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EX-32 - EXHIBIT 32 - SMART Modular Technologies (WWH), Inc.c15003exv32.htm
EX-31.1 - EXHIBIT 31.1 - SMART Modular Technologies (WWH), Inc.c15003exv31w1.htm
EX-31.2 - EXHIBIT 31.2 - SMART Modular Technologies (WWH), Inc.c15003exv31w2.htm
Table of Contents

 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
(Mark One)
     
þ   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended February 25, 2011
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                       to                      
Commission file number 000-51771
SMART MODULAR TECHNOLOGIES (WWH), INC.
(Exact name of registrant as specified in its charter)
     
Cayman Islands   20-2509518
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification Number)
39870 Eureka Drive, Newark, California 94560
(Address of principal executive offices, zip code)
(510) 623-1231
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes þ No o
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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
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 o   Accelerated filer þ   Non-accelerated filer o   Smaller reporting company o
        (Do not check if a 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 o No þ
The number of registrant’s ordinary shares outstanding as of March 28, 2011: 63,481,863.
 
 

 

 


 

SMART MODULAR TECHNOLOGIES (WWH), INC.
INDEX TO QUARTERLY REPORT
TABLE OF CONTENTS
         
    Page  
 
       
    3  
 
       
    3  
 
       
    20  
 
       
    29  
 
       
    29  
 
       
    29  
 
       
    29  
 
       
    29  
 
       
    31  
 
       
    32  
 
       
 Exhibit 31.1
 Exhibit 31.2
 Exhibit 32

 

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PART I. FINANCIAL INFORMATION
Item 1.  
Financial Statements
SMART MODULAR TECHNOLOGIES (WWH), INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
                 
    February 25,     August 27,  
    2011     2010  
    (In thousands, except  
    share data)  
ASSETS
               
 
               
Current assets:
               
Cash and cash equivalents
  $ 134,426     $ 115,474  
Accounts receivable, net of allowances of $1,863 and $1,660 as of February 25, 2011 and August 27, 2010, respectively
    184,724       208,377  
Inventories
    96,087       112,103  
Prepaid expenses and other current assets
    29,108       33,488  
 
           
Total current assets
    444,345       469,442  
Property and equipment, net
    52,996       46,221  
Other non-current assets
    26,066       21,217  
Other intangible assets, net
    5,980       6,460  
Goodwill
    1,061       1,061  
 
           
Total assets
  $ 530,448     $ 544,401  
 
           
 
               
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
 
               
Current liabilities:
               
Accounts payable
  $ 118,840     $ 151,885  
Accrued liabilities
    24,649       29,318  
 
           
Total current liabilities
    143,489       181,203  
Long-term debt
    55,072       55,072  
Other long-term liabilities
    6,225       4,546  
 
           
Total liabilities
    204,786       240,821  
 
           
Commitments and contingencies
               
Shareholders’ equity:
               
Ordinary shares, $0.00016667 par value; 600,000,000 shares authorized; 63,382,037 and 62,740,650 shares issued and outstanding as of February 25, 2011 and August 27, 2010, respectively
    11       10  
Additional paid-in capital
    124,892       118,123  
Accumulated other comprehensive income
    18,832       11,658  
Retained earnings
    181,927       173,789  
 
           
Total shareholders’ equity
    325,662       303,580  
 
           
Total liabilities and shareholders’ equity
  $ 530,448     $ 544,401  
 
           
See accompanying notes to unaudited condensed consolidated financial statements.

 

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SMART MODULAR TECHNOLOGIES (WWH), INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
                                 
    Three Months Ended     Six Months Ended  
    February 25,     February 26,     February 25,     February 26,  
    2011     2010     2011     2010  
    (In thousands, except per share data)  
 
                               
Net sales
  $ 170,549     $ 160,110     $ 386,908     $ 283,203  
Cost of sales (1)
    142,024       118,097       314,374       212,424  
 
                       
Gross profit
    28,525       42,013       72,534       70,779  
 
                       
Operating expenses:
                               
Research and development (1)
    7,852       5,219       16,012       10,949  
Selling, general and administrative (1)
    15,169       14,331       30,017       27,697  
Restructuring charges
    2,831             2,831        
Technology access charge
                7,534        
 
                       
Total operating expenses
    25,852       19,550       56,394       38,646  
 
                       
Income from operations
    2,673       22,463       16,140       32,133  
Interest expense, net
    (230 )     (1,163 )     (941 )     (2,826 )
Other income, net
    285       3,225       835       4,517  
 
                       
Total other income (expense)
    55       2,062       (106 )     1,691  
 
                       
Income before provision for income taxes
    2,728       24,525       16,034       33,824  
Provision for income taxes
    2,557       8,433       7,896       13,150  
 
                       
Net income
  $ 171     $ 16,092     $ 8,138     $ 20,674  
 
                       
 
                               
Net income per share, basic
  $ 0.00     $ 0.26     $ 0.13     $ 0.33  
 
                       
Net income per share, diluted
  $ 0.00     $ 0.25     $ 0.12     $ 0.32  
 
                       
Shares used in computing net income per ordinary share
    63,178       62,211       63,039       62,092  
 
                       
Shares used in computing net income per diluted share
    66,087       65,010       65,923       64,513  
 
                       
 
                               
(1)   Stock-based compensation by category:
                               
 
                               
Cost of sales
  $ 223     $ 162     $ 461     $ 319  
Research and development
    398       307       784       604  
Selling, general and administrative
    1,627       1,370       3,148       2,562  
See accompanying notes to unaudited condensed consolidated financial statements.

 

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SMART MODULAR TECHNOLOGIES (WWH), INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Unaudited)
                                 
    Three Months Ended     Six Months Ended  
    February 25,     February 26,     February 25,     February 26,  
    2011     2010     2011     2010  
    (In thousands)  
 
                               
Net income
  $ 171     $ 16,092     $ 8,138     $ 20,674  
Other comprehensive income:
                               
Net changes in unrealized gain or loss on derivative instruments accounted for as cash flow hedges
          513             988  
Foreign currency translation
    2,630       (6,465 )     7,174       (1,094 )
 
                       
Comprehensive income
  $ 2,801     $ 10,140     $ 15,312     $ 20,568  
 
                       
See accompanying notes to unaudited condensed consolidated financial statements.

 

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SMART MODULAR TECHNOLOGIES (WWH), INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
                 
    Six Months Ended  
    February 25,
2011
    February 26,
2010
 
    (In thousands)  
Cash flows from operating activities:
               
Net income
  $ 8,138     $ 20,674  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Depreciation and amortization
    11,483       7,525  
Stock-based compensation
    4,393       3,485  
Provision for (recovery of) doubtful accounts receivable and sales returns
    203       (711 )
Amortization of debt issuance costs
    199       722  
(Gain) loss on sale of assets
    511       (3 )
Deferred income tax provision
    286        
Gain on early repayment of long-term debt
          (1,178 )
Changes in operating assets and liabilities:
               
Accounts receivable
    24,032       (50,406 )
Inventories
    17,085       (27,825 )
Prepaid expenses and other assets
    (3,990 )     (4,932 )
Accounts payable
    (31,042 )     48,317  
Accrued expenses and other liabilities
    (2,343 )     9,249  
 
           
Net cash provided by operating activities
    28,955       4,917  
 
           
Cash flows from investing activities:
               
Capital expenditures
    (12,342 )     (7,991 )
Cash deposits on equipment
    (623 )     (2,107 )
Proceeds from sale of property and equipment
          276  
 
           
Net cash used in investing activities
    (12,965 )     (9,822 )
 
           
Cash flows from financing activities:
               
Repayment of long-term debt
          (25,000 )
Proceeds from issuance of ordinary shares from stock option exercises
    2,377       663  
 
           
Net cash provided by (used in) financing activities
    2,377       (24,337 )
 
           
Effect of exchange rate changes on cash and cash equivalents
    585       259  
 
           
Net increase (decrease) in cash and cash equivalents
    18,952       (28,983 )
Cash and cash equivalents at beginning of period
    115,474       147,658  
 
           
Cash and cash equivalents at end of period
  $ 134,426     $ 118,675  
 
           
 
               
Supplemental disclosures of cash flow information:
               
Cash paid during the year:
               
Interest
  $ 1,653     $ 2,866  
Taxes
    11,483       11,311  
Non-cash activities information:
               
Change in indemnification receivable and payable for ICMS assessment
  $ 1,336     $  
Change in fair value of derivative instruments
          (755 )
See accompanying notes to unaudited condensed consolidated financial statements.

 

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SMART MODULAR TECHNOLOGIES (WWH), INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1 — Basis of Presentation and Principles of Consolidation
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements of SMART Modular Technologies (WWH), Inc. and subsidiaries (“SMART” or the “Company”) are as of February 25, 2011 and August 27, 2010 and for the three and six months ended February 25, 2011 and February 26, 2010. These unaudited condensed consolidated financial statements have been prepared by the Company in accordance with generally accepted accounting principles in the United States (“U.S. GAAP”). The results of operations for the interim periods shown in this report are not necessarily indicative of results to be expected for the full fiscal year ending August 26, 2011. In the opinion of the Company’s management, the unaudited interim financial statements reflect all adjustments, consisting only of normal, recurring adjustments considered necessary for a fair statement of the financial position, results of operations and cash flows for the periods indicated. The interim unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements as of and for the fiscal year ended August 27, 2010, which are included in the Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”).
The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries and operations located in Phoenix, Arizona; Newark and Irvine, California; Westford, Massachusetts; South Korea; Scotland; Puerto Rico; Malaysia; and Brazil. The financial information for one of the Company’s subsidiaries, SMART Modular Technologies Indústria de Componentes Eletrônicos Ltda. (“SMART Brazil”) is included in the Company’s consolidated financial statements on a one month lag.
The preparation of unaudited condensed consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and assumptions.
Product and Service Revenue
The Company recognizes revenue in accordance with ASC 605, Revenue Recognition. Product revenue is recognized when there is persuasive evidence of an arrangement, product delivery has occurred, the sales price is fixed or determinable, and collectability is reasonably assured. Product revenue typically is recognized at the time of shipment or when the customer takes title of the goods. All amounts billed to a customer related to shipping and handling are classified as revenue, while all costs incurred by the Company for shipping and handling are classified as cost of sales. Sales taxes collected from customers and remitted to governmental authorities are accounted for on a net basis and therefore are excluded from revenues in the consolidated statements of income.
In addition, the Company has classes of transactions with customers that are accounted for on an agency basis (that is, the Company recognizes as revenue the net profit associated with serving as an agent with immaterial or no associated cost of sales). The Company provides procurement, logistics, inventory management, temporary warehousing, kitting and packaging services for these customers. Revenue from these arrangements is recognized as service revenue and is determined by a fee for services based on material procurement costs. The Company recognizes service revenue upon the completion of the services, typically upon shipment of the product. There are no post-shipment obligations subsequent to shipment of the product under the agency arrangements.

 

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The following is a summary of our gross billings to customers and net sales for services and products (in thousands):
                                 
    Three Months Ended     Six Months Ended  
    February 25,     February 26,     February 25,     February 26,  
    2011     2010     2011     2010  
 
                               
Service revenue, net
  $ 9,586     $ 9,790     $ 20,072     $ 17,742  
Cost of sales — service (1)
    252,955       211,390       481,323       364,994  
 
                       
Gross billings for services
    262,541       221,180       501,395       382,736  
Product net sales
    160,963       150,320       366,836       265,461  
 
                       
Gross billings to customers
  $ 423,504     $ 371,500     $ 868,231     $ 648,197  
 
                       
 
                               
Product net sales
  $ 160,963     $ 150,320     $ 366,836     $ 265,461  
Service revenue, net
    9,586       9,790       20,072       17,742  
 
                       
Net sales
  $ 170,549     $ 160,110     $ 386,908     $ 283,203  
 
                       
 
     
(1)  
Represents cost of sales associated with service revenue reported on a net basis.
Recent Accounting Pronouncements
With the exception of those discussed below, there have been no recent accounting pronouncements or changes in accounting pronouncements during the six months ended February 25, 2011 that are of significance, or potential significance, to the Company.
In January 2010, the FASB issued ASU 2009-16, Accounting for Transfers of Financial Assets (FASB Statement No. 166, Accounting for Transfers of Financial Assets), or ASU 2009-16, which eliminates the concept of a “qualifying special-purpose entity” (QSPE), revises conditions for reporting a transfer of a portion of a financial asset as a sale (e.g., loan participations), clarifies the derecognition criteria, eliminates special guidance for guaranteed mortgage securitizations, and changes the initial measurement of a transferor’s interest in transferred financial assets. ASU 2009-16 is effective for financial statements issued for fiscal years, and interim periods within those fiscal years, beginning after November 15, 2009. The Company adopted the provisions of this ASU in fiscal 2011 and it did not have a material impact on its consolidated results of operations and financial condition.
In January 2010, the FASB issued ASU 2009-17, Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities (FASB Statement No. 167, Amendments to FASB Interpretation No. 46 (R)), which revises analysis for identifying the primary beneficiary of a variable interest entity, or VIE, by replacing the previous quantitative-based analysis with a framework that is based more on qualitative judgments. The new guidance requires the primary beneficiary of a VIE to be identified as the party that both (i) has the power to direct the activities of a VIE that most significantly impact its economic performance and (ii) has an obligation to absorb losses or a right to receive benefits that could potentially be significant to the VIE. ASU 2009-17 is effective for financial statements issued for fiscal years, and interim periods within those fiscal years, beginning after November 15, 2009. The Company adopted the provisions of this ASU in fiscal 2011 and it did not have a material impact on its consolidated results of operations and financial condition.
In October 2009, the FASB issued Accounting Standards Update (“ASU”) 2009-13, Revenue Recognition (Topic 605) — Multiple-Deliverable Revenue Arrangements. This guidance modifies the fair value requirements of FASB ASC subtopic 605-25, Revenue Recognition-Multiple Element Arrangements, by allowing the use of the “best estimate of selling price” in addition to vendor specific objective evidence and third-party evidence for determining the selling price of a deliverable. This guidance establishes a selling price hierarchy for determining the selling price of a deliverable, which is based on: (a) vendor-specific objective evidence, (b) third-party evidence, or (c) estimates. In addition, the residual method of allocating arrangement consideration is no longer permitted. ASU 2009-13 is effective for fiscal years beginning on or after June 15, 2010. The Company adopted ASU 2009-13 in fiscal 2011 and it did not have a material impact on its consolidated results of operations and financial condition.
In October 2009, the FASB issued ASU 2009-14, Software (Topic 985) — Certain Revenue Arrangements that Include Software Elements. This guidance modifies the scope of FASB ASC subtopic 965-605, Software-Revenue Recognition, to exclude from its requirements non-software components of tangible products and 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 2009-14 is effective for fiscal years beginning on or after June 15, 2010. The Company adopted ASU 2009-14 in fiscal 2011 and it did not have a material impact on its consolidated results of operations and financial condition.

 

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NOTE 2 — Stock-Based Compensation
The Company accounts for stock-based compensation under ASC 718, Compensation — Stock Compensation, which requires companies to recognize in their statement of operations all share-based payments, including grants of stock options and other types of equity awards, based on the grant date fair value of such share-based awards.
Total stock-based compensation expense for options, restricted share units and other awards recognized for the three months ended February 25, 2011 and February 26, 2010 was approximately $2.2 million and $1.8 million, respectively. Total stock-based compensation expense for options, restricted share units and other awards recognized for the six months ended February 25, 2011 and February 26, 2010 was approximately $4.4 million and $3.5 million, respectively.
Stock Options
The Company’s stock option plan provides for grants of options to employees and independent directors of the Company to purchase the Company’s ordinary shares at the fair value of such shares on the grant date. The options generally vest over a four-year period beginning on the grant date and have a 10-year term. As of February 25, 2011, there were 12,831,334 ordinary shares reserved for issuance under this plan, of which 2,467,687 ordinary shares represented the number of shares available for grant.
For stock options, excluding restricted share units and other awards, the stock-based compensation expense recognized for the three months ended February 25, 2011 and February 26, 2010 was approximately $1.4 million for each period. For stock options, excluding restricted share units and other awards, the stock-based compensation expense recognized for the six months ended February 25, 2011 and February 26, 2010 was approximately $2.7 million for each period.
Summary of Assumptions and Activity for Stock Options
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model that uses the assumptions noted in the following table. Expected volatility for the six months ended February 25, 2011 is based on the Company’s historical common stock volatility, compared to prior periods when the Company used a weighted average of the Company’s historical common stock volatility (80% weighting) together with the historical volatilities of the common stock of comparable publicly traded companies (20% weighting). The expected term of options granted represents the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and our historical exercise patterns. The risk-free interest rate for the expected term of the options is based on the average U.S. Treasury yield curve at the end of the quarter. The following assumptions were used to value stock options:
                 
    Six Months Ended  
    February 25,     February 26,  
    2011     2010  
Stock options:
               
Expected term (years)
    4.7       4.7  
Expected volatility
    81 %     78 %
Risk-free interest rate
    2.16 %     2.33 %
Expected dividends
           

 

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A summary of option activity as of and for the six months ended February 25, 2011 is presented below (dollars and shares in thousands, except per share data):
                                 
                    Weighted        
                    Average        
            Weighted     Remaining        
            Average     Contractual     Aggregate  
            Exercise     Term     Intrinsic  
    Shares     Price     (Years)     Value  
Options outstanding at August 27, 2010
    8,434     $ 4.39                  
Options granted
    892       6.34                  
Options exercised
    (571 )     4.16                  
Options forfeited and cancelled
    (327 )     6.70                  
 
                           
Options outstanding at February 25, 2011
    8,428     $ 4.52       6.56     $ 23,193  
 
                       
Options exercisable at February 25, 2011
    5,000     $ 4.03       5.51     $ 16,746  
 
                       
Options vested and expected to vest at February 25, 2011
    8,140     $ 4.47       6.47     $ 22,807  
 
                       
The Black-Scholes weighted average fair value of options granted during the three months ended February 25, 2011 and February 26, 2010 was $4.17 and $4.59 per option, respectively. The Black-Scholes weighted average fair value of options granted during the six months ended February 25, 2011 and February 26, 2010 was $3.86 and $2.69 per option, respectively. The total intrinsic value of employee stock options exercised during the six months ended February 25, 2011 and February 26, 2010 was approximately $1.6 million and $1.9 million, respectively. Upon the exercise of options, the Company issues new ordinary shares from its authorized shares.
A summary of the status of the Company’s non-vested stock options as of February 25, 2011, and changes during the six months ended February 25, 2011, is presented below (shares in thousands):
                 
            Weighted  
            Average  
            Grant Date Fair  
    Shares     Value Per Share  
Non-vested stock options at August 27, 2010
    3,739     $ 2.61  
Stock options granted
    892     $ 3.86  
Vested stock options
    (877 )   $ 2.16  
Forfeited and cancelled stock options
    (327 )   $ 3.89  
 
           
Non-vested stock options at February 25, 2011
    3,428     $ 2.93  
 
           
As of February 25, 2011, there was approximately $9.2 million of total unrecognized compensation costs related to employee and independent director stock options. Such cost is expected to be recognized over the weighted average period of 2.4 years. The total fair value of shares vested during the six months ended February 25, 2011 was approximately $1.9 million.
Restricted Share Units (“RSUs”)
The Company’s equity incentive plan also provides for grants of RSUs, and, beginning with the first quarter of fiscal 2009, the Company began issuing performance-based and time-based RSUs.
The time-based RSUs vest over a period ranging from one year to four years and their fair value is determined by the closing price of the Company’s ordinary shares on the date of grant.
The Company has issued two types of performance-based RSUs, one based on an internal metric and the other based on an external metric, the Russell MicroCap index (IWC).
The performance-based RSUs containing an internal metric which were issued in fiscal 2009 would have vested in fiscal 2011 if the Company achieved its fiscal 2009 adjusted EBIT target as approved by the Board of Directors. In the first quarter of fiscal 2010, these performance-based RSUs were not awarded because the target was not met.
In the first and second quarters of fiscal 2010 and the first quarter of fiscal 2011, the Company issued performance-based RSUs that contained an external stock market index as a benchmark for performance (“market-based RSUs”). The number of market-based RSUs awarded will depend upon the Company’s stock performance compared to an external stock market index on a date three days before the date set for vesting. The ultimate number of market-based RSUs awarded will then vest three years after the grant date. The fair value of market-based RSUs is determined by using a Monte Carlo valuation model.

 

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A summary of the changes in RSUs outstanding under the Company’s equity incentive plan during the six months ended February 25, 2011 is presented below (dollars and shares in thousands, except per share data):
                         
            Weighted        
            Average     Aggregate  
            Grant Date     Intrinsic  
    Shares     FairValue     Value  
Awards outstanding at August 27, 2010
    1,153     $ 5.25          
Awards granted
    895       7.01          
Awards vested
    (70 )     5.09          
Awards forfeited and cancelled
    (42 )     6.43          
 
                   
Awards outstanding at February 25, 2011
    1,936     $ 6.42     $ 13,650  
 
                 
The stock-based compensation expense related to RSUs for the three months ended February 25, 2011 and February 26, 2010 was approximately $0.9 million and $0.5 million, respectively. The stock-based compensation expense related to RSUs for the six months ended February 25, 2011 and February 26, 2010 was approximately $1.7 million and $0.8 million, respectively.
As of February 25, 2011, the Company had approximately $6.8 million of unrecognized compensation expense related to RSUs, net of estimated forfeitures and cancellations, which will be recognized over a weighted average estimated remaining life of 2.1 years.
NOTE 3 — Goodwill and Other Intangible Assets, net
In accordance with ASC 350, Intangibles — Goodwill and Other, the Company performs a goodwill impairment test annually during the fourth quarter of its fiscal year and more frequently if events or circumstances indicate that impairment may have occurred. Such events or circumstances may include significant adverse changes in the general business climate, among others. There were no events or circumstances in the fiscal quarter ended February 25, 2011 indicating that impairment may have occurred. As of February 25, 2011, the carrying value of goodwill on the Company’s unaudited condensed consolidated balance sheet was $1.1 million.
The Company operates in one reporting unit, one operating and reportable segment: the design, manufacture, and sale of electronic subsystem products and services to various segments of the electronics industry.
The Company reviews its long-lived assets for impairment in accordance with ASC 360, Property, Plant and Equipment. Under ASC 360, long-lived assets, excluding goodwill, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset group may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset group to the future undiscounted cash flows expected to be generated by the asset group. If such assets are considered to be impaired, the impairment is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed are reported at the lower of the carrying amount or fair value, less cost to sell.
The following table summarizes the gross amounts and accumulated amortization of other intangible assets from the Adtron acquisition by type as of February 25, 2011 and August 27, 2010 (in thousands):
                                                 
    Weighted     Value at     As of February 25, 2011     As of August 27, 2010  
    Avg. Life     Date of     Accumulated     Carrying     Accumulated     Carrying  
    (years)     Acquisition     Amortization     Value     Amortization     Value  
Amortized intangible assets:
                                               
Customer relationships
    10     $ 3,700     $ 1,110     $ 2,590     $ 925     $ 2,775  
Technology
    7       2,800       1,200       1,600       1,000       1,800  
Company trade name
    20       2,040       306       1,734       255       1,785  
Leasehold interest
    3       260       244       16       203       57  
Product names
    9       60       20       40       17       43  
 
                                     
Total
          $ 8,860     $ 2,880     $ 5,980     $ 2,400     $ 6,460  
 
                                     
Amortization expense related to identifiable intangible assets totaled approximately $0.2 million and $0.3 million for the three months ended February 25, 2011 and February 26, 2010, respectively and $0.5 million for both six-month periods ended February 25, 2011 and February 26, 2010. Acquired intangibles with definite lives are amortized on a straight-line basis over the remaining estimated economic life of the underlying intangible assets.

 

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Estimated amortization expenses of these intangible assets for the remainder of fiscal 2011, the next four fiscal years and all years thereafter are as follows (in thousands):
         
Fiscal Year:   Amount  
Remainder of fiscal 2011
  $ 455  
2012
    879  
2013
    879  
2014
    879  
2015
    678  
Thereafter
    2,210  
 
     
Total
  $ 5,980  
 
     
NOTE 4 — Net Income Per Share
Basic net income per ordinary share is calculated by dividing net income by the weighted average of ordinary shares outstanding during the period. Diluted net income per ordinary share is calculated by dividing the net income by the weighted average of ordinary shares and dilutive potential ordinary shares outstanding during the period. Dilutive potential ordinary shares consist of dilutive shares issuable upon the exercise of outstanding stock options and vesting of RSUs computed using the treasury stock method.
The following table sets forth for all periods presented the computation of basic and diluted net income per ordinary share, including the reconciliation of the numerator and denominator used in the calculation of basic and diluted net income per share (dollars and shares in thousands, except per share data):
                                 
    Three Months Ended     Six Months Ended  
    February 25,     February 26,     February 25,     February 26,  
    2011     2010     2011     2010  
Numerator:
                               
Net income
  $ 171     $ 16,092     $ 8,138     $ 20,674  
Denominator:
                               
Weighted average ordinary shares, basic
    63,178       62,211       63,039       62,092  
Effect of dilutive securities:
                               
Stock options and RSUs
    2,909       2,799       2,884       2,421  
 
                       
Weighted average ordinary shares, diluted
    66,087       65,010       65,923       64,513  
 
                       
 
                               
Net income per ordinary share, basic
  $ 0.00     $ 0.26     $ 0.13     $ 0.33  
 
                       
Net income per ordinary share, diluted
  $ 0.00     $ 0.25     $ 0.12     $ 0.32  
 
                       
The Company excluded 3,926,619 and 4,169,503 weighted shares from stock options and RSUs from the computation of diluted net income per share for the three and six months ended February 25, 2011, respectively, as the effect of their inclusion would have been anti-dilutive. The Company excluded 4,134,283 and 4,646,930 weighted shares from stock options and RSUs from the computation of diluted net income per share for the three and six months ended February 26, 2010, respectively, as the effect of their inclusion would have been anti-dilutive.
NOTE 5 — Balance Sheet Details
Inventories
Inventories consisted of the following (in thousands):
                 
    February 25,     August 27,  
    2011     2010  
Raw materials
  $ 38,243     $ 44,180  
Work-in-process
    8,552       13,309  
Finished goods
    49,292       54,614  
 
           
Total inventories *
  $ 96,087     $ 112,103  
 
           
 
     
*  
As of February 25, 2011 and August 27, 2010, inventory held under service arrangements was approximately 46% and 41% of total inventories, respectively, and is primarily classified as finished goods.

 

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Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets consisted of the following (in thousands):
                 
    February 25,     August 27,  
    2011     2010  
Prepaid ICMS taxes in Brazil *
  $ 3,958     $ 11,277  
Indemnification receivable for ICMS assessment *
    4,473       4,115  
Prepayment for property and equipment taxes
    2,393       2,122  
Unbilled receivables
    7,515       6,182  
Receivable from subcontractors
    2,228       3,594  
Deferred and other income taxes
    897       1,197  
Other prepaid expenses and other current assets
    7,644       5,001  
 
           
Total prepaid expenses and other current assets
  $ 29,108     $ 33,488  
 
           
 
     
*  
See Note 9 — Commitments and Contingencies.
Property and Equipment, net
Property and equipment consisted of the following (in thousands):
                 
    February 25,     August 27,  
    2011     2010  
Office furniture, software, computers, and equipment
  $ 6,774     $ 5,751  
Manufacturing equipment
    90,517       78,901  
Leasehold improvements
    19,280       18,317  
 
           
 
    116,571       102,969  
Less accumulated depreciation and amortization
    63,575       56,748  
 
           
Property and equipment, net
  $ 52,996     $ 46,221  
 
           
Depreciation expense totaled approximately $5.3 million and $11.0 million for the three and six months ended February 25, 2011, respectively. Depreciation expense totaled approximately $3.6 million and $7.0 million for the three and six months ended February 26, 2010, respectively.
Other Non-Current Assets
Other non-current assets consisted of the following (in thousands):
                 
    February 25,     August 27,  
    2011     2010  
Prepaid ICMS taxes in Brazil *
  $ 12,194     $ 6,358  
Judicial deposit and indemnification receivable related to Brazil ICMS assessment *
    5,809       4,115  
Prepayment for property and equipment taxes
    4,487       4,114  
Deposits on property and equipment
    623       3,076  
Other
    2,953       3,554  
 
           
Total other non-current assets
  $ 26,066     $ 21,217  
 
           
 
     
*  
See Note 9 — Commitments and Contingencies.

 

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Accrued Liabilities
Accrued liabilities consisted of the following (in thousands):
                 
    February 25,     August 27,  
    2011     2010  
Accrued employee compensation
  $ 7,891     $ 15,406  
VAT and other transaction taxes payable
    5,210       5,966  
Accrued restructuring
    2,831        
Accrued warranty reserve
    1,097       732  
Income taxes payable
    788       3,145  
Other accrued liabilities
    6,832       4,069  
 
           
Total accrued liabilities
  $ 24,649     $ 29,318  
 
           
NOTE 6 — Income Taxes
The provision for income tax expense is summarized as follows (in thousands):
                                 
    Three Months Ended     Six Months Ended  
    February 25,     February 26,     February 25,     February 26,  
    2011     2010     2011     2010  
 
                               
Current
  $ 2,409     $ 8,443     $ 7,610     $ 13,171  
Deferred
    148       (10 )     286       (21 )
 
                       
Total
  $ 2,557     $ 8,433     $ 7,896     $ 13,150  
 
                       
Income (loss) before provision for income taxes for the three and six months ended February 25, 2011 and February 26, 2010, consisted of the following components (in thousands):
                                 
    Three Months Ended     Six Months Ended  
    February 25,     February 26,     February 25,     February 26,  
    2011     2010     2011     2010  
 
                               
U.S. loss
  $ (6,108 )   $ (1,731 )   $ (18,495 )   $ (5,994 )
Non-U.S. income
    8,836       26,256       34,529       39,818  
 
                       
Total
  $ 2,728     $ 24,525     $ 16,034     $ 33,824  
 
                       
The effective tax rates for the three months ended February 25, 2011 and February 26, 2010 were approximately 94% and 34%, respectively. The effective tax rates for the six months ended February 25, 2011 and February 26, 2010 were approximately 49% and 39%, respectively. The increase in the effective tax rate for the three months ended February 25, 2011, as compared to the three months ended February 26, 2010, and for the six months ended February 25, 2011, as compared to the six months ended February 26, 2010 is primarily due to an increase in losses in the U.S. and Puerto Rico (including restructuring charges) that provide no tax benefit and a decline of income being generated in non-U.S. tax jurisdictions that are subject to lower tax rates.
Effective February 1, 2011, the Company started to participate in a Brazilian government investment incentive program, known as “PADIS.” This program is specifically designed to promote the development of the local semiconductor industry. The Brazilian government approved our application for certain beneficial tax treatment under the PADIS system. This beneficial tax treatment includes a reduction in the Brazil statutory income tax rate from 34% to 9% on taxable income from the semiconductor portion of our operations. In order to receive the expected benefits, the Company is required to make significant investments in research and development activities, which investments are determined by the amount of sales. In computing the tax expense for the three months and six months ended February 25, 2011, the Company estimated its annual effective tax rate incorporating the anticipated impact of beneficial tax treatment under the PADIS system, which included the reduction in the Brazil statutory income tax rate from 34% to 9% on semiconductor operations in Brazil.
At February 25, 2011, the liability for uncertain tax positions was $0.2 million.
As of February 25, 2011, the Company evaluated its valuation allowance on deferred tax assets to determine if a change in circumstances caused a change in judgment regarding the realization of deferred tax assets in future years. The Company has a cumulative loss for the U.S. in recent years and projects a tax loss for the U.S. in the current fiscal year and for the foreseeable future. A cumulative loss in recent years within the U.S. represents significant evidence in evaluating the need for a valuation allowance on U.S. net deferred tax assets. As a result, the Company continues to record a full valuation allowance on its U.S. deferred tax assets. The Company also projects a tax loss for Puerto Rico in the current fiscal year. During the second quarter of fiscal 2011, the Company initiated a restructuring plan to close its Puerto Rico facility. As of August 27, 2010, the Company had net deferred taxes of approximately $48 thousand at its Puerto Rico facility. The Company anticipates no future taxable income to realize the tax benefit of existing Puerto Rico deferred tax assets. As a result, the Company has recorded a full valuation allowance on its Puerto Rico deferred tax assets.

 

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NOTE 7 — Indebtedness
On March 28, 2005, the Company issued $125.0 million in senior secured floating rate notes due on April 1, 2012 (the “144A Notes”) in an offering exempted from registration under the Securities Act of 1933, as amended (the “Offering”). The 144A Notes were jointly and severally guaranteed on a senior basis by all of our restricted subsidiaries, subject to limited exceptions. In addition, the 144A Notes and the guarantees were secured on a second-priority basis by the capital stock of, or equity interests in, most of our subsidiaries and substantially all of the Company’s and most of its subsidiaries’ assets. The 144A Notes accrued interest at the three-month London Inter Bank Offering Rate, or LIBOR, plus 5.50% per annum, payable quarterly in arrears, and were redeemable under certain conditions and limitations. The 144A Notes were then registered and exchanged for the senior secured floating rate exchange notes (the “Notes”) on October 27, 2005. The terms of the Notes are identical in all material respects to the terms of the 144A Notes, except that the transfer restrictions and registration rights related to the 144A Notes do not apply to the Notes. On August 13, 2008, the Company de-registered the Notes with the SEC to suspend on-going reporting obligations to file reports under Sections 13 and 15(d) with respect to the Notes. The indenture relating to the Notes contains various covenants including limitations on our ability to engage in certain transactions and limitations on our ability to incur debt, pay dividends and make investments. The Company was in compliance with such covenants as of February 25, 2011.
The Company incurred approximately $4.9 million in related debt issuance costs, the remaining portion of which is included in other non-current assets in the accompanying unaudited condensed consolidated balance sheets. Except for the portion written off in connection with the repurchase discussed below, debt issuance costs related to the Notes are being amortized to interest expense on a straight-line basis, which approximates the effective interest rate method, over the life of the Notes.
On October 13, 2009, the Board of Directors approved up to $25.0 million to repurchase and/or redeem a portion of the outstanding Notes, excluding unpaid accrued interest. On October 22, 2009, using available cash, the Company repurchased and retired a portion of the Notes representing $26.2 million of aggregate principal for $25.0 million; at 95.5% of the principal or face amount. In connection with the repurchase, a gain of $1.2 million was recognized in other income (expense) in fiscal 2010, offset by a $0.4 million write-off of debt issuance costs. As of August 27, 2010, the aggregate principal amount of Notes that remained outstanding was $55.1 million. As of February 25, 2011, the fair value of the Notes that remained outstanding was estimated to be approximately $55.1 million.
The Company also has a senior secured credit facility in the amount of $35 million with Wells Fargo Bank. As of April 30, 2010, SMART Modular Technologies, Inc., SMART Modular Technologies (Europe) Limited, and SMART Modular Technologies (Puerto Rico) Inc., as borrowers (the “Borrowers”), entered into the Third Amendment to Second Amended and Restated Loan and Security Agreement (the “Third Amendment”), with the lenders identified therein (the “Lenders”) and Wells Fargo Bank, National Association, as the arranger, administrative agent and security trustee for the Lenders. The Second Amended and Restated Loan and Security Agreement dated April 30, 2007, as amended by the First Amendment dated November 26, 2008, the Second Amendment dated August 14, 2009 and the Third Amendment dated April 30, 2010, is referred to as the “WF Credit Facility”. The WF Credit Facility is jointly and severally guaranteed on a senior basis by all of our subsidiaries, subject to limited exceptions. In addition, the WF Credit Facility and the guarantees are secured by the capital stock of, or equity interests in, most of the Company’s subsidiaries and substantially all of the Company’s and most of its subsidiaries’ assets. As a result of the Third Amendment, the Maturity Date, as defined in the WF Credit Facility, was extended to April 30, 2012, and the Company is again required to comply with certain financial covenants as modified and as set forth in the WF Credit Facility. The Base Rate Margin and LIBOR Rate Margin, as defined in the WF Credit Facility, were changed to 1.25% and 2.25%, respectively. The Company has not borrowed under the WF Credit Facility since November 2007 and had no borrowings outstanding as of February 25, 2011. While the Company was in compliance with the financial covenants required to borrow funds under the WF Credit Facility as of February 25, 2011 and expects to be able to satisfy the financial covenants in the future, it may not meet the financial covenants or financial condition test during all periods before it expires on April 30, 2012 and therefore may not be able to borrow funds if and when it needs funds in the future.
NOTE 8 — Fair Value Measurements
Effective in the first quarter of fiscal 2010, the Company adopted the provisions of ASC 820, Fair Value Measurements and Disclosures, for all non-financial assets and non-financial liabilities.
The fair value of the Company’s cash, cash equivalents, accounts receivable, accounts payable and WF Credit Facility approximates the carrying amount due to the relatively short maturity of these items. Cash and cash equivalents consist of funds held in general checking and savings accounts, money market accounts and certificates of deposit with an original maturity on the date of purchase of three months or less. The Company does not have investments in variable rate demand notes or auction rate securities.

 

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The FASB guidance establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets to identical assets or liabilities (level 1 measurements) and the lowest priority to unobservable inputs (level 3 measurements). The three levels of the fair value hierarchy are described below:
 
Level 1. Valuations based on quoted prices in active markets for identical assets or liabilities that an entity has the ability to access. The Company’s Level 1 assets include money market funds and certificates of deposit that are classified as cash equivalents.
 
Level 2. Valuations based on quoted prices for similar assets or liabilities, quoted prices for identical assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable data for substantially the full term of the assets and liabilities. The Company does not have any assets or liabilities measured under Level 2.
 
Level 3. Valuations based on inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. The Company does not have any assets or liabilities measured under Level 3.
Assets and liabilities measured at fair value on a recurring basis include the following (in millions):
                                 
    Quoted Prices in     Observable/              
    Active Markets     Unobservable              
    for Identical     Inputs     Significant        
    Assets or     Corroborated by     Unobservable        
    Liabilities     Market Data     Inputs        
    Level 1     Level 2     Level 3     Total  
Balances as of February 25, 2011:
                               
Assets:
                               
Cash
  $ 76.8     $     $     $ 76.8  
Money market funds
    54.6                   54.6  
Certificates of deposit
    3.0                   3.0  
 
                       
Total assets measured at fair value (1)
  $ 134.4     $     $     $ 134.4  
 
                       
 
                               
Balances as of August 27, 2010:
                               
Assets:
                               
Cash
  $ 45.7     $     $     $ 45.7  
Money market funds
    69.8                   69.8  
 
                       
Total assets measured at fair value (1)
  $ 115.5     $     $     $ 115.5  
 
                       
 
     
(1)  
Included in cash and cash equivalents on the Company’s condensed consolidated balance sheets.
NOTE 9 — Commitments and Contingencies
Product Warranty and Indemnities
Product warranty reserves are established in the same period that revenue from the sale of the related products is recognized, or in the period that a specific issue arises as to the functionality of a Company’s product. The amounts of the reserves are based on established terms and the Company’s best estimate of the amounts necessary to settle future and existing claims on products sold as of the balance sheet date.
The following table reconciles the changes in the Company’s accrued warranty reserve (in thousands):
         
    Six Months Ended  
    February 25,  
    2011  
Balance of accrual at August 27, 2010
  $ 732  
Settlement of warranty claims
    (489 )
Provision for product warranties
    854  
 
     
Balance of accrual at February 25, 2011
  $ 1,097  
 
     
Product warranty reserves are recorded in accrued liabilities in the accompanying unaudited condensed consolidated balance sheets.
In addition to potential liability for warranties related to defective products, the Company currently has in effect a number of agreements in which it has agreed to defend, indemnify and hold harmless its customers and suppliers from damages and costs which may arise from product defects as well as from any alleged infringement by its products of third-party patents, trademarks or other proprietary rights. The Company believes its internal development processes and other policies and practices limit its exposure related to such indemnities. Maximum potential future payments cannot be estimated because many of these agreements do not have a maximum stated liability. However, to date, the Company has not had to reimburse any of its customers or suppliers for any losses related to these indemnities. The Company has not recorded any liability in its financial statements for such indemnities.

 

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Technology Access and Development Agreements
During the first quarter of fiscal 2011, the Company entered into a strategic joint development project with a semiconductor company. On November 24, 2010, the Company signed a Technology Access Agreement (“TAA”) with this strategic partner which allowed the Company access to certain in-process technology as developed to date by the semiconductor company in order to accelerate the development of the Company’s solid state drives (“SSDs”). In connection with the TAA, the Company also entered into a development agreement under which the Company will compensate the semiconductor company for the development of this in-process technology into a commercially viable product. The total consideration to be paid by the Company to the semiconductor company under the access and development arrangements is $10 million, of which $7 million was paid on November 29, 2010 and the remaining $3 million will be paid in installments as milestones are achieved under the development agreement. The Company determined that the relative fair value of the technology access charge and the development agreement was approximately $7.5 million and $2.5 million, respectively based on the terms and conditions of the agreements and the expected future discounted cash flows of the SSD products.
In the first quarter of fiscal 2011, the Company recognized a technology access charge of $7.5 million associated with the TAA since the technological feasibility associated with this in-process technology had not yet been established and there were remaining development costs to be incurred to complete the development of this technology into a commercially viable product. In addition, the access and use of this in-process technology was restricted only to this development project and thus, there were no alternative future uses by the Company of this in-process technology. The Company also recognized research and development expenses of $1.2 million and $0.7 million during the first and second quarters of fiscal 2011, respectively, associated with the development agreement, which represented the effort incurred by the semiconductor company under the development agreement during the respective periods.
Legal Matters
From time to time the Company is involved in legal matters that arise in the normal course of business. Litigation in general and intellectual property and employment litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. The Company believes that it has defenses to the cases pending, including those set forth below. Except as noted below, the Company is not currently able to estimate, with reasonable certainty, the possible loss, or range of loss, if any, from such legal matters, and accordingly no provision for any potential loss which may result from the resolution of these matters has been recorded in the accompanying consolidated financial statements. In the Company’s opinion, the estimated resolution of these disputes and litigation is not expected to have a material impact on its consolidated financial position, results of operations or cash flow.
Tessera
On December 7, 2007, Tessera, Inc. filed a complaint under section 337 of the Tariff Act of 1930 (“Tariff Act”), 19 U.S.C. § 1337, in the U.S. International Trade Commission (“ITC”) against a subsidiary of the Company, as well as several other respondents. Tessera alleged that “small-format Ball Grid Array (“BGA”) semiconductor packages” and products containing such semiconductor packages, including memory module products sold by the Company, infringe certain claims of United States Patent Nos. 5,697,977; 6,133,627; 5,663,106 and 6,458,681 (the “Asserted Patents”). On January 3, 2008, the ITC instituted an investigation entitled, “In the Matter of Certain Semiconductor Chips with Minimized Chip Package Size and Products Containing Same (III)”, Inv. No. 337-TA-630. In May 2008, Tessera withdrew one of the four Asserted Patents (U.S. Patent No. 6,458,681) from the ITC investigation. On December 29, 2009, the ITC issued a final determination stating that there has been no violation of §337 of the Tariff Act, and that it had terminated the investigation (the “Final Determination”). In the Final Determination, the ITC found no infringement by the Company’s subsidiary. As the ‘627 and ‘977 patents expired in September 2010, Tessera is only appealing the Final Determination as to the ‘106 patent.
Tessera also filed a parallel patent infringement claim in the Eastern District of Texas, Case No. 2:07-cv-534, alleging infringement of the same patents at issue in the ITC action. The district court action seeks an unspecified amount of damages and injunctive relief. The district court action has been stayed pending the completion of the ITC action.
The Company believes that it has meritorious defenses against Tessera’s allegations and that the likelihood of any material charge for this matter is not probable.
Creative Mobile Technologies
On March 7, 2011 Creative Mobile Technologies LLC (“CMT”) filed a complaint in the Supreme Court of the State of New York, County of Queens, alleging, among other things, breach of contract, fraud and fraud in the inducement, and negligent misrepresentation. The allegations are in connection with the sale of certain display and embedded products starting in calendar year 2008, and a settlement agreement and release entered into between CMT and the Company in December 2009 (the “CMT Settlement Agreement”). CMT is seeking a rescission of the CMT Settlement Agreement and punitive and other damages not less than $7.5 million.

 

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The Company believes that it has valid defenses against CMT’s claims, which claims the Company believes are without merit. The Company intends to vigorously defend this lawsuit and to file counterclaims against CMT to, among other things, seek to recover moneys owed to the Company by CMT. The Company believes that the likelihood of any material charge for this matter is remote.
Contingencies
Brazil ICMS Assessment
On October 3, 2008, the Company’s subsidiary in Brazil (“SMART Brazil”) received a notice from the Sao Paulo State Treasury Office providing an assessment for the collection of State Value-Added Tax (“ICMS”) as well as interest and penalties (collectively the “Assessment”) related to the transfer of ICMS credits during 2004 between two Brazilian entities. These transfers occurred prior to the acquisition in April 2004 of SMART from Solectron Corporation (“Solectron”). Solectron was subsequently acquired by Flextronics International Ltd. (“Flextronics”). The Company believes that the Assessment is covered by indemnification pursuant to the Transaction Agreement dated February 11, 2004 dealing with the acquisition of SMART from Solectron, and pursuant to the Flextronics Settlement Agreement described below, and, under the terms of the Transaction Agreement, Flextronics elected to assume responsibility to contest the Assessment on SMART Brazil’s behalf. In June 2010, the Company was advised by tax counsel that the efforts to contest the Assessment in the administrative level were unsuccessful. In October 2010, the attorneys appointed by Flextronics filed a proceeding in the judicial sphere aiming, among other things, to: (i) dispute the enforceability of the state legislation that is involved in the Assessment; and (ii) dispute the penalties against SMART Brazil.
As of February 25, 2011, the Company’s unaudited condensed consolidated balance sheet reflects both a long-term liability for the Assessment and a corresponding long-term indemnity receivable from Flextronics for approximately $5.8 million (or 9.7 million Brazilian Reais “BRL”) which is based on an amount set forth on a government website where assessments are listed and includes interest on the tax, punitive penalties, interest on the penalties, and attorney’s fees. The balance of the assessment increases daily. The Company believes that the Assessment, as revised, is covered by the indemnity from Solectron and/or Flextronics discussed herein and as such, it is not likely to have a material adverse effect on the Company’s cash flows, results of operations or financial condition. While the Company believes that the Assessment as revised is subject to the indemnity, there can be no absolute assurance that Solectron and/or Flextronics will comply with their contractual indemnity obligations in this regard.
Prepaid ICMS Taxes in Brazil
Since 2004, the Sao Paulo State tax authorities have granted SMART Brazil a tax benefit to defer and eventually eliminate the payment of ICMS levied on certain imports from independent suppliers. This benefit, known as an ICMS Special Ruling, is subject to renewal every two years and expired on March 31, 2010. SMART Brazil applied for a renewal of this benefit, but the renewal was not granted until August 4, 2010. The Company was originally advised by tax counsel that the renewal of the benefit would be denied if SMART Brazil did not post a deposit against the Assessment for the benefit of the tax authorities in the event that the tax authorities prevail on any contests against the Assessment. In order to post the deposit, SMART Brazil instituted a judicial proceeding requesting an injunction which was granted on June 16, 2010. In connection with this injunction, on June 17, 2010, SMART Brazil made a judicial deposit (the deposit, as may be increased from time to time is referred to as the “Judicial Deposit”) in the amount of the Assessment at that time which totaled $4.1 million (or 7.2 million BRL). As of February 25, 2011, the Judicial Deposit increased to $4.5 million (or 7.5 million BRL) due to the effect of exchange rate fluctuations. On March 8, 2011, the Company and certain of its subsidiaries entered into a Private Deed of Settlement and Release with Flextronics (the “Flextronics Settlement Agreement”) pursuant to which Flextronics agreed to pay to SMART Brazil $4.5 million (or 7.5 million BRL) as a reimbursement of the Judicial Deposit balance which was received by SMART Brazil on March 24, 2011. The Judicial Deposit is classified in other non-current assets in the accompanying condensed consolidated balance sheet.
On June 22, 2010, the Sao Paulo authorities published a regulation allowing companies that applied for a timely renewal of an ICMS Special Ruling, such as SMART Brazil, to continue utilizing the benefit until a final conclusion on the renewal request was rendered. As a result of this publication, SMART Brazil was temporarily allowed to utilize the benefit while it waited for its renewal. From April 1, 2010, when the ICMS benefit lapsed, through June 22, 2010 when the regulation referred to above was published, SMART Brazil was required to pay the ICMS taxes on imports. The payment of ICMS generates tax credits that may be used to offset ICMS generated from sales by SMART Brazil of its products, however, the vast majority of SMART Brazil’s sales in Sao Paulo are either subject to a lower ICMS rate or are made to customers that are entitled to other ICMS benefits that enable them to eliminate the ICMS levied on their purchases of products from SMART Brazil. As a result, from April 1, 2010 through June 22, 2010, SMART Brazil did not have sufficient ICMS collections against which to apply the credits accrued upon payment of the ICMS on SMART Brazil’s imports. Although the renewal has been granted, there was no refund of ICMS tax credits that accumulated during the period when the Company was waiting for the renewal.

 

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As of February 25, 2011, the amount of accumulated ICMS tax credits reported on the Company’s unaudited condensed consolidated balance sheet relating to the April 1, 2010 through June 22, 2010 period was $16.2 million (or 27.0 million BRL), with $4.0 million (or 6.6 million BRL) classified as other current assets and $12.2 million (or 20.4 million BRL) classified as other non-current assets. It is expected that $4.0 million of the excess ICMS credits will be recovered during the next twelve months, with the remainder of $12.2 million being recovered primarily in fiscal 2012 and 2013. The Company updates its forecast of the recoverability of the ICMS credits quarterly, considering the following key variables in Brazil: timing of government approvals of automated credit utilization, the total amount of sales, the inter-state mix of sales, the timing of fixed asset purchases and the amount of semiconductor component imports. These expectations are based on various estimates including the mix of products and regions where the Company’s sales will occur. If these estimates or the mix of products or regions vary, it could take longer or shorter than expected to fully recover the ICMS credits accumulated to date, resulting in a reclassification of ICMS credits from current to non-current, or vice versa. The accumulation of the excess credits had an adverse impact on the Company’s cash flows and there can be no absolute assurance that the ICMS credits will be fully recoverable.
NOTE 10 — Segment and Geographic Information
The Company operates in one operating segment: the design, manufacture, and sale of electronic subsystem products and services to the electronics industry. The Company’s chief operating decision-maker, the President and CEO, evaluates financial performance on a company-wide basis.
A summary of the Company’s net sales and property and equipment by geographic area is as follows (in thousands):
                                 
    Three Months Ended     Six Months Ended  
    February 25,     February 26,     February 25,     February 26,  
    2011     2010     2011     2010  
Geographic net sales:
                               
U.S.
  $ 38,813     $ 47,950     $ 87,026     $ 91,054  
Brazil
    82,821       66,668       202,229       110,673  
Asia
    38,861       30,984       76,307       55,876  
Europe
    5,554       9,832       12,102       18,462  
Other Americas
    4,500       4,676       9,244       7,138  
 
                       
 
  $ 170,549     $ 160,110     $ 386,908     $ 283,203  
 
                       
                 
    February 25,     August 27,  
    2011     2010  
Property and equipment, net:
               
U.S.
  $ 6,300     $ 6,298  
Brazil
    38,788       32,175  
Malaysia
    7,712       7,705  
Other
    196       43  
 
           
 
  $ 52,996     $ 46,221  
 
           
NOTE 11 — Major Customers
A majority of the Company’s net sales are attributable to customers operating in the information technology industry. Net sales to SMART’s major customers, defined as net sales in excess of 10% of total net sales or those who have outstanding customer accounts receivable balance at the end of each fiscal period of 10% or more of total net accounts receivable, are as follows:
                                 
    Percent of Net Sales  
    Three Months Ended     Six Months Ended  
    February 25,     February 26,     February 25,     February 26,  
    2011     2010     2011     2010  
Customer A
    21 %     22 %     21 %     22 %
Customer B
    14 %     18 %     14 %     18 %
Customer C
    17 %     13 %     17 %     12 %
As of February 25, 2011, approximately 53%, 20% and 6% of accounts receivable were concentrated with Customer A, B and C, respectively. As of August 27, 2010, approximately 42%, 26% and 9% of accounts receivable were concentrated with Customer A, B and C, respectively. The loss of a major customer or a significant reduction in revenue from a major customer could have a material adverse effect on the Company’s business, financial condition and results of operations.

 

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NOTE 12 — Restructuring
During the second quarter of fiscal 2011, the Company initiated a restructuring plan to close its Puerto Rico facility as a result of a continuing long-term decline in production at the location. Charges resulting from the restructuring plan are expected to be between $3.6 million to $4.0 million and will include severance payments, severance-related benefits, lease costs associated with the closure of the Puerto Rico facility and other exit costs.
The following table summarizes the restructuring accrual activity for the six months ended February 25, 2011 (in thousands):
                 
    Severance and        
    Benefits     Total  
Accrual as of August 27, 2010
  $     $  
Restructuring charges
    2,831       2,831  
Payments
           
 
           
Accrual as of February 25, 2011
  $ 2,831     $ 2,831  
 
           
All severance payments and severance-related benefits accrued as of February 25, 2011 are expected to be paid by August 2011. Total restructuring costs accrued as of February 25, 2011 are recorded in accrued liabilities in the accompanying condensed consolidated balance sheets. There were no restructuring activities for the three months ended February 26, 2010.
NOTE 13 — Other Income, net
Other income, net consisted of the following (in thousands):
                                 
    Three Months Ended     Six Months Ended  
    February 25,     February 26,     February 25,     February 26,  
    2011     2010     2011     2010  
Foreign currency gains (losses)
  $ (45 )   $ 2     $ 88     $ (48 )
Gain on legal settlement*
          3,044             3,044  
Gain on early repayment of long-term debt
                      1,178  
Other
    330       179       747       343  
 
                       
Total other income, net
  $ 285     $ 3,225     $ 835     $ 4,517  
 
                       
 
     
*  
In December 2009, the Company received this settlement as a non-active participant, class member in a class action against certain component suppliers initiated in 2002.
Item 2.  
Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Quarterly Report on Form 10-Q, including this Management’s Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements regarding future events and our future results that are subject to the safe harbors created under the Securities Act of 1933, as amended (the “Securities Act”) and the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These statements are based on current expectations, estimates, forecasts and projections about the industries in which we operate and the beliefs and assumptions of our management. Words such as “expects,” “anticipates,” “targets,” “goals,” “projects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” “continues,” “will,” “may,” and variations of such words and similar expressions are intended to identify such forward-looking statements. In addition, any statements that refer to projections of our future financial performance, our anticipated trends in our businesses, and other characterizations of future events or circumstances are forward-looking statements. Readers are cautioned not to place undue reliance on any forward-looking statements as these are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict, including those identified elsewhere herein, and those discussed in Part I, Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended August 27, 2010 filed with the SEC on November 3, 2010 as revised in Part II, Item 1A, “Risk Factors” in our Quarterly Report on Form 10-Q for the three months ended November 26, 2010 filed with the SEC on January 4, 2011, as well as in Part II, Item 1A, “Risk Factors” in this Quarterly Report on Form 10-Q below. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. We undertake no obligation to revise or update any forward-looking statements for any reason.
The following discussion should be read in conjunction with our unaudited condensed consolidated financial statements and notes thereto included elsewhere in this Quarterly Report on Form 10-Q.

 

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Overview
We are a leading independent designer, manufacturer and supplier of value added subsystems sold primarily to Original Equipment Manufacturers (“OEMs”). Our subsystem products include memory modules, flash memory cards and other solid state storage products such as embedded flash and solid state drives or SSDs. We offer our products to customers worldwide. We also offer custom supply chain services including procurement, logistics, inventory management, temporary warehousing, kitting and packaging services. Our products and services are used for a variety of applications in the computing, networking, communications, printer, storage, aerospace, defense and industrial markets worldwide. Products that incorporate our subsystems include servers, routers, switches, storage systems, workstations, personal computers (“PCs”), notebooks, printers and gaming machines.
Generally, increases in overall demand by end users for, and increases in memory or storage content in products that incorporate our subsystems should have a positive effect on our business, financial condition and results of operations. Conversely, decreases in product demand should have a negative effect on our business, financial condition and results of operations. Generally, declines in DRAM pricing reduce our sales and gross profit margins particularly in our operations in Brazil due to on-hand inventory purchased when prices were higher, and conversely, increases in DRAM pricing have the opposite effect. We cannot predict when DRAM price declines will occur, how severe the declines will be and for how long the periods of decline will last and conversely, we cannot predict when DRAM price increases will occur, by how much they will increase or for how long the periods of increase will last. In a declining DRAM pricing environment, our specialty memory business outside of Brazil can also be adversely impacted when customers slow their purchases and reduce inventory as there is usually excess product availability and customers wait to see if prices on these products will decline. We are somewhat insulated from volatility in DRAM pricing on our specialty memory products because a substantial portion of this business involves legacy DRAM which has less price volatility. In addition, the specialty modules that we sell to our customers incorporate DRAM components acquired at market prices and include substantial value added features such as custom or semi-custom design, thermal analysis, unique testing, application integration, signal integrity analysis, different form factors and high density packaging, which also results in less price volatility.
Our business was originally founded in 1988 as SMART Modular Technologies, Inc. (“SMART Modular”) and SMART Modular became a publicly traded company in 1995. Subsequently, SMART Modular was acquired by Solectron Corporation (“Solectron”) in 1999 and operated as a subsidiary of Solectron. In April 2004, a group of investors led by TPG, Francisco Partners and Shah Capital Partners acquired SMART Modular from Solectron (the “Acquisition”), at which time we began to operate our business as an independent company under the name SMART Modular Technologies (WWH), Inc. incorporated under the laws of the Cayman Islands. In February 2006, SMART again became a publicly traded company.
Since the Acquisition, we have repositioned our business by focusing on delivery of certain higher value added products, diversifying our end markets and our capabilities, extending into new vertical markets, creating more technically engineered products and solutions, migrating manufacturing to low cost regions and controlling expenses. In fiscal 2006, we completed a new manufacturing facility in Atibaia, Brazil where we import finished wafers, package them into memory integrated circuits and build memory modules. In fiscal 2008, we acquired Adtron Corporation (“Adtron”), a leading designer and global supplier of high performance and high capacity SSDs for the defense, aerospace and industrial markets which we renamed to SMART Modular Technologies (AZ), Inc. In fiscal 2010, we expanded our development of SSD products and expect to continue to do so in fiscal 2011 to address the significant growth opportunities in the enterprise market. Also in fiscal 2010, we invested in our Brazilian operations to launch initial flash production in fiscal 2011.
We operate in one reportable segment: the design, manufacture, and sale of electronic subsystem products and services to various sectors of the electronics industry. The Company’s chief operating decision-maker, the President and CEO, evaluates financial performance on a company-wide basis. In April 2010, we sold our display business for net proceeds of $2.2 million and incurred a loss of $0.5 million in the third quarter of fiscal 2010. Management’s decision to exit display and embedded products was based on a determination that the market for these products was not scalable to significant revenue growth by the Company. These non-core product lines accounted for only three percent or less of net sales for each of the five fiscal quarters prior to the sale of the display business and therefore we do not believe that exiting these product lines had a material impact on our sales, operating results or our financial condition. We concluded that the display business was a business component that did not require separate reporting of its activities under discontinued operations.
In February 2011, we announced the closure of our Puerto Rico facility as a result of a continuing long-term decline in production at this facility. In the second quarter of fiscal 2011, we recognized restructuring charges of $2.8 million for severance and severance-related benefits which will be primarily paid out during the third quarter of fiscal 2011. In the third quarter of fiscal 2011, we expect to record additional restructuring charges of between $0.8 to $1.2 million, consisting of lease exit costs associated with the closure of the Puerto Rico facility and other exit costs. Our Puerto Rico product lines, which are all non-core products, accounted for five percent or less of net sales for fiscal 2011 and 2010. Products that we manufacture in our Puerto Rico facility can be transitioned to our other facilities if necessary; therefore we do not believe that closing this facility will have a material impact on our sales, operating results or our financial condition.

 

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Key Business Metrics
The following is a brief description of the major components of the key line items in our financial statements.
Net Sales
We generate product revenues predominantly from sales of our value added subsystems, including memory modules, flash memory cards and other solid state storage products, principally to leading computing, networking, communications, printer, storage, aerospace, defense and industrial OEMs. Sales of our products are generally made pursuant to purchase orders rather than long-term commitments. We generate service revenue from a limited number of customers by providing procurement, logistics, inventory management, temporary warehousing, kitting and packaging services. Our net sales are dependent upon demand in the end markets that we serve and fluctuations in end-user demand can have a rapid and material effect on our net sales. Furthermore, sales to relatively few customers have accounted for, and we expect will continue to account for, a significant percentage of our net sales in the foreseeable future.
Cost of Sales
The most significant components of cost of sales are materials, fixed manufacturing costs, labor, depreciation, freight, and customs charges. Increases in capital expenditures may increase our future cost of sales due to higher levels of depreciation expense. Cost of sales also includes any inventory write-downs. We may write down inventory for a variety of reasons, including obsolescence, excess quantities and declines in market value to below our cost.
Research and Development Expenses
Research and development expenses consist primarily of the costs associated with the design and testing of new products. These costs relate primarily to compensation of personnel involved with development efforts, materials and outside design and testing services. Our customers typically do not separately compensate us for design and engineering work involved in the development of custom products.
Selling, General and Administrative Expenses
Selling, general and administrative expenses consist primarily of personnel costs, including salaries, bonuses, commissions and benefits, facilities and non-manufacturing equipment costs, allowances for bad debt, costs related to advertising and marketing and other support costs including utilities, insurance and professional fees.
Critical Accounting Policies
Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our financial statements which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make certain estimates that affect the reported amounts in our financial statements. We evaluate our estimates on an ongoing basis, including those related to our net sales, inventories, asset impairments, restructuring charges, income taxes, stock-based compensation and commitments and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.
We believe the following critical accounting policies are the most significant to the presentation of our financial statements and they at times require the most difficult, subjective and complex estimates.
Revenue Recognition
Our product revenues are predominantly derived from the sale of value added subsystems, including memory modules, flash memory cards and solid state storage products, which we design and manufacture. We recognize revenue when persuasive evidence of an arrangement exists, product delivery has occurred, the sales price is fixed or determinable, and collectability is reasonably assured. Product revenue typically is recognized at the time of shipment or when the customer takes title of the goods. Amounts billed to customers related to shipping and handling are classified as sales, while costs incurred by us for shipping and handling are classified as cost of sales. Taxes, including value added taxes, assessed by a government authority that are both imposed on and concurrent with a specific revenue producing transaction are excluded from revenue.
Our service revenues are derived from procurement, logistics, inventory management, temporary warehousing, kitting and packaging services. The terms of our contracts vary, but we generally recognize service revenue upon the completion of the contracted services. Our service revenue is accounted for on an agency basis. Service revenue for these arrangements is typically based on material procurement costs plus a fee for the services provided. We determine whether to report revenue on a net or gross basis depending on a number of factors, including whether we are the primary obligor in the arrangement, have general inventory risk, have the ability to set the price, have the ability to determine who the suppliers are, can physically change the product, or have credit risk. Under some service arrangements, we retain inventory risk. All inventories held under service arrangements are included in the inventories reported on the accompanying condensed consolidated balance sheets.

 

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The following is a summary of our gross billings to customers and net sales for services and products (in thousands):
                                 
    Three Months Ended     Six Months Ended  
    February 25,     February 26,     February 25,     February 26,  
    2011     2010     2011     2010  
 
                               
Service revenue, net
  $ 9,586     $ 9,790     $ 20,072     $ 17,742  
Cost of sales — service (1)
    252,955       211,390       481,323       364,994  
 
                       
Gross billings for services
    262,541       221,180       501,395       382,736  
Product net sales
    160,963       150,320       366,836       265,461  
 
                       
Gross billings to customers
  $ 423,504     $ 371,500     $ 868,231     $ 648,197  
 
                       
 
                               
Product net sales
  $ 160,963     $ 150,320     $ 366,836     $ 265,461  
Service revenue, net
    9,586       9,790       20,072       17,742  
 
                       
Net sales
  $ 170,549     $ 160,110     $ 386,908     $ 283,203  
 
                       
 
     
(1)  
Represents cost of sales associated with service revenue reported on a net basis.
Accounts Receivable
We evaluate the collectability of accounts receivable based on several factors. When we are aware of circumstances that may impair a specific customer’s ability to meet its financial obligations, we record a specific allowance against amounts due, and thereby reduce the net recognized receivable to the amount we reasonably believe will be collected. Increases to the allowance for sales returns or credits are offset against the revenue. Increases to the allowance for bad debt are recorded as a component of general and administrative expenses. For all other customer accounts receivable, we record an allowance for doubtful accounts based on a combination of factors including the length of time the receivables are outstanding, industry and geographic concentrations, the current business environment, and historical experience.
As a result of the macroeconomic environment and associated credit market conditions, both liquidity and access to capital have impacted some of our customers. We have continued to closely monitor our credit exposure with our customers to anticipate exposures and manage our risk.
Inventory Valuation
We evaluate our inventories for excess quantities and obsolescence. This evaluation includes analyses of sales levels by product family. Among other factors, we consider historical demand and forecasted demand in relation to the inventory on hand, competitiveness of product offerings, market conditions and product life cycles when determining obsolescence and net realizable value. We adjust the carrying values to approximate the lower of our manufacturing cost or net realizable value. Inventory cost is determined on a specific identification basis and includes material, labor and manufacturing overhead. From time to time, our customers may request that we purchase and maintain significant inventory of raw materials for specific programs. Such inventory purchases are evaluated for excess quantities and potential obsolescence and could result in a provision at the time of purchase or subsequent to purchase. Inventory levels may fluctuate based on inventory held under service arrangements. Our provisions for excess and obsolete inventory are also impacted by our arrangements with our customers and/or suppliers, including our ability or inability to sell such inventory. If actual market conditions or our customers’ product demands are less favorable than those projected or if our customers or suppliers are unwilling or unable to comply with any arrangements related to their purchase or sale of inventory, additional provisions may be required and would have a negative impact on our gross margins in that period. We have had material inventory write-downs in the past for reasons such as obsolescence, excess quantities and declines in market value below our costs, and we may be required to do so from time to time in the future.
Income Taxes
We use the asset and liability method of accounting for income taxes. Deferred tax assets and liabilities are recognized for the future consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and net operating loss and credit carryforwards. When necessary, a valuation allowance is recorded or reduced to value tax assets to amounts expected to be realized. The effect of changes in tax rates is recognized in the period in which the rate change occurs. U.S. income and foreign withholding taxes are not provided on that portion of unremitted earnings of foreign subsidiaries that are expected to be reinvested indefinitely.
After excluding ordinary losses in a tax jurisdiction for which no tax benefit can be recognized, we estimate our annual effective tax rate and apply such rate to year-to-date income, adjusting for unusual or infrequent items that are treated as discrete events in the period. We also evaluate our valuation allowance to determine if a change in circumstances causes a change in judgment regarding realization of deferred tax assets in future years. If the valuation allowance is adjusted as a result of a change in judgment regarding future years, that adjustment is recorded in the period of such change affecting our tax expense in that period.

 

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The calculation of our tax liabilities involves accounting for uncertainties in the application of complex tax rules, regulations and practices. We recognize benefits for uncertain tax positions based on a two-step process. The first step is to evaluate the tax position for recognition of a benefit (or the absence of a liability) by determining if the weight of available evidence indicates that it is more likely than not that the position taken will be sustained upon audit, including resolution of related appeals or litigation processes, if any. If it is not, in our judgment, more likely than not that the position will be sustained, we do not recognize any benefit for the position. If it is more likely than not that the position will be sustained, a second step in the process is required to estimate how much of the benefit we will ultimately receive. This second step requires that we estimate and measure the tax benefit as the largest amount that is more than 50 percent likely of being realized upon ultimate settlement. It is inherently difficult and subjective to estimate such amounts. We reevaluate these uncertain tax positions on a quarterly basis. This evaluation is based on a number of factors including, but not limited to, changes in facts or circumstances, changes in tax law, new facts, correspondence with tax authorities during the course of an audit, effective settlement of audit issues, and commencement of new audit activity. Such a change in recognition or measurement could result in the recognition of a tax benefit or an additional charge to the tax provision in the period.
Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed
We review our long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the future undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed are reported at the lower of the carrying amount or fair value, less cost to sell.
Stock-Based Compensation
We account for stock-based compensation under ASC 718, Compensation — Stock Compensation, which requires us to recognize expenses in our statement of operations related to all share-based payments, including grants of stock options and RSUs, based on the grant date fair value of such share-based awards. The key assumptions used in valuing share-based awards are described in Note 2 to the Unaudited Condensed Consolidated Financial Statements.
Results of Operations
The following is a summary of our results of operations for the three and six months ended February 25, 2011 and February 26, 2010 (in millions):
                                                                 
    Three Months Ended(1)     Six Months Ended(1)  
    February 25,     % of     February 26,     % of     February 25,     % of     February 26,     % of  
    2011     sales     2010     sales     2011     sales     2010     sales  
 
                                                               
Net sales
  $ 170.5       100 %   $ 160.1       100 %   $ 386.9       100 %   $ 283.2       100 %
Cost of sales
    142.0       83 %     118.1       74 %     314.4       81 %     212.4       75 %
 
                                               
Gross profit
    28.5       17 %     42.0       26 %     72.5       19 %     70.8       25 %
 
                                               
Research and development
    7.9       5 %     5.2       3 %     16.0       4 %     10.9       4 %
Selling, general and administrative
    15.2       9 %     14.3       9 %     30.0       8 %     27.7       10 %
Restructuring charges
    2.8       2 %                 2.8       1 %            
Technology access charge
                            7.5       2 %            
 
                                               
Total operating expenses
    25.9       15 %     19.6       12 %     56.4       15 %     38.6       14 %
 
                                               
Income from operations
    2.7       2 %     22.5       14 %     16.1       4 %     32.1       11 %
Interest expense, net
    (0.2 )     0 %     (1.2 )     -1 %     (0.9 )     0 %     (2.8 )     -1 %
Other income, net
    0.3       0 %     3.2       2 %     0.8       0 %     4.5       2 %
 
                                               
Total other income (expense)
    0.1       0 %     2.1       1 %     (0.1 )     0 %     1.7       1 %
 
                                               
Income before provision for income taxes
    2.7       2 %     24.5       15 %     16.0       4 %     33.8       12 %
Provision for income taxes
    2.6       1 %     8.4       5 %     7.9       2 %     13.2       5 %
 
                                               
Net income
  $ 0.2       0 %   $ 16.1       10 %   $ 8.1       2 %   $ 20.7       7 %
 
                                               
 
     
(1)  
Summations may not compute precisely due to rounding.

 

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Three and Six Months Ended February 25, 2011 as Compared to the Three and Six Months Ended February 26, 2010
Net Sales
Net sales for the three months ended February 25, 2011 were $170.5 million, a 7% increase from $160.1 million for the three months ended February 26, 2010. Net sales for the six months ended February 25, 2011 were $386.9 million, a 37% increase from $283.2 million for the six months ended February 26, 2010. These increases were primarily due to strength in PC and notebook end-user demand in Brazil and increased demand for our solid state storage products. Investments to increase capacity at our Brazil operations have enabled us to meet strong end-user demand by substantially increasing volume. These unit volume increases offset the decrease in net sales due to declining DRAM prices during these periods. Our solid state storage products also grew significantly due to increased demand for our enterprise products, defense products and embedded flash drives. The increases in net sales were partially offset by decreased net sales from display and embedded computing products, which we exited in the third quarter of fiscal 2010. We believe that pricing in the DRAM market appears to have stabilized when compared to the substantial declines in DRAM pricing we experienced throughout the first six months of fiscal 2011.
Cost of Sales
Cost of sales for the three months ended February 25, 2011 was $142.0 million, a 20% increase from $118.1 million for the three months ended February 26, 2010. The increase in cost of sales was primarily due to an $18.9 million increase in the cost of products resulting from the increase in net sales as discussed above. In addition, our factory overhead and other components of cost of sales increased by $5.0 million, primarily due to increased volume, especially in Brazil, including increased depreciation expense of $1.4 million primarily due to our continued capital investment to expand capacity primarily in Brazil.
Cost of sales for the six months ended February 25, 2011 was $314.4 million, a 48% increase from $212.4 million for the six months ended February 26, 2010. The increase in cost of sales was primarily due to a $90.7 million increase in the cost of products resulting from the increase in net sales as discussed above. Our factory overhead and other components of cost of sales also increased by $11.2 million, primarily due to increased volume, especially in Brazil, as well as higher import duties and customs charges and increased depreciation expense of $3.4 million primarily due to our continued capital investment to expand capacity primarily in Brazil.
Gross Profit
Gross profit for the three months ended February 25, 2011 was $28.5 million, a 32% decrease from $42.0 million for the three months ended February 26, 2010. The decrease in gross profit was primarily due to the fact that our Brazil modules pricing adjusts faster than our inventory, partially offset by volume increases as described above. Gross profit for the six months ended February 25, 2011 was $72.5 million, a 2% increase from $70.8 million for the six months ended February 26, 2010. The increase in gross profit was primarily due to higher net sales as explained above, significantly offset by the rapid decline in the DRAM module selling prices as previously discussed.
Gross profit percentage decreased to 17% for the three months ended February 25, 2011 from 26% for the three months ended February 26, 2010. Gross profit percentage decreased to 19% for the six months ended February 25, 2011 from 25% for the six months ended February 26, 2010. These decreases in gross profit percentage were primarily due to increased cost of products as a percentage of net sales resulting from the rapid decline in DRAM prices which reduced the selling prices of our modules in Brazil. In addition, gross profit percentage was also negatively impacted by an unfavorable mix of products sold during the periods.
Research and Development Expenses
Research and development (“R&D”) expenses for the three months ended February 25, 2011 were $7.9 million, a 50% increase from $5.2 million for the three months ended February 26, 2010. R&D expenses for the six months ended February 25, 2011 were $16.0 million, a 46% increase from $10.9 million for the six months ended February 26, 2010. These increases were primarily due to increased spending on development of enterprise SSDs, which included $0.7 million and $2.0 million of R&D expenses incurred under a development agreement with a strategic partner for the three and six months ended February 25, 2011, respectively, as well as higher payroll and other employee-related expenses due to a significant increase in R&D headcount, partially offset by lower bonus expense. During the balance of fiscal 2011, we expect to further increase R&D spending on enterprise SSDs and to initiate spending on our recently announced corporate R&D center in Brazil.
Selling, General and Administrative Expenses
Selling, general and administrative (“SG&A”) expenses for the three months ended February 25, 2011 were $15.2 million, a 6% increase from $14.3 million for the three months ended February 26, 2010. Sales and marketing expenses decreased by $0.2 million primarily due to lower payroll and other employee-related expenses resulting from decreased headcount, partially offset by higher commissions resulting from the growth in sales. General and administrative expenses increased $1.1 million primarily due to higher professional services, mostly relating to our implementation of the Brazilian government investment incentive program known as “PADIS”, as well as increased payroll and other employee-related expenses and increased stock-based compensation expense, all partially offset by lower bonus expense.
SG&A expenses for the six months ended February 25, 2011 were $30.0 million, an 8% increase from $27.7 million for the six months ended February 26, 2010. Sales and marketing expenses increased by $0.3 million primarily due to higher commissions resulting from the growth in sales, partially offset by lower bonus expense. General and administrative expenses increased $2.0 million primarily due to increased payroll and other employee-related expenses, higher professional services mostly in Brazil, and increases in stock-based compensation expense, all partially offset by lower bonus expense.

 

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Restructuring Charges
During the second quarter of fiscal 2011, the Company initiated a restructuring plan to close its Puerto Rico facility as a result of a continuing long-term decline in production at the location. Charges resulting from the restructuring plan are expected to be between $3.6 million to $4.0 million and will include severance payments, severance-related benefits, lease exit costs associated with the closure of the Puerto Rico facility and other exit costs. In the three months ended February 25, 2011, we recognized restructuring costs of $2.8 million for severance and severance-related benefits, which will be primarily paid out during the third quarter of fiscal 2011. There were no restructuring charges in the three and six months ended February 26, 2010.
Technology Access Charge
A one-time technology access charge of $7.5 million for the six months ended February 25, 2011 was incurred to gain access to in-process technology in order to accelerate our development of enterprise SSDs. Please refer to Note 9 of our Notes to Unaudited Condensed Consolidated Financial Statements for additional detail.
Interest Expense, net
Net interest expense for the three months ended February 25, 2011 was $0.2 million compared to $1.2 million for the three months ended February 26, 2010. The decrease in net interest expense was primarily due to a $0.6 million decrease in interest expense mostly resulting from the expiration of an interest swap agreement in April 2010, as well as a $0.3 million increase in interest income due to higher amounts on deposit.
Net interest expense for the six months ended February 25, 2011 was $0.9 million compared to $2.8 million for the six months ended February 26, 2010. The decrease in net interest expense was primarily due to a $1.8 million decrease in interest expense resulting from lower outstanding long-term debt and the expiration of an interest swap agreement in April 2010.
Other Income, net
Net other income for the three months ended February 25, 2011 was $0.3 million compared to $3.2 million for the three months ended February 26, 2010. Net other income for the six months ended February 25, 2011 was $0.8 million compared to $4.5 million for the six months ended February 26, 2010. These decreases were largely due to a $3.0 million gain from a legal settlement in the second quarter of fiscal 2010 and a $1.2 million gain on the partial repurchase of a portion of our long-term debt in the first quarter of fiscal 2010, both of which did not recur in fiscal 2011.
Provision for Income Taxes
The effective tax rates for the three months ended February 25, 2011 and February 26, 2010 were approximately 94% and 34%, respectively. The effective tax rates for the six months ended February 25, 2011 and February 26, 2010 were approximately 49% and 39%, respectively. The increase in the effective tax rate for both the three and six month periods was primarily due to an increase in losses in the U.S. and Puerto Rico (including restructuring charges) that provided no tax benefit and a decline of income being generated in non-U.S. tax jurisdictions that are subject to lower tax rates.
Liquidity and Capital Resources
Our principal sources of liquidity are cash flows from operations and borrowings under our senior secured floating rate notes that remain outstanding. We also have an unutilized senior secured line of credit facility available. Our principal uses of cash and capital resources are debt service requirements as described below, capital expenditures, potential acquisitions, research and development expenditures and working capital requirements. From time to time, surplus cash may be used to pay down long-term debt to reduce interest expense.
Cash and cash equivalents consist of funds held in demand deposit accounts, money market funds and certificates of deposit. Cash is held in multiple jurisdictions outside the United States. There are no significant restrictions or tax costs on the transfer of or repatriation of such assets.
Debt Service
As of February 25, 2011, we had total long-term indebtedness of $55.1 million, which represents the aggregate principal amount outstanding under the Notes (defined below) that remain outstanding.
Senior Secured Floating Rate Exchange Notes Due April 2012 (the “Notes”). As of February 25, 2011, the Notes bear an interest rate of 5.80%, which is equal to LIBOR plus 5.50% per annum, and are guaranteed by most of our subsidiaries. The interest rate is reset quarterly. The guarantees are secured on a second-priority basis by the capital stock of, or equity interests in, most of our subsidiaries and substantially all of our and most of our subsidiaries’ assets. Interest on the Notes is payable quarterly in cash. The Notes contain customary covenants and events of default, including covenants that limit our ability to incur debt, pay dividends and make investments. We were in compliance with such covenants as of February 25, 2011.

 

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Senior Secured Revolving Line of Credit Facility. The Company has a senior secured credit facility in the amount of $35 million with Wells Fargo Bank. On April 30, 2010, the Third Amendment to Second Amended and Restated Loan and Security Agreement (the “Third Amendment”) was entered into by and among SMART Modular Technologies, Inc., SMART Modular Technologies (Europe) Limited, and SMART Modular Technologies (Puerto Rico), Inc., as borrowers (the “Borrowers”), and Wells Fargo Bank, National Association, as arranger, administrative agent and security trustee for the Lenders named therein. The Second Amended and Restated Loan and Security Agreement dated April 30, 2007, as amended by the First Amendment dated November 26, 2008, the Second Amendment dated August 14, 2009 and the Third Amendment dated April 30, 2010, is referred to as the “WF Credit Facility”. The WF Credit Facility is jointly and severally guaranteed on a senior basis by all of our subsidiaries, subject to limited exceptions. In addition, the WF Credit Facility and the guarantees are secured by the capital stock of, or equity interests in, most of the Company’s subsidiaries and substantially all of the Company’s and most of its subsidiaries’ assets. As a result of the Third Amendment, the Maturity Date, as defined in the WF Credit Facility, was extended to April 30, 2012, and the Company is again required to comply with certain financial covenants as modified and as set forth in the WF Credit Facility. The Base Rate Margin and LIBOR Rate Margin, as defined in the WF Credit Facility, were changed to 1.25% and 2.25%, respectively. While the Company was in compliance with the financial covenants required to borrow funds under the WF Credit Facility as of February 25, 2011 and expects to be able to satisfy such financial covenants in the future, we may not meet the financial covenants during all periods. If we do not meet the financial covenants or financial condition test, we will be in default of the WF Credit Facility and, among other things, we will be unable to borrow under the WF Credit Facility if and when we need the funds in the future. We have not borrowed under the WF Credit Facility since November 2007 and we had no borrowings outstanding as of February 25, 2011.
Capital Expenditures
We expect that future capital expenditures will primarily focus on our Brazil operations, establishing our corporate research and development center in Brazil, manufacturing equipment upgrades and/or acquisitions, IT infrastructure and software upgrades. The WF Credit Facility contains restrictions on our ability to make capital expenditures. Based on current estimates, we believe that the amount of capital expenditures permitted to be made under the WF Credit Facility will be adequate to implement our current plans.
Sources and Uses of Funds
On October 13, 2009, the Board of Directors approved up to $25.0 million, excluding unpaid accrued interest, to repurchase and/or redeem a portion of the outstanding Notes. On October 22, 2009, using available cash, we repurchased and retired $26.2 million of aggregate principal amount of Notes for $25.0 million; at 95.5% of the principal or face amount. As of February 25, 2011, the aggregate principal amount under the Notes that remain outstanding was $55.1 million which is due April 2012. We may, however, repurchase additional Notes prior to this maturity.
In Brazil, an ICMS Special Ruling tax benefit received from the Sao Paulo State tax authorities expired on March 31, 2010. Even though we filed a timely application for renewal with the appropriate authorities on January 27, 2010, the renewal was not received until August 4, 2010. As a result, starting on April 1, 2010, we began accruing excess ICMS credits. On June 22, 2010, the Sao Paulo tax authorities published a regulation allowing companies that applied for a timely renewal of an ICMS Special Ruling to continue utilizing the benefit until a final conclusion on the renewal request was rendered. For the period April 1, 2010 through June 22, 2010, SMART Brazil was required to pay ICMS taxes on imports for which we received related tax credits. As of February 25, 2011, we had a balance of $16.2 million (or 27.0 million BRL) of ICMS credits which we expect to recover over a period of time through fiscal 2013. It is expected that $4.0 million (or 6.6 million BRL) of the ICMS credits will be recovered during the next twelve months, with the remainder of $12.2 million (or 20.4 million BRL) being recovered primarily in fiscal 2012 and 2013. Please refer to Contingencies under Note 9 of our Notes to Unaudited Condensed Consolidated Financial Statements for more details.
We anticipate that our existing cash and anticipated cash generated from operations will be sufficient to meet our working capital needs, fund our R&D and capital expenditures, and service the requirements on our debt obligations for at least the next 12 months. Our ability to fund our cash requirements or to refinance our indebtedness beyond the next 12 months will depend upon our future operating performance, which will be affected by general economic, financial, competitive, business and other factors beyond our control.
From fiscal 2004 through fiscal 2009, our annual capital expenditures were 3% or less of net sales. In fiscal 2010, our capital expenditures were 4% of net sales due to capacity expansion and the initiation of flash packaging in Brazil. In fiscal 2011, we expect our capital expenditures to be approximately 4% of net sales primarily due to our Brazil operations, establishing our corporate research and development center in Brazil, manufacturing equipment upgrades and/or acquisitions, IT infrastructure and software upgrades.
From time to time, we may explore financing options in order to fund cash flow requirements for internal growth, to repay existing indebtedness, and/or to fund any future acquisitions. This additional funding could include additional share issuances and/or debt financing or a combination thereof. There can be no assurance that additional funding will be available to us on acceptable terms or at all.
Historical Trends
Historically, our financing requirements have been funded primarily through cash generated by operating activities. As of February 25, 2011, our cash and cash equivalents were $134.4 million.

 

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Cash Flows from Operating Activities. Net cash provided by operating activities of $29.0 million for the six months ended February 25, 2011 was primarily comprised of $8.1 million from net income, $17.1 million from non-cash expenses and $3.7 million from changes in our operating assets and liabilities. The $3.7 million change in operating assets and liabilities includes cash generated from a reduction in accounts receivable of $24.0 million and an inventory decrease of $17.1 million. The reduction in accounts receivable was mostly due to improved collections. In addition, both the accounts receivable and inventory decreases were related to lower gross sales during the second quarter of fiscal 2011. This was partially offset by cash used for a decrease in accounts payable of $31.0 million, a decrease in accrued liabilities of $2.3 million and an increase in prepaid expenses and other assets of $4.0 million. The decrease in accounts payable was primarily due to reduced inventory purchases, as well as increased early payment discounts taken during the period.
Net cash provided by operating activities of $4.9 million for the six months ended February 26, 2010 was primarily comprised of $20.7 million of net income and $9.8 million of non-cash related expenses, offset by a $25.6 million change in our net operating assets and liabilities. The $25.6 million change in operating assets and liabilities includes an increase in accounts receivable of $50.4 million, an inventory increase of $27.8 million and an increase in prepaid expenses and other assets of $4.9 million. The increase in accounts receivable was primarily due to increased gross sales, as well as slower collections resulting from the Chinese New Year holidays in February 2010. The increase in inventory was mainly due to our positioning in a shortage market, as well as to prepare for increases in demand for our logistics business. Cash used in the period was partially offset by cash generated from increases in accounts payable of $48.3 million and an increase in accrued expenses and other liabilities of $9.2 million.
Cash Flows from Investing Activities. Net cash used in investing activities of $13.0 million for the six months ended February 25, 2011 was primarily due to purchases of $12.3 million in property and equipment and $0.6 million of cash deposits on equipment. Net cash used in investing activities of $9.8 million for the six months ended February 26, 2010 was primarily due to purchases of $8.0 million in property and equipment and $2.1 million of cash deposits on equipment, partially offset by proceeds from sales of property and equipment of $0.3 million.
Cash Flows from Financing Activities. Net cash provided by financing activities of $2.4 million for the six months ended February 25, 2011 was due to proceeds from ordinary share issuances through option exercises. Net cash used in financing activities of $24.3 million for the six months ended February 26, 2010 was primarily due to $25.0 million used for the partial repurchase of the Notes, partially offset by $0.7 million provided by proceeds from ordinary share issuances through option exercises.
Contractual Obligations
There have been no material changes to contractual obligations previously disclosed in our Annual Report on Form 10-K for the year ended August 27, 2010.
Off-Balance Sheet Arrangements
We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not have any undisclosed borrowings or debt, and we have not entered into any synthetic leases. We are, therefore, not materially exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.
We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial conditions, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Inflation
We do not believe that inflation has had a material effect on our business, financial condition or results of operations. If our costs were to become subject to significant inflationary pressures, we may not be able to fully offset such higher costs through price increases. Our inability or failure to do so could adversely affect our business, financial condition and results of operations.
Recent Accounting Pronouncements
See Note 1 of our Notes to Unaudited Condensed Consolidated Financial Statements for information regarding the effect of recent accounting pronouncements on our financial statements.

 

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Item 3.  
Quantitative and Qualitative Disclosures About Market Risk
Our exposure to market rate risk includes risk of foreign currency exchange rate fluctuations and changes in interest rates.
Foreign Exchange Risks
We are subject to inherent risks attributed to operating in a global economy. Our international sales and our operations in foreign countries subject us to risks associated with fluctuating currency values and exchange rates. Because sales of our products are denominated mainly in United States dollars, increases in the value of the United States dollar could increase the price of our products so that they become relatively more expensive to customers in a particular country, possibly leading to a reduction in sales and profitability in that country. Some of the sales of our products are denominated in foreign currencies. Gains and losses on the conversion to U.S. dollars of accounts receivable arising from such sales, and of other associated monetary assets and liabilities, may contribute to fluctuations in our results of operations. In addition, we have certain costs that are denominated in foreign currencies, and decreases in the value of the U.S. dollar could result in increases in such costs that could have a material adverse effect on our results of operations. We do not currently purchase financial instruments to hedge foreign exchange risk, but may do so in the future.
Interest Rate Risk
We are subject to interest rate risk in connection with our long-term debt of $55.1 million under the Notes that remain outstanding as of February 25, 2011. Although we did not have any balances outstanding as of February 25, 2011 under our WF Credit Facility, this facility provides for borrowings of up to $35 million that would also bear interest at variable rates. Assuming that we will satisfy the financial covenants required to borrow and that the WF Credit Facility is fully drawn, other variables are held constant and the impact of any hedging arrangements is excluded, each 1.0% increase in interest rates on our variable rate borrowings would result in an increase in annual interest expense and a decrease in our cash flow and income before taxes of $0.9 million per year.
Item 4.  
Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures. Our President and Chief Executive Officer and our Senior Vice President and Chief Financial Officer, after evaluating the effectiveness of the Company’s “disclosure controls and procedures” (as defined in the Exchange Act Rules 13a-15(e) or 15d-15(e)) as of the end of the period covered by this quarterly report, have concluded that our disclosure controls and procedures are effective based on their evaluation of these controls and procedures required by paragraph (b) of Exchange Act Rules 13a-15 or 15d-15.
(b) Changes in Internal Control Over Financial Reporting. There were no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1.  
Legal Proceedings
See Note 9 of our Notes to Unaudited Condensed Consolidated Financial Statements for information regarding legal matters.
Item 1A.  
Risk Factors
There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the year ended August 27, 2010 that was filed on November 3, 2010 and in our Quarterly Report on Form 10-Q for the three months ended November 26, 2010 that was filed on January 4, 2011, except for the risk factors below which have been updated as follows:
Worldwide political conditions, civil unrest, armed conflicts and threats of terrorist attacks may adversely affect our business, the cost of and demand for our products and our results of operations.
The occurrence or threat of terrorist attacks may in the future adversely affect the cost of and demand for our products. In addition, such attacks may negatively affect our operations directly or indirectly and such attacks or other armed conflicts may directly impact our physical facilities or those of our suppliers or customers. Such attacks may make travel and the transportation of our products more difficult and more expensive, ultimately having a negative effect on our business.

 

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Also, any armed conflicts around the world, including current tensions and/or hostilities in the Korean Peninsula, could have a substantial impact on our sales, our supply chain and our ability to deliver products to our customers. Political and economic instability, civil unrest and armed conflicts in some regions of the world including Libya and the Middle East and their effect on the price of oil could also have a negative impact on the cost of our products and on our business in general. More generally, various events could cause consumer confidence and spending to decrease or result in increased volatility to the U.S. and the worldwide economies.
Any such occurrences could have a material adverse effect on our business, our results of operations and our financial condition.
Natural disasters in certain regions could adversely affect our supply chain which, in turn, could have a negative impact on our business, the cost of and demand for our products and our results of operations.
The occurrence of natural disasters in certain regions, such as the recent earthquake and tsunami in Japan, could have a substantial negative impact on our supply chain, our ability to deliver products to our customers and on the cost of and demand for our products. These events could cause consumer confidence and spending to decrease or result in increased volatility to the U.S. and worldwide economies. Any such occurrences could have a material adverse effect on our business, our results of operations and our financial condition.
Our dependence on a small number of sole or limited source suppliers and technology partners subjects us to certain risks and our results of operations would be materially and adversely affected if we are unable to obtain adequate supplies and technology development in a timely manner.
We depend on a small number of sole or limited source suppliers and technology partners for certain materials and technology, including critical components and technologies that we use or intend to use in manufacturing and/or developing our products. We purchase almost all of our materials from our suppliers on a purchase order basis and generally do not have long-term commitments from suppliers. Our suppliers are not required to supply us with any minimum quantities and there is no assurance that our suppliers will supply the quantities of components we may need to meet our production goals. Our major suppliers include Hynix, Micron, Elpida and Samsung. Since a large percentage of our purchases are from a small number of major suppliers, these suppliers are able to exert, have exerted, and we expect they will continue to exert, pressure on us with respect to pricing and purchasing practices which pressures can adversely affect our business, our results of operations and our financial condition.
The markets in which we operate have experienced, and may experience in the future, shortages in components. These shortages cause some suppliers to place their customers, including us, on component allocation. As a result, we may not be able to obtain the components that we need to fill customer orders. Furthermore, if any of our suppliers experience quality control or intellectual property infringement problems, we may not be able to fill customer orders. Similarly, if any of our technology partners are unable to successfully complete development of expected technologies, or their developed technologies experience quality control or intellectual property infringement or other problems, we may not be able to fill customer orders and may not recoup the investments and expenses incurred in the development of the relevant technology. For example, in the first half of fiscal 2011, we recognized a technology access charge of $7.5 million as well as R&D expenses of $2.0 million associated with a development project with a technology partner to accelerate the development of our SSD products. There could be significant additional costs incurred before the relevant technology is developed into a commercially viable product, and the feasibility associated with the relevant technology has not yet been established and may never be established. Additionally, we have no alternative use for the relevant technology as the access and use of the technology is restricted only to this development project. There is no guarantee that this development project or other similar projects will be successful such that we can recoup the expenses and investments associated with such efforts. Furthermore, our products that utilize components from a supplier or technology partner that has quality, infringement or performance issues may be disqualified by one or more of our customers and we may not be able to fill orders from those customers. The inability to fill customer orders could cause delays, customer cancellations, disruptions or reductions in product shipments or require product redesigns and/or re-qualifications which could, in turn, damage relationships with current or prospective customers, increase costs or prices and have a material adverse effect on our business, results of operations and financial condition. The failure of performance or acceptance of developed technologies can also result in write-offs of investments in research and development.
If one of our suppliers or technology partners were to be acquired by a competitor, that could result in a disruption or termination of a key source of supply. A disruption in or termination of a supply relationship or a technology partnership, by acquisition or otherwise, with any of our significant suppliers or technology partners, or our inability to develop relationships with new suppliers or technology partners, if required, would cause delays, disruptions or reductions in product manufacturing and shipments or require product redesigns which could damage relationships with our customers, increase our costs or the prices of our products and materially and adversely affect our business, our results of operations and our financial condition.

 

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New product development, particularly our solid state storage products, requires significant investment and if we fail to develop new or enhanced products and introduce them in a timely manner, this could have a material adverse impact on our competitiveness, our results of operations and our financial condition.
The markets in which we compete are subject to rapid technological change, product obsolescence, frequent new product introductions and feature enhancements, changes in end-user requirements, and evolving industry standards. Our ability to successfully compete in these markets and to continue to grow our business depends in significant part upon our ability to develop, introduce and sell new and enhanced products on a timely and cost-effective basis, and to anticipate and respond to changing customer requirements. More specifically, the solid state storage industry is an emerging industry with several different technology platforms each of which has significant costs of entry. We are a relatively new entrant into the solid state storage industry and have limited experience in this market. We have experienced, and may experience in the future, delays and unanticipated expenses in the development and introduction of new products. A failure to develop products with required feature sets or performance standards, or a delay as short as a few months in bringing a new product to market could significantly reduce our net sales which would have a material adverse effect on our business, our results of operations and our financial condition.
Delays in the development, introduction and qualification of new products could provide a competitor a first-to-market opportunity and allow a competitor to achieve greater market share or permit a customer to cancel orders without penalty. Defects or errors found in our products after commencement of commercial shipment could result in delays in market acceptance of these products. Lack of market acceptance for our new products for any reason would jeopardize our ability to recoup substantial research and development expenditures, hurt our reputation and have a material adverse effect on our business, our results of operations and our financial condition. Accordingly, there can be no assurance that our future product development efforts will be successful or result in products that gain market acceptance. We have supported in the past and expect in the future to support new technologies and emerging markets. If these new technologies and emerging markets fail to gain acceptance or grow, this would have a material adverse effect on our business, our results of operations and our financial condition.
In particular, we have made and expect to continue to make in the future, significant investments in SSDs and other solid state storage products through research and development and other expenditures. Substantially all of our investments to date in research and development and other expenditures with respect to enterprise SSDs have been focused on a limited set of customers. Lack of acceptance, for any reason, of our new products by these customers upon whom we are initially depending would jeopardize our ability to recoup substantial research and development expenditures and would damage our reputation. While we believe that our investments in solid state storage will enable us to participate in several important growth markets, there is significant competition in these markets and there can be no assurance that the products we develop and introduce will be timely, will gain any market acceptance or will result in any significant increase in our net sales. If these investments fail to provide the expected returns this would have a material adverse effect on our business, our results of operations and our financial condition.
Industry consolidation and company failures could adversely affect our business by reducing the number of potential customers, increasing our reliance on our existing key customers, reducing the competitiveness of our supplier base and/or increasing the competitive advantages of our competitors.
Some participants in the industries which we serve have merged and/or been acquired and this trend may continue. In addition, there have been company failures among both our customer and supplier base. Industry consolidation and company failures will likely decrease the number of potential significant customers for our products and services. The decrease in the number of significant customers will increase our reliance on key customers and, due to the increased size of these companies, may negatively impact our bargaining position and thus our profit margins. Consolidation and company failures in some of our customers’ industries may result in the loss of customers. The loss of, or a reduced role with, key customers due to industry consolidation and company failures could negatively impact our business, our results of operations and our financial condition.
Consolidation and company failures in our supplier base could reduce our purchasing alternatives and reduce the level of competition to win our business resulting in higher cost of goods and less availability of components which would have a negative impact on our business, our results of operations and our financial condition.
Consolidation of our competitors has been occurring and the trend is expected to continue. Consolidation by our competitors may enhance their resources, capacity, capabilities and purchasing power and lower their cost structure, causing us to be less competitive.
Item 6.  
Exhibits
The following exhibits are filed herewith:
         
Exhibit No.   Exhibit Title
       
 
  31.1    
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
  31.2    
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
  32    
Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

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SMART MODULAR TECHNOLOGIES (WWH), INC.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, SMART Modular Technologies (WWH), Inc. has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
         
  SMART MODULAR TECHNOLOGIES (WWH), INC.
 
 
  By:   /s/ IAIN MACKENZIE    
    Name:   Iain MacKenzie   
    Title:   President and Chief Executive Officer
(Principal Executive Officer) 
 
     
  By:   /s/ BARRY ZWARENSTEIN    
    Name:   Barry Zwarenstein   
    Title:   Senior Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer)
 
     
  Date: April 1, 2011  

 

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EXHIBIT INDEX
         
Exhibit No.   Exhibit Title
       
 
  31.1    
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
  31.2    
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
  32    
Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

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