MONOLITHIC SYSTEM TECHNOLOGY INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark one)

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

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 000-32929

Monolithic System Technology, Inc.
(Exact name of registrant as specified in its charter)

Delaware		77-0291941
(State or other jurisdiction of Incorporation or organization)		(I.R.S. Employer Identification Number)

1020 Stewart Drive Sunnyvale, California, 94085
(Address of principal executive office and zip code)

(408) 731-1800
(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to filing requirements for the past 90 days.

YES ý NO o

As of August 13, 2002, 30,113,882 shares of the Registrant’s common stock, $0.01 par value, were outstanding.

MONOLITHIC SYSTEM TECHNOLOGY, INC.

FORM 10-Q

June 30, 2002

INDEX

PART I -		FINANCIAL INFORMATION

Item 1.	Financial Statements:


	a.		Condensed Consolidated Balance Sheets as of June 30, 2002 (Unaudited) and December 31, 2001

	b.		Condensed Consolidated Statements of Operations for the three months ended June 30, 2002 and 2001 and six months ended June 30, 2002 and 2001 (Unaudited)

	c.		Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2002 and 2001 (Unaudited)

	d.		Notes to Condensed Consolidated Financial Statements (Unaudited)


Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations


Item 3.	Qualitative and Quantitative Disclosure About Market Risk


PART II -		OTHER INFORMATION


Item 2.	Changes In Securities and Use of Proceeds

Item 4.	Submission of Matters to a Vote of Security Holders

Item 6.	Exhibits and Reports on Form 8-K


	Signatures

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

MONOLITHIC SYSTEM TECHNOLOGY, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

	June 30, 2002				December 31, 2001
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$		23,699		$		47,363
Short-term investments	61,836				36,930
Accounts receivable, net	792				208
Inventories	1,456				1,693
Prepaid expenses and other current assets	4,243				1,506
Total current assets	92,026				87,700

Property and equipment, net	2,234				1,668
Other assets	111				93
Total assets	$		94,371		$		89,461

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$		627		$		254
Accrued expenses and other liabilities	1,595				1,820
Deferred revenue	1,393				3,283
Total current liabilities	3,615				5,357

Stockholders’ equity:
Preferred stock, $0.01 par value; 20,000 shares authorized; none issued and outstanding at June 30, 2002 and December 31, 2001	—				—
Common stock, $0.01 par value; 120,000 shares authorized; 30,088 shares and 29,492 shares issued and outstanding at June 30, 2002 and December 31, 2001	301				295
Additional paid-in capital	96,732				96,272
Notes receivable from stockholders	(15			)	(253			)
Deferred stock-based compensation	(1,042			)	(1,406			)
Accumulated other comprehensive income	95				16
Accumulated deficit	(5,315			)	(10,820			)
Total stockholders’ equity	90,756				84,104
Total liabilities and stockholders’ equity	$	94,371			$	89,461

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

MONOLITHIC SYSTEM TECHNOLOGY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share amounts)

	Three Months Ended June 30,						Six Months Ended June 30,
	2002			2001			2002			2001
Net revenue:
Product	$	648		$	3,151		$	1,541		$	7,059
Licensing	2,620			1,949			4,504			2,468
Royalty	3,262			301			6,880			434
	6,530			5,401			12,925			9,961
Cost of net revenue:
Product	383			1,256			830			2,965
Licensing	339			91			651			239
	722			1,347			1,481			3,204
Gross profit	5,808			4,054			11,444			6,757
Operating expenses:
Research and development	1,490			1,160			2,821			2,000
Selling, general and administrative	1,187			1,188			2,179			2,317
Stock compensation based compensation expense	156			493			364			850
Total operating expenses	2,833			2,841			5,364			5,167
Net income from operations	2,975			1,213			6,080			1,590
Interest and other income	433			259			800			626
Income before income taxes	3,408			1,472			6,880			2,216
Provision for income taxes	(681		)	(73		)	(1,375		)	(110		)
Net income	$	2,727		$	1,399		$	5,505		$	2,106
Net income per share:
Basic	$	0.09		$	0.13		$	0.19		$	0.20
Diluted	$	0.09		$	0.05		$	0.17		$	0.08
Shares used in computing net income per share:
Basic	29,690			10,600			29,630			10,484
Diluted	31,318			25,630			31,530			25,799

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

MONOLITHIC SYSTEM TECHNOLOGY, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

	Six Months Ended June 30,
	2002			2001
Cash flows from operating activities:
Net income	$	5,505		$	2,106
Adjustments to reconcile net income to net cash provided (used in) by operations:
Depreciation and amortization	509			351
Amortization of deferred stock-based compensation	364			850
Interest income on notes receivable from stockholders	(7		)	(17		)
Changes in current assets and liabilities:
Accounts receivable	(584		)	(518		)
Inventories	236			(1,299		)
Prepaid expenses and other assets	(2,756		)	(1,155		)
Accounts payable	373			136
Accrued expenses and other liabilities	(225		)	273
Deferred revenue	(1,890		)	(1,669		)
Net cash provided by (used in) operating activities	1,525			(942		)
Cash flows from investing activities:
Purchase of property and equipment	(1,075		)	(793		)
Purchase of short-term investments	(24,826		)	(2,994		)
Net cash used in investing activities	(25,901		)	(3,787		)
Cash flows from financing activities:
Payment of note receivable from shareholder	246			—
Proceeds from issuance of common stock upon exercise of stock options	466			1,230
Net cash provided by financing activities	712			1,230
Net decrease in cash and cash equivalents	(23,664		)	(3,499		)
Cash and cash equivalents at beginning of period	47,363			23,397
Cash and cash equivalents at end of period	$	23,699		$	19,898

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

MONOLITHIC SYSTEM TECHNOLOGY, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Background and Basis of Presentation

The Company

Monolithic System Technology, Inc. (the “Company” or “MoSys”) was incorporated in California on September 16, 1991 to design, develop and market high performance semiconductor memory products and technologies used by the semiconductor industry and electronic product manufacturers. On September 12, 2000, the shareholders approved the Company’s reincorporation in Delaware.

The Company has developed an innovative embedded-memory technology, called 1T-SRAM, which the Company licenses worldwide on a non-exclusive basis to semiconductor companies and electronic products manufacturers. Through 1998, the Company focused primarily on the sale of stand-alone memory products. In the fourth quarter of 1998, the Company changed the emphasis of its business model to focus primarily on the licensing of its 1T-SRAM technology.

The Company closed the sale of a total of 5,750,000 shares of common stock in July 2001 in an initial public offering (“IPO”) at a price of $10.00 per share. The Company realized total net proceeds of approximately $51.6 million upon the close of the IPO.

The accompanying condensed consolidated financial statements of the Company have been prepared without audit in accordance with the rules and regulations of the Securities and Exchange Commission (the “SEC”). Certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted in accordance with these rules and regulations. The information in this report should be read in conjunction with the Company’s financial statements and notes thereto included in its most recent annual report on Form 10-K filed with the Securities and Exchange Commission.

In the opinion of management, the accompanying unaudited condensed financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary to summarize fairly the Company’s financial position, results of operations and cash flows for the interim periods presented. The operating results for the three month and six month periods ended June 30, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002 or for any other future period.

Use of estimates

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reported period. Actual results could differ from those estimates.

We believe that our revenue recognition and inventory valuation accounting policies are affected by estimates and judgments in the following manner:

Revenue. If a licensing contract involves performance specifications that we have significant experience in meeting and the cost of contract completion can be reasonably estimated, we recognize the revenue over the period in which the contract services are performed using the percentage of completion method. We follow this method because we can obtain reasonably dependable estimates of the costs to perform the contracted services. During the contract performance period we review estimates of cost to complete the contracts as the contract progresses to completion and will revise our estimates of revenue and gross profit under the contract if we revise the estimations of the cost to complete. Our policy is to reflect any revision in the contract gross profit estimate in reported income for the period in which the facts giving rise to the revision become known.

Inventory. We state inventories at the lower of cost or market, determined using the first-in, first-out method. Our policy is to write down our inventory for estimated obsolescence or unmarketable inventory to the extent the cost exceeds the estimated market value. We base the estimate on our assumptions about future demand and market conditions. If actual market conditions are less favorable than those assumed in our estimates, additional inventory write-downs may be required. Our policy is to reflect any revaluation of inventory in reported income for the period in which the facts giving rise to the inventory revaluation become known.

Revenue recognition

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collection is probable.

Revenue from product sales is recognized upon shipment to customers. The terms of all product sales are FOB shipping point. The Company’s sales agreements do not provide for any customer acceptance provisions. The Company has no obligation to provide any modification, customization, upgrades, enhancements, post-contract customer support or additional products. Upon shipment, the Company records reserves for estimated returns. There are no rights of return unless the product does not perform according to specifications. Provisions for estimated returns, and to a lesser degree potential warranty liability, are recorded when revenue is recognized.

Licensing revenue consists of fees paid for engineering development and engineering support services. All contracts entered into to date require that the Company meet performance specifications. For contracts involving performance specifications that the Company has not met, the Company defers the recognition of revenue until the licensee manufactures products that meet the contract performance specifications and recognizes this revenue using the completed contract method. However, if the contracts involve performance specifications that the Company has significant experience in meeting and the cost of services under the contract can be reasonably estimated, the Company recognizes revenue over the period in which the contract services are performed under the guidelines of the percentage of completion method. Labor costs incurred are used as a measure of progress towards completion. If the amount of revenue recognized exceeds the amount of billings to a customer, the excess amount is carried as an unbilled contract receivable. The Company has recorded $410,000 and $0 of unbilled contract receivable as of June 30, 2002 and December 31, 2001, respectively. Fees collected prior to revenue recognition are recorded as deferred contract revenue.

Licensing contracts provide also for royalty payments at a stated rate and require licensees to report the manufacture or sale of products that include the Company’s technology after the end of the quarter in which the sale or manufacture occurs. The Company recognizes royalties in the quarter in which the Company receives the licensee’s report.

Inventory

The Company states inventories at the lower of cost or market, determined using the first-in, first-out method. The Company’s policy is to write down its obsolete or unmarketable inventory to the extent the cost exceeds the estimated market value. The Company bases the estimate on its assumptions about future demand and market conditions. If actual market conditions are less favorable than those assumed in the estimates, additional inventory write-downs may be required. The Company’s policy is to reflect any revaluation of inventory in reported income for the period in which the facts giving rise to the inventory revaluation become known.

Net income per share

Basic net income per share is computed by dividing net income for the period by the weighted-average number of shares of common stock outstanding during the period. Diluted net income per share is computed by dividing the net income available to common stockholders for the period by the weighted average number of common and potential common equivalent shares outstanding during the period. Potential common equivalent shares are composed of incremental shares of common stock issuable upon the exercise of stock options and warrants.

The following table presents the calculation of basic and diluted income per share (in thousands, except per share amounts):

	Three Months Ended June 30,				Six Months Ended June 30,
	2002		2001		2002		2001
Numerator:
Net income	$	2,727	$	1,399	$	5,505	$	2,106
Denominator:
Shares used in computing net income per share:
Basic	29,690		10,600		29,630		10,484
Employee stock options and unvested common stock outstanding	1,162		1,808		1,320		1,741
Warrants	466		491		580		843
Preferred stock	—		12,731		—		12,731
Diluted	31,318		25,630		31,530		25,799
Net income per share:
Basic	$	0.09	$	0.13	$	0.19	$	0.20
Diluted	$	0.09	$	0.05	$	0.17	$	0.08

Note 2. Inventories

Inventories consist of the following (in thousands):

	June 30, 2002		December 31, 2001

Work-in-process	$	959	$	1,297
Finished goods	497		396
	$	1,456	$	1,693

Note 3. Segment Information

The Company operates in a single industry segment, supplying semiconductor memories to the electronics industry. The Company sells its products and technology to customers in the Far East, North America and Europe. Net revenue by geographic area was (in thousands):

	Three Months Ended June 30,				Six Months Ended June 30,
	2002		2001		2002		2001

United States	$	2,874	$	3,222	$	4,681	$	5,939
Japan	2,632		1,619		5,747		1,807
Other Asian Countries	614		541		2,080		1,875
Europe	410		19		417		340
Total	$	6,530	$	5,401	$	12,925	$	9,961

A few customers account for a significant percentage of our total revenue. For the quarter ended June 30, 2002, NEC and Nintendo represented 24.2% and 15.4% of total revenue, respectively. In the second quarter of 2001, three customers, NEC, Cisco Systems, Inc., and Flextronics International USA, Inc. represented 28.5%, 16.9% and 15.9% of our total revenue, respectively. For the six months ended June 30, 2002, NEC and Nintendo represented 28.1% and 15.5% of total revenue, respectively. In the first half of 2001, our two largest customers, Cisco Systems, Inc., and NEC, represented 18.7% and 16.1% of our total revenue, respectively.

Note 4. Contingencies

In the normal course of business, the Company from time to time may receive and make inquiries with regard to possible patent infringement. Management does not believe that any such patent infringement inquiries represent material contingencies.

Note 5. Comprehensive Income

Statement of Financial Accounting Standards No. 130 “Reporting Comprehensive Income” (“SFAS No. 130”) requires the Company to display comprehensive income (loss) and its components as part of the financial statements. Comprehensive income (loss) includes certain charges in equity that are excluded from net income. The Company’s only component of comprehensive income is unrealized gains on short-term investments for the three and six months ended June 30, 2002 and 2001. Comprehensive income for the three months ended June 30, 2002 and 2001 was $141,000 and $0, respectively, and for the six months ended June 30, 2002 and 2001 was $79,000 and $0. Accumulated other comprehensive income was $95,000 and $16,000 for the quarter ended June 30, 2002 and the year ended December 31, 2001, respectively.

Note 6. Acquisition

Effective as of June 10, 2002, the Company entered into a letter of agreement with Atmos Corporation (“Atmos”) setting forth binding terms for the acquisition of 100% of the outstanding shares of Atmos capital stock by the Company. Also, on June 10, 2002, the Company loaned $500,000 to Atmos under a promissory note due on July 31, 2002,which is included in prepaid expenses and other current assets. The note and certain obligations of Atmos under the letter of agreement have been collateralized with the intellectual property assets of Atmos. The Company recently agreed to extend the maturity date of the promissory note to August 14, 2002. The

letter of agreement obligates the Company to cancel the promissory note and forgive the loan as a form of break-up fee, if the Company abandons the acquisition under certain circumstances. The Company is actively engaged in the process of completing the acquisition but has not set a closing date.

In connection with this proposed acquisition, we have received a letter dated June 17, 2002, from legal counsel for Virage Logic Corporation (“Virage”) telling us that Virage intends to sue Atmos and us each for damages of US$30,000,000 and punitive damages of CAN$5,000,000 for entering into the letter of agreement in violation of certain contractual rights asserted by Virage. We have informed Virage that we consider the matter to be a dispute between Virage and Atmos for which we are not responsible or liable. To date, Virage has not initiated litigation. We intend to vigorously defend any suit brought by Virage.

Note 7. TSMC Warrant

Pursuant to the terms of an Amended Common Stock Purchase Warrant (the “Warrant”) for the purchase of 1,200,000 shares of our common stock at $6.50 per share, Taiwan Semiconductor Manufacturing Co., Ltd. (TSMC) has exercised the Warrant on a “cashless,” or net, basis by surrendering the Warrant and receiving 470,346 shares of common stock. Resale of these shares is subject to a lock-up agreement under which TSMC has agreed not to sell or otherwise dispose of the shares for a period of 180 days after June 14, 2002.

Note 8. Provision for Income Taxes

The Company’s provision for income taxes for the six months ended June 30, 2002 was $1.4 million. We used an effective income tax rate of 20% for the second quarter of 2002 compared to a 5% effective tax rate used for the same period in 2001. Our effective tax rate increased due primarily to limitations on the utilization of certain net operating loss carryforwards and tax credits imposed under Internal Revenue Code section 382 for the year ended December 31, 2002.

ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the accompanying condensed consolidated financial statements and notes included in this report. This Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which include, without limitation, statements about the market for our technology, our strategy, competition, expected financial performance, all information disclosed under Item 3 of this Part I., and other aspects of our business identified in the Company’s most recent annual report on Form 10-K filed with the Securities and Exchange Commission and in other reports that we file from time to time with the Securities and Exchange Commission. Any statements about our business, financial results, financial condition and operations contained in this Form 10-Q that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words “believes,” “anticipates,” “expects,” “intends,” “projects,” or similar expressions are intended to identify forward-looking statements. Our actual results could differ materially from those expressed or implied by these forward-looking statements as a result of various factors, including the risk factors described in Risk Factors and elsewhere in this report. We undertake no obligation to update publicly any forward-looking statements for any reason, except as required by law, even as new information becomes available or other events occur in the future.

MoSys®, MultiBank®, MDRAM®, MCACHE® and 1T-SRAM® are our trademarks. Product names, trade names and trademarks of other companies are also referred to in this report.

Overview

We design, develop, license and market memory technologies used by the semiconductor industry and electronic product manufacturers. We have developed a patented semiconductor memory technology, called 1T-SRAM, that offers a combination of high density, low power consumption, high speed and low cost that other available memory technologies do not match. We license this technology to companies that incorporate, or embed, memory on complex integrated circuits. We also sell memory chips based on our 1T-SRAM technology. The sale of our 1T-SRAM memory chips supports the future development and marketing of our 1T-SRAM technology to licensees.

Until the second quarter of 2001, almost all of our revenue was generated by product sales of memory chips from four product lines, 1T-SRAM, MDRAM, MCACHE and SGRAM. Using elements of our existing memory technology as a foundation, we completed the development of our 1T-SRAM technology in the fourth quarter of 1998 and changed our primary focus to licensing this memory technology.

Also in 1998, we completed development of our first memory chips incorporating our 1T-SRAM technology and changed our marketing strategy for memory chips to focus on selling 1T-SRAM memory chips to customers in the communications equipment business. At the same time, we began to phase out our three other product lines. We anticipate that virtually all of our future product revenue will derive from sales of 1T-SRAM memory chips.

We signed our first license agreement related to 1T-SRAM technology at the end of the fourth quarter of 1998 and recognized licensing revenue from our 1T-SRAM technology for the first time in the first quarter of 2000.

As of June 30, 2002, we had signed agreements related to our 1T-SRAM technology with 33 companies. Generally, we expect our total sales cycle, or the period from our initial discussion with a prospective licensee to our receipt of royalties from the licensee’s use of our 1T-SRAM technology, to run from 18 to 24 months.

We believe that quarterly and annual results of operations will be affected by a variety of factors that could materially and adversely affect revenue, gross profit and income from operations. Accordingly, and in light of the limited operating history of our intellectual property licensing business, we believe that period-to-period comparisons of our results of operations should not be relied upon as an indication of future performance.

Revenue. We generate three types of revenue: licensing, royalty and product revenue. Prior to 2001, almost all of our revenue consisted of product revenue from the sale of memory chips. Since the beginning of 2001, product revenue as a percentage of total revenue has declined each quarter while the percentage of our license and royalty revenues has grown each quarter. In the third quarter of 2001, for the first time, combined license and royalty revenue exceeded product revenue. We anticipate this trend to continue for the foreseeable future.

Our license agreements involve long sales cycles, which make it difficult to predict the timing of signing agreements. We anticipate that licensing revenue will fluctuate from period to period and that it will be difficult to predict the timing and magnitude of such revenue. We

believe that the amount of licensing revenues for any period is not necessarily indicative of results for any future period. Our future revenue results are subject to a number of factors, however, particularly those described in “Risk Factors”.

We recognized licensing revenue for the first time in the first quarter of 2000. Our licensing revenue consists of fees for providing circuit design, layout and design verification support to a licensee that is embedding our memory technology into its product. For some licensees, we also provide engineering support services to assist commencement of production of their products that utilize 1T-SRAM technology. Licensing fees range from several hundred thousand dollars to several million dollars, depending on the scope and complexity of the development project, the licensee’s rights and the royalty to be paid under the agreement. The licensee generally pays licensing fees in installments at the beginning of the license and upon achieving certain milestones. All contracts entered into to date require us to meet performance specifications. For contracts involving performance specifications that we have not met and for which we lack the historical experience to reasonably estimate the costs, we defer the recognition of revenue until the licensee manufactures products that meet the contract performance specifications and recognize revenue using the completed contract method. Fees collected prior to revenue recognition are recorded as deferred contract revenue. However, if the contracts involve performance specifications that we have significant experience in meeting and the cost of contract completion can be reasonably estimated, we recognize revenue over the period in which the contract services are performed under the guidelines of the percentage of completion method. Labor costs incurred are used as a measure of progress towards completion. Under this accounting method, if the amount of revenue recognized exceeds the amount of billings to a customer, the excess amount is carried as an unbilled contract receivable. This impacted our revenue for the first time in the second quarter of 2002, as we recognized $410,000 of unbilled contract revenue during the period.

Our license agreements are associated with lengthy and complicated engineering development projects, and so the completion of development and commencement of production may be difficult for us to predict. In addition, our licensees may cancel a project during the development phase. These cancellations are beyond our control. We believe they have occurred as a result of the licensees’ responses to changing economic, marketing or strategic factors. Our contracts however, allow for us to retain the licensees’ cash payments received and amounts owed for services rendered prior to the date of cancellation.

From time to time, our licensees may cancel a project during the development phase. These cancellations occur beyond our control and are often caused by changes in market conditions or our licensee's business. Our contracts allow for us to retain the licensees cash payments received or to be received up to the point of cancellation.

Each licensing agreement provides for royalty payments at a stated rate. We negotiate royalty rates by taking into account such factors as the amount of licensing fees to be paid, the anticipated volume of the licensee’s sales of products that utilize our technology and the cost savings to be achieved by the licensee when using our technology. Our agreements require licensees to report the manufacture or sale of products that include our technology after the end of the quarter in which the sale or manufacture occurs. We generally recognize royalties in the quarter in which we receive the licensee’s report. We recorded our first royalty revenue in the quarter ended December 31, 2000.

The timing and level of royalties are likewise difficult to predict because they depend on the licensees’ ability to market, produce and ship product that incorporates our technology. Under our licensing business model, our future revenue is tied to royalties on the production and sale of our licensees’ products. Many of these products are consumer products, such as electronic game players, for which demand is seasonal and generally highest in the fourth quarter, which we would report in the first quarter of the following year. For a discussion of factors that could contribute to the fluctuation of our revenues, please see “Risk Factors—Our lengthy licensing cycle and our licensees’ lengthy development cycles will make the operating results of our licensing business difficult to predict.”

Product sales are typically on a purchase–order basis, with shipment of product from one to six months later. Provisions for estimated returns and to a lesser degree potential warranty liability are recorded at the time revenue is recognized.

Currently, Taiwan Semiconductor Manufacturing Co., Ltd., or TSMC, manufactures all of the memory chips that we sell. Our products are assembled and tested prior to shipment by independent, third-party contractors. We contract for manufacturing services on a purchase-order basis and have no long-term commitments for the supply of any of our memory chip products. If we are unable to obtain manufacturing, assembly or testing services required to fill our customer orders for these products, our revenues from these products will decline substantially.

Our memory chips are subject to competitive pricing pressure that might result in fluctuating gross profits, which we have experienced in the past. Prior to 1999, we sold most of our memory chips to the personal computer market, which is seasonal, and experienced the strongest demand for these products in the fourth quarter each year. From late 1998 to date, our memory chip sales have consisted primarily of 1T-SRAM chips sold to customers in the communications equipment business, and we have not seen the effect of seasonal demand in the market.

The semiconductor industry is currently experiencing a difficult economic environment and downturn. Most of our memory chip sales are made to communications equipment manufacturers, which experienced a sharp economic downturn in 2001. Our product revenues for the second quarter of 2002 were only 21% of our product revenues for the same quarter of last year. We have limited visibility of our customer’s chip requirements in 2002 and anticipate a continuing low level of product revenue.

A few customers account for a significant percentage of our total revenue. For the second quarter ended June 30, 2002, NEC and Nintendo represented 24.2% and 15.4% of total revenue, respectively. In the second quarter of 2001, three customers, NEC, Cisco Systems, Inc., and Flextronics International USA, Inc. represented 28.5%, 16.9% and 15.9% of our total revenue, respectively. For the six months ended June 30, 2002, NEC and Nintendo represented 28.1% and 15.5% of total revenue, respectively. In the first half of 2001, our two largest customers, Cisco Systems Inc., and NEC, represented 18.7% and 16.1% of our total revenue, respectively. For information regarding revenues received by us in the three months and six months ended June 30, 2002 and 2001 from customers residing in the United States or residing in a foreign country, please refer to note 3, “Segment Information,” of Notes to Condensed Consolidated Financial Statements. All of our sales are denominated in U.S. dollars.

Cost of Revenue. Cost of product revenue consists primarily of costs associated with the manufacture, assembly and testing of our memory chip products by independent, third-party contractors.

Cost of licensing revenue consists primarily of engineering costs directly related to engineering development projects specified in agreements we have with licensees of our 1T-SRAM technology. These projects typically include customization of 1T-SRAM circuitry to enable embedding our memory on a licensee’s integrated circuit and may include engineering support to assist in the commencement of production of a licensee’s products. If licensing revenue is recognized using the percentage of completion method, the associated cost of licensing revenue is recognized in the period in which we incur the engineering expense. If licensing revenue is recognized using the completed contract method, and to the extent that the amount of engineering costs does not exceed the amount of the related licensing revenues, these costs are deferred on a contract-by-contract basis from the time we have established technological feasibility of the product to be developed under the license. Technological feasibility is established when we have completed all activities necessary to demonstrate that the licensee’s product can be produced to meet the performance specifications when incorporating our technology. Deferred costs are charged to cost of licensing revenue when the related revenue is recognized. However, for the contracts entered into prior to establishing technical feasibility, we do not defer development costs related to these contracts, but rather expense these costs in the period they are incurred. Consequently, upon completion of these contracts, we recognize related revenue from these contracts without any corresponding costs. There are no reported costs associated with royalty revenue.

Research and Development. Research and development expenses consist primarily of salaries and related employee expenses, material costs for prototype and test units and expenses associated with engineering development software and equipment. Prior to 1998, our research and development expenses were incurred primarily in support of the design, development and production of memory chips.

Since changing our business model in 1998, we have devoted our research and development efforts primarily to developing the 1T-SRAM technology and related licensing activities. Some of these efforts have been directly related to projects specified in various license agreements we have with the early adopters of our memory technology. Research and development expenses can also include development and design of variations of the 1T-SRAM technology for use in different manufacturing processes used by licensees and the development and testing of prototypes to prove the technical feasibility of embedding our memory designs in the licensees’ products.

We generally record engineering cost as research and development expense in the period incurred, except when the engineering cost is being deferred under a licensing agreement for which technological feasibility has been established.

Selling, General and Administrative Expenses. Selling, general and administrative expenses consist primarily of employee-related expenses, sales commissions to independent sales representatives and professional fees. We pay commissions to our independent sales representatives on most of our sales of memory chips. We have engaged one sales representative in Japan, who receives a commission on licensing revenue generated from licensees that this sales representative introduces to us. Facility and occupancy costs are allocated to each functional department in proportion to its headcount. We seek to leverage our licensing and co-marketing relationships to promote our technology.

Critical Accounting Policies

Use of estimates. Our discussion and analysis of our financial condition and results of operation are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make certain estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis we make these estimates based on our historical experience and on assumptions that we consider reasonable under the circumstances. Actual results may differ from these estimates, and reported results could differ under different assumptions or conditions.

We believe that our revenue recognition and inventory valuation accounting policies are affected by estimates and judgments in the following manner:

Results of Operations

Three Months Ended June 30, 2002 and 2001

Revenue. Total revenue increased to $6.5 million for the three months ended June 30, 2002 from $5.4 million for the three months ended June 30, 2001. Product revenue, however, decreased to $648,000 in the second quarter of 2002 from $3.2 million in the same period of 2001, and was 10.0% of total revenue, compared to 58.3% in the same period in 2001. We attribute the product revenue decrease primarily to the economic downturn in the communications equipment industry, which is the primary market for our memory chips. Licensing revenue increased to $2.6 million in the second quarter of 2002 from $1.9 million in the same period of 2001, as we recognized more revenue from an increased number of new licensees. Licensing revenue was 40.1% of total revenue, compared to 36.1% in the same period in 2001.

In the three months ended June 30, 2002, royalty revenue increased to $3.3 million from $301,000 in the same period of 2001, and was 50.0% of total revenue, compared to 5.6% for the same period in 2001. Royalty revenue for the three months ended June 30, 2002 was derived primarily from the sales of NEC memory chips to Nintendo for the GAMECUBE video game console. Additional royalty revenue was earned from several other licensees. There was an insignificant amount of royalty revenue related to the GAMECUBE video game console included in the same period of 2001.

Gross Profit. Gross profit increased to $5.8 million in the three months ended June 30, 2002 from $4.1 million in the same period of 2001. Gross profit as a percentage of total revenue increased to 88.9% in the first quarter of 2002 from 75.1% in the same period of 2001. The increases in gross profit and gross profit percentage resulted from our much higher proportion of royalty revenue and lower product revenue. Product gross margin as a percentage of product revenue declined to 41.0% in the second quarter of 2002 compared to 60.1% in the same quarter of 2001. This decline occurred because there were far fewer units of product shipped in the second quarter of 2002 while total manufacturing fixed costs were similar in both periods. Licensing gross profit also declined to 87.1% in the second quarter of 2002 compared to 95.3% in the same period of 2001.

In the second quarter of 2002, 32.4% of our licensing revenue came from the contracts accounted under the completed contract method compared to 91.7% of licensing revenue in the same quarter of 2001. These contracts were entered into before the technical feasibility was established; therefore, costs associated with these contracts were already expensed prior to the recognition of revenue occurring. In the future, we expect a majority of our licensing contracts to be accounted for under the percentage of completion method, and, therefore, expect the gross margin percentage from licensing revenue to be lower than the current level.

Research and Development. Research and development expenses increased to $1.5 million in the second quarter of 2002 from $1.2 million in the same period of 2001, as we added engineering staff to support the continued development of our 1T-SRAM technology and expanding licensing activities. Research and development expenses as a percent of total revenue were 22.8% and 21.5% for the quarters ended June 30, 2002 and 2001, respectively.

Selling, General and Administrative. Selling, general and administrative expenses were $1.2 million for the second quarters of 2002 and 2001 as increases in administrative, sales and marketing staff expenses were offset by lower product sales commissions in each period. Selling, General and Administrative expenses as a percentage of total revenue were 18.2% and 22.0% for the quarters ended June 30, 2002 and 2001, respectively.

Interest and Other Income. Interest and other income, which were earned primarily from interest on short-term investments, increased to $433,000 in the second quarter of 2002 from $259,000 in the same quarter of 2001. The increase was due to higher average cash balances and was partially offset by a decline in interest rates. Interest and other income as a percent of total revenue were 6.6% and 4.8% for the quarters ended June 30, 2002 and 2001, respectively.

Provision for Income Taxes. The provision for income taxes increased to $681,000 in the second quarter of 2002 from $73,000 in the same period of 2001. We used an effective income tax rate of 20% for the second quarter of 2002 compared to a 5% effective tax rate used for the same period in 2001. Our effective tax rate increased due primarily to limitations on the utilization of certain net operating loss carryforwards and tax credits imposed under Internal Revenue Code section 382 for the year ended December 31, 2002. For the remainder of 2002, we anticipate that our effective income tax rate will be less than the full applicable corporate income tax rate but higher than last year’s for financial reporting purposes.

Six Months Ended June 30, 2002 and 2001

Revenue. Total revenue increased to $12.9 million for the six months ended June 30, 2002 from $10.0 million in the same period of 2001. Product revenue, however, decreased to $1.5 million in first six months of 2002 from $7.1 million in the same period of 2001, and was 12.0% of total revenue, compared to 70.9% in the same period in 2001. We attribute the product revenue decrease primarily to the economic downturn in the communications equipment industry, which is the primary market for our memory chips. Licensing revenue increased to $4.5 million in the first half of 2002 from $2.5 million in the same period of 2001 because we recognized more revenue from an increased number of new licensees. Licensing revenue was 34.8% of total revenue, compared to 24.8% in the same period in 2001.

In the six months ended June 30, 2002, royalty revenue increased to $6.9 million from $434,000 in the same period of 2001, and was 53.2% of total revenue, compared to 4.4% in the same period in 2001. Royalty revenue for the six months ended June 30, 2002 was derived primarily from the sales of NEC memory chips to Nintendo for the GAMECUBE video game console. Additional royalty revenue was earned from several other licensees. There was an insignificant amount of royalty revenue related to the GAMECUBE video game console included in the same period of 2001.

Gross Profit. Gross profit increased to $11.4 million in the six months ended June 30, 2002 from $6.8million in the same period of 2001. Total gross profit as a percentage of total revenue increased to 88.5% in the first half of 2002 from 67.8% in the same period of 2001. The increases in gross profit and gross profit percentage resulted from our much higher proportion of royalty revenue and lower product revenue. Product gross margin as a percentage of product revenue declined to 46.1% in the first half of 2002 compared to 58.0% in the same period of 2001. This decline occurred because there were far fewer units of product shipped in the second half of 2002 while total manufacturing fixed costs were similar in both periods. Licensing gross profit declined to 85.5% in the first six months of 2002 compared to 90.3% in the same period of 2001.

In the first six months of 2002, 28.9% of our licensing revenue came from the contracts accounted under the completed contract method compared to 73.9% of licensing revenue in the same period of 2001. These contracts were entered into before the technical feasibility was established; therefore, costs associated with these contracts were already expensed prior to the recognition of revenue occurring. In the future, we expect a majority of our licensing contracts to be accounted for under the percentage of completion method, and, therefore, expect the gross margin percentage from licensing revenue to be lower than the current level.

Research and Development. Research and development expenses increased to $2.8 million in the six months ended June 30, 2002 from $2.0 million in the same period of 2001. The increases resulted from added engineering staff, and expanded licensing activities. Research and development expenses as a percent of total revenue were 21.8% and 20.1% for the six months ended June 30, 2002 and 2001, respectively.

Selling, General and Administrative. Selling, general and administrative expenses decreased to $2.2 million in the first six months of 2002 from $2.3 million in same period of 2001. This decrease resulted primarily from a reduction of a portion of a bad debt reserve, which was no longer required, as well as lower product sales commissions. We increased administrative, sales and marketing staff expenses during the first half of 2002, however. Selling, general and administrative expenses as a percent of total revenue were 16.9% and 23.3% for the six months ended June 30, 2002 and 2001, respectively.

Interest and Other Income. Interest and other income increased to $800,000 in the first half of 2002 from $626,000 in the same period of 2001. The increase was due to higher average cash balances, although interest rates declined from the first half of 2001. Interest and other income as a percent of total revenue were 6.2% and 6.3% for the six months ended June 30, 2002 and 2001, respectively.

Provision for Income Taxes. The provision for income taxes increased to $1.4 million in the first half of 2002 from $110,000 in the same period of 2001. We used an effective income tax rate of 20% for the first six months of 2002 compared to a 5% effective tax rate used for the same period in 2001. For the remainder of 2002, we anticipate that our effective income tax rate will be less than the full applicable corporate income tax rate but higher than last year’s for financial reporting purposes.

Liquidity and Capital Resources

As of June 30, 2002, we had cash and cash equivalents of $23.7 million and short-term investments of $61.8 million. Our primary capital requirements are for working capital. We believe that our current focus on licensing and royalty revenues and reduced levels of memory chip sales has lessened the volatility of our business and generally has enabled us to steadily improve our cash position.

Net cash provided by operating activities was $1.5 million for the six months ended June 30, 2002 compared to net cash used of $942,000 for the same period of 2001, as we achieved higher net income in 2002, while increasing prepaid expenses and other assets, and reducing deferred revenue. For the first six months of 2001, a reduction in deferred revenue, increased inventory purchases and an increase in prepaid expenses and other assets exceeded the cash provided through net income, resulting in net usage of cash for operating activities during the period.

Net cash used in investing activities was approximately $25.9 million and $3.7 million for the first six months ended June 30, 2002 and 2001, respectively. Net cash used in investing activities for the first half of 2002 and 2001 consisted primarily of purchases of short-term marketable securities. We also used cash to acquire licenses for engineering design software.

Net cash provided by financing activities was $712,000 and $1.2 million for the first six months ended 2002 and 2001, respectively. Most of the cash provided by financing activities for the first half of 2002 primarily consisted of proceeds received from the exercise of employee options to purchase common stock. Net cash provided by financing activities for the first half of 2001consisted primarily of proceeds received from the exercise of warrants.

Our future liquidity and capital requirements are expected to vary from quarter to quarter, depending on numerous factors, including—

• amount and timing of royalties earned on product manufacturing or shipment by licensees of 1T-SRAM technologies;

• level and timing of licensing and memory chip sales revenues;

• cost, timing and success of technology development efforts;

• market acceptance of our existing and future technologies and products;

• competing technological and market developments;

• cost of maintaining and enforcing patent claims and intellectual property rights; and

• variations in manufacturing yields, materials costs and other manufacturing risks.

We expect that our current cash and investments, together with our existing capital and cash generated from operations, if any, will be sufficient to meet our capital requirements for the foreseeable future, including funds needed for the acquisition and integration of Atmos Corporation in the event we complete our pending acquisition of that company. We expect that a licensing business such as ours generally will require less cash to support operations after multiple licensees begin to ship products and pay royalties. However, we cannot be certain that we will not require additional financing at some point in time. Should our cash resources prove inadequate, we might need to raise additional funding through public or private financing. There can be no assurance that such additional funding will be available to us on favorable terms, if at all. The failure to raise capital when needed could have a material, adverse effect on our business and financial condition.

We have contractual cash obligations under a non-cancelable operating lease for our office space. The following table summarizes the contractual cash obligations as of June 30, 2002:

Payments Due by Period	Operating Leases

Less that 1 year	$	838
1-3 years	$	1,803
4-5 years	—
After 5 years	—
Total	$	2,641

There are no other purchase commitments.

Pending Acquisition

Effective as of June 10, 2002, we entered into a letter of agreement with Atmos Corporation (“Atmos”), a semiconductor memory company, setting forth binding terms for the acquisition of 100% of the outstanding shares of Atmos capital stock by the Company. Also, on June 10, 2002, we loaned $500,000 to Atmos under a promissory note due on July 31, 2002, which is included in prepaid expenses and other current assets. The note and certain obligations of Atmos under the letter of agreement have been collateralized with the intellectual property assets of Atmos. The Company recently agreed to extend the maturity date of the promissory note to August 14, 2002. The letter of agreement obligates the Company to cancel the promissory note and forgive the loan as a form of break-up fee, if the Company abandons the acquisition under certain circumstances. The Company is actively engaged in the process of completing the acquisition but has not set a closing date.

RISK FACTORS

If any of the following risks actually occur, our business, results of operations and financial condition could suffer significantly.

Our success depends upon the semiconductor market’s acceptance of our 1T-SRAM technology.

The future prospects of our business depend on the acceptance by our target markets of our 1T-SRAM technology for embedded memory applications and any future technology we might develop. Our technology is intended to allow our licensees to develop embedded memory integrated circuits to replace other embedded memory technology with different cost and performance parameters.

Our core technology solution utilizes a fundamentally different internal circuitry with which the industry is not familiar. Therefore, it might prove difficult to convince product designers of the viability of our embedded memory solution and to adopt our technology instead of other memory solutions which have proven effective in their products. We cannot assure you that our technology will achieve widespread market acceptance.

An important part of our strategy to gain market acceptance is to penetrate new markets by targeting market leaders as licensees of our technology. This strategy is designed to encourage other participants in those markets to follow these leaders in adopting our technology. Should a high-profile industry participant adopt our technology for one or more of its products but fail to achieve success with those products, other industry participants’ perception of our technology could be harmed. Any such event could reduce the number of future licenses of our technology. Likewise, were a market leader to adopt and achieve success with a competing technology, our reputation and licensing program could be harmed.

Our embedded memory technology might not integrate as well as anticipated with other semiconductor functions in all intended applications, which would slow or prevent adoption of our technology and reduce our revenue. Detailed aspects of our technology could cause unforeseen problems in the efficient integration of our technology with other functions of particular integrated circuits. Any significant compatibility problems with our technology could reduce the attractiveness of our solution, impede its acceptance in the industry and result in a decrease in demand for our technology.

Our embedded memory technology is new and has a limited high volume production history, and the discovery of defects in this technology, the occurrence of manufacturing difficulties, or low production yields could hinder market acceptance of our technology and reduce future revenue.

We entered into our first license of our 1T-SRAM technology for embedded memory applications in March 1999 and the first volume production by a licensee began in late 2000. Our technology has been fabricated and verified to be operational in the most widely used standard logic manufacturing process generations. While our licensees and we have evaluated and tested this technology, only seven licensees are now in volume manufacture of products incorporating our technology and problems that neither we nor these licensees have experienced could arise in the future. Complex technology like ours often contains errors or defects when first incorporated into customer products. For example, semiconductor manufacturing yield could be adversely affected by difficulties in adapting our 1T-SRAM technology to our licensees’ product design or to the manufacturing process technology of a particular foundry or semiconductor manufacturer. Any weakness in manufacturing yields of integrated circuits utilizing our technology could impede the acceptance of our technology in the industry. The discovery of defects or problems regarding the reliability, quality or compatibility of our technology could require significant expenditures and resources to fix, significantly delay or hinder market acceptance of our technology, reduce anticipated revenues and damage our reputation.

Our lengthy licensing cycle and our licensees’ lengthy product development cycles will make the operating results of our licensing business difficult to predict.

We anticipate difficulty in accurately predicting the timing and amounts of revenue generated from licensing our 1T-SRAM technology. The establishment of a business relationship with a potential licensee is a lengthy process, frequently spanning a year or more. Following the establishment of the relationship, the negotiation of licensing terms can be time consuming, and a potential licensee could require an extended evaluation and testing period.

Once a license agreement is executed, the timing and amount of licensing and royalty revenue from our licensing business will remain difficult to predict. The completion of the licensees’ development projects and the commencement of production will be subject to the licensees’ efforts, development risks and other factors outside our control. Our royalty revenue may depend on such factors as the licensees’ production and shipment volumes, the timing of product shipments and when the licensees report to us the manufacture or sale of products that include our 1T-SRAM technology. All of these factors will prevent us from making predictions of revenue with any certainty and could cause us to experience substantial period-to-period fluctuations in operating results.

In addition, none of our licensees are under any obligation to incorporate our technology in any present or future product or to pursue the manufacture or sale of any product incorporating our technology. A licensee’s decision to complete a project or manufacture a product is subject to changing economic, marketing or strategic factors. The long development cycle of our licensees’ products increases the risk that these factors will cause the licensee to change its plans. In the past, some of our licensees have discontinued development of products incorporating our technology. These customers’ decisions were based on factors unrelated to our technology, but, as a result, it is unlikely that we will receive royalties in connection with those products. We expect that, from time to time, our licensees will discontinue a product line or cancel a product introduction, which could adversely affect our future operating results and business.

Anything that negatively affects the businesses of our licensees could negatively impact our revenue.

The timing and level of our royalties depend on our licensees’ ability to market, produce and ship products incorporating our technology. Because we expect licensing and royalty revenue to be the largest source of our future revenue, anything that negatively affects a significant licensee or group of licensees could negatively affect our results of operations and financial condition. Many issues beyond our control influence the success of our licensees, including, for example, the highly competitive environment in which they operate, the strength of the markets for their products, their engineering capabilities and their financial and other resources.

Likewise, we have no control over the product development, pricing and marketing strategies of our licensees, which directly affect sales of their products and the corresponding royalties payable to us. A decline in sales of our licensees’ royalty-generating products for any reason would reduce our royalty revenue. In addition, seasonal and other fluctuations in demand for our licensees’ products could cause our operating results to fluctuate, which could cause our stock price to fall.

Our failure to continue to enhance our technology or develop new technology on a timely basis could diminish our ability to attract and retain licensees and product customers.

The existing and potential markets for memory products and technology are characterized by ever increasing performance requirements, evolving industry standards, rapid technological change and product obsolescence. These characteristics lead to frequent new product and

technology introductions and enhancements, shorter product life cycles and changes in consumer demands. In order to attain and maintain a significant position in the market, we will need to continue to enhance our technology in anticipation of these market trends.

In addition, the semiconductor industry might adopt or develop a completely different approach to utilizing memory for many applications, which could render our existing technology unmarketable or obsolete. We might not be able to successfully develop new technology, or adapt our existing technology, to comply with these innovative standards.

Our future performance depends on a number of factors, including our ability to—

• identify target markets and relevant emerging technological trends, including new standards and protocols;

• develop and maintain competitive technology by improving performance and adding innovative features that differentiate our technology from alternative technologies;

• enable the incorporation of enhanced technology in our licensees’ and customers’ products on a timely basis and at competitive prices; and

• respond effectively to new technological developments or new product introductions by others.

We cannot assure you that the design and introduction schedules of any additions and enhancements to our existing and future technology will be met, that this technology will achieve market acceptance or that we will be able to license this technology on terms that are favorable to us. Our failure to develop future technology that achieves market acceptance could harm our competitive position and impede our future growth.

We depend substantially on semiconductor foundry partners to assist us in attracting potential licensees and a loss or failure of these relationships could inhibit our growth and reduce our revenue.

A significant part of our marketing strategy is dependent upon our agreements with semiconductor foundries. These foundries have existing relationships, and continually seek new relationships, with companies in the markets we target, and have agreed to utilize these relationships to introduce our technology to potential licensees. If we fail to maintain our current relationships with these foundries, we might fail to achieve anticipated growth.

In 2001 and the first six months of 2002, we experienced a significant decline in revenue from sales of our stand alone memory chips and there is no assurance that we will regain the level of product revenue we have had in the past, and product revenue could decline further from current levels.

Product revenues since 1998, when we changed our business strategy, have represented 58%, 90% and 100% of our total revenues for 2001, 2000 and 1999, respectively. Our product revenues fell to $1.5 million for the six months ended June 30, 2002 from $7.1 million in the same period of 2001. The decline reflects a general weakness in demand for our customers’ products and a corresponding inventory correction that resulted in reduced purchases of our memory chips. We cannot assure you that our customers will increase their orders for our memory chips in future periods.

A decline in the average selling prices of our memory chips could reduce our product revenue and gross profit.

As has been typical in the semiconductor industry, we expect that the average unit selling prices of our memory chips will decline over the course of their commercial lives, principally due to the supply of competing products, falling demand from customers and product cycle changes. We experienced a significant decline in average selling prices for our primary memory chip from 1997 to 1998, with a corresponding decline in gross margin for that product. Declining average selling prices will adversely affect gross margins from the sale of our memory chips. We might not be able to adjust our costs rapidly or deeply enough to offset the pricing declines and, as a consequence, our product revenue and profit margins could fall.

We have an initial history of operating losses, have achieved quarterly profitability consistently only since the third quarter of 2000 and cannot provide assurance of our future profitability.

We recorded operating losses in each year from our inception through 1998. From our inception through 1994, we were engaged primarily in research and product development. From 1995 through the third quarter of 1998, we focused on the sale of memory chips. Beginning in the fourth quarter of 1998, we altered our business plan to concentrate on developing and licensing our 1T-SRAM technology. Prior to the quarter ended September 30, 2000, we had recorded operating losses in each quarter since our entry into the

licensing business. While we have been profitable each quarter since the third quarter of 2000, we are still in the early stages of our new licensing business, offering a relatively new technology, and cannot assure you that we will be profitable on a quarterly or annual basis in the future.

Royalty amounts owed to us might be difficult to verify, and we might find it difficult, expensive and time consuming to enforce our license agreements.

The standard terms of our license agreements require our licensees to document the manufacture and sale of products that incorporate our technology and report this data to us after the end of each quarter. We must rely to a large extent upon the accuracy of these reports, as we do not have the capacity to independently verify this information. Though our standard license terms give us the right to audit the books and records of any licensee to attempt to verify the information provided to us in these reports, an audit of a licensee’s records can be expensive and time consuming, and potentially detrimental to the business relationship. A failure to fully enforce the royalty provisions of our license agreements could cause our revenue to decrease and impede our ability to maintain profitability.

We expect our revenue to be highly concentrated among a small number of licensees and customers, and our results of operations could be harmed if we lose and fail to replace this revenue.

We expect that royalty revenue will be highly concentrated among a few licensees for the foreseeable future. In particular, a substantial portion of our licensing revenue in 2001 has come from the licenses for integrated circuits to be used by Nintendo in its GAMECUBE and we expect the same source to represent a substantial portion of royalty revenue in 2002. Nintendo faces intense competitive pressure in the video game market, which is characterized by extreme volatility, frequent new product introductions and rapidly shifting consumer preferences. We cannot assure you that Nintendo’s sales of product incorporating our technology will increase or remain at current levels and that we will continue to receive significant royalty revenue from Nintendo.

Currently, our licensing and royalty revenue is highly concentrated. For the six months ended June 30, 2002, two customers, who are both licensees, represented 28.1% and 15.5% of our total revenue. Two customers, one a purchaser of memory chips and the other a licensee, represented 21.7% and 18.6%, respectively, of our total revenue in 2001. Prior to 2001, only product customers accounted for our major customers. Revenue from one customer represented 26.2% of our total revenue in 2000, while two customers represented 16.4% and 10.9% of our total revenue in 1999. We expect that a relatively small number of licensees will continue to account for a substantial portion of our revenue for the foreseeable future.

As a result of this revenue concentration, our results of operations could be impaired by the decision of a single key licensee or customer to cease using our technology or products or by a decline in the number of products that incorporate our technology that are sold by a single licensee or customer or by a small group of licensees or customers.

Our product revenue concentration might pose credit risks, which could negatively affect our cash flow and financial condition.

We might face credit risks associated with the concentration of our product revenue among a small number of licensees and customers. As of June 30, 2002, two customers represented 62% of total trade receivables. As of December 31, 2001, two customers accounted for 54% of total trade receivables. Our failure to collect receivables from any customer that represents a large percentage of receivables on a timely basis, or at all, could adversely affect our cash flow or results of operations and might cause our stock price to fall.

We might not be able to protect and enforce our intellectual property rights, which could impair our ability to compete and reduce the value of our technology.

Our technology is complex and is intended for use in complicated integrated circuits. A very large number of new and existing products utilize embedded memory, and a large number of companies manufacture and market these products. Because of these factors, policing the unauthorized use of our intellectual property is difficult and expensive. We cannot be certain that we will be able to detect unauthorized use of our technology or prevent other parties from designing and marketing unauthorized products based on our technology. Although we are not aware of any past or present infringement of our patents, copyrights or trademarks, or any violation of our trade secrets, confidentiality procedures or licensing agreements, we cannot assure you that the steps taken by us to protect our proprietary information will be adequate to prevent misappropriation of our technology. Our inability to protect adequately our intellectual property would reduce significantly the barriers of entry for directly competing technologies and could reduce the value of our technology. Furthermore, we might initiate claims or litigation against third parties for infringement of our proprietary rights or to establish the validity of our proprietary rights. Litigation by us could result in significant expense and divert the efforts of our technical and management personnel, whether or not such litigation results in a determination favorable to us.

Our existing patents might not provide us with sufficient protection of our intellectual property, and our patent applications might not result in the issuance of patents, either of which could reduce the value of our core technology and harm our business.

We rely on a combination of patents, trademarks, copyrights, trade secret laws and confidentiality procedures to protect our intellectual property rights. As of June 30, 2002, we held 44 patents in the United States, which expire at various times from 2011 to 2020, and 23 corresponding foreign patents. In addition, as of June 30, 2002, we had 17 patent applications pending in the United States and 21 pending foreign applications, and had received notice of allowance of six patent applications pending in the United States. We cannot be sure that any patents will issue from any of our pending applications or that any claims allowed from pending applications will be of sufficient scope or strength, or issued in all countries where our products can be sold, to provide meaningful protection or any commercial advantage to us. Also, competitors might be able to design around our patents. Failure of our patents or patent applications to provide meaningful protection might allow others to utilize our technology without any compensation to us and impair our ability to increase our licensing revenue.

Any claim that our products or technology infringe third-party intellectual property rights could increase our costs of operation and distract management and could result in expensive settlement costs or the discontinuance of our technology licensing or product offerings.

The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights or positions, which has resulted in often protracted and expensive litigation. We are not aware of any currently pending intellectual property litigation or threatened claim against us. However, our licensees or we might, from time to time, receive notice of claims that we have infringed patents or other intellectual property rights owned by others. Litigation against us could result in significant expense and divert the efforts of our technical and management personnel, whether or not the litigation results in a determination adverse to us. In the event of an adverse result in any such litigation, we could be required to pay substantial damages, cease the licensing of certain technology or the sale of infringing products, and expend significant resources to develop non-infringing technology or obtain licenses for the infringing technology. We cannot assure you that we would be successful in such development or that such licenses would be available on reasonable terms, or at all.

The discovery of defects in our technology could expose us to liability for damages.

The discovery of a defect in our 1T-SRAM technology could lead our licensees to seek damages from us. Our standard license terms include provisions waiving implied warranties regarding our technology and limiting our liability to our licensees. We also maintain insurance coverage that is intended to protect us against potential liability for defects in our technology. We cannot be certain, however, that the waivers or limitations of liability contained in our license contracts will be enforceable, that insurance coverage will continue to be available on reasonable terms or in amounts sufficient to cover one or more large claims or that our insurer will not disclaim coverage as to any future claim. The successful assertion of one or more large claims that exceed available insurance coverage or changes in our insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements, could cause our expenses to rise significantly and consequently harm our profitability.

Our failure to compete effectively in the market for embedded memory technology and products could reduce our revenue.

Competition in the market for embedded memory technology and products is intense. Our licensees and prospective licensees can meet their need for embedded memory by using traditional memory solutions with different cost and performance parameters. If alternative technologies are developed that provide comparable system performance at lower cost than our 1T-SRAM technology or do not require the payment of comparable royalties, or if the industry generally demonstrates a preference for applications for which our 1T-SRAM technology does not offer significant advantages, our ability to realize revenue from our 1T-SRAM technology could be impaired.

We might be challenged by competitive developers of alternative technologies who are more established, benefit from greater market recognition and have substantially greater financial, development, manufacturing and marketing resources than we have. These advantages might permit these developers to respond more quickly to new or emerging technologies and changes in licensee requirements. We cannot assure you that future competition will not have a material adverse effect on the adoption of our technology and our market penetration.

We might be unable to deliver our customized memory technology in the time frame demanded by our licensees, which could damage our reputation and harm our ability to attract future licensees.

The majority of our licenses require us to customize our 1T-SRAM technology within a certain delivery timetable. Not all of the factors relating to this customization are within our control. We cannot assure you that we will be able to meet the time requirements under these licenses. Any failure to meet significant license milestones could damage our reputation in the industry and harm our ability to attract new licensees and could preclude our receipt of licensing fees.

We intend to grow rapidly, and our failure to manage this growth could reduce our potential revenue and threaten our future profitability.

The efficient management of our planned expansion of the development, licensing and marketing of our technology will require us to continue to—

• implement and manage new marketing channels to penetrate different and broader markets for our 1T-SRAM technology;

• manage an increasing number of complex relationships with licensees and co-marketers and their customers and other third parties;

• improve our operating systems, procedures and financial controls on a timely basis;

• hire additional key management and technical personnel; and

• expand, train and manage our workforce and, in particular, our development, sales, marketing and support organizations.

We cannot assure you that we will adequately manage our growth or meet the foregoing objectives. A failure to do so could jeopardize our future revenues and cause our stock price to fall.

If we fail to retain key personnel, our business and growth could be negatively affected.

Our business has been dependent to a significant degree upon the services of a small number of executive officers and technical employees, including Dr. Fu-Chieh Hsu, our Chairman of the Board, President and Chief Executive Officer, and Dr. Wingyu Leung, our Executive Vice President and Chief Technical Officer. The loss of their services could negatively impact our technology development efforts and our ability to perform our existing agreements and obtain new customers. We generally have not entered into employment or non-competition agreements with any of our employees and do not maintain key-man life insurance on the lives of any of our key personnel.

We obtain the manufacture, assembly and testing of our products from third parties that we do not control and a loss of these services could harm our licensing business and decrease our product revenue.

We are a fabless semiconductor company, and currently rely on Taiwan Semiconductor Manufacturing Co., Ltd., or TSMC, for the manufacture of all of our memory chips. We presently do not have a firm, written agreement with TSMC or any other semiconductor foundry that guarantees the fabrication of our memory chips. As a result, we cannot assure you that we will always be able to obtain these products in sufficient numbers and on a timely basis to meet our sales objectives. A failure to ensure the timely fabrication of our products could cause us to lose customers and could have a material adverse effect on our profits. If TSMC ceases to provide us with required production capacity with respect to our memory chips, we cannot assure you that we will be able to enter into manufacturing arrangements with other foundries on commercially reasonable terms, or that these arrangements, if established, will result in the successful manufacturing of our products. These arrangements might require us to share control over our manufacturing process technologies or to relinquish rights to our technology and might be subject to unilateral termination by the foundries. Even if such capacity is available from another manufacturer, we would need to qualify the manufacturer, which process could take six months or longer. We cannot assure you that we would be able to identify or qualify manufacturing sources that would be able to produce wafers with acceptable manufacturing yields.

All of our semiconductor memory chip products are assembled and tested by third-party vendors, primarily in Taiwan. Our reliance on independent assembly and testing vendors involves a number of risks, including reduced control over delivery schedules, quality assurance and costs. The inability of these third-party contractors to deliver products of acceptable quality and in a timely manner could result in the loss of customers and a reduction in our product revenue.

Our marketing efforts with respect to licensing our 1T-SRAM technology include the use of our 1T-SRAM memory chips to demonstrate the performance and manufacturability of the underlying technology and to facilitate acceptance of our technology by potential licensees. A loss of foundry capacity, assembly services or testing services for our memory chips, or any other failure to produce our 1T-SRAM memory chips, could materially impair our ability to market our technology to potential licensees and reduce our revenue.

The volatility of and uncertainties inherent in the semiconductor industry may make it difficult to plan our memory chip business and could cause our results of operations to fluctuate substantially.

In the past, we have generally experienced significant fluctuations in our operating results due to significant economic downturns in the semiconductor industry. Specifically, in 1998 and again in late 2000, product demand fell, prices eroded and inventory levels fluctuated. Our ability to sell memory chips has also been hampered by alternating periods of manufacturing over-capacity and capacity constraints. Any recurrence of these conditions could cause us to experience substantial period-to-period fluctuations in revenues and costs associated with our memory chip business.

Our failure to successfully address the potential difficulties associated with our international operations could increase our costs of operation and negatively impact our revenue.

We are subject to many difficulties posed by doing business internationally, including—

• foreign currency exchange fluctuations;

• unanticipated changes in local regulation;

• potentially adverse tax consequences, such as withholding taxes;

• difficulties regarding timing and availability of export and import licenses;

• political and economic instability; and

• reduced or limited protection of our intellectual property.

Because we anticipate that licenses to companies that operate primarily outside the United States will account for a substantial portion of our licensing revenue in future periods, the occurrence of any of these circumstances could significantly increase our costs of operation, delay the timing of our revenue and harm our profitability.

Provisions of our certificate of incorporation and bylaws or Delaware law might delay or prevent a change of control transaction and depress the market price of our stock.

Various provisions of our certificate of incorporation and bylaws might have the effect of making it more difficult for a third party to acquire, or discouraging a third party from attempting to acquire, control of our company. These provisions could limit the price that certain investors might be willing to pay in the future for shares of our common stock. Certain of these provisions eliminate cumulative voting in the election of directors, limit the right of stockholders to call special meetings and establish specific procedures for director nominations by stockholders and the submission of other proposals for consideration at stockholder meetings.

We are also subject to provisions of Delaware law which could delay or make more difficult a merger, tender offer or proxy contest involving our company. In particular, Section 203 of the Delaware General Corporation Law prohibits a Delaware corporation from engaging in any business combination with any interested stockholder for a period of three years unless specific conditions are met. Any of these provisions could have the effect of delaying, deferring or preventing a change in control, including without limitation, discouraging a proxy contest or making more difficult the acquisition of a substantial block of our common stock.

Our board of directors may issue up to 20,000,000 shares of preferred stock without stockholder approval on such terms as the board might determine. The rights of the holders of common stock will be subject to, and might be adversely affected by, the rights of the holders of any preferred stock that might be issued in the future.

Our stockholder rights plan could prevent stockholders from receiving a premium over the market price for their shares from a potential acquiror.

We have adopted a stockholder rights plan, which entitles our stockholders to rights to acquire additional shares of our common stock generally when a third party acquires 15% of our common stock or commences or announces its intent to commence a tender offer for at least 15% of our common stock. This plan could delay, deter or prevent an investor from acquiring us in a transaction that could otherwise result in stockholders receiving a premium over the market price for their shares of common stock.

A limited number of stockholders will have the ability to influence the outcome of director elections and other matters requiring stockholder approval.

Our executive officers, directors and entities affiliated with them, in the aggregate, beneficially own approximately 40% of our common stock. These stockholders acting together have the ability to exert substantial influence over all matters requiring the approval of our stockholders, including the election and removal of directors and any proposed acquisition, consolidation or sale of all or substantially all of our assets. In addition, they could dictate the management of our business and affairs. This concentration of ownership could have the effect of delaying, deferring or preventing a change in control, or impeding an acquisition, consolidation, takeover or other business combination, which might otherwise involve the payment of a premium for your shares of our common stock.

Any acquisitions we make, such as our anticipated acquisition of Atmos Corporation, could disrupt our business and harm our financial condition.

As part of our growth strategy, we might consider opportunities to acquire other businesses or technologies that would complement our current offerings, expand the breadth of our markets or enhance our technical capabilities. To date, we have not made any acquisitions, although we have entered into a letter of agreement and are engaged actively in the process of acquiring Atmos. Acquisitions present a number of potential challenges that could, if not overcome, disrupt our business operations, increase our operating costs and reduce the value to us of the acquired company, including—

• integration of the acquired employees, operations, technologies and products with our existing business and products;

• focusing management’s time and attention on our core business;

• retention of business relationships with suppliers and customers of the acquired company;

• entering markets in which we lack prior experience;

• retention of key employees of the acquired company; and

• amortization of intangible assets, write-offs, stock-based compensation and other charges relating to the acquired business and our acquisition costs.

Potential volatility of the price of our common stock could negatively affect your investment.

We cannot assure you that there will continue to be an active trading market for our common stock. Recently, the stock market, as well as our common stock, has experienced significant price and volume fluctuations. Market prices of securities of technology companies have been highly volatile and frequently reach levels that bear no relationship to the operating performance of such companies. These market prices generally are not sustainable and are subject to wide variations. If our common stock trades to unsustainably high levels, it is likely that the market price of our common stock will thereafter experience a material decline.

In the past, securities class action litigation has often been brought against a company following periods of volatility in the market price of its securities. We could be the target of similar litigation in the future. Securities litigation could cause us to incur substantial costs, divert management’s attention and resources, harm our reputation in the industry and the securities markets and reduce our profitability.

The price of our stock could decrease as a result of shares being sold in the market by directors, officers and other significant stockholders.

Sales of a substantial number of shares of common stock in the public market could adversely affect the market price of the common stock prevailing from time to time. The number of shares of our common stock available for sale in the public market is limited by restrictions under the Securities Act of 1933, as amended, or the Securities Act, but taking into account sales of stock made in accordance with the provisions of Rules 144(k), 144 and 701, substantially all the shares of common stock currently outstanding are eligible for sale in the public market.

Dr. Fu-Chieh Hsu, our Chairman of the Board, President and Chief Executive Officer, Dr. Wingyu Leung, our Executive Vice President and Chief Technical Officer and Mark Eric Jones, our Vice President and General Manager each entered into a plan for selling a portion of their shares of common stock in the manner described under Rule 10b5-1 of the Securities Exchange Act of 1934. Each plan is non-discretionary and is administered by an independent brokerage firm. Plans for Drs. Hsu and Leung provide for the automatic sale of

shares of common stock in 10,000 share blocks twice each week between January 28, 2002 and July 31, 2002. Mr. Jones’s plan provides for automatic weekly sales that vary from 2,000 to 10,000 shares per week between February 21, 2002 and February 28, 2003, depending on the market price of our stock. Sales of the shares are further subject to the volume restrictions set forth in SEC Rule 144(e). Each plan provides for termination upon the completion of the specified trading program, the instruction of the stockholder, or the occurrence of other specified events, whichever is earliest. All of the shares are sold through broker-dealers in ordinary market transactions. Under his plan, Dr. Hsu intended to sell 540,000 shares, but he cancelled his plan on February 25, 2002 after selling 90,000 shares in late January and February, 2002. Dr. Leung’s plan expired on July 31, 2002. He sold 520,000 shares under his plan. Mr. Jones’s plan remains in effect.

ITEM 3. Qualitative and Quantitative Disclosure about Market Risk

Our investment portfolio consists of money market funds, corporate-backed debt obligations and mortgage-backed government obligations generally due within one year. The primary objective of our investment portfolio is to invest available cash while preserving principal and meeting liquidity needs. In accordance with our investment policy, we place investments with high credit quality issuers and limit the amount of credit exposure to any one issuer. These securities, which approximate $63,837,000 as of June 30, 2002, and have an average interest rate of approximately 2.157%, are subject to interest rate risks. However, based on the investment portfolio contents and our ability to hold these investments until maturity, we believe that if a significant change in interest rates were to occur, it would not have a material effect on our financial condition.

PART II — OTHER INFORMATION

ITEM 2. Changes in Securities and Use of Proceeds

On June 14, 2002, the Company amended an existing warrant held Taiwan Semiconductor Manufacturing Company Ltd. (“TSMC”) to acquire up to 1,200,000 shares of Common Stock at a per share exercise price of $6.50 that the Company had issued to TSMC on August 6, 1998. The amended warrant issued to TSMC on June 14, 2002 was substantially identical to the warrant issued August 6, 1998, except that the June 14, 2002 warrant permitted TSMC to exercise the warrant on a “cashless,” or net, issue basis and prohibited TSMC from reselling or otherwise disposing the shares of Common Stock received upon exercise for a period of 180 days after exercise of the June 14, 2002 warrant. The Company received no additional consideration from TSMC or any other person for the amendment of the warrant or the issuance of shares of common stock upon TSMC’s “cashless” exercise of the warrant. No commission or other remuneration was paid or given directly or indirectly for soliciting such exchanges. The amendment of the warrant and the issuance of shares of common stock upon exercise of the warrant were not registered under the Securities Act of 1933 in reliance upon Section 3(a)(9) and Section 4(2) of such Act.

The Securities and Exchange Commission declared the Company’s first registration statement, filed on Form S-1 under the Securities Act of 1933 (File No. 333-43122) relating to the Company’s initial public offering of its common stock, effective on June 27, 2001. The initial public offering resulted in aggregate gross proceeds of $57,500,000, $4,025,000 of which was applied to the underwriting discount and approximately $1,921,000 of which was applied to related expenses. The Company realized approximately $51,554,000 after offering expenses. To date, the Company has not used any of the net proceeds of the offering. Following the completion of the offering, all series of the Company’s issued and outstanding preferred stock, par value $0.01, converted automatically into 12,731,446 shares of common stock with a par value of $0.01 per share.

ITEM 4. Submission of Matters to a Vote of Security Holders

	(a)	The Annual Meeting of Stockholders of Monolithic System Technology, Inc. was held at 9:30 a.m. Pacific Daylight Time, on May 9, 2002 at the Company’s corporate headquarters located at 1020 Stewart Drive, Sunnyvale, California 94085.

	The two proposals presented at the meeting were:

	1.	To elect five members of the Board of Directors to hold office until the next Annual Meeting of Stockholders.

	2.	To ratify the appointment of the accounting firm of Ernst & Young LLP as independent auditors for the Company for the fiscal years ending December 31, 2001 and 2002.

(b)

Each of the five individuals nominated to serve as a member of the Board of Directors was elected to hold office until the next Annual Meeting of Stockholders and received the number of votes set forth below:

Name	For	Withheld
Carl E. Berg	24,689,508	108,291
Fu-Chieh Hsu	20,994,141	3,803,658
Denny R.S. Ko	24,648,261	149,538
Wingyu Leung	20,990,350	3,807,449
Wei Yen	24,689,509	108,290

There were no abstentions or broker non-votes.

(c)

The ratification of the appointment of the accounting firm of Ernst & Young LLP as independent auditors for the Company for the fiscal years ending December 31, 2001 and 2002 was approved by the votes set forth below:

For		Against		Abstentions
24,766,214		31,470		115

ITEM 6. Exhibits and Reports on Form 8-K

(a)	Exhibits

	99.1 Certification of CEO and CFO

(b)	Reports on Form 8-K

	On June 25, 2002, we filed a report on Form 8-K regarding the June 10, 2002 letter of agreement to acquire Atmos Corporation and the amendment and net exercise of a warrant to purchase common stock by TMSC.

Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Dated: August14, 2002


	/s/ Mark Voll

	Vice President, Finance and Administration,
	Chief Financial Officer and Secretary
	(Duly Authorized and Principal Accounting Officer)