SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

ý QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2004

 

OR

 

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                    to                   .

 

Commission file number:  000-26887

 

Silicon Image, Inc.

(Exact name of registrant as specified in its charter)

 

 

1060 East Arques Avenue
Sunnyvale, California 94085

(Address of principal executive offices and zip code)

 

(408) 616-4000

(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) Yes ý No o and (2) has been subject to such filing requirements for the past 90 days Yes ý No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ý No o

 

The number of shares of the registrant’s Common Stock, $0.001 par value per share, outstanding as of April 30, 2004 was 74,017,564 shares.

 

 

Silicon Image, Inc.
Quarterly Report on Form 10-Q
Three Months Ended
March 31, 2004

 

Table of Contents

 

Part I	Financial Information (Unaudited)
Item 1	Financial Statements
	Condensed Consolidated Statements of Operations for the three months ended March 31, 2004 and 2003
	Condensed Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003
	Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2004 and 2003
	Notes to Unaudited Condensed Consolidated Financial Statements
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3	Quantitative and Qualitative Disclosures About Market Risk
Item 4	Controls and Procedures
Part II	Other Information
Item 1	Legal Proceedings
Item 2	Change in Securities and Use of Proceeds
Item 3	Defaults Upon Senior Securities
Item 4	Submission of Matters to a Vote of Security Holders
Item 5	Other Information
Item 6	Exhibits and Reports on Form 8-K
Signatures
Certifications

 

 

Part I.  Financial Information

 

Item 1.  Financial Statements

 

Silicon Image, Inc.
Condensed Consolidated Statements of Operations
(in thousands, except per share amounts)
(unaudited)

 

 

(1)          Includes stock compensation expense (benefit) of $1.2 million and ($135,000) for the three months ended March 31, 2004 and 2003, respectively.

 

(2)          Includes stock compensation expense of $6.2 million and $127,000 for the three months ended March 31, 2004 and 2003, respectively.

 

(3)          Includes stock compensation expense (benefit) of $4.7 million and ($354,000) for the three months ended March 31, 2004 and 2003, respectively.

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

 

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Silicon Image, Inc.
Condensed Consolidated Balance Sheets
(in thousands, except share amounts)
(unaudited)

 

		March 31, 2004			Dec. 31, 2003
Assets
Current Assets:
Cash and cash equivalents		$	40,199		$	24,059
Short-term investments		9,459			13,195
Accounts receivable, net of allowances for doubtful accounts of $722 at March 31 and $670 at December 31		19,093			12,754
Inventories		9,618			10,312
Prepaid expenses and other current assets		2,309			2,703
Total current assets		80,678			63,023
Property and equipment, net		7,439			7,411
Goodwill		13,021			13,021
Intangible assets, net		2,671			3,028
Other assets		1,181			1,259
Total assets		$	104,990		$	87,742
Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts payable		$	9,211		$	6,442
Accrued liabilities		8,823			8,726
Deferred license revenue		4,906			1,175
Debt obligations		1,234			1,732
Deferred margin on sales to distributors		9,162			7,274
Total liabilities		33,336			25,349
Stockholders’ Equity:
Common stock, par value $0.001; shares authorized: 150,000,000 – March 31 and December 31; shares issued and outstanding: 73,593,748 – March 31 and 72,367,129 – December 31		74			72
Additional paid-in capital		260,205			243,171
Unearned stock compensation		(8,111		)	(8,196		)
Accumulated deficit		(180,514		)	(172,654		)
Total stockholders’ equity		71,654			62,393
Total liabilities and stockholders’ equity		$	104,990		$	87,742

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

 

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Silicon Image, Inc.
Condensed Consolidated Statements of Cash Flows
(in thousands)
(unaudited)

 

		Three Months Ended March 31,
		2004			2003
Cash flows from operating activities:
Net income (loss)		$	(7,860	)	$	3,231
Adjustments to reconcile net loss to cash provided by (used in) operating activities:
Depreciation and amortization		1,150			947
Provision for doubtful accounts receivable		52			4
Stock compensation expense (benefit)		12,068			(362		)
Amortization of intangible assets		357			—
Non-cash restructuring		—			646
Non-cash gain on escrow settlement, before cash costs		—			(4,692		)
Changes in assets and liabilities:
Accounts receivable		(6,391		)	(1,963		)
Inventories		694			576
Prepaid expenses and other assets		472			409
Accounts payable		2,769			(1,981		)
Accrued liabilities and deferred license revenue		3,828			(2,141		)
Deferred margin on sales to distributors		1,888			164
Cash provided by (used in) operating activities		9,027			(5,162		)
Cash flows from investing activities:
Proceeds from sales of short-term investments		12,281			5,693
Purchases of short-term investments		(8,545		)	(2,600		)
Purchases of property and equipment		(1,178		)	(1,282		)
Cash provided by investing activities		2,558			1,811
Cash flows from financing activities:
Proceeds from issuances of common stock, net		5,053			2,653
Repayment of stockholders’ notes receivable, net		—			109
Repayments of debt obligations		(498		)	(699		)
Cash provided by financing activities		4,555			2,063
Net increase (decrease) in cash and cash equivalents		16,140			(1,288		)
Cash and cash equivalents – beginning of period		24,059			26,263
Cash and cash equivalents – end of period		$	40,199		$	24,975
Supplemental cash flow information:
Financing of property and equipment		$	—		$	383
Cash payments for taxes		$	217		$	—

 

See accompanying Notes to Unaudited Condensed Consolidated Financial Statements.

 

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Silicon Image, Inc.
Notes to Unaudited Condensed Consolidated Financial Statements
March 31, 2004

 

1.               Basis of Presentation

 

In the opinion of management, the accompanying unaudited condensed consolidated financial statements of Silicon Image, Inc. included herein have been prepared on a basis consistent with our December 31, 2003 audited financial statements and include all adjustments, consisting of normal recurring adjustments, necessary to fairly state the consolidated financial position of Silicon Image and its subsidiaries (collectively, the “Company”) at March 31, 2004 and the consolidated results of the Company’s operations and cash flows for the three months ended March 31, 2004 and 2003.  All significant intercompany accounts and transactions have been eliminated.  These interim financial statements should be read in conjunction with the audited financial statements and notes thereto included in our Form 10-K for the fiscal year ended December 31, 2003.  Certain comparative amounts have been reclassified to conform with current presentation. Results of operations for the three months ended March 31, 2004 are not necessarily indicative of future operating results.

 

2.               Recent Accounting Pronouncements

 

In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation Number (“FIN”) 46, “Consolidation of Variable Interest Entities.” In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The consolidation requirements of FIN 46 apply immediately to variable interest entities created after January 31, 2003. Certain of the disclosure requirements apply to all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The effective dates of certain elements of FIN 46 have been deferred. We do not believe that the adoption of this standard will have a material impact on our consolidated financial statements.

 

In December 2003, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition (“SAB 104”). SAB 104 revises or rescinds portions of the interpretive guidance included in Topic 13 of the codification of staff accounting bulletins in order to make this interpretive guidance consistent with current authoritative accounting and auditing guidance and SEC rules and regulations. The adoption of SAB 104 had no effect on our results of operations or financial condition.

 

Stock-Based Compensation

 

We account for stock-based awards to employees and directors using the intrinsic value method of accounting in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Under the intrinsic value method, if the exercise price of our employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized.

 

Had we recorded compensation expense for our stock options based on the grant-date fair value as prescribed by SFAS No. 123 and SFAS No. 148, our net loss would have been as follows (in thousands, except per share amounts):

 

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		Three Months Ended March 31,
		2004			2003
Net income (loss) - as reported		$	(7,860	)	$	3,231
Stock-based employee compensation expense determined using fair value method		(5,137		)	(6,020		)
Stock-based employee compensation cost (benefit)  included in the determination of net loss as reported		9,286			(721		)
Pro forma net loss		$	(3,711	)	$	(3,510	)
Basic net loss per share—pro forma		$	(0.05	)	$	(0.05	)
Basic net income (loss) per share—as reported		$	(0.11	)	$	0.05
Diluted net loss per share—pro forma		$	(0.05	)	$	(0.05	)
Diluted net income (loss) per share—as reported		$	(0.11	)	$	0.04

 

The weighted average grant-date fair value of our stock options was $6.65 and $4.31 for the three months ended March 31, 2004 and 2003, respectively. These values were estimated using the Black-Scholes pricing model with the following assumptions:

 

		Three Months Ended March 31
		2004		2003
Expected life		5.0		5.0
Interest rate		3.0	%	3.1	%
Volatility		90	%	90	%
Dividend yield		—		—

 

The weighted average, grant-date fair value of stock purchase rights granted under our Employee Stock Purchase Plan was $2.69 and $2.76 for the three months ended March 31, 2004 and 2003, respectively. These values were estimated using the Black-Scholes pricing model with the following assumptions:

 

		Three Months Ended March 31
		2004		2003
Expected life (years)		1.5		1.5
Interest rate		1.2	%	1.3	%
Volatility		90	%	90	%
Dividend yield		—		—

 

3.               Net Income (Loss) Per Share

 

Basic net income (loss) per share is computed using the weighted-average number of common shares outstanding during the period, excluding shares subject to repurchase, and diluted net income (loss) per share is computed using the weighted-average number of common shares and diluted equivalents outstanding during the period, if any, determined using the treasury stock method. The following table sets forth the computation of basic and diluted net income (loss) per share (in thousands, except per share amounts):

 

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		Three Months Ended March 31,
		2004			2003
Net income (loss)		$	(7,860	)	$	3,231
Weighted average shares		73,108			66,938
Unvested common shares subject to repurchase		(780		)	(110		)
Weighted average common shares outstanding for basic net income per share		72,328			66,828
Weighted-average common shares for diluted net income (loss) per share		72,328			73,696
Basic net income (loss) per share		$	(0.11	)	$	0.05
Diluted net income (loss) per share		$	(0.11	)	$	0.04

 

The following is a reconciliation of the weighted-average common shares used to calculate basic net income per share to the weighted-average common shares used to calculate diluted net income per share for the three months ended March 31, 2003 (in thousands):

 

Weighted-average common shares for basic net income per share		66,828
Weighted-average dilutive stock options outstanding under the treasury stock method		6,776
Unvested common shares subject to repurchase		92
Weighted-average common shares for diluted net income per share		73,696

 

Had we generated net income for the three month period ended March 31, 2004, the number of weighted average securities outstanding that would have been added to weighted average shares for purposes of calculating diluted earnings per share would have been  (in thousands):

 

		March 31, 2004
Unvested common stock subject to repurchase		780
Stock options		10,307
Total		11,087

 

As a result of our net loss for the three-months ended March 31, 2004, all common share equivalents would have been anti-dilutive and have therefore been excluded from the diluted net loss per share calculation. The weighted average securities that were anti-dilutive and excluded from our calculation of diluted net income (loss) per share were approximately 20,411,000 and 8,600,000 for the three-month periods ended March 31, 2004 and 2003, respectively.

 

4.                   Balance Sheet Components

 

		March 31, 2004			Dec. 31, 2003
		(in thousands)
Inventories:
Raw materials		$	2,865		$	3,128
Work in process		2,985			2,532
Finished goods		3,768			4,652
		$	9,618		$	10,312
Accrued liabilities:
Accrued payroll and related expenses		$	3,021		$	2,533
Restructuring accrual		1,648			1,875
Accrued legal fees		1,099			1,137
Warranty accrual		351			271
Other accrued liabilities		2,704			2,910
		$	8,823		$	8,726

 

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Warranty Accrual

 

At the time of revenue recognition, we provide an accrual for estimated costs to be incurred pursuant to our warranty obligation. Our estimate is based primarily on historical experience.  Warranty accrual activity for the three months ended March 31, 2004 and 2003 was as follows (in thousands):

 

		2004			2003
Balance at January 1		$	271		$	223
Provision for warranties issued during the period		130			50
Cash and other settlements made during the period		(50		)	(50		)
Balance at March 31		$	351		$	223

 

5.                   Stock-Based Compensation

 

We account for stock-based compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees,” and related interpretations, and comply with the disclosure provisions of Statement of Financial Accounting Standard No. 148 (SFAS No. 148), “Accounting for Stock-Based Compensation—Transition and Disclosure (an amendment of FASB Statement No. 123).” Expense associated with stock-based compensation is amortized over the vesting period of the individual award using an accelerated method, as described in Financial Accounting Standards Board Interpretation No. 28.

 

We are required to determine the fair value of stock option grants to non-employees and to record the amount as an expense over the period during which services are provided to us. Management calculates the fair value of these stock option grants using the Black-Scholes model, which requires us to estimate the life of the stock option, the volatility of our stock, an appropriate risk-free interest rate, and our dividend yield. The calculation of fair value is highly sensitive to the expected life of the stock option and the volatility of our stock, both of which we estimate based primarily on historical experience.

 

The following table summarizes the components of our stock compensation expense (benefit) for the three months ended March 31, 2004 and 2003 (in thousands):

 

		Three Months Ended March 31,
		2004			2003
Options granted to employees		$	31		$	222
Options granted to non-employees		1,503			359
Option repricings		10,121			(1,358		)
Options assumed in connection with acquisitions		413			415
Stock compensation expense (benefit)		$	12,068		$	(362	)

 

The repricing expense for the three months ended March 31, 2004 was higher relative to the three month period ended March 31, 2003, as our average stock price during the three months ended March 31, 2004 was higher. During the three months ended March 31, 2003, we modified options for employees involuntarily terminated in connection with our restructuring program. A charge of $646,000 for these modifications is included in restructuring expense for the period ended March 31, 2003.

 

6.             Asset impairment and restructuring activities

 

During the third quarter of 2001, we began a program to focus our business on products and technology, including those obtained through acquisitions, in which we have, or believe we can achieve, a market leadership position. As part of this program, we decided to cancel numerous products under development, to remove certain

 

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projects from our development plan, to phase out or de-emphasize certain existing products and to integrate the operations of two acquired companies—CMD Technology (“CMD”) and Silicon Communication Lab (“SCL”).

 

In connection with this program, we reduced our workforce in the fourth quarter of 2001 by approximately 60 people, or 20%. This workforce reduction was the initial step in eliminating duplicate positions that resulted from our acquisitions, and also represented the elimination of other positions based on our new product and technology focus. Positions were eliminated from all functional areas—operations, R&D and SG&A. Because of this workforce reduction, we recorded a restructuring expense of $1.5 million in the fourth quarter of 2001, consisting of cash severance-related costs of $599,000, non-cash severance-related costs of $303,000 representing the intrinsic value of modified stock options, an expected loss on leased facilities of $500,000 and fixed asset write-downs of $50,000. In addition, we reversed $286,000 of unearned compensation, a component of stockholders’ equity, for unvested stock options that were cancelled in connection with employee terminations.

 

For 2001, we recorded $29.9 million of expense for the impairment of goodwill and intangible assets recorded in connection with the acquisitions of DVDO and CMD. DVDO goodwill and intangible assets became impaired primarily as a result of our decision to phase out or de-emphasize certain existing digital video processing products and to cease funding of certain digital video processing development projects. Additionally, prevailing economic and industry conditions and the departure of certain key DVDO employees during the quarter ended September 30, 2001 also contributed to the impairment expense of $13.9 million. We recorded impairment expense of $16.0 million in the fourth quarter of 2001 related to goodwill and intangible assets recorded in connection with our CMD acquisition. This impairment resulted from a decrease in our initial estimate of future revenue from CMD’s products.

 

In the first quarter of 2002, we implemented a second workforce reduction in connection with the program discussed above, eliminating an additional 35 positions, or 13% of our workforce. Positions were eliminated from all functional areas. This reduction resulted from the continued integration of acquired companies, as well as continued execution of our product and technology strategy, whereby we decided to phase out the legacy storage subsystem board products we acquired from CMD and to develop new board products only if we believed it would facilitate or accelerate the use of our storage semiconductor products. In connection with this workforce reduction, we recorded a restructuring expense of $2.2 million in the first quarter of 2002, consisting of cash severance-related costs of $198,000, non-cash severance-related costs of $318,000 representing the intrinsic value of modified stock options, an expected loss on leased facilities of $1.2 million and fixed asset write-downs of $500,000 for assets to be disposed of. In addition, we reversed $76,000 of unearned compensation, a component of stockholders’ equity, for unvested stock options that were cancelled in connection with employee terminations.

 

In April 2002, we decided to transition to a licensing model for our storage subsystem board products, whereby instead of developing, manufacturing and selling board products to facilitate or accelerate the use of our storage semiconductor products, we would develop and license board designs in exchange for license fees, royalties and the use of our semiconductor products. In connection with this decision, we implemented a third workforce reduction, eliminating 14 positions, or 5% of our workforce, and recorded a restructuring expense of $3.5 million, consisting of cash severance-related costs of $450,000, non-cash severance-related costs of $1.6 million representing the intrinsic value of modified stock options and fixed asset write-downs of $1.5 million for assets to be disposed of. We also reversed $302,000 of unearned compensation, a component of stockholders’ equity, for unvested stock options that were cancelled in connection with employee terminations.

 

In connection with our decision to stop selling board products and to transition to a licensing model, we assessed recoverability of our intangible assets subject to amortization in accordance with SFAS No. 144. During the quarter ended September 30, 2002, an impairment expense of $749,000 was recognized for acquired technology and $60,000 was recognized for patent and other intangible assets, based upon our projection of significantly reduced future cash flows. Additionally, we reduced our estimate of the useful lives of the remaining intangible assets subject to amortization such that these assets were fully amortized by the end of 2002. We also tested the carrying value of goodwill for impairment in accordance with SFAS No. 142. As a result of our impairment test, a goodwill impairment expense of $4.4 million was recognized during the second quarter of 2002. To determine the amount of the impairment, we estimated the fair value of our storage systems business based primarily on expected future cash flows. We then reduced this amount by the fair value of identifiable tangible and intangible assets other than goodwill (also based primarily on expected future cash flows), and compared the unallocated fair value of the business to the carrying value of goodwill. To the extent goodwill exceeded the unallocated fair value of the business, an impairment expense was recognized.

 

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In December 2002, we revised our estimate of the loss we expect to incur on subleased facilities and recorded a restructuring expense of $1.5 million. Real estate market conditions deteriorated in the fourth quarter of 2002, causing us to reassess the length of time it would take to find tenants and the fair value lease rate of our available space. As of December 31, 2003, our expected loss on subleased facilities was based on estimated sublease income of approximately $1.0 million over the remaining lease terms. To the extent we are unable to generate $1.0 million of sublease income, our future results of operations and financial condition will be negatively affected.

 

In March 2003, we reorganized parts of the marketing and product engineering activities of the company into lines of business for personal computer (“PC”), consumer electronics (“CE”) and storage products to enable us to better manage our long-term growth potential. The central engineering, sales, manufacturing, and general and administrative activities were not organized into the line of business structure. In connection with this reorganization, we reduced our workforce by 27 people, or approximately 10%. These reductions were primarily in engineering and operations functions. Because of this workforce reduction, we recorded restructuring expense of $986,000 in the first quarter of 2003, consisting of cash severance-related costs of $340,000 and non-cash severance-related costs of $646,000, representing the intrinsic value of modified stock options.

 

Severance related costs were determined based on the amount of pay people received that was not for services performed and by measuring the intrinsic value of stock options that were modified to the benefit of terminated employees. For those employees terminated in the three month period ending March 31, 2003, the remaining service period from the communication date did not exceed 60 days. The expected loss on leased facilities resulted from our plan to consolidate our remaining workforce to the extent practicable and sublease any excess space. To determine the expected loss, we compared our lease and operating costs for the space to our estimate of the net amount we would be able to recover by subleasing the space. This estimate was based on a number of assumptions, including the length of time it will take to secure a tenant, the sublease rate per square foot, the cost of necessary improvements or modifications and real estate broker commissions. The fixed asset write-downs in 2001 and 2002 were determined based on the estimated fair value of assets, primarily computer hardware and software that would no longer be utilized after the employees’ termination dates.

 

Severance and benefits payments are substantially complete. Lease payments will be made in the form of cash through the end of the related lease term of November 2005. The following table presents restructuring activity for 2001 through March 31, 2004 (in thousands):

 

		Severance and Benefits			Leased Facilities			Fixed Assets			Total
2001 provision		$	902		$	500		$	50		$	1,452
Cash payments		(191		)	—			—			(191		)
Non-cash activity		(303		)	(115		)	—			(418		)
Balance as of December 31, 2001		408			385			50			843
2002 provision		2,547			2,633			2,013			7,193
Cash payments		(865		)	(420		)	—			(1,285		)
Non-cash activity		(1,952		)	—			(2,063		)	(4,015		)
Balance as of December 31, 2002		138			2,598			—			2,736
2003 provision		986			—			—			986
Cash payments		(441		)	(760		)	—			(1,201		)
Non-cash activity		(646		)	—			—			(646		)
Balance as of December 31, 2003		$	37		$	1,838		$	—		$	1,875
Cash payments		(4		)	(223		)	—			(227		)
Balance as of March 31, 2004		$	33		$	1,615		$	—		$	1,648

 

7.                                             Debt Facility

 

In October 2002, we entered into a $3.6 million term loan to refinance $3.1 million of debt acquired in connection with our acquisition of CMD and $500,000 of other bank debt. This loan bears interest at prime (4.0% at March 31, 2004) plus 0.25% and requires monthly payments through its maturity of October 1, 2004. During the three months ended March 31, 2003, we borrowed $383,000 to finance certain capital equipment. This term loan bears interest at 5% and requires monthly payments through its maturity in February 2005. As of March 31, 2004, $1,234,000 was outstanding under these term loans. Our debt facilities contain certain quarterly and annual financial

 

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covenants with which we must comply. In the fourth fiscal quarter of 2003, we fell out of compliance with the lending institution’s quarterly covenants regarding providing periodic financial statements. We were granted a waiver from the lending institution and were not in default of the loan agreement. Due to the nature of the underlying covenants, we have classified all amounts outstanding as current liabilities as of March 31, 2004. During the period ended March 31, 2004, we entered into an agreement to extend this debt facility by way of a revolving line of credit with an availability of up to $10.0 million, and an equipment line of credit of up to $3.0 million. Borrowings under the revolving line are limited to the lesser of $10.0 million or 80% of eligible accounts receivable as defined in the loan agreement. This revolving line of credit expires in March 2005 and bears interest at either prime plus 0.25% or LIBOR plus 2.75%, at our option. Equipment advances pursuant to the equipment line of credit are available to us through August 2004 and will be repayable in twenty four equal monthly installments commencing September 1, 2004 bearing interest at either prime or LIBOR plus 2.5%, at our option. Quarterly and annual financial covenants are contained within this revised agreement. No amounts have been drawn down against this line of credit as at March 31, 2004. As of March 31, 2004, we were in compliance with all covenants.

 

8.                                       Legal Proceedings

 

On April 24, 2001, we filed suit in the U.S. District Court for the Eastern District of Virginia against Genesis Microchip Corp. and Genesis Microchip, Inc. (collectively, “Genesis”) for infringement of our U.S. patent number 5,905,769 (USDC E.D. Virginia Civil Action No.: CA-01-266-R) (the “Federal Suit”). On April 24, 2001, we also filed a complaint against Genesis with the International Trade Commission of the United States government (“ITC”) for unlawful trade practices related to the importation of articles infringing our patent (the “ITC investigation”). The actions sought injunctions to halt the importation, sale, manufacture and use of Genesis DVI receiver chips that infringe our patent, and monetary damages. We voluntarily moved to dismiss the ITC investigation, with notice that we would proceed directly in the Federal Suit. Our motion to dismiss was granted on February 7, 2002. We filed an amended complaint in the Federal Suit as of February 28, 2002, adding a claim for infringement of our U.S. patent number 5,974,464. In April 2002, Genesis answered and made counterclaims against us for non-infringement, license, patent invalidity, fraud, antitrust, unfair competition and patent misuse. Also in April 2002, we filed a motion to dismiss certain of Genesis’s counterclaims. In addition, we filed a motion to bifurcate trial of the counterclaims to the extent the court does not dismiss them. In May 2002, the Court granted our motion to dismiss certain of the counterclaims, with leave to amend. Genesis re-filed counterclaims against us for fraud and patent misuse. We filed another motion to dismiss these counterclaims. In December 2002, the parties entered into a memorandum of understanding (MOU) to settle the case. In January, the parties presented different interpretations of the MOU to the Court. On July 15, 2003, the Court granted our motion to interpret the MOU in the manner we requested, and ruled that Genesis had engaged in efforts to avoid its obligations under the MOU. On August 6, 2003, the Court entered a final judgment based on its July 15, 2003 ruling. Under the final judgment order, Genesis was ordered to make a substantial cash payment, and to make royalty payments; although Genesis has made a cash payment to the Court, it has not made all the payments that are required under the final judgment order. We filed motions for reimbursement of some of our expenses, including some of our legal fees, and for modification and/or clarification of certain items of the judgment, and to hold Genesis in contempt of Court for breaching the protective order in the case by disclosing secret information to at least one of our competitors. On December 19, 2003, the Court granted our motions in part and denied them in part: the court issued an amended judgment, and held Genesis in contempt of Court for breaching the protective order. Under the amended judgment, Genesis was ordered to make a substantial cash payment, royalty payments, and interest; although Genesis has made and continues to make cash payments to the Court, it may not have made all the payments that are required under the amended judgment. The Court has not ruled on pending motions regarding the disposition of the money held by the Court. On January 16, 2004, Genesis filed a notice of appeal. To date, we have not received any cash payments nor have we recognized any revenue associated with this litigation. Due to the continuing and contentious nature of this litigation, we will not record any income or revenue related to this matter until the litigation is complete and all other income and revenue recognition criteria have been satisfied. Management intends to prosecute our position vigorously until this matter is resolved. Through March 31, 2004, we have spent approximately $10.6 million on this matter and expect to continue to incur significant legal costs through at least the fourth quarter of 2004.

 

Silicon Image, certain officers and directors, and Silicon Image’s underwriters have been named as defendants in a securities class action lawsuit captioned Gonzales v. Silicon Image, et al., No. 01 CV 10903 (SDNY 2001) pending in Federal District Court for the Southern District of New York. The lawsuit alleges that all defendants were part of a scheme to manipulate the price of Silicon Image’s stock in the aftermarket following Silicon Image’s initial

 

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public offering in October 1999. Response to the complaint and discovery in this action on behalf of Silicon Image and individual defendants has been stayed by order of the court. The lawsuit is proceeding as part of a coordinated action of over 300 such cases brought by plaintiffs in the Southern District of New York. Pursuant to a tolling agreement, individual defendants have been dropped from the suit for the time being. In February 2003, the Court denied the underwriters’ motion to dismiss and ordered that the case may proceed against issuers including against Silicon Image. A proposed settlement has been negotiated that has yet to be reviewed and approved by the Court. In the event that the settlement is approved, we do not expect it to have a material effect on our results of operations or financial position. In the event that the settlement is not approved, we could not accurately predict the outcome the litigation, but we intend to defend this matter vigorously.

 

Silicon Image, certain officers and directors, and Silicon Image’s underwriters were named as defendants in a securities class action lawsuit captioned Liu v. Credit Suisse First Boston Corp., et al., No. 03-20459 (S.D. Fla. 2003) pending in Federal District Court for the Southern District of Florida. The plaintiff filed an action on behalf of a putative class of shareholders who purchased stock from some or all of approximately 50 issuers whose public offerings were underwritten by Credit Suisse First Boston. The lawsuit alleges that Silicon Image and certain officers were part of a scheme by Credit Suisse First Boston to artificially inflate the price of Silicon Image’s stock through the dissemination of allegedly false analysts’ reports. Silicon Image has not been served with a copy of the complaint. The plaintiff in this matter has filed an amended complaint in which Silicon Image, and the named officers, were dropped as defendants. We believe that the proposed settlement described above, if approved, would encompass the claims in this case. We believe that these claims were without merit and, if revived, and not subject to the settlement, we would defend this matter vigorously.

 

Certain officers and directors of Silicon Image have been named as defendants in consolidated shareholder derivative litigation, captioned “In re Silicon Image, Inc. Derivative Litigation, No. 1:03CV010302”, commenced on December 4, 2003 and pending in the Superior Court of California, County of Santa Clara. The plaintiffs purport to sue the individual defendants on behalf of Silicon Image. The lawsuit alleges that as a result of the recently completed examination conducted by the Audit Committee of Silicon Image’s Board of Directors, Silicon Image will be required to restate its financial results for 2002 and 2003. The lawsuit further alleges that such a restatement would be due to breaches by the individual defendants of their fiduciary duties to Silicon Image; that certain of the individual defendants are liable to Silicon Image for insider trading under California law; and that the individual defendants are liable to Silicon Image for mismanagement, abuse of control, and waste. Before filing suit, the plaintiffs did not make a demand upon the board of directors to pursue any such claims directly on behalf of Silicon Image. Following the announcement by the Audit Committee of Silicon Image’s Board of Directors that it has completed its examination and that it has concluded that no changes to Silicon Image’s previously announced financial results are required, the Company agreed to provide plaintiffs with certain specified information concerning the examination.  Plaintiffs agreed to dismiss the lawsuit following their good-faith review of such information to confirm the independence, scope and adequacy of the examination.  Although the Company, acting through the Audit Committee of its Board of Directors, provided the specified information, plaintiffs have failed to discuss the lawsuit.  As a result, the Company has filed a cross-complaint for breach of contract, seeking an order discussing the derivative action and awarding the Company its attorneys fees. The individual defendants believe the lawsuit is without merit, and they intend to defend the action vigorously if plaintiffs do not dismiss it. Plaintiffs may seek to amend the complaint, and we cannot predict what claims plaintiffs might assert in such an amended complaint.

 

Silicon Image and certain of its officers have been named as defendants in consolidated securities class action litigation captioned “In re Silicon Image, Inc. Securities Litigation, No. C-03-5579 JW PVT”, commenced on December 11, 2003 and pending in the United States District Court for the Northern District of California. Plaintiffs filed the action on behalf of a putative class of shareholders who purchased Silicon Image stock between April 15, 2002 and November 15, 2003. The lawsuit alleges that Silicon Image had materially overstated its licensing revenue, net income and financial results during this time period, and that Silicon Image was being forced to restate its financial results. Following the announcement by the Audit Committee of Silicon Image’s Board of Directors that it has completed its examination and that it has concluded that no changes to Silicon Image’s previously announced financial results are required, the plaintiffs dismissed the lawsuit.

 

In addition, we have been named as defendants in a number of judicial and administrative proceedings incidental to our business and may be named again from time to time. We intend to defend such matters vigorously, and although adverse decisions or settlements may occur in one or more of such cases, the final resolution of these matters, individually or in the aggregate, is not expected to have a material adverse effect on our results of operations or financial position.

 

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9.                                       Customer and Geographic Information

 

Revenue by geographic area was as follows (in thousands):

 

 

Revenue by product line was as follows (in thousands):

 

 

Revenue by product line, including development, licensing and royalties, was as follows (in thousands):

 

 

For each period presented, substantially all long-lived assets were located within the United States.

 

For the three months ended March 31, 2004, one customer generated 15% of our revenue and another customer generated 11% of our revenue, and as of March 31, 2004, two customers represent 16% and 14% of gross accounts receivable. For the three months ended March 31, 2003, one customer generated 12% of our revenue and two customers each generated 10% of our revenue.  At December 31, 2003, three customers represented 17%, 12% and 10% of gross accounts receivable.

 

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10.                                 Guarantees

 

Certain of our licensing agreements indemnify our customers for any expenses or liabilities resulting from claimed infringements of patent, trademark or copyright by third parties related to the intellectual property content of our products. Certain of these indemnification provisions are perpetual from execution of the agreement and, in some instances, the maximum amount of potential future indemnification is not limited. To date, we have not paid any such claims or been required to defend any lawsuits with respect to any claim. However, there can be no assurance that such claims will not be filed in the future.

 

11.           Intangible Assets, net

 

Components of intangible assets are as follows (in thousands):

 

		March 31, 2004						December 31, 2003
		Gross Carrying Amount			Accumulated Amortization			Gross Carrying Amount			Accumulated Amortization
Intangible assets subject to amortization:
Acquired technology		$	1,780		$	(497	)	$	1,780		$	(375	)
Non-compete agreement		1,849			(625		)	1,849			(472		)
Assembled workforce		502			(338		)	502			(256		)
		$	4,131		$	(1,460	)	$	4,131		$	(1,103	)
Intangible assets not subject to amortization:
Goodwill		$	13,021		$	—		$	13,021		$	—

 

Estimated future amortization expense for our intangible assets is as follows for fiscal years ending December 31 (in thousands):

 

2004		988
2005		1,097
2006		508
2007		78
		$	2,671

 

The amortization expense for the three months ended March 31, 2004 and 2003 was $357,000 and 0, respectively.

 

12.           Income taxes

 

For the first quarter of fiscal 2004, we provided an income tax provision of $317,000. This includes approximately $217,000 relating to taxes payable in a foreign jurisdiction relating to licensing revenues received from that jurisdiction. In addition, we have provided approximately $100,000 relating to other income taxes in certain foreign jurisdictions and for estimated alternative minimum tax in the United States. As of March 31, 2004, we have net operating loss carryforward for federal income tax purposes of approximately $71.4 million and such loss carryforwards, which will expire in various years through 2023, will be available to offset our future taxable income. We continue to maintain a full valuation allowance for all deferred tax assets given uncertainty as to realization. As such the income tax provision for the three months ended March 31, 2004, is not reflective of our fully taxed rate.

 

13.                                 Escrow Settlement

 

On August 7, 2002, we filed a demand for arbitration with the American Arbitration Association, file #74 Y 117 01399 02 GAP, against the principal shareholders of CMD Technology (“CMD”) relating to shares held in escrow in connection with our acquisition of CMD. Pursuant to agreements by which we acquired CMD, a portion

 

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of the Silicon Image common stock issued to the principal shareholders of CMD was held in two separate escrow pools as collateral for the indemnification obligations of these shareholders. We previously made indemnification claims against these escrow pools for the release of escrow shares with a value of approximately $5.4 million, which claims were contested by the principal shareholders of CMD. On February 28, 2003, we and the principal shareholders of CMD entered into a settlement agreement and mutual release, pursuant to which our indemnification claims were resolved. As a result of the settlement, we received 949,780 of the escrowed shares, valued at approximately $4.7 million, and recorded a net non-operating gain of $4.6 million in the first quarter of 2003.

 

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

 

This report contains forward-looking statements within the meaning of Section 21E of the Securities and Exchange Act of 1934 and Section 27A of the Securities Act of 1933. These forward-looking statements involve a number of risks and uncertainties, including those identified in the section of this Form 10-Q entitled “Factors Affecting Future Results,” that may cause actual results to differ materially from those discussed in, or implied by, such forward-looking statements. Forward-looking statements within this Form 10-Q are identified by words such as “believes,” “anticipates,” “expects,” “intends,” “may,” “will” and other similar expressions. However, these words are not the only means of identifying such statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. We undertake no obligation to publicly release the results of any revisions to these forward-looking statements that may be made to reflect events or circumstances occurring subsequent to the filing of this Form 10-Q with the SEC. Our actual results could differ materially from those anticipated in, or implied by, forward-looking statements as a result of various factors, including the risks outlined elsewhere in this report. Readers are urged to carefully review and consider the various disclosures made by Silicon Image, Inc. in this report and in our other reports filed with the SEC that attempt to advise interested parties of the risks and factors that may affect our business.

 

Overview

 

Silicon Image is a leader in multi-gigabit semiconductor solutions for the secure transmission, storage and display of rich digital media. The company’s mission is to be the leader in defining the architectures, intellectual property (IP) and semiconductor technology required to build secure digital content delivery systems. To ensure that rich digital content is always available on any device, consumer electronics (CE), PC and storage devices must be architected for content compatibility and interoperability.

 

                Silicon Image’s strategy entails establishing industry-standard, high-speed digital interfaces and building market momentum and leadership through its first-to-market, standards-based IC products. Further leveraging its strong IP portfolio, the company broadens market adoption of the Digital Visual Interface (DVI), High-Definition Multimedia Interface (HDMI) and Serial ATA (SATA) interfaces by licensing its proven IP cores to companies providing advanced system-on-a-chip solutions incorporating these interfaces. Licensing, in addition to creating revenue and return on engineering investment in market segments we choose not to address, creates products complementary to our own that expand the markets for our products and help to improve industry wide interoperability.

 

                Silicon Image is a leader in the global PC/display arena with its innovative PanelLink^® digital interconnect technology, which enables an all-digital connection between PC host systems and digital displays such as LCD monitors, plasma displays and projectors. PanelLink technology is the basis for the DVI industry standard the company pioneered and remains the most popular DVI implementation with more than 42 million units shipped to date.

 

In 2000, in order to decrease our absolute dependence on the PC business, we embarked upon a plan to diversify into the CE and storage markets. Products sold into the PC market have been declining as a percentage of our total revenues and generated 27% of our revenue in the first three months of 2004 and 35.6% of our revenues in the first three months of 2003 (including licensing revenues, these percentages were 27% and 36.2% for the first three months of 2004 and 2003, respectively).

 

Leveraging our core technology and standards-setting expertise, Silicon Image is a leading force in advancing the adoption of HDMI (High Definition Multimedia Interface), the new digital interface standard for the consumer electronics market. Introduced by founders Hitachi, Matsushita (Panasonic), Philips, Silicon Image, Sony, Thomson and Toshiba, HDMI enables the distribution of uncompressed, high-definition video and multi-channel audio in a single, all-digital interface that dramatically simplifies cabling. Silicon Image’s HDMI technology is marketed under the PanelLink Cinema™ brand and includes High-bandwidth Digital Content Protection (HDCP), which is supported by certain Hollywood studios as the technology of choice for the secure distribution of premium content over certain digital connections. The PanelLink Cinema chip and the first HDMI-compliant silicon are on the market and are featured in the world’s first consumer electronics products with HDMI functionality.

 

Products sold into the CE market have been increasing as a percentage of our total revenues and generated 31.7% of our total revenues in the first three months of 2004, compared to 13.2% of our total revenues for the first

 

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three months of 2003 (including licensing revenues, these numbers were 34.3% and 17.4% for the first three months of 2004 and 2003 respectively). Our CE products offer a securable interface for transmission of digital video and audio to consumer devices, such as digital TVs and DVD players. Demand for these products will be driven primarily by the adoption rate of new technologies, such as High-Definition Multimedia Interface (“HDMI”) and High-Bandwidth Digital Content Protection (“HDCP”).

 

In the storage market, Silicon Image has assumed a leadership role in Serial ATA (“SATA”), the new high-bandwidth, point-to-point interface that is replacing Parallel ATA in desktop storage and making inroads in the enterprise arena due to its price/performance. Silicon Image is a leading supplier of discrete SATA devices with hundreds of motherboard and add-in-card design wins. Silicon Image’s SATALink™-branded solutions are fully SATA-compliant and offer advanced features and capabilities such as Native Command Queuing, port multiplier capability and ATAPI support. Silicon Image also supplies high-performance, low-power Fibre Channel Serializer/Deserializer (SerDes) to leading switch manufacturers.

 

Products sold into the storage market, as a percentage of our total revenues, generated 30.7% of our revenue in the first three months of 2004, compared to 31.1% of our revenue in the first three months of 2003 (including licensing revenues it was 38.8% and 46.3% of our revenue for the first three months of 2004 and 2003, respectively). Demand for our storage semiconductor products is dependent upon the rate at which interface technology transitions from parallel to serial, and the extent to which SATA and fibre channel functionality are integrated into chip sets and controllers offered by other companies, which would make our discrete devices unnecessary.

 

License revenue is recognized when an agreement with a licensee exists, the price is fixed or determinable, delivery or performance has occurred, and collection is reasonably assured. Generally, we expect to meet these criteria and recognize revenue at the time we deliver the agreed-upon items. However, we may defer recognition of revenue until cash is received if collection is not reasonably assured at the time of delivery. A number of our license agreements require customer acceptance of deliverables, in which case we would defer recognition of revenue until the licensee has accepted the deliverables and either payment has been received or is expected within 90 days of acceptance. Certain licensing agreements provide for royalty payments based on agreed upon royalty rates. Such rates can be fixed or variable depending on the terms of the agreement. The amount of revenue we recognize is determined based on a time period or on the agreed-upon royalty rate, extended by the number of units shipped by the customer. To determine the number of units shipped, we rely upon actual royalty reports from our customers when available and rely upon estimates in lieu of actual royalty reports when we have a sufficient history base of receiving royalties from a specific customer for us to make an estimate based on available information from the licensee such as quantities held, manufactured and other information. These estimates for royalties necessarily involve the application of management judgment. As a result of our use of estimates, period-to-period numbers are “trued-up” in the following period to reflect actual units shipped. To date, such “true-up” adjustments have not been significant. In cases where royalty reports and other information are not available to allow us to estimate royalty revenue, we recognize revenue only when royalty payments are received. Development revenue is recognized when project milestones have been completed and acknowledged by the other party to the development agreement and collection is reasonably assured. In certain instances, we recognize development revenue using the lesser of non-refundable cash received or the results of using a proportional performance measure.

 

Our licensing activity is complementary to our product sales because we believe this activity can help us monetize our intellectual property as well as accelerate adoption curves associated with our technology. Most of our licenses include a field of use restriction that prevents the licensee from building a chip in direct competition with those market segments we have chosen to pursue. Revenue from development, licensing and royalties accounted for 10.6% and 20.1% of our revenues, and represented 16.9% and 36.7% of our total gross margin, for the three months ended March 31, 2004 and 2003, respectively. Licensing contracts are complex and depend upon many factors including completion of milestones, allocation of values to delivered items, and customer acceptances. Although we attempt to make these factors predictable, many of these factors require significant judgments.

 

In October 1999, we raised approximately $48 million in our initial public offering. We have incurred losses in all but one quarterly period since our inception and, as of March 31, 2004, we had an accumulated deficit of $180.5 million.

 

Prior to 2000 we focused most of our efforts on the sale and development of PanelLink transmitters, receivers and controllers for the PC/Display market. In 2000, we began focusing our resources on entering two new markets, storage and CE, which we believed would grow significantly and in which we believed we could apply our technology and expertise in high-speed serial interfaces. During 2000, we acquired Zillion, a developer of high-

 

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speed transmission technology for data storage applications, and DVDO, a provider of digital video processing systems for the CE market.

 

In 2001, we focused on accelerating our entry into the CE and storage markets, leveraging our IP into licensing revenue, and restructuring the company to improve profitability. During 2001, we acquired CMD, a provider of storage subsystems and semiconductors designed for storage area networks, and SCL, a provider of mixed-signal and high-speed circuit designs.

During 2002, we achieved double-digit sequential revenue growth in each fiscal quarter, resulting in record annual revenue of $81.5 million, which was a 57% increase from 2001 revenue levels. We also began to see the benefits of our diversification strategy, which resulted in establishing a presence in the CE and storage markets. Additionally, we were able to successfully leverage our intellectual property to generate $6.7 million of development, licensing and royalty revenue. We also focused on improving our profitability and reducing our cash usage.

 

During 2003, we achieved significant growth, resulting in record annual revenue of $103.5 million, representing a 27% increase compared to 2002. We were also able to continue to take advantage of our diversification strategy effectively, which resulted in our being able to expand our presence in the CE and storage markets, both of which we expect will experience significant growth rates during the next several years. Additionally, we were able to successfully leverage our intellectual property to generate $14.2 million of development, licensing and royalty revenue.

 

Outlook

 

We expect 2004 revenue to increase from the level achieved in 2003, and believe our revenue in the second quarter of 2004 will grow 8-13% sequentially from the first quarter of 2004.

 

We believe our expected revenue growth during 2004 will be driven by several factors. First, DVI adoption rates are expected to increase as demand for notebook computers and graphics cards containing our products increase during the year. Second, in the CE market we have had a number of important design wins, some which begin mass production in early 2004 and we expect the production of other designs already in mass production to increase during the year. As the CE industry continues to transition to an all-digital solution, we expect the marketplace for our products to grow significantly. Third, Serial ATA adoption rates are expected to increase. Lastly, we expect our licensing market to continue to be attractive and as our licensing base grows, we also expect to see an increase in royalty revenues. Licensing revenues have fluctuated significantly from period to period and may continue to do so in the future; because of their high margin content they can have a disproportionate impact on gross margins and profitability.

 

Among the factors that may cause our actual results to differ materially from those anticipated by our assumptions include the rate at which the PC market adopts DVI, acceptance of all digital solutions in the PC market, use of DVI as a replacement for LVDS in the PC notebook market, CE market acceptance of our DVI with HDCP and HDMI products, the rate at which the storage market for 2 Gb fibre channel switches grows and serial ATA technology adoption, consumer demand in the PC and CE markets, the availability of serial ATA-enabled hard drives and other peripherals, whether and how quickly OEMs are able to integrate transmitters in their graphics chips and serial ATA functionality into their chip sets, our ability to leverage our intellectual property into licensing revenue and the ability of our semiconductor foundry vendors to manufacture our products in commercial volumes at an acceptable cost and in a timely manner. In addition, our revenue remains subject to competition and general economic and market conditions, none of which can be accurately predicted.

 

We expect our overall gross margins to decline 100-200 basis points in the second quarter of 2004, relative to the first quarter of 2004 primarily as a result of additional price pressures and product mix. However,  we expect our gross margin percentage to increase in 2004 from 2003 levels as a result of higher licensing and royalty revenue, for which there is no associated cost of sales, manufacturing cost reductions on certain of our higher volume products, higher unit volume and shifts in product mix whereby higher margin CE products will grow faster than our PC or storage product lines that have lower gross margins. We expect that these positive effects will be offset by declining average selling prices (“ASPs”), especially for products in the PC market, and higher manufacturing overhead spending to support increased production levels for products in all three of our markets.

 

Excluding non-cash charges for stock compensation expense, we expect the dollar amount of our R&D expense in the second quarter of 2004 to increase approximately 10 - - 20% from the first quarter of 2004. R&D expense will

 

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be incurred for enhancements to existing products and for further development of technology related to consumer electronics and storage applications. Excluding non-cash charges for stock compensation expense, we expect the dollar amount of our SG&A expense to decrease by approximately 5 - 10% during the second quarter of 2004, primarily as a result of the reduced costs associated with the Audit Committee examination. We cannot predict the R&D or SG&A expenses including the non-cash charges for stock compensation expense, which will fluctuate with changes in our stock price and volatility.

 

We expect to incur substantial non-cash stock compensation expense in 2004 and future periods as a result of previous stock option repricings, stock options assumed in connection with our prior acquisitions, the issuance of stock options to consultants, and modifications to stock options. We may also incur non-cash stock compensation expense in connection with future acquisitions. The amount of stock compensation expense in each period will fluctuate with changes in our stock price and volatility.

 

During 2004 and future periods, we may also incur non-cash expenses for the impairment or amortization of intangible assets.

 

We will also incur legal fees in 2004 in conjunction with our patent infringement lawsuit against Genesis, and other outstanding litigation. The amount of legal fees incurred will depend on the duration of the litigation, as well as the nature and extent of the litigation activities. We are not able to accurately estimate the amount of legal fees we will incur with respect to this matter; however, we do expect to incur substantial amounts through at least the fourth quarter of 2004.

 

Commitments, Contingencies and Concentrations

 

Historically, a relatively small number of customers and distributors have generated a significant portion of our revenue. For instance, our top five customers, including distributors, generated 47% of our revenue in the first quarter of 2004 and 40% of our revenue in 2003.  Additionally, the percentage of revenue generated through distributors tends to be significant, since many OEM’s rely upon third party manufacturers or distributors to provide purchasing and inventory management functions. In the first quarter of 2004, 44% of our revenue was generated through distributors, compared to 36% in 2003. Our licensing revenue is not generated through distributors, and to the extent licensing revenue increases faster than product revenues, we would expect a decrease in the percentage of our total revenues generated through distributors.

 

A significant portion of our revenue is generated from products sold overseas. Sales to customers in Asia, including distributors, generated 71% of our revenue in the first quarter of 2004 and 2003, respectively. The reason for our geographical concentration in Asia is that most of our products are part of flat panel displays, graphic cards and motherboards, the majority of which are manufactured in Asia. The percentage of our revenue derived from any country is dependent upon where our end customers choose to manufacture their products. Accordingly, variability in our geographic revenue is not necessarily indicative of any geographic trends, but rather is the combined effect of new design wins and changes in customer manufacturing locations. All revenue to date has been denominated in U.S. dollars.

 

In September 1998, we entered into an agreement with Intel to develop and promote the adoption of a digital display interface specification. In connection with this agreement, we granted Intel a warrant to purchase 285,714 shares of our common stock at $1.75 per share. Under the same agreement, we granted Intel a warrant to purchase 285,714 shares of our common stock at $0.18 per share upon achievement of a specified milestone that was reached during the first quarter of 1999. Both of these warrants were exercised in May 2001. Additionally, if a second specified milestone is achieved, which we do not believe is likely, we would be required to grant Intel a third warrant to purchase 285,714 shares of our common stock at $0.18 per share. The estimated fair value of the warrant at March 31, 2004 was $2.9 million.

 

Critical Accounting Policies

 

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect amounts reported in our consolidated financial statements and accompanying notes. We base our estimates on historical experience and all known facts and circumstances that we believe are relevant. Actual results may differ materially from our estimates. We believe the following accounting policies to be most critical to an understanding of our financial condition and results of operations because they require us to make estimates, assumptions and judgments about matters that are inherently uncertain.

 

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Revenue recognition

 

For products sold directly to end-users, or to distributors that do not receive price concessions and do not have rights of return, we recognize revenue upon shipment and title transfer if we believe collection is reasonably assured. Reserves for sales returns and allowances are estimated based primarily on historical experience and are provided at the time of shipment. The amount of sales returns and allowances has not been, and is not expected to be, material.

 

The majority of our products are sold to distributors with agreements allowing for price concessions and product returns. We recognize revenue based on our best estimate of when the distributor sold the product to its end customer based on point of sales reports received from our distributors. Due to the timing of receipt of these reports, we recognize distributor sell-through using information that lags quarter end by one month. Revenue is not recognized upon shipment since, due to various forms of price concessions, the sales price is not substantially fixed or determinable at that time. Price concessions are recorded when incurred, which is generally at the time the distributor sells the product to an end-user. Additionally, these distributors have contractual rights to return products, up to a specified amount for a given period of time. Revenue is earned when the distributor sells the product to an end-user, at which time our sales price to the distributor becomes fixed. Our revenue is highly dependent on receiving pertinent and accurate data from our distributors in a timely fashion. Distributors provide us periodic data regarding the product, price, quantity, and end customer on their shipments as well as the quantities of our products they still have in stock. In determining the appropriate amount of revenue to recognize, we use this data and apply judgment in reconciling differences between their reported inventories and activities. If distributors incorrectly report their inventories or activities, or if our judgment is in error, it could lead to inaccurate reporting of our revenues and income.

 

License revenue is recognized when an agreement with a licensee exists, the price is fixed or determinable, delivery or performance has occurred, and collection is reasonably assured. Generally, we expect to meet these criteria and recognize revenue at the time we deliver the agreed-upon items. However, we may defer recognition of revenue until cash is received if collection is not reasonably assured at the time of delivery. A number of our license agreements require customer acceptance of deliverables, in which case we would defer recognition of revenue until the licensee has accepted the deliverables and either payment has been received or is expected within 90 days of acceptance. Certain licensing agreements provide for royalty payments based on agreed upon royalty rates. Such rates can be fixed or variable depending on the terms of the agreement. The amount of revenue we recognize is determined based on a time period or on the agreed-upon royalty rate, extended by the number of units shipped by the customer. To determine the number of units shipped, we rely upon actual royalty reports from our customers when available, and rely upon estimates in lieu of actual royalty reports when we have a sufficient history base of receiving royalties from a specific customer for us to make an estimate based on available information from the licensee such as quantities held, manufactured and other information. These estimates for royalties necessarily involve the application of management judgment. As a result of our use of estimates, period-to-period numbers are “trued-up” in the following period to reflect actual units shipped. To date, such “true-up” adjustments have not been significant. In cases where royalty reports and other information are not available to allow us to estimate royalty revenue, we recognize revenue only when royalty payments are received. Development revenue is recognized when project milestones have been completed and acknowledged by the other party to the development agreement, and collection is reasonably assured. In certain instances, we recognize development revenue using the lesser of non-refundable cash received or the results of using a proportional performance measure. Our license revenue recognition depends upon many factors including completion of milestones, allocation of values to delivered items and customer acceptances. Many of these factors require significant judgments, and if our judgment is in error it could lead to inaccurate reporting of our revenues and income.

 

Allowance for Doubtful Accounts Receivable

 

We review collectibility of accounts receivable on an on-going basis and provide an allowance for amounts we estimate will not be collectible. During our review, we consider our historical experience, the age of the receivable balance, the credit-worthiness of the customer, and the reason for the delinquency. Write-offs to date have not been material. At March 31, 2004, we had $19.8 million of gross accounts receivable and an allowance for doubtful accounts of $722,000. While we endeavor to accurately estimate the allowance, we may record unanticipated write-offs in the future.

 

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Inventories

 

We record inventories at the lower of standard cost, determined on a first-in first-out basis, or market. Standard cost approximates actual cost. Provisions are recorded for excess and obsolete inventory, and are estimated based on a comparison of the quantity and cost of inventory on hand to management’s forecast of customer demand. Customer demand is dependent on many factors and requires us to use significant judgment in our forecasting process. We must also make assumptions regarding the rate at which new products will be accepted in the marketplace and the rate at which customers will transition from older products to newer products. Generally, inventories in excess of six months demand are written down to zero and the related provision is recorded as a cost of revenue. While we endeavor to accurately predict demand and stock commensurate inventory levels, we may record unanticipated material inventory write-downs in the future.

 

Long-Lived Assets

 

Consideration paid in connection with acquisitions is required to be allocated to the assets, including identifiable intangible assets, and liabilities acquired. Acquired assets and liabilities are recorded based on our estimate of fair value, which requires significant judgment with respect to future cash flows and discount rates.

 

For certain long-lived assets, primarily fixed assets and intangible assets, we are required to estimate the useful life of the asset and recognize its cost as an expense over the useful life. We use the straight-line method to depreciate long-lived assets. We regularly compare the carrying value of long-lived assets to our projection of future undiscounted cash flows attributable to such assets and in the event that the carrying value exceeds the future undiscounted cash flows, we record an impairment charge against income equal to the excess of the carrying value over the asset’s fair value. Predicting future cash flows attributable to a particular asset is difficult, and requires the use of significant judgment.

 

Goodwill

 

We adopted the Statement of Financial Accounting Standard No.142 (SFAS 142), “Goodwill and Other Intangible Assets” on January 1, 2002. This standard requires that goodwill no longer be amortized, and instead, be tested for impairment on a periodic basis. The process of evaluating the potential impairment of goodwill is highly subjective and requires significant judgment at many points during the analysis. In estimating the fair value of the business, we make estimates and judgments about the future cash flows. Although our cash flow forecasts are based on assumptions that are consistent with the plans and estimates we are using to manage our business, there is significant judgment in determining such future cash flows. We also consider market capitalization (adjusted for unallocated monetary assets such as cash, marketable debt securities and debt) on the date we perform the analysis. Based on our annual impairment test performed for 2003, we concluded that there was no impairment of goodwill in fiscal 2003. However, there can be no assurance that we will not incur charges for impairment of goodwill in the future, which could adversely affect our earnings. An impairment test was not performed in the three month period ended March 31, 2004, as no event has occurred that would provide an indication of impairment.

 

Deferred Tax Assets

 

We account for income taxes using an asset and liability approach, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements, but have not been reflected in our taxable income. A valuation allowance is established to reduce deferred tax assets to their estimated realizable value. Therefore, we provide a valuation allowance to the extent we do not believe it is more likely than not that we will generate sufficient taxable income in future periods to realize the benefit of our deferred tax assets. To date, as a result of our recurring losses we have provided a 100% valuation allowance against all of our deferred tax assets. Predicting future taxable income is difficult, and requires the use of significant judgment.

 

Accrued Liabilities

 

Certain of our accrued liabilities are based largely on estimates. For instance, we record a liability on our balance sheet each period for the estimated cost of goods and services rendered to us, for which we have not received an invoice. Additionally, a component of our restructuring accrual related to a loss we expect to incur for excess leased facility space is based on numerous assumptions and estimates, such as the market value of the space and the time it will take to sublease the space. Our estimates are based on historical experience, input from sources

 

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outside the company, and other relevant facts and circumstances. Actual amounts could differ materially from these estimates.

 

Certain of our licensing agreements indemnify our customers for expenses or liabilities resulting from claimed infringements of patent, trademark or copyright by third parties related to intellectual property content of our products. Certain of these indemnification provisions are perpetual from execution of the agreement and, in some instances, the maximum amount of potential future indemnification is not limited. To date, we have not paid any such claims or been required to defend any lawsuits with respect to a claim.

 

Stock-Based Compensation Expense

 

We are required to determine the fair value of stock option grants to non-employees, and to record the amount as an expense over the period during which services are provided to us. Management calculates the fair value of these stock option grants using the Black-Scholes model, which requires us to estimate the life of the stock option, the volatility of our stock, an appropriate risk-free interest rate, and our dividend yield. The calculation of fair value is highly sensitive to the expected life of the stock option and the volatility of our stock, both of which we estimate based primarily on historical experience.

 

Legal Matters

 

We are subject to various legal proceedings and claims, either asserted or unasserted. We evaluate, among other factors, the degree of probability of an unfavorable outcome and reasonably estimate the amount of the loss. Significant judgment is required in both the determination of the probability and as to whether an exposure can be reasonably estimated. When we determine that it is probable that a loss has been incurred, the effect is recorded promptly in the consolidated financial statements. Although the outcome of these claims cannot be predicted with certainty, we do not believe that any of the existing legal matters will have a material adverse effect on our financial condition and results of operations. However, significant changes in legal proceedings and claims or the factors considered in the evaluation of those matters could have a material adverse effect on our business, financial condition and results of operations.

 

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Results of Operations for the Three Months Ended March 31, 2004 Compared to Results of Operations for the Three Months Ended March 31, 2003

 

REVENUE

 

		Three months ended March 31,
		2004			2003			Change
		Dollars in thousands
Personal Computers		$	9,667		$	8,793		9.9	%
Consumer Electronics		11,367			3,250			249.8	%
Storage products		11,016			7,679			43.5	%
Product revenue		32,050			19,722			62.5	%
Percentage of total revenue		89.4		%	79.9		%	9.5	pts
Development, licensing and royalties		3,808			4,954			(23.1%	)
Percentage of total revenue		10.6		%	20.1		%	(9.5pts	)
Total revenue		$	35,858		$	24,676		45.3	%

 

REVENUE (with development, licensing and royalty revenues, collectively licensing revenues, by product line)

 

		Three months ended March 31,
		2004			2003			Change
		Dollars in thousands
Personal Computers		$	9,680		$	8,944		8.2	%
Consumer Electronics		12,282			4,298			185.8	%
Storage products		13,896			11,434			21.5	%
Total revenue		$	35,858		$	24,676		45.3	%

 

Revenue was $35.9 million for the first quarter of 2004, an increase of 45.3% from the year ago quarter. The increase in revenue is primarily due to increased sales of CE products, which contributed an additional $8.1 million ($8.0 million including licensing) of revenue, increased sales of storage products, which contributed an additional $3.3 million ($2.5 million including licensing) in revenue, and increased sales of PC products, which contributed $0.9 million ($0.7 million, including licensing), offset by a $1.1 million decrease in overall licensing revenue. The increases in the CE and storage products are primarily attributable to our new product offerings, as well as the overall growth in these markets, resulting in increased volumes. The relatively lower level of increase in demand for our PC products, is attributable to loss of market share due primarily to integration and an overall weakness in the PC market. We license our technology in each of our areas of business, but usually limit the scope of the license to market areas that are complementary to our products sales and that do not directly compete with our direct product offerings. The decrease in development, licensing and royalty revenues as a component of total revenues was primarily due to the inherently uneven nature of our licensing revenues.

 

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COST OF REVENUE AND GROSS MARGIN

 

		Three months ended March 31,
		2004			2003			Change
		Dollars in thousands
Product gross margin (excluding licensing revenue)		$	17,535		$	8,667
Percentage of product revenue		54.7		%	43.9		%	10.8	pts
Gross margin		21,343			13,621
Percentage of total revenue		59.5		%	55.2		%	4.3	pts
Stock compensation expense		1,152			(135		)
Product gross margin (excluding stock compensation expense and licensing revenue)		18,687			8,532
Percentage of product revenue		58.3		%	43.3		%	15	pts
Gross margin (excluding stock compensation expense)		$	22,495		$	13,486
Percentage of total revenue		62.7		%	54.7		%	8	pts

 

Cost of revenue consists primarily of costs incurred to manufacture, assemble and test our products, as well as related overhead costs. Gross margin (revenue minus cost of revenue, as a percentage of revenue was 59.5%, and 55.2% for the three month periods ended March 31, 2004 and 2003, respectively), and excluding non-cash stock compensation expense (benefit), was 62.7% and 54.7% for the three-month periods ended March 31, 2004 and 2003, respectively. The increase in gross margin is attributable primarily to the effect of leverage on higher volume, lower manufacturing costs, higher pricing during the first quarter of 2004, and the impact, during the first quarter of 2003, of certain yield and quality issues related to certain new products and higher sales of storage IC products, which have lower margins relative to our other volume products. Non-cash stock compensation expense (benefit) associated with cost of revenue was $1.2 million and $(135,000) for the three-month periods ended March 31, 2004 and 2003, respectively.

 

OPERATING EXPENSES

 

		Three months ended March 31,
		2004			2003			Change
		Dollars in thousands
Research and development (1)		$	10,585		$	8,837		19.8	%
Percentage of total revenue		29.5		%	35.8		%	(6.3	)pts
Selling, general and administrative (2)		6,947			4,308			61.3	%
Percentage of total revenue		19.4		%	17.5		%	1.9	pts
Stock compensation expense		12,068			(362		)	3433.7	%
Percentage of total revenue		33.7		%	-1.5		%	35.2	pts
Amortization of intangible assets		357			—			100.0	%
Percentage of total revenue		1.0		%
Restructuring		—			986			(100.0	)%
Patent defense and acquisition integration costs		165			1,213			(86.4	)%
Interest income and other, net		84			109			(22.9	)%
Gain on escrow settlement, net		$	—		$	4,618		(100.0	)%

 

(1)               Excludes non-cash stock compensation expense of $6.2 million and $127,000 for the three month periods ended March 31, 2004 and 2003, respectively

 

(2)               Excludes non-cash stock compensation expense (benefit) of $4.7 million and $(354,000) for the three month periods ended March 31, 2004 and 2003, respectively

 

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Research and Development.   R&D expense consists primarily of compensation and related costs for employees, fees for independent contractors, the cost of software tools used for designing and testing our products, and costs associated with prototype materials. R&D expense, excluding non-cash stock compensation expense, was $10.6 million, or 29.5% of revenue, for the first quarter of 2004, compared to $8.8 million, or 35.8% of revenue, for the first quarter of 2003. The increase in 2004 was primarily due to an increase in the number of R&D projects to support the multiple markets in which we operate, as well as additional personnel, including personnel from TransWarp Networks, which we acquired during the second quarter of 2003. R&D excludes non-cash stock compensation expense of $6.2 million and $127,000 for the three-month periods ended March 31, 2004 and 2003, respectively. Including stock compensation expense, R&D expense was $16.8 million and $9.0 million or 46.8% and 36.4% of revenue for the three month periods ended March 31, 2004 and 2003, respectively. Excluding non-cash charges for stock compensation expense, we expect the dollar amount of our R&D expense in the second quarter of 2004 to increase approximately 10 - - 20% from the first quarter of 2004.

 

Selling, General and Administrative.   SG&A expense consists primarily of employee compensation and benefits, sales commissions, and marketing and promotional expenses. Excluding non-cash stock compensation expense, SG&A expense was $6.9 million, or 19.4% of revenue for the first quarter of 2004, compared to $4.3 million, or 17.5% of revenue for the first quarter of 2003. The increase in spending for 2004 can be attributed to the increased headcount to support the increased rate of growth of the Company, and approximately $1.0 million incurred during the first quarter of 2004 relating to the costs associated with the Audit Committee examination. SG&A excludes non-cash stock compensation expense (benefit) of $4.7 million and $(354,000) for the three-month periods ended March 31, 2004 and 2003, respectively. Including stock compensation expense, SG&A expense was $11.6 million and $4.0 million or 32.5% and 16.0% of revenue for the three month periods ended March 31, 2004 and 2003, respectively. Excluding non-cash charges for stock compensation expense, we expect the dollar amount of our SG&A expense to decrease by approximately 15 - 20% during the second quarter of 2004.

 

Stock Compensation.   Stock compensation expense (benefit) was $12.1 million or 33.7% of revenue for the first quarter of 2004 and $(362,000) or (1.5)% of revenue for the three month period ended March 31, 2003. The increase in total stock compensation can be attributed primarily to the higher stock price during the first quarter of 2004 and the resultant impact on expense relating to our repriced options offset to some extent by a decrease in expense associated with the options granted in connection with acquisitions and a decline in the number of options subject to variable accounting, as certain older options expire.

 

We will incur substantial non-cash stock compensation expense in future periods as a result of (1) the issuance of, or modifications to, restricted stock awards and stock option grants to employees and consultants, (2) the stock option repricing programs we implemented in 2000 and 2001, and (3) amortization of our existing unearned compensation balance. Since the expense associated with our stock option repricings and stock options issued to consultants is dependent on our stock price and volatility, stock compensation expense may fluctuate significantly from period to period. To date we have recognized over $17.8 million of expense in connection with our stock option repricings, and this may continue to be a significant component of our stock compensation expense in future periods if our stock price significantly exceeds the average stock price for the quarter ended March 31, 2004.

 

Amortization of Intangible Assets.   During the first quarter of 2004, we recorded amortization of intangible assets amounting to $357,000, relating to intangible assets on our balance sheet, pursuant to our acquisition of Transwarp Netwoks, Inc. during the second quarter of 2003. We did not have any expense relating to amortization of intangible assets during the three-month period ended March 31, 2003.

 

Restructuring.    During the third quarter of 2001, we began a program to focus our business on products and technology, including those obtained through acquisitions, in which we have, or believe we can achieve, a market leadership position. As part of this program, we decided to cancel numerous products under development, to remove certain projects from our development plan, to phase out or de-emphasize certain existing products and to integrate the operations of two acquired companies—CMD Technology (“CMD”) and Silicon Communication Lab (“SCL”).

 

In connection with this program, we reduced our workforce in the fourth quarter of 2001 by approximately 60 people, or 20%. This workforce reduction was the initial step in eliminating duplicate positions that resulted from our acquisitions, and also represented the elimination of other positions based on our new product and technology focus. Positions were eliminated from all functional areas—operations, R&D and SG&A. Because of this workforce reduction, we recorded a restructuring expense of $1.5 million in the fourth quarter of 2001, consisting of cash severance-related costs of $599,000, non-cash severance-related costs of $303,000 representing the intrinsic value of

 

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modified stock options, an expected loss on leased facilities of $500,000 and fixed asset write-downs of $50,000. In addition, we reversed $286,000 of unearned compensation, a component of stockholders’ equity, for unvested stock options that were cancelled in connection with employee terminations.

 

In the first quarter of 2002, we implemented a second workforce reduction in connection with the program discussed above, eliminating an additional 35 positions, or 13% of our workforce. Positions were eliminated from all functional areas. This reduction resulted from the continued integration of acquired companies, as well as continued execution of our product and technology strategy, whereby we decided to phase out the legacy storage subsystem board products we acquired from CMD and to develop new board products only if we believed it would facilitate or accelerate the use of our storage semiconductor products. In connection with this workforce reduction, we recorded a restructuring expense of $2.2 million in the first quarter of 2002, consisting of cash severance-related costs of $198,000, non-cash severance-related costs of $318,000 representing the intrinsic value of modified stock options, an expected loss on leased facilities of $1.2 million and fixed asset write-downs of $500,000 for assets to be disposed of. In addition, we reversed $76,000 of unearned compensation, a component of stockholders’ equity, for unvested stock options that were cancelled in connection with employee terminations.

 

In April 2002, we decided to transition to a licensing model for our storage subsystem board products, whereby instead of developing, manufacturing and selling board products to facilitate or accelerate the use of our storage semiconductor products, we would develop and license board designs in exchange for license fees, royalties and the use of our semiconductor products. In connection with this decision, we implemented a third workforce reduction, eliminating 14 positions, or 5% of our workforce, and recorded a restructuring expense of $3.5 million, consisting of cash severance-related costs of $450,000, non-cash severance-related costs of $1.6 million representing the intrinsic value of modified stock options and fixed asset write-downs of $1.5 million for assets to be disposed of. We also reversed $302,000 of unearned compensation, a component of stockholders’ equity, for unvested stock options that were cancelled in connection with employee terminations.

 

In connection with our decision to stop selling board products and to transition to a licensing model, we assessed recoverability of our intangible assets subject to amortization in accordance with SFAS No. 144. During the quarter ended September 30, 2002, an impairment expense of $749,000 was recognized for acquired technology and $60,000 was recognized for patent and other intangible assets, based upon our projection of significantly reduced future cash flows. Additionally, we reduced our estimate of the useful lives of the remaining intangible assets subject to amortization such that these assets were fully amortized by the end of 2002. We also tested the carrying value of goodwill for impairment in accordance with SFAS No. 142. As a result of our impairment test, a goodwill impairment expense of $4.4 million was recognized during the second quarter of 2002. To determine the amount of the impairment, we estimated the fair value of our storage systems business based primarily on expected future cash flows. We then reduced this amount by the fair value of identifiable tangible and intangible assets other than goodwill (also based primarily on expected future cash flows), and compared the unallocated fair value of the business to the carrying value of goodwill. To the extent goodwill exceeded the unallocated fair value of the business, an impairment expense was recognized.

 

In December 2002, we revised our estimate of the loss we expect to incur on subleased facilities and recorded a restructuring expense of $1.5 million. Real estate market conditions deteriorated in the fourth quarter of 2002, causing us to reassess the length of time it would take to find tenants and the fair value lease rate of our available space. As of December 31, 2003, our expected loss on subleased facilities was based on estimated sublease income of approximately $1.0 million over the remaining lease terms. To the extent we are unable to generate $1.0 million of sublease income, our future results of operations and financial condition will be negatively affected.

 

In March 2003, we reorganized parts of the marketing and product engineering activities of the company into lines of business for PC, CE and storage products to enable us to better manage our long-term growth potential. The central engineering, sales, manufacturing, and general and administrative activities were not organized into the line of business structure. In connection with this reorganization, we reduced our workforce by 27 people, or approximately 10%. These reductions were primarily in engineering and operations functions. Because of this workforce reduction, we recorded restructuring expense of $986,000 in the first quarter of 2003, consisting of cash severance-related costs of $340,000 and non-cash severance-related costs of $646,000, representing the intrinsic value of modified stock options.

 

Severance related costs were determined based on the amount of pay people received that was not for services performed and by measuring the intrinsic value of stock options that were modified to the benefit of terminated employees. For those employees terminated in the three-month period ending March 31, 2003, the remaining service

 

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period from the communication date did not exceed 60 days. The expected loss on leased facilities resulted from our plan to consolidate our remaining workforce to the extent practicable and sublease any excess space. To determine the expected loss, we compared our lease and operating costs for the space to our estimate of the net amount we would be able to recover by subleasing the space. This estimate was based on a number of assumptions, including the length of time it will take to secure a tenant, the sublease rate per square foot, the cost of necessary improvements or modifications and real estate broker commissions. The fixed asset write-downs in 2001 and 2002 were determined based on the estimated fair value of assets, primarily computer hardware and software that would no longer be utilized after the employees’ termination dates.

 

Severance and benefits payments are substantially complete. Lease payments will be made in the form of cash through the end of the related lease term of November 2005. The following table presents restructuring activity for 2001 through March 31, 2004 (in thousands):

 

		Severance and Benefits			Leased Facilities			Fixed Assets			Total
2001 provision		$	902		$	500		$	50		$	1,452
Cash payments		(191		)	—			—			(191		)
Non-cash activity		(303		)	(115		)	—			(418		)
Balance as of December 31, 2001		408			385			50			843
2002 provision		2,547			2,633			2,013			7,193
Cash payments		(865		)	(420		)	—			(1,285		)
Non-cash activity		(1,952		)	—			(2,063		)	(4,015		)
Balance as of December 31, 2002		138			2,598			—			2,736
2003 provision		986			—			—			986
Cash payments		(441		)	(760		)	—			(1,201		)
Non-cash activity		(646		)	—			—			(646		)
Balance as of December 31, 2003		$	37		$	1,838		$	—		$	1,875
Cash payments		(4		)	(223		)	—			(227		)
Balance as of March 31, 2004		$	33		$	1,615		$	—		$	1,648

 

Patent defense costs.   Patent defense costs were $0.2 million for the first quarter of 2004 compared to $1.2 million during the same period in 2003. Patent defense costs are related to the lawsuit we filed against Genesis in April 2001, and acquisition integration costs represent costs incurred to integrate CMD and SCL. The decrease in 2004 compared to 2003 is attributable to a lower level of activity during the first quarter of 2004. However, we expect to incur significant patent defense costs through at least the fourth quarter of 2004. The amount of legal fees incurred in 2004 will depend on the duration of the litigation, as well as the nature and extent of the litigation activities. We are not able to accurately estimate the amount of legal fees we will incur.

 

Interest Income and other, net.   This principally includes interest income and interest expense. The net amount was $84,000 for the first quarter of 2004, compared to $109,000 for the first quarter of 2003. The decrease is principally due the lower interest rates during 2004, offset by higher cash balances and lower debt balances.

 

Gain on escrow settlement, net.   During the quarter ended March 31, 2003, we recognized a net gain of $4.6 million associated with the settlement of an escrow claim against the principal selling shareholders of CMD.

 

Provision for Income Taxes.   For the quarter ended March 31, 2004, we have recorded a provision for income taxes of $317,000. This includes approximately $217,000 relating to withholding taxes payable in connection with our licensing contracts, and a provision of $100,000 relating to taxes in foreign jurisdictions where we have recently commenced operations and estimated provision for U.S. alternative minimum taxes for the fiscal year ending December 31, 2004. At March 31, 2004, we had a net operating loss carryforward for federal income tax purposes of approximately $71.4 million that expires in various years through 2023. These future tax benefits have not been recognized as an asset on our balance sheet due to uncertainties surrounding our ability to generate sufficient taxable income in future periods to realize these tax benefits. Under the Tax Reform Act of 1986, the amounts of, and benefits from, net operating loss carryforwards may be restricted or limited in certain circumstances. We do not expect to be subject to these restrictions or limitations.

 

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LIQUIDITY, CAPITAL RESOURCES AND FINANCIAL CONDITION

 

		March 31, 2004			December 31, 2003			Change
		Dollars in thousands
Cash and cash equivalents		$	40,199		$	24,059		$	16,140
Short term investments		9,459			13,195			(3,736		)
Total cash, cash equivalents and short term investments		49,658			37,254			12,404
Percentage of total assets		47.3		%	42.5		%	4.8 pts
Total current assets		80,678			63,023			17,655
Total current liabilities		33,336			25,349			7,987
Working capital		$	47,342		$	37,674		$	9,668
		Three months ended March 31,
		2004			2003			Change
Cash provided by (used in) operating activities		$	9,027		$	(5,162	)	$	14,189
Cash provided by investing activities		2,558			1,811			747
Cash provided by financing activities		4,555			2,063			2,492
Net increase (decrease) in cash and cash equivalents		$	16,140		$	(1,288	)	$	17,428

 

Since our inception, we have financed our operations through a combination of private sales of convertible preferred stock, our initial public offering, lines of credit, capital lease financing and cash flows from operations. At March 31, 2004, we had $47.3 million of working capital and $49.7 million of cash, cash equivalents and short-term investments. If we are not able to generate cash from operating activities, stock option exercises, and proceeds from sales of shares under our employee stock purchase plan, we will liquidate short-term investments or, to the extent available, utilize credit arrangements to meet our cash needs.

 

Working capital

 

The principal components of the current assets and liabilities and an analysis of the same is given below:

 

Net accounts receivable increased to $19.1 million at March 31, 2004 from $12.8 million at December 31, 2003. The increase is primarily due to increased sales volume and in particular a $3 million increase in distributor shipments during March 2004 versus during December 2003. The days of sales outstanding (“DSO”) was 49 days at March 31, 2004, compared to 38 days at December 31, 2003. The increase in the DSO days is primarily as a result of the increase in the March 2004 versus December 2003 distributor shipments. We expect the DSO days to be in the 45-50 days range during the second quarter of 2004.

 

Inventories decreased to $9.6 million at March 31, 2004 from $10.3 million at December 31, 2003. The decrease is attributable to increased business volume and a general tightening of available foundry capacities. Our inventory turn rate increased to 5.6 as at March 31, 2004 from 5.1 as at December 31, 2003. Inventory turns are computed on an annualized basis, and are a measure of the number of times inventory is replenished during the year. Our inventory turns increased primarily due to higher business volume during the first quarter of 2004 and lower inventory balances as at March 31, 2004. We expect this measure to be at the 5.0 to 5.5 level during the second quarter of 2004.

 

Accounts payable and accrued liabilities increased to $9.2 million and $13.7 million, respectively, at March 31, 2004 from $6.4 million and $9.9 million, respectively, at December 31, 2003. The increase in accounts payable was due to the timing of when payables became due and were processed, and the increase in accrued liabilities is primarily due to an increase in deferred license revenue of $3.7 million.

 

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Deferred margin on sales to distributors increased to $9.2 million at March 31, 2004 from $7.3 million at December 31, 2003. The increase is principally due to the effect of increased distributor related shipments at March 31, 2004 compared to December 31, 2003.

 

Operating activities

 

Operating activities generated $9.0 million of cash during the first quarter of 2004. For the first quarter of 2004, our net income excluding depreciation, stock compensation expense, amortization of intangible assets was $5.7 million. Increases in accounts payable, accrued liabilities, deferred margin on sales to distributors and decreases in inventories, prepaid expenses and other assets offset by an increase in accounts receivable contributed $3.3 million. Operating activities used $5.2 million of cash during the first quarter of 2003.  During the first quarter of 2003, our net loss excluding depreciation, stock compensation expense, a non-cash gain on escrow settlement and the non-cash portion of our restructuring charges was $230,000, which accounts for some of the cash used in operating activities.  Other uses of cash for operating activities consisted of decreases in accounts payable and accrued liabilities of $4.1 million, and an increase in accounts receivable of $2.0 million.  These uses of cash were offset in part by a $409,000 decrease in prepaid expenses and other assets.

 

Investing and financing activities

 

Investing activities provided $2.6 million and $1.8 million of cash during the three months ended March 31, 2004 and 2003. The source of cash for both periods was net proceeds from sales of short-term investments, partially offset by capital expenditures.

 

We generated $4.6 million and $2.1 million from financing activities during the three months ended March 31, 2004 and 2003. Cash provided by financing activities in both periods was primarily from stock option exercises and proceeds from sales of shares under our employee stock purchase plan, partially offset by repayments of our capital leases and other obligations.

 

Debt and Lease Obligations

 

In October 2002, we entered into a $3.6 million term loan to refinance $3.1 million of debt acquired in connection with our acquisition of CMD and $500,000 of other bank debt. This loan bears interest at prime (4.0% at March 31, 2004) plus 0.25% and requires monthly payments through its maturity of October 1, 2004. During the three months ended March 31, 2003, we borrowed $383,000 to finance certain capital equipment. This term loan bears interest at 5% and requires monthly payments through its maturity in February 2005. As of March 31, 2004, $1,234,000 was outstanding under these term loans. Our debt facilities contain certain quarterly and annual financial covenants with which we must comply. In the fourth fiscal quarter of 2003, we fell out of compliance with the lending institution’s quarterly covenants regarding providing periodic financial statements. We were granted a waiver from the lending institution and were not in default of the loan agreement. Due to the nature of the underlying covenants, we have classified all amounts outstanding as current liabilities as of March 31, 2004. During the period ended March 31, 2004, we entered into an agreement to extend this debt facility by way of a revolving line of credit with an availability of up to $10.0 million, and an equipment line of credit of up to $3.0 million. Borrowings under the revolving line are limited to the lesser of $10.0 million or 80% of eligible accounts receivable as defined in the loan agreement. This revolving line of credit expires in March 2005 and bears interest at either prime plus 0.25% or LIBOR plus 2.75%, at our option. Equipment advances pursuant to the equipment line of credit are available to us through August 2004 and will be repayable in twenty four equal monthly installments commencing September 1, 2004 bearing interest at either prime or LIBOR plus 2.5%, at our option. Quarterly and annual financial covenants are contained within this revised agreement. No amounts have been drawn down against this line of credit as at March 31, 2004. As of March 31, 2004, we were in compliance with all covenants.

 

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Future minimum payments for our operating leases, debt and inventory related purchase obligations outstanding at March 31, 2004 are as follows (in thousands):

 

					Payments due in
Contractual obligations		Total			Less than 1 year			1-3 years			3-5 years			More than 5 years
Debt obligations		$	1,234		$	1,234		$	—		$	—		$	—
Operating lease obligations		9,122			2,512			3,104			2,064			1,442
Inventory purchase obligations		5,734			5,734			—			—			—
Total		$	16,090		$	9,480		$	3,104		$	2,064		$	1,442

 

Future minimum lease payments under operating leases have not been reduced by expected sublease rental income or by the amount of our restructuring accrual that relates to leased facilities.

 

We plan to spend approximately $5-6 million during the remainder of the 2004 fiscal year for equipment, furniture and software.

 

Based on our estimated cash flows, we believe our existing cash and short-term investments are sufficient to meet our capital and operating requirements for at least the next 12 months. Our future operating and capital requirements depend on many factors, including the levels at which we generate product revenue and related margins, the extent to which we generate cash through stock option exercises and proceeds from sales of shares under our employee stock purchase plan, the timing and extent of development, licensing and royalty revenues, investments in inventory and accounts receivable, the cost of securing access to adequate manufacturing capacity, our operating expenses, including legal and patent defense costs, and general economic conditions. In addition, cash may be required for future acquisitions should we choose to pursue any. To the extent existing resources and cash from operations are insufficient to support our activities, we may need to raise additional funds through public or private equity or debt financing. These funds may not be available, or if available, we may not be able to obtain them on terms favorable to us.

 

Factors Affecting Future Results

 

You should carefully consider the following risk factors, together with all other information contained or incorporated by reference in this filing, before you decide to purchase shares of our common stock. These factors could cause our future results to differ materially from those expressed in or implied by forward-looking statements made by us. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also harm our business. The trading price of our common stock could decline due to any of these risks, and you may lose all or part of your investment.

 

We operate in rapidly evolving markets, which makes it difficult to evaluate our future prospects.

 

The revenue and income potential of our business and the markets we serve is early in their lifecycle and is difficult to predict. The Digital Visual Interface (“DVI”) specification, which is based on technology developed by us and used in many of our products, was first published in April 1999. We completed our first generation of consumer electronics and storage IC products in mid-to-late 2001. In addition, the preliminary serial ATA specification was first published in August 2001 and the High Definition Multimedia Interface (“HDMI”) specification was first released in December 2002. Accordingly, we face risks and difficulties frequently encountered by companies in new and rapidly evolving markets. If we do not successfully address these risks and difficulties, our results of operations could be negatively affected.

 

We have a history of losses and may not become profitable.

 

We have incurred net losses in each fiscal year since our inception, including net losses of $7.9 million for the three months ended March 31, 2004 and $12.8 million and $40.1 million for the years ended December 31, 2003 and 2002, respectively. We expect to continue to incur net losses for the foreseeable future. Accordingly, we may not achieve and sustain profitability.

 

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Our quarterly operating results may fluctuate significantly and are difficult to predict.

 

Our quarterly operating results are likely to vary significantly in the future based on a number of factors over which we have little or no control. These factors include, but are not limited to:

 

•                  the growth, evolution and rate of adoption of industry standards for our key markets, including digital-ready PCs and displays, consumer electronics and storage devices;

 

•                  the fact that our licensing revenue is heavily dependent on a few key deals being completed for any given period, the timing of which is not always predictable and is especially susceptible to delay beyond the period in which completion is expected, and our concentrated dependence on a few licensees in any period for substantial portions of our expected licensing revenue;

 

•                  competitive pressures, such as the ability of competitors to successfully introduce products that are more cost-effective or that offer greater functionality than our products, including by integrating into their products functionality offered by our products, and the prices set by competitors for their products, and the potential for alliances, combinations, mergers and acquisitions among our competitors;

 

•                  average selling prices of our products, which are influenced by competition and technological advancements, among other factors;

 

•                  government regulations regarding the timing and extent to which digital content must be made available to consumers;

 

•                  the availability of other semiconductors or other key components that are required to produce a complete solution for the customer; usually, we supply one of many necessary components;

 

•                  the cost of components for our products and prices charged by the third parties who manufacture, assemble and test our products;

 

•                  fluctuations in the price of our common stock, which drive a substantial portion of our non-cash stock compensation expense;

 

•                  the nature and extent of litigation activities, particularly our patent infringement suit against Genesis, and any subsequent legal proceedings related to the matters raised in that suit; and.

 

•                  any legal matters resulting from the recent audit committee examination, in particular the shareholder and derivative lawsuits against the company and its directors and some of its officers.

 

Because we have little or no control over these factors and/or their magnitude, our operating results are difficult to predict. Any substantial adverse change in any of these factors could negatively affect our business and results of operations.

 

Our future quarterly operating results are highly dependent upon how well we manage our business.

 

Our quarterly operating results may fluctuate based on how well we manage our business. Some of the factors that may affect how well we manage our business include the following:

 

•                  our ability to manage product introductions and transitions;

 

•                  our ability to successfully manage our business in multiple markets such as PC, storage and CE;

 

•                  our ability to close licensing deals and timely make deliverables and milestones on which recognition of revenue often depends;

 

•                  our ability to engineer customer solutions that adhere to industry standards in a timely, cost-effective manner;

 

•                  our ability to achieve acceptable manufacturing yields and develop automated test programs within a reasonable time frame for our new products;

 

•                  our ability to manage joint projects, design services, and our supply chain partners;

 

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•                  our ability to monitor the activities of our licensees to ensure compliance with license restrictions and remittance of royalties;

 

•                  our ability to structure our organization to enable achievement of our operating objectives and to meet the needs of our customers and markets;

 

•                  the success of the distribution channels through which we choose to sell our products; and

 

•                  our ability to manage expense and inventory levels.

 

If we fail to effectively manage our business, this could adversely affect our results of operations.

 

The licensing component of our business strategy increases business risk and volatility.

 

Part of our business strategy is to license certain of our technology to companies that address markets in which we do not want to directly participate. We have limited experience marketing and selling our technology on a licensing basis. In conjunction with the business strategy we adopted in late 2001, we signed our first license contract in December 2001, and have signed others since then. There can be no assurance that additional companies will be interested in licensing our technology on commercially favorable terms or at all. We also cannot ensure that companies who license our technology will introduce and sell products incorporating our technology, will accurately report royalties owed to us, will pay agreed upon royalties, will honor agreed upon market restrictions, will not infringe upon or misappropriate our intellectual property and will maintain the confidentiality of our proprietary information. Licensing contracts are complex and depend upon many factors including completion of milestones, allocation of values to delivered items, and customer acceptances. Many of these factors require significant judgments. Licensing revenues could fluctuate significantly from period to period because it is heavily dependent on a few key deals being completed in a particular period, the timing of which is difficult to predict. Because of their high margin content, licensing revenues can have a disproportionate impact on gross margins and profitability. Also, generating revenue from licensing arrangements is a lengthy and complex process that may last beyond the period in which efforts begin, and once an agreement is in place, the timing of revenue recognition may be dependent on customer acceptance of deliverables, achievement of milestones, our ability to track and report progress on contracts, customer commercialization of the licensed technology, and other factors. In addition, in any period, our expectation of licensing revenue is or may be dependent on one or a few licenses being completed. Licensing that occurs in the course of actual or contemplated litigation is subject to risk that the adversarial nature of the transaction will induce non-compliance or non-payment. The accounting rules associated with recognizing revenue from licensing transactions are increasingly complex and subject to interpretation. Due to these factors, the amount of license revenue recognized in any period may differ significantly from our expectations.

 

We face additional risks and costs as a result of the delayed filing of our quarterly report on Form 10-Q for the quarter ended September 30, 2003 and our recent Audit Committee examination.

 

As a result of the delayed filing of our Form 10-Q for the quarter ended September 30, 2003, and the Audit Committee’s examination, we have experienced additional risks and costs. The Audit Committee’s examination has been time-consuming, required us to incur additional expenses and has affected management’s attention and resources. Further, the measures to strengthen internal controls being implemented may require greater management time and company resources to implement and monitor. We incurred approximately $1.1 million of costs associated with the Audit Committee examination in the fourth quarter of 2003 and an additional $1.0 million in the first quarter of 2004. These costs include payments made by us pursuant to indemnity agreements between us and certain individuals. Pending litigation costs associated with the examination cannot be accurately projected for the following quarters and could be significant. In addition, measures being implemented as a result of this examination, previously described in our 2003 Form 10-K, may adversely affect our operations.

 

Further, certain of our officers and directors have been named as defendants in shareholder derivative litigation, which alleges, among other matters, that as a result of the examination, we will be required to restate our financial results for 2002 and 2003 and that such a restatement would be due to breaches by the individual defendants of the fiduciary duties to us. In addition, we and certain of our officers and directors have been named as defendants in securities class-action litigation, which alleges that we had materially overstated our licensing revenue, net income and financial results during the time period from April 15, 2002 to November 15, 2003. Although the Audit Committee has completed its examination and concluded that no changes to our financial statements or the results previously announced for the quarter ended September 30, 2003, are required, these lawsuits may be amended or

 

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continued, or new suits may be brought in connection with the delayed filing of the Form 10-Q or the Audit Committee’s examination. Such litigations could be time-consuming, require us to incur significant expenses and could divert our management’s attention and resources. In addition, any unfavorable outcome of any of such litigation could adversely impact our business, financial condition and results of operations.

 

In addition, we have been informed by the NASDAQ staff that the continued listing of our common stock is conditioned on our timely filing of all periodic reports under the Securities Exchange Act of 1934, such as our annual report on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, for all reporting periods ending on or before December 31, 2004. Should we fail to timely make any such filing, NASDAQ has informed us that we will not be entitled to a new hearing with the NASDAQ staff and our common stock may be transferred to the NASDAQ SmallCap Market, provided we could demonstrate compliance with applicable maintenance criteria for such market and an ability to sustain long-term compliance, or immediately delisted from the NASDAQ National Market. The NASDAQ staff has reserved the right to reconsider the terms of the foregoing exception permitting continued listing of our common stock upon a review of our publicly filed financial statements or if any event, condition or circumstance that exists or develops that would, in the opinion of the staff, make continued listing of our stock inadvisable or unwarranted.

 

Finally, as a result of our delayed filing of our Form 10-Q, we will be ineligible to register our securities on Form S-3 for sale by us or resale by others until we have timely filed all periodic reports under the Securities Exchange Act of 1934 for one year. The Company may use Form S-1 to raise capital or complete acquisitions, which could increase transaction costs and adversely affect our ability to raise capital or complete acquisitions of other companies during this period.

 

We face intense competition in our markets, which may lead to reduced revenue from sales of our products and increased losses.

 

The PC, CE and storage markets in which we operate are intensely competitive. These markets are characterized by rapid technological change, evolving standards, short product life cycles and declining selling prices. Our display products face competition from a number of sources, including analog solutions, DVI-based solutions, dual (analog and DVI based) solutions and other digital interface solutions. We expect competition in the display market to increase. For example, Analog Devices, ATI, Broadcom, Chrontel, Genesis Microchip, Matrox, National Semiconductor, Novatek, nVidia, Phillips, Pixelworks, SIS, Smart ASIC, ST Microelectronics, Sunplus, Texas Instruments, Thine, and Weltrend, are shipping products or have announced intentions to introduce products and/or other digital interface solutions that we expect will compete with our PanelLink products. Other companies have announced DVI-based solutions and we expect that additional companies are likely to enter the market. Current or potential customers, including our own licensees, may also develop solutions that could compete with us, directly or indirectly, such as the integration of a DVI transmitter into a graphics processing unit or integration of a DVI receiver into a monitor controller.

 

In the CE market, our digital interface products are used to connect cable set-top boxes, satellite set-top boxes and DVD players to digital televisions. These products incorporate DVI and High-bandwidth Digital Content Protection (“HDCP”), or HDMI with or without HDCP support. Companies that have announced or are shipping DVI-HDCP solutions include Texas Instruments (“TI”), Thine, Broadcom and Genesis Microchip (“Genesis”). In addition, our video processing products face competition from products sold by AV Science, Broadcom, Focus Enhancements, Genesis, Mediamatics, Micronas Semiconductor, Oplus, Philips, Pixelworks and Trident. We also compete, in some instances, against in-house processing solutions designed by large original equipment manufacturers. We expect competition for HDMI products from the other HDMI founders and adopters, including Hitachi, Matsushita, Philips, Sony, Thomson and Toshiba. Toshiba and Matsushita have or are close to having working HDMI solutions.

 

In the storage market, our fibre channel products face competition from companies selling similar discrete products, including Agilent, PMC Sierra and Vitesse, from other fibre channel Serializer-Deserializer (“SerDes”) providers who license their core technology, such as LSI Logic, and from companies that sell Host Bust Adapters (“HBA”) controllers with integrated SerDes, such as QLogic and Agilent. In the future, our current or potential customers may also develop their own proprietary solutions that may include integration of SerDes.

 

Our serial ATA products compete with similar products from Marvell and Promise. In addition, other companies such as Adaptec, APT, ATI, Intel, LSI Logic, ServerWorks and Vitesse, have developed or announced

 

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intentions to develop serial ATA controllers. We also compete against Intel and other motherboard chipset makers that have integrated serial ATA functionality into their chipsets.

 

Our parallel ATA products compete with similar products from Promise and Highpoint. Our RAID controller board products face competition from Mylex, Infortrend, and Chaparral.

 

Some of these competitors have already established supplier or joint development relationships with current or potential customers and may be able to leverage their existing relationships to discourage these customers from purchasing products from us or persuade them to replace our storage products with theirs. Many of our competitors have longer operating histories, greater presence in key markets, better name recognition, access to larger customer bases and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other resources than we do. In addition, some of our competitors could merge (for example, Genesis and Pixelworks announced, and then terminated, such a merger), which may enhance their market presence. As a result, they may be able to adapt more quickly to new or emerging technologies and customer requirements, or devote more resources to the promotion and sale of their products. We cannot assure you that we can compete successfully against current or potential competitors, or that competition will not reduce our revenue and increase our losses.

 

Growth of the market for our PC products depends on the widespread adoption and use of the DVI specification.

 

Our success is largely dependent upon the rapid and widespread adoption of the DVI specification, which defines a high-speed data communication link between computers and digital displays. We cannot predict the rate at which manufacturers of computers and digital displays will adopt the DVI specification. To date, relatively few systems implementing all of the electrical and mechanical aspects of the DVI specification have been shipped. The DVI adoption rate in the PC market was reported to be approximately 12% , and, 7% in 2002 and 2001, respectively. The 2003 DVI adoption rate is estimated to be in the range of 15-20%. Adoption of the DVI specification may be affected by the availability of computer components able to communicate DVI-compliant signals, such as transmitters, receivers, connectors and cables necessary to implement the specification. Other specifications may also emerge that could adversely affect the acceptance of the DVI specification. For example, a number of companies have promoted alternatives to the DVI specification using other interface technologies, such as low voltage differential signaling, or LVDS. Further delays in the widespread adoption of the DVI specification could reduce acceptance of our products, limit or reduce our revenue growth and increase our losses.

 

Our success depends on the growth of the digital display market.

 

Our PC business depends on the growth of the digital display market. The potential size of the digital display market and its rate of development are uncertain and will depend on many factors, including:

 

•                  the number of digital-ready computers that are being produced and consumer demand for these computers;

 

•                  the rate at which display manufacturers replace analog or non-compliant DVI interfaces with fully DVI-compliant interfaces;

 

•                  the availability of cost-effective semiconductors that implement a fully DVI-compliant interface; and

 

•                  improvements to analog technology, which may decrease consumer demand for our digital display products.

 

In order for the digital display market to grow, digital displays must be widely available and affordable to consumers. In the past, the supply of digital displays, such as flat panels, has been cyclical and consumers have been very price sensitive. Also, some manufacturers have implemented DVI interfaces that are not fully DVI-compliant. These interfaces often interfere with the operability of our products which function best with a fully DVI-compliant interface. Our ability to sustain or increase our revenue may be limited should there not be an adequate supply of, or demand for, affordable digital displays with fully DVI-compliant interfaces.

 

A significant amount of our revenue is associated with the adoption of new or emerging technologies within the PC industry. The PC industry has slowed and the adoption of these new technologies may not occur as planned.

 

A large portion of our revenue is directly or indirectly related to the PC industry and the adoption of new or emerging technologies within the PC industry. Accordingly, we are highly dependent on the adoption of new or

 

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emerging technologies within the PC industry, which experienced a slowdown in growth during the second half of 2000 that has continued through 2003. We cannot predict the duration or severity of the downturn in the PC and display market, or in the general economy, or its effect on our revenue and operating results, including the adoption of these new or emerging technologies. If the market for PCs and PC-related displays continues to grow at a slow rate or contracts whether due to reduced demand from end users, macroeconomic conditions or other factors, our business and results of operations could be negatively affected.

 

Although we are attempting to broaden our product offerings to include more products for the consumer electronics and storage markets, there can be no guarantee that we will succeed in this effort. To date, we have achieved reasonable success, but if we fail to consistently achieve design wins in the consumer electronics and storage markets, we will remain highly dependent on the PC industry.

 

Demand for our consumer electronics products is dependent on the adoption and widespread use of the HDMI 1.0 specification.

 

Our success in the consumer electronics market is largely dependent upon the rapid and widespread adoption of the HDMI 1.0 specification, which combines high-definition video and multi-channel audio in one digital interface and uses our patented underlying transition minimized differential signaling (“TMDS”®) technology, and optionally Intel’s HDCP technology, as the basis for the interface. Version 1.0 of the specification was published for adoption on December 9, 2002. We cannot predict the rate at which manufacturers will adopt the HDMI specification or if the specification will be adopted at all. Adoption of the HDMI specification may be affected by the availability of consumer products, such as DVD players and televisions, and of computer components that implement this new interface. Other competing specifications may also emerge that could adversely affect the acceptance of the HDMI specification. Delays in the widespread adoption of the HDMI specification could reduce acceptance of our products, limit or reduce our revenue growth and increase our losses.

 

We believe that the adoption of our CE products may be affected in part by U.S. and International regulations relating to digital television, cable, satellite and over-the-air digital transmissions, specifically regulations relating to the transition from analog to digital television. The Federal Communications Commission (“FCC”) has adopted rules governing the transition from analog to digital television, which include rules governing the requirements for television sets sold in the United States designed to speed the transition to digital television. The FCC has delayed such requirements and timetables for phasing in digital television in the past. We cannot predict whether the FCC will further delay its rules relating to the digital television requirements and timetables. In the event that additional regulatory activity, either in the United States or internationally, delay or postpone the transition to digital television beyond the anticipated time frame, that could reduce the demand for our CE products.

 

In addition, we believe that the rate of HDMI adoption may be accelerated by the proposed FCC rules requiring that all high-definition set top boxes distributed by cable operators include a DVI or HDMI interface and that all CE products marketed or labeled as “digital cable ready” include a DVI or HDMI interface. However, we cannot predict whether the proposed rules will be adopted in their current form or when any final rules will be put into effect. In the event that mandatory use of a DVI or HDMI interface were to be delayed beyond the currently anticipated time frame or not required at all, that could reduce the demand for our CE products, which would adversely affect our business.

 

Our ability to increase sales of our products for display systems depends on host system manufacturers including DVI-compliant transmitters in their systems.

 

Our success in the PC market depends on increasing sales of our receiver products to display manufacturers. To increase sales of our receiver products, we need computer manufacturers to incorporate DVI-compliant transmitters in their systems, making these systems digital-ready. During 2002, we introduced a low-cost add-in card that can be used in conjunction with Intel’s 845G chip set to provide an all-digital connection to flat panels. Intel’s 845G chip set is intended to provide an all-digital path on the motherboard bus, and should make it easier to provide digital video out. Use of Intel’s 845G chip set, or any digital path chip set, is not universal and may not gain market acceptance. If computers are not digital-ready, they will not operate with digital displays, which will limit and may reduce the demand for our digital host and receiver products.

 

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Our success depends on the development and growth of markets for products based on new and emerging storage technologies.

 

Our product development efforts in the storage market are focused on the development of products using new interface technologies such as fibre channel and serial ATA. The markets for these new interface technologies are at an early stage of development, and there can be no assurance that they will replace other storage interfaces that are now widely used, such as parallel ATA and SCSI. The potential size and rate of development of these markets are uncertain and will depend on many factors, including:

 

•                  the rate at which manufacturers of storage subsystems adopt new interface technologies, which may be more costly to implement than existing interface technologies until volumes are sufficient to bring costs to competitive levels;

 

•                  the availability of cost-effective semiconductors and components for storage subsystems, such as serial ATA-enabled hard drives and serial ATA enabled optical drives (CD and DVD), that implement new interface technologies for the storage market;

 

•                  whether Intel or other motherboard manufacturers integrate the functionality of our products, such as serial ATA, into their chips and chip sets; and

 

•                  improvement to existing storage interface technologies such as parallel ATA and SCSI, or the introduction of other new storage interface technologies, either of which may decrease consumer demand for our storage products.

 

In particular, the rate of implementation of the serial ATA interface will depend on how quickly drive manufacturers, motherboard and PC providers and chipmakers are able to resolve technical communication and functionality issues to enable a “plug and play” environment in which a computer system is automatically able to recognize and configure storage devices. Resolution of these issues could be time-consuming, and will depend in good measure on the ability of chipmakers to incorporate the required high-speed serial data transfer capabilities into their semiconductors without sacrificing manufacturing yields.

 

Any delay in acceptance of new interface technologies, or a reduction in the growth or size of the market for systems based on serial ATA or fibre channel technologies, would limit sales of our storage products and reduce our revenue. Any delay in the availability of serial ATA compatible drives or acceleration of serial ATA or fibre channel SerDes integration efforts by motherboard or storage controller manufacturers may also reduce our revenue.

 

We have promulgated a SATALite specification to which we have invited key industry members to participate. This program includes certain licenses to our technology that we hope will increase market acceptance of our serial ATA products. There can be no assurance that this program will succeed, or that SATALite participants will not use our technology to compete against us.

 

To date, we have achieved a number of design wins for our serial ATA and fibre channel storage products. Even after we have achieved a design win from an Original Equipment Manufacturer (OEM), we may not realize any revenue, or significant revenue, from that OEM since a design win is not a binding commitment to purchase our products and the OEM may not achieve market acceptance for their product. Further delay in serial ATA-enabled drive availability may lead OEMs to re-open their designs and designs we have won may be subject to being lost, which could reduce our revenue and increase our operating expenses in competing to re-win designs.

 

We do not have long-term commitments from our customers and we allocate resources based on our estimates of customer demand.

 

Substantially all of our sales are made on the basis of purchase orders, rather than long-term agreements. In addition, our customers may cancel or reschedule purchase orders. We purchase inventory components and build our products according to our estimates of customer demand. This process requires us to make multiple assumptions, including volume and timing of customer demand for each product, manufacturing yields and product quality. If we overestimate customer demand or product quality or under estimate manufacturing yields, we may build products that we may not be able to sell at an acceptable price or at all. As a result, we would have excess inventory, which would increase our losses. Additionally, if we underestimate customer demand or if sufficient manufacturing capacity is unavailable, we will forego revenue opportunities or incur significant costs for rapid increases in production, lose market share and damage our customer relationships.

 

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Our lengthy sales cycle can result in a delay between incurring expenses and generating revenue, which could harm our operating results.

 

Because our products are based on new technology and standards, a lengthy sales process, typically requiring several months or more, is often required before potential customers begin the technical evaluation of our products. This technical evaluation can exceed nine months before the potential customer informs us whether we have achieved a design win, which is not a binding commitment to purchase our products. After achieving a design win, it can then be an additional nine months before a customer commences volume shipments of systems incorporating our products, if at all. Given our lengthy sales cycle, we may experience a delay between the time we incur expenditures and the time we generate revenue, if any. As a result, our operating results could be seriously harmed if a significant customer reduces or delays orders, or chooses not to release products incorporating our products.

 

We depend on a few key customers and the loss of any of them could significantly reduce our revenue.

 

Historically, a relatively small number of customers and distributors have generated a significant portion of our revenue. For the three months ended March 31, 2004, shipments to World Peace International, an Asian distributor, generated 15% of our revenue, and shipments to Microtek, a distributor, generated 11% of our revenue. For the year ended December 31, 2003, shipments to World Peace International, generated 15% of our revenue, and shipments to Weikeng, a distributor, generated 8% of our revenue. For the year ended December 31, 2002, shipments to World Peace International generated 15% of our revenue, and shipments to Weikeng generated 11% of our revenue. In addition, an end-customer may buy through multiple distributors, contract manufacturers, and / or directly, which could create an even greater concentration. We cannot be certain that customers and key distributors that have accounted for significant revenue in past periods, individually or as a group, will continue to sell our products and generate revenue. As a result of this concentration of our customers, our results of operations could be negatively affected if any of the following occurs:

 

•                  one or more of our customers, including distributors, becomes insolvent or goes out of business;

 

•                  one or more of our key customers or distributors significantly reduces, delays or cancels orders; or

 

•                  one or more significant customers selects products manufactured by one of our competitors for inclusion in their future product generations.

 

Due to our participation in multiple markets, our customer base has broadened significantly and we therefore anticipate being less dependent on a relatively small number of customers to generate revenue. However, as product mix fluctuates from quarter to quarter, we may become more dependent on a small number of customers or a single customer for a significant portion of our revenue in a particular quarter, the loss of which could adversely affect our operating results.

 

We sell our products through distributors, which limits our direct interaction with our customers, therefore reducing our ability to forecast sales and increasing the complexity of our business.

 

Many original equipment manufacturers rely on third-party manufacturers or distributors to provide inventory management and purchasing functions. Distributors generated 44% of our revenue for the three months ended March 31, 2004, 42% of our revenue for the year ended December 31, 2003, and 42% of our revenue for the year ended December 31, 2002. Selling through distributors reduces our ability to forecast sales and increases the complexity of our business, requiring us to:

 

•                  manage a more complex supply chain;

 

•                  monitor and manage the level of inventory of our products at each distributor;

 

•                  estimate the impact of credits, return rights, price protection and unsold inventory at distributors; and

 

•                  monitor the financial condition and credit-worthiness of our distributors, many of which are located outside of the United States, and the majority of which are not publicly traded.

 

Any failure to manage these challenges could disrupt or reduce sales of our products and unfavorably impact our financial results.

 

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Our success depends on the development and introduction of new products, which we may not be able to do in a timely manner because the process of developing high-speed semiconductor products is complex and costly.

 

The development of new products is highly complex, and we have experienced delays, some of which exceeded one year, in the development and introduction of new products on several occasions in the past. In 2001 and 2002, we announced our first products for the storage market and we expect to introduce new consumer electronics, storage and DVI products in the future. As our products integrate new, more advanced functions, they become more complex and increasingly difficult to design, manufacture and debug. Successful product development and introduction depends on a number of factors, including, but not limited to:

 

•                  accurate prediction of market requirements and evolving standards, including enhancements to existing standards such as DVI, HDCP and SATA, and development and adoption of new or emerging standards such as HDMI, or significant modifications to existing standards such as SATA II;

 

•                  development of advanced technologies and capabilities, and new products that satisfy customer requirements;

 

•                  competitors’ and customers’ integration of the functionality of our products into their products, which puts pressure on us to continue to develop and introduce new products with new functionality;

 

•                  timely completion and introduction of new product designs;

 

•                  management of product life cycles;

 

•                  use of leading-edge foundry processes and achievement of high manufacturing yields and low cost testing; and

 

•                  market acceptance of new products.

 

Accomplishing all of this is extremely challenging, time-consuming and expensive and there is no assurance that we will succeed. Product development delays may result from unanticipated engineering complexities, changing market or competitive product requirements or specifications, difficulties in overcoming resource limitations, the inability to license third party technology or other factors. Competitors and customers may integrate the functionality of our products into their products that would reduce demand for our products. If we are not able to develop and introduce our products successfully and in a timely manner, our costs could increase or our revenue could decrease, both of which would adversely affect our operating results. In addition, it is possible that we may experience delays in generating revenue from these products or that we may never generate revenue from these products. We must work with a semiconductor foundry and with potential customers to complete new product development and to validate manufacturing methods and processes to support volume production and potential re-work. Each of these steps may involve unanticipated difficulties, which could delay product introduction and reduce market acceptance of the product. In addition, these difficulties and the increasing complexity of our products may result in the introduction of products that contain defects or that do not perform as expected, which would harm our relationships with customers and our ability to achieve market acceptance of our new products. There can be no assurance that we will be able to achieve design wins for our planned new products, that we will be able to complete development of these products when anticipated, or that these products can be manufactured in commercial volumes at acceptable yields, or that any design wins will produce any revenue. Failure to develop and introduce new products, successfully and in a timely manner, may adversely affect our results of operations.

 

We have made acquisitions in the past and may make acquisitions in the future, if advisable, and these acquisitions involve numerous risks.

 

Our growth depends upon market growth and our ability to enhance our existing products and introduce new products on a timely basis. One of the ways we develop new products and enter new markets is through acquisitions. In 2000, we completed the acquisitions of Zillion and DVDO, and in 2001, we completed the acquisitions of CMD and SCL. In April 2003, we acquired TWN. We may acquire additional companies or technologies. Acquisitions involve numerous risks, including, but not limited to, the following:

 

•                  difficulty and increased costs in assimilating employees, including our possible inability to keep and retain key employees of the acquired business;

 

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•                  disruption of our ongoing business;

 

•                  discovery of undisclosed liabilities of the acquired companies and legal disputes with founders or shareholders of acquired companies;

 

•                  inability to successfully incorporate acquired technology and operations into our business and maintain uniform standards, controls, policies and procedures;

 

•                  inability to commercialize acquired technology; and

 

•                  the need to take impairment charges or write-downs with respect to acquired assets.

 

No assurance can be given that our prior acquisitions or our future acquisitions, if any, will be successful or provide the anticipated benefits, or that they will not adversely affect our business, operating results or financial condition. Failure to manage growth effectively and to successfully integrate acquisitions made by us could materially harm our business and operating results.

 

The cyclical nature of the semiconductor industry may create constrictions in our foundry, test and assembly capacity.

 

In the past, the semiconductor industry has been characterized by significant downturns and wide fluctuations in supply and demand. For example, demand in the semiconductor industry rose to record levels in 1999, and then declined until recently when it appears to be recovering. The industry has also experienced significant fluctuations in anticipation of changes in general economic conditions. This cyclicality has led to significant fluctuations in product demand and in the foundry, test and assembly capacity of third party suppliers. Production capacity for fabricated semiconductors are subject to allocation, whereby not all of our production requirements would be met. This may impact our ability to meet demand and could also increase our production costs. Cyclicality has also accelerated decreases in average selling prices per unit. We may experience fluctuations in our future financial results because of changes in industry-wide conditions.

 

We depend on third-party sub-contractors to manufacture, assemble and test nearly all of our products, which reduces our control over the production process.

 

We do not own or operate a semiconductor fabrication facility. We rely on Taiwan Semiconductor Manufacturing Company (“TSMC”), an outside foundry, to produce the vast majority all of our semiconductor products. We also rely on Kawasaki, UMC and Atmel, for outside foundry services, and on Amkor and ASE to test certain of our semiconductor products. Our reliance on independent foundries, assembly and test facilities involves a number of significant risks, including, but not limited to:

 

•                  reduced control over delivery schedules, quality assurance, manufacturing yields and production costs;

 

•                  lack of guaranteed production capacity or product supply;

 

•                  lack of availability of, or delayed access to, next-generation or key process technologies; and

 

•                  our ability to transition to alternate sources if services are unavailable from primary suppliers.

 

In addition, our semiconductor products are assembled and tested by several independent subcontractors. We do not have a long-term supply agreement with our subcontractors, and instead obtain production services on a purchase order basis. Our outside sub-contractors have no obligation to supply products to us for any specific period of time, in any specific quantity or at any specific price, except as set forth in a particular purchase order. Our requirements represent a small portion of the total production capacity of our outside foundries, assembly and test facilities and our sub-contractors may reallocate capacity to other customers even during periods of high demand for our products. These foundries may allocate or move production of our products to different foundries under their control, even in different locations, which may be time consuming, costly, and difficult, have an adverse affect on quality, yields, and costs, and require us and/or our customers to re-qualify the products, which could open up design wins to competition and result in the loss of design wins and design-ins. If our subcontractors are unable or unwilling to continue manufacturing our products in the required volumes, at acceptable quality, yields and costs, and in a timely manner, our business will be substantially harmed. As a result, we would have to identify and qualify substitute contractors, which would be time-consuming, costly and difficult. This qualification process may also require significant effort by our customers, and may lead to re-qualification of parts, opening up design wins to

 

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competition, and loss of design wins and design-ins. Any of these circumstances could substantially harm our business. In addition, if competition for foundry, assembly and test capacity increases, our product costs may increase and we may be required to pay significant amounts or make significant purchase commitments to secure access to production services.

 

The nature of our production process is complex, which reduces identification of problems until well into the production cycle or, in some cases, after the product has been shipped.

 

The manufacture of semiconductors is a complex process, and it is often difficult for semiconductor foundries to achieve acceptable product yields. Product yields depend on both our product design and the manufacturing process technology unique to the semiconductor foundry. Since low yields may result from either design or process difficulties, identifying problems can often only occur well into the production cycle, when an actual product exists that can be analyzed and tested.

 

Further, we only test our products after they are assembled, as their high-speed nature makes earlier testing difficult and expensive. As a result, defects often are not discovered until after assembly. This could result in a substantial number of defective products being assembled and tested or shipped, thus lowering our yields and increasing our costs. These risks could result in product shortages or increased costs of assembling, testing or even replacing our products.

 

Although we test our products before shipment, they are complex and may contain defects and errors. In the past we have encountered defects and errors in our products. Because our products are sometimes integrated with products from other vendors, it can be difficult to identify the source of any particular problem. Delivery of products with defects or reliability, quality or compatibility problems, may damage our reputation and our ability to retain existing customers and attract new customers. In addition, product defects and errors could result in additional development costs, diversion of technical resources, delayed product shipments, increased product returns, warranty and product liability claims against us that may not be fully covered by insurance. Any of these circumstances could substantially harm our business.

 

We face foreign business, political and economic risks because a majority of our products and our customers’ products are manufactured and sold outside of the United States.

 

A substantial portion of our business is conducted outside of the United States. As a result, we are subject to foreign business, political and economic risks. Nearly all of our products are manufactured in Taiwan or elsewhere in Asia, and for the three months ended March 31, 2004, 73% of our revenue, and for the years ended December 31, 2003, 2002, and 2001 74%, 72%, and 79% of our revenue respectively was generated from customers and distributors located outside of the United States, primarily in Asia. We anticipate that sales outside of the United States will continue to account for a substantial portion of our revenue in future periods. Accordingly, we are subject to international risks, including, but not limited to:

 

•                  difficulties in managing from afar;

 

•                  political and economic instability, including international tension in Iraq, Korea and the China Strait and lack of normal diplomatic relationships between the United States and Taiwan;

 

•                  less developed infrastructures in newly industrializing countries;

 

•                  susceptibility of foreign areas to terrorist attacks;

 

•                  susceptibility to interruptions of travel, including those due to international tensions (including the war in and occupation of Iraq), the SARS and Avian Flu epidemics (particularly affecting the Asian markets we serve), and the financial instability and bankruptcy of major air carriers;

 

•                  bias against foreign, especially American, companies;

 

•                  difficulties in collecting accounts receivable;

 

•                  expense and difficulties in protecting our intellectual property in foreign jurisdictions;

 

•                  difficulties in complying with multiple, conflicting and changing laws and regulations, including export requirements, tariffs, import duties, visa restrictions, environmental laws and other barriers;

 

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•                  exposure to possible litigation or claims in foreign jurisdictions; and

 

•                  competition from foreign-based suppliers and the existence of protectionist laws and business practices that favor these suppliers, such as withholding taxes on payments made to us.

 

These risks could adversely affect our business and our results of operations. In addition, original equipment manufacturers that design our semiconductors into their products sell them outside of the United States. This exposes us indirectly to foreign risks. Because sales of our products are denominated exclusively in United States dollars, relative increases in the value of the United States dollar will increase the foreign currency price equivalent of our products, which could lead to a reduction in sales and profits in that country.

 

The success of our business depends upon our ability to adequately protect our intellectual property.

 

We rely on a combination of patent, copyright, trademark, mask work and trade secret laws, as well as nondisclosure agreements and other methods, to protect our proprietary technologies. We have been issued patents and have a number of pending patent applications. However, we cannot assure you that any patents will be issued as a result of any applications or, if issued, that any claims allowed will protect our technology. In addition, we do not file patent applications on a worldwide basis, meaning we do not have patent protection in some jurisdictions. It is possible that existing or future patents may be challenged, invalidated or circumvented and effective patent, copyright, trademark and trade secret protection may be unavailable or limited in foreign countries. It may be possible for a third party to copy or otherwise obtain and use our products or technology without authorization, develop similar technology independently or design around our patents in the United States and in other jurisdictions. It is also possible that some of our existing or new licensing relationships will enable other parties to use our intellectual property to compete against us. Legal actions to enforce intellectual property rights tend to be lengthy and expensive, and the outcome often is not predictable. As a result, despite our efforts and expenses, we may be unable to prevent others from infringing upon or misappropriating our intellectual property, which could harm our business. In addition, practicality also limits our assertion of intellectual property rights. Patent litigation is expensive and its results are often unpredictable. Assertion of intellectual property rights often results in counterclaims for perceived violations of the defendant’s intellectual property rights and/or antitrust claims. Certain parties after receipt of an assertion of infringement will cut off all commercial relationships with the party making the assertion, thus making assertions against suppliers, customers, and key business partners unwise. Accordingly, if we forgo making such claims, we may risk creating legal and equitable defenses for an infringer.

 

Our participation in the Digital Display Working Group requires us to license some of our intellectual property for free, which may make it easier for others to compete with us in the DVI PC market.

 

We are a promoter of the DDWG, which published and promotes the DVI specification. Our strategy includes establishing the DVI specification as the industry standard, promoting and enhancing this specification and developing and marketing products based on this specification and future enhancements. As a result:

 

•                  we must license for free specific elements of our intellectual property to others for use in implementing the DVI specification; and

 

•                  we may license additional intellectual property for free as the DDWG promotes enhancements to the DVI specification.

 

Accordingly, companies that implement the DVI specification in their products can use specific elements of our intellectual property for free to compete with us.

 

Our participation as a founder in the working group developing HDMI requires us to license some of our intellectual property, which may make it easier for others to compete with us in the market.

 

In April 2002, together with Sony, Philips, Thomson, Toshiba, Matsushita and Hitachi, we announced the formation of a working group to define the next-generation digital interface specification for consumer electronics products. Version 1.0 of the specification was published for adoption on December 9, 2002. The HDMI specification combines high-definition video and multi-channel audio in one digital interface and uses Silicon Image’s patented underlying TMDS technology, optionally, along with Intel’s HDCP as the basis for the interface. The founders of the working group have signed a founder’s agreement in which each commits to license certain intellectual property to each other, and to adopters of the specification.

 

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Our strategy includes establishing the HDMI specification as the industry standard, promoting and enhancing this specification and developing and marketing products based on this specification and future enhancements. As a result:

 

•                  we must license specific elements of our intellectual property to others for use in implementing the HDMI specification; and

 

•                  we may license additional intellectual property as the HDMI founders group promotes enhancements to the HDMI specification.

 

Accordingly, companies that implement the HDMI specification in their products can use specific elements of our intellectual property to compete with us. Although there will be license fees and royalties associated with the adopters agreements, there can be no assurance that such license fees and royalties will adequately compensate us for having to license our intellectual property. Fees and royalties received during the early years of adoption will be used to cover costs we incur to promote the HDMI standard and to develop and perform interoperability tests; in addition, after an initial period, the HDMI founders may reallocate the license fees and royalties amongst themselves to reflect each founder’s relative contribution of intellectual property to the HDMI specification.

 

Our success depends on managing our relationship with Intel.

 

Intel has a dominant role in many of the markets in which we compete, such as PCs and storage, and is a growing presence in the CE market. We have a multi-faceted relationship with Intel that is complex and requires significant management attention, including:

 

•                  Intel has been an investor of ours;

 

•                  Intel and we have been parties to a business cooperation agreement;

 

•                  Intel and we are parties to a patent cross-license;

 

•                  Intel and we worked together to develop HDCP;

 

•                  An Intel subsidiary has the exclusive right to license HDCP, of which we are a licensee;

 

•                  Intel and we were two of the original founders of the Digital Display Working Group (“DDWG”);

 

•                  Intel is a promoter of the serial ATA working group, of which we are a contributor;

 

•                  Intel is a supplier to us and a customer for our products;

 

•                  We believe that Intel has the market presence to drive adoption of DVI and serial ATA by making them widely available in its chip sets and motherboards, which could affect demand for our products;

 

•                  We believe that Intel has the market presence to affect adoption of HDMI by either endorsing the technology or promulgating a competing standard, which could affect demand for our products;

 

•                  Intel may potentially integrate the functionality of our products, including fibre channel, serial ATA or DVI, into its own chips and chip sets, thereby displacing demand for some of our products;

 

•                  Intel may design new technologies that would require us to re-design our products for compatibility, thus increasing our R&D expense and reducing our revenue;

 

•                  Intel’s technology, including its 845G chip set, may lower barriers to entry to other parties who may enter the market and compete with us; and

 

•                  Intel may enter into or continue relationships with our competitors that can put us at a relative disadvantage.

 

Our cooperation and competition with Intel can lead to positive benefits if managed effectively. If our relationship with Intel is not managed effectively, it could seriously harm our business, negatively affect our revenue, and increase our operating expenses.

 

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We have granted Intel rights with respect to our intellectual property, which could allow Intel to develop products that compete with ours or otherwise reduce the value of our intellectual property.

 

We have entered into a patent cross-license agreement with Intel in which each of us granted the other a license to use the grantor’s patents, except for identified types of products. We believe that the scope of our license to Intel excludes our current products and anticipated future products. Intel could, however, exercise its rights under this agreement to use our patents to develop and market other products that compete with ours, without payment to us. Additionally, Intel’s rights to our patents could reduce the value of our patents to any third party who otherwise might be interested in acquiring rights to use our patents in such products. Finally, Intel could endorse competing products, including a competing digital interface, or develop its own proprietary digital interface. Any of these actions could substantially harm our business and results of operations.

 

We are and may continue to become the target of securities class action suits and derivative suits which could result in substantial costs and divert management attention and resources.

 

Securities class action suits are often brought against companies, particularly technology companies, following periods of volatility in the market price of their securities. Defending against these suits, even if meritless, can result in substantial costs to us and could divert the attention of our management. We and certain of our officers and directors, together with certain investment banks, have been named as defendants in a securities class action suit filed against us on behalf of purchasers of our securities between October 5, 1999 and December 6, 2000. It is alleged that the prospectus related to our initial public offering was misleading because it failed to disclose that the underwriters of our initial public offering had solicited and received excessive commissions from certain investors in exchange for agreements by investors to buy our shares in the aftermarket for predetermined prices. Due to inherent uncertainties in litigation, we cannot accurately predict the outcome of this litigation; however, a proposed settlement has been negotiated that has yet to be reviewed and approved by the Court. In the event that the settlement is not approved, we believe that these claims are without merit and we intend to defend vigorously against them. We and certain of our officers, together with certain investment banks and their current or former employees, were named as defendants in a securities class action suit filed against us on behalf of a putative class of shareholders who purchased stock from some or all of approximately 50 issuers whose public offerings were underwritten by Credit Suisse First Boston. The lawsuit alleges that Silicon Image and certain officers were part of a scheme by Credit Suisse First Boston to artificially inflate the price of Silicon Image’s stock through the dissemination of allegedly false analysts’ reports. The plaintiff in this matter has filed an amended complaint in which Silicon Image, and the named officers, were dropped as defendants. We believe that the settlement described above, if approved, would encompass the claims in this case. We believe that these claims were without merit and, if revived, and not subject to the settlement, we intend to defend vigorously against them. Certain of our officers and directors have been named as defendants in consolidated shareholder derivative litigation. The lawsuit alleges that as a result of the examination conducted by our Audit Committee, we will be required to restate our financial results for 2002 and 2003. The lawsuit further alleges that such a restatement would be due to breaches by the individual defendants of their fiduciary duties to us, that certain of the individual defendants are liable to us for insider trading under California law, and that the individual defendants are liable to us for mismanagement, abuse of control, and waste. We and certain of our officers have also been named as defendants in consolidated securities class action litigation. Plaintiffs filed the action on behalf of a putative class of shareholders who purchased our stock between April 15, 2002 and November 15, 2003. The lawsuit alleges that we had materially overstated our licensing revenue, net income and financial results during this time period, and that were being forced to restate our financial results. With the announcement by the Audit Committee of Silicon Image’s Board of Directors that it has completed its examination and that it has concluded that no changes to Silicon Image’s previously announced financial results are required, the securities class action litigation has been dismissed but the shareholder derivative litigation has not been dismissed and the plaintiffs may amend that complaint once as a matter of right.

 

We believe that claims against us are without merit and we intend to defend vigorously against them. These suits and any others that may be brought, even if meritless, could require us to incur expenses and could divert our management’s attention and resources. In addition, any unfavorable outcome of any of these litigations could adversely impact our business, financial condition and results of operations.

 

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We are currently engaged in intellectual property litigation that is time-consuming and expensive to prosecute. We may become engaged in additional intellectual property litigation that could be time-consuming, maybe be expensive to prosecute or defend, and could adversely affect our ability to sell our product.

 

In recent years, there has been significant litigation in the United States and in other jurisdictions involving patents and other intellectual property rights. This litigation is particularly prevalent in the semiconductor industry, in which a number of companies aggressively use their patent portfolios to bring infringement claims. In addition, in recent years, there has been an increase in the filing of so-called “nuisance suits,” alleging infringement of intellectual property rights. These claims may be asserted as counterclaims in response to claims made by a company alleging infringement of intellectual property rights. These suits pressure defendants into entering settlement arrangements to quickly dispose of such suits, regardless of merit. In addition, as is common in the semiconductor industry, from time to time we have been notified that we may be infringing certain patents or other intellectual property rights of others. Responding to such claims, regardless of their merit, can be time consuming, result in costly litigation, divert management’s attention and resources and cause us to incur significant expenses. As each claim is evaluated, we may consider the desirability of entering into settlement or licensing agreements. No assurance can be given that settlements will occur or that licenses can be obtained on acceptable terms or that litigation will not occur. In the event there is a temporary or permanent injunction entered prohibiting us from marketing or selling certain of our products, or a successful claim of infringement against us requiring us to pay damages or royalties to a third party, and we fail to develop or license a substitute technology, our business, results of operations or financial condition could be materially adversely affected.

 

In April 2001, we filed suit against Genesis Microchip for infringement of one of our U.S. patents. At that time, we also filed a complaint against Genesis for unlawful trade practices related to the importation of articles infringing our patent. In February 2002, our motion to dismiss the unlawful trade practices complaint was granted and we filed an amended complaint against Genesis alleging infringement of two of our U.S. patents. These patents relate to our DVI receiver products, which generate a significant portion of our revenue. The amended complaint seeks a declaration that Genesis has infringed our patents, that Genesis’ behavior is not licensed, an injunction to halt the importation, sale, manufacture and use of Genesis DVI receiver chips that infringe our patents, and monetary damages. In April 2002, Genesis answered and made counterclaims against us for non-infringement, license, patent invalidity, fraud, antitrust, unfair competition and patent misuse. We filed a motion to dismiss certain of Genesis’s counterclaims. In addition, we filed a motion to bifurcate trial of the counterclaims to the extent the court does not dismiss them. In May 2002, the Court granted our motion to dismiss certain of the counterclaims, with leave to amend. Genesis re-filed counterclaims against us for fraud and patent misuse. We filed another motion to dismiss these counterclaims. In August 2002, the Court granted our motion and dismissed Genesis’s re-filed counterclaims with prejudice. In December 2002, the parties entered into a memorandum of understanding (“MOU”) to settle the case. In January, the parties presented different interpretations of the MOU to the Court. On July 15, 2003, the Court granted our motion to interpret the MOU in the manner we requested, and ruled that Genesis had engaged in efforts to avoid its obligations under the MOU. On August 6, 2003, the Court entered a final judgment order based on its July 15, 2003 ruling. Under the final judgment order, Genesis was ordered to make a substantial cash payment, and to make royalty payments; although Genesis has made and continues to make cash payments to the Court, it may not have made all the payments that are required under the final judgment order. We filed motions for reimbursement of some of some of expenses, including some of our legal fees, and for modification and/or clarification of certain items of the judgment, and to hold Genesis in contempt of Court for breaching the protective order in the case by disclosing secret information to at least one of our competitors. On December 19, 2003, the Court granted our motions in part and denied them in part: the court issued an amended judgment, and held Genesis in contempt of Court for breaching the protective order. On January 16, 2004, Genesis filed a notice of appeal.

 

There can be no assurance that Genesis will not undertake further efforts to avoid its obligations under the MOU, and that further proceedings (lawsuits, contempt citations, etc.) against Genesis, and certain of its executives, its counsel, and others may not be required to obtain compliance or to obtain redress for non-compliance. There can be no assurance that an appellate court will uphold the Court’s rulings or the MOU. There can be no assurance that further delays or noncompliance will not occur. The Court’s rulings of July 15, 2003 and December 19, 2003 indicate that Genesis violated certain provisions of the MOU, and of the protective order in the case, including disclosure of confidential information to Pixelworks. On August 5, 2003, Genesis and Pixelworks issued a joint press release terminating their proposed merger. In that press release, Genesis and Pixelworks jointly stated that “Pixelworks has confirmed that prior to signing the merger agreement, it reviewed the Memorandum of

 

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Understanding that purported to settle the lawsuit between Genesis Microchip and Silicon Image, Inc.” While this litigation, including the appeal or any possible derivative proceedings, is pending, Genesis can use the technology covered by these patents to develop products that might compete with ours. If we are unsuccessful in this litigation, we could be unable to prevent Genesis or others from using the technology covered by these patents. Even if we prevail in this litigation, uncertainties regarding the outcome prior to that time may reduce demand for our products, or Genesis’s use of our technology in products that compete with our products may reduce demand or pricing for our products. In addition, even if the MOU is upheld on appeal, future disputes may occur, including those regarding whether and what intellectual property licenses were granted and the scope of any such licenses and the royalty rates and payment terms for such licenses, whether the MOU was breached, whether consent was fraudulently obtained, and whether a merger partner may succeed to the rights and/or the obligations under the MOU. These disputes may result in additional costly and time-consuming litigation or the license of additional elements of our intellectual property for free.

 

Any potential intellectual property litigation against us could also force us to do one or more of the following:

 

•                  stop selling products or using technology that contain the allegedly infringing intellectual property;

 

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

 

•                  attempt to redesign products that contain the allegedly infringing intellectual property.

 

If we take any of these actions, we may be unable to manufacture and sell our products. We may be exposed to liability for monetary damages, the extent of which would be very difficult to accurately predict. In addition, we may be exposed to customer claims, for potential indemnity obligations, and to customer dissatisfaction and a discontinuance of purchases of our products while the litigation is pending. Any of these consequences could substantially harm our business and results of operations.

 

We have entered into, and may again be required to enter into, patent or other intellectual property cross-licenses.

 

Many companies have significant patent portfolios or key specific patents, or other intellectual property in areas in which we compete. Many of these companies appear to have policies of imposing cross-licenses on other participants in their markets, which may include areas in which we compete. As a result, we have been required, either under pressure of litigation or by significant vendors or customers, to enter into cross licenses or non-assertion agreements relating to patents or other intellectual property. This permits the cross-licensee, or beneficiary of a non-assertion agreement, to use certain or all of our patents and/or certain other intellectual property for free to compete with us.

 

We must attract and retain qualified personnel to be successful, and competition for qualified personnel is increasing in our market.

 

Our success depends to a significant extent upon the continued contributions of our key management, technical and sales personnel, many of who would be difficult to replace. The loss of one or more of these employees could harm our business. Although we have entered into a limited number of employment contracts with certain executive officers, we generally do not have employment contracts with our key employees. We do not have key person life insurance for any of our key personnel. Our success also depends on our ability to identify, attract and retain qualified technical, sales, marketing, finance and managerial personnel. Competition for qualified personnel is particularly intense in our industry and in our location. This makes it difficult to retain our key personnel and to recruit highly qualified personnel. We have experienced, and may continue to experience, difficulty in hiring and retaining candidates with appropriate qualifications. To be successful, we need to hire candidates with appropriate qualifications and retain our key executives and employees.

 

The volatility of our stock price has had an impact on our ability to offer competitive equity-based incentives to current and prospective employees, thereby affecting our ability to attract and retain highly qualified technical personnel. If these adverse conditions continue, we may not be able to hire or retain highly qualified employees in the future and this could harm our business. In addition, new regulations adopted by The NASDAQ National Market requiring shareholder approval for all stock option plans, as well as new regulations adopted by the New York Stock Exchange prohibiting NYSE member organizations from giving a proxy to vote on equity compensation

 

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plans unless the beneficial owner of the shares has given voting instructions, could make it more difficult for us to grant options to employees in the future. There have been several proposals on whether and /or how to account for stock options. To the extent that new regulations make it more difficult or expensive to grant options to employees, we may incur increased cash compensation costs or find it difficult to attract, retain and motivate employees, either of which could harm our business.

 

We use contractors to provide services to the company, which often involves contractual complexity, tax and employment law compliance, and being subject to audits and other governmental actions. We have been audited for our contracting policies in the past, and may be in the future. Burdening our ability to freely use contractors to provide services to the company may increase the expense of obtaining such services, and/or require us to discontinue using contractors and attempt to find, interview, and hire employees to provide similar services. Such potential employees may not be available in a reasonable time, or at all, or may not be hired without undue cost.

 

Industry cycles may strain our management and resources.

 

Cycles of growth and contraction in our industry may strain our management and resources. To manage these industry cycles effectively, we must:

 

•                  improve operational and financial systems;

 

•                  train and manage our employee base;

 

•                  successfully integrate operations and employees of businesses we acquire or have acquired;

 

•                  attract, develop, motivate and retain qualified personnel with relevant experience; and

 

•                  adjust spending levels according to prevailing market conditions.

 

If we cannot manage industry cycles effectively, our business could be seriously harmed.

 

Our operations and the operations of our significant customers, third-party wafer foundries and third-party assembly and test subcontractors are located in areas susceptible to natural disasters.

 

Our operations are headquartered in the San Francisco Bay Area, which is susceptible to earthquakes, and the operations of CMD, which we acquired, are based in the Los Angeles area, which is also susceptible to earthquakes. TSMC and UMC, the outside foundries that produce the majority of our semiconductor products, are located in Taiwan. Advanced Semiconductor Engineering, or ASE, one of the subcontractors that assembles and tests our semiconductor products, is also located in Taiwan. For the three months ended March 31, 2004 and for the year ended December 31, 2003, customers and distributors located in Taiwan generated 26% and 34% of our revenue, respectively, and customers and distributors located in Japan generated 21% and 15% of our revenue, respectively. For the year ended December 31, 2002, customers and distributors located in Taiwan generated 34% of our revenue and customers and distributors located in Japan generated 12% of our revenue. Both Taiwan and Japan are susceptible to earthquakes, typhoons and other natural disasters.

 

Our business would be negatively affected if any of the following occurred:

 

•                  an earthquake or other disaster in the San Francisco Bay Area or the Los Angeles area damaged our facilities or disrupted the supply of water or electricity to our headquarters or our Irvine facility;

 

•                  an earthquake, typhoon or other disaster in Taiwan or Japan resulted in shortages of water, electricity or transportation, limiting the production capacity of our outside foundries or the ability of ASE to provide assembly and test services;

 

•                  an earthquake, typhoon or other disaster in Taiwan or Japan damaged the facilities or equipment of our customers and distributors, resulting in reduced purchases of our products; or

 

•                  an earthquake, typhoon or other disaster in Taiwan or Japan disrupted the operations of suppliers to our Taiwanese or Japanese customers, outside foundries or ASE, which in turn disrupted the operations of these customers, foundries or ASE and resulted in reduced purchases of our products or shortages in our product supply.

 

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Changes in environmental rules and regulations could increase our costs and reduce our revenue.

 

Several jurisdictions are considering whether to implement rules that would require that certain products, including semiconductors, be made lead-free. We anticipate that some jurisdictions may finalize and enact such requirements. Some jurisdictions are also considering whether to require abatement or disposal obligations for products made prior to the enactment of any such rules. Although several of our products are available to customers in a lead-free condition, most of our products are not lead-free. Any requirement that would prevent or burden the development, manufacture or sales of lead-containing semiconductors would likely reduce our revenue for such products and would require us to incur costs to develop substitute lead-free replacement products, which may take time and may not always be economically or technically feasible, and may require disposal of non-compliant inventory. In addition, any requirement to dispose or abate previously sold products would require us to incur the costs of setting up and implementing such a program.

 

Provisions of our charter documents and Delaware law could prevent or delay a change in control, and may reduce the market price of our common stock.

 

Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. These provisions include:

 

•                  authorizing the issuance of preferred stock without stockholder approval;

 

•                  providing for a classified board of directors with staggered, three-year terms;

 

•                  requiring advance notice of stockholder nominations for the board of directors;

 

•                  providing the board of directors the opportunity to expand the number of directors without notice to stockholders;

 

•                  prohibiting cumulative voting in the election of directors;

 

•                  requiring super-majority voting to amend some provisions of our certificate of incorporation and bylaws;

 

•                  limiting the persons who may call special meetings of stockholders; and

 

•                  prohibiting stockholder actions by written consent.

 

Provisions of Delaware law also may discourage, delay or prevent someone from acquiring or merging with us.

 

The price of our stock fluctuates substantially and may continue to do so.

 

The stock market has experienced extreme price and volume fluctuations that have affected the market valuation of many technology companies, including Silicon Image. These factors, as well as general economic and political conditions, may materially and adversely affect the market price of our common stock in the future. The market price of our common stock has fluctuated significantly and may continue to fluctuate in response to a number of factors, including, but not limited to:

 

•                  actual or anticipated changes in our operating results;

 

•                  changes in expectations of our future financial performance;

 

•                  changes in market valuations of comparable companies in our markets;

 

•                  changes in market valuations or expectations of future financial performance of our vendors or customers;

 

•                  changes in our key executives and technical personnel; and

 

•                  announcements by us or our competitors of significant technical innovations, design wins, contracts, standards or acquisitions.

 

Due to these factors, the price of our stock may decline. In addition, the stock market experiences volatility that is often unrelated to the performance of particular companies. These market fluctuations may cause our stock price to decline regardless of our performance.

 

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We are in the process of implementing an enterprise resource platform

 

We are in the process of implementing an enterprise resource platform (ERP) system, and of hosting that system on our site. The system is comprised of hardware and software, and services, all of which we acquired from vendors; however, we are also customizing portions of the system with in-house resources. This requires careful management of the skills and resources to implement the ERP system and to establish disaster recovery plans. If we are unsuccessful, or if the hardware or software should fail, we could lose access to the data needed to book and fill customer orders, ship products, and produce financial reports, which would have a material adverse effect on our business.

 

Continued terrorist attacks or war could lead to further economic instability and adversely affect our operations, results of operations and stock price.

 

The United States has taken, and continues to take, military action against terrorism and has engaged in war with Iraq and currently has an occupation force there and in Afghanistan. In addition, the current nuclear arms crises in North Korea and Iran could escalate into armed hostilities or war. Acts of terrorism or armed hostilities may disrupt or result in instability in the general economy and financial markets and in consumer demand for the OEM’s products that incorporate our products. Disruptions and instability in the general economy could reduce demand for our products or disrupt the operations of our customers, suppliers, distributors and contractors, many of whom are located in Asia, which would in turn adversely affect our operations and results of operations. Disruptions and instability in financial markets could adversely affect our stock price. Armed hostilities or war in South Korea could disrupt the operations of the research and development contractors we utilize there, which would adversely affect our research and development capabilities and ability to timely develop and introduce new products and product improvements.

 

We have recently established an office in Japan

 

We have recently established an office in Japan. Accordingly, we are subject to risks, including, but not limited to:

 

•                  being subject to Japanese tax laws and potentially liable for paying taxes in Japan;

 

•                  profits, if any, earned in Japan will be subject to local tax laws and may not be repatriable to the United States;

 

•                  we have and will enter into employment agreements in connection with hiring personnel for the Japanese office and are governed by the provisions of the Japanese labor laws; and

 

•                  the operations of the local office are and will be subject to the provisions of other local laws and regulations.

 

We have recently established an office in the Republic of Korea (South Korea)

 

We have recently established an office in the Republic of Korea (South Korea). Accordingly, we are subject to risks, including, but not limited to:

 

•                  being subject to South Korean tax laws and potentially liable for paying taxes in South Korea;

 

•                  profits, if any, earned in South Korea will be subject to local tax laws and may not be repatriable to the United States;

 

•                  we have and will enter into employment agreements in connection with hiring personnel for the South Korea office and are governed by the provisions of the South Korean labor laws; and

 

•                  the operations of the local office are and will be subject to the provisions of other local laws and regulations.

 

We indemnify certain of our licensing customers against infringement.

 

We indemnify certain of our licensing agreements customers for any expenses or liabilities resulting from third-party claims of infringements of patent, trademark, trade secret, or copyright rights by the technology we license.  Certain of these indemnification provisions are perpetual from execution of the agreement and, in some instances,

 

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the maximum amount of potential future indemnification is not limited. To date, we have not paid any such claims or been required to defend any lawsuits with respect to any claim. In the event that we were required to defend any lawsuits with respect to our indemnification obligations, or to pay any claim, our results of operations could be materially adversely affected.

 

 

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

 

Interest Rate Risk

 

Our cash equivalents and short-term investments consist primarily of fixed-income securities that are subject to interest rate risk and will decline in value if interest rates increase. Due to the short duration of our cash equivalents and short-term investments, an immediate 10% change in interest rates would not be expected to have a material effect on our near-term results of operations or financial condition. Our long-term capital lease obligations bear interest at fixed rates; therefore, our results of operations would not be affected by immediate changes in interest rates.  Also, components of our stock compensation expense are tied to our stock price.  Changes in our stock price can have a significant affect on the amount recorded as stock compensation expense.

 

Foreign Currency Exchange Risk

 

All of our sales are denominated in U.S. dollars, and substantially all of our expenses are incurred in U.S. dollars, thus limiting our exposure to foreign currency exchange risk. We currently do not enter into forward exchange contracts to hedge exposures denominated in foreign currencies and do not use derivative financial instruments for trading or speculative purposes. The effect of an immediate 10% change in foreign currency exchange rates should not have a material effect on our future operating results or cash flows; however, a long term change in foreign currency rates would likely result in increased wafer, packaging, assembly or testing costs.

 

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Item 4.  Controls and Procedures

 

(a)           Evaluation of Controls and Procedures.  We maintain disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

 

In designing and evaluating the disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

 

As required by Rule 13a-15(b) and 15d-15(b) under the Exchange Act, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures at the end of the fiscal quarter covered by this report.  The evaluation took into account the conduct of and results of the Audit Committee examination completed in February 2004, and the receipt of notice from the Company’s independent auditors that, in connection with the 2003 year-end audit, they had identified a reportable condition relating to internal controls.  The evaluation also took into account a written confirmation of the reportable condition recently provided by our auditors stating they were aware of deficiencies in the Company’s internal control structure design related to the overall internal control environment regarding our Chief Executive Officer’s communication and operating style and his periodic involvement in revenue recognition discussions.  Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our controls and procedures as of the end of the period covered by this report were effective, except that with respect to the reportable condition and as the number and complexity of licensing transactions increase, the Company’s control environment could and should be enhanced, as discussed below:

 

(b)           Changes in Internal Controls.  As a result of our own evaluation, as well as recommendations provided by the Audit Committee we are in the process of implementing a series of internal measures designed to enhance the Company’s overall internal control environment.  These measures include (i) restructuring some reporting relationships among management and clarifying management roles and responsibilities, (ii) improving communication within the management team and between the management team and the Board of Directors, including the Audit Committee, (iii) formalizing licensing review processes by requiring additional documentation of items necessary for licensing revenue recognition decisions and increasing the standardization of licensing deliverables and post-contract customer support for revenue recognition purposes, (iv) adding additional resources and personnel to key control functions and (v) implementing training and compliance programs.  Implementation of the measures is underway, but will by its nature be an ongoing effort, subject to the review of our Board of Directors, Audit Committee and auditors.

 

Part II.  Other Information

 

Item 1.  Legal Proceedings

 

On April 24, 2001, we filed suit in the U.S. District Court for the Eastern District of Virginia against Genesis Microchip Corp. and Genesis Microchip, Inc. (collectively, “Genesis”) for infringement of our U.S. patent number 5,905,769 (USDC E.D. Virginia Civil Action No.: CA-01-266-R) (the “Federal Suit”). On April 24, 2001, we also filed a complaint against Genesis with the International Trade Commission of the United States government (“ITC”) for unlawful trade practices related to the importation of articles infringing our patent (the “ITC investigation”). The actions sought injunctions to halt the importation, sale, manufacture and use of Genesis DVI receiver chips that infringe our patent, and monetary damages. We voluntarily moved to dismiss the ITC investigation, with notice that we would proceed directly in the Federal Suit. Our motion to dismiss was granted on February 7, 2002. We filed an amended complaint in the Federal Suit as of February 28, 2002, adding a claim for infringement of our U.S. patent number 5,974,464. In April 2002, Genesis answered and made counterclaims against us for non-infringement, license, patent invalidity, fraud, antitrust, unfair competition and patent misuse. Also in April 2002, we filed a

 

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motion to dismiss certain of Genesis’s counterclaims. In addition, we filed a motion to bifurcate trial of the counterclaims to the extent the court does not dismiss them. In May 2002, the Court granted our motion to dismiss certain of the counterclaims, with leave to amend. Genesis re-filed counterclaims against us for fraud and patent misuse. We filed another motion to dismiss these counterclaims. In December 2002, the parties entered into a memorandum of understanding (MOU) to settle the case. In January, the parties presented different interpretations of the MOU to the Court. On July 15, 2003, the Court granted our motion to interpret the MOU in the manner we requested, and ruled that Genesis had engaged in efforts to avoid its obligations under the MOU. On August 6, 2003, the Court entered a final judgment based on its July 15, 2003 ruling. Under the final judgment order, Genesis was ordered to make a substantial cash payment, and to make royalty payments; although Genesis has made a cash payment to the Court, it has not made all the payments that are required under the final judgment order. We filed motions for reimbursement of some of our expenses, including some of our legal fees, and for modification and/or clarification of certain items of the judgment, and to hold Genesis in contempt of Court for breaching the protective order in the case by disclosing secret information to at least one of our competitors. On December 19, 2003, the Court granted our motions in part and denied them in part: the court issued an amended judgment, and held Genesis in contempt of Court for breaching the protective order. Under the amended judgment, Genesis was ordered to make a substantial cash payment, royalty payments, and interest; although Genesis has made and continues to make cash payments to the Court, it may not have made all the payments that are required under the amended judgment. The Court has not ruled on pending motions regarding the disposition of the money held by the Court. On January 16, 2004, Genesis filed a notice of appeal. To date, we have not received any cash payments nor have we recognized any revenue associated with this litigation. Due to the continuing and contentious nature of this litigation, we will not record any income or revenue related to this matter until the litigation is complete and all other income and revenue recognition criteria have been satisfied. Management intends to prosecute our position vigorously until this matter is resolved. Through March 31, 2004, we have spent approximately $10.6 million on this matter and expect to continue to incur significant legal costs through at least the fourth quarter of 2004.

 

Silicon Image, certain officers and directors, and Silicon Image’s underwriters have been named as defendants in a securities class action lawsuit captioned Gonzales v. Silicon Image, et al., No. 01 CV 10903 (SDNY 2001) pending in Federal District Court for the Southern District of New York. The lawsuit alleges that all defendants were part of a scheme to manipulate the price of Silicon Image’s stock in the aftermarket following Silicon Image’s initial public offering in October 1999. Response to the complaint and discovery in this action on behalf of Silicon Image and individual defendants has been stayed by order of the court. The lawsuit is proceeding as part of a coordinated action of over 300 such cases brought by plaintiffs in the Southern District of New York. Pursuant to a tolling agreement, individual defendants have been dropped from the suit for the time being. In February 2003, the Court denied the underwriters’ motion to dismiss and ordered that the case may proceed against issuers including against Silicon Image. A proposed settlement has been negotiated that has yet to be reviewed and approved by the Court. In the event that the settlement is approved, we do not expect it to have a material effect on our results of operations or financial position. In the event that the settlement is not approved, we could not accurately predict the outcome the litigation, but we intend to defend this matter vigorously.

 

Silicon Image, certain officers and directors, and Silicon Image’s underwriters were named as defendants in a securities class action lawsuit captioned Liu v. Credit Suisse First Boston Corp., et al., No. 03-20459 (S.D. Fla. 2003) pending in Federal District Court for the Southern District of Florida. The plaintiff filed an action on behalf of a putative class of shareholders who purchased stock from some or all of approximately 50 issuers whose public offerings were underwritten by Credit Suisse First Boston. The lawsuit alleges that Silicon Image and certain officers were part of a scheme by Credit Suisse First Boston to artificially inflate the price of Silicon Image’s stock through the dissemination of allegedly false analysts’ reports. Silicon Image has not been served with a copy of the complaint. The plaintiff in this matter has filed an amended complaint in which Silicon Image, and the named officers, were dropped as defendants. We believe that the proposed settlement described above, if approved, would encompass the claims in this case. We believe that these claims were without merit and, if revived, and not subject to the settlement, we would defend this matter vigorously.

 

Certain officers and directors of Silicon Image have been named as defendants in consolidated shareholder derivative litigation, captioned “In re Silicon Image, Inc. Derivative Litigation, No. 1:03CV010302”, commenced on December 4, 2003 and pending in the Superior Court of California, County of Santa Clara. The plaintiffs purport to sue the individual defendants on behalf of Silicon Image. The lawsuit alleges that as a result of the recently completed examination conducted by the Audit Committee of Silicon Image’s Board of Directors, Silicon Image will be required to restate its financial results for 2002 and 2003. The lawsuit further alleges that such a restatement

 

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would be due to breaches by the individual defendants of their fiduciary duties to Silicon Image; that certain of the individual defendants are liable to Silicon Image for insider trading under California law; and that the individual defendants are liable to Silicon Image for mismanagement, abuse of control, and waste. Before filing suit, the plaintiffs did not make a demand upon the board of directors to pursue any such claims directly on behalf of Silicon Image. Following the announcement by the Audit Committee of Silicon Image’s Board of Directors that it has completed its examination and that it has concluded that no changes to Silicon Image’s previously announced financial results are required, the Company agreed to provide plaintiffs with certain specified information concerning the examination. Plaintiffs agreed to dismiss the lawsuit following their good-faith review of such information to confirm the independence, scope and adequacy of the examination. Although the Company, acting through the Audit Committee of its Board of Directors, provided the specified information, plaintiffs have failed to dismiss the lawsuit. As a result, the Company has filed a cross-complaint for breach of contract, seeking an order dismissing the derivative action and awarding the Company its attorneys fees. The individual defendants believe the lawsuit is without merit, and they intend to defend the action vigorously if plaintiffs do not dismiss it. Plaintiffs may seek to amend the complaint, and we cannot predict what claims plaintiffs might assert in such an amended complaint.

 

Silicon Image and certain of its officers have been named as defendants in consolidated securities class action litigation captioned “In re Silicon Image, Inc. Securities Litigation, No. C-03-5579 JW PVT”, commenced on December 11, 2003 and pending in the United States District Court for the Northern District of California. Plaintiffs filed the action on behalf of a putative class of shareholders who purchased Silicon Image stock between April 15, 2002 and November 15, 2003. The lawsuit alleges that Silicon Image had materially overstated its licensing revenue, net income and financial results during this time period, and that Silicon Image was being forced to restate its financial results. Following the announcement by the Audit Committee of Silicon Image’s Board of Directors that it has completed its examination and that it has concluded that no changes to Silicon Image’s previously announced financial results are required, the plaintiffs dismissed the lawsuit.

 

In addition, we have been named as defendants in a number of judicial and administrative proceedings incidental to our business and may be named again from time to time. We intend to defend such matters vigorously, and although adverse decisions or settlements may occur in one or more of such cases, the final resolution of these matters, individually or in the aggregate, is not expected to have a material adverse effect on our results of operations or financial position.

 

The amount of legal fees we incur with respect to the litigation matters described above will depend on the duration of our litigation matters, as well as the nature and extent of the litigation activities. We are not able to accurately estimate the amount of legal fees we will incur in 2004 with respect to the litigation matters described above, however, we do expect to incur substantial amounts through 2004.

 

Item 2.  Changes in Securities and Use of Proceeds

 

In connection with our acquisition of Zillion Technologies, LLC, we are obligated under an exchange agreement to periodically issue to the two founders of Zillion shares of our common stock as consideration for their membership interests in Zillion which we acquired and services provided pursuant to their employment agreements with us.  The Zillion founders were granted registration rights with respect to the shares to be issued under this exchange agreement.  These issuances of shares were made in reliance on an exemption from registration under Section 4(2) of the Securities Act.  On March 31, 2004, we issued 9,375 shares of our common stock to one of the Zillion founders pursuant to the exchange agreement.  The issuances of shares were made without general solicitation or advertising and were only made to one individual.

 

Item 3.  Defaults Upon Senior Securities

 

Not applicable.

 

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

 

Not applicable.

 

Item 5.  Other Information

 

Not applicable.

 

Item 6.  Exhibits and Reports on Form 8-K

 

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(a)   Exhibits

 

Exhibit 10.35          Bonus Plan for Fiscal Year 2004

 

31.1                         Certification under Section 302 of the Sarbanes-Oxley Act of 2002

 

31.2                         Certification under Section 302 of the Sarbanes-Oxley Act of 2002

 

32.1                         Certification pursuant to 12 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

32.1                         Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(b)   Reports on Form 8-K

 

On February 23, 2004, we furnished a current report on Form 8-K to furnish under Item 12 our press release and conference call transcript for the quarter and year ended December 31, 2003.

 

On March 3, 2004, we filed a current report on Form 8-K to report under Item 5, trading plans entered into by several officers and a member of the Board of Directors pursuant to Rule 10b5-1 under the Securities Exchange Act of 1934.

 

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Signatures

 

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

 

Dated:  May 7, 2004	Silicon Image, Inc.
	/s/  Robert G. Gargus
	Robert G. Gargus
	Vice President Finance and Administration and Chief
	Financial Officer
	(Principal Financial and Accounting Officer)

 

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