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EX-31.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER - Freescale Semiconductor, Ltd.dex311.htm
EX-32.2 - SECTION 1350 CERTIFICATION (CHIEF FINANCIAL OFFICER) - Freescale Semiconductor, Ltd.dex322.htm
EX-31.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER - Freescale Semiconductor, Ltd.dex312.htm
EX-12.1 - STATEMENT OF COMPUTATION OF RATIOS - Freescale Semiconductor, Ltd.dex121.htm
EX-32.1 - SECTION 1350 CERTIFICATION (CHIEF EXECUTIVE OFFICER) - Freescale Semiconductor, Ltd.dex321.htm
EX-21.1 - SUBSIDIARIES OF FREESCALE SEMICONDUCTOR HOLDINGS I, LTD. - Freescale Semiconductor, Ltd.dex211.htm
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

 

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

For the fiscal year ended December 31, 2009

or

 

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

For the transition period from              to             

Commission File Number 333-141128-05

 

 

FREESCALE SEMICONDUCTOR HOLDINGS I, LTD.

(Exact name of registrant as specified in its charter)

 

 

 

BERMUDA   98-0522138
(Jurisdiction)   (I.R.S. Employer Identification No.)

 

6501 William Cannon Drive West

Austin, Texas

  78735
(Address of principal executive offices)   (Zip Code)

(512) 895-2000

(Registrant’s telephone number)

 

 

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  x    No  ¨

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large Accelerated Filer ¨    Accelerated Filer ¨

Non-Accelerated Filer x    

(Do not check if a smaller reporting company)

   Smaller reporting company ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

There is no public trading market for the registrant’s common stock. As of January 29, 2010, there were 1,012,299,152 shares of the registrant’s common stock, par value $0.005 per share, outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

None.

 

 

 


Table of Contents

Table of Contents

 

          Page
   PART I   
Item 1.    Business    3
Item 1A.    Risk Factors    10
Item 1B.    Unresolved Staff Comments    20
Item 2.    Properties    20
Item 3.    Legal Proceedings    20
Item 4.    Submission of Matters to a Vote of Security Holders    22
   PART II   
Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    22
Item 6.    Selected Financial Data    24
Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations    26
Item 7A.    Quantitative and Qualitative Disclosures About Market Risk    47
Item 8.    Financial Statements and Supplementary Data    50
Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    92
Item 9A.    Controls and Procedures    92
Item 9B.    Other Information    93
   PART III   
Item 10.    Directors, Executive Officers and Corporate Governance    93
Item 11.    Executive Compensation    97
Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    111
Item 13.    Certain Relationships and Related Transactions, and Director Independence    115
Item 14.    Principal Accountant Fees and Services    116
   PART IV   
Item 15.    Exhibits, Financial Statement Schedules    117

 

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PART I

Holdings I (which may be referred to as the “Company,” “Freescale,” “we,” “us” or “our”) means Freescale Semiconductor Holdings I, Ltd. and its subsidiaries, as the context requires.

 

Item 1: Business

Our Company

With over 50 years of operating history, Freescale is a leader in the design and manufacture of embedded processors. We are based in Austin, Texas and have design, research and development, manufacturing and sales operations around the world. We generated $3.5 billion in revenue for the year ended December 31, 2009.

Our largest end-markets are the automotive and networking markets, but we also provide products to both industrial and consumer electronics markets. In each of our markets, we offer families of embedded processors. In their simplest forms, embedded processors provide the basic intelligence for electronic devices and can be programmed to address specific applications or functions. Examples of our embedded processors include microcontrollers, digital signal, applications and communications processors.

In addition to our embedded processors, we offer our customers a broad portfolio of complementary devices that provide connectivity between products, across networks and to real-world signals, such as sound, vibration and pressure. Our complementary products include sensors, radio frequency semiconductors, power management and other analog and mixed-signal integrated circuits. Through our embedded processors and complementary products, we also offer customers complex combinations of semiconductors with software, which we refer to as “platform-level products.” We believe that our ability to offer platform-level products will be increasingly important to our long-term success in many markets within the semiconductor industry as our customers continue to move toward providers of embedded processors and complementary products.

Freescale Semiconductor, Inc. (“FSL, Inc.”) was incorporated in Delaware in 2003. In the second quarter of 2004, Motorola, Inc. (“Motorola”) transferred substantially all of its semiconductor businesses’ assets and liabilities to FSL, Inc. (the “Contribution”) in anticipation of an initial public offering (“IPO”) of FSL, Inc. Class A common stock. The IPO was completed on July 21, 2004. Prior to the IPO, FSL, Inc. was a wholly owned subsidiary of Motorola. All of the FSL, Inc. Class B shares of common stock were held by Motorola until Motorola distributed its remaining ownership interest in us by means of a special dividend to its common stockholders (the “Distribution”) on December 2, 2004 (the “Distribution Date”).

On December 1, 2006, FSL, Inc. was acquired by a consortium of private equity funds (“the Merger”). The consortium includes The Blackstone Group, The Carlyle Group, funds advised by Permira Advisers, LLC, TPG Capital and others (collectively, the “Sponsors”). The acquisition was accomplished pursuant to the terms of an Agreement and Plan of Merger entered into on September 15, 2006 (the “Merger Agreement”). Pursuant to the terms of the Merger Agreement, FSL, Inc. became an indirect subsidiary of Freescale Semiconductor Holdings I, Ltd. (“Holdings I”) which in turn is a direct subsidiary of Freescale Holdings, L.P., a Cayman Islands limited partnership (“Parent”), an entity controlled by the Sponsors. Holdings I is a Bermuda exempted limited liability company and was organized in 2006. Additional information regarding Freescale can be found on our website at www.freescale.com. The inclusion of our website address in this Annual Report on Form 10-K does not include or incorporate by reference into this Annual Report any information on our website. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, amendments to those reports and other filings are available free of charge through our website as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the Securities and Exchange Commission.

Our Industry

Cyclicality of Semiconductor Industry and Current Business Conditions

Our business is highly dependent on demand for electronic content in automobiles, networking and wireless infrastructure equipment and other electronic devices. Historically, the relationship between supply and demand in the semiconductor industry has caused cyclicality in the market, characterized by technological change, product obsolescence, price erosion, evolving standards and fluctuations in product supply and demand. The industry has experienced downturns, often in connection with, or in anticipation of, maturing product cycles of both semiconductor companies’ and their customers’ products and declines in general economic conditions. These downturns can lead to diminished product demand, production overcapacity, higher inventory levels and accelerated erosion of average selling prices. We have historically experienced adverse effects on our profitability and cash flows during such downturns.

In the second half of 2008 and continuing into 2009, the semiconductor industry experienced a downturn driven by overall weakness in global macroeconomic demand for semiconductor products. We experienced lower revenues and profitability, as well as lower factory utilization compared to peak levels because of the downturn in general and our position as an electronic content provider to the automotive industry, which experienced significant declines in demand in 2009 compared to peak levels.

 

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In response to these economic pressures, we executed a series of strategic investment and cost reduction actions in late 2008 and 2009 to sharpen our strategic focus on growth markets and key market leadership positions where we anticipate above market growth opportunities over the long term. Specifically, during 2009, we executed actions to align our cost structure with our prior decision to wind-down our cellular handset business. We also announced the initiation of a plan to exit our remaining 150mm manufacturing capability in Sendai, Japan and Toulouse, France as well as finalized the closure of our 150mm manufacturing capability in East Kilbride, Scotland because of a general migration away from 150mm technologies and products to more cost-effective advanced technologies and products.

Going forward, we intend to focus our resources on our core automotive and networking products, as well as targeted opportunities in various industrial and consumer electronics markets. Our future revenue and profitability will be affected by, among other factors, a combination of (i) the extent to which a recovery occurs in the general global economic environment, both in size and duration, and (ii) our ability to secure design wins and adequately meet product development launch cycles in our targeted markets.

Semiconductor Overview

Semiconductors perform a broad variety of functions within electronic products and systems, such as processing data, storing information and converting or controlling signals. Advances in semiconductor technology have increased the functionality and performance of semiconductors, improving the features, functionality and power consumption characteristics of the devices enabled while reducing their size and cost of manufacturing. These advances have resulted in a proliferation of electronic content across a diverse array of products.

Semiconductors vary significantly depending upon the specific function or application of the end product in which the semiconductor is embedded. Within these classifications, semiconductors vary significantly depending upon a number of technical characteristics. Examples of these characteristics include:

 

   

Degree of Integration. “Integration” refers to the extent to which different elements are combined onto a single chip. Customers today are increasingly demanding higher degrees of integration from their semiconductor suppliers, resulting in more products that combine analog, digital, and memory circuitry onto a single chip. These types of semiconductors are often referred to as systems-on-a-chip.

 

   

Customization. “Customization” refers to the extent to which a semiconductor has been customized for a specific customer or application. Standard products are semiconductors that are not customized and can be used by a large number of customers for numerous applications. In addition, some standard products, such as microcontrollers, can be customized by using software rather than by changing the device hardware. Changing the device hardware can be a time-intensive and costly process. Customized semiconductors, also referred to as application specific integrated circuits, are made to perform specific functions in specific applications, sometimes for a specific customer.

 

   

Process Technology. Semiconductors are manufactured by using different process technologies, which can be likened to “recipes.” The process technology utilized during manufacturing impacts a semiconductor’s performance for a given application. As semiconductor materials science has evolved, the minimum feature sizes in each new process technology continue to decrease. This reduces the size and, generally, unit cost of semiconductors made with the new process technology. Today’s leading edge process technology typically refers to a minimum feature size of 45 nanometers, which is currently in volume production. Initial production launches at 32 nanometers have recently occurred and development of 22 nm feature size is underway. Each new reduction in feature size generally takes 18 to 24 months to develop. We will continue to utilize internal resources as well as existing foundry relationships for our process technology and manufacturing needs.

Customers, Sales and Marketing

We sell our products directly to original equipment manufacturers, original design manufacturers and contract manufacturers through our global direct sales force. Our direct sales force is organized by customer end markets in order to bring dedicated expertise and knowledge and response to our customers. We have 59 sales offices located in 22 countries that align us with the development efforts of our customers and enable us to respond directly to customer requirements. We also maintain a network of distributors that we believe has the global infrastructure and logistics capabilities to serve a wide and diversified customer base for our products. Expansion of our distribution sales network represents an opportunity for us to leverage our products and services to a wider array of customers.

Our net product sales in the Americas, Europe, Middle East and Africa (“EMEA”), Asia-Pacific and Japan regions represented approximately 38%, 34%, 18% and 8%, respectively, of our net sales in 2009. For additional information on our net sales by country, see Note 12 to the accompanying audited consolidated financial statements. We believe our Asia-Pacific region represents a market growth opportunity and, accordingly, we intend to enhance our sales and marketing capabilities and infrastructure in the Asia-Pacific region by strengthening our direct sales force and expanding the scope of our distribution network.

We generally target customers who are leaders in industries in which our products are used as well as companies that we believe will be future leaders in these industries. In the past, we have relied on a limited number of customers for a substantial portion of our

 

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total sales. Our ten largest end customers accounted for approximately 46% of our net sales in 2009. Continental Automotive and Motorola represented 11% and 10% of our total net sales, respectively, in 2009. Historically, Motorola was our largest end customer, comprising approximately 23% and 24% of our net sales in 2008 and 2007, respectively. In connection with the decision to wind-down our cellular handset business in 2008 and our agreement to cancel our purchase and supply agreement with Motorola, our cellular products sales to Motorola declined significantly beginning in the fourth quarter of 2008. Motorola continues, however, to be serviced by our cellular, networking and communications product portfolio. Beyond Motorola, no other end customer represented more than 10% of our total net sales for the last three years other than Continental Automotive, which represented approximately 11% of our total net sales in 2009. In 2009, excluding Continental Automotive and Motorola, the next eight largest end customers comprised approximately 25% of our total net sales. In 2008 and 2007, excluding Motorola, the next nine largest end customers comprised approximately 31% and 33% of our total net sales, respectively.

Research and Development

Our research and development activities comprise both product and technology development. Our product design engineering activities, which constitute the majority of our research and development expenditures, are primarily aligned with our product design groups, and the areas of focus for these investments are described within the relevant product and application sections. Our technology development programs primarily support our product design engineering efforts, and also cover process technology, packaging technology and system-on-a-chip design technology. Specialty technologies are also developed to provide differentiation and competitive advantage, such as embedded memories (particularly non-volatile), Silicon-On-Insulator (SOI), SMARTMOS, radio frequency and mixed-signal technologies. We believe that this approach allows us to apply our investments in process, packaging and design technologies across a broad portfolio of products.

We participate in alliances and other arrangements with external partners in the area of process technology, design technology, manufacturing technology and materials development to reduce the cost of development and accelerate access to new technologies. We have several research projects with IMEC (Leuven, Belgium) and collaborative research programs with CEA-LETI (Grenoble, France) and CNRS-LAAS (Toulouse, France). We continually review our memberships in these technology research alliances and arrangements, and we may make changes from time to time. Our research and development locations include facilities in the United States, Brazil, Canada, Mexico, Czech Republic, France, Germany, Israel, Romania, Russia, United Kingdom, China, India and Malaysia.

During 2009, we funded our research and development initiatives directed at our automotive, networking, consumer and industrial end-markets consistent with our strategy to focus on growth markets and key market leadership positions where we anticipate market growth opportunities over the long-term. Following our decision in 2008 to wind-down the cellular handset business, we reduced our research and development expenditures related to this area. Research and development expense was $833 million, $1,140 million and $1,139 million for the years ended December 31, 2009, 2008 and 2007, respectively.

Manufacturing

We manufacture our products either at our own facilities or obtain manufacturing services from contract manufacturers. We currently manufacture a substantial portion of our products at our own facilities. However, as part of our asset-light strategy, we utilize a balance of internal capabilities and contract manufacturing services for standard CMOS processes and high-volume products. This is intended to allow us to efficiently manage both our supply competitiveness and factory utilization in order to minimize the risk associated with market fluctuations and maximize cash flow. We have relationships with several wafer foundries and assembly and test subcontractors to meet our contract manufacturing needs, including 300-millimeter wafer size and scaling down to 45-nanometer technologies.

Semiconductor manufacturing is comprised of two broad stages: wafer manufacturing, or “front-end,” and assembly and test, or “back-end.” Based on total units produced in 2009, approximately 23% of our front-end manufacturing was outsourced to wafer foundries. We outsourced approximately 43% of our back-end manufacturing to assembly and test subcontractors, based on total units produced in 2009. Both of these percentages may change as our business and our product mix changes. We continually evaluate the in-sourcing or out-sourcing of selected wafer assembly and test products and technologies in order to improve our supply competitiveness, gross margin and cash flows.

 

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We own and operate seven manufacturing facilities, five of which are wafer fabrication facilities and the remaining two are assembly and test facilities. These facilities are certified to the ISO/TS 16949:2002 international quality standards. This technical specification aligns existing U.S., German, French and Italian automotive quality system standards within the global automotive industry. These operations also are certified to ISO 9001:2000. Our ISO 14001 management systems are designed to meet and exceed regulatory requirements, with certified manufacturing operations in the United States, Scotland, France, Japan, China and Malaysia. The following table describes our manufacturing facilities:

 

Name & Location

 

Representative Products

 

Technologies Employed

WAFER FABS    
Toulouse, France (1)  

Power management

Motor controllers

Power semiconductors

 

150 mm wafers

Power CMOS

0.5 micron

Sendai, Japan (2)  

Microcontrollers

Sensors

 

150 mm wafers

CMOS, embedded NVM, MEMs

0.5 micron

Oak Hill, Austin, Texas  

Radio frequency transceivers

Radio frequency amplifiers

Power management

Sensors

Radio frequency LDMOS

 

200 mm wafers

CMOS, BiCMOS, Silicon Germanium

Power CMOS

0.25 micron

Chandler, Arizona  

Microcontrollers

Power management

Embedded processors

 

200 mm wafers

CMOS, embedded NVM, power CMOS

0.18 micron

ATMC, Austin, Texas  

Communications processors

Host processors

Applications processors

Embedded processors

 

200 mm wafers

Advanced CMOS, system-on-a-chip

90 nm

ASSEMBLY & TEST    
Kuala Lumpur, Malaysia  

Communications processors

Host processors

Microcontrollers

Power management

Analog and mixed-signal devices

Radio frequency devices

 
Tianjin, China  

Communications processors Microcontrollers

Power management

Analog and mixed-signal devices

 

 

(1) We have initiated a formal consultation with employees at our Toulouse fabrication facility to close the manufacturing portion of this facility in the first half of 2011.
(2) This manufacturing facility is scheduled to close in the second half of 2011.

Our manufacturing processes require many raw materials, such as silicon wafers, mold compound, packaging substrates and various chemicals and gases, and the necessary equipment for manufacturing. We obtain these materials and equipment from a large number of suppliers located throughout the world. These suppliers deliver products to us on a just-in-time basis, and we believe that they have sufficient supply to meet our current needs, although it is possible that we could experience inadequate supply due to a sudden worldwide surge in demand or supply chain disruption.

Like many global companies, we maintain plans to respond to external developments that may affect our employees, facilities or business operations. Business continuity is very important to us as we strive to ensure reliability of supply to our customers. TS16949 quality standards and our internal quality standards all require a business continuity plan to effectively return critical business functions to normal in the case of an unplanned event, and our operations are certified to all of these standards. We require our major foundries, assembly and test providers and other suppliers to have a business continuity plan as well. However, in the event that our manufacturing capacity, either internal or through contract manufacturers, is disrupted, we could experience difficulty fulfilling customer orders.

 

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Our business continuity plan covers issues related to continuing operations (for example, continuity of manufacturing and supply to customers), crisis management of our business sites (for example, prevention and recovery from computer, data, hardware and software loss) and information protection. We perform annual risk assessments at each site, reviewing activities, scenarios, risks and actual events and conduct annual test drills. Generally, we maintain multiple sources of supply of qualified technologies. We also audit our suppliers’ compliance with their plans.

Competition

The semiconductor industry is highly competitive and characterized by constant and rapid technological change, short product lifecycles, significant price erosion and evolving standards. Although few companies compete with us in all of our product areas, our competitors range from large, international companies offering a full range of products to smaller companies specializing in narrow markets within the semiconductor industry. The competitive environment is also changing as a result of increased alliances among our competitors and through strategic acquisitions. Our competitors may have greater financial, personnel and other resources than we have in a particular market or overall. We expect competition in the markets in which we participate to continue to increase as existing competitors improve or expand their product offerings or as new participants enter our markets. Increased competition may result in reduced profitability and reduced market share.

We compete in our different product lines primarily on the basis of price, technology offered, product features, warranty, quality and availability of service, time-to-market and reputation. Our ability to develop new products to meet customer requirements and to meet customer delivery schedules are also critical factors. New products represent the most significant opportunity to overcome the increased competition and pricing pressure inherent in the semiconductor industry.

Our primary competitors are other integrated device manufacturers, such as Infineon Technologies AG, Intel Corporation, Renesas Technology Corporation (expected to complete merger with NEC Electronics Corporation), STMicroelectronics, Microchip Technology Incorporated, Atmel Corporation, Analog Devices Incorporated, Cavium Networks, Inc., Texas Instruments Incorporated and Broadcom Corporation.

Products and Applications

We design, develop, manufacture and market a broad range of semiconductor products that are based on our core capabilities in embedded processing. In addition, we offer customers differentiated products that complement our embedded processors, such as sensors, radio frequency semiconductors, and power management and other analog and mixed-signal semiconductors. Our capabilities enable us to offer customers a broad range of product offerings, from individual devices to platform-level products that combine semiconductors with software for a given application.

During 2008 and continuing in 2009, we refined our strategy and narrowed our focus on the markets in which we intend to invest going forward. Within our automotive business, we expect to continue to invest in our core legacy markets, including body electronics, chassis and safety and powertrain systems, where we have market leadership positions in microcontrollers, analog and sensor products. We also intend to focus on expected growth opportunities in the automotive industry, including hybrid and electric vehicles and driver information systems. Within our networking business, we expect to continue to invest in our core legacy markets, including wireless infrastructure and enterprise networking, where we have market leadership positions in communications processors, applications processors and digital signal processors. In addition, we intend to pursue expected networking growth opportunities in the broadband and telecommunications markets. We plan to leverage our product portfolio beyond our core automotive and networking markets into targeted industrial and consumer markets as well, where we believe significant growth opportunities exist in smart mobile devices (such as “smartbooks”), electronic reading devices, smart energy, appliance control, factory automation and medical markets. This effort includes networking products for broadband triple play services to the small office/home office space, the i.MX family of applications processor to manage complex processing requirements for portable consumer multimedia and computing devices, and our power management products to help maintain the performance and efficient power usage of digital still cameras, appliances and converging multimedia devices. In addition to these consumer and industrial growth markets, we currently have a significant presence in certain other consumer and industrial markets, including appliance and energy conversion, smartphones and mobile devices in emerging markets, where we plan to continue to extend our position. In order to achieve our goals of establishing and advancing our positions in these markets, we will be utilizing the technologies, software and product portfolio offered in the three product design groups described in the following discussion.

Microcontroller Solutions

Overview

Microcontroller Solutions product offerings include the key components of embedded control systems. These components include embedded processors, specifically microcontrollers and embedded microprocessors. We provide comprehensive product offerings, including development tools, application support, training, documentation and platforms.

Embedded control systems are found in a number of applications. For example, Microcontroller Solutions products can serve as the “brains” of automotive control systems, from wipers that respond to the intensity of rainfall to engine management systems that

 

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have reduced exhaust emissions and fuel consumption while giving drivers enhanced performance. In smart energy meters, Microcontroller Solutions products help in energy conservation and reduce greenhouse emissions through load shifting and improved transparency between utilities and their customers. They can drive energy and water usage reduction in modern appliances through monitoring of the load condition. Our Microcontroller Solutions products measure glucose level and blood pressure in portable medical equipment and control robots and motors on manufacturing lines. They are also found in homes in places such as remote controls, microwave ovens, thermostats, as well as gaming and general-purpose toys.

Primary application areas for Microcontroller Solutions products include:

 

   

automotive (for use in airbags, anti-lock braking systems, comfort, engine management, vehicle stability control, instrument cluster, and entertainment / communications systems);

 

   

consumer (for use in alarm systems, home appliances, remote controls, toys and other electronic devices);

 

   

industrial (for use in electronic motor control drive, power conversion, manufacturing process control, test and measurement equipment, building control, lighting, heating, ventilation and air conditioning (“HVAC”), and point-of-sale equipment); and

 

   

computer peripherals (for use in displays, keyboards, mice, printers and other peripherals).

Market Opportunity

Microcontroller Solutions addresses the markets for microcontrollers as well as portions of the embedded microprocessor market. Automotive, industrial, consumer and computer peripherals are the primary application areas for Microcontroller Solutions’ products.

The automotive industry currently represents the largest portion of Microcontroller Solutions sales. Semiconductor demand in this market is driven by vehicle production and the increasing electronic content in vehicles, particularly in the areas of safety, powertrain management, comfort and entertainment features. The desire to reduce fuel consumption and emissions drives demand in powertrain management. Instrument clusters are becoming more sophisticated, requiring high performance graphics capability. The increasing demand for advanced safety systems, such as vehicle dynamics control, as well as radar and vision systems, also impacts demand in this market.

We believe the industrial, consumer and computer peripheral industries also represent market opportunities for Microcontroller Solutions. Our Microcontroller Solutions strategy is to expand our portfolio of both general purpose and application specific products for the industrial, consumer and computer peripheral markets.

Principal Products

 

   

Microcontrollers. Microcontrollers are computers on a chip, integrating all the major components of a computing system onto a single integrated circuit. Microcontrollers are the “brains” of many electronic applications, controlling electrical equipment or analyzing sensor inputs. We offer 8-bit, 16-bit and 32-bit microcontrollers, as well as digital signal controllers.

 

   

Embedded Microprocessors. Embedded microprocessors are very similar to microcontrollers except that they do not integrate the memory storing the software program. Examples of applications using our embedded microprocessors include automotive telematics systems (which combine computing capabilities with wireless systems), printers and industrial control systems.

Networking and Multimedia

Overview

Networking and Multimedia product offerings include embedded processors for the wired and wireless networking, industrial and consumer markets. We offer systems solutions that facilitate the transmission, switching and processing of data and voice signals. Our products are used in a variety of types of networking and multimedia equipment, including:

 

   

wireless infrastructure equipment (such as cellular base stations);

 

   

network communications equipment (such as switches and routers for data and voice traffic);

 

   

network access equipment (such as media gateways);

 

   

pervasive computing equipment (such as networked storage, gaming, printing, imaging and multimedia devices);

 

   

industrial applications (such as automated vehicles, robotics and ATM machines); and

 

   

mobile consumer applications (such as portable media players, smart mobile devices (such as “smartbooks”), electronic reading devices, and in-car infotainmet).

 

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Market Opportunity

As the number and types of devices that access the network continue to expand in conjunction with the proliferation of multimedia applications, the demand for bandwidth also expands. The move to a converged, information-based network is expected to be accompanied by an increased demand for high performance, low power, secure processing at each node in the network. Media agnostic processing nodes that are capable of making wire speed decisions on traffic classification, prioritization, security and routing, etc. are designed to enable this level of performance. We target emerging markets that are focused on the mobile and wireless consumer, industrial and automotive devices and systems, smart mobile devices (such as “smartbooks”), electronic reading devices and other consumer devices.

Principal Products

 

   

Networking Processors. We provide highly-integrated single and multi-core networking processors that perform tasks related to control and manipulation of data, as well as network interfaces. Our networking processors include our PowerQUICC ™ and QorIQ™ families of processor products. We also provide our customers with software and tools to help them meet their performance, cost and time-to-market objectives. We sell our networking processors primarily for use in wired and wireless network access equipment, enterprise switching and routing equipment, industrial equipment and small business / customer premises equipment. We also sell networking processors to customers for control and processing functions in a variety of media and data storage applications, as well as for applications requiring security features that we enable through our encryption technology and our VortiQa security application software.

 

   

Digital Signal Processors. Digital signal processors are special-purpose processors designed to handle parallel arithmetic and algorithmically intensive applications in real time. Our digital signal processors used in networking applications provide the very high levels of data analysis required for wireless / wireline infrastructure, voice / audio and video processing. In these applications the digital signal processor is used to analyze and transform the data from analog input sources (cellular RF signals, HD video streams and audio / voice streams) into data packets that can be appropriately handled and managed in core IP networks. Our digital signal processors are used in a variety of applications such as wireless network basestations, wireline media gateways, video conferencing and transmission systems, as well as audio / video receivers.

 

   

Multimedia Application Processors. Our multimedia application processors are used in a variety of devices such as portable media players and computing devices, personal video and navigation devices, cellular phones and in-car infotainment, smart mobile devices (such as “smartbooks”) and electronic reading devices known as “eBooks”. Application processors provide the processing required to enable high-level operating systems and rich multimedia functionality, such as the encoding, decoding and display of audio, video and image content.

Radio Frequency, Analog and Sensors

Overview

Radio Frequency, Analog and Sensors products include analog and mixed-signal integrated circuits, sensors, and radio frequency devices. Our sensor devices and analog and mixed signal integrated circuits serve as the interface between the outside world and the embedded systems. Our radio frequency products are high power radio frequency devices used in cellular base transceiver stations and other industrial, scientific and medical applications. These products complement our portfolio of microcontrollers and microprocessors.

Market Opportunity

Radio Frequency, Analog and Sensors’ product portfolio targets the markets for radio frequency, analog and mixed-signal semiconductors. Automotive, industrial, consumer, wireless, networking and computer peripherals are the primary application areas for Radio Frequency, Analog and Sensors’ products.

Principal Products

 

   

Analog and Mixed-Signal Integrated Circuits. Our analog and mixed-signal integrated circuits perform one or more of a number of functions, including driving actuators (such as motors, valves, lights and speakers), providing power to the electronic components in a system, filtering or amplifying signals and providing the voltage and current for communications devices. These integrated circuits combine logic, analog, audio and power circuits.

 

   

Sensors. We provide three primary categories of semiconductor-based sensors: pressure sensors, inertial sensors and proximity sensors. Pressure sensors measure the pressure of gases or liquids. For example, automotive engine management systems require the measurement of air pressure to optimize the combustion process. Other applications include blood pressure measurement, water level sensing in washing machines and tire pressure monitoring systems. Inertial sensors measure acceleration and gravitational fields. Common applications for inertial sensors are airbag systems to detect crashes and vehicle stability control systems to prevent crashes. Low-g inertial sensors can be used for

 

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non-automotive applications, such as measuring the vibration of washing machines, gauging running speed and distance in running shoes, or detecting “free fall” in handheld devices to trigger mechanisms that protect disc drives. Proximity sensors use electric fields to detect nearby objects. Touch pads are a typical application.

 

   

Radio Frequency Devices. These products amplify radio frequency signals in preparation for transmission over a wireless network or for alternative high power energy transmission. We sell radio frequency devices primarily to transmit and receive signals in wireless infrastructure products, which include 2G, 2.5G, and 3G cellular base transceiver stations. Our radio frequency devices for wireless infrastructure applications include base station integrated circuit drivers, base station module pre-drivers, and radio frequency high-power transistors. In addition, our radio frequency devices have applications in broadcast transmission, scientific markets, avionics, and high powered medical systems.

Other

In 2008, we announced plans to wind-down our cellular handset business. Historically, product offerings in our cellular handset business included baseband processors, power management integrated circuits, radio frequency subsystems and platform-level products (integrated semiconductor components with core operating software). Although we are in the process of winding-down these product offerings, in the near term we expect to provide products to our existing cellular customers. We expect the revenue associated with our cellular products to continue declining over time.

Backlog

Our backlog was $1.0 billion at December 31, 2009 compared to $0.7 billion at December 31, 2008. Orders are placed by customers for delivery for up to as much as 12 months in the future, but for purposes of calculating backlog, only the next 13 weeks’ requirements are reported. An order is removed from the backlog only when the product is shipped, the order is cancelled or the order is rescheduled beyond the 13-week delivery window used for backlog reporting. In the semiconductor industry, backlog quantities and shipment schedules under outstanding purchase orders are frequently revised in response to changes in customer needs. Typically, agreements calling for the sale of specific quantities at specific prices are contractually subject to price or quantity revisions and are, as a matter of industry practice, rarely formally enforced. Therefore, we believe that most of our order backlog is cancelable. For these reasons, the amount of backlog as of any particular date is not an accurate indicator of future results.

Environmental Matters

For a discussion of the material effects of compliance with environmental laws, please see the “Environmental Matters” discussion in “Item 3: Legal Proceedings.”

Employees

As of December 31, 2009 we employed approximately 18,000 full-time employees. None of our U.S. employees are represented by labor unions. A portion of our non-U.S. employees are represented by labor unions or work councils. We consider relations with our employees to be satisfactory.

 

Item 1A: Risk Factors

Set forth below and elsewhere in this report and in other documents we file with the Securities and Exchange Commission are risks and uncertainties that could cause our actual results to materially differ from the results contemplated. Additional risks and uncertainties not presently known to us, or that we currently deem immaterial, may also impair our business operations.

Risks Related to Our Business

The continuing pressure on the global credit and financial markets could materially and adversely affect our business and results of operations.

As widely reported, global credit and financial markets have been experiencing extreme disruptions since the second half of 2008, including severely diminished liquidity and credit availability, volatility in consumer confidence, declines in economic growth, increases in unemployment rates, and uncertainty about economic stability. We cannot assure you that there will not be further deterioration in credit and financial markets and confidence in economic conditions. These economic uncertainties affect businesses such as ours in a number of ways, making it difficult to accurately forecast and plan our future business activities. The current tightening of credit in financial markets may lead consumers and businesses to postpone spending, which may cause our customers to cancel, decrease or delay their existing and future orders with us. In addition, financial difficulties experienced by our suppliers or distributors could result in product delays, increased accounts receivable defaults and inventory challenges. Government stimulus programs for the automotive industry and other industries that we service may increase the volatility of demand for our products. Our ability to incur additional indebtedness to fund operations or refinance maturing obligations as they become due may be constrained. We are unable to predict the likely duration and severity of the current disruptions in the credit and financial markets and adverse

 

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global economic conditions, and if the current uncertain economic conditions continue or further deteriorate, our business and results of operations could be materially and negatively affected.

Our operating results may be adversely affected if economic conditions impact the financial viability of our customers, distributors, or suppliers, particularly in the automotive industry.

We regularly review the financial performance of our customers, distributors and suppliers. However, global economic conditions may adversely impact the financial viability of and increase the credit risk associated with our customers, distributors or suppliers. Customer insolvencies in key industries most affected by the economic downturn, such as the automotive industry, or the financial failure of a large customer or distributor, an important supplier, or a group thereof, could have an adverse impact on our operating results and could result in our inability to collect our accounts receivable balances.

The loss of one or more of our significant customers or a decline in demand from one or more of these customers could have a material negative impact on net sales.

Historically, we have relied on a limited number of customers for a substantial portion of our total sales. Our ten largest end customers accounted for approximately 46% of our net sales in 2009. As a result, the loss of or a reduction in demand from one or more of these customers, either as a result of industry conditions or specific events relating to a particular customer, could have a material negative impact on net sales. During 2009, our largest customer was Continental Automotive, with revenues of approximately 11% of our total net sales, followed by Motorola, with revenues of approximately 10% of our total net sales (in 2008, revenue from Motorola approximated 23% of our total net sales). As described elsewhere is this Annual Report on Form 10-K, we expect revenues from Motorola to continue to decline commensurate with our decision to wind-down the cellular handset business. No other customer represented more than 10% of our total net sales in 2009.

We operate in the highly cyclical semiconductor industry, which is subject to significant downturns.

The semiconductor industry is highly cyclical and is characterized by constant and rapid technological change, rapid product obsolescence and price erosion, evolving standards, short product life-cycles and fluctuations in product supply and demand. The industry has experienced significant downturns, often in connection with, or in anticipation of, maturing product cycles of both semiconductor companies’ and their customers’ products and declines in general economic conditions. These downturns have been characterized by diminished product demand, production overcapacity, higher inventory levels and accelerated erosion of average selling prices. We have experienced these conditions in our business in the past, are currently experiencing these conditions and may experience such downturns in the future. We may not be able to effectively respond to this or future downturns which could have a material negative impact on our business, financial condition and results of operations.

In difficult market conditions, our high fixed costs combined with potentially lower revenues may negatively impact our results.

The semiconductor industry is characterized by high fixed costs and, notwithstanding our utilization of third-party contract manufacturers, most of our production requirements are met by our own manufacturing facilities. During periods of reduced demand, we are generally faced with a decline in the utilization rates of our manufacturing facilities due to decreases in product demand. During such periods, our fabrication plants do not operate at full capacity and the costs associated with this excess capacity are charged directly to cost of sales. The market conditions in the future may continue to adversely affect our utilization rates and consequently our future gross margins, and this, in turn, could have a material negative impact on our business, financial condition and results of operations.

Our operating results are subject to substantial quarterly and annual fluctuations.

Our revenues and operating results have fluctuated in the past and are likely to fluctuate in the future. These fluctuations are due to a number of factors, many of which are beyond our control. These factors include, among others:

 

   

changes in end-user demand for the products manufactured and sold by our customers;

 

   

the timing of receipt, reduction or cancellation of significant orders by customers;

 

   

fluctuations in the levels of component inventories held by our customers;

 

   

the gain or loss of significant customers;

 

   

market acceptance of our products and our customers’ products;

 

   

our ability to develop, introduce and market new products and technologies on a timely basis;

 

   

the timing and extent of product development costs;

 

   

new product and technology introductions by competitors;

 

   

fluctuations in manufacturing yields;

 

   

availability and cost of products from our suppliers;

 

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changes in our product mix or customer mix;

 

   

intellectual property disputes;

 

   

natural disasters, such as floods, hurricanes and earthquakes, as well as interruptions in power supply resulting therefrom or due to other causes;

 

   

loss of key personnel or the shortage of available skilled workers;

 

   

the effects of competitive pricing pressures, including decreases in average selling prices of our products;

 

   

the effects of adverse economic conditions in the United States and international markets, including the current crisis in global credit and financial markets;

 

   

the effectiveness of our efforts to refocus our operations and reduce our cost structure;

 

   

manufacturing, assembly and test capacity; and,

 

   

our ability to hire, retain and motivate key employees to meet the demands of our customers.

The foregoing factors are difficult to forecast, and these, as well as other factors, could have a material negative impact on our quarterly or annual operating results. In addition, a significant amount of our operating expenses is relatively fixed in nature due to our research and development and manufacturing costs. If we cannot adjust spending quickly enough to compensate, it could have a material negative impact on our business, financial condition and results of operations.

Winning business is subject to a competitive selection process that can be lengthy and requires us to incur significant expense, and we may not be selected. Even after we win and begin a product design, a customer may decide to cancel or change its product plans, which could cause us to generate no sales from a product and adversely affect our results of operations.

Our primary focus is on winning competitive bid selection processes, known as “design wins,” to develop products for use in our customers’ equipment. These selection processes can be lengthy and can require us to incur significant design and development expenditures. We may not win the competitive selection process and may never generate any revenue despite incurring significant design and development expenditures. Because of the rapid rate of technological change, the loss of a design win could result in our failure to offer a generation of a product. In addition, the failure to offer a generation of a product to a particular customer could prevent access to that customer for several years. The risks are particularly pronounced in the automotive market, where there are longer design cycles. Our failure to win a sufficient number of designs could result in lost sales and hurt our competitive position in future selection processes because we may not be perceived as being a technology or industry leader, each of which could have a material negative impact on our business, financial condition and results of operations.

After winning a product design for one of our customers, we may still experience delays in generating revenue from our products as a result of the lengthy development and design cycle. In addition, a delay or cancellation of a customer’s plans could significantly and adversely affect our financial results, as we may have incurred significant expense and generated no revenue. Finally, if our customers fail to successfully market and sell their equipment, it could have a material negative impact on our business, financial condition and results of operations as the demand for our products falls.

We have become dependent on third-party contract manufacturing relationships as part of our asset-light strategy. If our production or manufacturing capacity at one of these facilities is delayed, interrupted or eliminated, we may not be able to satisfy customer demand.

We continue to develop outsourcing arrangements for the manufacture and test and assembly of certain products and components. Based on total units produced, we outsourced approximately 23% of our wafer fabrication and approximately 43% of our assembly, packaging and testing in 2009. As a result, we are relying on the utilization of third-party contract manufacturers and assembly and test capacity. If production or manufacturing capacity is delayed, reduced or eliminated at one or more facilities, with fewer alternative facilities, manufacturing could be disrupted, we could have difficulties or delays in fulfilling our customer orders, and our sales could decline. In addition, if a third-party contract manufacturer fails to deliver quality products and components on time and at reasonable prices, we could have difficulties fulfilling our customer orders, and our sales could decline. As a result, our business, financial condition and results of operations could be adversely affected.

To the extent we rely on alliances and third-party design and/or manufacturing relationships, we face the following risks:

 

   

reduced control over delivery schedules and product costs;

 

   

manufacturing costs that are higher than anticipated;

 

   

inability of our manufacturing partners to develop manufacturing methods and technology appropriate for our products and their unwillingness to devote adequate capacity to produce our products;

 

   

decline in product reliability;

 

   

inability to maintain continuing relationships with our suppliers; and

 

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restricted ability to meet customer demand when faced with product shortages.

In addition, purchasing rather than manufacturing these products may adversely affect our gross profit margin if the purchase costs of these products become higher than our own manufacturing costs would have been. Our internal manufacturing costs include depreciation and other fixed costs, while costs for products outsourced are based on market conditions. Prices for foundry products also vary depending on capacity utilization rates at our suppliers, quantities demanded, product technology and geometry. Furthermore, these outsourcing costs can vary materially from quarter-to-quarter and, in cases of industry shortages, they can increase significantly, negatively impacting our gross margin.

If any of these risks are realized, we could experience an interruption in our supply chain or an increase in costs, which could delay or decrease our revenue or adversely affect our business, financial condition and results of operations.

If we fail to keep pace with technological advances in our industry and associated manufacturing processes, or if we pursue technologies that do not become commercially accepted, our products may not be as competitive, our customers may not buy our products and our business, financial condition and results of operations may be adversely affected.

Technology and associated manufacturing processes are an important component of our business and growth strategy. Our success depends to a significant extent on the development, implementation and acceptance of new product designs and improvements. Commitments to develop new products must be made well in advance of any resulting sales. Technologies, standards or manufacturing processes may change during development, potentially rendering our products outdated or uncompetitive before their introduction. Our ability to develop products and related technologies to meet evolving industry requirements and at prices acceptable to our customers will be significant factors in determining our competitiveness in our target markets. If we are unable to successfully develop new products, our revenues may decline and our business could be negatively impacted.

We face significant competitive pressures that may cause us to lose market share and harm our financial performance.

The semiconductor industry is highly competitive and characterized by constant and rapid technological change, short product lifecycles, significant price erosion and evolving standards. Our growth objectives depend on competitive success and increased market share in our markets. If we fail to keep pace with the rest of the semiconductor industry, we could lose market share in the markets in which we compete. Any such loss in market share could have a material negative impact on our financial condition and results of operations.

Although few companies compete with us in all of our product areas, our competitors range from large, international companies offering a full range of products to smaller companies specializing in narrow markets within the semiconductor industry. The competitive environment is also changing as a result of increased alliances among our competitors and through strategic acquisitions. Our competitors may have greater financial, personnel and other resources than we have in a particular market or overall. We expect competition in the markets in which we participate to continue to increase as existing competitors improve or expand their product offerings or as new participants enter our markets. Increased competition may result in reduced profitability and reduced market share.

We compete in our different product lines primarily on the basis of price, technology offered, product features, warranty, quality and availability of service, time-to-market and reputation. Our ability to develop new products to meet customer requirements and to meet customer delivery schedules are also critical factors. New products represent the most important opportunity to overcome the increased competition and pricing pressure inherent in the semiconductor industry. If we are unable to keep pace with technology changes, our market share could decrease and our business would be adversely affected.

The demand for our products depends in large part on continued growth in the industries into which they are sold. A market decline in any of these industries, or particular products in those industries, could have a material negative impact on our results of operations.

Our growth is dependent, in part, on end-user demand for our customers’ products. Any industry downturns that adversely affect our customers or their customers, including increases in bankruptcies in relevant industries, could adversely affect end-user demand for our customers’ products, which would adversely affect demand for our products.

Growth in demand in the markets we serve has in the past and may in the future fluctuate significantly based on numerous factors, including:

 

   

capital spending levels of our networking customers;

 

   

consumer spending;

 

   

worldwide automotive production levels;

 

   

rate of adoption of new or alternative technologies;

 

   

changes in consumer preferences;

 

   

changes in regulation of products and services provided; and

 

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general economic conditions.

The rate, or extent to which, the industries we serve will grow, if at all, is uncertain. In addition, there can be no assurance that particular products within these industries will experience the growth in demand that we expect. The industries we serve are currently experiencing weak general economic conditions, which could result in slower growth or a decline in demand for our products, which could have a material negative impact on our business, financial condition and results of operations. Furthermore, government stimulus programs for the automotive industry and other industries that we service may increase the volatility of demand for our products.

Our automotive customer base is comprised largely of suppliers to U.S. and European automotive manufacturers. Light vehicle production by the Big 3 U.S. automakers declined significantly in 2008 and continued to be below historical levels in 2009. Shifts in demand away from U.S. and European automotive manufacturers or continued lower demand for U.S. and European automobiles could adversely affect our sales.

The specific products in which our semiconductors are incorporated may not be successful, or may experience price erosion or other competitive factors that affect the prices manufacturers are willing to pay us. Such customers may vary order levels significantly from period to period, request postponements to scheduled delivery dates, modify their orders or reduce lead times. This is particularly common during times of low demand for those end products. This can make managing our business difficult, as it limits our ability to effectively predict future demand. Furthermore, projected industry growth rates may not be as forecast, resulting in spending on process and product development well ahead of market requirements, which could have a material negative impact on our business, financial condition and results of operations.

We may be subject to claims of infringement of third-party intellectual property rights or demands that we license third-party technology, which could result in significant expense and impair our freedom of operation.

We depend significantly on patents and other intellectual property rights to protect our products and proprietary design and fabrication processes against infringement or misappropriation by others. From time to time, third parties may and do assert against us their patent, copyright, trademark and other intellectual property rights relating to technologies that are important to our business. Any claims that our products or processes infringe these rights (including claims arising through our contractual indemnification of our customers), regardless of their merit or resolution, could be costly and may divert the efforts and attention of our management and technical personnel. We may not prevail in such proceedings given the complex technical issues and inherent uncertainties in intellectual property litigation. If such proceedings result in an adverse outcome, we could be required to:

 

   

pay substantial damages (potentially treble damages in the United States);

 

   

cease the manufacture, use or sale of the infringing products or processes;

 

   

discontinue the use of the infringing technology;

 

   

expend significant resources to develop non-infringing technology;

 

   

license technology from the third party claiming infringement, which license may not be available on commercially reasonable terms, or may not be available at all;

 

   

comply with the terms of import restrictions imposed by the International Trade Commission, or similar administrative or regulatory authority; or

 

   

forego the opportunity to license our technology to others or to collect royalty payments based upon successful protection and assertion of our intellectual property against others.

Our use of intellectual property rights is subject to license agreements, some of which contain provisions that may require the consent of the counterparties to remain in effect after a change of control. If we are unable to obtain any required consents under any material license agreements, our rights to use intellectual property licensed under those agreements may be at risk.

Any of the foregoing could affect our ability to compete or have a material negative impact on our business, financial condition and results of operations.

We may not be successful in protecting our intellectual property rights or developing or licensing new intellectual property, which may harm our ability to compete and may have a material negative impact on our results of operations.

We depend heavily on our rights to protect our technology from infringement and to ensure that we have the ability to generate royalty and other licensing revenues. Revenues are generated from the license of patents and manufacturing technologies to third parties. Our future intellectual property revenues depend in part on the continued strength of our intellectual property portfolio and enforcement efforts, and on the sales and financial stability of our licensees. We rely primarily on patent, copyright, trademark and trade secret laws, as well as on nondisclosure and confidentiality agreements and other methods, to protect our proprietary technologies. In the past, we have found it necessary to engage in litigation with other companies to force those companies to execute revenue-bearing license agreements with us or prohibit their use of our intellectual property. Some of these proceedings did, and

 

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future proceedings may, require us to expend significant resources and to divert the efforts and attention of our management from our business operations. In connection with our intellectual property:

 

   

the steps we take to prevent misappropriation or infringement of our intellectual property may not be successful;

 

   

our existing or future patents may be challenged, limited, invalidated or circumvented; and

 

   

the measures described above may not provide meaningful protection.

Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use our technology without authorization, develop similar technology independently or design around our patents. Our trade secrets may be vulnerable to disclosure or misappropriation by employees, contractors and other persons. Further, we may not be able to obtain patent protection or secure other intellectual property rights in all the countries in which we operate, and under the laws of such countries, patents and other intellectual property rights may be unavailable or limited in scope. If any of our patents fails to protect our technology, it would make it easier for our competitors to offer similar products. Any inability on our part to protect adequately our intellectual property may have a material negative impact on our business, financial condition and results of operations.

Our business, financial condition and results of operations could be adversely affected by the political and economic conditions of the countries in which we conduct business and other factors related to our international operations.

We sell our products throughout the world. In 2009, 77% of our products were sold in countries other than the United States. In addition, a majority of our operations and employees are located outside of the United States. Multiple factors relating to our international operations and to particular countries in which we operate could have a material negative impact on our business, financial condition and results of operations. These factors include:

 

   

negative economic developments in economies around the world and the instability of governments, including the threat of war, terrorist attacks, epidemic or civil unrest;

 

   

adverse changes in laws and governmental policies, especially those affecting trade and investment;

 

   

pandemics, such as the flu, which may adversely affect our workforce as well as our local suppliers and customers;

 

   

import or export licensing requirements imposed by governments;

 

   

foreign currency exchange and transfer restrictions;

 

   

differing labor standards;

 

   

differing levels of protection of intellectual property;

 

   

the threat that our operations or property could be subject to nationalization and expropriation;

 

   

varying practices of the regulatory, tax, judicial and administrative bodies in the jurisdictions where we operate; and

 

   

potentially burdensome taxation and changes in foreign tax laws.

International conflicts are creating many economic and political uncertainties that are impacting the global economy. A continued escalation of international conflicts could severely impact our operations and demand for our products.

In certain of the countries where we sell our products, effective protections for patents, trademarks, copyrights and trade secrets may be unavailable or limited in nature and scope. In addition, as we target increased sales in Asia, differing levels of protection of our intellectual property in Asian countries could have a significant impact on our business. As a result, the laws, the enforcement of laws, or our efforts to obtain and enforce intellectual property protections in any of these jurisdictions may not be sufficient to protect our intellectual property.

A majority of our products are manufactured in Asia, primarily in China, Japan, Malaysia and Taiwan. Any conflict or uncertainty in these countries, including due to public health or safety concerns or natural disasters (such as earthquakes), could have a material negative impact on our business, financial condition and results of operations. In addition, if the government of any country in which our products are manufactured or sold sets technical standards for products made in or imported into their country that are not widely shared, it may lead certain of our customers to suspend imports of their products into that country, require manufacturers in that country to manufacture products with different technical standards and disrupt cross-border manufacturing partnerships which, in each case, could have a material negative impact on our business, financial condition and results of operations.

Our ability to meet customer demand depends, in part, on our production capacity, on obtaining supplies, a number of which are obtained from a single source, and on forecasting future demand; and a reduction or disruption in our production capacity or our supplies or an incorrect forecast could negatively impact our business.

Demand for our products is subject to significant fluctuation. If we overestimate demand, we may experience underutilized capacity and excess inventory levels. If we underestimate demand, we may miss sales opportunities and incur additional costs for labor overtime, equipment overuse and logistical complexities. Additionally, our production capacity could be affected by

 

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manufacturing problems. Difficulties in the production process could reduce yields or interrupt production, and, as a result of such problems, we may not be able to deliver products on time or in a cost-effective, competitive manner. As the complexity of both our products and our fabrication processes has become more advanced, manufacturing tolerances have been reduced and requirements for precision have become more demanding. We have in the past experienced manufacturing difficulties that have given rise to delays in delivery and quality control problems. Our failure to adequately manage our capacity could have a material negative impact on our business, financial condition and results of operations.

Furthermore, we may suffer disruptions in our manufacturing operations, either due to production difficulties such as those described above or as a result of external factors beyond our control. We use highly combustible materials such as silane and hydrogen in our manufacturing processes and are therefore subject to the risk of explosions and fires, which can cause significant disruptions to our operations. These can occur even in the absence of any fault on our part. If operations at a manufacturing facility are interrupted, we may not be able to shift production to other facilities on a timely basis or at all. In addition, certain of our products are only capable of being produced at a single manufacturing facility and to the extent that any of these facilities fail to produce these products, this risk will be increased. Even if a transfer is possible, transitioning production of a particular type of semiconductor from one of our facilities to another can take between six to twelve months to accomplish, and in the interim period we would likely suffer significant or total supply disruption and incur substantial costs. Such an event could have a material negative impact on our business, financial condition and results of operations. In the third quarter of 2009 and in connection with our decision to eliminate our 150mm manufacturing capability, we began the process of transitioning certain technologies to our other manufacturing facilities and contract manufacturers.

Our ability to meet customer demands also depends on our ability to obtain timely and adequate delivery of materials, parts and components from our suppliers. From time to time, suppliers may extend lead times, limit the amounts supplied to us or increase prices due to capacity constraints or other factors. Supply disruptions may also occur due to shortages in critical materials, such as silicon wafers or specialized chemicals, or energy or other general supplier disruptions. We have experienced shortages in the past that have adversely affected our operations. Although we work closely with our suppliers to avoid these types of shortages, we may encounter these problems in the future. In addition, a number of our supplies are obtained from a single source. A reduction or interruption in supplies or a significant increase in the price of one or more supplies could have a material negative impact on our business, financial condition and results of operations.

We may engage in acquisitions, joint ventures and other transactions intended to complement or expand our business. We may not be able to complete these transactions and, if executed, these transactions pose significant risks and could have a negative effect on our operations.

Our future success may be dependent on opportunities to enter into joint ventures and to buy other businesses or technologies that could complement, enhance or expand our current business or products or that might otherwise offer us growth opportunities. If we are unable to identify suitable targets, our growth prospects may suffer, and we may not be able to realize sufficient scale advantages to compete effectively in all markets. In addition, in pursuing acquisitions, we may face competition from other companies in the semiconductor industry. Our ability to acquire targets may also be limited by applicable antitrust laws and other regulations in the United States, the European Union and other jurisdictions in which we do business. To the extent that we are successful in making acquisitions, we may have to expend substantial amounts of cash, incur debt, assume loss-making divisions and incur other types of expenses. We may not be able to complete such transactions, for reasons including, but not limited to, a failure to secure financing or as a result of restrictive covenants in our debt instruments. Any transactions that we are able to identify and complete may involve a number of risks, including:

 

   

the diversion of our management’s attention from our existing business to integrate the operations and personnel of the acquired or combined business or joint venture;

 

   

possible negative impacts on our operating results during the integration process; and

 

   

our possible inability to achieve the intended objectives of the transaction.

In addition, we may not be able to successfully or profitably integrate, operate, maintain and manage our newly acquired operations or employees. We may not be able to maintain uniform standards, controls, procedures and policies, and this may lead to operational inefficiencies.

We are subject to environmental, health and safety laws, which could increase our costs and restrict our operations in the future.

Our operations are subject to a variety of environmental laws and regulations in each of the jurisdictions in which we operate governing, among other things, air emissions, wastewater discharges, the use, handling and disposal of hazardous substances and wastes, soil and groundwater contamination and employee health and safety. We could incur significant costs as a result of any failure by us to comply with, or any liability we may incur under, environmental, health and safety laws and regulations, including the limitation or suspension of production, monetary fines or civil or criminal sanctions, clean-up costs or other future liabilities in excess of our reserves. We are also subject to laws and regulations governing the recycling of our products, the materials that may be included in our products, and our obligation to dispose of our products at the end of their useful life. For example, the European Directive 2002/95/Ec on restriction of hazardous substances (“RoHS”), bans the placing on the

 

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EU market of new electrical and electronic equipment containing more than specified levels of lead, and other hazardous compounds. As more countries enact requirements like the RoHS Directive, and as exemptions are phased out, we could incur substantial additional costs to convert the remainder of our portfolio, conduct required research and development, alter manufacturing processes, or adjust supply chain management. Such changes could also result in significant inventory obsolescence. In addition, compliance with environmental, health and safety requirements could restrict our ability to expand our facilities or require us to acquire costly pollution control equipment, incur other significant expenses or modify our manufacturing processes. In the event of the discovery of new or previously unknown contamination, additional requirements with respect to existing contamination, or the imposition of other cleanup obligations for which we are responsible, we may be required to take remedial or other measures which could have a material negative impact on our business, financial condition and results of operations.

In addition to the costs of complying with environmental, health and safety requirements, we have incurred and may in the future incur costs defending against environmental litigation brought by government agencies and private parties. We have been and may be in the future defendants in lawsuits brought by parties in the future alleging environmental damage, personal injury or property damage. A significant judgment against us could harm our business, financial condition and results of operations.

We may be subject to liabilities as a result of personal injury claims based on alleged links between the semiconductor manufacturing process and certain illnesses.

In the last few years, there has been increased media scrutiny and associated reports focusing on an alleged link between working in semiconductor manufacturing clean room environments and certain illnesses, primarily different types of cancers. Because we utilize these clean rooms, we may become subject to liability as a result of claims alleging personal injury. In addition, these reports may also affect our ability to recruit and retain employees. A significant judgment against us could harm our business, financial condition and results of operations.

Our products may be subject to product liability and warranty claims, which could be expensive and could divert management’s attention.

We make highly complex electronic components and, accordingly, there is a risk that defects may occur in any of our products. Such defects may damage our reputation and can give rise to significant costs, including expenses relating to recalling products, replacing defective items, writing down defective inventory, delays in, cancellations of, rescheduling or return of orders or shipments and loss of potential sales. In addition, the occurrence of such defects may give rise to product liability and warranty claims, including liability for damages caused by such defects. If we release defective products into the market, our reputation could suffer and we could lose sales opportunities and become liable to pay damages. Moreover, since the cost of replacing defective semiconductor devices is often much higher than the value of the devices themselves, we may at times face damage claims from customers in excess of the amounts they pay us for our products, including consequential damages.

We also face exposure to potential liability resulting from the fact that our customers typically integrate the semiconductors we sell into numerous consumer products, which are then in turn sold into the marketplace. We may be named in product liability claims even if there is no evidence that our products caused a loss. Product liability claims could result in significant expenses relating to defense costs or damages awards. In particular, the sale of systems and components for the transportation and medical industries involves a high degree of risk that such claims may be made. In addition, we may be required to participate in a recall if any of our systems prove to be defective, or we may voluntarily initiate a recall or make payments related to such claims as a result of various industry or business practices or in order to maintain good customer relationships. Each of these actions would likely harm our reputation and lead to substantial expense. Any product recall or product liability claim brought against us could have a material negative impact on our reputation, business, financial condition and results of operations.

Our industry is highly capital intensive and, if we are unable to obtain the necessary capital, we may not remain competitive.

To remain competitive, we must constantly improve our facilities and process technologies and carry out extensive research and development, each of which requires investment of significant amounts of capital. This risk is magnified by our high level of debt, since we are required to use a significant portion of our cash flow to service that debt, and also because our level of debt limits our ability to raise additional capital. If we are unable to generate sufficient cash or raise sufficient capital to meet both our debt service and capital investment requirements, or if we are unable to raise required capital on favorable terms when needed, our business, financial condition and results of operations could be materially negatively impacted.

Loss of our key management and other personnel, or an inability to attract key management and other personnel, could impact our business.

We depend on our senior executive officers and other key personnel to run our business and on technical experts to develop new products and technologies. Future turnover in these positions or the loss of other key personnel could adversely affect our operations. Competition for qualified employees among companies that rely heavily on engineering and technology is intense, and the loss of qualified employees or an inability to attract, retain and motivate additional highly skilled employees required for the operation and expansion of our business could hinder our ability to conduct research and development activities successfully and develop marketable products. In the technology sector, the use of equity as incentive compensation is an important part of the compensation package for

 

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professionals. Although we maintain an incentive compensation plan, our equity is not publicly traded, which may have a negative impact on our ability to recruit and retain professionals.

We have recorded significant charges for reorganization of business activities, interest expense and amortization expense in the past and may do so again in the future, which could have a material negative impact on our business.

In 2009 and 2008, we recorded restructuring and asset impairment charges relating to our efforts to consolidate manufacturing operations and streamline our global organizational structure in the amount of $345 million and $320 million, respectively. Due to a combination of the constant and rapid change experienced in the semiconductor industry, we may incur employee termination, exit costs and asset impairment charges in the future and such charges may have a material negative impact on our business, financial condition and results of operations.

We have also recorded higher interest expense and amortization expense in connection with the Merger, and as a result, we have incurred net and operating losses since 2006. In addition, we expect to make significant expenditures related to the development of our products, including research and development and sales and administrative expenses. Additionally, we may encounter unforeseen difficulties, complications, product delays and other unknown factors that require additional expenditures. As a result of these increased expenditures, we may have to generate and sustain substantially increased revenue to achieve profitability. Accordingly, we may not be able to achieve or maintain profitability and we may continue to incur significant losses in the future.

From time to time we may also decide to divest certain product lines and businesses or restructure our operations, including through the contribution of assets to joint ventures. However, our ability to successfully extricate ourselves from product lines and businesses, or to close or consolidate operations, depends on a number of factors, many of which are outside of our control. For example, if we are seeking a buyer for a particular product line, none may be available. In addition, we may face internal obstacles to our efforts. In some cases, particularly with respect to our European operations, there may be laws or other legal impediments affecting our ability to carry out such sales or restructuring. As a result, we may be unable to exit a product line or business, or to restructure our operations, in a manner we deem to be advantageous.

We rely on manufacturing capacity located in geologically unstable areas, which could affect the availability of supplies and services.

We, like many companies in the semiconductor industry, rely on internal manufacturing capacity, wafer fabrication foundries and other sub-contractors in geologically unstable locations around the world. This reliance involves risks associated with the impact of earthquakes on us and the semiconductor industry, including temporary loss of capacity, availability and cost of key raw materials, utilities and equipment and availability of key services, including transport of our products worldwide. Any prolonged inability to utilize one of our manufacturing facilities, or those of our subcontractors or third-party wafer fabrication foundries, as a result of fire, natural disaster, unavailability of utilities or otherwise, would have a material negative effect on our results of operations and financial condition.

Risks Related to Indebtedness

Our subsidiaries are highly leveraged. The substantial leverage could adversely affect our ability to raise additional capital to fund our operations, limit our ability to react to changes in the economy or our industry, expose us to interest rate risk to the extent of our variable rate debt and prevent us from meeting our obligations under the notes.

Our subsidiaries are highly leveraged. As of December 31, 2009, the total indebtedness of our subsidiaries was approximately $7,911 million. Our subsidiaries also had an additional $15 million available for borrowing under the senior secured revolving credit facility. In addition, under the Senior PIK-Election Notes due 2014 (“PIK-Election Notes”), our subsidiaries have elected to use the payment-in-kind (“PIK”) feature of the outstanding PIK-Election Notes in lieu of making cash interest payments (“PIK Interest”) through the interest period ending June 15, 2010, and have the option to continue to elect to pay interest in the form of PIK Interest through December 15, 2011. In the event we make a PIK Interest election in each period in which we are entitled to make such an election, our debt will increase by the amount of such interest. We are a guarantor of the indebtedness.

Our subsidiaries elected to use the PIK Interest feature for the interest periods ending on June 15, 2009 and December 15, 2009. As a result, our subsidiaries issued a total of approximately $53 million of incremental PIK-Election Notes in 2009. In addition, our subsidiaries drew down $460 million and $184 million under a senior secured revolving credit facility, net of non-funded commitments by Lehman Commercial Paper, Inc. (“LCPI”), in the fourth quarter of 2008 and first quarter of 2009, respectively. As of December 31, 2009, $15 million was available for borrowing under the senior secured revolving credit facility, net of $31 million of outstanding letters of credit and non-funded commitments by LCPI.

This high degree of leverage could have important consequences, including:

 

   

increasing our vulnerability to adverse economic, industry or competitive developments;

 

   

requiring a substantial portion of cash flow from operations to be dedicated to the payment of principal and interest on the indebtedness, therefore reducing our ability to use cash flow to fund operations, capital expenditures and future business opportunities;

 

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exposing us to the risk of increased interest rates because certain of the borrowings, including borrowings under the senior secured credit facilities and the senior floating rate notes, are at variable rates of interest;

 

   

making it more difficult to satisfy obligations with respect to our indebtedness, and any failure to comply with the obligations of any of our debt instruments, including restrictive covenants and borrowing conditions, could result in an event of default under the agreements governing the indebtedness;

 

   

restricting us from making strategic acquisitions or causing us to make non-strategic divestitures;

 

   

limiting our ability to obtain additional financing for working capital, capital expenditures, product development, debt service requirements, acquisitions and general corporate or other purposes; and

 

   

limiting our flexibility in planning for, or reacting to, changes in our business or market conditions and placing us at a competitive disadvantage compared to competitors who are less highly leveraged and who therefore, may be able to take advantage of opportunities that our leverage prevents us from exploiting.

Our cash interest expense for the year ended December 31, 2009 was $444 million, excluding $75 million of PIK interest on our PIK-Election Notes. At December 31, 2009, there was approximately $4,210 million aggregate principal amount of variable indebtedness under the senior floating rate notes and senior secured credit facility. A 1% increase in such rates would increase the annual interest expense by approximately $42 million.

At December 31, 2009, our indebtedness included (i) a revolving credit facility with a committed capacity of $690 million, and $644 million outstanding thereunder, which will be available through December 1, 2012, at which time all outstanding principal amounts under the revolving credit facility will be due and payable; (ii) $3,372 million in term loans maturing on December 1, 2013; (iii) $917 million in incremental term loans maturing on December 15, 2014; (iv) $2,136 million aggregate principal amount outstanding under our senior notes due 2014; (v) $764 million aggregate principal amount outstanding under our senior subordinated notes due 2016 and (vi) $61 million of other indebtedness (see Note 4 to the accompanying audited consolidated financial statement for further information). Our ability to make scheduled payments or to refinance our indebtedness depends on our financial and operating performance, which is subject to prevailing economic and competitive conditions and to certain financial, business and other factors beyond our control. We may not be able to maintain a level of cash flow from operations sufficient to permit us to pay the principal, premium, if any, and interest on our indebtedness. If our cash flows and capital resources are insufficient to fund our debt service obligations, we may be forced to reduce or delay capital expenditures, sell assets or operations, seek additional capital or restructure or refinance our indebtedness. We may not be able to take any of these actions, and these actions may not be successful or permit us to meet our scheduled debt service obligations and these actions may not be permitted under the terms of our existing or future debt agreements. In the absence of such operating results and resources, we could face substantial liquidity problems and might be required to dispose of material assets or operations to meet our debt service and other obligations. Our debt agreements restrict our ability to dispose of assets. We may not be able to consummate such dispositions, which could result in our inability to meet debt service obligations.

If we cannot make scheduled payments on our indebtedness, we will be in default under one or more of our debt agreements and, as a result, we could be forced into bankruptcy or liquidation.

Despite the high indebtedness level, we and our subsidiaries may be able to incur significant additional amounts of debt, which could further exacerbate the risks associated with our substantial indebtedness.

We and our subsidiaries may be able to incur substantial additional indebtedness in the future. Although the agreements governing the indebtedness contain restrictions on the incurrence of additional indebtedness, these restrictions are subject to a number of significant qualifications and exceptions, and under certain circumstances, the amount of indebtedness that could be incurred in compliance with these restrictions could be substantial. Our subsidiaries have $15 million available for borrowing under the revolving credit facility. In addition, under the PIK-Election Notes, our subsidiaries have elected and have the option to continue to pay interest in the form of PIK Interest through December 15, 2011, which would increase the amount of debt by the amount of any such interest. If new debt is added to our and our subsidiaries’ existing debt levels, the related risks that we now face would increase.

The debt agreements contain restrictions that limit our flexibility in operating our business.

The agreements governing our indebtedness contain various covenants that limit the ability to engage in specified types of transactions. These covenants limit our, the restricted parent guarantors’ and our restricted subsidiaries’ ability to, among other things:

 

   

incur additional indebtedness or issue certain preferred shares;

 

   

pay dividends on, repurchase or make distributions in respect of our capital stock or make other restricted payments;

 

   

make certain investments;

 

   

sell certain assets;

 

   

create liens;

 

   

consolidate, merge, sell or otherwise dispose of all or substantially all of our assets; and

 

   

enter into certain transactions with our affiliates.

A breach of any of these covenants could result in a default under one or more of these agreements, including as a result of cross default provisions and, in the case of the revolving credit facility, permit the lenders to cease making loans to us. Upon the occurrence of an event of default under the senior secured credit facilities, the lenders could elect to declare all amounts outstanding under the senior secured credit facility to be immediately due and payable and terminate all commitments to extend further credit. Such actions

 

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by those lenders could cause cross defaults under our other indebtedness. If we were unable to repay those amounts, the lenders under the senior secured credit facilities could proceed against the collateral granted to them to secure that indebtedness. We have pledged a significant portion of our assets as collateral under the senior secured credit facilities. If the lenders under the senior secured credit facilities accelerate the repayment of borrowings, we may not have sufficient assets to repay the senior secured credit facilities as well as our unsecured indebtedness.

Rises in interest rates could adversely affect our financial condition.

An increase in prevailing interest rates has an immediate effect on LIBOR (the interest rate index on which our variable rate debt is based), which fluctuates on a regular basis. Although interest rates actually decreased in fiscal 2009, any increased interest expense associated with increases in interest rates affects our cash flow and our ability to service our debt. As a protection against rising interest rates, we have entered and may in the future enter into agreements such as interest rate swaps contracts. However, the other parties to the agreements may fail to perform or the terms may be unfavorable to us depending on rate movements.

 

Item 1B: Unresolved Staff Comments

Not applicable.

 

Item 2: Properties

Our principal executive offices are at 6501 William Cannon Drive West, in Austin, Texas. We also operate manufacturing facilities, design centers and sales offices throughout the world. As of December 31, 2009, we owned 15 facilities and leased 74 facilities. Our total square footage consists of approximately 12 million square feet, of which approximately 10 million square feet is owned and approximately 2 million square feet is leased. Our lease terms range from one to sixteen years.

The following table describes our facilities:

 

Region

  

Description

  

Principal Locations

   Total Owned
Square
Footage
   Total Leased
Square
Footage
Americas   

4 owned facilities,

30 leased facilities

  

Austin, Texas

Chandler, Arizona

Tempe Arizona (1)

   5.6 million    1.4 million
Asia   

6 owned facilities,

23 leased facilities

  

Kuala Lumpur, Malaysia

Noidia, India

Tianjin, China

Sendai, Japan (2)

   1.9 million    0.5 million
Europe, Middle East, Africa   

4 owned facilities,

21 leased facilities

  

Toulouse, France (3)

Munich, Germany

Tel Aviv, Israel

   2.8 million    0.3 million

 

(1) This manufacturing facility closed in May 2009.
(2) This manufacturing facility is scheduled to close in the second half of 2011.
(3) We have initiated a formal consultation with employees at our Toulouse fabrication facility to close the manufacturing portion of this facility in the first half of 2011.

We believe that all of our facilities and equipment are in good condition, are well maintained and are able to operate at present levels.

We have a concentration of manufacturing (including assembly and test) in Asia, primarily in China, Japan, Malaysia, Taiwan and Korea, either in our own facilities or in the facilities of third parties. If manufacturing in the region were disrupted, our overall production capacity could be significantly reduced.

 

Item 3: Legal Proceedings

Intellectual Property Matters

Protection of our patent portfolio and other intellectual property rights is very important to our operations. We intend to continue to license our intellectual property to third parties. We have a broad portfolio of approximately 6,300 patent families and numerous licenses, covering manufacturing processes, packaging technology, software systems and circuit design. A patent family includes all of the equivalent patents and patent applications that protect the same invention, covering different geographical regions. These

 

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patents are typically valid for 20 years from the date of filing. We do not believe that any individual patent, or the expiration thereof, is or would be material to our business.

Legal Proceedings

We are a defendant in various lawsuits, including intellectual property suits, and are subject to various claims which arise in the normal course of business. We record an associated liability when a loss is probable and the amount is reasonably estimable.

From time to time, we are involved in legal proceedings arising in the ordinary course of business, including tort and contractual disputes, claims before the United States Equal Employment Opportunity Commission and other employee grievances, and intellectual property litigation and infringement claims. Intellectual property litigation and infringement claims could cause us to incur significant expenses or prevent us from selling our products. Under agreements with Motorola, FSL, Inc. must indemnify Motorola for certain liabilities related to our business incurred prior to our separation from Motorola.

A purported class action, Howell v. Motorola, Inc., et al., was filed against Motorola and certain of its directors, officers and employees in the United States District Court for the Northern District of Illinois (“Illinois District Court”) on July 21, 2003, alleging breach of fiduciary duty and violations of the Employment Retirement Income Security Act (“ERISA”). The complaint alleged that the defendants had improperly permitted participants in the Motorola 401(k) Plan (“Plan”) to purchase or hold shares of common stock of Motorola because the price of Motorola’s stock was artificially inflated by a failure to disclose vendor financing to Telsim in connection with the sale of telecommunications equipment by Motorola. The plaintiff sought to represent a class of participants in the Plan for whose individual accounts the Plan purchased or held shares of common stock of Motorola from “May 16, 2000 to the present,” and sought an unspecified amount of damages. On September 30, 2005, the Illinois District Court dismissed the second amended plaintiff’s complaint. Three new purported lead plaintiffs intervened in the case, and filed a motion for class certification seeking to represent Plan participants for whose individual accounts the Plan purchased and/or held shares of Motorola common stock from May 16, 2000 through December 31, 2002. On September 28, 2007, the Illinois District Court granted the motion for class certification but narrowed the requested scope of the class. On October 25, 2007, the Illinois District Court granted summary judgment dismissing two of the individually-named defendants in light of the narrowed class, and ruled that the judgment as to the original named plaintiff, Howell, would be immediately appealable. The class as certified includes all Plan participants for whose individual accounts the Plan purchased and/or held shares of Motorola common stock from May 16, 2000 through May 14, 2001 with certain exclusions. Motorola and its codefendants appealed the District Court certification decision and filed motions for summary judgment on all claims asserted by the class. The United States Court of Appeals for the Seventh Circuit heard Motorola’s interlocutory appeal of the District Court’s order certifying the class on October 23, 2008. On June 17, 2009, the district court granted defendants’ motions for summary judgment on all claims. The plaintiffs appealed the June 17, 2009 ruling of the district court and that appeal has been consolidated with the class certification appeal. Both Plaintiffs (Appellants) and Defendants (Appellees) have filed their principal briefs regarding the summary judgment appeal, and briefing is complete in the class certification appeal. As a result of the terms of its separation from Motorola, it is possible that FSL, Inc. could be held responsible to Motorola for a portion of any judgment or settlement in this matter. We do not expect the payments or damages resulting from this action to be material.

On April 17, 2007, Tessera Technologies, Inc. (“Tessera”) filed a complaint against FSL, Inc., ATI Technologies, Inc., Motorola, Inc., Qualcomm, Inc., Spansion, Inc., Spansion LLC, and STMicroelectronics N.V. (collectively, the “Respondents”) in the International Trade Commission (“ITC”) requesting the ITC to enter an injunction barring the importation of any product containing a device that infringes two identified patents related to ball grid array (“BGA”) packaging technology. On April 17, 2007, Tessera filed a parallel lawsuit in the United States District Court for the Eastern District of Texas against ATI, FSL, Inc., Motorola and Qualcomm claiming an unspecified amount of monetary damage as compensation for the alleged infringement of the same Tessera patents. Tessera’s patent claims relate to BGA packaging technology. On December 1, 2008, the ALJ issued his determination finding in favor of the Respondents and recommended that no injunction barring importation of the Respondents’ products be entered. In accordance with its rights, Tessera petitioned the ITC to review the ALJ’s determination on December 15, 2008. On May 20, 2009 the ITC issued a final order finding that all the Respondents infringe on Tessera’s asserted patents, and granted Tessera’s request for a Limited Exclusion Order prohibiting the importation of Respondents’ infringing products. Freescale appealed the ITC’s decision to the Federal Court of Appeals. During the pendency of the appellate process, we are taking all necessary actions to comply with the Limited Exclusion Order. We continue to assess the merits of this action as well as the potential effect on our consolidated financial position, results of operations and cash flows.

On March 25, 2009, a group of senior lenders under the senior secured credit facility of FSL, Inc. and Holdings II, IV and V (the “Credit Facility”), including ING Prime Rate Trust (“ING”), filed a complaint against FSL, Inc. and certain unnamed unsecured debtholders in the Supreme Court of the State of New York, County of New York. The plaintiffs filed an amended complaint on May 20, 2009 adding additional plaintiffs and removing the unnamed unsecured debtholders as defendants. The suit challenges our issuance of new Incremental Term Loans under the Credit Facility to certain holders of the Existing Notes (as defined and discussed in Note 4 to the accompanying audited consolidated financial statements), thereby allowing those unsecured debtholders to become secured lenders with loans that are equal in priority to the plaintiffs’ loans. The plaintiffs claim that this action has devalued their loans and put the repayment of their loans at additional risk. The complaint asserts that our representation and warranty that FSL, Inc. has not experienced a Material Adverse Effect (“MAE”) since the closing of the Credit Facility, which we made as a prerequisite to the

 

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issuance of new Incremental Term Loans, was untrue when made. The plaintiffs argue that FSL, Inc. suffered a MAE between 2006 and the issuance of the new Incremental Term Loans. Among other things, the plaintiffs are seeking monetary damages suffered as a result of the issuance of new Incremental Term Loans. FSL, Inc. filed a motion to dismiss the suit on June 19, 2009. The motion to dismiss was denied by the trial court on October 27, 2009. FSL, Inc. has appealed the denial of the motion to dismiss to the New York state appellate court. On December 10, 2009, plaintiffs filed a motion for partial summary judgment, seeking a judicial declaration that a MAE had occurred. On January 26, 2010, the New York state appellate court ordered the proceedings in the trial court stayed pending the disposition of FSL, Inc.’s appeal from the denial of its motion to dismiss, provided that the plaintiffs may petition the court to vacate the stay in the event that FSL, Inc. issues new debt. We believe that all claims made by the lenders are without merit and intend to vigorously defend this action.

Environmental Matters

Our operations are subject to a variety of environmental laws and regulations in each of the jurisdictions in which we operate governing, among other things, air emissions, wastewater discharges, the use, handling and disposal of hazardous substances and wastes, soil and groundwater contamination, and employee health and safety. As with other companies engaged in similar industries, environmental compliance obligations and liability risks are inherent in many of our manufacturing and other activities. In the United States, certain environmental remediation laws, such as the federal “Superfund” law, can impose the entire cost of site clean-up, regardless of fault, upon any single potentially responsible party, including companies that owned, operated, or sent wastes to a site. In some jurisdictions, environmental requirements may become more stringent in the future which could affect our ability to obtain or maintain necessary authorizations and approvals or could result in increased environmental compliance costs. We believe that our operations are in compliance in all material respects with current requirements under applicable environmental laws.

Motorola was identified as a potentially responsible party in the past, and has been engaged in investigations, administrative proceedings and/or cleanup processes with respect to past chemical releases into the environment. FSL, Inc. agreed to indemnify Motorola for certain environmental liabilities related to its business, including the sites described below. Potential future liability at these or other sites (excluding costs spent to date) may adversely affect our results of operations.

52nd Street Facility, Phoenix, AZ. In 1983, a trichloroethane leak from a solvent tank led to the discovery of chlorinated solvents in the groundwater underlying a former Motorola facility located on 52nd Street in Phoenix, Arizona, which resulted in the facility and adjacent areas being placed on the federal National Priorities List of Superfund sites. The 52nd Street site was subsequently divided into three operable units by the Environmental Protection Agency (EPA), which is overseeing site investigations and cleanup actions with the Arizona Department of Environmental Quality (ADEQ). To date, two separate soil cleanup actions have been completed at the first operable unit (“Operable Unit One”), for which Motorola received letters stating that no further action would be required with respect to the soils. We also implemented and are operating a system to treat contaminated groundwater in Operable Unit One and prevent migration of the groundwater from Operable Unit One. The EPA has not announced a final remedy for Operable Unit One and it is therefore possible that costs to be incurred at this operable unit in future periods may vary from our estimates. In relation to the second operable unit, the EPA issued a record of decision in July 1994, and subsequently issued a consent decree, which required Motorola to design a remediation plan targeted at containing and cleaning up solvent groundwater contamination downgradient of Operable Unit One. That remedy is now being implemented by FSL, Inc. and another potentially responsible party pursuant to an administrative order. The EPA and ADEQ are currently performing a remedial investigation at the third operable unit (“Operable Unit Three”) to determine the extent of groundwater contamination. A number of additional potentially responsible parties, including Motorola, have been identified in relation to Operable Unit Three. Because this investigation is in its early stages, we cannot predict at this time the extent to which we may be held liable for cleanup at Operable Unit Three or whether that liability would be material.

56th Street Facility, Phoenix, AZ. In 1985, the EPA initiated an inquiry concerning the former Motorola facility located on 56th Street in Phoenix, Arizona following the discovery of organic compounds in certain local area wells. Motorola completed several remedial actions at this site including soil excavation and cleanup. We subsequently undertook voluntary negotiations with ADEQ, which assumed primary responsibility for this matter in 2004 under the state’s Water Quality Assurance Revolving Fund Program.

 

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

Not applicable.

PART II

 

Item 5: Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market Information and Holders

Our outstanding common stock is privately held, and there is no established public trading market for our common stock. As of the date of this filing, there were thirteen holders of record of our common stock.

 

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Dividend Policy

We have never declared or paid cash dividends on shares of our capital stock. We currently intend to retain all of our earnings, if any, for use in our business and in acquisitions of other businesses, assets, products or technologies. In addition, our debt documents contain restrictions on our subsidiaries’ ability to declare dividends. However, we may decide to declare or pay a dividend in the future.

Equity Compensation Plan Information

The following tables summarize our equity compensation plan information as of December 31, 2009.

Freescale Semiconductor, Inc.

 

Plan Category

   Number of securities to
be issued upon exercise
of outstanding options,
warrants and rights
    Weighted-average
exercise price of
outstanding
options, warrants
and rights
    Number of securities
remaining available for
future issuance under
equity compensation
plans (excluding
securities reflected in
the first column)

Equity compensation plans approved by security holders

   213,127 (1)    $ 31.69 (2)   

Equity compensation plans not approved by security holders

        $     
            

Total

   213,127      $ 31.69     
            

 

(1) This includes restricted stock units and options to purchase Freescale Class A common stock awarded under the 2004 Omnibus Incentive Plan and the Omnibus Incentive Plan of 2005. We ceased making grants under these plans on December 1, 2006, the effective date of the Merger.
(2) This weighted exercise price does not include outstanding restricted stock units.

Freescale Semiconductor Holdings I, Ltd.

 

Plan Category

   Number of securities to
be issued upon exercise
of outstanding options,
warrants and rights
   Weighted-average
exercise price of
outstanding
options, warrants
and rights
    Number of securities
remaining available for
future issuance under
equity compensation
plans (excluding
securities reflected in
the first column)

Equity compensation plans approved by security holders

      $     

Equity compensation plans not approved by security holders(1)

   71,267,393    $ 1.41 (2)    9,161,289
           

Total

   71,267,393    $ 1.41      9,161,289
           

 

(1) This includes restricted stock units and options to purchase common shares of Holdings I awarded under the 2006 Management Incentive Plan and options to purchase common shares of Holdings I awarded under the 2007 Employee Incentive Plan (both described in Note 6 to the accompanying audited consolidated financial statements).
(2) This weighted exercise price does not include outstanding restricted stock units.

Freescale Holdings, L.P.

 

Plan Category

   Number of securities to
be issued upon exercise
of outstanding options,
warrants and rights
   Weighted-average
exercise price of
outstanding
options, warrants
and rights
   Number of securities
remaining available for
future issuance under
equity compensation
plans (excluding
securities reflected in
the first column)

Equity compensation plans approved by security holders

      $   

Equity compensation plans not approved by security holders(1)

   129,749    $   
            

Total

   129,749    $   
            

 

(1) This includes Class B limited partnership interest units in Freescale Holdings, L.P. awarded under the 2006 Profits Interest Plan.

 

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Item 6: Selected Financial Data

Freescale Semiconductor Holdings I, Ltd. and Subsidiaries

Five Year Financial Summary

 

    Successor     Combined (1)     Successor          Predecessor  

(Dollars in millions)

  Year Ended
December 31,
2009
    Year Ended
December 31,
2008
    Year Ended
December 31,
2007
    (Unaudited)
Year Ended
December 31,
2006
    Period from
December 2
through
December 31,
2006
         Period from
January 1
through
December 1,
2006
    Year Ended
December 31,
2005
 

Operating Results

                 

Net sales

  $ 3,508      $ 5,226      $ 5,722      $ 6,359      $ 565          $ 5,794      $ 5,843   

Cost of sales

    2,563        3,154        3,821        3,625        450            3,175        3,377   
                                                           

Gross margin

    945        2,072        1,901        2,734        115            2,619        2,466   

Selling, general and administrative

    499        673        653        729        59            670        652   

Research and development

    833        1,140        1,139        1,204        99            1,105        1,178   

Amortization expense for acquired intangible assets

    486        1,042        1,310        117        106            11        7   

In-process research and development

                         2,260        2,260                   10   

Reorganization of businesses, contract settlement, and other

    345        53        64        (12                (12     9   

Impairment of goodwill and intangible assets

           6,981        449                                   

Merger and separation expenses

           11        5        522        56            466        10   
                                                           

Operating (loss) earnings

    (1,218     (7,828     (1,719     (2,086     (2,465         379        600   

Gain (loss) on extinguishment of long-term debt, net

    2,296        79               (15                (15       

Other (expense) income, net

    (576     (733     (780     (8     (56         48        13   
                                                           

Earnings (loss) before income taxes and cumulative effect of accounting change

    502        (8,482     (2,499     (2,109     (2,521         412        613   

Income tax (benefit) expense

    (246     (543     (886     (108     (134         26        50   
                                                           

Earnings (loss) before cumulative effect of accounting change

    748        (7,939     (1,613     (2,001     (2,387         386        563   

Cumulative effect of accounting change, net of income tax expense

                         7                   7          
                                                           

Net earnings (loss)

  $ 748      $ (7,939   $ (1,613   $ (1,994   $ (2,387       $ 393      $ 563   
                                                           

Balance Sheet (End of Period)

                 

Total cash and cash equivalents, short-term investments and marketable securities (2)

  $ 1,363      $ 1,394      $ 751      $ 710              $ 3,025   

Total assets

  $ 5,093      $ 6,651      $ 15,117      $ 17,739              $ 7,170   

Total debt and capital lease obligations

  $ 7,552      $ 9,786      $ 9,497      $ 9,526              $ 1,253   

Total stockholders’ (deficit) equity

  $ (3,894   $ (4,692   $ 3,190      $ 4,717              $ 4,447   

Other Data

                 

EBITDA(3) (Unaudited)

  $ 2,251      $ (5,955   $ 406      $ (1,326   $ (2,299       $ 973      $ 1,331   

Capital expenditures, net

  $ 85      $ 239      $ 327      $ 713      $ 89          $ 624      $ 491   

% of sales

    2     5     6     11     16         11     8

Research and development expenditures

  $ 833      $ 1,140      $ 1,139      $ 1,204      $ 99          $ 1,105      $ 1,178   

% of sales

    24     22     20     19     18         19     20

Earnings to fixed charges ratio(4) (Unaudited)

    1.9x                      N/A                   5.6 x        7.0 x   

Net cash provided by operating activities

  $ 76      $ 405      $ 426      $ 1,301      $ 60          $ 1,241      $ 1,300   

Net cash provided by (used for) investing activities

  $ 374      $ (59   $ (366   $ (16,299   $ (17,900       $ 1,601      $ (1,431

Net cash provided by (used for) financing activities

  $ 9      $ 342      $ (47   $ 14,954      $ 16,181          $ (1,227   $ (21

 

(1) Our combined results for the year ended December 31, 2006 represent the addition of the Predecessor Period from January 1, 2006 through December 1, 2006 and the Successor Period from December 2, 2006 to December 31, 2006. This combination does not comply with generally accepted accounting principles in the United States (“U.S. GAAP”) or with the rules for pro forma presentation, but is presented because we believe it provides the most meaningful comparison of our results.

 

(2) The following table provides a reconciliation of total cash and cash equivalents, short-term investments and marketable securities to the amounts reported in our accompanying audited Consolidated Balance Sheets at December 31, 2009, 2008, 2007, 2006 and 2005 or in their accompanying Notes:

 

     Successor         Predecessor

(Dollars in millions)

   December 31,
2009
   December 31,
2008
   December 31,
2007
   December 31,
2006
        December 31,
2005

Cash and cash equivalents

   $ 1,363    $ 900    $ 206    $ 177        $ 212

Short-term investments

          494      545      533          1,209

Marketable securities

                             1,604
                                      

Total

   $ 1,363    $ 1,394    $ 751    $ 710        $ 3,025
                                      

 

(3)

We believe that earnings before interest, income taxes, depreciation and amortization (“EBITDA”) is a useful financial metric to assess our ability to generate cash from operations sufficient to pay taxes, to service debt and to undertake capital expenditures. Given the significant investments that we have made in the past in property, plant and equipment, depreciation and amortization expense comprises a meaningful portion of our cost structure. We believe that EBITDA will provide investors with a useful tool for assessing the comparability between periods of our ability to generate cash from operations sufficient to pay taxes, to service debt and to undertake capital expenditures because it eliminates depreciation and amortization expense attributable to our historically higher levels of capital expenditures. The term EBITDA is not defined under generally accepted accounting principles

 

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in the U.S., or U.S. GAAP, and EBITDA is not a measure of operating income, operating performance or liquidity presented in accordance with U.S. GAAP. In addition, EBITDA is impacted by reorganization of businesses and other restructuring-related charges. When assessing our operating performance or our liquidity, you should not consider this data in isolation, or as a substitute for, our net cash from operating activities or other cash flow data that is calculated in accordance with U.S. GAAP. In addition, our EBITDA may not be comparable to EBITDA or similarly titled measures utilized by other companies since such other companies may not calculate EBITDA in the same manner as we do. A reconciliation of net earnings (loss), the most directly comparable U.S. GAAP measure, to EBITDA for each of the respective periods indicated is as follows:

 

    Successor     Combined     Successor          Predecessor  

(Dollars in millions)

  Year Ended
December 31,
2009
    Year Ended
December 31,
2008
    Year Ended
December 31,
2007
    (Unaudited)
Year Ended
December 31,
2006
    Period from
December 2
through
December 31,
2006
         Period from
January 1
through
December 1,
2006
    Year Ended
December 31,
2005
 

Earnings (loss) before cumulative effect of accounting change

  $ 748      $ (7,939   $ (1,613   $ (2,001   $ (2,387       $ 386      $ 563   

Interest expense (income), net

    556        702        784        5        58            (53     (6

Income tax (benefit) expense

    (246     (543     (886     (108     (134         26        50   

Depreciation and amortization*

    1,193        1,825        2,121        778        164            614        724   
                                                           

EBITDA

  $ 2,251      $ (5,955   $ 406      $ (1,326   $ (2,299       $ 973      $ 1,331   
                                                           

 

  * Excludes amortization of debt issuance costs, which are included in interest expense (income), net.

 

(4) The ratio of earnings to fixed charges is calculated by dividing the sum of earnings (loss) from operations before provision for income taxes, earnings (loss) from equity investees and fixed charges, by fixed charges. Fixed charges consist of interest expense, capitalized interest and imputed interest on our lease obligations. Earnings were inadequate to cover fixed charges for the years ended December 31, 2008 and 2007 and the Successor Period in 2006 by $8.5 billion, $2.5 billion, and $2.5 billion, respectively.

 

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Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND

RESULTS OF OPERATIONS

The following is a discussion and analysis of our financial position and results of operations for each of the three years ended December 31, 2009, 2008 and 2007. You should read the following discussion of our results of operations and financial condition in conjunction with our accompanying audited consolidated financial statements and the notes in “Item 8: Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. This discussion contains forward looking statements and involves numerous risks and uncertainties, including, but not limited to, those described in the “Risk Factors” in Part I, Item 1A of this Annual Report on Form 10-K. Actual results may differ materially from those contained in any forward looking statements.

Overview

On December 1, 2006, Freescale Semiconductor, Inc. (“FSL, Inc.”) was acquired by a consortium of private equity funds (the “Merger”). At the close of the Merger, all assets, liabilities, rights and obligations were transferred and assigned to Freescale Holdings L.P., a Cayman Islands limited partnership (“Parent”). Pursuant to the terms of the Merger, FSL, Inc. continues as a wholly owned indirect subsidiary of Parent. At the close of the Merger, FSL, Inc. became a subsidiary of Freescale Semiconductor Holdings V, Inc. (“Holdings V”), which is wholly owned by Freescale Semiconductor Holdings IV, Ltd. (“Holdings IV”), which is wholly owned by Freescale Semiconductor Holdings III, Ltd. (“Holdings III”), which is wholly owned by Freescale Semiconductor Holdings II, Ltd. (“Holdings II”), which is wholly owned by Freescale Semiconductor Holdings I, Ltd. (“Holdings I”), substantially all of which is wholly owned by Parent. All six of these companies were formed for the purposes of facilitating the Merger and are collectively referred to as the “Parent Companies.” The reporting entity subsequent to the Merger is Holdings I. Holdings I refers to the operations of Freescale Semiconductor Holdings I, Ltd. and its subsidiaries and may be referred to as the “Company,” “Freescale,” “we,” “us” or “our,” as the context requires.

In connection with the Merger, FSL, Inc. incurred significant indebtedness (see the “Liquidity and Capital Resources” discussion). In addition, the purchase price paid in connection with the Merger was allocated to state the acquired assets and assumed liabilities at fair value. The purchase accounting adjustments (i) increased the carrying value of our inventory and property, plant and equipment, (ii) established intangible assets for our trademarks / tradenames, customer lists, developed technology / purchased licenses, and in-process research and development (“IPR&D”) (which was expensed in the financial statements after the consummation of the Merger), and (iii) revalued our long-term benefit plan obligations, among other things. Subsequent to the Merger, interest expense and non-cash depreciation and amortization charges significantly increased. During 2008, however, we incurred substantial non-cash impairment charges against the intangible assets established at the time of the Merger. Furthermore, in 2009, in connection with a modification of our outstanding debt, we reduced the carrying value of our overall long-term indebtedness by $1,929 million. These events served to reduce the post-Merger increase in our interest expense and non-cash amortization charges, although they are still above historical levels.

Our Business. With over 50 years of operating history, FSL, Inc. is a leader in the design and manufacture of embedded processors. Our largest end-markets are the automotive and networking markets, however we also provide products to targeted industrial and consumer electronics markets. In addition to our embedded processors, we offer our customers a broad portfolio of complementary devices that provide connectivity between products, across networks and to real-world signals, such as sound, vibration and pressure. Our complementary products include sensors, radio frequency semiconductors, power management and other analog and mixed-signal integrated circuits. Through our embedded processors and complementary products, we also offer our customers platform-level products, which incorporate both semiconductors with software. We believe that our ability to offer platform-level products will be increasingly important to our long-term success in many markets within the semiconductor industry as our customers continue to move toward providers of embedded processors and complementary products.

Revenues and Expenses. Our revenues are derived from the sale of our embedded processing and connectivity products and the licensing of our intellectual property.

We currently manufacture a substantial portion of our products internally at our five wafer fabrication facilities and two assembly and test facilities. We track our inventory and cost of sales by using standard costs that are reviewed at least once a year and are valued at the lower of cost or market value.

Our gross margin is significantly influenced by our utilization. Utilization refers only to our wafer fabrication facilities and is based on the capacity of the installed equipment. As utilization rates decrease, there is less operating leverage as fixed manufacturing costs are spread over lower output. We have experienced a moderate increase in our utilization rate to 60% in the fourth quarter of 2009, compared to 51% in the fourth quarter of 2008. Although significantly below historical levels, utilization has shown consistent improvement since the first quarter of 2009, reflecting an increase of 24 percentage points by the end of the year. We anticipate continued pressure on our utilization and gross margin as compared to peak historical periods due to the current macroeconomic environment.

 

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Trends in Our Business. We have experienced continued pressure on revenues associated with the macroeconomic weakness, particularly in the automotive industry. Although we have experienced sequential increases in revenues during 2009, there continues to be pressure on revenues associated with the macroeconomic weakness as compared to peak historical levels, particularly in the automotive industry. We expect continued uncertainty with respect to the automotive industry as well as with other of our end markets. Examples of such uncertainty are unscheduled or temporary increases in demand that may challenge our ability to timely fill customer orders as well as sudden decreases in demand. This uncertainty may continue to affect our revenues and profitability in 2010. Going forward, we intend to focus our resources on our core automotive and networking businesses, as well as targeted opportunities in various industrial and consumer electronics markets. Our revenue and profitability recovery in future periods will be dependent upon the extent to which a general global economic recovery occurs and our ability to achieve design wins and adequately meet product development launch cycles in our targeted markets, among other conditions.

We have been significantly impacted by the continued weakness in the global automotive market, as light vehicle production by the Big 3 U.S. automakers in 2009 declined approximately 39% versus 2008. The bankruptcies of both General Motors (“GM”) and Chrysler, and to a lesser extent, Visteon and Lear, have further impacted automotive factory production. Our Microcontroller Solutions and Radio Frequency, Analog and Sensor automotive revenues in 2009 declined by 31%, as compared to the prior year. Although the automotive industry has shown some signs of recovery, we expect continued weakness, as compared to historical industry levels, to adversely affect our revenues and profitability compared to prior peak periods. We are not able to precisely forecast the level and duration of such weakened demand as compared to prior peak periods. In addition to the impact on our automotive business, our cellular handset product group revenues decreased 56% in 2009 versus the prior year following the termination of an arrangement with Motorola, whereby Motorola agreed to provide certain consideration in exchange for our eliminating their remaining minimum purchase commitments.

In light of our renewed focus on key market leadership positions and given general market conditions, beginning in the fourth quarter of 2008, we initiated a series of restructuring actions that we refer to as the “Reorganization of Business Program” in order to streamline our cost structure and re-direct some research and development investments into expected growth markets. These actions have continued through the end of 2009 and have reduced our workforce in our supply chain, research and development, sales, marketing and general and administrative functions. Furthermore, in the first quarter of 2009 we implemented certain non-severance austerity measures (executive salary reductions, mandatory time off without pay, savings plan company match elimination in countries where lawfully allowed, and certain other employee benefits curtailments) from which we realized benefits throughout 2009. We terminated these austerity measures effective January 1, 2010, as a result of improving levels of profitability as of the end of 2009.

In association with the ongoing restructuring actions described above, on April 22, 2009 we announced actions to align our cost structure with our prior decision to wind-down the cellular handset business. As of December 31, 2009, we have completed the majority of the employment reductions and paid certain related severance costs.

Total severance and related cash requirements associated with all of the aforementioned restructuring actions total approximately $300 million, with expected corresponding annualized savings of approximately $800 million which are expected to be realized during 2010. We have paid approximately $230 million of the cash restructuring charges in connection with the actions taken through December 31, 2009, resulting in approximately $700 million in expected annualized cost savings.

On April 22, 2009, we also announced that we were executing a plan to exit our 150mm manufacturing capability, as we have experienced a migration from 150mm technologies and products to advanced technologies and products. The long-term trend in declining overall demand for the bulk of the products served by our 150mm fabs has resulted in low factory utilization, which has been accelerated by the weaker global economic climate. Accordingly, we closed our 150mm fabrication facility in East Kilbride, Scotland in the second quarter of 2009 and have announced the closure of our 150mm fabrication facility in Sendai, Japan in the second half of 2011. We have also initiated a formal consultation with employees at our Toulouse, France fabrication facility. The plan to close that facility is being evaluated through consultation with our works council in Toulouse. We estimate the costs of the elimination of our 150mm manufacturing capability to be approximately $200 million, including approximately $190 million in cash severance costs and $10 million in cash costs for other exit costs. We anticipate these costs to be paid over the course of 2010 and 2011. We expect these actions will result in expected annualized cost savings of approximately $100 million.

Going forward, we expect our business will be highly dependent on demand for electronic content in automobiles, networking and wireless infrastructure equipment and other electronic devices. In addition, we operate in an industry that is highly cyclical and subject to constant and rapid technological change, product obsolescence, price erosion, evolving standards, short product life-cycles and wide fluctuations in product supply and demand. For more information on trends and other factors affecting our business, see Part I, “Item 1A: Risk Factors” in this December 31, 2009 Annual Report on Form 10-K.

 

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Results of Operations

Operating Results

 

(Dollars in millions)

   Year Ended
December 31,
2009
    Year Ended
December 31,
2008
    Year Ended
December 31,
2007
 

Orders (unaudited)

   $ 3,719      $ 4,845      $ 5,406   
                        

Net sales

   $ 3,508      $ 5,226      $ 5,722   

Cost of sales

     2,563        3,154        3,821   
                        

Gross margin

     945        2,072        1,901   

Selling, general and administrative

     499        673        653   

Research and development

     833        1,140        1,139   

Amortization expense for acquired intangible assets

     486        1,042        1,310   

Reorganization of businesses, contract settlement, and other

     345        53        64   

Impairment of goodwill and intangible assets

            6,981        449   

Merger expenses

            11        5   
                        

Operating loss

     (1,218     (7,828     (1,719

Gain on extinguishment of long-term debt, net

     2,296        79          

Other expense, net

     (576     (733     (780
                        

Earnings (loss) before income taxes

     502        (8,482     (2,499

Income tax benefit

     (246     (543     (886
                        

Net earnings (loss)

   $ 748      $ (7,939   $ (1,613
                        
Percentage of Net Sales       
     Year Ended
December 31,
2009
    Year Ended
December 31,
2008
    Year Ended
December 31,
2007
 

Orders (unaudited)

     106.0     92.7     94.5
                        

Net sales

     100.0     100.0     100.0

Cost of sales

     73.1     60.4     66.8
                        

Gross margin

     26.9     39.6     33.2

Selling, general and administrative

     14.2     12.9     11.4

Research and development

     23.7     21.8     19.9

Amortization expense for acquired intangible assets

     13.9     19.9     22.9

Reorganization of businesses, contract settlement, and other

     9.8     1.0     1.1

Impairment of goodwill and intangible assets

         133.6     7.8

Merger expenses

         0.2     0.1
                        

Operating loss

     -34.7     -149.8     -30.0

Gain on extinguishment of long-term debt, net

     65.4     1.5    

Other expense, net

     -16.4     -14.0     -13.7
                        

Earnings (loss) before income taxes

     14.3     -162.3     -43.7

Income tax benefit

     -7.0     -10.4     -15.5
                        

Net earnings (loss)

     21.3     -151.9     -28.2
                        

Year Ended December 31, 2009 Compared to Year Ended December 31, 2008

Net Sales

We operate in one industry segment and engage primarily in the design, development, manufacture and marketing of a broad range of semiconductor products that are based on our core capabilities in embedded processing. In addition, we offer customers differentiated products that complement our embedded processors and provide connectivity, such as sensors, radio frequency semiconductors, and power management and other analog and mixed-signal semiconductors. Our capabilities enable us to offer customers a broad range of product offerings, from individual devices to platform-level products that combine semiconductors with software for a given application.

We sell our products to distributors and original equipment manufacturers (“OEMs”) in a broad range of market segments. The majority of our sales are derived from three major product design groups: Microcontroller Solutions, Networking and Multimedia and Radio Frequency, Analog and Sensors. We also derive sales from our former Cellular Products group which we are winding-down in connection with our decision to wind-down the cellular handset business. Although we are in the process of winding-down these cellular product offerings, in the near term, we expect to continue to provide products to our existing cellular customers. We expect the revenue stream associated with our cellular products to continue declining over time. Finally, Other sales are attributable to revenue from intellectual property, software, contract manufacturing sales to other semiconductor companies and miscellaneous items.

Our net sales and orders of approximately $3,508 million and $3,719 million in 2009 decreased 33% and 23%, respectively, compared to the prior year. We experienced lower net sales in almost all product segments as a result of (i) the termination of certain minimum purchase commitments of our cellular products by Motorola, (ii) decreasing production in the global automotive industry

 

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along with the impact of the GM and Chrysler bankruptcies and the bankruptcies of certain of our other customers, (iii) decreased demand from our distribution supply chain customers for consumer and industrial products, (iv) lower capital spending in enterprise and wireline infrastructure, and (v) a decline in consumer spending affecting digital home and multimedia products which negatively impacts our networking business. Distribution sales approximated 21% of our total net sales and fell by 21% compared to the prior year. Distribution inventory, in dollars, was 11.4 weeks of net sales at December 31, 2009, compared to 14.0 weeks of net sales at December 31, 2008.

Net sales by product design group for the years ended December 31, 2009, 2008 and 2007 were as follows:

 

(Dollars in millions)

   Year Ended
December 31,
2009
   Year Ended
December 31,
2008
   Year Ended
December 31,
2007

Microcontroller Solutions

   $ 1,114    $ 1,640    $ 1,884

Networking and Multimedia

     929      1,161      1,121

RF, Analog and Sensors

     814      1,032      1,048

Cellular

     471      1,063      1,217

Other

     180      330      452
                    

Total Net Sales

   $ 3,508    $ 5,226    $ 5,722
                    

Microcontroller Solutions

Our Microcontroller Solutions product line represents the largest component of our total net sales. Microcontrollers and associated application development systems represented approximately 32%, 31% and 33% of our total net sales in 2009, 2008 and 2007, respectively. Demand for our microcontroller products is driven by the automotive, consumer, industrial and computer peripherals markets. The automotive end market accounted for 64%, 65% and 67% of Microcontroller Solutions’ net sales in 2009, 2008 and 2007, respectively.

Microcontroller Solutions net sales declined in 2009 by $526 million, or 32%, compared to 2008, primarily as a result of decreased global automotive demand and production cuts in the U.S. automotive market, where the Big 3 U.S. automakers produced 39% fewer vehicles during 2009 as compared to the prior year. We were also affected by reduced demand in the consumer and industrial markets purchased through our distribution channel. Despite the overall decline from the prior year, sequentially we noted improving sales volumes of our Microcontroller Solutions’ products in the second half of 2009. Our Microcontroller Solutions’ net sales increased by 29% in total, and by 27% in the automotive marketplace, in the second half of 2009 as compared to the first half of the year. This increase related primarily to a 46% increase in units produced by the Big 3 in the second half of 2009 and corresponding increases in our foreign markets, compared to the first half of the year, resulting from government incentive programs and the replenishment of inventories. In 2008, Microcontroller Solutions net sales declined by $244 million, or 13%, compared to 2007, primarily as a result of production cuts in the U.S. automotive market. As in 2009, we were also affected by reduced demand in the consumer and industrial markets purchased through our distribution channel.

Networking and Multimedia

Our networking and multimedia product line, which includes communications and digital signal processors, networked multimedia devices and application processors, represented 26%, 22% and 19% of our total net sales in 2009, 2008 and 2007, respectively. Our primary end markets for our networking and multimedia products are the wireless, wireline infrastructure, enterprise, SOHO and home networking, and mobile consumer markets.

Networking and Multimedia net sales decreased in 2009 by $232 million, or 20%, compared to 2008, as a result of lower capital spending in communications infrastructure, combined with a decline in consumer spending affecting digital home and multimedia products. In 2008, Networking and Multimedia net sales increased by $40 million, or 4%, compared to 2007, due to the inclusion of revenue related to the acquisition of SigmaTel, Inc. (“SigmaTel”) on April 30, 2008, as well as increased demand for set-top box products and communication processors, partially offset by declines in legacy revenues. SigmaTel was a fabless semiconductor company which designed, developed and marketed mixed-signal ICs for the consumer electronics market. Excluding SigmaTel, our Networking and Multimedia product line revenue in 2008 was relatively unchanged compared with 2007, as increased demand for set-top box products and communication processors were partially offset by declines in DSP product revenues.

Radio Frequency, Analog and Sensors

Our Radio Frequency, Analog and Sensors product line, which includes radio frequency devices, analog devices and sensors, represented 23%, 20% and 18% of our total net sales in 2009, 2008 and 2007, respectively. Demand for our Radio Frequency, Analog and Sensors products is driven by the automotive, consumer, industrial, wireless infrastructure and computer peripherals markets; however, the automotive end market accounted for 49%, 53% and 59% of Radio Frequency, Analog and Sensors’s sales in 2009, 2008 and 2007, respectively.

 

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Radio Frequency, Analog and Sensors net sales declined in 2009 by $218 million, or 21%, compared to 2008, as a result of lower demand for both analog and sensor products from weaker automotive vehicle production. In addition, we have also experienced a decline in radio frequency product demand due to the end of the current phase of China’s investment in that country’s 3G wireless infrastructure. Despite the overall decline from the prior year, in the second half of 2009, Radio Frequency, Analog and Sensors’ net sales increased sequentially by 11% in total, and by 48% in the automotive marketplace, as compared to the first half of 2009. This increase related primarily to a 46% increase in units produced by the Big 3 in the second half of 2009 and corresponding increases in our foreign markets, as compared to the first half of 2009, resulting from government incentive programs and the replenishment of inventories. In 2008, Radio Frequency, Analog and Sensors net sales decreased modestly by $16 million, or 2%, compared to 2007, as a result of lower demand for both analog and sensor products from weaker U.S. automotive vehicle production, partially offset by stronger sales in both the analog consumer and the wireless infrastructure markets.

Cellular Products

As discussed above in “Trends in Our Business,” we are executing the wind-down of our cellular handset business. Cellular Products, which includes baseband processors and power management integrated circuits, represented 13%, 20% and 22% of our total net sales in 2009, 2008 and 2007, respectively. Our primary target segment was the cellular communications device (cellular handset) market, with over 50% of Cellular Products sales attributable to Motorola in 2009 and over 90% of Cellular Product sales attributable to Motorola in 2008 and 2007. Cellular Products net sales declined by $592 million, or 56%, in 2009 compared to 2008 and by $154 million, or 13%, in 2008 compared to 2007 due primarily to significantly lower demand from Motorola.

In January 2008, we entered into an amended and extended arrangement with Motorola whereby we received cash proceeds, provided certain pricing modifications and relieved Motorola of certain obligations (“Q1 2008 Motorola Agreement”). We deferred revenue related to the cash proceeds received, which was being recognized over the updated term of the arrangement beginning in the first quarter of 2008. During the third quarter of 2008, we updated our agreement with Motorola whereby Motorola agreed to provide certain consideration in exchange for eliminating their remaining minimum purchase commitments (“Q3 2008 Motorola Settlement Agreement”). As a result of the Q3 2008 Motorola Settlement Agreement and our current sales being only for legacy products, our cellular handset revenues decreased by 82% for the fourth quarter of 2008 versus the fourth quarter of 2007. See “Trends in Our Business” and “Reorganization of Businesses, Contract Settlement, and Other” for further discussion.

Other

We consider the following to be classified as other sales (“Other”): sales to other semiconductor companies, intellectual property revenues, product revenues associated with end markets outside of our product design group target markets, and revenues from sources other than semiconductors. Other represented 5%, 7% and 8% of our total net sales in 2009, 2008 and 2007, respectively. Demand for our Other products is driven primarily by capacity requirements of other semiconductor companies and the ability to license our intellectual property; both of these revenue streams are susceptible to timing and volume fluctuations.

Other net sales declined by $150 million, or 46%, in 2009 as compared to 2008 due principally to a $175 million, or 71%, decrease in contract manufacturing sales. In 2008, Other net sales declined by $123 million, or 27%, as compared to 2007 primarily as a result of a 60% decrease in intellectual property revenue and a 20% decrease in contract manufacturing sales. As a percentage of net sales, intellectual property was 2%, 1% and 2% for 2009, 2008 and 2007, respectively.

Gross Margin

In 2009, our gross margin decreased $1,127 million compared to 2008. As a percentage of net sales, gross margin was 26.9%, reflecting a decline of 12.7 percentage points. This decrease was attributable to substantially reduced revenues which resulted in a significant decline in average year-to-date factory utilization of approximately 20 percentage points, as compared to 2008. This negatively impacted gross margin, as we were experiencing less operating leverage of fixed manufacturing costs. In response to these circumstances, we have executed several cost savings initiatives, including reducing our cost of procured materials and services, internalizing certain wafer manufacturing and assembly and test contract services and executing a workforce reduction across our manufacturing organization. On average, our manufacturing and supply chain operations workforce was reduced 22% during 2009 versus 2008.

Selling, General and Administrative

Our selling, general and administrative expenses decreased $174 million, or 26%, in 2009 compared to 2008. This decrease was the result of a coordinated effort to reduce costs across all selling, general and administration departmental functions and categories of expenses. We executed workforce reductions and focused cost restructuring in the information technology, legal, sales and marketing functions. On average, our selling, general and administrative workforce was reduced 21% during 2009 versus 2008. As a percent of

 

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our net sales, our selling, general and administrative expenses were 14.2%, reflecting an increase of 1.3 percentage points over the prior year primarily due to lower net sales.

Research and Development

Our research and development expense for 2009 decreased $307 million, or 27%, compared to 2008. This decrease was the result of savings from an identified transformation plan including the restructuring of our participation in the IBM alliance, a jointly-funded research alliance created to develop 300-millimeter technologies, the exit of our MRAM business and some initial savings from the strategic realignment of our cellular handset business. As a result, on average, our research and development workforce was reduced 20% during 2009 versus 2008. These savings were partially offset by external acquisitions in 2008 and internal organic investments in our remaining core businesses. As a percent of our net sales, our research and development expenses were 23.7%, increased 1.9 percentage points over the prior year due primarily to lower net sales.

Amortization Expense for Acquired Intangible Assets

Amortization expense for acquired intangible assets related to developed technology, tradenames, trademarks and customer relationships decreased by $556 million in 2009 compared to 2008. The decrease was the result of a lower asset base following non-cash impairment charges recorded against these assets in the second half of 2008.

Reorganization of Businesses, Contract Settlement, and Other

In light of our renewed focus on key market leadership positions and given general market conditions, beginning in the fourth quarter of 2008, we initiated the Reorganization of Business Program which has continued through the current year and has reduced our workforce in our supply chain, research and development, sales, marketing and general and administrative functions. In 2009, we recorded $298 million in employee severance related primary to the elimination of our 150mm fabrication capability, the wind-down of our cellular handset business and the general consolidation of certain research and development, sales and marketing, and logistical and administrative operations. In addition to these severance charges, we recorded $24 million in lease exit costs in connection with a consolidation of certain research and development activities, $25 million of non-cash asset impairment charges and $4 million of gains related to the sale and disposition of certain capital assets.

We also recorded $15 million in charges in 2009 related to our Japanese subsidiary’s pension plan in reorganization of businesses, contract settlement, and other. These charges are related to certain termination benefits and settlement costs in connection with our plan to discontinue our manufacturing operations in Sendai, Japan in 2011 and other previously executed severance actions in Japan. In addition, in connection with our proposed closure of our fabrication facility in Toulouse, France, we recorded a $9 million curtailment gain attributable to certain of our French subsidiary’s employee obligations. We have initiated a formal consultation with employees at our Toulouse fabrication facility. The plan to close the facility in 2011 is being evaluated through consultation with our works council in Toulouse.

In 2008, we recorded a benefit of $296 million in reorganization of businesses, contract settlement, and other in connection with the Q3 2008 Motorola Settlement Agreement, which included the recognition of $187 million of previously deferred revenue recorded under the Q1 2008 Motorola Agreement. This benefit was partially offset by a $38 million charge for future foundry deliveries and contract termination fees associated with the cancellation of certain third-party manufacturing agreements. This charge resulted from the execution of the Q3 2008 Motorola Settlement Agreement.

We also accrued $151 million in employee severance and other exit costs in connection with our Reorganization of Business Program in 2008. We also recorded additional exit costs of $43 million related to a strategic decision to restructure our participation in the IBM alliance, a jointly-funded research alliance created to develop 300-millimeter technologies. In addition to these Reorganization of Business Program charges, we recorded $88 million of non-cash impairment charges in 2008 related to (i) idle property, plant and equipment assets, (ii) certain research and development assets, (iii) the closure of our manufacturing facility located in Tempe, Arizona and (iv) certain other assets classified as held-for-sale as of December 31, 2008.

As a result of a change in executive leadership in 2008, we recorded in reorganization of businesses, contract settlement, and other a $17 million non-cash charge for equity compensation expense as a result of the accelerated vesting of Class B Interests in connection with the execution of a separation agreement with our former Chief Executive Officer. We also recognized $8 million in severance costs related to this separation and $1 million in compensation related to the hiring of our current Chief Executive Officer. In addition, we recorded $12 million in charges related to severance payments and accelerated compensation expense related to the turnover we experienced in a number of our senior management positions.

Finally, we finalized a grant related to our former research and manufacturing alliance in Crolles, France. We recognized a benefit of $9 million for the grant in reorganization of businesses, contract settlement, and other related to the portion of the grant for assets disposed of during 2008.

Gain on Extinguishment of Long-Term Debt

In 2009, a $2,264 million gain on the Debt Exchange was recorded in other, net. Upon completion of the Debt Exchange, the carrying value of our outstanding long-term debt obligations on the Existing Notes declined by $2,853 million, including $24 million

 

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of accrued PIK Interest. This decline was partially offset by the issuance of Incremental Term Loans with a carrying value of $540 million. We recorded $17 million of debt issuance costs in connection with the Incremental Term Loans. We also recorded a $32 million pre-tax gain, net in the accompanying audited Consolidated Statement of Operations in connection with the repurchase of $60 million of our Fixed Rate Notes and $39 million of our PIK-Election Notes in 2009.

During 2008, we recorded a $79 million pre-tax gain, net in connection with the repurchase of $89 million of our Senior Subordinated Notes, $63 million of our Fixed Rate Notes and $25 million of our Floating Rate Notes. (Terms defined and discussed in “Liquidity and Capital Resources” below and in Note 4 to the accompanying audited consolidated financial statements.)

Other Expense, Net

Other expense, net decreased $157 million in 2009 compared to 2008. Net interest expense in 2009 included interest expense of $571 million partially offset by interest income of $15 million. Net interest expense in 2008 included interest expense of $738 million partially offset by interest income of $36 million. The $167 million decrease in interest expense over the prior year period was due to (i) savings related to the Debt Exchange and the retirement of outstanding debt during 2009, and (ii) lower interest rates on our outstanding floating rate debt. This was partially offset by an increase in our interest paid on our revolving credit facility in the fourth quarter of 2008 and the first quarter of 2009. During 2009, we recorded a $10 million pre-tax loss in other, net related to other than temporary impairment charges for certain of our investments accounted for under the cost method, as well as a $5 million pre-tax loss on one of our investments accounted for under the equity method.

During the second quarter of 2008, in accordance with ASC Topic 815, “Derivatives and Hedging” (“ASC Topic 815”), we recognized a $38 million pre-tax loss in other expense related to the cumulative ineffective portion and subsequent change in fair value of our interest rate swaps that are no longer classified as a cash flow hedge. In 2008, we also recorded in other, net (i) a $12 million pre-tax gain as a result of the sale of all of the shares in one of our investments accounted for under the cost method, (ii) a $5 million pre-tax loss attributable to one of our investments accounted for under the equity method, and (iii) foreign currency fluctuations.

Income Tax Benefit

In 2009, our effective tax rate was an income tax expense of less than 1%, excluding a net income tax benefit of $253 million recorded for discrete events occurring in 2009. These discrete events primarily reflect a non-cash tax benefit of $270 million related to the release of a U.S. valuation allowance in connection with unremitted earnings of one of our foreign subsidiaries. Other discrete events offsetting the non-cash benefit described above include income tax expense related to a valuation allowance associated with the deferred tax assets of one of our foreign subsidiaries. The impact of the valuation allowance was partially offset by the release of income tax reserves related to foreign audit settlements and statute expirations.

During 2009, we recorded a $2,264 million net gain as a result of the reduction in our outstanding long-term debt in connection with the Debt Exchange. We continue to be in an overall three year U.S. cumulative loss position, inclusive of the cancellation of debt gain. A valuation allowance of $560 million was recorded on our U.S. deferred tax assets as of December 31, 2008, so substantially all of the U.S. income tax expense related to the cancellation of debt income was offset by a beneficial release of the valuation allowance on our U.S. deferred tax assets.

Our annual effective tax rate is less than the U.S. statutory tax rate of 35% percent due to (i) the aforementioned $270 million non-cash tax benefit recorded in connection with the release of our U.S. valuation allowance, (ii) minimal tax expense in our U.S. earnings due to the utilization of deferred tax assets, which were subject to a valuation allowance and (iii) the mix of earnings and losses by taxing jurisdictions and foreign tax rate differentials.

In 2008, our effective tax rate was a tax benefit of 6%. Our effective tax rate was less than the U.S. statutory tax rate of 35% primarily due to nondeductible nature of goodwill impairments and valuation allowances of $560 million recorded against net U.S. deferred tax assets at the time. The recognition of the valuation allowance resulted from having incurred cumulative losses in the U.S., which is a strong indication that it is more likely than not that all or a portion of our U.S. deferred tax assets may not be recoverable. The effective rate included the tax impact recorded for discrete events of $22 million related to increases in valuation allowances associated with certain of our foreign deferred tax assets, foreign tax rate changes, tax audits settlements, and interest expense associated with tax reserves.

Year Ended December 31, 2008 Compared to Year Ended December 31, 2007

Net Sales

Our net sales and orders of approximately $5,226 million and $4,845 million in 2008 decreased 9% and 10%, respectively, compared to 2007. Lower net sales were driven by a decrease in microcontroller, analog and sensor product shipments due to decreasing production in the global automotive industry and in connection with the termination of certain minimum purchase commitments of our cellular products by Motorola. These items were partially offset by higher radio frequency product shipments related to increased demand in the Asian wireless infrastructure market. Intellectual property revenue decreased 60% in 2008,

 

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compared to 2007, to 1% as a percentage of net sales. Distribution sales approximated 17% of our total net sales and fell by 3% compared to 2007. Distribution inventory, in dollars, was 14.0 weeks of net sales at December 31, 2008, compared to 11.8 weeks of net sales at December 31, 2007.

Gross Margin

In 2008, our gross margin increased $171 million compared to 2007. As a percentage of net sales, gross margin was 39.6%, reflecting an improvement of 6.4 percentage points. This increase was attributable to a $416 million purchase accounting charge to cost of sales in the first quarter of 2007 resulting from the step-up to fair value of our inventory at the Merger date. Our gross margin also benefited from lower costs associated with our foundry and assembly and test operations, as well as our exit from the Crolles alliance in the fourth quarter of 2007. Partially offsetting these items was a decrease in factory utilization and a $7 million increase in cost of sales resulting from the step-up to fair value of our inventory in connection with the SigmaTel acquisition.

Selling, General and Administrative

Our selling, general and administrative expenses increased $20 million, or 3%, in 2008 compared to 2007. This increase was primarily the result of an increase in strategic sales support costs and legal expenses required in connection with defending various patent infringement claims. These items were partially offset by focused cost-cutting initiatives, including reorganization programs initiated in the second quarter of 2008 and the prior year. As a percent of our net sales, our selling, general and administrative expenses increased 1.5 percentage points primarily due to lower net sales.

Research and Development

Our research and development expense for 2008 remained consistent with 2007. Increased spending in specific strategic growth product areas including consumer devices in connection with the SigmaTel acquisition was offset by savings from (i) our withdrawal from the research and manufacturing alliance in Crolles, France in the fourth quarter of 2007, (ii) the restructuring of our participation in the IBM alliance (a jointly-funded research alliance created to develop 300-millimeter technologies) in the third quarter of 2008 and (iii) reorganization programs initiated in the second quarter 2008 and the prior year. As a percent of our net sales, our research and development expenses increased 1.9 percentage points due to lower net sales.

Amortization Expense for Acquired Intangible Assets

Amortization expense for acquired intangible assets related to developed technology, tradenames, trademarks and customer relationships decreased by $268 million compared to 2007. The decrease was the result of a lower asset base following non-cash impairment charges recorded against these assets in the fourth quarter of 2007 and the second half of 2008.

Reorganization of Businesses, Contract Settlement, and Other

In 2008, we recorded a benefit of $296 million in reorganization of businesses, contract settlement, and other in connection with the Q3 2008 Motorola Settlement Agreement, which included the recognition of $187 million of previously deferred revenue recorded under the Q1 2008 Motorola Agreement. This benefit was partially offset by a $38 million charge for future foundry deliveries and contract termination fees associated with the cancellation of certain third-party manufacturing agreements. This charge resulted from the execution of the Q3 2008 Motorola Settlement Agreement.

We accrued $151 million in employee severance and other exit costs in connection with our Reorganization of Business Program in 2008. We also recorded exit costs of $43 million related to a strategic decision to restructure our participation in the IBM alliance, a jointly-funded research alliance created to develop 300-millimeter technologies. In addition to these Reorganization of Business Program charges, we recorded $88 million of non-cash impairment charges in 2008 related to (i) idle property, plant and equipment assets, (ii) certain research and development assets, (iii) the closure of our manufacturing facility located in Tempe, Arizona and (iv) certain other assets classified as held-for-sale as of December 31, 2008.

As a result of a change in executive leadership in 2008, we recorded in reorganization of businesses, contract settlement, and other a $17 million non-cash charge for equity compensation expense as a result of the accelerated vesting of Class B Interests in connection with the execution of a separation agreement with our former Chief Executive Officer. We also recognized $8 million in severance costs related to this separation and $1 million in compensation related to the hiring of our current Chief Executive Officer. We also recorded $12 million in charges related to severance payments and accelerated compensation expense related to the turnover we experienced in a number of our senior management positions.

Finally, we finalized a grant related to our former research and manufacturing alliance in Crolles, France. We recognized a benefit of $9 million for the grant in reorganization of businesses, contract settlement, and other related to the portion of the grant for assets sold during 2008.

In 2007, we recorded net severance charges of $35 million in reorganization of businesses, contract settlement, and other attributable to a reorganization program initiated in the second quarter of 2007. We also recorded non-cash impairment charges of $20 million in reorganization of businesses, contract settlement, and other related to our then held-for-sale assets at our former 300-millimeter wafer fabrication facility located in Crolles, France where we ended a strategic development and manufacturing relationship with two other semiconductor manufacturers. The impairment charge was in connection with management reaching an

 

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agreement to sell our related assets. In connection with the conclusion of the research and manufacturing alliance in Crolles, France, we recorded $5 million in exit costs. Finally, we also recorded non-cash impairment charges of approximately $4 million on certain assets previously held-for-sale.

Impairment of Goodwill and Intangible Assets

In 2008, in connection with the termination of the Q1 2008 Motorola Agreement, the significant decline in the market capitalization of the public companies in our peer group as of December 31, 2008, our then announced intent to pursue strategic alternatives for our cellular handset product group and the impact from weakening global market conditions in our remaining businesses, we concluded that indicators of impairment existed related to our goodwill and intangible assets. As a result, we recorded impairment charges of $5,350 million and $1,631 million associated with goodwill and intangible assets, respectively. These goodwill and intangible assets were primarily established in purchase accounting at the completion of the Merger in December 2006.

During the fourth quarter of 2007, we began discussions regarding our then existing supply agreement with Motorola. We concluded in connection with these discussions that indicators of impairment existed related to the developed technology, customer relationship and trademark / tradename intangible assets associated with our cellular handset product group. As a result, in 2007 we recorded a $449 million impairment charge related to the intangible assets of our cellular handset product group.

Merger Expenses

Merger expenses were $11 million in 2008 and consisted primarily of retention costs associated with the SigmaTel acquisition and accounting, legal and other professional fees. Such expenses were $5 million in 2007 and consisted of accounting, legal and other professional fees.

Gain on Extinguishment of Long-Term Debt

During 2008, we recorded a $79 million pre-tax gain, net in connection with the repurchase of $89 million of our Senior Subordinated Notes, $63 million of our Fixed Rate Notes and $25 million of our Floating Rate Notes. (Terms defined and discussed in Note 4 to the accompanying audited consolidated financial statements.)

Other Expense, Net

Other expense, net decreased $47 million in 2008 compared to 2007. Net interest expense in 2008 included interest expense of $738 million partially offset by interest income of $36 million. Net interest expense in 2007 included interest expense of $834 million partially offset by interest income of $50 million. The $96 million decrease in interest expense over the prior year was due to (i) savings related to the retirement of outstanding debt during 2008, partially offset by an increase in our revolving credit facility in the fourth quarter of 2008, and (ii) lower interest rates on outstanding floating rate debt. The $14 million decrease in interest income over the prior year was primarily attributable to lower investment interest rates, partially offset by an approximate $600 million increase in funds available for investment as a result of proceeds associated with the Q1 2008 Motorola Agreement and asset dispositions related to our exit from the Crolles alliance in 2008.

During the second quarter of 2008, in accordance with ASC Topic 815, we recognized a $38 million pre-tax loss in other expense related to the cumulative ineffective portion and subsequent change in fair value of our interest rate swaps that are no longer classified as a cash flow hedge. In 2008, we also recorded in other, net (i) a $12 million pre-tax gain as a result of the sale of all of the shares in one of our investments accounted for under the cost method, (ii) a $5 million pre-tax loss attributable to one of our investments accounted for under the equity method, and (iii) foreign currency fluctuations.

Income Tax Benefit

In 2008, our effective tax rate was a tax benefit of 6%. Our effective tax rate was less than the U.S. statutory tax rate of 35% primarily due to nondeductible nature of goodwill impairments and valuation allowances of $560 million recorded against net U.S. deferred tax assets at the time. The recognition of the valuation allowance resulted from having incurred cumulative losses in the U.S., which is a strong indication that it is more likely than not that all or a portion of our deferred tax assets may not be recoverable. The effective rate included the tax impact recorded for discrete events of $22 million related to increases in valuation allowances associated with certain of our foreign deferred tax assets, foreign tax rate changes, tax audits settlements, and interest expense associated with tax reserves.

 

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In 2007, our effective tax rate was 35%, including the tax impact recorded for discrete events which had no net material impact on our effective tax rate. The discrete events relate primarily to tax rate changes in foreign jurisdictions and changes in the valuation allowance associated with the deferred tax assets of certain of our foreign subsidiaries. During 2007, we adopted the provisions of ASC Topic 740, “Income Taxes” (“ASC Topic 740”) which determine the accounting for uncertainty in income taxes. The adoption resulted in a $5 million increase in the liability for unrecognized tax benefits, which was accounted for as an increase to goodwill as of January 1, 2007.

Reorganization of Businesses, Contract Settlement, and Other

We have implemented plans to reduce our workforce, discontinue product lines, exit or refocus our business strategies and consolidate manufacturing and administrative operations in an effort to improve our operational effectiveness, reduce costs and simplify our product portfolio. At each reporting date, we evaluate our accruals for exit costs and employee separation costs, which consist primarily of termination benefits (principally severance and relocation payments), to ensure that our accruals are still appropriate. In certain circumstances, accruals are no longer required because of efficiencies in carrying out our plans or because employees previously identified for separation resigned unexpectedly and did not receive severance or were redeployed due to circumstances not foreseen when the original plans were initiated. We reverse accruals to income when it is determined they are no longer required.

Year Ended December 31, 2009

During the fourth quarter of 2008, we executed a renewed strategic focus on key market leadership positions. In connection with this announcement and given general market conditions, we initiated a series of restructuring actions to streamline our cost structure and re-direct some research and development investments into growth markets (“Reorganization of Business Program”). These actions include (i) the winding-down of our cellular handset business, (ii) restructuring our participation in the IBM alliance (a jointly-funded research alliance), (iii) discontinuing our 150mm manufacturing operations at our facilities in East Kilbride, Scotland, Sendai, Japan and Toulouse, France and (iv) consolidating certain research and development, sales and marketing, and logistical and administrative operations. We incurred $345 million in severance and exit costs associated with the Reorganization of Business Program, pension termination benefits, asset impairment charges and disposition activities in 2009. These actions have reduced and will reduce our workforce in our supply chain, research and development, sales, marketing and general and administrative functions.

The following table displays a roll-forward from January 1, 2009 to December 31, 2009 of the employee separation and exit cost accruals established related to the Reorganization of Business Program:

 

(in millions, except headcount)

   Accruals at
January 1,
2009
   Charges    Adjustments     2009
Amounts
Used
    Accruals at
December 31,
2009

Employee Separation Costs

            

Supply chain

   $ 70    197    (9   (77   $ 181

Selling, general and administrative

     20    24    (2   (28     14

Research and development

     25    92    (4   (69     44
                              

Total

   $ 115    313    (15   (174   $ 239
                              

Related headcount

     2,640    3,610    (300   (4,200     1,750
                              

Exit and Other Costs

   $ 26    22    2      (34   $ 16
                              

In 2009, we recorded $298 million in charges for severance costs in connection with our decision to exit our manufacturing facilities in Sendai, Japan and Toulouse, France and severance costs associated with the wind-down of our cellular handset product offerings. Additional reorganization costs consist primarily of severance costs related to our ongoing Reorganization of Business Program, including the general consolidation of certain research and development, sales and marketing, and logistical and administrative operations.

We separated approximately 4,200 employees during 2009. The $174 million used reflects cash payments made to employees separated as part of the Reorganization of Business Program through December 31, 2009. We will make additional payments to these separated employees and the remaining approximately 1,750 employees through 2011. We also reversed $15 million of severance accruals as a result of 300 employees previously identified for separation who either resigned and did not receive severance or were redeployed due to circumstances not foreseen when original plans were approved.

During 2009, we also recorded charges for exit costs of $24 million related primarily to costs to terminate various operating leases in connection with a consolidation of certain research and development activities resulting from our Reorganization of Business Program. As of December 31, 2009, $8 million of these exit costs have been paid. During the third quarter of 2008, we recorded exit and other costs related to a strategic decision to restructure our participation in the IBM alliance, a jointly-funded research alliance

 

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among several semiconductor manufacturers which was formed to develop 300-millimeter technologies. We paid the remaining $26 million of the related charge for this action during the second quarter of 2009.

Termination Benefits

We recorded $15 million in charges in 2009 related to our Japanese subsidiary’s pension plan. These charges are related to certain termination benefits and settlement costs in connection with our plan to discontinue our manufacturing operations in Sendai, Japan in the second half of 2011 and other previously executed severance actions in Japan. In connection with our proposed closure of our fabrication facility in Toulouse, France in the first half of 2011, we recorded a $9 million curtailment gain attributable to certain of our French subsidiary’s employee obligations. We have initiated a formal consultation with employees at our Toulouse fabrication facility, and the plan to close the facility in 2011 is being evaluated through consultation with our works council in Toulouse.

Asset Impairment Charges and Disposition Activities

During 2009, we recorded $25 million of non-cash impairment charges related to certain assets classified as held-for-sale (or previously classified as held-for-sale) and in connection with our consolidation of leased facilities. During 2009, we also recorded gains of (i) $2 million associated with the disposition of certain equipment formerly used in our cellular handset business, and (ii) $2 million in connection with the sale of a parcel of land at our Toulouse, France manufacturing facility.

Other Reorganization of Business Programs

In 2009, we reversed $4 million of severance accruals related to reorganization of business programs initiated in periods preceeding the third quarter of 2008. These reversals were due to a number of employees previously identified for separation who resigned and did not receive severance or were redeployed due to circumstances not foreseen when original plans were approved. As December 31, 2009, we have $3 million of remaining severance, relocation and exit cost accruals associated with these programs. We expect to make the final payments related to these programs by the end of 2010.

Year Ended December 31, 2008

Motorola Arrangements and Cellular Strategy

On October 2, 2008, we announced that we intended to renew our focus on key market leadership positions. In support of this targeted approach, we evaluated strategic options for our cellular handset product group. Concurrently, in September 2008, we updated our arrangement with Motorola, our largest cellular product customer. We had previously entered into the Q1 2008 Motorola Agreement whereby we received cash proceeds, provided certain pricing modifications and relieved Motorola of certain obligations. We deferred revenue related to the cash proceeds received, which was being recognized over the term of the arrangement beginning in the first quarter of 2008. In the third quarter of 2008, the Q1 2008 Motorola Agreement was terminated.

In the Q3 2008 Motorola Settlement Agreement, Motorola agreed to provide certain consideration in exchange for eliminating its remaining minimum purchase commitments. We recorded a benefit of $296 million in reorganization of businesses, contract settlement, and other in connection with the Q3 2008 Motorola Settlement Agreement, which included the recognition of all remaining previously deferred revenue recorded under the Q1 2008 Motorola Agreement. As a result of these updated arrangements, our cellular handset revenues and our total operating earnings have decreased.

This benefit was partially offset by a $38 million charge for future foundry deliveries and contract termination fees associated with the cancellation of certain third-party manufacturing agreements. This charge resulted from the execution of the Q3 2008 Motorola Settlement Agreement.

Reorganization of Business Programs

In 2008, we recorded $123 million of severance accruals related to our Reorganization of Business Program. In addition to these severance costs, we recorded exit and other costs of $43 million in reorganization of businesses, contract settlement, and other in 2008 related to a strategic decision to restructure our participation in the IBM alliance, a jointly-funded research alliance among several semiconductor manufacturers which was formed to develop 300-millimeter technologies. This cash charge represents a one-time fee to terminate future rights and obligations under the jointly-funded research alliance.

In 2008, we also recorded $30 million of severance accruals and other exit costs related to other reorganization of business programs initiated prior to the third quarter of 2008. We also reversed $2 million of severance accruals related to these earlier reorganization of business programs due to a number of employees previously identified for separation who either resigned and did not receive severance or were redeployed due to circumstances not foreseen when original plans were approved. An additional $8 million of severance accruals were reversed to goodwill due to efficiencies achieved through the execution of a research and design center consolidation program and the redeployment of certain resources.

Executive Leadership Transition

During 2008, $26 million was recorded in reorganization of businesses and other related to the change in executive leadership. Of this amount, $17 million was a non-cash charge for equity compensation expense as a result of the accelerated vesting of certain Class B Interests in connection with the execution of a separation agreement with Michel Mayer, our former Chairman of the Board

 

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and Chief Executive Officer. We also recognized $8 million in severance costs related to Mr. Mayer’s separation and $1 million in compensation related to the sign-on bonus for Richard Beyer, our current Chairman of the Board and Chief Executive Officer. We also recorded $12 million in charges related to severance payments and accelerated compensation expense related to the turnover we experienced in a number of our senior management positions.

Asset Impairment Charges

During 2008, we recorded $88 million of non-cash impairment charges, including a $59 million related to certain idle property, plant and equipment assets included in all of our manufacturing facilities, $18 million attributable to certain research and development assets, $7 million associated with the closure of our manufacturing facility located in Tempe, Arizona and $4 million charge related to certain other assets previously classified as held-for-sale.

Crolles Manufacturing and Research Alliance

During 2008, we finalized a grant related to our former research and manufacturing alliance in Crolles, France. We recognized a benefit of $9 million for the grant in reorganization of businesses, contract settlement and other related to the portion of the grant for assets disposed of during 2008. We also recorded a benefit of $5 million to research and development expense in connection with the receipt of this grant.

Liquidity and Capital Resources

Cash and Cash Equivalents

Of the $1,363 million of cash and cash equivalents and short-term investments at December 31, 2009, $691 million was held by our U.S. subsidiaries and $672 million was held by our foreign subsidiaries. Repatriation of some of these funds could be subject to delay and could have potential tax consequences, principally with respect to withholding taxes paid in foreign jurisdictions.

Operating Activities

We generated cash flow from operations of $76 million and $405 million during the years ended December 31, 2009 and 2008, respectively. The decrease in cash flow provided by operations from the prior year period is primarily attributable to our significant decline in revenues during 2009, as well as 2008 benefitting from the receipt of funds in connection with an updated arrangement with Motorola. Our days sales outstanding decreased to 36 days at December 31, 2009 from 38 days at December 31, 2008. Our days of inventory on hand (excluding the impact of purchase accounting on inventory and cost of sales) decreased to 87 days at December 31, 2009 from 93 days at December 31, 2008 as a result of declining inventory levels. Days purchases outstanding increased to 45 days at December 31, 2009 from 36 days at December 31, 2008 primarily due to fluctuations in the timing of payments.

Investing Activities

Our net cash provided by investing activities was $374 million in 2009, and our net cash used for investing activities was $59 million in 2008. Our investing activities are driven by investment of our excess cash, capital expenditures, strategic acquisitions and investments in other companies and sales of investments and businesses. Our capital expenditures were $85 million and $239 million in 2009 and 2008, respectively, and represented 2% and 5% of our net sales, respectively.

The increase in the cash provided by investing activities in 2009 versus the prior year period was primarily the result of the generation of $488 million from the sale of our short-term investments in connection with re-directing our investments in a wholly-owned money market fund to cash equivalent money market accounts. The factors impacting our investing cash flows during 2008 were the proceeds from the sale of our property, plant and equipment located at the 300-millimeter wafer fabrication facility located in Crolles, France, where we ended a strategic development and manufacturing relationship with two other semiconductor manufacturers in the fourth quarter of 2007, partially offset by the utilization of $94 million of cash during 2008 in connection with the acquisition of SigmaTel, Inc.

Financing Activities

Our net cash provided by financing activities was $9 million and $342 million in 2009 and 2008, respectively. The decrease in cash provided by financing activities is attributable primarily to receiving $313 million more in proceeds from draw downs on the Revolver, as well as on a foreign subsidiary revolving loan agreement, in 2008. This decrease was partially offset by the utilization of less cash in 2009 on repurchases of our Existing Notes and other additional contractual long-term debt and capital lease payments.

Debt Exchange

On February 10, 2009, FSL, Inc. invited eligible holders of each of its (i) Senior Floating Rate Notes due 2014 (“Floating Rate Notes”), (ii) 9.125%/9.875% Senior PIK-Election Notes due 2014 (“PIK-Election Notes”), (iii) 8.875% Senior Fixed Rate Notes due 2014 (“Fixed Rate Notes”) and (iv) 10.125% Senior Subordinated Notes due 2016 (“Senior Subordinated Notes”) to participate as a lender in the issuance of new senior secured incremental term loans under the existing Credit Facility (the “Incremental Term Loans”) in a transaction referred to as the “Debt Exchange”. The aggregate principal amount of Incremental Term Loans available to eligible holders in the invitations was $1,000 million, including the incremental term loans payable as compensation to certain of FSL, Inc.’s

 

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advisors. (The Floating Rate Notes, the PIK-Election Notes, the Fixed Rate Notes and the Senior Subordinated Notes are collectively referred to as the “Existing Notes” and are discussed further in this section.)

On March 10, 2009, FSL, Inc.’s invitation to participate in the Debt Exchange expired for all Floating Rate Notes, Fixed Rate Notes and Senior Subordinated Notes. On March 24, 2009, FSL, Inc.’s invitation to participate in the Debt Exchange expired for all PIK-Election Notes. Through the Debt Exchange, $2,829 million aggregate principal amounts of Existing Notes were retired, including $281 million of Floating Rate Notes, $957 million of PIK-Election Notes, $845 million of Fixed Rate Notes and $746 million of Senior Subordinated Notes. Based on the principal amount of Floating Rate Notes, Fixed Rate Notes and Senior Subordinated Notes delivered and accepted, FSL, Inc. issued approximately $665 million principal amount of Incremental Term Loans under the Incremental Amendment dated March 17, 2009. On March 26, 2009, based on the principal amount of PIK-Election Notes validly delivered and accepted, FSL, Inc. issued an additional $237 million principal amount of Incremental Term Loans. Furthermore, as compensation for the arranger services, additional Incremental Term Loans with a principal of $22 million were issued, for a total of approximately $924 million aggregate principal amount of Incremental Term Loans. At December 31, 2009, the Incremental Term Loans are recorded on the accompanying audited Consolidated Balance Sheet at a $359 million discount, which is subject to accretion to par value over the term of the restructured debt using the effective interest method. The Incremental Term Loans were valued based upon the public trading prices of the Existing Notes exchanged immediately prior to the launch of the Debt Exchange.

Upon completion of the Debt Exchange, the carrying value of FSL, Inc.’s outstanding long-term debt obligations on the Existing Notes declined by $2,853 million, including $24 million of accrued PIK Interest (as defined later in this section). This decline was partially offset by the issuance of Incremental Term Loans with a carrying value of $540 million. FSL, Inc. recorded $17 million of debt issuance costs in connection with the Incremental Term Loans.

Credit Facility

At December 31, 2009, FSL, Inc., Holdings III, IV and V had a senior secured credit facility (“Credit Facility”) that included (i) a $3.5 billion term loan (“Term Loan”), (ii) the aforementioned Incremental Term Loans and (iii) a revolving credit facility, including letters of credit and swing line loan sub-facilities, with a committed capacity of $690 million (“Revolver”), excluding a non-funding commitment attributable to Lehman Commercial Paper, Inc. (“LCPI”), which filed a petition under Chapter 11 of the U.S. Bankruptcy Code with the United States Bankruptcy Court for the Southern District of New York on October 5, 2008. LCPI has a commitment in the amount of $60 million of the Revolver; but, borrowing requests have not been honored by LCPI.

In January 2009, FSL, Inc. drew down $184 million, net of LCPI non-funding, from the Revolver. FSL, Inc. made this financial decision to further enhance its liquidity and net cash position.

FSL, Inc.’s debt agreements require additional payments from proceeds received upon certain asset dispositions, excess cash flows and the incurrence or issuance of certain debt, as defined in the debt agreements. Based on our operating results for the year ended December 31, 2008, we made a mandatory prepayment of approximately $24 million in 2009 based on excess cash flows.

The Term Loan will mature on December 1, 2013. The Revolver will be available through December 1, 2012, at which time all outstanding principal amounts under the Revolver will be due and payable. Borrowings under the Credit Facility may be used for working capital purposes, capital expenditures, investments, share repurchases, acquisitions and other general corporate purposes. At December 31, 2009, $3,372 million and $644 million were outstanding under the Term Loan and Revolver, respectively, and the Revolver had a remaining capacity of $15 million, excluding the LCPI commitment and $31 million in outstanding letters of credit.

The Term Loan and Revolver bear interest, at FSL, Inc.’s option, at a rate equal to an applicable margin over either (i) a base rate equal to the higher of either (a) the prime rate of Citibank, N.A. or (b) the federal funds rate, plus one-half of 1%; or, (ii) a LIBOR rate based on the cost of funds for deposit in the currency of borrowing for the relevant interest period, adjusted for certain additional costs. The interest rate on the Term Loan and the Revolver at December 31, 2009 was 1.99% and 2.23%, respectively. The applicable margin for borrowings under the Revolver may be reduced subject to the attainment of certain leverage ratios. FSL, Inc. is also required to repay a portion of the outstanding Term Loan balance in quarterly installments in aggregate annual amounts equal to 1% of the initial outstanding balance for the first six years and nine months after the Term Loan closing date, with the remaining balance due upon maturity. FSL, Inc. is also required to pay quarterly facility commitment fees on the unutilized capacity of the Revolver at an initial rate of 0.50% per annum. The commitment fee rate may be reduced subject to our attaining certain leverage ratios. FSL, Inc. is also required to pay customary letter of credit fees.

The Incremental Term Loans will mature on December 15, 2014. The Incremental Term Loans bear interest at a rate per annum equal to 12.5% and a default rate of 14.5%, and interest on the Incremental Term Loans is payable quarterly in arrears. FSL, Inc. is required to repay a portion of the outstanding Incremental Term Loan balance in quarterly installments in aggregate annual amounts equal to 1% of the initial outstanding balance (subject to reduction following prepayment of such Incremental Term Loans as set forth in the existing Credit Facility agreement), with the remaining balance due upon maturity. At December 31, 2009, $558 million was outstanding under the Incremental Term Loans, net of the aforementioned unamortized discount of $359 million.

The obligations under the Credit Facility are guaranteed by certain of the Parent Companies and certain subsidiaries of FSL, Inc. and are secured by a security interest in all of the collateral for the obligations of Freescale and the guarantors under the existing

 

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Credit Facility and related loan documents. See Note 4 in the notes to the accompanying audited consolidated financial statements for further discussion.

FSL, Inc. is currently seeking to amend the Credit Facility to, among other things, extend the maturity of certain of its term loans held by accepting lenders to December 1, 2016 and increase the interest rate with respect to such extended-maturity term loans and allow for one or more issuances of additional senior secured notes to be secured on a pari passu basis with the obligations under the Credit Facility, so long as, among other things, the net cash proceeds from any such issuance are used to prepay amounts outstanding under the Credit Facility at par. The proposed amendment of the Credit Facility is subject to lender consent and other conditions, and may not occur as described or at all.

Existing Notes

FSL, Inc. had an aggregate principal amount of $2,900 million in senior notes outstanding at December 31, 2009, consisting of (i) $194 million Floating Rate Notes bearing interest at a rate, reset quarterly, equal to 3-month LIBOR (which was 0.25% on December 31, 2009) plus 3.875% per annum, (ii) $1,382 million of Fixed Rate Notes, (iii) $560 million of PIK-Election Notes, and (iv) $764 million of Senior Subordinated Notes. Relative to our overall indebtedness, the Existing Notes (other than the Senior Subordinated Notes), rank in right of payment (i) equal to all senior unsecured indebtedness (ii) senior to all subordinated indebtedness (including the Senior Subordinated Notes), and (iii) junior to all secured indebtedness (including the Credit Facility), to the extent assets secure that indebtedness. The Senior Subordinated Notes are unsecured senior subordinated obligations and rank junior in right of payment to our senior indebtedness, including indebtedness under the Credit Facility and the other Existing Notes. The Existing Notes are governed by two Indentures dated as of December 1, 2006, as supplemented and amended. The Existing Notes are guaranteed by the same guarantors as under the Credit Facility.

As noted in the aforementioned “Debt Exchange” discussion, $2,829 million aggregate principal amounts of Existing Notes were retired in connection with the Debt Exchange in the first quarter of 2009, including $281 million of Floating Rate Notes, $957 million of PIK-Election Notes, $845 million of Fixed Rate Notes and $746 million of Senior Subordinated Notes. In 2009, Freescale also repurchased an additional $60 million of its Fixed Rate Notes and an additional $39 million of its PIK-Election Notes at a $32 million discount, net of $2 million in non-cash charges associated with the recognition of unamortized debt issuance costs associated with the early retirement of this debt. FSL, Inc. used funds from the cash and cash equivalents portfolio for the purchase and early retirement of these notes. The redemption price on the repurchases included accrued and unpaid interest up to, but not including, the redemption date.

For the interest periods ending on June 15, 2009 and December 15, 2009, FSL, Inc. elected to use the payment-in-kind (“PIK”) feature of its outstanding PIK-Election Notes in lieu of making cash interest payments (“PIK Interest”). In connection with this election, FSL, Inc. delivered notice to The Bank of New York Mellon (formerly The Bank of New York), in its capacity as trustee under the Indenture governing the PIK-Election Notes, that, with respect to the interest that would be due on such notes for these periods, it would make such interest payments by paying in kind at the PIK Interest rate of 9.875% instead of paying interest in cash. FSL, Inc. may elect to use the PIK feature of its PIK-Election Notes for any interest period through December 15, 2011. As a result, FSL, Inc. issued a total of approximately $53 million of incremental PIK-Election Notes in 2009. FSL, Inc. also elected to use the PIK feature of its outstanding PIK-Election Notes for the interest period ending on June 15, 2010 and accordingly, as of December 31, 2009, $2 million of accrued PIK Interest associated with the PIK-Election Notes was classified as long-term debt.

Hedging Transactions

In connection with the issuance of the Term Loan and Floating Rate Notes, FSL, Inc. entered into interest rate swap contracts with various counterparties as a hedge of the variable cash flows of our variable interest rate debt. Under the terms of the interest rate swap contracts, we have effectively converted $200 million of the variable interest rate debt to fixed interest rate debt from December 1, 2009 through December 1, 2012.

During 2009, FSL, Inc. also entered into two interest rate cap contracts with a counterparty as a hedge of the variable cash flows of our variable interest rate debt. Under the terms of these contracts, FSL, Inc. has effectively hedged $400 million of its variable interest rate debt at a cap rate of 2.75%. The caps became effective on December 1, 2009 and will mature on December 1, 2012. Accordingly, since December 1, 2009, FSL, Inc. continues to pay interest at a LIBOR-based rate on $400 million of its variable interest rate debt, so long as the LIBOR-based rate does not exceed 2.75%. If the LIBOR-based rate exceeds the cap rate in any given interest period, FSL, Inc. will subsequently receive a payment from its counterparty to ensure the LIBOR-based rate we pay is no more than 2.75%, net on the related variable interest rate debt.

Covenant Compliance

The Credit Facility and indentures governing our Existing Notes (“Indentures”) have restrictive covenants that limit the ability of our subsidiaries to, among other things, incur or guarantee additional indebtedness or issue preferred stock; pay dividends and make other restricted payments; incur restrictions on the payment of dividends or other distributions from our restricted subsidiaries; create or incur certain liens; make certain investments; transfer or sell assets; engage in transactions with affiliates; and, merge or consolidate with other companies or transfer all or substantially all of our assets. Under the Credit Facility and Indentures, FSL, Inc. must comply with conditions precedent that must be satisfied prior to any borrowing, as well as ongoing compliance with specified affirmative and

 

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negative covenants. The Credit Facility and Indentures also provide for customary events of default, including failure to pay any principal or interest when due, failure to comply with covenants and cross defaults or cross acceleration provisions. FSL, Inc. was in compliance with these covenants as of December 31, 2009.

Some of these covenants restrict us if we fail to meet financial ratios based on our level of profitability. The 2009 global economic environment has resulted in lower operating profitability, causing four financial ratios (the total leverage ratio, the senior secured first lien leverage ratio, the fixed charge coverage ratio and the consolidated secured debt ratio) to fall outside of the ranges set forth in the Credit Facility and Indentures. This change does not result in any form of non-compliance with our covenants contained within the Credit Facility and Indentures but does impose certain of the restrictions discussed in the preceding paragraph, such as our ability to transfer or sell assets, merge or consolidate with other companies, make certain investments and incur additional indebtedness.

Credit Ratings

As of December 31, 2009, our corporate credit ratings from Standard & Poor’s, Moody’s and Fitch were B-, Caa1 and CCC, respectively. These compared to corporate credit ratings from Standard & Poor’s, Moody’s and Fitch were B+, B1 and B, respectively, as of December 31, 2008.

Other Indebtedness

During the third quarter of 2006, one of our foreign subsidiaries requested and received a draw from an existing Japanese yen-denominated revolving loan agreement to repay an intercompany loan. In the fourth quarter of 2008, the foreign subsidiary drew down an additional $37 million under this revolving loan in order to enhance its cash position and liquidity, increasing the total amount outstanding to $92 million at December 31, 2008. In the third quarter of 2009, we entered into an amended arrangement for this revolving loan balance, whereby we make quarterly payments of approximately $15 million beginning in the third quarter of 2009 and concluding in the fourth quarter of 2010. Accordingly, in the second half of 2009, we made payments of $31 million on our obligation under this loan. This revolving loan bears interest at 3.5% per annum. The land and buildings located at our Sendai, Japan manufacturing facility are pledged as collateral on this revolving loan until the fourth quarter of 2010 when the loan is fully repaid. As of December 31, 2009, $61 million was outstanding under this loan.

EBITDA/Adjusted EBITDA

Adjusted earnings before cumulative effect of accounting change, interest, taxes, depreciation and amortization (“Adjusted EBITDA”) is a non-U.S. GAAP measure that we use to determine our compliance with certain covenants contained in the Credit Facility and Indentures. Adjusted EBITDA is defined as EBITDA adjusted to add back certain non-cash, non-recurring and other items that are included in EBITDA and/or net earnings (loss), as required by various covenants in the Indentures and the Credit Facility. We believe that the presentation of Adjusted EBITDA is appropriate to provide additional information to investors to demonstrate compliance with our financing covenants. Our ability to engage in activities such as incurring additional indebtedness, making investments and paying dividends is tied to ratios based on Adjusted EBITDA.

Adjusted EBITDA does not represent, and should not be considered an alternative to, net earnings (loss), operating earnings (loss), or cash flow from operations as those terms are defined by U.S. GAAP and does not necessarily indicate whether cash flows will be sufficient to fund cash needs. While Adjusted EBITDA and similar measures are frequently used as measures of operations and the ability to meet debt service requirements by other companies, our use of Adjusted EBITDA is not necessarily comparable to such other similarly titled captions of other companies. The definition of Adjusted EBITDA in the Indentures and the Credit Facility allows us to add back certain charges that are deducted in calculating EBITDA and/or net earnings (loss). However, some of these expenses may recur, vary greatly and are difficult to predict. Further, our debt instruments require that Adjusted EBITDA be calculated for the most recent four fiscal quarters. As a result, the measure can be disproportionately affected by a particularly strong or weak quarter. Further, it may not be comparable to the measure for any subsequent four-quarter period or any complete fiscal year.

 

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The following is a reconciliation of net loss, which is a U.S. GAAP measure of our operating results, to Adjusted EBITDA, as defined in our debt agreements.

 

(in millions)

   Year Ended
December 31, 2009
 

Net income

   $ 748   

Interest expense, net

     556   

Income tax benefit

     (246

Depreciation and amortization (*)

     1,193   
        

EBITDA

     2,251   

Non-cash stock-based employee compensation (1)

     38   

Other non-cash charges (2)

     10   

Non-recurring/one-time items (3)

     (1,948

Cost savings (4)

     200   

Other defined terms (5)

     28   
        

Adjusted EBITDA

   $ 579   
        

 

  (*) Excludes amortization of debt issuance costs, which are included in interest expense, net
  (1) Reflects non-cash, stock-based employee compensation expense under the provisions of ASC Topic 718, “Compensation - Stock Compensation.”
  (2) Reflects the non-cash charges related to asset impairment charges and other non-cash items.
  (3) Reflects non-cash gain on debt extinguishment and charges incurred due to our Reorganization of Business Program.
  (4) Reflects cost savings that we expect to achieve from certain initiatives where actions have begun or have already been completed.
  (5) Reflects other adjustments required in determining our debt covenant compliance.

Contractual Obligations and Credit Facilities

We own most of our major facilities, but we do lease certain office, factory and warehouse space and land, as well as data processing and other equipment under principally non-cancelable operating leases.

Summarized in the table below are our obligations and commitments to make future payments under debt obligations and minimum lease payment obligations, net of minimum sublease income, as of December 31, 2009.

 

     Payments Due by Period

(in millions)

   2010    2011    2012    2013    2014    Thereafter    Total

Debt obligations (including short-term debt) (1)

   $ 105    $ 44    $ 688    $ 3,276    $ 3,017    $ 764    $ 7,894

Capital lease obligations (2)

     9      5      2      1                17

Operating leases (3)

     44      33      26      25      23      33      184

Software licenses

     38      38      32      25      11           144

Service obligations

     65      13      8      7      3      4      100

Foundry commitments (4)

     62                               62

Purchase commitments

     11                               11
                                                

Total cash contractual obligations (5)

   $ 334    $ 133    $ 756    $ 3,334    $ 3,054    $ 801    $ 8,412
                                                

 

  (1) Reflects the principal payments on the Credit Facility, the Notes and a Japanese yen-denominated revolving loan agreement of one of our foreign subsidiaries. These amounts exclude the discount on the Incremental Term Loans discussed in Note 4 to the accompanying audited consolidated financial statements, as well as cash interest payments of approximately $442 million in 2010, $525 million in 2011, $574 million in 2012, $564 million in 2013, $377 million in 2014 and $155 million thereafter.
  (2) Excludes interest of $1 million on capital lease obligations of $17 million at December 31, 2009.
  (3) Sublease income on operating leases is approximately $6 million in 2010, $4 million in 2011 and $3 million in 2012. Sublease income is less that $1 million in 2013, and currently, there is no sublease income scheduled beyond 2013.
  (4) Foundry commitments associated with our strategic manufacturing relationships are based on volume commitments for work in progress and forecasted demand based on 18-month rolling forecasts, which are adjusted monthly.
  (5) As of December 31, 2009, unrecognized tax benefits under ASC Topic 740 were $207 million. We are not including any amount related to uncertain tax positions in our long-term contractual obligations table presented because of the difficulty in making reasonably reliable estimates of the timing of cash settlements with the respective taxing authorities.

Future Financing Activities

Our primary future cash needs on a recurring basis will be for working capital, ongoing capital expenditures and debt service obligations. In addition, we expect to spend approximately $90 million

 

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during 2010 and approximately $180 million in 2011 in connection with the Reorganization of Business Program. We believe that our cash and cash equivalents balance as of December 31, 2009 of approximately $1,363 million and cash flows from operations will be sufficient to fund our working capital needs, capital expenditures, restructuring plan and other business requirements for at least the next 12 months. We also supplemented our liquidity by drawing down $184 million under our Revolver on January 21, 2009. Our ability to borrow under this Revolver is limited to $15 million as of December 31, 2009 after taking into account $31 million in outstanding letters of credit.

If our cash flows from operations are less than we expect or we require funds to consummate acquisitions of other businesses, assets, products or technologies, we may need to incur additional debt, sell or monetize certain existing assets or utilize our cash and cash equivalents. We incurred significant indebtedness and utilized significant amounts of cash and cash equivalents, short-term investments and marketable securities in order to complete the Merger. In the event additional funding is required, there can be no assurance that future funding will be available on terms favorable to us or at all.

As market conditions warrant, we and our major equity holders may from time to time repurchase debt securities issued by us, in privately negotiated or open market transactions, by tender offer or may seek to restructure or refinance our outstanding indebtedness. In 2009, upon completion of the Debt Exchange, the face amount of our outstanding long-term debt obligations decreased by approximately $1,929 million. In connection with the Debt Exchange, our expected annual cash interest expense is anticipated to decrease by approximately $140 million. FSL, Inc. also repurchased $60 million of its Fixed Rate Notes and $39 million of its PIK-Election Notes. FSL, Inc. used funds from our cash and cash equivalents balance for the repurchase and early retirement of long-term debt.

As of December 31, 2009, our election to use the PIK feature of our outstanding PIK-Election Notes in lieu of making cash interest payments was effective for the interest period ending on June 15, 2010. We will evaluate this option prior to the beginning of each eligible interest period, taking into account market conditions and other relevant factors at that time. In connection with this election, we will make the interest payment due on the PIK-Election Notes on June 15, 2010 by paying in kind at the PIK interest rate of 9.875% instead of paying interest in cash. FSL, Inc. may elect to use the PIK feature of its PIK-Election Notes for any interest period through December 15, 2011. After December 15, 2011, FSL, Inc. must pay all interest payments on the PIK-Election Notes in cash, and they will be treated as having been issued with original issue discount for federal income tax purposes.

As discussed in “Trends in Our Business,” the extent to which a general global economic recovery occurs will influence our revenue and profitability recovery in 2010 compared to peak historical periods. The maintenance of certain of our financial ratios is based on our level of profitability. The 2009 global economic environment resulted in lower operating profitability, causing four of our financial ratios (the total leverage ratio, the senior secured first lien leverage ratio, the fixed charge coverage ratio and the consolidated secured debt ratio) to fall outside of the ranges set forth in the Credit Facility and Indentures, which will impose certain of the restrictions as discussed in “Financing Activities.”

FSL, Inc. is currently seeking to amend the Credit Facility to, among other things, extend the maturity of certain of its term loans held by accepting lenders to December 1, 2016 and increase the interest rate with respect to such extended-maturity term loans and allow for one or more issuances of additional senior secured notes to be secured on a pari passu basis with the obligations under the Credit Facility, so long as, among other things, the net cash proceeds from any such issuance are used to prepay amounts outstanding under the Credit Facility at par. The proposed amendment of the Credit Facility is subject to lender consent and other conditions, and may not occur as described or at all.

Off-Balance Sheet Arrangements

We use customary off-balance sheet arrangements, such as operating leases and letters of credit, to finance our business. None of these arrangements has or is likely to have a material effect on our results of operations, financial condition or liquidity.

Significant Accounting Policies and Critical Estimates

The preparation of our financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of revenues and expenses during the reporting period.

Our management bases its estimates and judgments on historical experience, current economic and industry conditions and on various other factors that are believed to be reasonable under the circumstances. This forms the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our management believes the following accounting policies to be those most important to the portrayal of our financial condition and those that require the most subjective judgment:

 

   

valuation of long-lived assets;

 

   

restructuring activities;

 

   

accounting for income taxes;

 

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inventory valuation methodology;

 

   

product sales and intellectual property revenue recognition and valuation; and

 

   

purchase accounting.

If actual results differ significantly from management’s estimates and projections, there could be a material negative impact on our financial statements.

Valuation of Long-Lived Assets

We assess the impairment of investments and long-lived assets, which include goodwill, identifiable intangible assets and property, plant and equipment (“PP&E”), whenever events or changes in circumstances indicate that the carrying value may not be recoverable. During 2008, we concluded that indicators of impairment existed related to our goodwill and certain of our identifiable intangible assets in connection with the termination of the Q1 2008 Motorola Agreement, the significant decline in the market capitalization of the public companies in our peer group as of December 31, 2008, our then announced intent to pursue strategic alternatives for our cellular handset product group and the impact from weakening market conditions in our remaining businesses.

Identifiable Intangible Assets

In connection with the aforementioned 2008 impairment indicators, we determined that the net book value related our intangible assets exceeded the future undiscounted cash flows attributable to such intangible assets. Accordingly, and as further described below, we performed an analysis utilizing discounted future cash flows related to these intangible assets to determine the fair value of each of the respective assets as of December 31, 2008. As a result of this analysis, we recorded impairment charges of $724 million, $98 million and $809 million related to our customer relationship, trademark / tradename and developed technology / purchased license intangible assets, respectively, in 2008.

Additionally, in 2007, we had initiated discussions regarding our then existing supply agreement with Motorola. We concluded in connection with those discussions that indicators of impairment existed related to the customer relationships, trademark / tradename and developed technology / purchased license intangible assets associated with our cellular handset business. Upon concluding the net book value related to these assets exceeded the future undiscounted cash flows attributable to such intangible assets at the time, we performed an analysis utilizing discounted future cash flows related to the specific intangible assets to determine the fair value of each of the respective assets. As a result of this analysis, we recorded impairment charges of $186 million, $8 million and $255 million related to our customer relationship, trademark / tradename and developed technology / purchased license intangible assets, respectively, in 2007.

We determine the fair value of our intangible assets in accordance with ASC Topic 820, “Fair Value Measurements and Disclosures.” Our impairment evaluation of identifiable intangible assets and PP&E includes an analysis of estimated future undiscounted net cash flows expected to be generated by the assets over their remaining estimated useful lives. If the estimated future undiscounted net cash flows are insufficient to recover the carrying value of the assets over the remaining estimated useful lives, we record an impairment loss in the amount by which the carrying value of the assets exceeds the fair value. We determine fair value based on either market quotes, if available, or discounted cash flows using a discount rate commensurate with the risk inherent in our current business model for the specific asset being valued. Examples of discounted cash flow methodologies utilized are the excess earnings method for developed technology / purchased licenses and customer relationships and the royalty savings method for trademarks and tradenames.

When applying either the excess earnings method or the royalty savings method, the cash flows expected to be generated by the intangible asset are discounted to their present value equivalent using an appropriate weighted average cost of capital (“WACC”) for the respective asset being valued. The WACC is calculated by weighting the required returns on interest-bearing debt and common equity capital in proportion to their estimated percentages in the Company’s expected capital structure. The WACC is adjusted to reflect the relative risk associated with the cash flows of the asset being valued.

The valuations of our customer relationships and developed technology / purchased licenses are based on the excess earnings method, which incorporates our long-term revenue projections as a key assumption. The long-term revenue projections utilized in the valuation of our customer relationships are adjusted using a retention curve derived based on historical experience and current expectations. The revenue attributable to developed technology / purchased licenses is determined by adjusting our long-term revenue projections for the percentage of our total revenue allocated to developed technology / purchased licenses in consideration of the estimated life of the underlying technologies. As technology in-process at the time the intangible asset was established and future technology begin to generate revenue, sales from developed technology / purchased licenses are projected to decline. The revenues described above are reduced by production and operating costs. The resulting cash flows are tax effected using an assumed market participant rate. We then adjust the cash flows for various contributory asset charges (working capital, fixed assets, technology royalty, trademark / tradename and assembled workforce). The resulting cash flows are discounted and result in the estimated fair value of the respective intangible asset. We also incorporate an estimate of the future tax savings from amortization in the estimated fair value of developed technology / purchased licenses.

 

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We use the royalty savings method to value the trademark / tradename intangible asset. Our revenue projection over the expected remaining useful life of the trademarks / tradenames is a key assumption. We apply a royalty rate to the projected revenues. The royalty rate is based on product profitability, industry and markets served, trademark / tradename protection factors, and perceived licensing value. The resulting royalty savings are reduced by income taxes resulting from the annual royalty savings at a market participant corporate income tax rate to arrive at the after-tax royalty savings associated with owning the trademarks / tradnames. We also incorporate an estimate of the calculated future tax savings from the amortization of the trademarks / tradnames as an acquired intangible asset. Finally the present value of the estimated annual after-tax royalty savings for each year in the projection period and the present value of tax savings due to amortization are combined to estimate the fair value of the trademarks / tradnames.

The primary assumptions in each of these calculations are revenue and cost projections and the WACC utilized to discount the resulting cash flows. Our assumptions concerning revenues are impacted by global and local economic conditions in the various markets we serve. The primary drivers of the impairment recorded were the impact on future projected revenues of the termination of a supply agreement with Motorola, our intent to pursue strategic alternatives for our cellular handset product group and the weakening global market conditions. This global macroeconomic crisis resulted in weakening conditions in the automotive, industrial, consumer, networking and wireless semiconductor markets we serve with products such as communication processors, RF technology, multimedia processors, sensors and analog power management. Our cost projections include production, research and development and selling, general and administrative costs to generate the revenues associated with the asset being valued. These cost projections are based upon historical and projected levels of each cost category based on our overall projections for the Company.

Our projected revenues for 2009 at the time of the fair value estimate were anticipated to approximate two-thirds of our 2008 revenues. Also, in connection with the higher return of investment required by both debt and equity market participants on and around December 31, 2008, the WACC utilized was approximately 600 basis points higher than historical levels. Continued pressure on our forecasted product shipments in the future due to the current global macroeconomic environment, loss of one or more significant customers, loss of market share or lack of growth in the industries into which the Company’s products are sold or an inability to ensure our cost structure is aligned to associated decreases in revenues could result in further impairment charges. If, as a result of our analysis, we determine that our amortizable intangible assets or other long-lived assets have been impaired, we will recognize an impairment loss in the period in which the impairment is determined. As of December 31, 2009, however, we determined that no further indicators of impairment existed with regard to our intangible assets.

PP&E

Our impairment evaluation of PP&E includes an analysis of estimated future undiscounted net cash flows expected to be generated by the assets over their remaining estimated useful lives. If the estimated future undiscounted net cash flows are insufficient to recover the carrying value of the assets over the remaining estimated useful lives, we record an impairment loss in the amount by which the carrying value of the assets exceeds the fair value. We determine fair value based on either market quotes, if available, or discounted cash flows using a discount rate commensurate with the risk inherent in our current business model for the specific asset being valued. Major factors that influence our cash flow analysis are our estimates for future revenue and expenses associated with the use of the asset. Different estimates could have a significant impact on the results of our evaluation. If, as a result of our analysis, we determine that our PP&E has been impaired, we will recognize an impairment loss in the period in which the impairment is determined. Any such impairment charge could be significant and could have a material negative effect on our results of operations. During 2009, 2008 and 2007, we recorded various non-cash asset impairment charges of $25 million, $88 million and $24 million, respectively, in reorganization of businesses, contract settlement, and other.

Goodwill

Our impairment evaluation of goodwill is based on comparing the fair value to the carrying value of our enterprise. The enterprise fair value is measured using a combination of the income approach, utilizing the discounted cash flow method that incorporates our estimates of future revenues and costs for our business, and the public company comparables approach, utilizing multiples of profit measures in order to estimate the fair value of the enterprise. The estimates we use in evaluating goodwill are consistent with the plans and estimates that we use to manage our operations. If we fail to deliver new products, if the products fail to gain expected market acceptance, or if market conditions fail to materialize as anticipated, our revenue and cost forecasts may not be achieved and we may incur charges for goodwill impairment, which could be significant and could have a material negative effect on our results of operations. During the third quarter of 2008, we concluded that indicators of impairment existed related to our goodwill due to the aforementioned factors. We concluded that our enterprise net book value exceeded its fair value, and we therefore performed an allocation of our enterprise fair value to the fair value of our assets and liabilities to determine the implied fair value of our goodwill as of December 31, 2008. As a result of that analysis, we recorded impairment charges of $5,350 million, effectively reducing our goodwill balance to zero as of the end of 2008.

 

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The net book values of these tangible and intangible long-lived assets at December 31, 2009, 2008 and 2007 were as follows:

 

(in millions)

   Year Ended
December 31,
2009
   Year Ended
December 31,
2008
   Year Ended
December 31,
2007

Property, plant and equipment

   $ 1,315    $ 1,931    $ 2,517

Goodwill

               5,350

Intangible assets

     780      1,264      3,918
                    

Total net book value

   $ 2,095    $ 3,195    $ 11,785
                    

Restructuring Activities

We periodically implement plans to reduce our workforce, close facilities, discontinue product lines, refocus our business strategies and consolidate manufacturing, research and design center and administrative operations. We initiate these plans in an effort to improve our operational effectiveness, reduce costs or simplify our product portfolio. Exit costs primarily consist of facility closure costs. Employee separation costs consist primarily of severance payments to terminated employees. At each reporting date, we evaluate our accruals for exit costs and employee separation costs to ensure that the accruals are still appropriate. In certain circumstances, accruals are no longer required because of efficiencies in carrying out the plans or because employees previously identified for separation resigned from our company unexpectedly and did not receive severance or were redeployed due to circumstances not foreseen when the original plans were initiated. We reverse accruals to income when it is determined they are no longer required.

During the fourth quarter of 2008, in connection with our renewed strategic focus on key market leadership positions and given general market conditions, we initiated the Reorganization of Business Program in order to streamline our cost structure and re-direct some research and development investments into growth markets. These actions include (i) the winding-down of our cellular handset product offerings, (ii) restructuring our participation in the IBM alliance (a jointly-funded research alliance), (iii) discontinuing our 150mm manufacturing operations at our facilities in East Kilbride, Scotland, Sendai, Japan and Toulouse, France and (iv) consolidating certain research and development, sales and marketing, and logistical and administrative operations. We incurred $318 million and $232 million in severance and exit costs associated with the Reorganization of Business Program in 2009 and 2008, respectively. These actions have reduced and will reduce our workforce in our supply chain, research and development, sales, marketing and general and administrative functions.

Accounting for Income Taxes

We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax bases of assets, liabilities and net operating loss and credit carryforwards. The recognition of deferred tax assets is reduced by a valuation allowance if it is more likely than not that the tax benefits will not be realized. We regularly review our deferred tax assets for recoverability and establish a valuation allowance based on historical income, projected future income, the expected timing of the reversals of existing temporary differences and the implementation of tax-planning strategies.

Valuation allowances of $288 million have been recorded on substantially all our U.S. deferred tax assets as of December 31, 2009, as we have incurred cumulative losses in the U.S. We have not recognized tax benefits for these losses as we are precluded from considering the impact of future forecasted income pursuant to the provisions of ASC Topic 740 in assessing whether it is more likely than not that all or a portion of our deferred tax assets may be recoverable. The Company computes cumulative losses for these purposes by adjusting pre-tax results (excluding the cumulative effects of accounting method changes and including discontinued operations and other “non-recurring” items such as restructuring or impairment charges) for permanent items. At December 31, 2009 valuation allowances of $101 million have also been recorded on certain deferred tax assets in foreign jurisdictions.

We have reserves for taxes, associated interest, and other related costs that may become payable in future years as a result of audits by tax authorities. Although we believe that the positions taken on previously filed tax returns are fully supported, we nevertheless have established reserves recognizing that various taxing authorities may challenge certain positions, which may not be fully sustained. The tax reserves are reviewed quarterly and adjusted as events occur that affect our potential liability for additional taxes, such as lapsing of applicable statutes of limitations, proposed assessments by tax authorities, resolution of tax audits, negotiations between tax authorities of different countries concerning our transfer prices, identification of new issues, and issuance of new regulations or new case law.

We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. Whether the more-likely-than-not recognition threshold is met for a tax position is a matter of judgment based on the individual facts and circumstances of that position evaluated in light of all available evidence. As of December 31, 2009, we had reserves of $219 million for taxes, associated interest, and other related costs that may become payable in future years as a result of audits by tax authorities.

 

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Inventory Valuation Methodology

Inventory is valued at the lower of average cost or market. We write down our inventory for estimated obsolescence or unmarketable inventory in an amount equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those we project, additional inventory write-downs may be required. Inventory impairment charges establish a new cost basis for inventory. In estimating obsolescence, we utilize our backlog information for the next 13 weeks as well as projecting future demand.

We balance the need to maintain strategic inventory levels to ensure competitive delivery performance to our customers with the risk of inventory obsolescence due to rapidly changing technology and customer requirements. We also consider pending cancellation of product lines due to technology changes, long life cycle products, lifetime buys at the end of supplier production runs, business exits and a shift of production to outsourcing.

As of December 31, 2009 and 2008, we recorded $155 million and $136 million, respectively, in reserves for inventory deemed obsolete or in excess of forecasted demand. If actual future demand or market conditions are less favorable than those projected by our management, additional inventory write-downs may be required.

Product Sales and Intellectual Property Revenue Recognition and Valuation

We generally market our products to a wide variety of end users and a network of distributors. Our policy is to record revenue for product sales when title transfers, the risks and rewards of ownership have been transferred to the customer, the fee is fixed and determinable and collection of the related receivable is reasonably assured, which is generally at the time of shipment. We record reductions to sales for allowances for collectibility, discounts and price protection, product returns and incentive programs for distributors related to these sales, based on actual historical experience, current market conditions and other relevant factors at the time the related sale is recognized.

The establishment of reserves for sales discounts and price protection allowances are dependent on the estimation of a variety of factors, including industry demand and the forecast of future pricing environments. This process is also highly judgmental in evaluating the above-mentioned factors and requires significant estimates, including forecasted demand, returns and industry pricing assumptions.

In future periods, additional provisions may be necessary due to (1) a deterioration in the semiconductor pricing environment, (2) reductions in anticipated demand for semiconductor products and/or (3) lack of market acceptance for new products. If these factors result in a significant adjustment to sales discount and price protection allowances, they could significantly impact our future operating results.

Revenues from licensing our intellectual property have approximated 2%, 1% and 2% of net sales in 2009, 2008 and 2007, respectively. We expect to continue our efforts to monetize the value of our intellectual property in the future. These licensing agreements also can be linked with other contractual agreements and could represent multiple element arrangements under ASC Topic 605, “Revenue Recognition” or contain future performance provisions pursuant to SEC Staff Accounting Bulletin 104, “Revenue Recognition.” The process of determining the appropriate revenue recognition in such transactions is highly complex and requires significant judgments and estimates.

Purchase Accounting and Intangible Assets

As discussed above, the Merger was completed on December 1, 2006 and was financed by a combination of borrowings under the Credit Facility, the issuance of the Existing Notes, cash on hand and the equity investment of the Sponsors and management. The purchase price including direct acquisition costs was approximately $17.7 billion. Purchase accounting requires that all assets and liabilities be recorded at fair value on the acquisition date, including identifiable intangible assets separate from goodwill. Identifiable intangible assets include customer relationships, tradenames / trademarks, developed technology / purchased licenses and IPR&D. Goodwill represents the excess of cost over the fair value of net assets acquired. For the Merger and for other significant acquisitions, we obtain independent appraisals and valuations of the intangible (and certain tangible) assets acquired and certain assumed obligations as well as equity.

The estimated fair values and useful lives of identified intangible assets are based on many factors, including estimates and assumptions of future operating performance and cash flows of the acquired business, estimates of cost avoidance, the nature of the business acquired, the specific characteristics of the identified intangible assets and our historical experience and that of the acquired business. The estimates and assumptions used to determine the fair values and useful lives of identified intangible assets could change due to numerous factors, including product demand, market conditions, regulations affecting the business model of our operations, technological developments, economic conditions and competition. The carrying values and useful lives for amortization of identified intangible assets are reviewed on an ongoing basis, and any resulting changes in estimates could have a material negative impact on our financial results.

 

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Recent Accounting Pronouncements

In June 2009, the FASB issued guidance now codified as Accounting Standards Codification (“ASC”) Topic 105, “Generally Accepted Accounting Principles” (“ASC Topic 105”) as the single source of authoritative non-governmental U.S. GAAP. ASC Topic 105 does not change current U.S. GAAP, but is intended to simplify user access to all authoritative U.S. GAAP by providing all authoritative literature related to a particular topic in one place (the “Codification”). On the effective date of this Statement, the Codification superseded all then-existing non-SEC accounting and reporting standards, and all other non-grandfathered non-SEC accounting literature not included in the Codification became non-authoritative. The provisions of ASC Topic 105 are effective for interim and annual periods ending after September 15, 2009. We adopted ASC Topic 105 in the third quarter of 2009. This pronouncement had no effect on our consolidated financial position, results of operations or cash flows, but impacted our financial reporting process by replacing all references to pre-Codification standards with references to the applicable Codification topic.

In October 2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-13 “Revenue Recognition (ASC Topic 605): Multiple-Deliverable Revenue Arrangements” (“ASU No. 2009-13”). ASU No. 2009-13 addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting and how the arrangement consideration should be allocated among the separate units of accounting. ASU No. 2009-13 will be effective for fiscal years beginning on or after June 15, 2010 with early adoption permitted. The guidance may be applied retrospectively or prospectively for new or materially modified arrangements. We are currently assessing the impact on our consolidated financial position, results of operations or cash flows.

In October 2009, the FASB issued ASU No. 2009-14 “Software (ASC Topic 985): Certain Revenue Arrangements That Include Software Elements” (“ASU No. 2009-14”). ASU No. 2009-14 modifies the scope of the software revenue recognition guidance to exclude (i) non-software components of tangible products and (ii) software components of tangible products that are sold, licensed or leased with tangible products when the software components and non-software components of the tangible product function together to deliver the tangible product’s essential functionality. ASU No. 2009-13 will be effective for fiscal years beginning on or after June 15, 2010 with early adoption permitted. The guidance may be applied retrospectively or prospectively for new or materially modified arrangements. We are currently assessing the impact on our consolidated financial position, results of operations or cash flows.

In December 2007, the FASB issued guidance now codified as ASC Topic 805, “Business Combinations” (“ASC Topic 805”). Under ASC Topic 805, an entity is required to recognize the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. It further requires that acquisition-related costs be recognized separately from the acquisition and expensed as incurred, restructuring costs generally be expensed in periods subsequent to the acquisition date, and changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period impact income tax expense. In addition, acquired in-process research and development is capitalized as an intangible asset and amortized over its estimated useful life. The adoption of ASC Topic 805 has changed our accounting treatment for business combinations on a prospective basis beginning in the first quarter of 2009. As referenced in Note 7 to the accompanying audited consolidated financial statements, a portion of the income tax benefit recorded for discrete events occurring in the first quarter of 2009 included the release of income tax reserves related to foreign audit settlements, which was accounted for in accordance with ASC Topic 805.

 

Item 7A: Quantitative and Qualitative Disclosures About Market Risk

Foreign Currency Risk

As a multinational company, our transactions are denominated in a variety of currencies. We have a foreign exchange management process to manage currency risks resulting from transactions in currencies other than the functional currency of our subsidiaries. We use financial instruments to hedge, and therefore attempt to reduce our overall exposure to the effects of currency fluctuations on cash flows. Our policy prohibits us from speculating in financial instruments for profit on exchange rate price fluctuations, from trading in currencies for which there are no underlying exposures, and from entering into trades for any currency to intentionally increase the underlying exposure.

Our strategy in foreign exchange exposure issues is to offset the gains or losses of the financial instruments against losses or gains on the underlying operational cash flows or investments based on our management’s assessment of risk. Almost all of our non-functional currency receivables and payables, which are denominated in major currencies that can be traded on open markets, are hedged. We use forward contracts and options to hedge these currency exposures. In addition, we hedge some firmly committed transactions and may hedge some forecasted transactions and investments in foreign subsidiaries in the future. A portion of our exposure is from currencies that are not traded in liquid markets, such as those in Latin America and Asia, and these are addressed, to the extent reasonably possible, through managing net asset positions, product pricing, and component sourcing.

Effective January 1, 2008, we changed the functional currency for certain foreign operations to the U.S. dollar. Major changes in economic facts and circumstances supported this change in functional currency. The change in functional currency is applied on a prospective basis. The U.S dollar-translated amounts of nonmonetary assets and liabilities at December 31, 2007 became the historical accounting basis for those assets and liabilities at January 1, 2008 and for subsequent periods. As a result of this change in functional currency, exchange rate gains and losses are recognized on transactions in currencies other than the U.S. dollar and included in

 

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operations for the period in which the exchange rates changed. (See Note 1 to the accompanying audited consolidated financial statements for further discussion.)

At December 31, 2009, we had outstanding foreign exchange contracts not designated as accounting hedges with notional amounts totaling $192 million. The fair value of these forward contracts was a net unrealized loss of $2 million at December 31, 2009. Management believes that these financial instruments should not subject us to undue risk due to foreign exchange movements because gains and losses on these contracts should offset losses and gains on the assets, liabilities, and transactions being hedged. The following table shows, in millions of United States dollars, the notional amounts of the most significant foreign exchange hedge positions as of December 31, 2009:

 

Buy (Sell)

   December 31,
2009
 

Malaysian Ringget

   $ 64   

Euro

   $ 48   

Japanese Yen

   $ (20

Israeli Shekel

   $ 16   

Singapore Dollar

   $ 12   

Canadian Dollar

   $ 7   

Foreign exchange financial instruments that are subject to the effects of currency fluctuations, which may affect reported earnings, include financial instruments and other financial instruments which are not denominated in the functional currency of the legal entity holding the instrument. Derivative financial instruments consist primarily of forward contracts. Other financial instruments, which are not denominated in the functional currency of the legal entity holding the instrument, consist primarily of cash and cash equivalents, notes and accounts payable and receivable. The fair value of the foreign exchange financial instruments would hypothetically decrease by $52 million as of December 31, 2009, if the U.S. dollar were to appreciate against all other currencies by 10% of current levels. This hypothetical amount is suggestive of the effect on future cash flows under the following conditions: (i) all current payables and receivables that are hedged were not realized, (ii) all hedged commitments and anticipated transactions were not realized or canceled, and (iii) hedges of these amounts were not canceled or offset. We do not expect that any of these conditions will be realized. We expect that gains and losses on the derivative financial instruments should offset gains and losses on the assets, liabilities and future transactions being hedged. If the hedged transactions were included in the sensitivity analysis, the hypothetical change in fair value would be immaterial. The foreign exchange financial instruments are held for purposes other than trading.

Interest Rate Risk

Our financial instruments include cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities, notes payable, long-term debt, and other financing commitments.

At December 31, 2009 we had interest bearing cash and cash equivalents of $1,363 million. A 10% change in market rates would have less than a $1 million impact on interest income.

At December 31, 2009, we had total debt of $7,894 million, including $4,210 million of variable interest rate debt based on either 1-month or 3-month LIBOR. As of December 31, 2009, we have effectively fixed our interest rate on $200 million of our variable rate debt through December 1, 2012 through the use of interest rate swaps. In addition to our interest rate swap agreements, we also use interest rate cap agreements to manage our floating rate debt. As of December 31, 2009, we have effectively hedged $400 million of our variable interest rate debt at a cap rate of 2.75% through December 1, 2012. The fair value of the interest rate swap and interest rate cap agreements, excluding accrued interest, at December 31, 2009 was a $4 million obligation. Our remaining variable interest rate debt is subject to market rate risk, because our interest payments will fluctuate as the underlying interest rates change from market changes. A 10% change in interest rates would result in a change in interest and other, net expense of $1 million per year.

The fair value of our long-term debt, excluding accrued PIK Interest on the PIK-Election Notes, approximated $7,036 million at December 31, 2009, which was determined based upon quoted market prices. Since considerable judgment is required in interpreting market information, the fair value of the long-term debt is not necessarily indicative of the amount which could be realized in a current market exchange. A 10% decrease in market rates would have a $38 million impact on the fair value of our long-term debt and a $2 million impact on the fair value of our interest rate swap and interest rate cap agreements.

The fair values of the other financial instruments were not materially different from their carrying or contract values at December 31, 2009.

Counterparty Risk

Outstanding financial derivative instruments expose us to credit loss in the event of nonperformance by the counterparties to the agreements. The credit exposure related to these financial instruments is represented by the fair value of contracts with a positive fair

 

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value at the reporting date. On a periodic basis, we review the credit ratings of our counterparties and adjust our exposure as deemed appropriate. As of December 31, 2009, our exposure to counterparty risk is immaterial.

 

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Item 8: Financial Statements and Supplementary Data

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders

Freescale Semiconductor Holdings I, Ltd.:

We have audited the accompanying consolidated balance sheets of Freescale Semiconductor Holdings I, Ltd. and subsidiaries (the “Company”) as of December 31, 2009 and 2008, and the related consolidated statements of operations, stockholders’ deficit and cash flows for the years ended December 31, 2009, 2008 and 2007. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2009 and 2008, and the results of their operations and their cash flows for the years ended December 31, 2009, 2008 and 2007, in conformity with accounting principles generally accepted in the United States of America.

KPMG LLP

Austin, Texas

February 4, 2010

 

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Freescale Semiconductor Holdings I, Ltd.

Consolidated Statements of Operations

 

(in millions)

   Year ended
December 31,
2009
    Year ended
December 31,
2008
    Year ended
December 31,
2007
 

Net sales

   $ 3,508      $ 5,226      $ 5,722   

Cost of sales

     2,563        3,154        3,821   
                        

Gross margin

     945        2,072        1,901   

Selling, general and administrative

     499        673        653   

Research and development

     833        1,140        1,139   

Amortization expense for acquired intangible assets

     486        1,042        1,310   

Reorganization of businesses, contract settlement, and other

     345        53        64   

Impairment of goodwill and intangible assets

            6,981        449   

Merger expenses

            11        5   
                        

Operating loss

     (1,218     (7,828     (1,719

Gain on extinguishment of long-term debt, net

     2,296        79          

Other expense, net

     (576     (733     (780
                        

Earnings (loss) before income taxes

     502        (8,482     (2,499

Income tax benefit

     (246     (543     (886
                        

Net earnings (loss)

   $ 748      $ (7,939   $ (1,613
                        

See accompanying notes.

 

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Freescale Semiconductor Holdings I, Ltd.

Consolidated Balance Sheets

 

(in millions, except per share amount)

   December 31,
2009
    December 31,
2008
 

ASSETS

    

Cash and cash equivalents

   $ 1,363      $ 900   

Short-term investments

            494   

Accounts receivable, net

     379        394   

Inventory

     606        755   

Other current assets

     335        452   
                

Total current assets

     2,683        2,995   

Property, plant and equipment, net

     1,315        1,931   

Intangible assets, net

     780        1,264   

Other assets, net

     315        461   
                

Total assets

   $ 5,093      $ 6,651   
                

LIABILITIES AND STOCKHOLDERS’ DEFICIT

    

Notes payable and current portion of long-term debt and capital lease obligations

   $ 114      $ 163   

Accounts payable

     300        246   

Accrued liabilities and other

     481        595   
                

Total current liabilities

     895        1,004   

Long-term debt

     7,430        9,610   

Deferred tax liabilities

     131        376   

Other liabilities

     531        353   
                

Total liabilities

     8,987        11,343   

Stockholders’ deficit:

    

Common stock, par value $.005 per share; 2,000 shares authorized, 1,012 issued and outstanding at December 31, 2009 and 2008

     5        5   

Treasury stock at cost

     (1     (1

Additional paid-in capital

     7,255        7,211   

Accumulated other comprehensive earnings

     43        37   

Accumulated deficit

     (11,196     (11,944
                

Total stockholders’ deficit

     (3,894     (4,692
                

Total liabilities and stockholders’ deficit

   $ 5,093      $ 6,651   
                

See accompanying notes.

 

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Freescale Semiconductor Holdings I, Ltd.

Consolidated Statements of Stockholders’ Deficit

 

     Common Stock                              

(in millions)

   Number of
Shares
   Amount    Treasury
Stock
    Additional
Paid-in
Capital
   Accumulated
Other
Comprehensive
Earnings
    Accumulated
Deficit
    Comprehensive
Earnings
(Loss)
 
                                                   

Balances at January 1, 2007

   1,012    $ 5    $      $ 7,093    $ 6      $ (2,387   $ (2,381
                                                   

Net loss

                                (1,613     (1,613

Net foreign currency translation adjustments (net of tax effect)

                         21               21   

Net unrealized loss on derivative instruments (net of tax effect)

                         (18            (18

Adjustment for initially applying ASC Topic 715 (net of tax effect)

                         38               38   

Amortization of deferred compensation

                    45                      
                                                   

Balances at December 31, 2007

   1,012    $ 5    $      $ 7,138    $ 47      $ (4,000   $ (1,572
                                                   

Net loss

                                (7,939     (7,939

Net foreign currency translation adjustments (net of tax effect)

                         9               9   

Net unrealized loss on derivative instruments (net of tax effect)

                         (1            (1

ASC Topic 715 adjustment (net of tax effect)

                         (18       (18

Amortization of deferred compensation

                    73                      

Dividends

                                (5       

Stock option exercises

             (1                          
                                                   

Balances at December 31, 2008

   1,012    $ 5    $ (1   $ 7,211    $ 37      $ (11,944   $ (7,949
                                                   

Net earnings

                                748        748   

Net foreign currency translation adjustments (net of tax effect)

                         (2            (2

Net unrealized loss on derivative instruments (net of tax effect)

                         14               14   

ASC Topic 715 adjustment (net of tax effect)

                         (6       (6

Amortization of deferred compensation and other

                    44                      
                                                   

Balances at December 31, 2009

   1,012    $ 5    $ (1   $ 7,255    $ 43      $ (11,196   $ 754   
                                                   

See accompanying notes.

 

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Freescale Semiconductor Holdings I, Ltd.

Consolidated Statements of Cash Flows

 

(in millions)

   Year ended
December 31,
2009
    Year ended
December 31,
2008
    Year ended
December 31,
2007
 

Cash flows from operating activities:

      

Net earnings (loss)

   $ 748      $ (7,939   $ (1,613

Depreciation and amortization

     1,219        1,855        2,150   

Impairment charges and reorganization of businesses, contract settlement, and other

     355        7,034        513   

Stock-based compensation

     38        56        45   

Deferred incomes taxes

     (255     (573     (929

Gain on extinguishment of debt

     (2,296     (83       

In-process research and development and other non-cash items

     128        93        42   

Change in operating assets and liabilities, net of effects of acquisitions, dispositions:

      

Accounts receivable, net

     37        193        76   

Inventory

     126        (83     390   

Accounts payable and accrued liabilities

     (196     (263     (351

Other operating assets and liabilities

     172        115        103   
                        

Net cash provided by operating activities

     76        405        426   
                        

Cash flows from investing activities:

      

Capital expenditures, net

     (85     (239     (327

Acquisitions and strategic investments, net of cash acquired

            (121       

Proceeds from sale of businesses and investments

     8        26        32   

Sales and purchases of short-term investments, net

     488        51        (12

Proceeds from sale of property, plant and equipment and assets held for sale

     16        288        19   

Payments for purchase licenses and other assets

     (53     (64     (78
                        

Net cash provided by (used for) investing activities

     374        (59     (366
                        

Cash flows from financing activities (1):

      

Retirement of long-term debt, capital lease obligations and notes payable

     (176     (150     (45

Proceeds from revolving loans

     184        497          

Other

     1        (5     (2
                        

Net cash provided by (used for) financing activities

     9        342        (47
                        

Effect of exchange rate changes on cash and cash equivalents

     4        6        16   
                        

Net increase in cash and cash equivalents

     463        694        29   

Cash and cash equivalents, beginning of period

     900        206        177   
                        

Cash and cash equivalents, end of period

   $ 1,363      $ 900      $ 206   
                        

 

(1) In the first quarter of 2009, a $2,264 million non-cash gain on the extinguishment of long-term debt was recorded in connection with the Debt Exchange, as defined and discussed in Note 4.

See accompanying notes.

 

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Freescale Semiconductor Holdings I, Ltd.

Notes to Consolidated Financial Statements

(Dollars in millions, except as noted)

(1) Summary of Significant Accounting Policies

Basis of Presentation and Principles of Consolidation: Freescale Semiconductor, Inc. (“FSL, Inc.”) was incorporated in Delaware in 2003. In the second quarter of 2004, Motorola, Inc. (“Motorola”) transferred substantially all of its semiconductor businesses’ assets and liabilities to FSL, Inc. (the “Contribution”) in anticipation of an initial public offering (“IPO”) of FSL, Inc. Class A common stock; the IPO was completed on July 21, 2004. Prior to the IPO, FSL, Inc. was a wholly owned subsidiary of Motorola. All of the FSL, Inc. Class B shares of common stock were held by Motorola until Motorola distributed its remaining ownership interest in us by means of a special dividend to its common stockholders (the “Distribution”) on December 2, 2004 (the “Distribution Date”).

On December 1, 2006, FSL, Inc. was acquired by a consortium of private equity funds (the “Merger”). The consortium includes The Blackstone Group, The Carlyle Group, funds advised by Permira Advisers, LLC, TPG Capital and others (collectively, the “Sponsors”). The Merger was accomplished through the terms of an Agreement and Plan of Merger entered into on September 15, 2006 (the “Merger Agreement”). Pursuant to the terms of the Merger Agreement, FSL, Inc. became an indirect subsidiary of Freescale Semiconductor Holdings I, Ltd. (“Holdings I”), which in turn is a direct subsidiary of Freescale Holdings, L.P. (“Holdings”), a Cayman Islands limited partnership (“Parent”). Parent is an entity controlled by the Sponsors.

At the close of the Merger, FSL, Inc. became a subsidiary of Freescale Semiconductor Holdings V, Inc. (“Holdings V”), which is wholly owned by Freescale Semiconductor Holdings IV, Ltd. (“Holdings IV”), which is wholly owned by Freescale Semiconductor Holdings III, Ltd. (“Holdings III”), which is wholly owned by Freescale Semiconductor Holdings II, Ltd. (“Holdings II”), which is wholly owned by Freescale Semiconductor Holdings I, Ltd. (“Holdings I”), substantially all of which is wholly owned by Parent. All six of these companies were formed for the purpose of facilitating the Merger and are collectively referred to as the “Parent Companies.” The reporting entity subsequent to the Merger is Holdings I. Holdings I refers to the operations of Holdings I and its subsidiaries for both the Predecessor and Successor Periods. Holdings I (which may be referred to as the “Company,” “Freescale,” “we,” “us” or “our”) means Freescale Semiconductor Holdings I, Ltd. and its subsidiaries, as the context requires.

Our consolidated financial statements include all majority-owned subsidiaries and assets and liabilities of the Company. Investments in which the Company exercises significant influence, but which it does not control, are accounted for under the equity method of accounting. Investments in which the Company does not exercise significant influence are recorded at cost. All material intercompany transactions between and among the Company and its subsidiaries have been eliminated. Amounts pertaining to the non-controlling ownership interests held by third parties in the operating results and financial position of the Company’s majority-owned subsidiaries, are reported as minority interest in other liabilities.

In connection with the Merger, FSL, Inc. incurred significant indebtedness. In addition, the purchase price paid in connection with the Merger has been allocated to state the acquired assets and assumed liabilities at fair value. The purchase accounting adjustments (i) increased the carrying value of our inventory and property, plant and equipment, (ii) established intangible assets for our trademarks / tradenames, customer lists, developed technology / purchased licenses, and in-process research and development (“IPR&D”) (which was expensed in the financial statements after the consummation of the Merger), and (iii) revalued our long-term benefit plan obligations, among other things. Subsequent to the Merger, interest expense and non-cash depreciation and amortization charges have significantly increased. During 2008, however, we incurred substantial non-cash impairment charges against the intangible assets established at the time of the Merger. Furthermore, in 2009, in connection with a modification of our outstanding debt, we reduced the carrying value of our overall long-term indebtedness by $1,929 million. These events served to reduce the post-Merger increase in our interest expense and non-cash amortization charges, although they are still above historical levels.

We consider events or transactions that occur after the balance sheet date but before the financial statements are issued to provide additional evidence relative to certain estimates or to identify matters that require additional disclosure. Subsequent events have been evaluated through February 4, 2010, the date the consolidated financial statements were issued.

Risks and Uncertainties: In the second half of 2008 and continuing in 2009, the semiconductor industry experienced a downturn driven by overall weakness in global macroeconomic demand for semiconductor products. We experienced lower revenues and profitability, as well as lower factory utilization because of the downturn in general and our position as an electronic content provider to the automotive industry, which experienced significant declines in demand in 2009 compared to peak levels. Although we have experienced sequential increases in revenues during 2009, there continues to be pressure on revenues associated with the macroeconomic weakness as compared to peak levels, particularly in the automotive industry. We expect continued uncertainty with respect to the automotive industry as well as with other of our end markets. This uncertainty may continue to affect our revenues and profitability in 2010.

 

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Continued weakness in the global automotive market is substantiated by a 39% decline in light vehicle production by the Big 3 U.S. automakers in 2009 versus 2008. The bankruptcies of both General Motors (“GM”) and Chrysler further impacted automotive factory production. Our Microcontroller Solutions and Radio Frequency, Analog and Sensor automotive revenues in 2009 declined by 31%, as compared to the prior year. While we expect these conditions in the automotive industry to persist into future quarters and to adversely affect our revenues and profitability compared to peak levels, we are not able to precisely forecast the level and duration of such weakened demand.

In response to these economic pressures, we executed a series of strategic investment and cost reduction actions in late 2008 and 2009 in order to sharpen our strategic focus on growth markets and key market leadership positions where we anticipate above market growth opportunities over the long term. Specifically, during 2009, we executed actions to align our cost structure with our prior decision to wind-down the cellular handset business. We also announced that we are executing a plan to exit our remaining 150mm manufacturing capability in Sendai, Japan and Toulouse, France as well as finalized the closure of our 150mm manufacturing capability in East Kilbride, Scotland because of a general migration away from 150mm technologies and products to more cost-effective advanced technologies and products.

Our business is highly dependent on demand for electronic content in automobiles, networking and wireless infrastructure equipment and other electronic devices. Going forward, we intend to focus our resources on our core automotive and networking products, as well as targeted opportunities in various industrial and consumer electronics markets. Our revenue and profitability recovery in future periods will be dependent upon the extent to which a general global economic recovery occurs, both in size and duration, and our ability to adequately meet product development launch cycles in our targeted markets, among other conditions.

Revenue Recognition: We recognize revenue from product sales when title transfers, the risks and rewards of ownership have been transferred to the customer, the fee is fixed or determinable, and collection of the related receivable is reasonably assured, which is generally at the time of shipment. Sales with destination point terms, which are primarily related to European customers where these terms are customary, are recognized upon delivery. Accruals are established, with the related reduction to revenue at the time the related revenues are recognized, for allowances for discounts and product returns based on actual historical experience. Revenue is reported net of sales taxes. Revenue for services is recognized ratably over the contract term or as services are being performed. Revenue related to licensing agreements is recognized at the time we have fulfilled our obligations and the fee is fixed. Revenues from contracts with multiple elements are recognized as each element is earned based on the relative fair value of each element when there are no undelivered elements that are essential to the functionality of the delivered elements and when the amount is not contingent upon delivery of the undelivered elements. As a percentage of sales, revenue related to licensing agreements represented 2%, 1% and 2% for the years ended December 31, 2009, 2008 and 2007.

Distributor Sales: Revenue from sales to distributors of our products is recognized when title transfers, the risks and rewards of ownership have been transferred to the customer, the fee is fixed or determinable, and collection of the related receivable is reasonably assured, which is generally at the time of shipment. In response to competitive market conditions, we offer incentive programs common to the semiconductor industry. Accruals for the estimated distributor incentives are established at the time of the sale, along with a related reduction to revenue, based on the terms of the various incentive programs, historical experience with such programs, prevailing market conditions and current distributor inventory levels. Distributor incentive accruals are monitored and adjustments, if any, are recognized based on actual experience under these incentive programs.

Product-Related Expenses: Shipping and handling costs associated with product sales are included in cost of sales. Expenditures for advertising are expensed as incurred, and are included in selling, general and administrative expenses. Provisions for estimated costs related to product warranties are made at the time the related sale is recorded, based on historic trends. Research and development costs are expensed as incurred.

Government Grants: Investment incentives related to government grants are recognized when a legal right to the grant exists and there is reasonable assurance that both the terms and conditions associated with the grant will be fulfilled and the grant proceeds will be received. Government grants are recorded as a reduction of the cost being reimbursed.

Stock Compensation Costs: We have several stock-based employee compensation plans, which are more fully described in Note 6. We account for awards granted under those plans using the fair-value recognition provisions of ASC Topic 718, “Compensation-Stock Compensation” (“ASC Topic 718”). We estimated fair values for non-qualified stock options using the Black-Scholes option-pricing model with the weighted-average assumptions listed in Note 6.

Foreign Currency Transactions: The effects of remeasuring the non-functional currency assets or liabilities into the functional currency as well as gains and losses on hedges of existing assets or liabilities are marked-to-market, and the result is included within other expense, net in the accompanying audited Consolidated Statements of Operations. Gains and losses on financial instruments that hedge firm future commitments are deferred until such time as the underlying transactions are recognized or recorded immediately when it is probable the transaction will not occur. Gains or losses on financial instruments that do not qualify as hedges are recognized immediately as income or expense.

 

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Cash and Cash Equivalents: We consider all highly liquid investments, not considered short-term investments, purchased with an original maturity of three months or less to be cash equivalents.

Inventory: Inventory is valued at the lower of average cost (which approximates computation on a first-in, first-out basis) or market (net realizable value or replacement cost).

Property, Plant and Equipment: Property, plant and equipment are stated at cost less accumulated amortization and depreciation. Depreciation is recorded using the declining-balance or the straight-line methods, based on the lesser of the estimated useful or contractual lives of the assets (buildings and building equipment, 5-40 years; machinery and equipment, 3-17 years), and commences once the assets are ready for their intended use. The useful lives of the assets acquired by Holdings I as part of the Merger were established in connection with the allocation of fair values at December 2, 2006.

Assets Held for Sale: When management determines that an asset is to be sold and that it is available for immediate sale subject only to terms that are usual and customary, the asset is no longer depreciated and reclassified to assets held for sale. Assets held for sale are reported in other current assets at the lower of the carrying amount or fair value less costs to sell.

Goodwill and Intangible Assets: A goodwill balance represents the excess of the cost over the fair value of the assets of an acquired business and is reviewed annually for impairment. In 2008, we recorded a $5,350 million non-cash impairment charge against our goodwill, reducing the balance to zero. Our intangible assets are amortized on a straight line basis over their respective estimated useful lives ranging from 2 to 10 years. The useful lives of the intangible assets acquired by Holdings I as part of the Merger were established in connection with the allocation of fair values at December 2, 2006. We have no intangible assets with indefinite useful lives.

Impairment of Long-Lived Assets: Long-lived assets held and used by us and intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of assets may not be recoverable. We evaluate recoverability of assets to be held and used by comparing the carrying amount of an asset to future net undiscounted cash flows to be generated by the assets. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. We determine fair value based on either market quotes, if available, or discounted cash flows using a discount rate commensurate with the risk inherent in our current business model for the specific asset being valued.

Income Taxes: Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and also for net operating loss and credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.

We have reserves for taxes, associated interest, and other related costs that may become payable in future years as a result of audits by tax authorities. Although we believe that the positions taken on previously filed tax returns are fully supported, we nevertheless have established reserves recognizing that various taxing authorities may challenge certain positions, which may not be fully sustained. The tax reserves are reviewed quarterly and adjusted as events occur that affect our potential liability for additional taxes, such as lapsing of applicable statutes of limitations, proposed assessments by tax authorities, resolution of tax audits, negotiations between tax authorities of different countries concerning our transfer prices, identification of new issues, and issuance of new regulations or new case law.

Foreign Currency Translation: Prior to January 1, 2008, many of our non-U.S. operations used the respective local currencies as the functional currency. Those non-U.S. operations which did not use the local currency as the functional currency used the U.S. dollar. The effects of translating the financial position and results of operations of local currency functional operations into U.S. dollars were included in a separate component of stockholder’s equity.

Effective January 1, 2008, we changed the functional currency for certain foreign operations to the U.S dollar. In accordance with ASC Topic 830, “Foreign Currency Matters” (“ASC Topic 830”), once the functional currency for a foreign entity is determined, that determination shall be used consistently unless significant changes in economic facts and circumstances indicate clearly that the functional currency has changed. In December 2007, we formed Freescale Semiconductor EME&A SA (“SBE”), a European single billing entity established to provide sales and distribution service to our European external customers from one centralized location. Previously such activities were decentralized across our entities in Europe. The SBE negotiates and invoices for all contracts with our European external customers. Subsequent to the implementation of the SBE, the other local foreign operations in Europe provide support to the SBE in servicing our customers and only record inter-company commission revenue from the SBE, which is denominated in the U.S dollar. In addition, all inter-company transactions, inter-company loans and other types of financing are denominated in the U.S. dollar for all foreign operations in which the functional currency changed. In accordance with ASC Topic 830, the U.S. dollar is the proper functional currency as financing is provided by U.S dollar sources. The change in functional currency was applied on a prospective basis. The U.S dollar-translated amounts of nonmonetary assets and liabilities at December 31,

 

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2007 became the historical accounting basis for those assets and liabilities at January 1, 2008 and for subsequent periods. As a result of this change in functional currency, exchange rate gains and losses are recognized on transactions in currencies other than the U.S. dollar and included in operations for the period in which the exchange rate changed.

Deferred Financing Costs: We capitalize direct costs incurred to obtain financings and amortize these costs over the terms of the related debt using the effective interest method. Upon the extinguishment of the related debt, any unamortized capitalized debt financing costs are immediately expensed.

Fair Values of Financial Instruments: The fair values of financial instruments are determined based on quoted market prices and market interest rates as of the end of the reporting period. Our financial instruments include cash and cash equivalents, accounts receivable, investments, accounts payable, accrued liabilities, derivative contracts and long-term debt. Except for the fair value of our long-term debt, the fair values of these financial instruments were not materially different from their carrying or contract values at December 31, 2009 and 2008. See Notes 3, 4, 5 and 6 for further details concerning fair value measurement, the fair value of our long-term debt, foreign currency derivative contracts and pension plan assets, respectively.

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

Reclassifications: Certain amounts reported in previous periods have been reclassified to conform to the current presentation.

Business Segments: Management believes the current organizational structure of our sales and marketing, new product introduction, and supply chain operations enable us to execute to our strategic growth initiatives. We have three major focused product design groups to facilitate faster decision making and focus on delivering new products. As a result of the current organizational structure, we operate and account for our results in one reportable segment. We design, develop, manufacture and market high performance semiconductor products. Our Chief Executive Officer has been identified as the Chief Operating Decision Maker as defined by ASC Topic 280, “Segment Reporting” (“ASC Topic 280”). We have one operating segment, as defined by ASC Topic 280, and therefore, the aggregation criteria to determine the reportable segment are not applicable.

Recent Accounting Pronouncements: In June 2009, the FASB issued guidance now codified as Accounting Standards Codification (“ASC”) Topic 105, “Generally Accepted Accounting Principles” (“ASC Topic 105”) as the single source of authoritative non-governmental U.S. GAAP. ASC Topic 105 does not change current U.S. GAAP, but is intended to simplify user access to all authoritative U.S. GAAP by providing all authoritative literature related to a particular topic in one place (the “Codification”). On the effective date of this Statement, the Codification superseded all then-existing non-SEC accounting and reporting standards, and all other non-grandfathered non-SEC accounting literature not included in the Codification became non-authoritative. The provisions of ASC Topic 105 are effective for interim and annual periods ending after September 15, 2009. We adopted ASC Topic 105 in the third quarter of 2009. This pronouncement had no effect on our consolidated financial position, results of operations or cash flows, but impacted our financial reporting process by replacing all references to pre-Codification standards with references to the applicable Codification topic.

In October 2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-13 “Revenue Recognition (ASC Topic 605): Multiple-Deliverable Revenue Arrangements” (“ASU No. 2009-13”). ASU No. 2009-13 addresses how to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting and how the arrangement consideration should be allocated among the separate units of accounting. ASU No. 2009-13 will be effective for fiscal years beginning on or after June 15, 2010 with early adoption permitted. The guidance may be applied retrospectively or prospectively for new or materially modified arrangements. We are currently assessing the impact on our consolidated financial position, results of operations or cash flows.

In October 2009, the FASB issued ASU No. 2009-14 “Software (ASC Topic 985): Certain Revenue Arrangements That Include Software Elements” (“ASU No. 2009-14”). ASU No. 2009-14 modifies the scope of the software revenue recognition guidance to exclude (i) non-software components of tangible products and (ii) software components of tangible products that are sold, licensed or leased with tangible products when the software components and non-software components of the tangible product function together to deliver the tangible product’s essential functionality. ASU No. 2009-13 will be effective for fiscal years beginning on or after June 15, 2010 with early adoption permitted. The guidance may be applied retrospectively or prospectively for new or materially modified arrangements. We are currently assessing the impact on our consolidated financial position, results of operations or cash flows.

In December 2007, the FASB issued guidance now codified as ASC Topic 805, “Business Combinations” (“ASC Topic 805”). Under ASC Topic 805, an entity is required to recognize the assets acquired, liabilities assumed, contractual contingencies, and contingent consideration at their fair value on the acquisition date. It further requires that acquisition-related costs be recognized separately from the acquisition and expensed as incurred, restructuring costs generally be expensed in periods subsequent to the acquisition date, and changes in accounting for deferred tax asset valuation allowances and acquired income tax uncertainties after the measurement period impact income tax expense. In addition, acquired in-process research and development is capitalized as an intangible asset and amortized over its estimated useful life. The adoption of ASC Topic 805 has changed our accounting treatment for

 

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business combinations on a prospective basis beginning in the first quarter of 2009. As referenced in Note 7, a portion of the income tax benefit recorded for discrete events occurring in the first quarter of 2009 included the release of income tax reserves related to foreign audit settlements, which was accounted for in accordance with ASC Topic 805.

Other accounting standards that have been issued or proposed by the FASB, the EITF, the SEC and / or other standards-setting bodies that do not require adoption until a future date are not expected to have a material impact on our consolidated financial position, results of operations or cash flows upon adoption.

(2) Other Financial Data

Statements of Operations Supplemental Information

Merger Costs

In 2008, we incurred merger costs of $11 million, which consist primarily of retention costs associated with the SigmaTel, Inc. acquisition and accounting, legal and other professional fees. We incurred Merger costs of $5 million in 2007 primarily for accounting, legal and other professional fees.

Gain on Extinguishment of Long-Term Debt

We recorded a $2,264 million pre-tax gain for debt extinguishment, net in the accompanying audited Consolidated Statement of Operations in the first quarter of 2009 in connection with the Debt Exchange. (See Note 4 for further discussion of this transaction.) Upon completion of the Debt Exchange, the carrying value of our outstanding long-term debt obligations on the Existing Notes declined by $2,853 million, including $24 million of accrued PIK Interest. This decline was partially offset by the issuance of Incremental Term Loans with a carrying value of $540 million. The Incremental Term Loans were valued based upon the public trading prices of the Existing Notes exchanged immediately prior to the launch of the Debt Exchange. We recorded $17 million of debt issuance costs in connection with the Incremental Term Loans. In addition, during 2009, we have repurchased $60 million of our Fixed Rate Notes and $39 million of our PIK-Election Notes, resulting in $32 million in pre-tax gains, net.

During 2008, we recorded a $79 million pre-tax gain, net in connection with the repurchase of $89 million of our Senior Subordinated Notes, $63 million of our Fixed Rate Notes and $25 million of our Floating Rate Notes. (Refer to Note 4 for definitions of capitalized terms and discussion.)

Other Expense, Net

The following table displays the amounts comprising other expense, net in the accompanying audited Consolidated Statements of Operations:

 

     Year Ended
December 31,
2009
    Year Ended
December 31,
2008
    Year Ended
December 31,
2007
 

Interest expense

   $ (571   $ (738   $ (834

Interest income

     15        36        50   
                        

Interest expense, net

     (556     (702     (784
                        

Other, net

     (20     (31     4   
                        

Other expense, net

   $ (576   $ (733   $ (780
                        

Cash paid for interest was $445 million in 2009, $717 million in 2008 and $831 million in 2007.

Other, Net

During 2009, we recorded a $10 million pre-tax loss in other, net related to other than temporary impairment charges for certain of our investments accounted for under the cost method, as well as a $5 million pre-tax loss on one of our investments accounted for under the equity method. Additionally, in accordance with ASC Topic 815, we recognized pre-tax losses in other, net of $8 million related to the ineffective portion of our interest rate swaps that are no longer classified as a cash flow hedge, $4 million due to the change in the fair value of our interest rate swaps and interest rate caps, as well as $3 million attributable to foreign currency fluctuations. These losses were partially offset by pre-tax gains in other, net of (i) $5 million related to the change in fair value of our auction rate securities (“ARS”) and other derivatives (see further discussion of our ARS in the “Intangible Assets, Net” section of this Note, as well as in Note 3), and (ii) $4 million recorded in the second quarter of 2009 in connection with a settlement of a Lehman Brothers Special Financing, Inc. (“LBSF”) swap arrangement with a notional amount of $400 million (see further discussion of the LBSF swap arrangement in Note 4).

During 2008, in accordance with ASC Topic 815, we recognized a $38 million pre-tax loss in other, net related to the cumulative ineffective portion and subsequent change in fair value of our interest rate swaps that are no longer classified as a cash

 

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flow hedge. We also recognized $5 million in pre-tax losses primarily attributable to one of our investments accounted for under the equity method, as well as foreign currency fluctuations. During the first quarter of 2008, we also recorded a $12 million pre-tax gain in other, net as a result of the sale of all of the shares in one of our investments accounted for under the cost method.

Balance Sheet Supplemental Information

Short-Term Investments

Because continued macroeconomic weakness and financial market illiquidity may cause adverse pricing adjustments in its short-term investment portfolio, FSL, Inc. moved all of its short-term investments from a money market fund, which was a wholly owned subsidiary, to cash equivalent money market accounts in 2009. The money market fund ceased operations in the third quarter of 2009 and was dissolved in the fourth quarter of 2009.

Inventory

Inventory consisted of the following:

 

     December 31,
2009
   December 31,
2008

Work in process and raw materials

   $ 444    $ 531

Finished goods

     162      224
             
   $ 606    $ 755
             

We recognized $7 million and $416 million in cost of sales related to purchase accounting adjustments to inventory in the years ended December 31, 2008 and December 31, 2007, respectively.

As of December 31, 2009 and 2008, we recorded $155 million and $136 million, respectively, in reserves for inventory deemed obsolete or in excess of forecasted demand. If actual future demand or market conditions are less favorable than those projected by our management, additional inventory write-downs may be required.

Other Current Assets

Other current assets consisted of the following:

 

     December 31,
2009
   December 31,
2008

Deferred taxes

   $ 135    $ 129

Assets held for sale

     46      30

Miscellaneous receivables

     38      197

Prepaid expenses

     32      30

Auction rate securities

     30     

Income tax receivable

     21      35

Derivative contracts

     2      12

Other

     31      19
             
   $ 335    $ 452
             

Assets held for sale were $46 million and $30 million at December 31, 2009 and 2008, respectively. The assets held for sale at December 31, 2009 consisted primarily of facilities located in East Kilbride, Scotland, Dunfermline, Scotland and Sendai, Japan, as well as certain wafer packaging assets. The assets held for sale at December 31, 2008 consisted primarily of facilities located in Dunfermline, Scotland, and Tempe, Arizona, as well as a corporate jet.

Property, Plant and Equipment, Net

Property, plant and equipment, net consisted of the following:

 

     December 31,
2009
    December 31,
2008
 

Land

   $ 107      $ 113   

Buildings and improvements

     888        991   

Machinery and equipment

     2,116        2,150   

Assets not yet placed in service

     25        44   
                

Total

     3,136        3,298   

Less accumulated depreciation and amortization

     (1,821     (1,367
                
   $ 1,315      $ 1,931   
                

 

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Depreciation and amortization expense was $648 million and $709 million for the years ended December 31, 2009 and 2008, respectively, including capital lease amortization expense of $20 million in 2009 and 2008. Included in property, plant and equipment are capital lease assets of $22 million and $38 million as of December 31, 2009 and 2008, respectively. These asset amounts are net of accumulated amortization of $56 million and $36 million as of December 31, 2009 and 2008, respectively.

During 2009, FSL, Inc. completed the exit from its wafer manufacturing facility in East Kilbride, Scotland and its design center in Sendai, Japan. Accordingly, the associated East Kilbride facility and Sendai design center assets are classified as held for sale as of December 31, 2009 and are included in other current assets on the accompanying audited Consolidated Balance Sheet.

During 2008, FSL, Inc. sold assets located at the 300-millimeter wafer fabrication facility located in Crolles, France, where we ended a development and manufacturing relationship with two other semiconductor manufacturers in the fourth quarter of 2007.

Goodwill

The following table displays a roll-forward of the carrying amount of goodwill from January 1, 2008 to December 31, 2009:

 

Balance as of January 1, 2008

   $ 5,350   

Additions

     21   

Reductions

     (5,371
        

Balance as of December 31, 2008

   $   
        

2008 Goodwill Adjustments

In connection with the termination of the Q1 2008 Motorola Agreement, the significant decline in market capitalization of the public companies in our peer group throughout the year and as of December 31, 2008, our then announced intent to pursue strategic alternatives for our cellular handset product group and the impact from weakening market conditions in our remaining businesses, we concluded that indicators of impairment existed related to our goodwill and our developed technology / purchased licenses, customer relationship, and trademark / tradename intangible assets. The goodwill, developed technology / purchased licenses, customer relationships, and trademarks / tradenames were primarily established in purchase accounting at the completion of the Merger in December 2006.

In accordance with ASC Topic 350, “Intangibles-Goodwill and Other” (“ASC Topic 350”), goodwill is required to be tested for impairment annually and if an event or conditions change that would more likely than not reduce the fair value of our reporting unit below its carrying value. The determination of fair value used in the impairment evaluation is based on a combination of the income approach, utilizing the discounted cash flow method, and the public company comparables approach, utilizing multiples of profit measures in order to estimate the fair value of the enterprise. We determined that our carrying value exceeded our fair value, indicating that goodwill was potentially impaired. As a result, we initiated the second step of the goodwill impairment test which involves calculating the implied fair value of our goodwill by allocating the fair value of the Company to all of our assets and liabilities other than goodwill and comparing it to the carrying amount of goodwill. We determined that the implied fair value of our goodwill was less than its carrying value by $5,350 million, which was recorded as a goodwill impairment charge in 2008.

In the fourth quarter of 2008, we made a strategic acquisition which resulted in an $18 million increase to goodwill.

Intangible Assets, Net

Amortized intangible assets were composed of the following:

 

     December 31, 2009    December 31, 2008
     Amortized
Cost
   Accumulated
Amortization
   Amortized
Cost
   Accumulated
Amortization

Developed technology / purchased licenses

   $ 3,234    $ 2,542    $ 3,222    $ 2,060

Customer relationships

     362      362      362      360

Trademarks / tradenames

     153      65      153      53
                           
   $ 3,749    $ 2,969    $ 3,737    $ 2,473
                           

Amortization expense is estimated to be $478 million in 2010, $239 million in 2011, $14 million in 2012, $13 million in 2013, $12 million in 2014 and $24 million thereafter.

 

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SigmaTel, Inc.

We acquired SigmaTel, Inc. (“SigmaTel”) on April 30, 2008 for cash consideration of $115 million, including $5 million of direct acquisition costs. SigmaTel was a fabless semiconductor company which designed, developed and marketed mixed-signal ICs for the consumer electronics market. In accordance with the provisions of ASC Topic 805, the total purchase price was allocated to our net tangible and identifiable intangible assets based on their estimated fair values as of April 30, 2008. Included in the acquisition date tangible assets were $21 million in cash and cash equivalents and $32 million in ARS. The ARS are included in other current assets, net on the accompanying audited Consolidated Balance Sheet. Approximately $3 million of the acquisition date purchase price was allocated to in-process research and development. This amount was recognized as research and development expense upon the closing of the acquisition. During the second quarter of 2008, we also recorded a $7 million charge to cost of sales related to purchase accounting adjustments to inventory. There was no goodwill associated with the acquisition of SigmaTel. In the third quarter of 2008, FSL, Inc. sold $16 million of assets associated with SigmaTel’s business that designed and sold integrated circuits to the printer market. In addition, concurrent with the finalization of the purchase price allocation in the fourth quarter of 2008, we allocated $7 million of the purchase price to intangible assets.

Impairments

During 2008, as a result of the aforementioned impairment indicators discussed in “Goodwill” and in accordance with ASC Topic 360, “Property, Plant and Equipment” (“ASC Topic 360”), we performed an analysis utilizing discounted future cash flows related to the specific amortized intangible assets to determine the fair value of each of our intangible asset groups (developed technology / purchased licenses, customer relationships, and trademarks / tradenames). Prior to a business reorganization of FSL, Inc. resulting in a change of the overall operating structure of our company in the fourth quarter of 2007, we operated and accounted for our results under three reportable segments, and as such our intangible assets were included within those reportable segments. Upon concluding the net book value related to customer relationships, tradenames / trademarks and developed technology / purchased licenses intangible assets exceeded the future undiscounted cash flows and fair value attributable to such intangible assets, we recorded impairment charges of $724 million, $98 million and $809 million, respectively, related to those intangible assets in 2008.

Additionally, in 2007, we had initiated discussions regarding our then existing supply agreement with Motorola. We concluded in connection with those discussions that indicators of impairment existed related to the customer relationships, trademark / tradename and developed technology / purchased license intangible assets associated with our cellular handset business. Upon concluding the net book value related to these assets exceeded the future undiscounted cash flows attributable to such intangible assets at the time, we performed an analysis utilizing discounted future cash flows related to the specific intangible assets to determine the fair value of each of the respective assets. As a result of this analysis, we recorded impairment charges of $186 million, $8 million and $255 million related to our customer relationship, trademark / tradename and developed technology / purchased license intangible assets, respectively, in 2007.

Other Assets, Net

Other assets, net consisted of the following:

 

     December 31,
2009
   December 31,
2008

Deferred financing costs, net

   $ 127    $ 199

Deferred income taxes

     63      60

Other long-term receivables

     40      56

Asia land leases

     19      20

Fair value of interest rate cap contracts

     6     

Strategic investments

     6      21

Income tax receivable

     1      10

Auction rate securities

          33

Other

     53      62
             
   $ 315    $ 461
             

 

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Accrued Liabilities and Other

Accrued liabilities consisted of the following:

 

     December 31,
2009
   December 31,
2008

Compensation

   $ 158    $ 152

Severance

     76      126

Taxes other than income taxes

     36      25

Accrued technology cost

     34      49

Deferred revenue

     32      28

Stock-based compensation

     4      22

Interest payable

     25      29

Environmental liability

     5      6

Interest rate swap liability

          28

Income tax payable

     4      7

Other

     107      123
             
   $ 481    $ 595
             

Other Liabilities

Other liabilities consisted of the following:

 

     December 31,
2009
   December 31,
2008

Severance

   $ 162    $

Retiree healthcare obligation

     152      136

Income taxes payable

     73      80

Pension obligations

     56      54

Environmental liability

     40      39

Interest rate swap liability

     11      10

Capital leases

     8      15

Other

     29      19
             
   $ 531    $ 353
             

Additional Paid-In Capital

In connection with the closing of the Merger, we issued approximately 1,012 million shares of our common stock, par value $0.005, to our Parent in exchange for a contribution of approximately $7.1 billion. We issued to our Parent a warrant for the purchase of approximately 49.2 million shares of common stock with a strike price equal to the fair value on the date of grant. The fair value of the warrant, approximately $171 million, is included in additional paid-in capital on our accompanying audited Consolidated Balance Sheets.

Accumulated Other Comprehensive Earnings

The following table provides the components of accumulated other comprehensive earnings:

 

     Unrealized
Gain (Loss) on
Derivatives
    Unrealized
Gain (Loss) on

Postretirement
Obligation
    Foreign
Currency
Translation
    Total  

Balance at January 1, 2007

   $ 5      $      $ 1      $ 6   

Current period net change

     (18     38        21        41   
                                

Balance at December 31, 2007

     (13     38        22        47   

Current period net change

     (1     (18     9        (10
                                

Balance at December 31, 2008

   $ (14   $ 20      $ 31      $ 37   
                                

Current period net change

     14        (6     (2     6   
                                

Balance at December 31, 2009

   $      $ 14      $ 29      $ 43   
                                

During 2009, in accordance with ASC Topic 715, “Compensation-Retirement Benefits,” we recorded gains of $17 million to other comprehensive earnings related to curtailments, settlements and the actuarial impact associated with our Japanese and French pension obligations. These items were driven by our announcement to discontinue manufacturing in our Sendai, Japan facility by 2011, along with other severance actions in Japan. We have also initiated a formal consultation with employees at our Toulouse

 

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fabrication facility. The plan to close the facility in 2011 is being evaluated through consultation with our works council in Toulouse. (See further discussion in Note 10.)

The adjustment for initially applying ASC Topic 715 was recorded to accumulated other comprehensive earnings for $38 million, net of deferred tax of $20 million, as of December 31, 2007. See Note 6 for further discussion.

(3) Fair Value Measurement

Fair value is defined as the exit price, or the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants as of the measurement date. Authoritative guidance establishes a hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the most observable inputs be used when available. Observable inputs are market inputs participants would use in valuing the asset or liability and are developed based on market data obtained from sources independent of us. Unobservable inputs are inputs that reflect our assumptions about the factors market participants would use in valuing the asset or liability. The guidance establishes three levels of inputs that may be used to measure fair value:

Level 1 – quoted prices in active markets for identical assets or liabilities;

Level 2 – quoted prices for similar assets and liabilities in active markets or inputs that are observable;

Level 3 – inputs that are unobservable (for example, cash flow modeling inputs based on assumptions).

Assets and Liabilities Measured and Recorded at Fair Value on a Recurring Basis

We measure cash and cash equivalents and derivative contracts at fair value on a recurring basis. The table below sets forth, by level, the fair value of these financial assets and liabilities as of December 31, 2009. The table does not include assets and liabilities which are measured at historical cost or on any basis other than fair value.

 

As of December 31, 2009:    Total    Quoted Prices
in Active
Markets for
Identical
Assets
   Significant
Other
Observable
Inputs
   Significant
Unobservable
Inputs
      (Level 1)    (Level 2)    (Level 3)

Assets

           

Money market mutual funds (1)

   $ 1,013    $ 1,013    $    $

Time deposits (1)

     267      267          

Asset-backed security (2)

     5                5

Auction rate securities (3)

     30                30

Foreign currency derivative contracts (4)

     2           2     

Interest rate cap arrangements (5)

     6           6   

Other derivative (3)

     3                3
                           

Total Assets

   $ 1,326    $ 1,280    $ 8    $ 38
                           

Interest rate swap agreements (6)

   $ 11    $    $ 11    $

Foreign currency derivative contracts (4)

     4           4     
                           

Total Liabilities

   $ 15    $    $ 15    $
                           

 

The following footnotes indicate where the noted items are recorded in our accompanying audited Consolidated Balance Sheet at December 31, 2009:

 

  (1) Money market funds and time deposits are reported as cash and cash equivalents.
  (2) The asset-backed security is reported as other current assets.
  (3) ARS and other derivatives are reported as other current assets.
  (4) Foreign currency derivative contracts are reported as other current assets or accrued liabilities and other.
  (5) Interest rate cap arrangements are reported as other assets.
  (6) Interest rate swap agreements are reported as other liabilities.

Valuation Methodologies

The asset-backed security classified above as Level 3 is professionally managed and classified as other current assets. The pricing methodology applied includes a number of standard inputs to the valuation model including benchmark yields and other reference data. Due to the recent uncertainties in the credit markets, our asset-backed security with a fair value of $5 million as of December 31, 2009 is classified as Level 3.

 

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Our investments in student loan ARS were acquired as a result of the SigmaTel acquisition which occurred in the second quarter of 2008. Due to uncertainties in the credit markets, the auctions for these securities have failed to settle on their respective settlement dates, and as a result, Level 1 and Level 2 pricing is not available. Therefore, these securities are classified as Level 3 assets and we have used a discounted cash flow (“DCF”) model to determine the estimated fair value as of December 31, 2009. The assumptions used in preparing the DCF model include estimates for (i) the amount and timing of future interest and principal payments and (ii) the rate of return required by investors to own these securities in the current environment. In making these assumptions, we considered relevant factors including: the formula applicable to each security which defines the interest rate paid to investors in the event of a failed auction; forward projections of the interest rate benchmarks specified in such formulas; the likely timing of principal repayments; the probability of full repayment considering the guarantees by the U.S. Department of Education of the underlying student loans and guarantees by other third parties. Our estimate of the rate of return required by investors to own these securities also considers the current reduced liquidity for ARS. During the fourth quarter of 2008, FSL, Inc. received and accepted an offer from UBS whereby we can exercise our rights under the agreement and sell a portion of our eligible ARS to UBS during the period of June 30, 2010 through July 2, 2012 for par value. In the third quarter of 2009, this offer to sell was extended to include all of our ARS under the same terms and conditions of the original agreement. As a result, our ARS were classified as other current assets on the accompanying audited Consolidated Balance Sheet as of December 31, 2009. The $3 million value of the redemption rights was determined using a discounted cash flow model similar to that used to value the ARS.

In determining the fair value of our interest rate swap derivatives, we use the present value of expected cash flows based on market observable interest rate yield curves commensurate with the term of each instrument. The fair value of our interest rate caps was also estimated based on market observable interest rate yield curves, as well as market observable interest rate volatility indexes. For foreign currency derivatives, our approach is to use forward contract and option valuation models employing market observable inputs, such as spot currency rates, time value and option volatilities. Since we only use observable inputs in our valuation of our derivative assets and liabilities, they are considered Level 2. On the termination of $400 million notional amount of our interest rate swaps as a result of the bankruptcy filing of Lehman Commercial Paper, Inc. (the “LCPI swap arrangement”), we recorded an $11 million liability as of December 31, 2008. The LCPI swap arrangement was also classified as Level 2. A $4 million gain was recorded in 2009 in connection with its termination (see further discussion of the LBSF swap arrangement in Note 4).

The following table summarizes the change in the fair value for Level 3 inputs for the year ended December 31, 2009:

 

     Level 3 - Significant Unobservable Inputs  
Changes in Fair Value for the Year Ended December 31, 2009    Asset-backed
securities