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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

 

WASHINGTON, D.C.  20549

 

FORM 10-Q

 

ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2002

 

OR

 

o 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:  000-30269

 

PIXELWORKS, INC.

(Exact name of registrant as specified in its charter)

 

OREGON

 

91-1761992

(State or other jurisdiction of incorporation)

 

(I.R.S. Employer Identification No.)

 

8100 SW Nyberg Road, Third Floor
Tualatin, Oregon 97062

(503) 454-1750

(Address, including zip code, and telephone number, including
area code, of registrant’s principal executive offices)

 

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 last 90 days.

 

Yes  ý                   No  o

 

Number of shares of Common Stock outstanding as of July 31, 2002:        43,183,262

 

 



 

PIXELWORKS, INC.

 

Table of Contents

 

Part I

Financial Information

 

 

 

Condensed Consolidated Balance Sheets-June 30, 2002 and December 31, 2001

 

 

 

Condensed Consolidated Statements of Operations-Three and six months ended June 30, 2002 and 2001

 

 

 

Condensed Consolidated Statements of Cash Flows-Six months ended June 30, 2002 and 2001

 

 

 

Notes to Condensed Consolidated Financial Statements

 

 

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

 

Quantitative and Qualitative Disclosure About Market Risk

 

 

Part II

Other Information

 

 

 

Item 4

Submission of Matters to a Vote of Shareholders

 

Item 6

Exhibits and Reports on Form 8-K

 

 

Signatures

 

1



 

PART 1 - FINANCIAL INFORMATION

 

ITEM 1.  FINANCIAL STATEMENTS

 

PIXELWORKS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

 

(in thousands)

 

 

 

June 30,
2002

 

December 31,
2001

 

 

 

(Unaudited)

 

 

 

ASSETS

 

 

 

 

 

 

 

 

 

 

 

CURRENT ASSETS

 

 

 

 

 

Cash and cash equivalents

 

$

53,360

 

$

53,288

 

Short-term marketable securities

 

31,832

 

40,517

 

Accounts receivable, net

 

8,196

 

6,378

 

Inventories, net

 

5,054

 

4,176

 

Prepaid expenses and other current assets

 

4,280

 

3,667

 

Total current assets

 

102,722

 

108,026

 

 

 

 

 

 

 

Property and equipment, net

 

7,215

 

5,463

 

Long-term marketable securities

 

10,990

 

7,450

 

Goodwill, net

 

83,533

 

69,162

 

Other assets, net

 

18,016

 

12,738

 

Total assets

 

$

222,476

 

$

202,839

 

 

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS' EQUITY

 

 

 

 

 

 

 

 

 

 

 

CURRENT LIABILITIES

 

 

 

 

 

Accounts payable

 

$

2,755

 

$

2,391

 

Accrued liabilities and current portion of long-term debt

 

6,511

 

6,815

 

Total current liabilities

 

9,266

 

9,206

 

 

 

 

 

 

 

Shareholders' equity:

 

 

 

 

 

Common stock

 

278,613

 

259,363

 

Deferred stock compensation

 

(2,785

)

(5,658

)

Note receivable for common stock

 

(84

)

(84

)

Accumulated deficit

 

(62,534

)

(59,988

)

Total shareholders' equity

 

213,210

 

193,633

 

Total liabilities and shareholders' equity

 

$

222,476

 

$

202,839

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

2



 

PIXELWORKS, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

 

(Unaudited)

(in thousands, except share and per share data)

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2002

 

2001

 

2002

 

2001

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

24,644

 

$

22,732

 

$

46,649

 

$

44,075

 

Cost of revenue(1)

 

12,261

 

11,988

 

22,799

 

24,060

 

Gross profit

 

12,383

 

10,744

 

23,850

 

20,015

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Research and development(2)

 

5,275

 

4,310

 

10,727

 

8,534

 

Selling, general and administrative(3)

 

5,839

 

4,112

 

11,027

 

7,607

 

Amortization of goodwill and assembled workforce

 

 

4,359

 

 

7,265

 

In-process research and development expense

 

 

 

4,200

 

32,400

 

Amortization of deferred stock compensation

 

175

 

2,539

 

1,202

 

4,333

 

Total operating expenses

 

11,289

 

15,320

 

27,156

 

60,139

 

Income (loss) from operations

 

1,094

 

(4,576

)

(3,306

)

(40,124

)

 

 

 

 

 

 

 

 

 

 

Interest income

 

617

 

1,128

 

1,292

 

2,590

 

Interest expense

 

(23

)

 

(54

)

 

Interest income, net

 

594

 

1,128

 

1,238

 

2,590

 

Income (loss) before income taxes

 

1,688

 

(3,448

)

(2,068

)

(37,534

)

 

 

 

 

 

 

 

 

 

 

Income tax provision

 

327

 

 

478

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

1,361

 

$

(3,448

)

$

(2,546

)

$

(37,534

)

 

 

 

 

 

 

 

 

 

 

Basic and diluted net income (loss) per share

 

$

0.03

 

$

(0.08

)

$

(0.06

)

$

(0.94

)

 

 

 

 

 

 

 

 

 

 

Basic and diluted net income (loss) per share

 

$

0.03

 

$

(0.08

)

$

(0.06

)

$

(0.94

)

 

 

 

 

 

 

 

 

 

 

Weighted average shares - basic

 

42,804,499

 

40,956,346

 

42,613,282

 

40,108,316

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares - diluted

 

44,298,107

 

40,956,346

 

42,613,282

 

40,108,316

 

 


Amount excludes amortization of deferred stock compensation of:

 

(1) Cost of revenue

 

$

6

 

$

10

 

$

11

 

$

20

 

(2) Research and development

 

41

 

1,909

 

790

 

3,218

 

(3) Selling, general and administrative

 

128

 

620

 

401

 

1,095

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

3



 

PIXELWORKS, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

 

(Unaudited)

(in thousands)

 

 

 

Six Months Ended
June 30,

 

 

 

2002

 

2001

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(2,546

)

$

(37,534

)

Adjustments to reconcile net loss to net cash provided by operating activites:

 

 

 

 

 

Depreciation and amortization

 

2,781

 

2,065

 

Loss on disposal of assets

 

87

 

 

Amortization of goodwill and assembled workforce

 

 

7,265

 

Amortization of developed technology

 

220

 

 

Amortization of deferred stock compensation

 

1,202

 

4,333

 

In-process research and development expense

 

4,200

 

32,400

 

Changes in operating assets and liabilities, net of assets acquired:

 

 

 

 

 

Accounts receivable

 

(1,608

)

1,408

 

Inventories

 

(54

)

(2,500

)

Prepaid expenses and other current and long-term assets

 

(1,729

)

(1,415

)

Accounts payable

 

(969

)

(4,005

)

Accrued liabilities

 

(1,166

)

367

 

Net cash provided by operating activities

 

418

 

2,384

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Purchases of property and equipment

 

(3,450

)

(2,209

)

Purchases of other assets and investments

 

(912

)

(9,321

)

Acquisition, net of cash acquired

 

(1,541

)

 

Purchase of marketable securities

 

(21,880

)

(40,653

)

Maturities of marketable securities

 

27,025

 

56,361

 

Net cash provided by (used in) investing activities

 

(758

)

4,178

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Payments on long-term debt

 

(394

)

 

Proceeds from issuances of common stock

 

806

 

981

 

Cash provided by financing activities

 

412

 

981

 

 

 

 

 

 

 

Increase in cash and cash equivalents

 

72

 

7,543

 

Cash and cash equivalents at beginning of period

 

53,288

 

49,681

 

Cash and cash equivalents at end of period

 

$

53,360

 

$

57,224

 

 

 

 

 

 

 

Supplemental disclosure of cash flow information:

 

 

 

 

 

Interest paid

 

$

53

 

$

 

Taxes paid

 

$

35

 

$

66

 

Issuance of stock and stock options for acquisition of business

 

$

20,114

 

$

131,590

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

4



 

PIXELWORKS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except share and per share data)

 

Note 1:           Basis of Presentation

 

The financial information included herein for the three and six months ended June 30, 2002 and 2001 is unaudited; however, such information reflects all adjustments consisting only of normal recurring adjustments, which are, in the opinion of management, necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods.  The results of operations for the three and six months ended June 30, 2002 are not necessarily indicative of the results expected for the entire fiscal year ending December 31, 2002.

 

These financial statements have been prepared by Pixelworks, Inc. (the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such regulations, although the Company believes the disclosures provided are adequate to prevent the information presented from being misleading.

 

This report on Form 10-Q for the quarter ended June 30, 2002, should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2001 filed on March 25, 2002 (the “Form 10-K”).  Portions of the accompanying financial statements are derived from the audited year-end financial statements of the Company for the year ended December 31, 2001.

 

Segments – Statement of Financial Accounting Standards No. (“SFAS”) 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for disclosure about operating segments in annual financial statements and selected information in interim financial reports. Based on definitions contained within SFAS 131, the Company has determined that it operates within one segment. Substantially all of the assets of the Company are located in the United States.  Revenue by geographic region, attributed to countries based on the domicile of the customer, was as follows:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2002

 

2001

 

2002

 

2001

 

Japan

 

$

12,278

 

$

12,303

 

$

21,381

 

$

22,720

 

Taiwan

 

3,674

 

2,792

 

8,426

 

5,813

 

Korea

 

2,990

 

3,268

 

5,989

 

7,644

 

Malaysia

 

1,934

 

 

4,597

 

 

Other countries

 

3,768

 

4,369

 

6,256

 

7,898

 

Total revenue

 

$

24,644

 

$

22,732

 

$

46,649

 

$

44,075

 

 

5



 

Note 2:           Earnings per share

 

Basic earnings per share (“EPS”) is computed on the basis of the weighted average number of common shares outstanding.  Diluted EPS is computed on the basis of the weighted average common shares outstanding plus the effect of outstanding stock options using the “treasury stock” method, shares of convertible preferred stock on an as converted basis, and shares of restricted stock, if the potential common shares were not anti-dilutive.

 

The following weighted-average potential common shares have been excluded from the computation of diluted loss per share for the periods presented because the effect would have been anti-dilutive:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2002

 

2001

 

2002

 

2001

 

Potential common stock equivalent shares related to stock options

 

3,005,892

 

2,668,859

 

4,163,255

 

2,797,335

 

Shares of restricted stock subject to repurchase

 

 

134,051

 

55,500

 

145,771

 

 

Potential common stock equivalent shares related to stock options includes weighted shares for which the options’ exercise price was greater than the average market price of 3,005,892 and 211,661 for the three months ended June 30, 2002 and 2001, respectively and 2,482,826 and 659,486 for the six months ended June 30, 2002 and 2001, respectively.

 

Note 3:           Inventories

 

Inventories are stated at the lower of standard cost (approximates actual cost on a first-in, first-out basis) or market (net realizable value) and consist of the following:

 

 

 

June 30,
2002

 

December 31,
2001

 

 

 

 

 

 

 

Finished goods

 

$

3,299

 

$

3,993

 

Work-in-process

 

1,755

 

183

 

 

 

$

5,054

 

$

4,176

 

 

Note 4:           Acquisitions

 

On January 14, 2002, the Company acquired 100% of the outstanding shares of nDSP Delaware, Inc. (“nDSP”).  The results of nDSP’s operations have been included in the Company’s financial statements beginning on the date of acquisition.  nDSP is a fabless semiconductor company involved in the development of  video processing ICs for the advanced display market.  nDSP, headquartered in California, also has offices in Mainland China.  The acquisition of nDSP is expected to strengthen Pixelworks’ advanced video processing product and technology portfolio and enable the Company to compete in the analog CRT and digital TV market.  nDSP’s technologies complement the technology found in Pixelworks’ system-on-a-chip ICs.  Pixelworks plans to bring the nDSP technology to market in both the products originally developed by nDSP and new integrated products thus creating a portfolio of products that address a full range of price and performance criteria.

 

The aggregate purchase price of nDSP was approximately 1.2 million shares of Pixelworks common stock valued at $20.1 million. The estimated fair value of the shares issued was based on the average closing price of Pixelworks’ common stock on the day prior to the announcement of the Agreement and Plan of Merger, the day of the announcement, and the day following the announcement ($16.96 per share).

 

6



 

The purchase price for accounting purposes was derived as follows:

 

 

 

nDSP
Shares

 

Total
Pixelworks
Common Shares

 

Fair Value

 

nDSP Common

 

6,534,079

 

19,843

 

$

337

 

nDSP Series A preferred

 

6,692,918

 

381,209

 

6,465

 

nDSP Series B preferred

 

6,118,723

 

784,943

 

13,312

 

 

 

19,345,720

 

1,185,995

 

20,114

 

 

 

 

 

 

 

 

 

Estimated acquisition costs

 

 

 

 

 

857

 

 

 

 

 

 

 

 

 

Total purchase price

 

 

 

 

 

$

20,971

 

 

The purchase price was allocated to the assets and liabilities based on fair values as follows:

 

Assets acquired:

 

 

 

Current assets

 

$

1,409

 

Non-current assets

 

741

 

Acquired in-process research and development

 

4,200

 

Developed technology

 

3,700

 

Goodwill

 

14,371

 

 

 

 

 

Less:

 

 

 

Liabilities assumed

 

(3,450

)

 

 

 

 

Allocated purchase price

 

$

20,971

 

 

In connection with this acquisition, the Company obtained a third-party valuation of certain intangible assets.  Of the $22.3 million of acquired intangible assets, $3.7 million was assigned to acquired developed technology with a seven year estimated remaining life and $4.2 million was assigned to in-process research and development (“IPR&D”) assets that were expensed  at the date of acquisition in accordance with FASB Interpretation No. 4 (“FIN 4”), Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method.  The $14.4 million of goodwill was assigned to Pixelworks, the Company’s sole reporting unit.  In addition, the Company recorded a deferred tax asset of approximately $6.2 million, subject to a full valuation allowance, to recognize book basis and tax basis differences of various balance sheet assets and liabilities and corporate tax attributes acquired.  If the valuation allowance is subsequently reduced the amount of any adjustment will increase the goodwill recorded as part of the acquisition.

 

The value assigned to IPR&D related to research projects for which technological feasibility had not been established and no future alternative uses existed.  The fair value was determined using the income approach, which discounts expected future cash flows from projects under development to their net present value using a risk adjusted rate. Each project was analyzed to determine the technological innovations included; the utilization of core technology; the complexity, cost and time to complete development; any alternative future use or current technological feasibility; and the stage of completion.  Future cash flows were estimated, taking

 

7



 

into account the expected life cycles of the product and the underlying technology, relevant market sizes and industry trends.  The estimated net cash flows from these products were based on management’s estimates of related revenues, cost of goods sold, R&D costs, selling, general and administrative costs, income taxes and charges for the use of contributory assets.  A discount rate was determined for each project based on the technology of the product.  For the developed technology a discount rate of 35% was used.  The in-process technology rates utilized ranged from 40% to 55% and were based on the stage of completion of the project, the complexity of the development effort and the risks associated with reaching technological feasibility of the project. The nature of the efforts to develop the in-process technology into commercially viable products principally related to the completion of all planning, designing, prototyping, verification and testing activities that are necessary to establish that the product can be produced to meet its design specification, including function, features and technical performance requirements.

 

nDSP had three main product groups under development at the acquisition date, each contributing from 7% to 64% of the total IPR&D value.  The projects under development were video processing ICs targeting the digital display and analog CRT television markets.  The projects ranged from 20% to 80% complete.  All projects had expected completion dates within one year and an estimated aggregate cost to complete of $2.5 million.

 

On January 30, 2001, we completed the acquisition of all of the outstanding capital stock and stock options of Panstera, Inc. (“Panstera”), a privately held fabless semiconductor company located in San Jose, California, in exchange for 4.5 million shares of Pixelworks Common Stock.  The acquisition was recorded as a purchase transaction and the results of Panstera’s operations have been included in the Company’s financial statements beginning on the date of acquisition.  The Company incurred a charge of $32.4 million in the first quarter of 2001 for IPR&D related to the acquisition.

 

The following table reflects the unaudited combined results of Pixelworks, Inc., Panstera, and nDSP as if the mergers had taken place at the beginning of 2001.  Both periods exclude charges for in-process research and development expense. The pro forma information does not necessarily reflect the actual results that would have occurred nor is it necessarily indicative of future results of operations of the combined companies.

 

 

 

Three months ended
June 30,

 

Six months ended
June 30,

 

 

 

2001

 

2002

 

2001

 

Net revenue

 

$

23,802

 

$

46,710

 

$

45,346

 

Net income (loss)

 

(5,648

)

1,420

 

(12,332

)

Net income (loss) per share:

 

 

 

 

 

 

 

Basic and diluted

 

$

(0.13

)

$

0.03

 

$

(0.29

)

Weighted average shares outstanding:

 

 

 

 

 

 

 

Basic

 

42,142,341

 

42,797,770

 

42,535,293

 

Diluted

 

42,142,341

 

44,482,595

 

42,535,293

 

 

The company recently announced the exercise of its option to purchase the remaining interest in Jaldi Semiconductor for 1.85 million shares of Pixelworks common stock.  The Company expects the acquisition of Jaldi to be completed in the third quarter of 2002.  As of June 30, 2002, the Company had a $7.5 million cost-based investment in Jaldi and a $1.0 million note receivable from Jaldi, both of which were included in other assets on the Company’s balance sheet.

 

Goodwill and other acquisition related intangibles.  The Company adopted FAS 142 on January 1, 2002.  As a result goodwill and assembled workforce are no longer being amortized.  Through December 31, 2001, goodwill and assembled workforce were being amortized over an estimated life of 60 and 36 months respectively.  Upon adoption of FAS 142, assembled workforce was reclassified as goodwill.  Acquisition related intangibles, net of accumulated amortization at the end of each period consisted of the following:

 

8



 

 

 

June 30,
2002

 

December 31,
2001

 

Goodwill

 

$

83,533

 

$

67,912

 

Assembled workforce

 

 

1,250

 

Developed technology

 

3,480

 

 

 

 

$

87,013

 

$

69,162

 

 

The following schedule reconciles reported net loss for all periods presented to adjusted net loss and loss per share exclusive of amortization of goodwill and assembled workforce.

 

 

 

Three months ended
June 30,

 

Six months ended
June 30,

 

 

 

2002

 

2001

 

2002

 

2001

 

Net income (loss)

 

$

1,361

 

$

(3,448

)

$

(2,546

)

$

(37,534

)

Add back: amortization of goodwill and assembled workforce

 

 

4,359

 

 

7,265

 

Adjusted net income (loss)

 

$

1,361

 

$

911

 

$

(2,546

)

$

(30,269

)

 

 

 

 

 

 

 

 

 

 

Basic and diluted net income (loss) per share

 

$

0.03

 

$

(0.08

)

$

(0.06

)

$

(0.94

)

Adjusted basic and diluted net income (loss) per share

 

$

0.03

 

$

0.02

 

$

(0.06

)

$

(0.75

)

 

FAS 141 required, upon adoption of FAS 142, that the Company evaluate its existing intangible assets and goodwill that were acquired in a prior purchase business combination, and to make any necessary reclassifications in order to conform with the new criteria in FAS 141 for recognition apart from goodwill.  As a result, the Company reclassified $1.25 million of assembled workforce to goodwill on January 1, 2002. Upon adoption of FAS 142, the Company was required to reassess the useful lives and residual values of all intangible assets acquired, and make any necessary amortization period adjustments by the end of the first interim period after adoption.  In addition, to the extent an intangible asset is identified as having an indefinite useful life, the Company was required to test the intangible asset for impairment in accordance with the provisions of FAS 142 within the first interim period.  To accomplish this, the Company identified one reporting unit, Pixelworks, and determined the carrying value of that reporting unit by assigning the assets and liabilities, including the existing goodwill and intangible assets, to that reporting unit as of the date of adoption.  No impairment loss was indicated as of the date of adoption and the Company did not recognize any impairment loss as the cumulative effect of a change in accounting principle in the first interim period.  As of the date of adoption, the Company had $69.2 million, which is subject to the transition provisions of FAS 141 and 142.

 

Note 5:           Concentration of Credit Risk

 

As of June 30, 2002, Pixelworks had accounts receivable from one distributor representing 46% of accounts receivable.  Loss or non-performance by this significant customer could adversely affect Pixelworks financial position or results of operations.

 

9



 

Note 6:           Recent accounting pronouncements

 

In August 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 requires that the fair value of retirement obligations be recognized as a liability when they are incurred and that the associated retirement costs be capitalized as a long-term asset and expensed over its useful life. The provisions of SFAS No. 143 will be effective for fiscal years beginning after June 15, 2002. The Company does not expect that the adoption of SFAS No. 143 will have a material effect on its financial position or results of operations.

 

In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supercedes SFAS No. 121 and the accounting and reporting provisions of APB Opinion No. 30 as it relates to the disposal of a segment of a business. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. The Company adopted SFAS No. 144 effective January 1, 2002. The adoption of SFAS 144 has not had an impact on the Company’s consolidated financial position or results of operations.

 

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections.  SFAS No. 145 rescinds SFAS No. 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect.  Upon adoption of SFAS No., 145, companies will be required to apply the criteria in APB Opinion No. 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, in determining the classification of gains and losses resulting from the extinguishment of debt.  Additionally, SFAS No. 145 amends SFAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions.  SFAS No. 145 will be effective for fiscal years beginning after May 15, 2002 with early adoption of the provisions related to the rescission of SFAS No. 4 encouraged. The Company has not yet determined what effect this statement will have on its financial statements.

 

In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which changes the way a Company will report the expenses related to restructuring.  SFAS No. 146 is required to be adopted for exit or disposal activities initiated after December 31, 2002.

 

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ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

This Form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. These forward-looking statements involve a number of risks and uncertainties, including those identified in the section of this Form 10-Q titled “Additional Factors That May Affect Future Results,” which could cause actual results to differ materially from those discussed in the forward-looking statements. Forward-looking statements in this Form 10-Q are identified by words such as “believes,” “expects,” “anticipates,” “intends,” “estimates,” “should,” “will,” “may” and similar expressions. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. The forward-looking statements contained in this Form 10-Q speak only as of the date on which they are made, and the company does not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date of this filing.  You are urged to review carefully our various disclosures in this Form 10-Q and our other reports filed with the SEC, including our 2001 Annual Report on Form 10-K filed on March 25, 2002 (the “Form 10-K”), that attempt to advise you of the risks and factors that may affect our business.

 

Overview

 

We design, develop and market system-on-a-chip integrated circuits (“ICs”) and software for the advanced display industry. Our technology translates and optimizes video, computer graphics, and visual Web information for display on a wide variety of electronic devices. We have announced products in production with Compaq, Dell, Hewlett-Packard, Hitachi, InFocus Corporation, NEC-Mitsubishi, Samsung, SANYO, Seiko Epson, Sharp, Sony and ViewSonic.

 

On January 30, 2001, we invested $7.5 million in Jaldi Semiconductor Corporation (“Jaldi”), a privately held fabless semiconductor start-up developing application specific reconfigurable Digital Signal Processing (“DSP”) technology, in exchange for a minority interest in Jaldi.  At the time of the investment we acquired an option to purchase the remaining interest in Jaldi for 1.85 million shares of Pixelworks Common Stock.  On May 2, 2002, we announced that we exercised the option to acquire the remaining interest in Jaldi.  The transaction is expected to close in the third quarter of 2002.  We expect to incur a one-time charge in the third quarter of 2002 for purchased in-process research and development (“IPR&D”) related to the acquisition.

 

Also on January 30, 2001, we completed the acquisition of all of the outstanding capital stock and stock options of Panstera, Inc. (“Panstera”), a privately held fabless semiconductor company located in San Jose, California, in exchange for 4.5 million shares of Pixelworks Common Stock.  The acquisition was recorded as a purchase transaction and the Company incurred a charge of $32.4 million in the first quarter of 2001 for IPR&D related to the acquisition. At the time of the acquisition, Panstera was developing a line of mixed signal IC’s for the XGA resolution LCD monitor market, none of which had reached technological feasibility.  Panstera had four main product groups under development at the acquisition date, each contributing from 11% to 41% to the total IPR&D value.  The projects included the development of digital and analog receivers as well as digital processor ICs.  The projects ranged from an estimated 50% to 85% complete.  After the acquisition we redefined some of the product development efforts begun by Panstera by combining elements of technology developed prior to the acquisition at Panstera with technology developed at Pixelworks.  Development efforts on the four main product groups have now been concluded.

 

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On January 14, 2002, we acquired all of the outstanding shares of nDSP, Inc. in exchange for approximately 1.2 million shares of Pixelworks stock.  nDSP was a privately held fabless semiconductor company providing video processing ICs designed to enhance the picture quality of televisions, flat panel displays, and multimedia projectors.  The transaction was accounted for by the purchase method of accounting, and accordingly, the results of operations of nDSP, Inc. are included in the Company’s financial statements beginning on the date of acquisition.  Pixelworks recorded a one-time charge of $4.2 million in the quarter ended March 31, 2002 for purchased in-process research and development expenses related to the acquisition.  At the time of the acquisition nDSP had one product group in production and three main product groups under development, each contributing from 7% to 64% of the total IPR&D value.  The projects under development were video processing ICs targeting the digital display and analog CRT television markets.  The projects ranged from 20% to 80% complete with expected completion dates within one year and an estimated aggregate cost to complete of $2.5 million.  Since the date of the acquisition one of the products in development has been completed and the estimated completion dates of the other two products remain substantially unchanged.

 

We sell our products worldwide through a direct sales force and indirectly through distributors and manufacturers representatives. Distributors have been established in Europe, Japan, Taiwan and China. Sales to distributors represented 64% and 58% of total revenue for the six months ended June 30, 2002 and 2001, respectively.  Manufacturers representatives support some of our European and Korean sales. In addition to our Tualatin, Oregon corporate headquarters, we have facilities in California, Japan, Mainland China, Taiwan and Korea.

 

We recognize revenue from product sales upon shipment. Pixelworks applies the revenue recognition guidance summarized in Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements.  Reserves for sales returns and allowances are recorded at the time of shipment.

 

Historically, significant portions of our product revenue have been from a relatively small number of customers and distributors. Our top five customers accounted for 42% and 44% of total revenue for the six months ended June 30, 2002 and 2001, respectively.

 

Significant portions of our products are sold overseas. Sales outside the U.S. accounted for 99% and 92% of total revenue for the six months ended June 30, 2002 and 2001, respectively. Our end customers, branded manufacturers and integrators, incorporate our products into systems that are sold worldwide. All revenue to date has been denominated in U.S. dollars.

 

Critical Accounting Policies and Estimates

 

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. On an on-going basis, the Company evaluates its estimates, including those related to product returns, bad debts, inventories, investments, prepaid expenses, intangible assets, income taxes, warranty obligations, litigation and other contingencies. Pixelworks bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions.

 

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Pixelworks believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements. The Company records estimated reductions to revenue for customer returns based on historical experience.  If actual customer returns increase as a result of future product introductions, the Company may be required to recognize additional reductions to revenue. The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of Pixelworks’ customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Pixelworks provides for the estimated cost of product warranties at the time revenue is recognized. While Pixelworks engages in extensive product quality programs and processes, including actively monitoring and evaluating the quality of its suppliers, Pixelworks’ estimated warranty liability is affected by product failure rates and material usage and service delivery costs incurred in correcting a product failure. Should actual product failure rates, material usage or service delivery costs differ from Pixelworks’ estimates, revisions to the estimated warranty liability would be required.  Pixelworks establishes a reserve for its inventory for estimated obsolescence or unmarketable inventory by calculating the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required. Pixelworks records a valuation allowance to reduce its deferred tax assets to the amount that is more likely than not to be realized. Should Pixelworks determine that it would not be able to realize all or part of its net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.

 

Results of Operations

 

Three Months Ended June 30, 2002 Compared to Three Months Ended June 30, 2001

 

Revenue. Revenue for the three months ended June 30, 2002 increased to $24.6 million from $22.7 million in the three months ended June 30, 2001, an 8% increase.  Revenue from products shipped to advanced television and multimedia projector manufacturers increased approximately $3.7 million and $700,000, respectively, which was partially offset by a $2.5 million decrease in revenue from shipments to LCD monitor manufacturers. The increase in revenue from advanced television manufacturers resulted primarily from new product shipments of PW112, PW1210, and PW1220 ICs.  Revenue from projector manufacturers increased as a result of a 36% increase in unit shipments being partially offset by a reduction in the average selling price of the products.  Revenue from LCD monitor manufacturers decreased despite unit growth of 59% as a result of price reductions on existing products as well as the introduction of new products at prices substantially below those of existing products.  As a percentage of total revenue, products shipped to multimedia projector, LCD monitor, and advanced television manufacturers represented approximately 56%, 25%, and 17% of revenue, respectively, for the quarter ended June 30, 2002.  This compared to approximately 57%, 38%, and 2% of total revenue from products shipped into multimedia projectors, LCD monitors, and advanced televisions, respectively, in the quarter ended June 30, 2001.

 

Gross profit. Gross profit margin was 50.2% for the period ended June 30, 2002 compared to 47.2% for the period ended June 30, 2001, inclusive of amortization of deferred stock compensation of $6,000 and $10,000 respectively.  The improvement in gross profit margin resulted primarily from a greater percentage of revenue from products sold into advanced televisions, which carry higher average gross profit margins.

 

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Research and development. Research and development expense, inclusive of amortization of deferred stock compensation, was $5.3 million or 21.6% of total revenue for the three months ended June 30, 2002 which compared to $6.2 million or 27.4% of revenue for the three months ended June 30, 2001. The reduction in research and development expense resulted primarily from a decrease of  $1.9 million in stock compensation expense as the result of employee terminations, which was partially offset by an increase of $1.0 million in compensation expense primarily related to an increase in personnel resulting from our January 2002 acquisition of nDSP.

 

Selling, general and administrative. Selling, general and administrative expense, inclusive of amortization of deferred stock compensation, was $6.0 million or 24.2% of total revenue for the three months ended June 30, 2002 which compared to $4.7 million, or 20.8% of total revenue for the three months ended June 30, 2001. The increase in expense resulted primarily from a $588,000 increase in compensation expense due to an increase in the number of employees, $292,000 increase in rent expense resulting from leasing additional building space to support a greater number of employees, and $292,000 increase in accounting and legal fees.

 

Amortization of goodwill and assembled workforce.  As a result of FAS 142, effective January 1, 2002 goodwill and assembled workforce are no longer being amortized.  As a result, there were no expenses for the amortization of goodwill and assembled workforce for the three months ended June 30, 2002 compared to $4.4 million for the three months ended June 30, 2001.  As of June 30, 2002, there was $83.5 million in goodwill on the balance sheet as a result of the acquisitions of Panstera and nDSP.

 

Amortization of deferred stock compensation. Stock compensation expense was $175,000 for the three months ended June 30, 2002, a decrease of $2.3 million from $2.5 million for the three months ended June 30, 2001. The decrease was due primarily to the reversal of previously expensed stock compensation for unvested stock options that were cancelled upon employee termination.

 

Interest income, net. Interest income, net consists of interest income and interest expense.  Interest income, net decreased $534,000 from $1.1 million for the three months ended June 30, 2001 to $594,000 for the three months ended June 30, 2002.  This decrease was primarily the result of lower yields on invested cash in the current period due to overall interest rates declining over the past year.

 

Provision for income taxes.  The Company recorded a provision for income tax expense during the three months ended June 30, 2002 of $327,000.  This represented a 19% effective tax rate for the period.  The tax provision recorded in the period was determined by estimating the tax provision for the year and the proportionate amount of pretax income for tax purposes generated through June 30, 2002.  While the Company is estimating a book net loss for the year according to accounting principles generally accepted in the United States (GAAP), the Company expects to report pretax income for the year for tax purposes since the Company is not able to deduct certain expenses for tax purposes that are deducted when reporting financial results according to GAAP.  As a result of the merger with nDSP the Company added $6.2 million in deferred tax assets, related primarily to nDSP’s net operating loss carry-forward, which will be offset against goodwill when utilized.

 

Six Months Ended June 30, 2002 Compared to Six Months Ended June 30, 2001

 

Revenue. Revenue for the six months ended June 30, 2002 increased to $46.6 million from $44.1 million in the six months ended June 30, 2001, a 6% increase.  Overall, unit shipments increased 95% while the aggregate average selling price of products sold decreased 46%.  Revenue from products shipped to advanced television and multimedia projector manufacturers increased approximately $5.8 million and $800,000, respectively.  The increase in revenue from advanced

 

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television customers resulted primarily from shipment of new products including those resulting from the January 2002 acquisition of nDSP.  The increase in revenue from multimedia projector customers resulted from a 30% increase in unit shipments, which was partially offset by lower average selling prices.  The average selling price of IC’s being sold to projector manufacturers declined both due to price reductions given to customers and a shift in mix toward lower priced IC’s going into projectors with lower end user price points.  Revenue from products shipped to LCD monitor manufacturers decreased $3.9 million with unit growth of 61% being more than offset by the average selling price of LCD monitor ICs declining by 53%.  The decline in average selling price resulted primarily from the shipment of new products at price points below those of previous generation products.  As a percentage of total revenue, products shipped into multimedia projectors, LCD monitors, and advanced televisions represented approximately 56%, 27%, and 14% of revenue, respectively, for the six months ended June 30, 2002.  This compared to approximately 58%, 37%, and 2% of total revenue from products shipped into multimedia projectors, LCD monitors, and advanced televisions, respectively, in the period ended June 30, 2001.

 

Gross profit. Gross profit margin was 51.1% for the period ended June 30, 2002 compared to 45.4% for the period ended June 30, 2001, inclusive of amortization of deferred stock compensation of $11,000 and $20,000 respectively.  The improvement in gross profit margin resulted primarily from a greater percentage of revenue from higher margin products sold into advanced televisions and lower percentage of revenue from lower margin products sold into LCD monitors.  Gross profit margins were also positively affected by cost reductions on products being sold to projector customers.

 

Research and development. Research and development expense, inclusive of amortization of deferred stock compensation, was $11.5 million or 24.7% of total revenue for the six months ended June 30, 2002 which compared to $11.8 million, or 26.7% of revenue for the six months ended June 30, 2001. The reduction in research and development expense resulted primarily from a decrease of $2.4 million in stock compensation expense that was partially offset by a $2.1 million increase in compensation expense.  Stock compensation expense decreased as a result of employee terminations.  Compensation expense increased primarily due to an increase in personnel with most of the increase in headcount resulting from the acquisition of nDSP in January 2002.

 

Selling, general and administrative. Selling, general and administrative expense, inclusive of amortization of deferred stock compensation, was $11.4 million or 24.5% of total revenue for the six months ended June 30, 2002 which compared to $8.7 million or 19.7% of total revenue for the six months ended June 30, 2001. Most of the $2.7 million increase resulted from a $1.5 million increase in compensation expense related primarily to an increase in personnel, $563,000 increase in rent expense resulting from leasing additional building space, and $359,000 increase in accounting and legal expenses.

 

Amortization of goodwill and assembled workforce.  As a result of FAS 142, effective January 1, 2002 goodwill and assembled workforce are no longer being amortized.  As a result, there were no expenses for the amortization of goodwill and assembled workforce for the six months ended June 30, 2002 compared to $7.3 million for the six months ended June 30, 2001.  As of June 30, 2002, there was $83.5 million in goodwill on the balance sheet as a result of the acquisitions of Panstera and nDSP.

 

In-process R&D expense.  In-process R&D expense for the six months ended June 30, 2002, which resulted from the acquisition of nDSP, was $4.2 million.  This compared to in-process R&D expense for the six months ended June 30, 2001 of $32.4 million, which resulted from the

 

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acquisition of Panstera.  In-process R&D expense represents the discounted future cash flows from R&D projects in development, but not yet completed, at the time of our acquisitions of nDSP and Panstera.

 

Amortization of deferred stock compensation. Stock compensation expense was $1.2 million for the six months ended June 30, 2002, a decrease of $3.1 million from $4.3 million for the six months ended June 30, 2001. The decrease was due primarily to deferred stock compensation being amortized on an accelerated method which results in a decreasing amount of deferred stock compensation expense each year and as a result of the reversal of previously expensed stock compensation for unvested stock options that were cancelled upon employee termination in the current period.

 

Interest income, net. Interest income, net consists of interest income and interest expense.  Interest income, net decreased $1.3 million from $2.6 million for the six months ended June 30, 2001 to $1.3 million for the six months ended June 30, 2002.  This decrease was primarily the result of lower yields on invested cash in the current period due to overall interest rates declining over the past year.

 

Provision for income taxes.  The Company recorded a provision for income tax expense during the six months ended June 30, 2002 of $478,000.  Although the Company recognized a pretax book loss for the period and expects a pretax loss for the year ending December 31, 2002, the Company expects a tax provision will be necessary due to certain large non-cash expenses recognized for book purposes not being deductible for tax purposes which results in expected pretax income for tax purposes. These large non-cash expenses that are not deductible for tax purposes include primarily amortization of developed technology, in-process research and development expense, and stock compensation expense.

 

Liquidity and Capital Resources

As of June 30, 2002, the Company had cash and cash equivalents of $53.4 million and working capital of $93.5 million as compared to cash and cash equivalents of $53.3 million and working capital of $98.8 million as of December 31, 2001.  Principal sources of cash during the six months ended June 30, 2002 were cash generated by operating activities of $418,000, proceeds from the issuance of stock under the Company’s employee stock purchase plan and stock option plans of $806,000, and proceeds net of purchases of marketable securities of $5.1 million. Principal uses of cash during the six months ended June 30, 2002 were debt payments of $394,000, the acquisition of nDSP, net of cash received, of $1.5 million, property and equipment expenditures of $3.5 million, and purchases of other assets of $912,000.

 

Accounts Receivable.  Accounts receivable increased to $8.2 million on June 30, 2002 from $6.4 million at December 31, 2001, an increase of $1.8 million or 28%.  The increase in accounts receivable was primarily related to an increase in revenue in the quarter ended June 30, 2002 and the timing of shipments within the quarter.  Average days sales outstanding (“DSO”) were 30 and 26 days at June 30, 2002 and December 31, 2001, respectively.

 

Inventories.  Inventories increased $878,000 from $4.2 million at December 31, 2001 to $5.1 million at June 30, 2002.  The increase was due to a $1.6 million increase in work in process inventories that was partially offset by a $694,000 decrease in finished goods.  The increase in work in process inventories resulted from an increase in new product wafer starts.  Inventory turns were 7.6 and 10.0 at June 30, 2002 and December 31, 2001, respectively.  Inventory turns of 7.6 represented approximately 7 weeks of shipments in inventory.

 

Long-Term Marketable Securities and Other Assets.  Long-term marketable securities consisting of corporate and federal agency bonds with less than 2 years remaining to maturity were $11.0 million at June 30, 2002.  The Company has slightly increased the average maturity of its marketable securities to take advantage of higher long-term interest rates.

 

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Other assets increased $5.3 million from $12.7 million on December 31, 2001 to $18.0 million on June 30, 2002.  The increase was primarily the result of $3.7 million of purchased developed technology as a result of the nDSP acquisition on January 14, 2002 and a loan of $1.0 million to Jaldi Semiconductor (“Jaldi”).

 

As of June 30, 2002, principal commitments consisted of obligations outstanding under operating leases.  These commitments include leases for approximately 52,000 square feet in two facilities located in Tualatin, Oregon, expiring through 2006 and two facilities in California for approximately 20,000 square feet.  The total annual estimated costs for these commitments are $1.8 million, $1.8 million, $1.1 million, $885,000 and $530,000 for the years ending December 31, 2002, 2003, 2004, 2005 and 2006, respectively.  As a result of the acquisition of nDSP, the Company assumed some debt for equipment leases that as of June 30, 2002 represented approximately $600,000.  All of the equipment lease payments are scheduled for payment over the next 12 months.  Although the Company has no other material commitments, we anticipate a substantial increase in our capital expenditures consistent with anticipated growth in our operations, infrastructure and personnel. In the future we may also require a larger inventory of products in order to support anticipated growth in our business.

 

The company recently announced the exercise of its option to purchase the remaining interest in Jaldi for 1.85 million shares of Pixelworks common stock.  The Company expects the acquisition of Jaldi to be completed in the quarter ending September 30, 2002.  Pursuant to the original investment agreement, the Company agreed to provide debt financing to Jaldi of up to $2.0 million.  Jaldi may borrow on this commitment in two draw-downs of up to $1.0 million each in May and August 2002.  In the event the merger is not consummated, principal plus interest will be due on the second anniversary of the loans.  Interest will accrue at an annual rate of 7%.  The Company will incur a $10.0 million break-up fee in the event that Jaldi meets all conditions necessary for the merger to close and the Company does not complete the merger.  As of June 30, 2002, the Company had a $1.0 million note receivable from Jaldi included in other assets.

 

The Company believes that its existing cash and cash equivalents and funds generated from operations will be sufficient to fund its operations for the next twelve months and the foreseeable future.  From time to time, we may evaluate acquisitions of businesses, products or technologies that complement our business.  Any such transactions, if consummated, may consume a material portion of our working capital or require the issuance of equity securities that may result in dilution to existing shareholders.

 

Recent Accounting Pronouncements

 

In August 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 requires that the fair value of retirement obligations be recognized as a liability when they are incurred and that the associated retirement costs be capitalized as a long-term asset and expensed over its useful life. The provisions of SFAS No. 143 will be effective for fiscal years beginning after June 15, 2002. The Company does not expect that the adoption of SFAS No. 143 will have a material effect on its financial position or results of operations.

 

In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets and supercedes SFAS No. 121 and the accounting and reporting provisions of APB Opinion No. 30 as it relates to the disposal of a segment of a business. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. The Company adopted SFAS No. 144 effective January 1, 2002. The adoption of SFAS 144 has not had an impact on the Company’s consolidated financial position or results of operations.

 

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In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections.  SFAS No. 145 rescinds SFAS No. 4, which required all gains and losses from extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect.  Upon adoption of SFAS No., 145, companies will be required to apply the criteria in APB Opinion No. 30, Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, in determining the classification of gains and losses resulting from the extinguishment of debt.  Additionally, SFAS No. 145 amends SFAS No. 13 to require that certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions.  SFAS No. 145 will be effective for fiscal years beginning after May 15, 2002 with early adoption of the provisions related to the rescission of SFAS No. 4 encouraged. The Company has not yet determined what effect this statement will have on its financial statements.

 

In July 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which changes the way a Company will report the expenses related to restructuring.  SFAS No. 146 is required to be adopted for exit or disposal activities initiated after December 31, 2002.

 

Additional Factors That May Affect Future Results

 

Investing in our shares of common stock involves a high degree of risk.  If any of the following risks occur, the market price of our shares of common stock could decline and investors could lose all or part of their investment.

 

RISKS RELATED TO OUR OPERATIONS

 

While we have had quarterly periods of net income, including the most recently completed quarter ended June 30, 2002, we have incurred net losses on an annual basis since our inception and may not be able to achieve or sustain profitability on either a quarterly or annual basis in the future.

 

We incurred net losses of approximately $2.5 million for the six months ended June 30, 2002 and cumulative net losses of approximately $52.5 million through June 30, 2002. In the future we expect our research and development and selling, general and administrative expenses to increase.  Given expected increases in operating expense, we must increase revenues and gross profit to be profitable.  We cannot be certain that we will be profitable in the future or, if we do, that we can sustain or increase profitability on a quarterly or annual basis. This may in turn cause the price of our common stock to decline. In addition, if we are not profitable in the future we may be unable to continue our operations.

 

Fluctuations in our quarterly operating results make it difficult to predict our future performance and may result in volatility in the market price of our common stock.

 

Our quarterly operating results are likely to vary significantly in the future based on a number of factors related to our industry and the markets for our products, some of which are not in our control and any of which may cause the price of our common stock to fluctuate. These factors include:

 

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demand for flat panel monitors, advanced television displays, multimedia projectors and internet appliances;

 

demand for our products and the timing of orders for our products;

 

the deferral of customer orders in anticipation of our new products or product enhancements or due to a reduction in our end customers’ demand;

 

the loss of one or more of our key distributors or customers or a reduction, delay or cancellation of orders from one or more of these parties;

 

changes in the available production capacity at the semiconductor fabrication foundries that manufacture our products and changes in the costs of manufacturing;

 

our ability to provide adequate supplies of our products to customers and avoid excess inventory;

 

announcement or introduction of products and technologies by our competitors;

 

changes in product mix, product costs or pricing, or distribution channels; and

 

general economic conditions and economic conditions specific to the personal computer, display and semiconductor markets.

 

These factors are difficult to forecast, and these or other factors could seriously harm our business. We anticipate the rate of new orders may vary significantly from quarter to quarter. Our operating expenses and inventory levels are based on our expectations of future revenues and our operating expenses are relatively fixed in the short term. Consequently, if anticipated sales and shipments in any quarter do not occur when expected, operating expenses and inventory levels could be disproportionately high, and our operating results for that quarter and, potentially, future quarters may be negatively impacted. Any shortfall in our revenues would have a direct impact on our business. In addition, fluctuations in our quarterly results could adversely affect the price of our common stock in a manner unrelated to our long-term operating performance. Because our operating results are volatile and difficult to predict, you should not rely on the results of one quarter as an indication of our future performance. It is possible that in some future quarter our operating results will fall below the expectations of securities analysts and investors. In this event, the price of our common stock may decline significantly.

 

Our highly integrated products and high-speed mixed signal products are difficult to manufacture without defects and the existence of defects in the manufactured products could result in an increase in our costs and delays in the availability of our products.

 

The manufacture of semiconductors is a complex process and it is often difficult for semiconductor foundries to produce semiconductors free of defects. Because our products are more highly integrated than many other semiconductors and incorporate mixed analog and digital signal processing and embedded memory technology, they are even more difficult to produce without defects.

 

The ability to manufacture products of acceptable quality depends on both product design and manufacturing process technology. Since defective products can be caused by either design or manufacturing difficulties, identifying quality problems can occur only by analyzing and testing our semiconductors in a system after they have been manufactured. The difficulty in identifying defects is compounded because the process technology is unique to each of the multiple semiconductor foundries we contract with to manufacture our products. Failure to achieve defect-free products due to their increasing complexity may result in an increase in our cost and delays in the availability of our products. For example, we have experienced field failures of our IC’s in certain customer system applications that required us to institute additional IC level testing. As a result of these field failures we have incurred additional costs due to customers returning

 

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potentially affected products and have been required to resell products from third parties in order to meet certain customer commitments. Additionally, customers have experienced delays in receiving product shipments from us that resulted in the loss of revenue and profits.

 

If we do not achieve additional design wins in the future, our ability to grow would be seriously limited.

 

Our future success will depend on developers of advanced display devices designing our products into their systems. To achieve design wins we must define and deliver cost-effective, innovative and integrated semiconductors. Once a supplier’s products have been designed into a system, the developer may be reluctant to change its source of components due to the significant costs associated with qualifying a new supplier. Accordingly, the failure on our part to obtain additional design wins with leading branded manufacturers or integrators, and to successfully design, develop and introduce new products and product enhancements could harm our business, financial condition and results of operations.

 

Achieving a design win does not necessarily mean that a developer will order large volumes of our products. A design win is not a binding commitment by a developer to purchase our products. Rather, it is a decision by a developer to use our products in the design process of that developer’s products. Developers can choose at any time to discontinue using our products in their designs or product development efforts. If our products are chosen to be incorporated into a developer’s products, we may still not realize significant revenues from that developer, if that developer’s products are not commercially successful.

 

Because of the complex nature of our semiconductor designs and the associated manufacturing process and the rapid evolution of our customers’ product design we may not be able to develop new products or product enhancements in a timely manner, which could decrease customer demand for our products and reduce our revenues.

 

The development of our semiconductors, which incorporate mixed analog and digital signal processing, is highly complex. These complexities require that we employ advanced designs and manufacturing processes that are unproven. Since commencing our operations, we have experienced increased development time and delays in introducing new products. We will not always succeed in developing new products or product enhancements nor do so in a timely manner. With the acquisitions of Panstera and nDSP, we significantly added to the complexity of our product development efforts. We must now coordinate very complex product development programs between multiple, geographically dispersed locations that were formerly done in one location.

 

Many of our designs involve the development of new high-speed analog circuits that are difficult to simulate and require physical prototypes not required by the primarily digital circuits we currently design. The result could be longer and less predictable development cycles.

 

Successful development and timely introduction of new or enhanced products depends on a number of other factors, including:

 

accurate prediction of customer requirements and evolving industry standards, including digital interface and content piracy protection standards;

 

development of advanced display technologies and capabilities;

 

timely completion and introduction of new product designs;

 

use of advanced foundry processes and achievement of high manufacturing yields; and

 

market acceptance of the new products.

 

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If we are not able to successfully develop and introduce our products in a timely manner, our business and results of operations will be adversely affected.

 

Integration of software in our products adds complexity and cost that may affect our ability to achieve design wins and may affect our profitability.

 

Our products incorporate software and software development tools. The integration of software adds complexity, may extend our internal development programs and could impact our customers’ development schedules. This complexity requires increased coordination between hardware and software development schedules and may increase our operating expenses without a corresponding increase in product revenue. Some customers and potential customers may choose not to use our products because of the additional requirements of implementing our software, preferring to use a product that works with their existing software. This additional level of complexity lengthens the sales cycle and may result in customers selecting competitive products requiring less software integration.

 

A significant amount of our revenue comes from a few customers and distributors and any decrease in revenues from, or loss of any of, these customers or distributors could significantly reduce our total revenues.

 

We are and will continue to be dependent on a limited number of large distributors and customers for a substantial portion of our revenue. For the six months ended June 30, 2002, and year ended December 31, 2001, sales to distributors represented 64% and 61% of total revenue, respectively.  For the six months ended June 30, 2002, and year ended December 31, 2001, sales to Tokyo Electron Device Limited, our distributor in Japan, represented 43% and 52% of total revenue, respectively.  During the six months ended June 30, 2002 there were no end customers that represented 10% or more of total revenue.  Sales to our top five customers for the six months ended June 30, 2002 accounted for approximately 42% of our total sales.  Sales to our top five customers accounted for approximately 43%, 52% and 62% for the years ended December 31, 2001, 2000 and 1999, respectively. As a result of this customer and distributor concentration, any one of the following factors could significantly impact our revenues:

 

a significant reduction, delay or cancellation of orders from one or more of our key distributors, branded manufacturers or integrators; or

 

a decision by one or more significant customers to select products manufactured by a competitor, or its own internally developed semiconductor, for inclusion in future product generations.

 

The display manufacturing market is highly concentrated among relatively few large manufacturers. We expect our operating results to continue to depend on revenues from a relatively small number of distributors that sell our products to display manufacturers and their suppliers.

 

The concentration of our accounts receivable with a limited number of distributors exposes us to increased credit risk and could seriously harm our operating results and cash flows.

 

At June 30, 2002, we had two customers that represented more than 10% of our accounts receivable balance.  Tokyo Electron Device was the largest accounts receivable representing 46% of our total accounts receivable.  The failure of this distributor or any other customer representing 10% or more of our total accounts receivable to pay these accounts receivable would result in a significant expense that would seriously harm our operating results and would reduce our cash flows.

 

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International sales account for a significant portion of our revenue, and if we do not successfully address the risks associated with our international operations, our revenue could decrease.

 

Sales outside of the U.S. accounted for 99% for the six months ended June 30, 2002 and 91%, 96% and 93% of our total revenue in 2001, 2000 and 1999, respectively. Most of our customers are concentrated in Japan, Korea and Taiwan, with aggregate sales from those three countries accounting for 77% of total revenue for the first six months of 2002 and 82% and 88% of our total revenue during the year ended December 31, 2001 and 2000, respectively.  We anticipate that sales outside the U.S. will continue to account for a substantial portion of our revenues in future periods. In addition, customers who incorporate our products into their products sell them outside of the U.S., thereby exposing us indirectly to foreign risks. In addition, all of our products are manufactured outside of the U.S. We are, therefore, subject to many international risks, including:

 

increased difficulties in managing international distributors and manufacturers of our products and components due to varying time zones, languages and business customs;

 

foreign currency exchange fluctuations such as the Asian financial crisis that occurred in 1998 which caused a devaluation in the currencies of Japan, Taiwan and Korea resulting in an increased cost of procuring our semiconductors;

 

potentially adverse tax consequences such as license fee revenue taxes imposed in Japan;

 

difficulties regarding timing and availability of export and import licenses, which have limited our ability to freely move demonstration equipment and samples in and out of Asia;

 

political and economic instability, particularly in Taiwan and Korea;

 

reduced or limited protection of our intellectual property, significant amounts of which are contained in software which is more prone to design piracy;

 

increased transaction costs related to sales transactions conducted outside of the U.S. such as charges to secure letters of credit for foreign receivables;

 

difficulties in maintaining sales representatives outside of the U.S. that are knowledgeable of the display processor industry and our display processor products;

 

changes in the regulatory environment in Japan, Korea and Taiwan that may significantly impact purchases of our products by our customers; and

 

difficulties in collecting accounts receivable.

 

Our dependence on selling through distributors and integrators increases the complexity of managing our supply chain and may result in excess inventory or inventory shortages.

 

Selling through distributors reduces our ability to forecast sales and increases the complexity of our business. Since our distributors are an intermediary between us and the companies using our products, we must rely on our distributors to accurately report inventory levels and production forecasts. This arrangement requires us to manage a more complex supply chain and monitor the financial condition and credit worthiness of our distributors and customers. Our failure to manage one or more of these challenges could result in excess inventory or shortages that could seriously impact our operating revenue or limit the ability of companies using our semiconductors to deliver their products.

 

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Dependence on a limited number of sole-source, third party manufacturers for our products exposes us to shortages based on capacity allocation, price increases with little notice, volatile inventory levels and delays in product delivery which could result in delays in satisfying customer demand, increased costs and loss of revenues.

 

We do not own or operate a semiconductor fabrication facility and we do not have the resources to manufacture our products internally. We rely on third party foundries for wafer fabrication and other contract manufacturers for assembly and electrical testing of our products. Our requirements represent only a small portion of the total production capacity of our contract manufacturers. Our third-party manufacturers have in the past re-allocated capacity to other customers even during periods of high demand for our products. We expect that this may occur in the future.  We do not have a long-term supply contract with any of our contract manufacturers and they are not obligated to supply us with products for any specific period, in any specific quantity or at any specific price, except as may be provided in a particular purchase order. From time to time our third-party manufacturers increase prices charged to manufacture our products with little notice. This requires us to either increase the price we charge for our products or suffer a decrease in our gross margins. We try not to maintain substantial inventories of products, but need to order products long before we have firm purchase orders for those products which could result in excess inventory or inventory shortages.

 

If we are unable to obtain our products from manufacturers on schedule, our ability to satisfy customer demand will be harmed, and revenue from the sale of products may be lost or delayed. If orders for our products are canceled, expected revenues would not be realized. In addition, if the price charged by our third-party manufacturers increases we will be required to increase our prices, which could harm our competitiveness, or suffer declines in our gross margin.

 

We use a COT, or customer-owned tooling, process for manufacturing some of our products which exposes us to the possibility of poor yields on manufactured products negatively impacting our gross profit margins and could also result in a reduction or loss of revenue.

 

We have assumed greater responsibility for the process for our next-generation of products by subcontracting separately for the production of wafers and for their assembly and testing. We are building some products on a customer owned tooling basis, also known in the semiconductor industry as COT, where we directly contract the manufacture of wafers and assume the responsibility for the assembly and testing of our products. As a result, we are subject to increased risks arising from wafer manufacturing yields and associated with coordination of the manufacturing, assembly and testing process. Failure to effectively use this approach to manufacturing would reduce our revenues and harm our gross margin and results of operations.

 

We are dependent on our foundries to implement complex semiconductor technologies, which could adversely affect our operations if those technologies are not available, delayed or inefficiently implemented.

 

In order to increase performance and functionality and reduce the size of our products, we are continuously developing new products using advanced technologies that further miniaturize semiconductors. However, we are dependent on our foundries to develop and provide access to the advanced processes that enable such miniaturization. We cannot be certain that future advanced manufacturing processes will be implemented without difficulties, delays or increased expenses. Our business, financial condition and results of operations could be materially and adversely affected if advanced manufacturing processes are unavailable to us, substantially delayed or inefficiently implemented.

 

If we have to qualify a new contract manufacturer or foundry for any of our products, we may experience delays that result in lost revenues and damaged customer relationships.

 

Our products require manufacturing with state-of-the-art fabrication equipment and techniques. Because the lead-time needed to establish a relationship with a new contract manufacturer is at

 

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least six months, and the estimated time for us to adapt a product’s design to a particular contract manufacturer’s processes is at least four months, there is no readily available alternative source of supply for any specific product. This could cause significant delays in shipping products, which may result in lost revenues and damaged customer relationships.

 

Our future success depends upon the continued services of key personnel, many of whom would be difficult to replace and the loss of one or more of these employees could seriously harm our business by delaying product development.

 

Our future success depends upon the continued services of our executive officers, key hardware and software engineers, and sales, marketing and support personnel, many of whom would be difficult to replace. The loss of one or more of these employees could seriously harm our business. Particularly, because of the highly technical nature of our business, the loss of key engineering personnel could delay product introductions and significantly impair our ability to successfully create future products. In particular, the loss of the services of Allen Alley, our President, Chief Executive Officer and Chairman; Michael West, our Vice President and Chief Technology Officer; or Robert Greenberg, our Senior Vice President, could materially and adversely affect us. We are currently planning to hire a significant number of additional employees this year and in future periods, and we believe our success depends, in large part, upon our ability to identify, attract and retain qualified hardware and software engineers, and sales, marketing, finance and managerial personnel. Competition for talented personnel is intense and we may not be able to retain our key personnel or identify, attract or retain other highly qualified personnel in the future. We have experienced, and may continue to experience, difficulty in hiring and retaining employees with appropriate qualifications. If we do not succeed in hiring and retaining employees with appropriate qualifications, our product development efforts, revenues and business could be seriously harmed.

 

Because we do not have long-term commitments from our customers, and plan purchases based on estimates of customer demand, which may be inaccurate, we must contract for the manufacture of our products based on those potentially inaccurate estimates.

 

Our sales are made on the basis of purchase orders rather than long-term purchase commitments, which our customers may cancel or defer at any time. This process requires us to make multiple demand forecast assumptions, each of which may introduce errors into our estimates. If our customers or we overestimate demand, we may purchase products, which we may not be able to sell. As a result, we would have excess inventory, which would increase our losses. Conversely, if our customers or we underestimate demand or if sufficient manufacturing capacity were unavailable, we would forego revenue opportunities, lose market share and damage our customer relationships.

 

Development arrangements may cause us to incur substantial operating expenses without the guarantee of any associated revenue or far in advance of revenue.

 

We have had development arrangements with customers and other parties such as Intel Corporation that consume large amounts of engineering resources far in advance of product revenue. Our work under these arrangements is technically challenging and may require deliverables on an accelerated basis. These arrangements place considerable demands on our limited resources, particularly on our most senior engineering talent, and may not result in revenue for twelve to eighteen months, if at all. In addition, allocating significant resources to these arrangements may detract from or delay the completion of other important development projects. Any of these development agreements could be canceled at any time without notice. These factors could have a material and adverse effect on our long-term business and results of operations.

 

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Because of our long product development process and sales cycle, we may incur substantial expenses before we earn associated revenues and may not ultimately sell as many units of our products as we forecasted.

 

We develop products based on anticipated market and customer requirements and incur substantial product development expenditures, which can include the payment of large up-front, third-party license fees and royalties, prior to generating associated revenues. Because the development of our products incorporates not only our complex and evolving technology, but also our customers’ specific requirements, a lengthy sales process is often required before potential customers begin the technical evaluation of our products. Our customers typically perform numerous tests and extensively evaluate our products before incorporating them into their systems. The time required for testing, evaluation and design of our products into a customer’s equipment can take up to six months or more. It can take an additional six months before a customer commences volume shipments of systems that incorporate our products. However, even when we achieve a design win, the customer may never ship systems incorporating our products. Because of our relatively limited history in selling our products, we cannot assure you that the time required for the testing, evaluation and design of our products by our customers would not exceed six months. Because of this lengthy development cycle, we will experience delays between the time we incur expenditures for research and development, sales and marketing, inventory levels and the time we generate revenues, if any, from these expenditures.  Additionally, if actual sales volumes for a particular product are substantially less than originally forecasted, we may experience large write-offs of capitalized license fees and prepaid royalties that would negatively affect our operating results.

 

Shortages of other key components for our customers’ products could delay our ability to sell our products.

 

Shortages of components and other materials that are critical to the design and manufacture of our customers’ products could limit our sales. These components include liquid crystal display panels and other display components, analog-to-digital converters, digital receivers and video decoders. During 2000, some companies that used our products experienced delays in the availability of key components from other suppliers, which, in turn, threatened a delay in demand for the products that we supplied to them.

 

Shortages of materials used in the manufacturing of our products may increase our costs or limit our revenues and impair our ability to ship our products on time.

 

From time to time, shortages of materials that are used in our products may occur. In particular, we may experience shortages of semiconductor wafers and packages. If material shortages occur, we may incur additional costs or be unable to ship our products to our customers in a timely fashion, all of which could harm our business and negatively impact our earnings.

 

Our products could become obsolete if necessary licenses of third-party technology are not available to us or are only available on terms that are not commercially viable.

 

We license technology from third parties that is incorporated into our products or product enhancements. Future products or product enhancements may require additional third-party licenses that may not be available to us or are not available on terms that are commercially reasonable. If we are unable to obtain any third-party license required to develop new products and product enhancements, we may have to obtain substitute technology of lower quality or performance standards or at greater cost, either of which could seriously harm the competitiveness of our products.

 

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We may not be able to respond to the rapid technological changes in the markets in which we compete, or we may not be able to comply with industry standards in the future making our products less desirable or obsolete.

 

The markets in which we compete or seek to compete are subject to rapid technological change, frequent new product introductions, changing customer requirements for new products and features, and evolving industry standards. The introduction of new technologies and the emergence of new industry standards could render our products less desirable or obsolete, which could harm our business. Examples of changing industry standards include the introduction of high-definition television, or HDTV, new digital receivers and displays with resolutions that have required us to accelerate development of new products to meet these new standards.

 

Our software development tools may be incompatible with industry standards and challenging to implement, which could slow product development or cause us to lose customers and design wins.

 

Our existing products incorporate complex software tools designed to help customers bring products into production. Software development is a complex process and we are dependent on software development languages and operating systems from vendors that may compromise our ability to design software in a timely manner. Also, software development is a volatile market and new software languages are introduced to the market that may be incompatible with our existing systems and tools. New software development languages may not be compatible with our own requiring significant engineering efforts to migrate our existing systems in order to be compatible with those new languages.  Existing or new software development tools could make our current products obsolete or hard to use. Software development disruptions could slow our product development or cause us to lose customers and design wins.

 

Our integrated circuits and software could contain defects, which could reduce sales of those products or result in claims against us.

 

Despite testing by our customers and us, performance problems or errors may be found in existing or new semiconductors and software. This could result in a delay in the recognition or loss of revenues, loss of market share or failure to achieve market acceptance. These defects may cause us to incur significant warranty, support and repair costs. They could also divert the attention of our engineering personnel from our product development efforts and harm our relationships with our customers. The occurrence of these problems could result in the delay or loss of market acceptance of our semiconductors and would likely harm our business. Defects, integration issues or other performance problems in our semiconductors and software could result in financial or other damages to our customers or could damage market acceptance of our products. Our customers could also seek damages from us for their losses. A product liability claim brought against us even if unsuccessful, would likely be time consuming and costly to defend.

 

The concentration of our manufactures and customers in the same geographic region increases our risk that a natural disaster, labor strike or political unrest could disrupt our operations.

 

Our current manufacturers and most of our customers are located in Japan, Korea and Taiwan. The risk of earthquakes in the Pacific Rim region is significant due to the proximity of major earthquake fault lines in the area. In September 1999, a significant earthquake in Taiwan affected a current manufacturer’s facilities. As a consequence of this earthquake, this manufacturer suffered power outages and disruption that impaired its production capacity. Earthquakes, fire, flooding and other natural disasters in the Pacific Rim region, or political unrest, labor strikes or work stoppages in countries where our manufacturers’ and customers are located likely would result in the disruption of our foundry partners’ assembly capacity. Any disruption resulting from extraordinary

 

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events could cause significant delays in shipments of our solutions until we are able to shift our manufacturing or assembling from the affected contractor to another third-party vendor. There can be no assurance that alternative capacity could be obtained on favorable terms, if at all.

 

Others may bring infringement actions against us that could be time-consuming and expensive to defend.

 

We may become subject to claims involving patents or other intellectual property rights. For example, in early 2000 we were notified by InFocus Corporation (“InFocus”) that we were infringing patents held by InFocus. In February 2000, we entered into a license agreement with InFocus granting us the right to use the technology covered by the InFocus patents. As a result, we recorded a one-time charge of $4.1 million for patent settlement expense in the first quarter of 2000. Intellectual property claims could subject us to significant liability for damages and invalidate our proprietary rights. In addition, intellectual property claims may be brought against customers that incorporate our products in the design of their own products. These claims, regardless of their success or merit and regardless of whether we are named as defendants in a lawsuit, would likely be time-consuming and expensive to resolve and would divert the time and attention of management and technical personnel. Any future intellectual property litigation or claims also could force us to do one or more of the following:

 

stop selling products using technology that contains the allegedly infringing intellectual property;

 

attempt to obtain a license to the relevant intellectual property, which license may not be available on reasonable terms or at all;

 

attempt to redesign those products that contain the allegedly infringing intellectual property; and

 

pay damages for past infringement claims that are determined to be valid or which are arrived at in settlement of such litigation or threatened litigation.

 

  If we are forced to take any of the foregoing actions, we may be unable to manufacture and sell our products, which could seriously harm our business. In addition, we may not be able to develop, license or acquire non-infringing technology under reasonable terms. These developments could result in an inability to compete for customers or could adversely affect our ability to increase our earnings.

 

Our limited ability to protect our intellectual property and proprietary rights could harm our competitive position by allowing our competitors to access our proprietary technology and to introduce similar display processor products.

 

Our ability to compete effectively with other companies will depend, in part, on our ability to maintain the proprietary nature of our technology, including our semiconductor designs and software. We rely on a combination of patent, copyright, trademark and trade secret laws, as well as nondisclosure agreements and other methods to protect our proprietary technologies. We hold one patent and have nineteen patent applications pending with the U.S. Patent and Trademark Office for protection of our significant technologies. We cannot assure you that the degree of protection offered by patents or trade secret laws will be sufficient. Furthermore, we cannot assure you that any patents will be issued as a result of any pending applications, or that, if issued, any claims allowed will be sufficiently broad to protect our technology. In addition, it is possible that existing or future patents may be challenged, invalidated or circumvented. We provide the computer programming code for our software to selected customers in connection with their product development efforts, thereby increasing the risk that customers will misappropriate our proprietary software. Competitors in both the United States and foreign countries, many of which have substantially greater resources, may apply for and obtain patents that will prevent, limit or interfere with our ability to make and sell our products, or develop similar technology

 

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independently or design around our patents. Effective copyright, trademark and trade secret protection may be unavailable or limited in foreign countries.

 

Any acquisition or equity investment we make could disrupt our business and severely harm our financial condition.

 

We intend to continue to consider investments in or acquisitions of complementary businesses, products or technologies. To-date, we acquired Panstera, Inc. in January 2001 and nDSP in January 2002.  We also invested $7.5 million for a minority interest in Jaldi Semiconductor in January 2001 and recently exercised our option to acquire the remaining interest in Jaldi.  The acquisitions of Panstera and nDSP and the investment and pending acquisition in Jaldi contain a very high level of risk primarily because the investments were made based on in-process technological development that may not be completed, or if completed, may not be commercially viable. If this were the case, our financial results would likely be very negatively affected.

 

These and any future acquisitions and investments could result in:

 

                  issuance of stock that dilutes current stockholders’ percentage ownership;

 

                  incurrence of debt;

 

                  assumption of liabilities;

 

                  amortization expenses related to other intangible assets;

 

                  impairment of goodwill; or

 

                  large and immediate write-offs.

 

Our operation of any acquired business will also involve numerous risks, including:

 

                  problems combining the purchased operations, technologies or products;

 

                  unanticipated costs;

 

                  diversion of management’s attention from our core business;

 

                  adverse effects on existing business relationships with customers;

 

                  risks associated with entering markets in which we have no or limited prior experience; and

 

                  potential loss of key employees, particularly those of the acquired organizations.

 

We may not be able to successfully integrate businesses, products, technologies or personnel that we might acquire in the future and any failure to do so could disrupt our business and seriously harm our financial condition.

 

Goodwill represents a significant portion of the Company’s total assets.

 

As of June 30, 2002, goodwill amounted to $83.5 million, or approximately 38%, of the Company’s total assets. Effective January 1, 2002 with the adoption of new accounting standards the Company is required to review goodwill for possible impairment on an annual basis or when events and circumstances arise which indicate a possible impairment. The review of goodwill for impairment may result in large write-offs of goodwill, which could have a material adverse effect on results of operations.

 

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Failure to manage our expansion effectively could adversely affect our ability to increase our business and results of operations.

 

Our ability to successfully market and sell our products in a rapidly evolving market requires effective planning and management processes. We continue to increase the scope of our operations domestically and internationally and have increased our headcount substantially. Through internal growth as well as acquisition, our headcount grew from 109 to 176 employees in 2001, a 61 percent increase.  During the first six months of 2002, our headcount increased 37 to 213 employees on June 30, 2002, a 21% increase.  With our acquisition of nDSP we added 41 employees in the first quarter of 2002 with 25 of the employees located in China. We are currently planning to hire additional employees in the second half of this year. Additionally, we intend to acquire Jaldi Semiconductor in the third quarter of 2002 that will also increase our headcount and associated expenses.  Our past growth, and our expected future growth, places a significant strain on our management systems and resources including our financial and managerial controls, reporting systems and procedures. To manage our growth effectively, we must implement and improve operational and financial systems, train and manage our employee base, attract and retain qualified personnel with relevant experience. We must also manage multiple relationships with customers, business partners, contract manufacturers, suppliers and other third parties. Moreover, we will spend substantial amounts of time and money in connection with our rapid growth and may have unexpected costs. Our systems, procedures or controls may not be adequate to support our operations and we may not be able to expand quickly enough to exploit potential market opportunities. While we have not, to date, suffered any significant adverse consequences due to our growth, if we do not continue to manage growth effectively our business would be seriously harmed.

 

RISKS RELATED TO OUR INDUSTRY

 

Failure of consumer demand for flat panel displays and other display technologies to increase could impede our growth.

 

Our product development strategies anticipate that consumer demand for flat panel displays and other emerging display products will increase in the future. The success of our products is dependent on increased demand for these products, which are at early stages of development. The potential size of the flat panel display market and the timing of its development are uncertain and will depend upon a number of factors, all of which are beyond our control. In order for the market for many of our products to grow, advanced flat panel displays must be widely available and affordable to consumers. In the past, the supply of advanced flat panel displays has been cyclical. We expect this pattern to continue. Under-capacity in the advanced flat panel display market may limit our ability to increase our revenues because our customers may limit their purchases of our products if they cannot obtain sufficient supplies of advanced flat panel displays. In addition, advance flat panel display prices may remain high because of limited supply, and consumer demand may not grow if the supply of advanced flat panel displays does not increase.

 

If products incorporating our semiconductors are not compatible with computer display protocols, video standards and other devices, the market for our products will be reduced and our business prospects could be significantly limited.

 

Our products are incorporated into our customers’ products, which have different parts and specifications and utilize multiple protocols that allow them to be compatible with specific computers, video standards and other devices. If our customers’ products are not compatible with these protocols and standards, consumers will return these products, or consumers will not purchase these products, and the markets for our customers’ products could be significantly reduced. As a result, a portion of our market would be eliminated, and our business would be harmed.

 

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Intense competition in our markets may reduce sales of our products, reduce our market share, decrease our gross profit and result in large losses.

 

Rapid technological change, evolving industry standards, compressed product life cycles and declining average selling prices are characteristics of our market and could have a material adverse effect on our business, financial condition and results of operations. As the overall price of advanced flat panel display screens continues to fall, we may be required to offer our products to manufacturers at discounted prices due to increased price competition. At the same time, new, alternative display processing technologies and industry standards may emerge that directly compete with technologies that we offer. We may be required to increase our investment in research and development at the same time that product prices are falling. In addition, even after making this investment, we cannot assure you that our technologies will be superior to those of our competitors or that our products will achieve market acceptance, whether for performance or price reasons. Failure to effectively respond to these trends could reduce the demand for our products.

 

We compete with a range of specialized and diversified electronic and semiconductor companies that offer display processors. In particular, we compete against Genesis Microchip, Inc., Macronix International Co., Ltd., Media Reality Technologies, Inc. (MRT, Inc.), Philips, Silicon Image, Inc., SmartASIC, Inc., STMicroelectronics NV, Topro, Trumpion, and other companies. Potential competitors may include diversified semiconductor manufacturers including Broadcom Corporation, Intel Corporation, National Semiconductor Corp., Texas Instruments, Inc. and other diversified semiconductor companies. We also compete in some instances against in-house processing solutions designed by our customers. Many of our competitors have longer operating histories and greater resources to support development and marketing efforts. Some of our competitors may operate their own fabrication facilities. These competitors may be able to react faster and devote more resources to efforts that compete directly with our own. In the future, our current or potential customers may also develop their own proprietary display processors and become our competitors. In addition, start-up companies may seek to compete in our markets. Our competitors may develop advanced technologies enabling them to offer more cost-effective and higher quality semiconductors to our customers than those offered by us. Increased competition could harm our business, financial condition and results of operations by, for example, increasing pressure on our profit margin or causing us to lose sales opportunities. We cannot assure you that we can compete successfully against current or potential competitors.

 

The market for Internet enabled display products may not evolve rapidly enough to support expanded market acceptance of our products and industry standards in this market continue to evolve.

 

If the emerging market for Internet enabled display products does not develop or does not evolve fast enough to support rapid market acceptance of our products, our business, financial condition and results of operations will be materially and adversely affected. The Internet enabled display products market includes netTVs, screenphones, e-mail terminals, Web terminals and tablets. Our success will depend on our ability to achieve design wins with customers developing new products and enhanced products for the Internet enabled display products market and their ability to successfully introduce and promote these products. There can be no assurance that the Internet enabled display products market will develop to the extent or in the timeframes necessary to support expansion of our business. We anticipate that Internet enabled display products will be generally based on industry standards, which are continually evolving. The emergence of new industry standards could render our products or our customers’ products unmarketable or obsolete and we may incur substantial unanticipated costs to comply with any new standards. Moreover, our past sales have resulted, to a significant extent, from our ability to anticipate changes in technology and industry standards and to develop and introduce new and enhanced products

 

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addressing changes within our industry. Our continued ability to adapt to industry changes and to anticipate future standards, and the rate of adoption and acceptance of those standards, will be a significant factor in maintaining or improving our competitive position and our prospects for growth. There can be no assurance that we will be able to anticipate the evolving standards in the semiconductor industry and, in particular, the applications in the Internet enabled display products market, or that we will be able to successfully develop and introduce new products into this market.

 

The cyclical nature of the semiconductor industry may lead to significant variances in the demand for our products and could harm our operations.

 

In the past, the semiconductor industry has been characterized by significant downturns and wide fluctuations in supply and demand. Also, during this time, the industry has experienced significant fluctuations in anticipation of changes in general economic conditions, including economic conditions in Asia and North America. The cyclical nature of the semiconductor industry has led to significant variances in product demand and production capacity. It has also accelerated erosion of average selling prices per unit. We may experience periodic fluctuations in our future financial results because of changes in industry-wide conditions.

 

OTHER RISKS

 

The anti-takeover provisions of Oregon law and in our articles of incorporation could adversely affect the rights of the holders of our common stock by preventing a sale or takeover of us at a price or prices favorable to the holders of our common stock.

 

The anti-takeover provisions of Oregon law and our articles of incorporation may make a change in control of our business more difficult, even if a change in control would be beneficial to the shareholders. These provisions may allow the board of directors to prevent changes in the management and control of our business. Under Oregon law, our board of directors may adopt additional anti-takeover measures in the future. One anti-takeover provision that we have is the ability of our board of directors to determine the terms of preferred stock and issue preferred stock without the approval of the holders of the common stock. At this time, there are no shares of preferred stock outstanding. However, because the rights and preferences of any series of preferred stock may be set by the board of directors in its sole discretion without approval of the holders of the common stock, the rights and preferences of this preferred stock may be superior to those of the common stock. Accordingly, the rights of the holders of common stock may be adversely affected.

 

Our principal shareholders have significant voting power and may take actions that may make it more difficult to sell our shares at a premium to take over candidates.

 

Our executive officers, directors and other principal shareholders, in the aggregate, beneficially owned 9,686,121 shares or approximately 23% of our outstanding common stock as of June 30, 2002. These shareholders currently have, and will continue to have, significant influence with respect to the election of our directors and approval or disapproval of our significant corporate actions. This influence over our affairs might be adverse to the interest of our other shareholders. In addition, the voting power of these shareholders could have the effect of delaying or preventing a change in control of our business or otherwise discouraging a potential acquirer from attempting to obtain control of us, which could prevent our other shareholders from realizing a premium over the market price for their common stock.

 

The price of our common stock has and may continue to fluctuate substantially.

 

Investors may not be able to sell shares of our common stock at or above the price they paid due to a number of factors, including:

 

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actual or anticipated fluctuations in our operating results;

 

changes in expectations as to our future financial performance;

 

changes in financial estimates of securities analysts;

 

announcements by us or our competitors of technological innovations, design wins, contracts, standards or acquisitions;

 

the operating and stock price performance of other comparable companies;

 

changes in market valuations of other technology companies; and

 

inconsistent trading volume levels of our common stock.

 

In particular, the stock prices of technology companies like us have been highly volatile. These fluctuations often have been unrelated or disproportionate to the operating performance of those companies. Market fluctuations as well as general economic, political and market conditions including recessions, interest rate changes or international currency fluctuations, may negatively impact the market price of our common stock. Therefore, the price of our common stock may decline, and the value of your investment may be reduced regardless of our performance.

 

We may be unable to meet our future capital requirements, which would limit our ability to grow.

 

We believe our current cash balances will be sufficient to meet our capital requirements for the next 12 months; however, we may need, or could elect, to seek additional funding prior to that time. To the extent that currently available funds are insufficient to fund our future activities, we may need to raise additional funds through public or private equity or debt financing. Additional funds may not be available on terms favorable to us, or our shareholders. Further, if we issue equity securities, our shareholders may experience additional dilution or the new equity securities may have rights, preferences or privileges senior to those of our common stock. If we cannot raise funds on acceptable terms, we may not be able to develop or enhance our products, take advantage of future opportunities or respond to competitive pressures or unanticipated requirements.

 

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ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

 

Our primary market risk exposure is the impact of interest rate fluctuations on interest income earned on our investment portfolio. The risks associated with market, liquidity and principal are mitigated by investing in high-credit quality securities and limiting concentrations of issuers and maturity dates. Derivative financial instruments are not part of our investment portfolio.

 

All of our sales are denominated in U.S. dollars and as a result, we have relatively little exposure to foreign currency exchange risk with respect to any of our sales. We do not currently hedge against foreign currency rate fluctuations.  The effect of an immediate 10% change in exchange rates would not have a material impact on our future operating results or cash flows.

 

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PART II - OTHER INFORMATION

 

Item 4:

Submission of Matters to a Vote of Shareholders

 

The Company’s 2002 Annual Meeting of Shareholders was held on May 6, 2002 to consider and vote upon a proposal to elect directors and a proposal to amend the Pixelworks Inc. 1997 Stock Incentive Plan to increase the aggregate number of shares of Pixelworks common stock that may be issued there under by 1,500,000 shares to a total of 15,340,116 shares.

 

The following nominees were elected as Directors by the votes and for the terms indicated below:

 

Nominee

 

For

 

Withheld

 

Term Ending

 

 

 

 

 

 

 

 

 

Allen H. Alley

 

26,910,226

 

6,873,915

 

2003

 

Oliver D. Curme

 

33,615,213

 

168,928

 

2003

 

Frank Gill

 

33,615,463

 

168,678

 

2003

 

Mark A. Stevens

 

33,615,363

 

168,778

 

2003

 

C. Scott Gibson

 

33,612,848

 

171,293

 

2003

 

 

The proposal to amend the Pixelworks Inc. 1997 Stock Incentive Plan was approved and received the following votes:

 

 

 

Votes

 

For

 

28,608,656

 

Against

 

5,129,776

 

Abstain

 

45,709

 

Broker non-votes:

 

0

 

 

Item 6:

Exhibits and Reports on Form 8-K

 

 

 

 

(a)

Exhibits

 

 

 

 

99.1

Certification of Chief Executive Officer

 

99.2

Certification of Chief Financial Officer

 

 

 

 

(b)

Reports on Form 8-K

 

 

 

During the three-month period ended June 30, 2002 there were no reports on Form 8-K filed

 

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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.

 

 

PIXELWORKS, INC.

 

 

 

 

 

 

Date:  August 14, 2002

/s/ Jeffrey B. Bouchard

 

 

Jeffrey B. Bouchard

 

Vice President, Finance and Chief Financial
Officer (Principal Financial and Accounting Officer)

 

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