- -------------------------------------------------------------------------------
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM 10-Q
(Mark One)
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarter ended April 30, 1999 OR
_ TRANSACTION REPORT PURSUANT TO SECTION 13 OR 15 (D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ________ to __________
Commission file number 000-22009
NEOMAGIC CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 77-0344424
[State or other jurisdiction [I.R.S. Employer Identification No.]
of incorporation or organization]
3260 JAY STREET
SANTA CLARA, CALIFORNIA 95054
[Address of principal executive offices] [Zip Code]
(408) 988- 7020
Registrant's telephone number, including area code
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
The number of shares of the Registrant's Common Stock, $.001 par value,
outstanding at May 2, 1999 was 25,000,867
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Page 1 of 25
NEOMAGIC CORPORATION
FORM 10-Q
INDEX
PAGE
PART I. CONSOLIDATED CONDENSED FINANCIAL INFORMATION
Item 1. Unaudited Consolidated Condensed Financial Statements:
Consolidated Condensed Statements of Income
Three months ended April 30, 1999 and 1998 3
Consolidated Condensed Balance Sheets
April 30, 1999 and January 31, 1999 4
Consolidated Condensed Statements of Cash Flows
Three months ended April 30, 1999 and 1998 5
Notes to Unaudited Consolidated Condensed Financial Statements 6-8
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 9-23
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 24
Item 2. Changes in Securities 24
Item 3. Defaults Upon Senior Securities 24
Item 4. Submission of Matters to a Vote of Security Holders 24
Item 5. Other Information 24
Item 6. Exhibits and Reports on Form 8-K 24
Signatures 25
Page 2 of 25
Part I. Financial Information
Item I. Financial Statements
NEOMAGIC CORPORATION
CONSOLIDATED CONDENSED STATEMENTS OF INCOME
(In thousands, except per share data)
(Unaudited)
Three Months Ended
April 30, April 30,
1999 1998
------------- --------------
Net sales $72,397 $47,738
Cost of sales 45,609 27,510
------------- --------------
Gross margin 26,788 20,228
Operating expenses:
Research and development 9,773 6,252
Sales, general and administrative 5,246 4,356
In-process research and development 5,348 -
------------- --------------
Total operating expenses 20,367 10,608
Income from operations 6,421 9,620
Interest income and other 784 975
Interest expense (252) (324)
------------- --------------
Income before income taxes 6,953 10,271
Provision for income taxes 3,692 3,595
------------- --------------
Net income $ 3,261 $ 6,676
============= ==============
Basic net income per share $ .13 $ .29
Diluted net income per share $ .13 $ .26
Weighted common shares outstanding 24,476 23,295
Weighted common shares outstanding assuming dilution 25,636 26,098
See accompanying notes to unaudited consolidated condensed financial statements.
Page 3 of 25
NEOMAGIC CORPORATION
CONSOLIDATED CONDENSED BALANCE SHEETS
(In thousands)
(Unaudited)
April 30, January 31,
1999 1999
------------- --------------
ASSETS
Current assets:
Cash and cash equivalents $ 35,100 $ 36,631
Short-term investments 42,298 56,097
Accounts receivable, net 25,144 19,363
Inventory 19,512 19,046
Other current assets 3,058 2,681
------------- --------------
Total current assets 125,112 133,818
Property, plant and equipment, net 11,846 8,335
Deferred tax asset 1,034 1,034
Other assets 7,383 1,187
------------- --------------
Total assets $ 145,375 $144,374
============= ==============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 25,425 $ 31,296
Compensation and related benefits 2,906 4,046
Income taxes payable 4,245 3,059
Other accruals 4,969 1,876
Obligations under capital leases 611 702
------------- --------------
Total current liabilities 38,156 40,979
Commitments and contingencies
Stockholders' equity:
Common stock 25 25
Additional paid-in-capital 67,661 67,286
Notes receivable from stockholders (554) (554)
Deferred compensation (1,575) (1,764)
Retained earnings 41,662 38,402
------------- --------------
Total stockholders' equity 107,219 103,395
------------- --------------
Total liabilities and stockholders' equity $ 145,375 $144,374
============= ==============
See accompanying notes to unaudited consolidated condensed financial
statements.
Page 4 of 25
NEOMAGIC CORPORATION
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Three Months Ended
---------------------------------------
April 30, April 30,
1999 1998
------------------ ----------------
OPERATING ACTIVITIES:
Net income $ 3,261 $ 6,676
Adjustments to reconcile net income to net cash provided by
(used for) operating activities:
Depreciation and amortization 1,033 662
Amortization of deferred compensation 150 224
Purchased in-process research and development 5,348 -
Changes in operating assets and liabilities:
Accounts receivable (5,781) 952
Inventory (466) (2,538)
Other current assets (377) (507)
Other assets (1,120) -
Accounts payable (5,871) 11,311
Compensation and related benefits (1,140) (48)
Income taxes 1,186 594
Other accruals 3,093 (146)
------------------ ----------------
Net cash provided by (used for) operating activities (684) 17,180
================== ================
INVESTING ACTIVITIES:
Purchases of property, plant and equipment (4,545) (1,766)
Purchases of short-term investments (33,538) (16,997)
Maturities of short-term investments 47,337 7,971
Purchase of the Optical Drive Development Group (3,901) -
Purchase of ACL (6,523) -
------------------ ----------------
Net cash provided by (used for) investing activities (1,170) (10,792)
================== ================
FINANCING ACTIVITIES:
Payments on lease obligation (91) (149)
Payments on working capital line of credit - (21,041)
Net proceeds from issuances of common stock 414 682
------------------ ----------------
Net cash provided by (used for) financing activities 323 (20,508)
================== ================
Net (decrease) in cash and cash equivalents (1,531) (14,120)
Cash and cash equivalents at beginning of period 36,631 35,004
------------------ ----------------
Cash and cash equivalents at end of period $35,100 $20,884
================== ================
Supplemental schedules of cash flow information
Cash paid for:
Interest $ 252 $ 324
Taxes $ 2,506 $ 6,000
Supplemental schedules of non-cash investing and financing activities:
Deferred compensation $ (39) $ -
See accompanying notes to unaudited consolidated condensed financial
statements.
Page 5 of 25
NEOMAGIC CORPORATION
NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS
1. Basis of Presentation:
The first quarters of fiscal 2000 and fiscal 1999 ended on May 2, 1999
and April 26, 1998, respectively. For ease of presentation, the accompanying
financial statements have been shown as ending on the last day of the calendar
month.
The unaudited consolidated condensed financial statements have been
prepared pursuant to the rules and regulations of the Securities and Exchange
Commission and include the accounts of NeoMagic Corporation and its wholly owned
subsidiaries, collectively ("NeoMagic" or the "Company"). All significant
intercompany balances and transactions have been eliminated. Certain information
and footnote disclosures, normally included in financial statements prepared in
accordance with generally accepted accounting principles, have been condensed or
omitted pursuant to such rules and regulations. In the opinion of the Company,
the financial statements reflect all adjustments, consisting only of normal
recurring adjustments, necessary for a fair presentation of the financial
position at April 30, 1999 and January 31, 1999, and the operating results and
cash flows for the three months ended April 30, 1999 and 1998. These financial
statements and notes should be read in conjunction with the Company's audited
financial statements and notes thereto for the year ended January 31, 1999,
included in the Company's Annual Report on Form 10-K filed with the Securities
and Exchange Commission.
The results of operations for the three months ended April 30, 1999 are
not necessarily indicative of the results that may be expected for the year
ending January 31, 2000.
Certain amounts for prior years have been reclassified to conform to
current year presentation.
2. Inventory:
Inventory is stated at the lower of cost or market value. Cost is
determined by the first-in, first-out method.
April 30, January 31,
Inventory consists of: 1999 1999
--------------- --------------
(in thousands)
Raw materials $ 4,061 $ 6,396
Work in process 3,812 4,717
Finished goods 11,639 7,933
--------------- --------------
Total $19,512 $19,046
=============== ==============
3. Acquisitions
The Company completed two acquisitions in February 1999. The Company
acquired the assets and intellectual property of ACL of Tel Aviv, Israel from
Robomatix Technology Ltd. for $6 million in cash and warrants to purchase up to
100,000 shares of NeoMagic common stock over a period of five years, at an
exercise price of $20 per share. The Company also acquired the assets and
intellectual property of the Optical Drive Development Group of Mitel
Corporation for $4 million in cash. Both acquisitions were accounted for as
purchases.
For the ACL transaction, the excess purchase price over the estimated
fair value of net tangible assets has been allocated to intangible assets,
primarily consisting of patents ($1.5 million), assembled workforce ($1.2
million), and goodwill ($0.2 million). In addition to the intangible assets
acquired, the Company recorded a $3.3 million charge, representing the write-off
of in-process research and development ("IPRD"). The risk adjusted discount rate
applied to after-tax cash flows to calculate the IPRD and patent valuation was
50%.
Page 6 of 25
For the Mitel transaction, the excess purchase price over the estimated
fair value of net tangible assets has been allocated to intangible assets,
primarily consisting of patents ($1.2 million), assembled workforce ($0.2
million), and goodwill ($0.4 million). In addition to the intangible assets
acquired, the Company recorded a $2.0 million charge, representing the write-off
of IPRD. The risk adjusted discount rate applied to after-tax cash flows to
calculate the IPRD and patent valuation was between 40-45%.
The allocation of $3.3 million and $2.0 million of the purchase price
to IPRD in the case of the ACL and the Mitel acquisitions, respectively,
represents the estimated fair value based on risk adjusted cash flows related to
each incomplete project. The Company believes that such fair values do not
exceed the amount a third party would pay for each such in-process technology.
At the date of each of the acquisitions, the projects associated with the IPRD
efforts had not yet reached technological feasibility and the in-progress
technology had no alternative future use. Accordingly, these costs were
expensed. In making its purchase price allocations for the ACL and Mitel
acquisitions, the Company used the income approach which considered present
value calculations of income, an analysis of project accomplishments and
completion costs, an assessment of overall contribution, as well as project
risks. The values assigned to IPRD for each acquisition were determined by
estimating the costs to develop the purchased in-process technology into
commercially viable products, estimating the resulting net cash flows from each
project, excluding the cash flows related to the portion of each project that
was incomplete at the acquisition date, and discounting the resulting net cash
flows to their present value. Each of these forecasts were based upon future
discounted cash flows, taking into account the state of development of each
in-process project, the cost to complete that project, the expected income
stream, the life cycle of the product ultimately developed, and the associated
risks. Projected future net cash flows attributable to the in-process
technology, assuming successful development of such technologies, were
discounted to their present value using a discount rate which was derived based
on the Company's estimated weighted average cost of capital plus a risk premium
to account for the inherent uncertainty surrounding the successful completion of
each project and the associated estimated cash flows. The value of the assembled
workforces was based upon the cost to replace that workforce. Intangible assets,
including goodwill, are being amortized over their estimated useful lives of
four years.
4. Earnings Per Share:
In 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 128, "Earnings per Share" ("SFAS 128"). SFAS
128 replaces the calculation of primary and fully diluted earnings per share
with basic and diluted earnings per share. Unlike primary earnings per share,
basic earnings per share exclude any dilutive effect of options, warrants, and
convertible securities. Diluted earnings per share is very similar to fully
diluted earnings per share.
Per share information calculated on this basis is as follows:
Three months ended April 30, 1999 1998
- ---------------------------------------------------------------------------- ----------- -----------
(in thousands, except per share amount)
Numerator:
Net income $ 3,261 $ 6,676
----------- -----------
Denominator:
Denominator for basic earnings per share - weighted average shares 24,476 23,295
Effect of dilutive securities:
Employee stock options 1,160 2,713
Warrants - 90
----------- -----------
Dilutive potential common shares 1,160 2,803
----------- -----------
Denominator for diluted earnings per share - adjusted weighted-
average shares 25,636 26,098
Basic earnings per share $ .13 $ .29
Diluted earnings per share $ .13 $ .26
Page 7 of 25
5. Recently Issued Accounting Pronouncements
The Company adopted Statement of Financial Accounting Standards No.
130, "Reporting Comprehensive Income," ("SFAS 130") during the quarter ended
April 30, 1998. SFAS 130 establishes new rules for the reporting and displaying
of comprehensive income and its components; however, the adoption of this
Statement had no impact on the Company's net income or stockholders' equity.
SFAS 130 requires unrealized gains or losses on the Company's available-for-sale
securities and foreign currency translation adjustments to be included in
comprehensive income. Gross unrealized gains and losses on available-for-sales
securities and foreign currency translation adjustments at April 30, 1999 and
1998 were immaterial.
In June 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 131, ("SFAS 131") "Disclosures about
Segments of an Enterprise and Related Information." The statement changes
standards for the way that public business enterprises identify and report
operating segments in annual and interim financial statements. This statement
requires selected information about an enterprise's operating segments.
Currently, the Company has one operating segment by which management evaluates
performance. All of the Company's net sales to date have been derived from the
sale of multimedia accelerators, and the Company expects this to continue
through fiscal 2000.
In June 1998, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 133, ("SFAS 133") "Accounting for
Derivative Instruments and Hedging Activities." The Standard will require
companies to record all derivatives held on the balance sheet at fair value.
Derivatives that are not hedges must be adjusted to fair value through income.
If the derivative is a hedge, changes in the fair value of the derivative is
either offset against the change in fair value of the hedged assets,
liabilities, or firm commitments through earnings, or recognized in other
comprehensive income until the value related to the ineffective portion of a
hedge, if any, is recognized in earnings. The Company expects to adopt SFAS 133
as of the beginning of its fiscal year 2001. The effect of adoption of the
Standard is currently being evaluated, but is not expected to have a material
effect on the Company's financial position or results of operations.
Page 8 of 25
PART I. FINANCIAL INFORMATION
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations
When used in this discussion, the words "expects," "anticipates" and
similar expressions are intended to identify forward-looking statements. Such
statements, which include statements concerning the timing of availability and
functionality of products under development, product mix, trends in average
selling prices, the growth rate of the market for notebook PCs, competition, the
percentage of export sales and sales to strategic customers, the adoption or
retention of industry standards, and the availability and cost of products from
the Company's suppliers, are subject to risks and uncertainties, including those
set forth below under "Factors that May Affect Results," that could cause actual
results to differ materially from those projected. These forward-looking
statements speak only as of the date hereof. The Company expressly disclaims any
obligation or undertaking to release publicly any updates or revisions to any
forward-looking statements contained herein, to reflect any changes in the
Company's expectations with regard thereto or any changes in events, conditions
or circumstances on which any such statement is based.
OVERVIEW
The Company designs, develops and markets high-performance
semiconductor solutions for sale to original equipment manufacturers ("OEM") of
mobile computing products including notebook PCs, and more recently digital
cameras and DVD drives. The Company pioneered the first commercially available
high-performance silicon technology that integrates DRAM, complex logic and
analog circuits into a single chip. The Company's proprietary MagicWare-TM-
technology eliminates the need to drive signals off-chip to discrete memory,
achieving its performance advantage while actually lowering the power
consumption and extending the battery life for smaller, lighter weight portable
devices. The first commercial application for the Company's technology is in the
design, development and marketing of multimedia accelerators for sale to
notebook computer manufacturers. To date, all of the Company's net sales have
been derived from the sale of the Company's MagicGraph128 and MagicMedia256
families of pin-compatible multimedia accelerators and companion audio chips.
The Company's products require semiconductor wafers manufactured with
state-of-the-art fabrication equipment and technology. NeoMagic has established
strategic relationships with Mitsubishi Electric Corporation ("Mitsubishi
Electric"), Toshiba Corporation ("Toshiba") and Infineon Technologies
("Infineon"), formerly Siemens Aktiengesellschaft Semiconductor Group, to
produce its semiconductor wafers and uses other independent contractors to
perform assembly, packaging and testing. The Company's foundry relationships are
formalized in separate five-year wafer supply agreements. These relationships
enable the Company to concentrate its resources on product design and
development, where NeoMagic believes it has greater competitive advantages, and
to eliminate the high cost of owning and operating a semiconductor wafer
fabrication facility. The Company depends on these suppliers to allocate to the
Company a portion of their manufacturing capacity sufficient to meet the
Company's needs, to produce products of acceptable quality and at acceptable
manufacturing yields and to deliver those products to the Company on a timely
basis. The Company is currently operating in a supply-constrained environment on
some of its principle products, which is expected to have an adverse effect on
the Company's fiscal 2000 net sales. Further, the Company anticipates it will
have to pay premium prices in order to obtain any incremental wafer capacity
from its suppliers, which will have an adverse effect on gross margins for
fiscal 2000. The Company is also dependent on its suppliers to advance, on a
timely basis, the process design technologies on which the manufacturing of the
Company's products are based. The Company is currently experiencing difficulty
in bringing to production its advanced 3D multimedia accelerators, which will
have an adverse effect on the Company's net sales in Fiscal 2000.
The Company purchases wafers and pays an agreed price for wafers
meeting certain acceptance criteria. To date, all of the Company's wafer
purchases, which constitute a significant part of its cost of sales, have been
priced in Japanese yen. As a result, exchange rate fluctuations can affect the
Company's gross margin. The Company has in the past hedged its exposure to
fluctuations in the exchange rate between the Japanese yen and the United States
dollar by purchasing forward contracts and options and may continue to do so in
the future. Any gains or losses associated with the Company's hedging activities
has been immaterial.
Page 9 of 25
The following information should be read in conjunction with the
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" on pages 8-20 of the Company's Fiscal 1999 Annual Report.
RESULTS OF OPERATIONS
The following table sets forth for the periods indicated certain financial data
as a percentage of net sales:
Three Months Ended
April 30, April 30,
1999 1998
----------- -----------
Net sales 100.0% 100.0%
Cost of sales 63.0 57.6
----------- -----------
Gross margin 37.0 42.4
Operating expenses:
Research and development 13.5 13.1
Selling, general and administrative 7.2 9.1
In-process research and development 7.4 -
----------- -----------
Total operating expenses 28.1 22.2
----------- -----------
Income from operations 8.9 20.2
Interest income and other 1.1 2.0
Interest expense (.4) (.7)
----------- -----------
Income before income taxes 9.6 21.5
Provision for income taxes 5.1 7.5
----------- -----------
Net income 4.5% 14.0%
=========== ===========
NET SALES
The Company's net sales to date have been generated from the sale of its
multimedia accelerators. The Company's products are used in, and its business is
dependent on, the personal computer industry with sales primarily in Asia,
Japan, and the United States. Net sales were $72.4 million for the three months
ended April 30, 1999, compared to $47.7 million for the three months ended April
30, 1998. Net sales increased primarily as a result of increased market
acceptance of the Company's products, introduction by the Company of additional
products in its MagicGraph128 and MagicMedia256 product families expanding the
portion of the market addressed by NeoMagic products, and the Company's
investment in sales and marketing activities. The Company expects that the
percentage of its net sales represented by any one product or type of product
may change significantly from period to period as new products are introduced
and existing products reach the end of their product life cycles. Due to
competition, a decrease in DRAM pricing and the trend in the market toward lower
cost notebook computers, the Company's products may experience declining unit
average selling prices over time, which at times can be substantial. In
addition, the Company is currently operating in a supply-constrained environment
on some of its principle products. This supply shortage is expected to have an
adverse effect on net sales for fiscal 2000.
Export sales accounted for 81.5% and 86.3% of net sales in the three
months ended April 30, 1999 and 1998, respectively. The Company expects that
export sales will continue to represent a significant portion of net sales,
although there can be no assurance that export sales as a percentage of net
sales will remain at current levels. All sale transactions were denominated in
U.S. dollars.
Five customers accounted for 21%, 15%, 13%, 13%, and 10% of net sales
for the three months ended April 30, 1999. Four customers accounted for 20%,
15%, 10%, and 10% of net sales for the three months ended April 30, 1998. The
Company expects a significant portion of its future sales to remain concentrated
within a limited number of strategic customers. There can be no assurance that
the Company will be able to retain its strategic customers or that such
customers will not cancel or reschedule orders or, in the event orders are
canceled, that such orders will be replaced by other sales. In addition, sales
to any particular customer may fluctuate significantly from quarter to
Page 10 of 25
quarter. The occurrence of any such events or the loss of a strategic
customer could have a material adverse effect on the Company's operating
results.
GROSS MARGIN
Gross margin was $26.8 million and $20.2 million for the three months
ended April 30, 1999 and 1998, respectively. Gross margin percentages decreased
to 37.0% for the three months ended April 30, 1999 from 42.4% in the three
months ended April 30, 1998. The decrease in gross margin percentage was due
primarily to declines in unit average selling prices stemming from the market
trend toward lower priced notebooks and increased competition. Also affecting
gross margin was a decrease in the dollar/yen exchange rate. These factors were
mitigated in part by other product cost decreases stemming from the Company's
cost reduction efforts.
In the future, the Company's gross margin percentages may be affected
by the continued trend in the market toward lower priced notebooks, increased
competition and related decreases in unit average selling prices (particularly
with respect to older generation products), changes in the mix of products sold,
timing of volume shipments of new products, the availability and cost of
products from the Company's suppliers, insufficient, excess or obsolete
inventory levels, manufacturing yields (particularly on new products) and
foreign currency exchange rate fluctuations. Further, as the Company is
currently operating in a supply-constrained environment, the Company anticipates
it will have to pay premium prices in order to obtain any incremental wafer
capacity from its suppliers, which will have an adverse effect on gross margins
for fiscal 2000.
RESEARCH AND DEVELOPMENT EXPENSES
Research and development expenses include compensation and associated
costs relating to development personnel, operating system software costs and
prototyping costs, which are comprised of photomask costs and pre-production
wafer costs. Research and development expenses were $9.8 million and $6.3
million for the three months ended April 30, 1999 and 1998, respectively. The
Company has made and intends to continue to make significant investments in
research and development to remain competitive by developing new and enhanced
products to serve its identified markets. Research and development expenses
increased primarily as a result of increased employee related expenses largely
related to additional personnel and to a lesser extent consulting, engineering
and equipment related expenses. Research and development spending is expected to
increase in absolute dollars in fiscal 2000.
SALES, GENERAL AND ADMINISTRATIVE EXPENSES
Sales, general and administrative expenses were $5.2 million and $4.4
million in the three months ended April 30, 1999 and 1998, respectively. Sales,
general and administrative expenses increased primarily as a result of increased
employee related expenses largely related to additional personnel. The Company
anticipates that sales, general and administrative expenses will increase in
absolute dollars in fiscal 2000.
IN-PROCESS RESEARCH AND DEVELOPMENT
In-process research and development expenses were $5.3 million in
the three months ended April 30, 1999. The Company completed two acquisitions
in February 1999. The Company acquired the assets and intellectual property
of ACL of Tel Aviv, Israel from Robomatix Technology Ltd. for $6 million in
cash and warrants to purchase up to 100,000 shares of NeoMagic common stock
over a period of five years, at an exercise price of $20 per share. The
Company also acquired the assets and intellectual property of the Optical
Drive Development Group of Mitel Corporation for $4 million in cash. Both
acquisitions were accounted for as purchases.
For the ACL transaction, the excess purchase price over the estimated
fair value of net tangible assets has been allocated to intangible assets,
primarily consisting of patents ($1.5 million), assembled workforce ($1.2
million), and goodwill ($0.2 million). In addition to the intangible assets
acquired, the Company recorded a $3.3 million charge, representing the write-off
of in-process research and development ("IPRD"). The risk adjusted discount rate
applied to after-tax cash flows to calculate the IPRD and patent valuation was
50%.
Page 11 of 25
For the Mitel transaction, the excess purchase price over the estimated
fair value of net tangible assets has been allocated to intangible assets,
primarily consisting of patents ($1.2 million), assembled workforce ($0.2
million), and goodwill ($0.4 million). In addition to the intangible assets
acquired, the Company recorded a $2.0 million charge, representing the write-off
of IPRD. The risk adjusted discount rate applied to after-tax cash flows to
calculate the IPRD and patent valuation was between 40-45%.
The allocation of $3.3 million and $2.0 million of the purchase price
to IPRD in the case of the ACL and the Mitel acquisitions, respectively,
represents the estimated fair value based on risk adjusted cash flows related to
each incomplete project. The Company believes that such fair values do not
exceed the amount a third party would pay for each such in-process technology.
At the date of each of the acquisitions, the projects associated with the IPRD
efforts had not yet reached technological feasibility and the in-progress
technology had no alternative future use. Accordingly, these costs were
expensed. In making its purchase price allocations for the ACL and Mitel
acquisitions, the Company used the income approach which considered present
value calculations of income, an analysis of project accomplishments and
completion costs, an assessment of overall contribution, as well as project
risks. The values assigned to IPRD for each acquisition were determined by
estimating the costs to develop the purchased in-process technology into
commercially viable products, estimating the resulting net cash flows from each
project, excluding the cash flows related to the portion of each project that
was incomplete at the acquisition date, and discounting the resulting net cash
flows to their present value. Each of these forecasts were based upon future
discounted cash flows, taking into account the state of development of each
in-process project, the cost to complete that project, the expected income
stream, the life cycle of the product ultimately developed, and the associated
risks. Projected future net cash flows attributable to the in-process
technology, assuming successful development of such technologies, were
discounted to their present value using a discount rate which was derived based
on the Company's estimated weighted average cost of capital plus a risk premium
to account for the inherent uncertainty surrounding the successful completion of
each project and the associated estimated cash flows. The value of the assembled
workforces was based upon the cost to replace that workforce. Intangible assets,
including goodwill, are being amortized over their estimated useful lives of
four years.
INTEREST INCOME AND OTHER
The Company earns interest on its cash and short-term investments.
Interest income and other was $784,000 and $975,000 for the first quarter of
fiscal 2000 and 1999, respectively. The decrease in interest income and other in
the first quarter of fiscal 2000 stemmed from an increase in tax-exempt
securities investments, which carry lower pre-tax yields.
INTEREST EXPENSE
The Company pays interest and commissions on wafer purchases and
interest on its capital leases. Interest expense was $252,000 and $324,000, in
the first quarter of fiscal 2000 and 1999, respectively. The decrease in
interest expense from fiscal 1999 reflects lower interest and commission rates
on wafer purchases and lower capital lease balances.
INCOME TAXES
The Company's effective tax rate for the three months ended April 30,
1999 was 30%, excluding the effect of the in-process research and development
charge of $5.3 million, compared to an effective tax rate for the three months
ended April 30, 1998 of 35%. The lower effective tax rate for the three months
ended April 30, 1999 is due primarily to changes in the geographical mix of
revenue and operating profits.
LIQUIDITY AND CAPITAL RESOURCES
The Company's cash, cash equivalents and short-term investments
decreased $15.3 million in the three months ended April 30, 1999 to $77.4
million from $92.7 million at January 31, 1999. The decrease is due primarily to
the two acquisitions completed in February 1999 for $10.4 million, an increase
in accounts receivable, and a
Page 12 of 25
decrease in accounts payable, offset in part by income from operations and
other accruals. Working capital decreased $5.8 million to $87.0 million at
April 30, 1999 from $92.8 million at January 31, 1999.
Net cash used in operating activities for the three months ended April
30, 1999 was $0.7 million compared to $17.2 million of net cash provided by
operating activities for the three months ended April 30, 1998. The cash used in
operating activities during the first quarter of fiscal 2000 relates primarily
to a $5.9 million decrease in accounts payable and a $5.8 million increase in
accounts receivable, partially offset by income from operations and an increase
in other accruals.
Net cash used for investing activities for the three months ended April
30, 1999 was $1.2 million, compared to $10.8 million for the three months ended
April 30, 1998. Cash used for investing activities during the first quarter of
fiscal 2000 stemmed from the $10.4 million associated with the acquisitions of
the Optical Drive Development Group and ACL and a $4.5 million increase in
property, plant and equipment, partially offset by net maturities of short-term
investments of $13.8 million. Continued expansion of the Company's business may
require higher levels of capital equipment purchases, technology investments,
foundry investments and other payments to secure manufacturing capacity. The
timing and amount of future investments will depend primarily on the growth of
the Company's future revenues.
Net cash provided by financing activities was $0.3 million for the
three months ended April 30, 1999 compared to net cash used in financing
activities of $20.5 for the three months ended April 30, 1998. Net cash provided
by financing activities for the three months ended April 30, 1999 relates
primarily to net proceeds from issuances of common stock. Net cash used in
financing activities for the three months ended April 30, 1998 relates primarily
to repayments against the working capital line of $21.0 million.
At April 30, 1999 the Company's principal sources of liquidity included
cash and cash equivalents and short-term investments of $77.4 million. The
Company believes these available funds and anticipated funds from operations
will satisfy the Company's projected working capital and capital expenditure
requirements through the next 12 months. Investments will continue in product
development in new and existing areas of technology. Cash may also be used to
acquire technology through purchases and strategic acquisitions. The Company's
future capital requirements will depend on many factors including the rate of
net sales growth, the timing and extent of spending to support research and
development programs, expansion of sales and marketing, the timing of
introductions of new products and enhancements to existing products, and market
acceptance of the Company's products. The Company expects that it may need to
raise additional equity or debt financing in the future. There can be no
assurance that additional equity or debt financing, if required, will be
available on acceptable terms or at all.
IMPACT OF CURRENCY EXCHANGE RATES
Because the Company currently purchases all wafers under purchase
contracts denominated in yen, significant appreciation in the value of yen
relative to the value of the U.S. dollar would make the wafers relatively more
expensive to the Company, which could have a material adverse effect on the
Company's business, financial condition and results of operations. The Company
generally enters into foreign currency forward contracts and foreign currency
options to minimize short-term foreign currency fluctuation exposures related to
these firm purchase commitments. The Company does not use derivative financial
instruments for speculative or trading purposes. The Company's accounting
policies for these instruments are based on the Company's designation of such
instruments as hedging transactions. The criteria the Company uses for
designating an instrument as a hedge include its effectiveness in risk reduction
and one-to-one matching of derivative instruments to underlying transactions.
Notwithstanding the measures the Company has adopted, due to the
unpredictability and volatility of currency exchange rates and currency
controls, there can be no assurance that the Company will not experience
currency losses in the future, nor can the Company predict the effect of
exchange rate fluctuations upon future operating results.
IMPACT OF YEAR 2000
Like many other companies, the year 2000 computer issue creates risks
for the Company. If computer systems do not correctly recognize and process date
information beyond calendar year 1999, there could be an
Page 13 of 25
adverse impact on the Company's operations. Computer programs that have
time-sensitive software may recognize a date using "00" as the year 1900
rather than the year 2000.
The Company has completed an initial assessment of its internal
computer systems, and does not believe that it will be required to modify or
replace significant portions of its internal systems so that they will function
properly with respect to dates in the year 2000 and thereafter. The Company's
internal computer systems consist primarily of third party software tools for
engineering, sales, finance and human resources functions. The Company has
reviewed its internal business software including system software for order
management, finance, purchasing and human resources. All major system software
was found to be year 2000 compliant. The Company is working closely with the
suppliers of its engineering software tools on the year 2000 issue, and plans to
have all such tools updated and tested for year 2000 compliance by the middle of
fiscal 2000. The Company is also reviewing its networks, telephones, PCs and
workstations, and expects all to be in compliance by the middle of fiscal 2000.
For all new software purchases, the Company requires year 2000 compliance.
NeoMagic does not operate its own manufacturing facilities. Rather, the
Company's products are manufactured and tested by independent third party
suppliers, primarily located in Asia and Japan. The Company believes that its
most reasonably likely worst case year 2000 scenario would relate to problems
with its third party suppliers rather than with the Company's internal systems
or its products. The Company has contacted critical suppliers of products and
services to determine whether or not the suppliers' operations and the products
and services they provide are year 2000 capable. Highest priority is being
placed on working with suppliers that are critical to the delivery of the
Company's products to customers. A worst case scenario involving a critical
supplier would be the partial or complete shutdown of the supplier and its
resulting inability to provide its products or services to the Company on a
timely basis. The Company continues to monitor its suppliers and will develop
specific contingency plans by the middle of fiscal 2000 to address issues
related to suppliers that are not considered to be taking all steps necessary to
ensure year 2000 capability. Where efforts to work with critical suppliers to
ensure year 2000 capability have not been successful, contingency planning
generally emphasizes the identification of substitute and second-source
suppliers where available or planned increases in inventory levels of specific
products in advance of the end of calendar year 1999. This contingency planning
is expected to be ongoing through calendar 1999.
The Company's year 2000 efforts to date have largely been carried out
with existing personnel, and the incremental costs incurred to date have been
less than $250,000. Management believes that incremental costs to be incurred
going forward to assure that its internal systems and products are year 2000
capable will be less than $250,000. However, the Company is not in a position to
identify or to avoid all possible adverse year 2000 scenarios, particularly as
it relates to its third party suppliers. Due to the large number of variables
involved, the Company cannot provide an estimate of the damage it might suffer
if any of these adverse scenarios were to occur. As such, there can be no
assurance that the failure to ensure year 2000 capability by a supplier or
another third party would not have a material adverse effect on the Company's
financial condition or overall results of operations.
FACTORS THAT MAY AFFECT RESULTS
FLUCTUATIONS IN QUARTERLY OPERATING RESULTS
NeoMagic's quarterly and annual results of operations are affected by a
variety of factors that could materially adversely affect net sales, gross
margin and income from operations. These factors include, among others, demand
for the Company's products, changes in product or customer mix (i.e. the portion
of the Company's revenues represented by the Company's various products and
customers), incorrect forecasting of future revenues, fluctuations in
manufacturing yields, availability and cost of manufacturing capacity,
insufficient, excess or obsolete inventory levels, foreign exchange rate
fluctuations, unanticipated delays or problems in the introduction or
performance of the Company's next generation of products, the Company's ability
to introduce new products in accordance with OEM design requirements and design
cycles, the Company's ability to leverage its technology across new markets,
market acceptance of the end-products of the Company's customers, changes in the
timing of product orders due to unexpected delays in the introduction of
products of the Company's customers or due to the life cycles of such customers'
products ending earlier than anticipated, new product announcements or product
introductions by NeoMagic's competitors, competitive pressures resulting in
lower average selling prices, the
Page 14 of 25
volume of orders that are received and can be fulfilled in a quarter, the
rescheduling or cancellation of orders by customers which cannot be replaced
with orders from other customers, supply constraints for the other components
incorporated into its customers' notebook PC products, the unanticipated loss
of any strategic relationship, the level of expenditures for research and
development and sales, general and administrative functions of the Company,
affect on the company's business due to internal systems or systems of
suppliers, infrastructure providers and other third parties adversely
affected by year 2000 problems, and litigation involving antitrust,
intellectual property, and other issues. Any one or more of these factors
could result in the Company failing to achieve its expectations as to future
revenues and profits. The Company may be unable to adjust spending
sufficiently in a timely manner to compensate for any unexpected sales
shortfall, which could materially adversely affect quarterly operating
results. Accordingly, the Company believes that period-to-period comparisons
of its operating results should not be relied upon as an indication of future
performance. In addition, the results of any quarterly period are not
indicative of results to be expected for a full fiscal year. In future
quarters, the Company's operating results may be below the expectations of
public market analysts or investors. In such event, the market price of the
Common Stock would be materially adversely affected.
RISKS ASSOCIATED WITH DEPENDENCE ON THE NOTEBOOK PC MARKET
The Company's products are currently used only in notebook PCs. The
notebook PC market is characterized by rapidly changing technology, evolving
industry standards, frequent new product introductions, significant price
competition, and the trend toward lower priced notebooks, which is resulting in
short product life cycles and regular reductions of average selling prices over
the life of a specific product. Although the notebook PC market has grown
substantially in recent years, there is no assurance that such growth will
continue. A reduction in sales of notebook PCs, or a reduction in the growth
rate of such sales, would likely reduce demand for the Company's products.
Moreover, such changes in demand could be large and sudden. Since PC
manufacturers often build inventories during periods of anticipated growth, they
may be left with excess inventories if growth slows or if they have incorrectly
forecasted product transitions. In such cases, the PC manufacturers may abruptly
suspend substantially all purchases of additional inventory from suppliers such
as the Company until the excess inventory has been absorbed. Any reduction in
the demand for notebook PCs in general, or for a particular product that
incorporates the Company's multimedia accelerators, could have a material
adverse impact on the Company's business, financial condition and results of
operations.
The Company's ability to compete in the future will depend on its
ability to identify and ensure compliance with evolving industry standards.
Unanticipated changes in industry standards could render the Company's products
incompatible with products developed by major hardware manufacturers and
software developers, including Intel Corporation and Microsoft Corporation. The
Company also will continue to need licenses from Intel, Microsoft and perhaps,
other companies in order to manufacture products that are compatible with
industry standards, including particularly the industry standards set by those
companies. There is no assurance that such licenses will always be available, or
will be available on reasonable terms. The Company could be required, as a
result, to invest significant time and effort to redesign its products to ensure
compliance with relevant standards. If the Company's products are not in
compliance with prevailing industry standards for a significant period of time,
or the Company is unable to obtain necessary licenses from industry standard
setters, the Company could miss crucial OEM design cycles, which could result in
a material adverse effect on the Company's business, financial condition and
results of operations. In addition, the Company's products are designed to
afford the notebook PC manufacturer significant advantages with respect to
product performance, power consumption and size. To the extent that other future
developments in notebook PC components or subassemblies incorporate one or more
of the advantages offered by the Company's products, the market demand for the
Company's products may be negatively impacted, which could result in a material
adverse effect on the Company's business, financial condition and results of
operations.
PRODUCT CONCENTRATION, RISKS ASSOCIATED WITH MULTIMEDIA PRODUCTS
The Company's revenues currently are entirely dependent on the market
for multimedia accelerators for notebook PCs, and on the Company's ability to
compete in that market. Since the Company has no other revenue generating
product line, the Company's revenues and results of operations would be
materially adversely affected if for any reason it were unsuccessful in selling
multimedia accelerators. The notebook PC market frequently undergoes transitions
in which products rapidly incorporate new features and performance standards on
an industry-
Page 15 of 25
wide basis. If the Company's products were unable to support the new feature
sets or performance levels stemming from such a transition, the Company would
likely not have the opportunity to compete for new design wins until it was
able to incorporate the new feature sets or performance requirements into its
products. The Company is currently experiencing difficulty in bringing to
production its advanced 3D multimedia accelerators, which will have an
adverse effect on the Company's annual net sales in Fiscal 2000. Failure by
the Company to develop and market, on a timely basis, products with the
required feature sets or performance standards could have a material adverse
effect on the Company's business, financial condition and results of
operations.
The notebook PC multimedia market is characterized by extreme price
competition. Leading-edge products may command higher average selling prices,
but prices decline throughout the product life cycle as comparable and more
advanced products are introduced into the market. As a result, the Company's
ability to maintain average selling prices and gross margins depends
substantially on its ability to continue introducing new products. Its ability
to maintain gross margins is also dependent upon its ability to reduce product
costs throughout a product life cycle by instituting cost reduction design
changes and yield improvements, persuading customers to adopt cost-reduced
versions of its products, and successfully managing its manufacturing and
subcontractor relationships. Failure by the Company to design and market
advanced products in a timely manner, and to reduce product costs on older
products, would have a material adverse effect on the Company's net sales, gross
margins and results of operations.
CONSUMER PRODUCT EXECUTION
The Company announced the formation of the Consumer Products division
in June 1998. The division will explore consumer, semiconductor product
opportunities in emerging markets such as digital video disks, digital cameras,
and other consumer products that can benefit from the advantages of embedded
DRAM MagicWare-TM- technology pioneered by NeoMagic. In February 1999, the
Company completed two acquisitions to further the development efforts of the
Consumer Products division. The Company acquired the Optical Drive Development
Group and associated DVD intellectual properties from Mitel Semiconductor in
Manchester, England and the assets and intellectual properties of ACL of Tel
Aviv, Israel from Robomatix Technologies Ltd. The DVD and digital camera markets
are new and evolving. The Company's ability to compete in these new markets will
depend on its ability to identify and ensure compliance with evolving industry
standards, develop and market compelling semiconductor solutions, and deliver
those solutions to the market in a timely and cost effective manner. Any such
new product development program faces substantial risks and uncertainties,
including risks as to the costs, timing and results of engineering efforts,
competitive risks and market development risks. There can be no assurance that
the products the Company expects to introduce will incorporate the features,
functionality and pricing demanded by the market, or will be introduced within
the appropriate window of market demand. The failure of the Company to
successfully introduce new products and achieve market acceptance for such
products would have a material adverse effect on the Company's business,
financial condition and results of operations.
CUSTOMER CONCENTRATION
The Company's sales are concentrated within a limited customer base in
the notebook PC market. The Company expects that a small number of customers
will continue to account for a substantial portion of its net sales for the
foreseeable future. Furthermore, the majority of the Company's sales are made on
the basis of purchase orders rather than pursuant to long-term purchase
agreements. As a result, the Company's business, financial condition and results
of operations could be materially adversely affected by the decision of a single
customer to cease using the Company's products, or by a decline in the number of
notebook PCs sold by a single customer.
EFFECTS OF CHANGES IN DRAM PRICING
The Company's products feature large DRAM memory integrated with analog
and logic circuitry on a single chip, while its competitors often provide
discrete analog and logic circuitry to be used in conjunction with DRAM supplied
by others. The selling prices of the Company's products reflect many factors,
including the prices of DRAM chips. As the Company places firm purchase
commitments for wafers some 3 to 4 months in advance, significant reductions in
the market price of DRAM could cause the Company's products to become less
competitively priced relative to competing discrete solutions with
non-integrated DRAM. In this circumstance, the Company could be forced to
respond to pricing pressures precipitated by changes in the DRAM market by
reducing
Page 16 of 25
the average selling prices of its products to current and prospective
customers. Recently, the DRAM market has experienced significant price
erosion, which has been a factor in the overall decline in the average
selling price of the Company's products. Because the Company's product costs
cannot be adjusted as rapidly as changes in the market price of DRAM, the
Company's business, financial condition and results of operations may be
materially and adversely affected by unanticipated changes in the price of
DRAM.
COMPETITION
The market for multimedia accelerators for notebook PCs in which the
Company competes is intensely competitive and is characterized by rapid
technological change, evolving industry standards and declining average selling
prices. NeoMagic believes that the principal factors of competition in this
market are performance, price, features, power consumption, size and software
support. The ability of the Company to compete successfully in the rapidly
evolving notebook PC market depends on a number of factors, including success in
designing and subcontracting the manufacture of new products that implement new
technologies in a timely manner, product quality, reliability, price, the
efficiency of production, design wins for NeoMagic's integrated circuits, ramp
up of production of the Company's products for particular system manufacturers,
end-user acceptance of the system manufacturers' products, market acceptance of
competitors' products and general economic conditions. There can be no assurance
that the Company will be able to compete successfully in the future.
NeoMagic competes with major domestic and international companies, some
of which have substantially greater financial and other resources than the
Company with which to pursue engineering, manufacturing, marketing and
distribution of their products. The Company's principal competitors include ATI
Technologies (ATI), Chips & Technologies, Inc. ("Chips & Technologies"- in
January 1998, Intel Corporation acquired Chips and Technologies) and Trident
Microsystems, Inc. ("Trident"). NeoMagic may also face increased competition
from new entrants into the notebook PC multimedia accelerator market including
companies currently selling products designed for desktop PCs. Some of the
Company's competitors, including Chips & Technologies and Trident have announced
or introduced multimedia accelerator products that integrate large DRAM with
analog and logic circuitry on a single chip. Certain of the Company's
competitors may offer products with more functionality and / or higher processor
speeds at the expense of battery life and power consumption than the Company's
product offerings. These feature sets may be more competitive for certain
applications than the Company's products. Potential competition also could come
from manufacturers that integrate the multimedia accelerator with other systems
components. For example, several of the Company's competitors have announced
plans to develop products that integrate the multimedia accelerator with the
core logic chip set. The successful commercial introduction by competitors of
products that integrate large DRAM with analog and logic circuitry on a single
chip or that eliminate the need for a separate multimedia accelerator in
notebook PCs could have a material adverse effect on the Company's business,
financial condition and results of operations.
Some of the Company's current and potential competitors operate their
own manufacturing facilities. Since the Company does not operate its own
manufacturing facility and must make binding commitments to purchase products,
it may not be able to reduce its costs and cycle time or adjust its production
to meet changing demand as rapidly as companies that operate their own
facilities, which could have a material adverse effect on the Company's results
of operations.
DEPENDENCE ON MANUFACTURING RELATIONSHIPS
The Company's products require wafers manufactured with
state-of-the-art fabrication equipment and techniques. The Company's wafers
currently are manufactured by Mitsubishi Electric and Toshiba in Japan. In
February 1999, the Company entered into a wafer supply agreement with Infineon
(formerly Siemens) of Germany. Each of these manufacturing relationships is
covered under the terms of a five-year wafer supply agreement. The Company
expects that, for the foreseeable future, some of its products will be
manufactured by a single source. Since, in the Company's experience, the lead
time needed to establish a strategic relationship with a new DRAM partner is at
least 12 months and the estimated time for a foundry to switch to a new product
line ranges from four to nine months, there may be no readily available
alternative source of supply for specific products. A manufacturing disruption
experienced by any of the Company's manufacturing partners or the failure of one
of the Company's manufacturing partners to dedicate adequate resources to the
production of the Company's products would have a
Page 17 of 25
material adverse effect on the Company's business, financial condition and
results of operations. Furthermore, in the event that the transition to the
next generation of manufacturing technologies by the Company's manufacturing
partners is unsuccessful, the Company's business, financial condition and
results of operations would be materially and adversely affected.
There are many other risks associated with the Company's dependence
upon third party manufacturers, including: reduced control over delivery
schedules, quality, manufacturing yields and cost; the potential lack of
adequate capacity during periods of excess demand; limited warranties on wafers
supplied to the Company; and potential misappropriation of NeoMagic intellectual
property. The Company is dependent on its manufacturing partners to migrate the
process technology in a timely manner, produce wafers with acceptable quality
and manufacturing yields, deliver those wafers on a timely basis to the
Company's third party assembly subcontractors and to allocate to the Company a
portion of their manufacturing capacity sufficient to meet the Company's needs.
Although the Company's products are designed using the process design rules of
the particular manufacturer, there can be no assurance that the Company's
manufacturing partners will be able to achieve or maintain acceptable yields or
deliver sufficient quantities of wafers on a timely basis or at an acceptable
cost. Additionally, there can be no assurance that the Company's manufacturing
partners will continue to devote adequate resources to the production of the
Company's products or continue to advance, on a timely basis, the process design
technologies on which the manufacturing of the Company's products are based. The
Company in the past has experienced difficulties in some of these areas, and is
currently operating in a supply-constrained environment on some of its principle
products which is expected to have an adverse effect on the Company's business,
financial position and results of operations during at least the second quarter
of fiscal 2000.
The Company's products are assembled and tested by third party
subcontractors. The Company does not have long-term agreements with any of these
subcontractors. Such assembly and testing is conducted on a purchase order
basis. As a result of its reliance on third party subcontractors to assemble and
test its products, the Company cannot directly control product delivery
schedules, which could lead to product shortages or quality assurance problems
that could increase the costs of manufacturing or assembly of the Company's
products. Due to the amount of time normally required to qualify assembly and
test subcontractors, product shipments could be delayed significantly if the
Company were required to find alternative subcontractors. Any problems
associated with the delivery, quality or cost of the assembly and test of the
Company's products could have a material adverse effect on the Company's
business, financial condition and results of operations.
INVENTORY RISK
Under its wafer supply agreements with Mitsubishi Electric, Toshiba and
Infineon, the Company is obligated to provide rolling 12-month forecasts of
anticipated purchases and to place binding purchase orders three to four months
prior to shipment from the suppliers. If the Company cancels a purchase order,
it must pay cancellation penalties based on the status of work in process or the
proximity of the cancellation to the delivery date. Forecasts of monthly
purchases may not increase or decrease by more than a certain percentage from
the previous month's forecast without the manufacturer's consent. Thus, the
Company must make forecasts and place purchase orders for wafers long before it
receives purchase orders from its own customers. This limits the Company's
ability to react to fluctuations in demand for its products, which can be
unexpected and dramatic, and from time-to-time will cause the Company to have an
excess or shortage of wafers for a particular product. Also, many of the
Company's customers are moving to "just in time" relationships with their
vendors, which can shift the risk of carrying inventory back to the supplier. As
a result of the long lead-time for manufacturing wafers and the increase in
"just in time" ordering by PC manufacturers, semiconductor companies such as the
Company from time-to-time must take charges for excess inventory. Significant
write-offs of excess inventory could have a material adverse effect on the
Company's financial condition and results of operations. Conversely, failure to
obtain sufficient wafers can cause the Company to miss revenue opportunities
and, if significant, could impact sales by the Company's customers. The Company
is currently experiencing such a wafer shortage on some of its principle
products, which is expected to have an adverse effect on the Company's business,
financial condition and results of operations through at least the second
quarter of fiscal 2000.
Page 18 of 25
MANUFACTURING YIELDS
The fabrication of semiconductors is a complex and precise process.
Because NeoMagic's products feature the integration of large DRAM memory with
analog and logic circuitry on a single chip, a manufacturer must obtain
acceptable yields of both the memory and logic portions of such products,
compounding the complexity of the manufacturing process. As a result, the
Company may face greater manufacturing challenges than its competitors. Minute
levels of contaminants in the manufacturing environment, defects in masks used
to print circuits on a wafer, difficulties in the fabrication process or other
factors can cause a substantial percentage of wafers to be rejected or a
significant number of die on each wafer to be nonfunctional. Many of these
problems are difficult to diagnose and time consuming or expensive to remedy. As
a result, semiconductor companies often experience problems in achieving
acceptable wafer manufacturing yields, which are represented by the number of
good die as a proportion of the total number of die on any particular wafer. The
Company purchases wafers, not die, and pays an agreed upon price for wafers
meeting certain acceptance criteria. Accordingly, the Company bears the risk of
the yield of good die from wafers purchased meeting the acceptance criteria.
Poor yields would materially adversely affect the Company's net sales, gross
margins and results of operations.
Semiconductor manufacturing yields are a function of both product
design, which is developed largely by the Company, and process technology, which
is typically proprietary to the manufacturer. Historically, the Company has
experienced lower yields on new products. Since low yields may result from
either design or process technology failures, yield problems may not be
effectively determined or resolved until an actual product exists that can be
analyzed and tested to identify process sensitivities relating to the design
rules that are used. As a result, yield problems may not be identified until
well into the production process, and resolution of yield problems would require
cooperation by and communication between the Company and the manufacturer. This
risk is compounded by the offshore location of the Company's manufacturers,
increasing the effort and time required identifying, communicating and resolving
manufacturing yield problems. As the Company's relationships with additional
manufacturing partners develop, yields could be adversely affected due to
difficulties associated with adopting the Company's technology and product
design to the proprietary process technology and design rules of each
manufacturer. Any significant decrease in manufacturing yields could result in
an increase in the Company's per unit product cost and could force the Company
to allocate its available product supply among its customers, potentially
adversely impacting customer relationships as well as revenues and gross
margins. There can be no assurance that the Company's manufacturers will achieve
or maintain acceptable manufacturing yields in the future. The inability of the
Company to achieve planned yields from its manufacturers could have a material
adverse effect on the Company's business, financial condition and results of
operations. Furthermore, the Company also faces the risk of product recalls
resulting from design or manufacturing defects which are not discovered during
the manufacturing and testing process. In the event of a significant number of
product returns, the Company's net sales and gross margin could be materially
adversely affected.
DEPENDENCE ON NEW PRODUCT DEVELOPMENT, RAPID TECHNOLOGICAL CHANGE
The Company's business, financial condition and results of operations
will depend to a significant extent on its ability to maintain its position in
the market for multimedia accelerator products that integrate large DRAM with
analog and logic circuitry on a single chip. As a result, the Company believes
that significant expenditures for research and development will continue to be
required in the future. The notebook PC market for which the Company's products
are designed is intensely competitive and is characterized by rapidly changing
technology, evolving industry standards and declining average selling prices.
Notebook PC manufacturers demand products incorporating rich features and
functionality in order to achieve product differentiation. The Company must
anticipate the features and functionality that the consumer of notebook PCs will
demand, incorporate those features and functionality into products that meet the
exacting design requirements of the notebook PC manufacturers, price its
products competitively, and introduce the products to the market on a timely
basis. For example, 3-D, digital audio and DVD functionality are becoming
increasingly important for notebook PCs. The Company's ability to compete may
depend on its ability to incorporate these features in its products. The success
of new product introductions is dependent on several factors, including proper
new product definition, timely completion and introduction of new product
designs, the ability of strategic manufacturing partners to effectively design
and implement the manufacture of new products, quality of new products,
differentiation of new products from those of the Company's competitors and
market acceptance of NeoMagic's and its customers' products. There can be no
Page 19 of 25
assurance that the products the Company expects to introduce will incorporate
the features and functionality demanded by system manufacturers and consumers of
notebook PCs, will be successfully developed, or will be introduced within the
appropriate window of market demand. The Company is currently experiencing
delays in bringing to production new products that incorporate hardware 3D
functionality. The failure of the Company to successfully introduce new products
and achieve market acceptance for such products would have a material adverse
effect on the Company's business, financial condition and results of operations.
The integration of large DRAM memory with analog and logic circuitry on
a single chip is highly complex and is critical to the Company's success.
Because of the complexity of its products, however, NeoMagic has experienced,
and is currently experiencing delays in completing development and introduction
of new products. Such delays in the completion of development of future
products, including the products currently expected to be announced over the
next year, are anticipated to adversely affect the Company's business, financial
condition, and results of operations. Although the development cycles for the
memory and logic portions of the Company's products have been relatively
synchronized to date, there can be no assurance that this synchronization will
continue in the future. In addition, there can be no assurance that fundamental
advances in either the memory or logic components of the Company's products will
not significantly increase the complexity inherent in the design and manufacture
of the Company's products, rendering the Company's product technologically
infeasible or uncompetitive. The multiple chip solutions offered by some of the
Company's competitors are less complex to design and manufacture than the
Company's integrated products. As a result, these competitive solutions may be
less expensive, particularly during periods of depressed DRAM prices. The time
required for competitors to develop and introduce competing products may be
shorter and manufacturing yields may be better than those experienced by the
Company.
As the markets for the Company's products continue to develop and
competition increases, NeoMagic anticipates that product life cycles will
shorten and average selling prices will decline. In particular, average selling
prices and, in some cases, gross margin for each of the Company's products will
decline as the products mature. Thus, the Company will need to continue
introducing compelling new products at relatively higher average selling prices
in order to maintain overall average selling prices. There can be no assurance
that the Company will successfully identify new product opportunities or develop
and bring to market new products in a timely manner. Further, there can be no
assurance that products or technologies developed by others will not render
NeoMagic's products or technologies obsolete or uncompetitive, or that the
Company's products will be selected for new designs by its customers. The
failure of the Company's new product development efforts and its ability to
bring new products to market on a timely basis would have a material adverse
effect on NeoMagic's business, financial condition and results of operations.
UNCERTAINTY REGARDING PATENTS AND PROTECTION OF PROPRIETARY RIGHTS
The Company relies in part on patents to protect its intellectual
property. In the United States, the Company has nineteen patents, each covering
certain aspects of the design and architecture of the Company's technology.
Additionally, the Company and its newly acquired businesses have patent
applications pending. There can be no assurance that the Company's pending
patent applications, or any future applications will be approved. Further, there
can be no assurance that any issued patents will provide the Company with
significant intellectual property protection, competitive advantages, or will
not be challenged by third parties, or that the patents of others will not have
an adverse effect on the Company's ability to do business. In addition, there
can be no assurance that others will not independently develop similar products,
duplicate the Company's products or design around any patents that may be issued
to the Company.
The Company also relies on a combination of mask work protection,
trademarks, copyrights, trade secret laws, employee and third-party
nondisclosure agreements and licensing arrangements to protect its intellectual
property. Despite these efforts, there can be no assurance that others will not
independently develop substantially equivalent intellectual property or
otherwise gain access to the Company's trade secrets or intellectual property,
or disclose such intellectual property or trade secrets, or that the Company can
meaningfully protect its intellectual property. A failure by the Company to
meaningfully protect its intellectual property could have a material adverse
effect on the Company's business, financial condition and results of operations.
Page 20 of 25
As a general matter, the semiconductor industry is characterized by
substantial litigation regarding patent and other intellectual property rights.
In December 1998, the Company filed a lawsuit in the United States District
Court for the District of Delaware against Trident Microsystems, Inc. The suit
alleges that Trident's embedded DRAM graphics accelerators infringe certain
patents held by NeoMagic Corporation. In January 1999, Trident filed a counter
claim against the Company alleging an attempted monopolization in violation of
antitrust laws, arising from NeoMagic's filing of the patent infringement action
against Trident in December. The Company has filed for a summary motion to
dismiss the antitrust claim. There can be no assurance as to the result of the
request for summary motion, the patent infringement suit and the counter-suit
for antitrust filed by Trident.
The Company in the past has been, and in the future may be, notified
that it may be infringing the intellectual property rights of third parties. For
example, in February 1997, Cirrus Logic Inc. ("Cirrus Logic") sent the Company
written notice asserting that the Company's MagicGraph128, MagicGraph128V and
MagicGraph128ZV products infringe six United States patents held by Cirrus
Logic. Since receiving the notice of alleged infringement, the Company has
advised Cirrus Logic that the Company does not believe that any of its products
infringe any claims of the patents. The Company also has undergone a
confidential external infringement review and has conducted its own internal
infringement review, and the Company continues to believe that the Cirrus Logic
infringement allegations are unfounded. However, there can be no assurances that
Cirrus Logic will not file a lawsuit against the Company or that the Company
would prevail in any such litigation. Any protracted litigation by Cirrus Logic
or the success of Cirrus Logic in any such litigation could have a material and
adverse effect on the Company's financial position or results of operations.
Further, in February 1999, the Company was contacted by two of its
customers that they have been notified of potential infringement by a holder of
three United States patents and are requesting indemnification from NeoMagic. At
this time, the Company's counsel is in the preliminary stage of analyzing these
patents but has not reached a conclusion. The Company may have certain
indemnification obligations to customers with respect to the infringement of
third-party intellectual property rights by its products. There can be no
assurance that the Company's potential obligations to indemnify such customers
will not have a material adverse effect on the Company's business, financial
condition and results of operations. Further, there can be no assurances that
the Company or such customers would prevail in any patent litigation, or that
such customers will continue to purchase the Company's products while the
Company is under the threat of litigation.
Any patent litigation, whether or not determined in the Company's favor
or settled by the Company, would at a minimum be costly and could divert the
efforts and attention of the Company's management and technical personnel from
productive tasks, which could have a material adverse effect on the Company's
business, financial condition and results of operations. There can be no
assurance that current or future infringement claims by third parties or claims
for indemnification by other customers or end users of the Company's products
resulting from infringement claims will not be asserted in the future or that
such assertions, if proven to be true, will not materially adversely affect the
Company's business, financial condition and results of operations. In the event
of any adverse ruling in any such matter, the Company could be required to pay
substantial damages, which could include treble damages, cease the
manufacturing, use and sale of infringing products, discontinue the use of
certain processes, or to obtain a license under the intellectual property rights
of the third party claiming infringement. There can be no assurance, however,
that a license would be available on reasonable terms or at all. Any limitations
on the Company's ability to market its products, or delays and costs associated
with redesigning its products or payments of license fees to third parties, or
any failure by the Company to develop or license a substitute technology on
commercially reasonable terms could have a material adverse effect on the
Company's business, financial condition and results of operations.
DEPENDENCE ON INTERNATIONAL SALES AND SUPPLIERS
Export sales are a critical part of the Company's business. Sales to
customers located outside the United States (including sales to the foreign
operations of customers with headquarters in the United States and foreign
system manufacturers that sell to United States-based OEMs) accounted for 81.5%
and 86.3% for the first three months of fiscal 2000 and fiscal 1999,
respectively. The Company expects that net sales derived from international
sales will continue to represent a significant portion of its total net sales.
Letters of credit issued by customers support a portion of the Company's
international sales. To date, the Company's international sales have been
Page 21 of 25
denominated in United States dollars. Increases in the value of the U.S. dollar
relative to the local currency of the Company's customers could make the
Company's products relatively more expensive than competitors' products sold in
the customer's local currency.
International manufacturers produce all of the Company's wafers. In
addition, many of the assembly and test services used by the Company are
procured from international sources. Under the Company's wafer supply agreements
with Mitsubishi Electric and Toshiba, wafers are priced in Japanese yen. As a
result, the Company's costs of goods sold are subject to fluctuations in the
yen-dollar exchange rates. The Company has in the past hedged its exposure to
fluctuations in foreign currency exchange rates by purchasing foreign exchange
contracts and will continue to do so in the future. However, there can be no
assurance that such hedging will be adequate. Significant wafer or assembly and
test service price increases, fluctuations in currency exchange rates or the
Company's inability to fully hedge against currency exchange rate fluctuations
could have a material and sudden adverse effect on the Company's business,
financial condition and results of operations.
International sales and manufacturing operations are subject to a
variety of risks, including fluctuations in currency exchange rates, tariffs,
import restrictions and other trade barriers, unexpected changes in regulatory
requirements, longer accounts receivable payment cycles, potentially adverse tax
consequences and export license requirements. In addition, the Company is
subject to the risks inherent in conducting business internationally including
foreign government regulation, political and economic instability, and
unexpected changes in diplomatic and trade relationships. Moreover, the laws of
certain foreign countries in which the Company's products may be developed,
manufactured or sold, including various countries in Asia, may not protect the
Company's intellectual property rights to the same extent as do the laws of the
United States, thus increasing the possibility of piracy of the Company's
products. There can be no assurance that one or more of these risks will not
have a material adverse effect on the Company's business, financial condition
and results of operations.
NEED FOR ADDITIONAL CAPITAL
The Company requires substantial working capital to fund its business,
particularly to finance inventories and accounts receivable and for capital
expenditures. The Company believes that its existing capital resources will be
sufficient to meet the Company's capital requirements through the next 12
months, although the Company could be required, or could elect, to seek to raise
additional capital during such period. The Company's future capital requirements
will depend on many factors, including the rate of net sales growth, timing and
extent of spending to support research and development programs in new and
existing areas of technology, expansion of sales and marketing support
activities, and timing and customer acceptance for new products and enhancements
to existing products. The Company may raise additional equity or debt financing
in the future. There can be no assurance that additional equity or debt
financing, if required, will be available on acceptable terms or at all.
MANAGEMENT OF EXPANDED OPERATIONS
The Company has experienced, and may continue to experience, periods of
rapid growth and expansion both domestically and internationally, which have
placed and may continue to place a significant strain on the Company's limited
personnel and other resources. To manage these expanded operations effectively,
including the operations of recently acquired entities in the U.K. and Israel,
the Company will be required to continue to improve its operational, financial
and management systems. The Company is dependent upon its ability to
successfully hire, train, motivate and manage its employees, especially its
management and development personnel. If the Company's management is unable to
manage its expanded operations effectively, the Company's business, financial
condition and results of operations could be materially adversely affected.
DEPENDENCE ON QUALIFIED PERSONNEL
The Company's future success depends in part on the continued service
of its key engineering, sales, marketing, manufacturing, finance and executive
personnel, and its ability to identify, hire and retain additional personnel.
There is intense competition for qualified personnel in the semiconductor
industry, and there can be no assurance that the Company will be able to
continue to attract and train qualified personnel necessary for the development
of its business. The Company's anticipated growth is expected to place increased
demands on the
Page 22 of 25
Company's resources and will likely require the addition of new management
personnel and the development of additional expertise by existing management
personnel. Failure to recruit key personnel in a timely manner, or the loss
of existing key technical and management personnel could be significantly
detrimental to the Company's product development programs or otherwise have a
material adverse effect on the Company's business, financial condition and
results of operations.
VOLATILITY OF STOCK PRICE
The market price of the Company's Common Stock, like that of other
semiconductor companies, has been and is likely to continue to be, highly
volatile. The market has from time to time experienced significant price and
volume fluctuations that may be unrelated to the operating performance of
particular companies. The market price of the Company's Common Stock could be
subject to significant fluctuations in response to various factors, including
quarter-to-quarter variations in the Company's anticipated or actual operating
results, announcements of new products, technological innovations or setbacks by
the Company or its competitors, general conditions in the semiconductor and PC
industries, unanticipated shifts in the notebook PC market or industry
standards, loss of key customers, changes in DRAM pricing, litigation
commencement or developments, changes in or the failure by the Company to meet
estimates of the Company's performance by securities analysts, market conditions
for high technology stocks in general, and other events or factors.
Page 23 of 25
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings
In December 1998, the Company filed a lawsuit in the United
States District Court for the District of Delaware against Trident
Microsystems, Inc. ("Trident"). The suit alleges that Trident's
embedded DRAM graphics accelerators infringe certain patents held by
NeoMagic Corporation. In January 1999, Trident filed a counter claim
against the Company alleging an attempted monopolization in violation
of antitrust laws, arising from NeoMagic's filing of the patent
infringement action against Trident in December. The Company has filed
for a summary motion to dismiss the antitrust claim. There can be no
assurance as to the results of the request for summary motion, the
patent infringement suit and the counter-suit for antitrust filed by
Trident.
In February 1999, the Company was informed by two of its
customers that they have been notified of potential patent infringement
by a holder of three United States patents and are requesting
indemnification from NeoMagic. At this time, the Company's counsel is
in the preliminary stage of analyzing these patents but has not reached
a conclusion. The Company may have certain indemnification obligations
to customers with respect to the infringement of third-party
intellectual property rights by its products. There can be no assurance
that NeoMagic's potential obligation to indemnify such customers will
not have a material adverse effect on the Company's business, financial
condition and results of operations. Further, there can be no
assurances that the Company or such customers would prevail in any
patent litigation, or that such customers will continue to purchase
products from the Company while under threat of litigation.
ITEM 2. Changes in Securities
None.
ITEM 3. Defaults Upon Senior Securities
None.
ITEM 4. Submission of Matters to a Vote of Security Holders
None.
ITEM 5. Other Information
Not applicable.
ITEM 6. Exhibits and Reports on Form 8-K
(a) Exhibits
EXHIBIT
NUMBER DESCRIPTION
------- -----------
27.1 Financial Data Schedule
(b) Reports on Form 8-K
The Company did not file any reports on Form 8-K during the three
months ended April 30, 1999.
Page 24 of 25
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.
NEOMAGIC CORPORATION
(Registrant)
Merle McClendon
---------------
MERLE MC CLENDON
Vice President, Finance
and Chief Financial Officer
(Principal Financial and Accounting Officer)
May 28, 1999
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