001. It was determined
that this decline was other than temporary, as defined by generally accepted
accounting principles and a loss of $14.0 million was recorded in the third
quarter of 2001.
Tower's completion of the wafer foundry facility is dependent on its
ability to obtain additional financing for the foundry construction from equity
and other sources and the release of grants and approvals for changes in grant
programs from the Israel government's Investment Center. If Tower is unable to
complete foundry construction in a timely manner or successfully complete the
development and transfer of advanced CMOS process technologies and ramp-up of
production, the value of our investment in Tower will decline and we may be
unable to obtain the wafers needed to manufacture our products, which would harm
our results of operations. In addition, the value of our investment in Tower may
be adversely affected by a further deterioration of conditions in the market for
foundry manufacturing services and the market for semiconductor products
generally. If the fair value of the Tower investment declines further, it may be
necessary to record additional losses.
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.
In the second and third quarters of 2001, we experienced a substantial drop
in demand from our MultiMediaCard customers, which we believe is attributable to
the switch by these customers to the Secure Digital Card as well as the
generally soft market conditions.
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
24
Toshiba plan to employ Toshiba's 0.16 micron and future 0.13 micron NAND flash
integrated circuit manufacturing technology and SanDisk's multi-level 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
began employing the 512 megabit technology in the second half of 2001, and
expect to commence shipments of cards employing the 1 gigabit technology in the
first quarter of 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 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, or if our cost structure is not competitive, 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 have experienced in the first nine months of 2001 and
continue to experience, 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. Currently we are experiencing severe price competition for
our CompactFlash and SmartMedia products which is adversely impacting our
product gross margins and overall profitability.
Our international operations make us vulnerable to changing conditions and
currency fluctuations.
Political risks
Currently, a significant portion of our flash memory wafers are produced by
Toshiba in Japan and UMC in Taiwan. We also use third-party subcontractors in
Taiwan for the assembly and testing of some of our card and component 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
card 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 relatively secure geographic location, the unrest may expand and even if it
remains at current levels, could cause scheduling delays, as well as economic
uncertainty, which could cause potential foundry customers to go elsewhere for
their foundry business. Moreover, if U.S. military actions in Afghanistan
result in retaliation against Israel, Tower's fabrication facility and our
engineering design center in Israel may be adversely impacted. 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.
25
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. Furthermore, if the current depressed business
conditions for semiconductor wafers persists beyond 2002, Tower may be unable to
operate their new fab at an optimum capacity utilization, which would cause them
to operate at a loss. 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
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 Toshiba's Yokkaichi fab, for a portion
of our flash memory wafers as we ramp up our wafer production at our FlashVision
joint venture in Virginia.
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 and Celestica, Inc.
in China. These 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. In
the third quarter of 2001, we adopted a plan to transfer all of our card
assembly and test manufacturing operations from our Sunnyvale location to
offshore subcontractors in the fourth quarter of 2001. 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
26
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.
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, PNY 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 entered into 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 among 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 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, Sony 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
27
storage applications and the Secure MultiMediaCard from Hitachi and Infineon.
Each competing standard is mechanically and electronically incompatible with
CompactFlash, MultiMediaCard and Secure Digital Card. If a manufacturer of
digital cameras or other consumer electronic devices designs in one of these
alternative competing standards, CompactFlash, MultiMediaCard, or Secure Digital
Card 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 1 gigabyte type I CompactFlash memory cards that we
introduced in the fourth quarter of 2001 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.
Sony's consumer electronics products, which use the Memory Stick, may erode
our overall market share for other cards formats. 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, Secure Digital
and CompactFlash products may decline. Our MultiMediaCard products also have
faced significant competition from Toshiba's SmartMedia flash cards. 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. Although this storage device has not yet been
widely adopted outside of Sanyo, 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. Sales to our top 10 customers accounted for
approximately 52% and 54% of our product revenues in the third quarter and first
nine months of 2001, compared to 56% and 49% in the same periods of 2000. In the
first nine months of 2001, sales to one customer totaled 12% of product sales,
and there was no customer that represented more than 10% of product sales in the
first nine months 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
28
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 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 FlashVision fabrication facility
that we are co-developing with Toshiba in Virginia, 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, and will be tasked to
"copy exactly" the same manufacturing flow employed by Toshiba in Yokkaichi,
Japan, 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 do not 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
29
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, Sony, 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.
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
Litigation is subject to inherent risks and uncertainties that may cause
actual results to differ materially from our expectations. Factors that could
cause litigation results to differ include, but are not limited to, the
discovery of previously unknown facts, changes in the law or in the
interpretation of laws, and uncertainties associated with the judicial
decision-making process. Furthermore, parties that we may sue for patent
infringement may countersue us for infringing their patents. See Part II, Item 1
for further discussion of litigation which we are currently involved in.
Our rapid growth may strain our operations.
In 2000, we experienced rapid growth, which 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. In the past, 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.
Terrorist attacks and threats, and government responses thereto, may negatively
impact all aspects of our operations, revenues, costs and stock price.
The recent terrorist attacks in the United States, and the U.S.
retaliation for these attacks, and related decline in consumer confidence and
continued economic weakness have had a substantial adverse impact on our retail
sales. If consumer confidence does not recover our revenues and profitability
may be adversely impacted in the fourth quarter of 2001 and beyond.
In addition, any similar future events may disrupt our operations or
those of our customers and suppliers and may affect the availability of
materials needed to manufacture our products or the means to transport those
materials to manufacturing facilities and finished products to customers. In
addition, these events have had and may continue to have an adverse impact on
the U.S. and world economy in general and consumer confidence and spending in
particular, which could harm our sales. Any of these events could increase
volatility in the U.S. and world financial markets which could harm our stock
price and may limit the capital resources available to us and our customers or
suppliers. This could have a significant impact on our operating results,
revenues and costs and may result in increased volatility in the market price of
our common stock.
30
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 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 September 30, 2001 our stock price fluctuated significantly from a
low of $8.08 to a high of $74.75. 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 and semiconductor 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.
Our Digital Portal Inc. (DPI) Joint Venture has an unproven product and an
untested market.
The Digital Photo Kiosk currently under development for DPI has
experienced delays in its U.S. market rollout, due primarily to modifications to
improve its operation as a standalone, reliable, user-friendly photo printing
kiosk. We cannot assure you that these kiosks, once introduced will function
reliably as intended, or that they will receive favorable acceptance from
consumers in a reasonable period of time. If DPI is unsuccessful our financial
results may be harmed.
31
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.
32
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
From time to time, it has been and may continue to be necessary to initiate
or defend litigation against third parties to preserve and defend our
intellectual property rights. These parties could in turn bring suit against us.
On May 10, 2001, we filed a declaratory judgment action in the United States
District Court for the Northern District of California against an individual
named Fredrik Buch seeking a declaration from the Court that Mr. Buch made no
contribution to and is not an inventor of twenty SanDisk patents (the
"Patents"). We filed this action in response to a written demand made by Mr.
Buch in which he claimed to have conceived of certain architectures for
fault-tolerant computer memories, which he also claimed to have disclosed to Dr.
Eli Harari, SanDisk's President and CEO, over 15 years ago. Mr. Buch further
claimed that the architectures he disclosed were incorporated in and became part
of the inventions claimed in the Patents, and that, as a consequence, he should
be named as an inventor on the Patents. Mr. Buch has never been an employee of
SanDisk and has never met any of the inventors of the Patents, other than Dr.
Harari. Mr. Buch filed an amended answer and counterclaims on June 19, 2001. In
his counterclaims, Mr. Buch sought to have the Court correct the inventorship of
the Patents to include his name, damages for misappropriation of trade secrets,
and recovery for the unjust enrichment of SanDisk by virtue of the revenue it
received from its patent license agreements relating to the Patents. On August
10, 2001, based on evidence we provided to Mr. Buch and to his counsel, Mr. Buch
voluntarily dismissed with prejudice all of his claims against SanDisk, and as a
result, we dismissed our declaratory judgment action against Mr. Buch. We did
not provide any monetary or any other type of compensation to Mr. Buch as part
of Mr. Buch's dismissal.
On May 10, 2001, we filed a complaint for patent infringement against Viking
Components, Inc. in the United States District Court for the Northern District
of California. The complaint seeks damages and an injunction against Viking
Components from making, selling or importing all Viking CompactFlash(TM) cards
that use controllers incorporated in CompactFlash cards that were found to
infringe SanDisk's U.S. Patent No. 5,602,987 in a previous lawsuit filed by
SanDisk against Lexar Media, Inc. On or about October 29, 2001, the parties
settled this litigation. Viking consented to a permanent injunction enjoining
Viking from selling in the United States CompactFlash cards manufactured by
Viking that incorporate certain of Lexar Media, Inc.'s controllers.
On or about August 3, 2001, the Lemelson Medical, Education & Research
Foundation (the "Lemelson Foundation") filed a complaint for patent infringement
against us. The suit, captioned Lemelson Medical, Education, & Research
Foundation, Limited Partnership vs. Broadcom Corporation, et al., Civil Case No.
CIV01 1440PHX MS, was filed in the United States District Court, District of
Arizona. The complaint alleges that we, and four other defendants, have
infringed certain patents held by the Lemelson Foundation pertaining to bar code
scanning technology. By its complaint, the Lemelson Foundation requests that
SanDisk be enjoined from its allegedly infringing activities and seeks
unspecified damages. To date, we have not been served with the complaint.
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.
Litigation is subject to inherent risks and uncertainties that may cause
actual results to differ materially from our expectations. Factors that could
cause litigation results to differ include, but are not limited to, the
discovery of previously unknown facts, changes in the law or in the
interpretation of laws, and uncertainties associated with the judicial
decision-making process.
Item 2. Changes in Securities
None
33
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
Registrant and Harris Trust and Savings Bank.(4)
4.9 First Amendment to Rights Agreement dated October 22, 1999,
between Harris Trust and Savings Bank and the Registrant.(11)
4.10 Second Amendment to Rights Agreement dated as of December 17,
1999, between Harris Trust and Savings Bank and the Registrant.
(10)
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 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)
34
Exhibit
Number Exhibit Title
------ -------------
10.33 Master Agreement, dated as of May 9, 2000, by and among the
Registrant, Toshiba Corporation and Semiconductor North America,
Inc.(13),(1)
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),(1)
10.36 Product Development Agreement, dated as of May 9, 2000, by and
between the Registrant and Toshiba Corporation.(13),(1)
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),(1)
10.42 Non-Solicitation Agreement, dated August 7, 2000, by and between
the Registrant, DigitalPortal Inc. and Photo-Me International,
Plc.(14),(1)
10.43 Exclusive Product Purchase Agreement, dated as of August 7, 2000,
by and between Photo-Me, International Plc., and DigitalPortal
Inc. (14),(1)
10.44 Stockholders' Agreement, dated as of August 7, 2000, by and among
the Registrant, DigitalPortal Inc. and Photo-Me, International,
Plc.(14),(1)
10.45 Bylaws of DigitalPortal Inc.(14),(1)
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),(1)
10.49 Master Lease agreement between FlashVision L.L.C. Corporation to
ABN AMRO Bank N.V. (16),(1)
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),(1)
___________
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 1999 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.
35
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
36
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: November 12, 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.)
37