We design, develop and sell semiconductor system solutions, comprised of semiconductor devices, software and reference designs, for use in broadband communications applications that enable high-speed transmission, processing and distribution of audio, video, voice and data to and throughout homes and business enterprises worldwide. Our access solutions connect people through personal communications access products, such as personal computers (PCs) and television set-top boxes (STBs), to audio, video, voice and data services over wireless and wire line broadband connections as well as over dial-up Internet connections. Our central office solutions are used by service providers to deliver high-speed audio, video, voice and data services over copper telephone lines and optical fiber networks to homes and businesses around the globe. In addition, our media processing products enable the capture, display, storage, playback and transfer of audio and video content in applications throughout home and small office environments. These solutions enable broadband connections and network content to be shared throughout a home or small office-home office environment using a variety of communications devices, which we describe as the broadband digital home.
We have many years of operating history in the communications semiconductor business, including as part of the semiconductor systems business of Rockwell International Corporation (now Rockwell Automation, Inc.), and have been an independent public company since January 1999, following our spin-off from Rockwell.
Since becoming an independent public company in 1999, we have completed the following series of transactions which transformed our company from a broad-based communications semiconductor supplier into a fabless communications semiconductor supplier focused on delivering the technology and products that are driving the digital home:
| • | On February 27, 2004, we completed our merger with GlobespanVirata, Inc. (GlobespanVirata) with GlobespanVirata becoming a wholly-owned subsidiary of Conexant Systems, Inc. In exchange for 100% of the outstanding shares of common stock of GlobespanVirata (approximately 150.7 million shares), we issued 1.198 shares of Conexant common stock for each share of GlobespanVirata common stock outstanding (or approximately 180.6 million shares of Conexant common stock) and each outstanding option and warrant to purchase GlobespanVirata common stock was adjusted and converted into an option or warrant to purchase Conexant common stock-based on the 1.198 merger ratio (or approximately 43.6 million options and warrants to purchase shares of Conexant common stock). In May 2004, the GlobespanVirata, Inc. subsidiary was renamed Conexant, Inc., and hereinafter will be referred to as Conexant, Inc. | ||
| • | On June 27, 2003, we completed the distribution to our shareholders of all outstanding shares of our wholly owned subsidiary Mindspeed Technologies, Inc. (Mindspeed), to which we contributed our Internet infrastructure business, including the stock of certain subsidiaries, and certain other assets and liabilities, including $100.0 million in cash. In the Mindspeed spin-off, Conexant shareholders received one share of Mindspeed common stock for every three Conexant shares held and the Conexant shareholders continued to hold their Conexant shares. Mindspeed issued us a warrant to purchase 30 million shares of Mindspeed common stock, representing approximately 20 percent of Mindspeed’s outstanding common stock on a diluted basis. The warrant is exercisable until June 27, 2013 at an exercise price of $3.408 per share. The fair value of the warrant is recorded as an asset on our consolidated balance sheet. Additionally, we entered into a senior secured revolving credit facility pursuant to which Mindspeed could have borrowed up to $50.0 million, subject to certain restrictions, for working capital and general corporate purposes. In December 2004, the Mindspeed credit facility was terminated. |
| • | On June 25, 2002, we completed the distribution to our shareholders of all outstanding shares of our wholly-owned subsidiary Washington Sub, Inc. (Washington), to which we contributed our wireless communications business, other than certain assets and liabilities which we retained. Immediately thereafter, Washington merged with and into Alpha Industries, Inc. (Alpha), with Alpha the surviving corporation. As a result of these transactions, Conexant shareholders received 0.351 of a share of Alpha common stock for each Conexant share held and the Conexant shareholders continued to hold their Conexant shares. Upon completion of these events, Alpha and its subsidiaries purchased our semiconductor assembly and test facility located in Mexicali, Mexico and our package design team that supports the Mexicali facility (together, the Mexicali Operations) for $150.0 million. Effective June 26, 2002, Alpha changed its name to Skyworks Solutions, Inc. (Skyworks). | ||
| • | In March 2002, we and The Carlyle Group formed a new specialty foundry company named Jazz Semiconductor, Inc. (Jazz). We contributed our Newport Beach, California wafer fabrication operations and related assets and liabilities and certain intellectual property to Jazz in exchange for $19.3 million in cash and a 45% equity interest in Jazz, having an estimated fair value of $42.5 million. In fiscal 2003, another party made an additional investment in Jazz thereby reducing our equity interest to 38%. In fiscal 2006, we and Jazz entered into a wafer supply termination agreement in which both parties agreed to terminate the wafer supply and services agreement. In connection with the termination agreement, Jazz issued additional shares to us, which increased our equity interest to 42%. On September 26, 2006, Jazz entered into a merger agreement with Acquicor Technology Inc. (Acquicor) pursuant to which we expect to receive upon completion of the merger cash proceeds of approximately $100.0 million for our ownership interests in Jazz, subject to adjustment based on Jazz’s working capital and possible future contingent payments. However, completion of the merger is subject to certain conditions precedent and there can be no assurance that the merger will be completed. In addition, we and the other current Jazz stockholders have agreed to provide Acquicor with financing in an aggregate amount of up to $80.0 million, in proportion to each stockholder’s equity interest in Jazz, to fund, under certain circumstances, a shortfall in Acquicor’s financing for the merger. |
Except where otherwise noted, the financial information contained herein represents our continuing operations including the results of GlobespanVirata since February 28, 2004, following the completion of the merger.
Strategy
Our objective is to become the leading supplier of communications semiconductor solutions to leading global original equipment manufacturer (OEM) and original design manufacturer (ODM) customers in the broadband access, broadband media processing, universal access and wireless networking markets. To achieve our objectives, we are pursuing the following strategies:
| • | Employ a market-focused business model, targeting broadband digital home applications, allowing us to concentrate our resources on high-growth, high-margin targeted markets; | ||
| • | Expand strategic relationships with industry-leading communications OEMs and maximize design win share; | ||
| • | Take advantage of engineering talent in low-cost regions to enhance the value of our research and development deployments; | ||
| • | Capitalize on the breadth of our product portfolio and depth of our engineering talent to create complete system solutions that provide enhanced functionality and accelerate the convergence of communications applications; | ||
| • | Operate as a fabless company, which allows us to focus our resources on designing, developing and marketing our products, while minimizing operating infrastructure costs and capital expenditures; | ||
| • | Enter target markets with standards-based systems solutions, enhancing market acceptance and enabling product interoperability for end-users; and | ||
| • | Monetize our non-core assets, principally our equity investments in Jazz, which is expected to occur in the first quarter of calendar 2007, and Mindspeed, as well as our real estate holdings in Newport Beach, California, at appropriate times to capture the value of these assets. We expect to use the proceeds from the sale of these non-core assets to pay down our indebtedness. |
Market Focused Product Lines
Our expertise in mixed-signal processing, digital signal processing (DSP) and standards-based communications protocol implementation allows us to deliver semiconductor devices and integrated systems for client, or end-customer, personal communications access products. We organize our product lines to address the four primary communications markets targeted at the digital home as more fully described below. For purposes of the following description, references to “market share” refer to our share of the total addressable market. Future products are expected to focus on delivering modular, combination products that leverage our wireless local area network (WLAN), video and digital subscriber line (DSL) product portfolios in order to address converged voice, video, and data “triple play” broadband market opportunities as well as other technology convergence opportunities within the markets we address.
Broadband Access Products
DSL technologies enable broadband data traffic over twisted pair copper telephone lines. Actual DSL speeds realized by the consumer range between 128 kilobits per second (kbps) and 100 megabits per second (Mbps). Faster data rates allow local exchange carriers to provide their customers with an array of new broadband services, including the transport of high definition video content in real time.
We possess a comprehensive portfolio of standards-based DSL products, including asymmetric DSL (ADSL), symmetric DSL (SDSL), ADSL2, ADSL2plus and both new versions of very-high-speed DSL (VDSL and VDSL2), including the unique configurations of DSL for North America, Europe, Japan and China. We have shipped in excess of 200 million DSL ports to customers around the globe.
Our DSL product portfolio is comprised of a family of System-on-Chip (SoC) integrated circuits for use in home and business DSL products that incorporate a combination of multiple system functions. Our DSL product offerings include various combinations of digital signal processors, network or communication processors, integrated software on silicon, and analog front-end chips, line drivers and reference design guides to help our customers deploy DSL modems, routers, gateways, and DSLAMs located in telephone service providers’ central offices.
Our DSL engineering support includes our advanced software-based development tools which allow ODMs, service providers and telecom companies to analyze, configure and troubleshoot their DSL networks remotely, saving time and expense. Our ISOS TM software works in combination with our semiconductor devices to manage data, routing, bridging, switching and protocol conversions needed to encapsulate and route information packets. ISOS TM is available on a variety of our platforms, and facilitates the rapid integration of new features, which enables manufacturers to streamline the product development process and improve time-to-market. Additional features of these products include system management, firewall security, embedded web server, auto-configuration of DSL services and Universal Plug-and-Play. We also offer customers a full set of software development tools including compilers, linkers and other special-purpose tools to enable the customer to design additional applications.
Our Accelity family of highly integrated VDSL and VDSL2 central office (CO) and customer premises equipment (CPE) semiconductor solutions for asynchronous transfer mode (ATM) and packet-based DSL access multiplexers (DSLAMs) and client-side terminals are targeted at voice, video and data “triple-play” broadband service deployments, remote terminal and fiber extension applications. VDSL2 technology provides higher downstream and upstream data rates than ADSL and ADSL2plus, and longer reach connectivity than VDSL. The Accelity chipset family is based on industry-standard discrete multi-tone (DMT) line code technology and is compliant with the ratified VDSL2/G.993.2 standard. In the VDSL market, industry analyst firm Dell’Oro expects VDSL integrated circuit port shipments to increase to 25.5 million ports in 2008 from 5.1 million ports in 2003, a 38% compound annual growth rate.
Our integrated Xenon SoC solution is targeted at the fiber access market. Specifically, this device is targeted at optical network terminals on the client-side of broadband passive optical networks (PONs). PONs provide cost-effective, high-speed “last mile” broadband connections to homes and businesses over a fiber optic cable and are a significant improvement over coaxial cable or copper-based connections. The Xenon SoC solution can also be used
in conjunction with our Accelity chipset to provide fiber-to-the-neighborhood, enabling the cost-effective delivery of “triple-play” voice, video and data services. Xenon is the first in a planned family of PON devices and supports downstream data rates of 622 Mbps and upstream rates of 155 Mbps. An optimized version for multiple dwelling unit applications provides 25 percent greater throughput. In March 2006, we introduced the Xenon II family of controllers which can also be used with our media processing, WLAN, and home networking chipsets to deliver quality service on every link of the home network.
Our ADSL2plus chipset for client-side gateway applications includes such key features as an integrated two-channel voice-over-Internet protocol (VoIP) processor and dual high-speed USB 2.0 interfaces that can be used to attach peripherals such as WLAN devices, storage products, printers and Web-based digital cameras directly to the DSL gateway. In addition, the chipset is upgradeable to VDSL/VDSL2 technology, allowing manufacturers to maximize their engineering and software investments while migrating to new DSL technologies. In May 2006, we launched a family of network processor devices with integrated Wi-Fi, ADSL2plus and VoIP functionality. These devices are targeted at products including DSL bridge/routers, wireless DSL routers and DSL VoIP integrated access devices (IADs) and deliver the processing power required for advanced triple-play applications.
Broadband Media Processing Products
Our broadband media processing products include a variety of broadcast audio and video decoder and encoder devices, as well as front-end communications components that enable the capture, display, storage, playback and transfer of audio and video content in digital home and small office products such as PCs, STBs, gaming consoles, personal video recorders and digital versatile disk (DVD) applications. Moving Picture Experts Group (MPEG) compression technology has gained wide support recently in satellite television, Internet protocol (IP) video, video telephony, high definition DVD and wireless consumer electronics applications, and is emerging as the next major technology of choice for television video transmission and storage applications as the demand for high definition television (HDTV) services and content rapidly increases.
MPEG is a set of international digital video and audio compression standards and file formats and is one of the enabling technologies for broadband multimedia delivery. There are three major MPEG standards: MPEG-1, MPEG-2 and MPEG-4. MPEG-4 AVC/H.264 (also known as MPEG-4 Part 10) codecs provide compression performance that delivers more than 50 percent greater efficiency than MPEG-2 codecs. This allows service providers to maximize bandwidth usage and efficiently deliver sophisticated programs containing audio, video, text, graphics and interactivity to their subscribers.
Our broadband media processing product offerings include devices and system-level solutions for the television STB market as well as products for other convergence video applications.
Set-top Box Products
In the STB family, we offer an extensive portfolio of components and system level solutions enabling digital cable, satellite, terrestrial and IP STBs. Our product offerings include silicon tuners, demodulators, MPEG audio and video decoders, and dial-up modems for back-channel applications. Reference designs that help manufacturers reduce cost and speed time-to-market are also offered, bundled with a range of operating systems, middleware, drivers and development tools.
A typical STB is comprised of front-end components and back-end components. Among the front-end components, sometimes referred to as the communications portion of the design, tuners and demodulators are employed to receive and prepare audio and video signals from a satellite, cable, terrestrial or IP network, and back-channel modems are used to communicate with the service provider. In June 2005, we announced that our cumulative global shipments of satellite tuners and demodulators surpassed the 120 million unit milestone. In the back-end, integrated MPEG decoders are designed to process the audio and video signals and to control the STB application software while video encoders format the video signal for display on either an analog or digital television.
We built upon our customer relationships established through our leadership in satellite front-end products to gain back-end product design wins. We introduced and began shipments of our new single-chip solution that incorporated demodulation, MPEG processing, audio and video outputs, graphic processing, back-channel communications capability and a control processor. Combined with one of our silicon tuner devices, this product offers a complete cost-effective STB solution for satellite, cable and terrestrial networks.
Our cable modem product portfolio includes our single-package cable modem solution containing an embedded microprocessor-based media access controller for North American Data Over Cable Service Interface Specification (DOCSIS), European DOCSIS and digital video broadcasting (DVB) applications. Our cable modem products are DOCSIS 1.0, DOCSIS 1.1, and DOCSIS 2.0 compliant. We also offer a single-chip silicon-based digital tuner, which supports both DOCSIS and DVB/Digital Audio Visual Council (DAVIC) standards for computer cable modems and set-top boxes. This device interfaces seamlessly with our digital cable transceiver solutions. Our cable modem technology is capable of delivering data, video, telephone and Internet access over existing coaxial cable networks at speeds up to 1,000 times faster than a standard voiceband analog modem. In addition, our product supports the PCI, USB and Ethernet interfaces for connection with a PC and our customers have used this product to successfully complete the rigorous North American CableLabs and European tComLabs certifications. These certifications give consumers and cable operators the assurance that systems comply with DOCSIS specifications and will be interoperable among multiple cable modem vendors.
We have a family of next-generation MPEG-4 AVC/H.264 video decoders for high-definition digital broadcast television systems. This family of decoders enables digital broadcast TV service providers to improve bandwidth utilization, allowing the cost-effective delivery of a wider range of video, voice, and data broadcast programming. H.264 compression provides greater recording capacity on STBs with personal video recording capabilities, increases the number of HDTV channels that a broadcaster can transmit, and enables live broadcast-quality video content over the Internet.
Our dual-channel radio frequency (RF) satellite tuner is a low-power, direct down conversion device which is intended for high-volume STB receivers used for personal and digital video recording (PVR/DVR) applications that support simultaneous watch and record capabilities. The highly integrated device supports 8PSK and the new DVB-S2 advanced modulation and coding specifications, which provide satellite operators with higher data rates and increased capacity to deliver additional HDTV channels and services using existing bandwidth and infrastructure. The dual-channel tuner can also be used with our advanced modulation satellite demodulators to provide a complete front- and back-end system solution.
We have a family of DVB decoders for mass market free-to-air (FTA) satellite STBs. The new SoC DVB decoders offer higher levels of integration and performance, and include options for both basic and advanced functionality which allow manufacturers and broadcasters to address a wider range of markets and end-user demands. As an illustration, each device within this new family of products includes an integrated high-speed data port that easily interfaces to a variety of broadband front-ends, allowing the decoders to serve as a common back-end platform for terrestrial and cable services. This flexibility provides manufacturers with economies of scale as they can leverage a single device across multiple product offerings.
There are several factors that are driving the overall growth in digital STB market. First, cable and satellite operators want to stay competitive with each other and drive up the dollar amount of average monthly subscriber bill. Both are offering HDTV, MPEG-4 compression technology and DVR functionality. The total addressable market for satellite and cable STBs has increased as a result of advanced modulation and compression technologies which allow service providers to earn more revenue per subscriber. and we were among the first to market with these new technologies. In addition to the “operator-based” segment dominant in North America, which consists of service providers who supply their customers with encrypted content satellite television service based on subscription contracts, a large “consumer” satellite segment exists, primarily in Europe and Asia, in which customers purchase their own STBs and have access to FTA programming or content that is not protected by encryption or other security schemes. According to industry analyst firm InStat, the worldwide market for FTA satellite STBs alone is projected to grow from 35 million units per year in 2005 to 45 million units per year in 2008. At the same time, telephone operators have plans to upgrade their network to FTTx (Fiber to Home/Curb/Node) to offer TV over internet protocol network (IPTV). Each IPTV subscriber would need a digital set top box in order to terminate the video signals. This market opportunity consists of a broadband pipe, such as DSL or VDSL CPE, with 802.11 and VOIP capabilities to bring data into the home, and a set top box with convergence video capabilities to project the video images onto the television screen.
Convergence Video Products
In our convergence video family, our digital video encoder integrated circuits provide a combination of features, video performance and flexibility for today’s PC video, DVD and other consumer video system products. These video encoder integrated circuits convert digital video stored on DVDs and other digital media into the analog signals which drive both standard and high definition televisions. In addition, our line of stand-alone video decoders and integrated PCI video decoders combine worldwide video standard support, integration and software support. Our analog video decoders are designed to convert analog signals received by an STB, PC video system or other consumer electronic analog video device into digital streams that can be displayed by a digital video monitor or saved using a form of digital recording media.
In March 2006, we announced a satellite television receiver card reference platform based on the industry’s newest digital video broadcast standard, DVB-S2, for PCs. This solution is based on two of our STB solutions and one PC video device. The two STB devices allow the capture and processing of satellite broadcast programming, and the audio/video decoder converts and transports the video stream so it can be viewed on a PC.
We believe our analog video decoder and audio/video (A/V) decoder families provide substantial quality advances in audio and video, enabling the next generation of high-fidelity video and PC products for the digital home.
Universal Access Products
We have a long history of technological innovation and leadership in modem technology, including the development of the world’s first analog modem chip. Dial-up technology, using the ordinary twisted pair copper telephone wire that connects many home and business computers to the telephone company, continues to be the world’s most ubiquitous Internet connectivity option and it is a practical choice for applications where high-speed connectivity is not available or is not a necessity.
Our analog modem chipsets connect hundreds of millions of users worldwide to the Internet through their desktop and notebook PCs, and are also embedded in a host of products including fax machines, multi-function peripherals (MFPs), point-of-sale (POS) terminals, television STBs, personal digital assistants (PDAs) and Internet appliances, such as Internet-connected televisions, digital picture frames and web phones.
Our dial-up modem chipset offering encompasses all major industry standards established by the International Telecommunication Union (ITU) including V.22, V.22 bis, V.32, V.34, V.44 and the two 56 Kbps standards, V.90 and V.92. We supply mixed-signal intensive, controllerless modem chipsets and software modem solutions that take advantage of the increasing power of PC central processors and use software to perform functions traditionally enabled by semiconductor components. Data bus architectures supported include the HD audio bus, PCI bus, USB, RS-232, and audio/modem chipsets that support audio codec (AC)-Link. Building on our expertise in modem technology, we believe we were the first supplier shipping integrated modem and audio combination solutions to meet the broader needs of our customers and the industry. We have a long heritage in voice band processing and hold an extensive intellectual property portfolio in voice processing and coding technology. We believe that our field-proven voice technology has enabled more than 100 million voice/data modems and has been incorporated in millions of voice ports.
We believe our universal access products have established and retained the leading market share in each of the three primary segments of analog (dial-up) modem technology—PC modems, facsimile modems and embedded modems. In June 2005, we announced that our cumulative shipments of dial-up modems surpassed the 750 million unit milestone. During 2005, we believe that we increased our combined market share in the PC, facsimile and embedded modem segments to greater than 55%. In PC modems, we continue to benefit from the continuing growth of notebook PCs as a percentage of total worldwide PC sales as the penetration of dial-up modems is greater for notebook PCs, at nearly 100%, than for consumer desktop PCs. In facsimile modems, our significant market share lead has been enhanced by the addition of fax, copy and scan functionality to the home and enterprise printer markets in MFPs, expanding the total addressable market well beyond that of the stand-alone fax machine. MFPs include two or more of the following functions: copy, fax, print and scan. Increasingly, wireless capabilities (WiFi, Bluetooth) are incorporated into MFPs to provide additional networking functionality. According to IDC, this move
by consumers and businesses from stand-alone printers to MFPs is expected to drive the expansion of the market for MFPs from 26.5 million units in 2005 to 54.1 million units in 2009. In embedded modems, we believe that we have a leadership position in dial-up modems embedded in products such as STBs, POS terminals, vending machines, gasoline pumps and other applications in which an analog modem is used to transmit and receive data without the benefit of a PC-type central processing unit (CPU).
Wireless Networking Products
We offer an extensive suite of WLAN solutions including 802.11a/b/g (Wi-Fi) and dual-band (2.4 and 5 GHz) chipsets, firmware, software, drivers and reference designs. These wireless networking solutions are used by the world’s leading telecom, networking and computer companies in a wide range of products including access points/routers, client cards, desktops, notebooks, PDAs, digital cameras, MP3 players and other hand-held networking appliances. They are available as standalone solutions or offered in conjunction with our DSL and cable modem semiconductor system solutions, VoIP chipsets and home network processors.
Our product offerings include various combinations of RF transceivers, analog base-band integrated circuits and digital base-band and medium or MAC chips and reference design guides. Many of our chipsets utilize common circuit blocks that leverage our overall product development resources and expedite our overall time to market. We offer a wide variety of wireless networking chipsets and reference designs that are enabling a new generation of wireless connectivity in notebooks, PDAs, digital cameras, MP3 players and other handheld networking appliances.
Our wireless networking products address the complementary high-growth wireless networking market by offering one of the industry’s most complete lines of 802.11 wireless products for all worldwide applications and standards. All products also adhere to and are certified by the Wi-Fi Alliance. With the longest history of wireless development and deployment, our PRISM ® technology has been widely utilized by industry-leading companies to enable wireless connectivity in thousands of innovative wireless networking products.
In fiscal 2005, we narrowed the market focus for our wireless networking products to include primarily:
| • | embedded WLAN opportunities in cellular phones and other handheld appliances; | ||
| • | converged wireless gateway platforms including either DSL or cable as the broadband access technology; and | ||
| • | yet-to-be-released 802.11n next generation technology. |
We believe that by limiting our focused efforts to these key areas, we enhance our opportunities to secure and defend our design positions and subsequent revenue streams by differentiating our product performance and support levels when compared to our competitors.
We have developed one of the world’s lowest power and smallest form factor 802.11g WLAN radio for embedded mobile applications. The single-chip solution is a power-efficient, compact chip targeted at high performance, battery operated mobile devices such as multimedia cellular phones, smartphones, VoIP handsets, digital cameras, MP3 players, gaming consoles, global positioning systems and PDAs. This device has been designed into several handset models by one the world’s largest cellular telephone manufacturers. According to industry analyst firm InStat, shipments of Wi-Fi enabled cellular handsets are expected to reach approximately 136 million units in 2010.
We have also developed physical layer (PHY) and analog front-end (AFE) products to support networking in the home. We offer a highly integrated, single-chip HomePlug semiconductor solution for Ethernet bridges, HomePlug wireless bridges and routers, and a variety of embedded applications such as media adaptors for PCs. HomePlug powerline technology uses the existing home electrical wiring to network devices such as PCs, providing Internet access and home connectivity through power outlets within the home. And because this solution was designed using our building block software platform approach, our HomePlug device can also be combined with our home network processors, DSL and cable modem solutions to allow designers to seamlessly incorporate HomePlug technology into a variety of multi-functional products.
To support the distribution of broadband content throughout the digital home, known as whole home networking, we offer products that enable personal communications devices to share data, voice, audio and video using existing telephone line, coaxial cable, power line and wireless links. We have developed a portfolio of home network processors which can be used at the core of a variety of devices, such as residential gateways, that consumers may use to access the Internet and share content using a wide range of existing and emerging connectivity technologies to link a network of home PCs and peripheral devices. In addition to connecting broadband services to networks inside the home, these processors offer processing power sufficient to implement a full-featured Statefull Packet Inspection (SPI)-based firewall. The importance of a secure firewall is greater than ever with the increasing use of “always on” Internet access in both the home and small office environments. The scalable system architecture of our home network processor product portfolio has also enabled digital voice terminals for voice-over-internet protocol applications, internet protocol-media terminals for video distribution, wireless data networking and other emerging connectivity applications.
Research and Development
We have significant research, development, engineering and product design capabilities. As of September 29, 2006, we had approximately 2,410 employees engaged in research and development activities at multiple design centers worldwide as compared to approximately 1,780 employees as of September 30, 2005. Part of our strategy is to take advantage of engineering talent in low-cost regions to enhance the value of our research and development deployments. As of September 29, 2006, approximately 64% of our engineering workforce was located internationally. In particular, our engineering headcount in the Asia-Pacific region was approximately 1,470 employees as of September 29, 2006, or approximately 61% of our engineering workforce. We expect to continue our engineering headcount growth trend in the Asia-Pacific region.
Our design centers provide design engineering and product application support as well as after-sales customer service. The design centers are strategically located around the world to be in close proximity to our OEM customers and to take advantage of key technical and engineering talent.
We incurred research and development expenses of $269.7 million, $268.0 million and $240.0 million during fiscal 2006, 2005 and 2004, respectively.
Manufacturing
We are a fabless semiconductor company, which means that we do not own or operate any wafer fabrication or assembly and test sites. Our primary wafer fabrication subcontractors include Taiwan Semiconductor Manufacturing Corporation (TSMC), United Microelectronics Corporation (UMC), Jazz, Chartered Semiconductor Manufacturing, and International Business Machines Corporation (IBM). Additionally, we use qualified suppliers as required to meet short-term upside requirements. We primarily use complementary metal-oxide semiconductor (CMOS) process technologies. On a very limited basis, we also use bipolar and bipolar CMOS (BiCMOS) process technology for certain mixed-signal devices, and silicon germanium (SiGe) for certain product-specific applications. Our products are manufactured in a variety of process technologies ranging from 0.8 micron technology, which is our most mature technology, to 90 nanometer, which is the most advanced. We currently have product development efforts underway at the 65 nanometer process technology node.
Our wafer probe testing is conducted by either our wafer fabrication subcontractors or other independent wafer probe test subcontractors. Following completion of the wafer probe tests, the die are assembled into packages and the finished products are tested by subcontractors. Our primary wafer assembly and test subcontractors include Amkor Technology, Advanced Semiconductor Engineering, Inc. (ASE), and STATSChipPAC Ltd. These vendors are located in Taiwan, Korea, Singapore, China, the Philippines and Malaysia. We use several different package types, tester platforms and handler configurations to fulfill our product needs at the key supplier sites.
Capacity is primarily obtained using a process of short- and long-term forecasting for suppliers to assess our demand, and committing supply to meet the forecasts. We maintain a strong presence at supplier sites to ensure our capacity needs are fulfilled adequately.
Social and Environmental Responsibility
We share the global concerns about the impact of our products on the environment and the working conditions under which they are manufactured. We are committed to ensuring that working conditions are safe, our employees are treated with respect and dignity, and that manufacturing processes are environmentally responsible. Based on recommendations from an internal team, we adopted three key industry standards to demonstrate our corporate commitment to these global initiatives: the International Organization for Standardization (ISO) 14001, Occupational Health and Safety Assessment Series (OHSAS) 18001 and Electronic Industry Code of Conduct (EICC). Our goal is to achieve and maintain compliance to these standards.
Over the last year, we maintained our compliance and certification to ISO 14001 at out Newport Beach, California and San Diego, California sites. In addition, we achieved third party certification to ISO 14001 at our Red Bank, New Jersey and Melbourne, Florida sites.
Our internal quality and reliability assurance department is on-track to self certify our Newport Beach, San Diego, Red Bank and Melbourne sites to OHSAS 18001 and EICC by the third quarter of fiscal 2007.
Social and environmental responsibilities present unique challenges to us and other fabless semiconductor companies because we do not directly manufacture semiconductor products and we rely on third party wafer fabrication, assembly, test and packaging suppliers. Our approach addresses both work performed internally by the company and by our suppliers. Our Quality Supplier Agreements require that our key suppliers also achieve and maintain third-party certification to ISO 14001 and OHSAS 18001. In addition, we require self certification to either EICC or Social Accountability International’s SA-8000 standards for humane workplaces (SA-8000).
Our quality and reliability assurance department regularly monitors our suppliers for compliance to these standards, takes appropriate actions for suppliers who have not yet achieved certification and ensures new suppliers meet these requirements or have plans to meet these requirements during our qualification process. Most of our suppliers are already certified to ISO 14001 and OHSAS 18001. We advised our key suppliers that they should be at least self-certified to EICC or SA-8000 within the 2007 calendar year.
We also support the worldwide Lead (Pb)-free, Restriction of Hazardous Substances (RoHS) and Waste Electrical and Electronic Equipment (WEEE) environmental initiatives and conform to industry standard practices wherever practical. We intend to continue to qualify and provide Pb-free and RoHS compliant products to our customers.
Quality and Reliability
Our quality and reliability assurance systems ensure that our products meet our customers’ and our internal product performance goals. Our quality management system maintained ISO 9001-2000 certification at our Newport Beach, San Diego, Red Bank and Noida, India facilities. During fiscal 2006, our Melbourne site achieved ISO 9001 certification. Since we are a fabless semiconductor company, we extended the ISO 9001 certification to our key suppliers through our Quality Supplier Agreements. Our key suppliers are either already certified to ISO 9001 or have provided us with plans to achieve certification.
Our quality and reliability assurance department performs extensive environmental tests demonstrating that our products meet the reliability performance goals. We use industry accepted environmental tests and test methods wherever practical during product qualification.
In addition, each business unit exercises extensive control during the definition, development and release to production of new products. We have a comprehensive set of design control procedures that:
| • | determine the quality, reliability and performance objectives for new products; | ||
| • | provide program/project management, resource identification and facilities; | ||
| • | ensure verification and validation activities; | ||
| • | provide criteria for acceptability; and | ||
| • | clearly define records that are necessary to provide confidence of conformity of the processes and resulting product. |
We qualify all key suppliers and their manufacturing processes. Our key suppliers must agree to our quality system requirements, pass a quality management system audit, and successfully complete a rigorous reliability test plan (wafer foundries and assembly subcontractors). We design these qualification requirements as preventive actions to eliminate the causes and occurrence of potential nonconformities. These qualification requirements, reliability test plans, and quality system audits are appropriate to the impact of the potential problems.
Customers, Marketing and Sales
We market and sell our semiconductor products and system solutions directly to leading OEMs of communication electronics products and indirectly through electronic components distributors. We also sell our products to third-party electronic manufacturing service providers, who manufacture products incorporating our semiconductor products for OEMs.
Sales to distributors and resellers accounted for approximately 35%, 28% and 36% of our net revenues in fiscal 2006, 2005 and 2004, respectively. In fiscal 2006, 2005 and 2004, no customer accounted for 10% or more of our net revenues. Sales to our twenty largest customers, including distributors, accounted for approximately 67%, 64% and 59% of our net revenues in fiscal 2006, 2005 and 2004, respectively.
Revenues derived from customers located in the Americas, the Asia-Pacific region and in Europe, the Middle East and Africa, as a percentage of total net revenues, were as follows:
| Fiscal Year Ended | ||||||||||||
| 2006 | 2005 | 2004 | ||||||||||
Americas |
10 | % | 12 | % | 11 | % | ||||||
Asia-Pacific |
82 | % | 80 | % | 80 | % | ||||||
Europe, Middle East and Africa |
8 | % | 8 | % | 9 | % | ||||||
| 100 | % | 100 | % | 100 | % | |||||||
We believe a portion of the products we sell to OEMs and third-party manufacturing service providers in the Asia-Pacific region are ultimately shipped to end markets in the Americas and Europe.
We have a worldwide sales and marketing organization comprised of approximately 340 employees as of September 29, 2006 in various domestic and international locations. To complement our direct sales and customer support efforts, we also sell our products through independent manufacturers’ representatives, distributors and dealers. In addition, our design and applications engineering staff is actively involved with customers during all phases of design and production and provides customer support through our worldwide sales offices, which are generally in close proximity to customers’ facilities.
Backlog
Our sales are made primarily pursuant to standard purchase orders for delivery of products, with such purchase orders officially acknowledged by us according to our own terms and conditions. Because industry practice allows customers to cancel orders with limited advance notice to us prior to shipment, we believe that backlog as of any particular date may not be indicative of our future revenue levels.
Competition
The communications semiconductor industry in general, and the markets in which we compete in particular, are intensely competitive. We compete worldwide with a number of U.S. and international suppliers that are both larger and smaller than us in terms of resources and market share. We anticipate that additional competitors will enter our markets and expect intense price and product competition to continue.
We compete primarily with Agere Systems, Inc., Atheros Communications, Inc., Broadcom Corporation, Centillium Communications, Inc., Infineon Technologies AG, Ikanos Communications, Inc., Intel Corporation, LSI Logic Corporation, Marvell Technology Group Ltd., NEC Corporation, NXP Semiconductors, Silicon Laboratories, Inc., STMicroelectronics N.V. and Texas Instruments Incorporated.
Intellectual Property and Proprietary Rights
We own or license a number of United States and foreign patents and patent applications related to our products, processes and technologies. We also cross-license portions of our intellectual property and are also cross-licensed under a number of intellectual property portfolios in the industry that are relevant to our technologies and products. We have filed and received federal and international trademark registrations of our Conexant trademarks. In addition, we have registered or applied to register a number of additional trademarks applicable to our products. We believe that intellectual property, including patents, patent applications, licenses and trademarks are of material importance to our business. In addition to protecting our proprietary technologies and processes, we constantly strive to strengthen and enhance our intellectual property portfolio. We use the portfolio to seek licensing opportunities, to negotiate cross-licenses with other intellectual property portfolios, to gain access to intellectual property of others and to avoid, defend against, or settle litigation. While in the aggregate our patents, patent applications, licenses and trademarks are considered important to our operations, they are not considered of such importance that the loss or termination of any one of them would materially affect our business or financial condition.
Environmental Regulation
Federal, state and local requirements relating to the discharge of substances into the environment, the disposal of hazardous wastes, and other activities affecting the environment have had, and will continue to have, an impact on our former manufacturing operations. To date, compliance with environmental requirements and resolution of environmental claims have been accomplished without material effect on our liquidity and capital resources, competitive position or financial condition. See “Item 1A. Risk factors – We may be liable for penalties under environmental laws, rules and regulations, which could adversely impact our business.”
We believe that any expenditures necessary for the resolution of environmental claims will not have a material adverse effect on our liquidity and capital resources, competitive position or financial condition. We cannot assess the possible effect of compliance with future requirements.
Cyclicality; Seasonality; Possible Significant Downturns
We operate in a highly cyclical industry. See “Item 1A. Risk factors – We operate in the highly cyclical semiconductor industry, which is subject to significant downturns.”
Sales of certain of our products are subject to seasonal fluctuation related to the increase in sales of end-user products which include our products, such as PCs, STBs, game consoles and facsimile machines, generally associated with the holiday season in December. Our sales of semiconductor products and system solutions used in these products generally increase beginning in August and September and continue at a higher level through the end of the calendar year.
Employees
As of September 29, 2006, we had approximately 3,120 employees, of which approximately 1,260 were in India. None of our employees are covered by collective bargaining agreements. We believe our future success will depend in large part upon our continued ability to attract, motivate, develop and retain highly skilled and dedicated employees.
Executive Officers
Our executive officers are:
| Name | Age | Position | ||||
Dwight W. Decker |
56 | Chairman of the Board and Chief Executive Officer | ||||
Lewis C. Brewster |
42 | Executive Vice President and Chief Operating Officer and General Manager—Broadband Media Processing | ||||
J. Scott Blouin |
56 | Senior Vice President and Chief Financial Officer | ||||
Dennis E. O’Reilly
|
62 | Senior Vice President, Chief Legal Officer and Secretary |
There are no family relationships among our directors or executive officers. Set forth below are the name, office and position held with Conexant and principal occupations and employment during the past 5 years of each of our executive officers.
Dwight W. Decker – Mr. Decker has been Chairman of the Board of Conexant since December 1998 and served as non-executive Chairman from the end of February 2004 to November 2004. He has been Chief Executive Officer of the Company from January 1999 to February 2004 and again since November 2004. Mr. Decker is non-executive Chairman of the Board and a director of each of Mindspeed Technologies, Inc. and Skyworks Solutions, Inc., and a director of Jazz Semiconductor, Inc. and Pacific Mutual Holding Company. He also serves as a director or member of numerous professional and civic organizations. Mr. Decker received a Ph.D. in applied mathematics from the California Institute of Technology and a B.Sc. in mathematics and physics from McGill University.
Lewis C. Brewster – Mr. Brewster has been Executive Vice President, Chief Operating Officer and General Manager—Broadband Media Processing since August 2006. He served as Executive Vice President and Chief Operating Officer from June 2003 to February 2004 and from November 2004 to August 2006. He was Executive Vice President, Sales, Operations and Quality from February 2004 to November 2004 and prior thereto served as Senior Vice President, Worldwide Sales. Mr. Brewster received an M.B.A. from Stanford University and a B.S. in electrical engineering and biomedical engineering from Duke University.
J. Scott Blouin – Mr. Blouin has been Senior Vice President and Chief Financial Officer since August 2004 and Senior Vice President and Chief Accounting Officer from February 2004 to August 2004. Before then, he was Senior Vice President and Chief Financial Officer from June 2003 to February 2004 and Senior Vice President, Chief Accounting Officer and Controller from March 2002 to June 2003. He also served as Senior Vice President and Chief Accounting Officer from January 2001 to March 2002. Mr. Blouin received an M.B.A. from Wake Forest University and a B.S. in administration from the University of New Hampshire at Durham.
Dennis E. O’Reilly – Mr. O’Reilly has been Senior Vice President, Chief Legal Officer and Secretary since February 2004. He served as Senior Vice President, General Counsel and Secretary from January 1999 to February 2004. Mr. O’Reilly received a J.D. from Boston University School of Law and a B.A. from the State University of New York at Binghamton.
Available Information
We maintain an Internet website at www.conexant.com. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, along with our annual report to shareowners and other information related to our company, are available free of charge on this site as soon as reasonably practicable after we electronically file or furnish these reports with the Securities and Exchange Commission. Our Internet website and the information contained therein or connected thereto are not intended to be incorporated into this Annual Report on Form 10-K.
Item 1A. Risk Factors
Our business, financial condition and results of operations can be impacted by a number of risk factors, any one of which could cause our actual results to vary materially from recent results or from our anticipated future results. Any of these risks could materially and adversely affect our business, financial condition and results of operations, which in turn could materially and adversely affect the price of our common stock or other securities.
References in this section to Conexant’s fiscal year refer to the fiscal year ending on the Friday nearest September 30 of each year.
We operate in the highly cyclical semiconductor industry, which is subject to significant downturns that may negatively impact our business, financial condition and results of operations.
The semiconductor industry is highly cyclical and is characterized by constant and rapid technological change, rapid product obsolescence and price erosion, evolving technical standards, short product life cycles (for semiconductors and for the end-user products in which they are used) and wide fluctuations in product supply and demand. From time to time these and other factors, together with changes in general economic conditions, cause significant upturns and downturns in the industry, and in our business in particular. Periods of industry downturns have been characterized by diminished product demand, production overcapacity, high inventory levels and accelerated erosion of average selling prices. These factors have caused substantial fluctuations in our revenues and results of operations. We have experienced these cyclical fluctuations in our business in the past and may experience them in the future.
Our operating results may be negatively affected by substantial quarterly and annual fluctuations and market downturns.
Our revenues, earnings and other operating results have fluctuated in the past and may fluctuate in the future. These fluctuations are due to a number of factors, many of which are beyond our control. These factors include, among others:
| • | changes in end-user demand for the products manufactured and sold by our customers; | ||
| • | the timing of receipt, reduction or cancellation of significant orders by customers; | ||
| • | seasonal customer demand; | ||
| • | the gain or loss of significant customers; | ||
| • | market acceptance of our products and our customers’ products; | ||
| • | our ability to develop, introduce and market new products and technologies on a timely basis; | ||
| • | the timing and extent of product development costs; | ||
| • | new product and technology introductions by competitors; | ||
| • | changes in the mix of products we develop and sell; | ||
| • | fluctuations in manufacturing yields; | ||
| • | availability and cost of products from our suppliers; | ||
| • | intellectual property disputes; and | ||
| • | the effects of competitive pricing pressures, including decreases in average selling prices of our products. |
The foregoing factors are difficult to forecast, and these as well as other factors could materially adversely affect our quarterly or annual operating results.
We face a risk that capital needed for our business and to repay our debt obligations will not be available when we need it.
As of September 29, 2006, we had a total of $706.5 million aggregate principal amount of convertible subordinated notes outstanding, of which $456.5 million is due in February 2007 and $250.0 million is due in March 2026. The conversion price of the notes due in February 2007 is substantially higher than the current market value of our common stock. We also have an $80.0 million credit facility with a bank, under which we had borrowed $80.0
million as of September 29, 2006. This credit facility had an initial term of 364 days, and in November 2006, the term of the credit facility was extended through November 28, 2007. The facility remains subject to additional 364-day renewal periods at the discretion of the bank.
On November 13, 2006, we issued $275.0 million aggregate principal amount of floating rate senior secured notes due November 2010. Proceeds from this issuance, net of fees, were approximately $268.1 million. These notes bear interest at three-month LIBOR (reset quarterly) plus 3.75%, and interest is payable in arrears quarterly on each February 15, May 15, August 15 and November 15, beginning on February 15, 2007. We intend to use the net proceeds of this offering, together with available cash, cash equivalents and marketable securities on hand, to repay at maturity or otherwise retire our outstanding $456.5 million aggregate principal amount of convertible subordinated notes due February 2007.
We may not have access to sufficient capital to repay amounts due under (i) our credit facility expiring November 2007 (if it is not renewed), (ii) our floating rate senior secured notes due November 2010, and (iii) our convertible subordinated notes due March 2026, and we may not be able to refinance any portion of this debt on favorable terms or at all.
In the future, we may need to make strategic investments and acquisitions to help us grow our business, which may require additional capital resources. We cannot assure you that the capital required to fund these investments and acquisitions will be available in the future.
We may be subject to claims of infringement of third-party intellectual property rights or demands that we license third-party technology, which could result in significant expense and loss of our ability to use, make, sell, export or import our products or one or more components comprising our products.
The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights. From time to time, third parties have asserted and may in the future assert patent, copyright, trademark and other intellectual property rights to technologies that are important to our business and have demanded and may in the future demand that we license their patents and technology. Any litigation to determine the validity of claims that our products infringe or may infringe these rights, including claims arising through our contractual indemnification of our customers, regardless of their merit or resolution, could be costly and divert the efforts and attention of our management and technical personnel. We cannot assure you that we would prevail in litigation given the complex technical issues and inherent uncertainties in intellectual property litigation. If litigation results in an adverse ruling we could be required to:
| • | pay substantial damages; | ||
| • | cease the manufacture, use or sale of infringing products, processes or technologies; | ||
| • | discontinue the use of infringing technology; | ||
| • | expend significant resources to develop non-infringing technology; or | ||
| • | license technology from the third party claiming infringement, which license may not be available on commercially reasonable terms, or at all. |
The value of our common stock may be adversely affected by market volatility.
The trading price of our common stock fluctuates significantly and may be influenced by many factors, including:
| • | our operating and financial performance and prospects; | ||
| • | our ability to repay our debt; | ||
| • | the depth and liquidity of the market for our common stock; | ||
| • | investor perception of us and the industry and markets in which we operate; | ||
| • | our inclusion in, or removal from, any equity market indices; | ||
| • | the level of research coverage of our common stock; | ||
| • | changes in earnings estimates or buy/sell recommendations by analysts; | ||
| • | general financial, domestic, international, economic and other market conditions; and | ||
| • | judgments favorable or adverse to us. |
In addition, public stock markets have experienced, and are currently experiencing, price and trading volume volatility, particularly in the technology sectors of the market. This volatility has significantly affected the market prices of securities of many technology companies for reasons frequently unrelated to or disproportionately impacted by the operating performance of these companies. These broad market fluctuations may adversely affect the market price of our common stock.
We have recently incurred substantial losses and we anticipate additional future losses.
Our net losses for fiscal 2006 and 2005 were $122.6 million and $176.0 million, respectively. We have implemented a number of expense reduction and restructuring initiatives to improve our operating cost structure. The cost reduction initiatives included workforce reductions, the closure or consolidation of certain facilities and an increasing shift of product development resources to lower-cost regions, among other actions. However, these expense reduction initiatives alone will not return us to profitability. In order to return to profitability, we must achieve substantial revenue growth. We cannot assure you as to whether or when we will return to profitability or whether we will be able to sustain such profitability, if achieved.
We are subject to intense competition.
The communications semiconductor industry in general and the markets in which we compete in particular are intensely competitive. We compete worldwide with a number of United States and international semiconductor providers that are both larger and smaller than us in terms of resources and market share. We currently face significant competition in our markets and expect that intense price and product competition will continue. This competition has resulted in and is expected to continue to result in declining average selling prices for our products. We also anticipate that additional competitors will enter our markets as a result of expected growth opportunities in communications electronics, the trend toward global expansion by foreign and domestic competitors, technological and public policy changes and relatively low barriers to entry in certain markets of the industry. Moreover, as with many companies in the semiconductor industry, customers for certain of our products offer other products that compete with similar products offered by us. Many of our competitors have certain advantages over us, such as significantly greater sales and marketing, manufacturing, distribution, technical, financial and other resources.
We believe that the principal competitive factors for semiconductor suppliers in our addressed markets are:
| • | time-to-market; | ||
| • | product quality, reliability and performance; | ||
| • | level of integration; | ||
| • | price and total system cost; | ||
| • | compliance with industry standards; | ||
| • | design and engineering capabilities; | ||
| • | strategic relationships with customers; | ||
| • | customer support; | ||
| • | new product innovation; and | ||
| • | access to manufacturing capacity. |
Current and potential competitors also have established or may establish financial or strategic relationships among themselves or with our existing or potential customers, resellers or other third parties. These relationships may affect customers’ purchasing decisions. Accordingly, it is possible that new competitors or alliances could emerge and rapidly acquire significant market share. We cannot assure you that we will be able to compete successfully against current and potential competitors.
The loss of a key customer could seriously impact our revenue levels and harm our business. In addition, if we are unable to continue to sell existing and new products to our key customers in significant quantities or to attract new significant customers, our future operating results could be adversely affected.
We have derived a substantial portion of our past revenue from sales to a relatively small number of customers. As a result, the loss of any significant customer could materially and adversely affect our financial condition and results of operations.
Sales to our twenty largest customers, including distributors, represented approximately 67%, 64% and 59% of our net revenues in fiscal 2006, 2005 and 2004, respectively. We expect that our largest customers will continue to account for a substantial portion of our net revenue in future periods. The identities of our largest customers and their respective contributions to our net revenue have varied and will likely continue to vary from period to period. We may not be able to maintain or increase sales to certain of our key customers for a variety of reasons, including the following:
| • | most of our customers can stop incorporating our products into their own products with limited notice to us and suffer little or no penalty; | ||
| • | our agreements with our customers typically do not require them to purchase a minimum quantity of our products; | ||
| • | many of our customers have pre-existing or concurrent relationships with our current or potential competitors that may affect the customers’ decisions to purchase our products; | ||
| • | our customers face intense competition from other manufacturers that do not use our products; and | ||
| • | some of our customers offer or may offer products that compete with our products. |
In addition, our longstanding relationships with some larger customers may also deter other potential customers who compete with these customers from buying our products. To attract new customers or retain existing customers, we may offer certain customers favorable prices on our products. The loss of a key customer, a reduction in sales to any key customer or our inability to attract new significant customers could seriously impact our revenue and materially and adversely affect our results of operations.
Our success depends on our ability to timely develop competitive new products and reduce costs.
Our operating results will depend largely on our ability to continue to introduce new and enhanced semiconductor products on a timely basis. Successful product development and introduction depends on numerous factors, including, among others:
| • | our ability to anticipate customer and market requirements and changes in technology and industry standards; | ||
| • | our ability to accurately define new products; | ||
| • | our ability to timely complete development of new products and bring our products to market on a timely basis; | ||
| • | our ability to differentiate our products from offerings of our competitors; | ||
| • | overall market acceptance of our products; | ||
| • | our ability to invest in significant amounts of research and development; and | ||
| • | our ability to transition product development efforts between and among our sites, particularly in India and China. |
As a result of the Paxonet Communications acquisition in December 2004 and organic growth, we have increased our headcount in India from approximately 180 employees at the end of fiscal 2004 to approximately 1,260 employees as of September 29, 2006. We plan to continue this growth trend in India and other international locations in the Asia-Pacific region. Expansion and transition of product development efforts to other locations entails risks associated with our ability to manage the development of products at remote geographic locations, to achieve key program milestones, and to attract and retain qualified management, technical and other personnel necessary for the design and development of our products. If we experience product design or development delays as a result of the transition, or an inability to adequately staff the programs, there could be a material adverse effect on our results of operations.
We may not have sufficient resources to make the substantial investment in research and development in order to develop and bring to market new and enhanced products. Furthermore, we are required to continually evaluate expenditures for planned product development and to choose among alternative technologies based on our expectations of future market growth. We cannot assure you that we will be able to develop and introduce new or enhanced products in a timely and cost-effective manner, that our products will satisfy customer requirements or achieve market acceptance, or that we will be able to anticipate new industry standards and technological changes. We also cannot assure you that we will be able to respond successfully to new product announcements and introductions by competitors.
In addition, prices of established products may decline, sometimes significantly and rapidly, over time. We believe that in order to remain competitive we must continue to reduce the cost of producing and delivering existing products at the same time that we develop and introduce new or enhanced products. We cannot assure you that we will be successful and as a result gross margins may decline in future periods.
We are subject to the risks of doing business internationally.
For fiscal 2006, 2005 and 2004, approximately 92%, 90% and 89%, respectively, of our net revenues were from customers located outside of the United States, primarily in the Asia-Pacific region. In addition, a significant portion of our workforce and many of our key suppliers are located outside the United States. Our international operations consist of research and development, sales offices, and other general and administrative functions. We plan to continue our international expansion, particularly in the Asia-Pacific region. Our international operations are subject to a number of risks inherent in operating abroad. These include, but are not limited to, risks regarding:
| • | currency exchange rate fluctuations; | ||
| • | local economic and political conditions; | ||
| • | disruptions of commerce and capital or trading markets due to or related to terrorist activity or armed conflict; | ||
| • | restrictive governmental actions, such as restrictions on the transfer or repatriation of funds and trade protection measures, including export duties and quotas and customs duties and tariffs; | ||
| • | changes in legal or regulatory requirements; | ||
| • | difficulty in obtaining distribution and support; | ||
| • | the laws and policies of the United States and other countries affecting trade, foreign investment and loans, and import or export licensing requirements; | ||
| • | tax laws, including the cost of services provided and products sold between us and our subsidiaries which are subject to review by taxing authorities; and | ||
| • | limitations on our ability under local laws to protect our intellectual property. |
Because most of our international sales are currently denominated in U.S. dollars, our products could become less competitive in international markets if the value of the U.S. dollar increases relative to foreign currencies.
From time to time, we may enter into foreign currency forward exchange contracts to minimize risk of loss from currency exchange rate fluctuations for foreign currency commitments entered into in the ordinary course of business. We have not entered into foreign currency forward exchange contracts for other purposes. Our financial condition and results of operations could be affected (adversely or favorably) by currency fluctuations.
We also conduct a significant portion of our international sales through distributors. Sales to distributors and other resellers accounted for approximately 35%, 28% and 36% of our net revenues for fiscal 2006, 2005 and 2004, respectively. Our arrangements with these distributors are terminable at any time, and the loss of these arrangements could have an adverse effect on our operating results. For those international distributors that we account for under a deferred revenue recognition model, we rely on the distributor to provide us timely and accurate product sell through information. No assurances can be given that these international distributors will continue to provide us this information. If we are unable to obtain this information on a timely basis, or if we determine that the information we do receive is unreliable, it may affect the accuracy of amounts recorded in our consolidated financial statements, and therefore have an adverse effect on our operating results.
We may not be able to keep abreast of the rapid technological changes in our markets.
The demand for our products can change quickly and in ways we may not anticipate because our markets generally exhibit the following characteristics:
| • | rapid technological developments; | ||
| • | rapid changes in customer requirements; | ||
| • | frequent new product introductions and enhancements; | ||
| • | short product life cycles with declining prices over the life cycle of the products; and | ||
| • | evolving industry standards. |
Our products could become obsolete sooner than anticipated because of a faster than anticipated change in one or more of the technologies related to our products or in market demand for products based on a particular technology, particularly due to the introduction of new technology that represents a substantial advance over current technology. Currently accepted industry standards are also subject to change, which may contribute to the obsolescence of our products.
We may not be able to attract and retain qualified management, technical and other personnel necessary for the design, development and sale of our products. Our success could be negatively affected if key personnel leave.
Our future success depends on our ability to attract and to retain the continued service and availability of skilled personnel, including our Chairman of the Board and Chief Executive Officer, members of our executive team, and those in design, technical, marketing and staff positions. As the source of our technological and product innovations, our key technical personnel represent a significant asset. The competition for such personnel can be intense in the semiconductor industry. While we have entered into employment agreements with some of our key personnel, we cannot assure you that we will be able to attract and retain qualified management and other personnel necessary for the design, development and sale of our products. In addition, we have relied on our ability to grant stock options as one mechanism for recruiting and retaining highly skilled talent. Recent accounting regulations requiring the expensing of stock options may impair our future ability to provide these incentives without incurring significant compensation costs. There can be no assurance that we will continue to successfully attract, motivate, and retain key personnel.
If OEMs of communications electronics products do not design our products into their equipment, we will be unable to sell those products. Moreover, a design win from a customer does not guarantee future sales to that customer.
Our products are not sold directly to the end-user but are components of other products. As a result, we rely on OEMs of communications electronics products to select our products from among alternative offerings to be designed into their equipment. We may be unable to achieve these “design wins”. Without design wins from OEMs, we would be unable to sell our products. Once an OEM designs another supplier’s semiconductors into one of its product platforms, it will be more difficult for us to achieve future design wins with that OEM’s product platform because changing suppliers involves significant cost, time, effort and risk. Achieving a design win with a customer does not ensure that we will receive significant revenues from that customer and we may be unable to convert design wins into actual sales. Even after a design win, the customer is not obligated to purchase our products and can choose at any time to stop using our products if, for example, it or its own products are not commercially successful.
Because of the lengthy sales cycles of many of our products, we may incur significant expenses before we generate any revenues related to those products.
Our customers may need six months or longer to test and evaluate our products and an additional six months or more to begin volume production of equipment that incorporates our products. The lengthy period of time required
also increases the possibility that a customer may decide to cancel or change product plans, which could reduce or eliminate sales to that customer. As a result of this lengthy sales cycle, we may incur significant research and development, and selling, general and administrative expenses before we generate the related revenues for these products, and we may never generate the anticipated revenues if our customer cancels or changes its product plans.
Uncertainties involving the ordering and shipment of our products could adversely affect our business.
Our sales are typically made pursuant to individual purchase orders and we generally do not have long-term supply arrangements with our customers. Generally, our customers may cancel orders until 30 days prior to shipment. In addition, we sell a portion of our products through distributors and other resellers, some of whom have a right to return unsold products to us. Sales to distributors and other resellers accounted for approximately 35%, 28% and 36% of our net revenues for fiscal 2006, 2005 and 2004, respectively. Our distributors may offer products of several different suppliers, including products that may be competitive with ours. Accordingly, there is a risk that the distributors may give priority to other supplier products and may not sell our products as quickly as forecasted, which may impact their future order levels. We routinely purchase inventory based on estimates of end-market demand for our customers’ products, which is difficult to predict. This difficulty may be compounded when we sell to OEMs indirectly through distributors and other resellers or contract manufacturers, or both, as our forecasts of demand are then based on estimates provided by multiple parties. In addition, our customers may change their inventory practices on short notice for any reason. The cancellation or deferral of product orders, the return of previously sold products or overproduction due to the failure of anticipated orders to materialize could result in our holding excess or obsolete inventory, which could result in write-downs of inventory. For example, the reduced demand outlook for fiscal year 2005 and the further decline of average selling prices for certain of our products resulted in net inventory charges of approximately $45.0 million in the first quarter of fiscal 2005.
We are dependent upon third parties for the manufacture, assembly and test of our products.
We are entirely dependent upon outside wafer fabrication facilities (known as foundries or fabs). Under our fabless business model, our revenue growth is dependent on our ability to obtain sufficient external manufacturing capacity, including wafer production capacity. If the semiconductor industry experiences a shortage of wafer fabrication capacity in the future, we may experience delays in shipments or increased manufacturing costs. We do not have any long-term supply arrangements.
There are significant risks associated with our reliance on third-party foundries, including:
| • | the lack of assured wafer supply, potential wafer shortages and higher wafer prices; | ||
| • | limited control over delivery schedules, manufacturing yields, production costs and product quality; and | ||
| • | the unavailability of, or delays in obtaining, access to key process technologies. |
The foundries we use may allocate their limited capacity to fulfill the production requirements of other customers that are larger and better financed than us. If we choose to use a new foundry, it typically takes several months to redesign our products for the process technology and intellectual property cores of the new foundry and to complete the qualification process before we can begin shipping products from the new foundry.
We are also dependent upon third parties for the assembly and test of our products. Our reliance on others to assemble and test our products subjects us to many of the same risks as are described herein with respect to our reliance on outside wafer fabrication facilities. Wafer fabrication facilities and assembly and test companies are currently experiencing increased demand for their capacity.
Wafer fabrication processes are subject to obsolescence, and foundries may discontinue a wafer fabrication process used for certain of our products. In such event, we generally offer our customers a “last time buy” program to satisfy their anticipated requirements for our products. The unanticipated discontinuation of wafer fabrication processes on which we rely may adversely affect our revenues and our customer relationships.
The foundries and other suppliers on whom we rely may experience financial difficulties or suffer disruptions in their operations due to causes beyond our or their control, including labor strikes, work stoppages, electrical power outages, fire, earthquake, flooding or other natural disasters. Certain of our suppliers’ manufacturing facilities are located near major earthquake fault lines in California and the Asia-Pacific region. In the event of a disruption of the operations of one or more of our suppliers, we may not have a second manufacturing source immediately available. Such an event could cause significant delays in shipments until we could shift the products from an affected facility or supplier to another facility or supplier. The manufacturing processes we rely on are specialized and are available from a limited number of suppliers. Alternate sources of manufacturing capacity, particularly wafer production capacity, may not be available to us on a timely basis. Even if alternate wafer production capacity is available, we may not be able to obtain it on favorable terms, or at all. Difficulties or delays in securing an adequate supply of our products on favorable terms, or at all, could impair our ability to meet our customers’ requirements and have a material adverse effect on our operating results.
In addition, the highly complex and technologically demanding nature of semiconductor manufacturing has caused foundries from time to time to experience lower than anticipated manufacturing yields, particularly in connection with the introduction of new products and the installation and start-up of new process technologies. Lower than anticipated manufacturing yields may affect our ability to fulfill our customers’ demands for our products on a timely basis. Moreover, lower than anticipated manufacturing yields may adversely affect our cost of goods sold and our results of operations.
We may experience difficulties in transitioning to smaller geometry process technologies or in achieving higher levels of design integration, which may result in reduced manufacturing yields, delays in product deliveries, increased expenses and loss of design wins to our competitors.
To remain competitive, we expect to continue to transition our semiconductor products to increasingly smaller line width geometries. This transition requires us to modify the manufacturing processes for our products and to redesign some products as well as standard cells and other integrated circuit designs that we may use in multiple products. We periodically evaluate the benefits, on a product-by-product basis, of migrating to smaller geometry process technologies to reduce our costs. Currently our products are manufactured in a variety of process technologies ranging from 0.8 micron technology, which is our most mature technology, to 90 nanometer, which is the most advanced. We currently have product development efforts underway at the 65 nanometer process technology node. In the past, we have experienced some difficulties in shifting to smaller geometry process technologies or new manufacturing processes, which resulted in reduced manufacturing yields, delays in product deliveries and increased expenses. We may face similar difficulties, delays and expenses as we continue to transition our products to smaller geometry processes. We are dependent on our relationships with our foundries to transition to smaller geometry processes successfully. We cannot assure you that our foundries will be able to effectively manage the transition or that we will be able to maintain our existing foundry relationships or develop new ones. If our foundries or we experience significant delays in this transition or fail to implement this transition efficiently, we could experience reduced manufacturing yields, delays in product deliveries and increased expenses, all of which could negatively affect our relationships with our customers and result in the loss of design wins to our competitors, which in turn would adversely affect our results of operations. As smaller geometry processes become more prevalent, we expect to continue to integrate greater levels of functionality, as well as customer and third party intellectual property, into our products. However, we may not be able to achieve higher levels of design integration or deliver new integrated products on a timely basis, or at all. Moreover, even if we are able to achieve higher levels of design integration, such integration may have a short-term adverse impact on our operating results, as we may reduce our revenue by integrating the functionality of multiple chips into a single chip.
If we are not successful in protecting our intellectual property rights, it may harm our ability to compete.
We use a significant amount of intellectual property in our business. We rely primarily on patent, copyright, trademark and trade secret laws, as well as nondisclosure and confidentiality agreements and other methods, to protect our proprietary technologies and processes. At times we incorporate the intellectual property of our customers into our designs, and we have obligations with respect to the non-use and non-disclosure of their intellectual property. In the past, we have engaged in litigation to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of proprietary rights of others, including our customers. We
may engage in future litigation on similar grounds, which may require us to expend significant resources and to divert the efforts and attention of our management from our business operations. We cannot assure you that:
| • | the steps we take to prevent misappropriation or infringement of our intellectual property or the intellectual property of our customers will be successful; | ||
| • | any existing or future patents will not be challenged, invalidated or circumvented; or | ||
| • | any of the measures described above would provide meaningful protection. |
Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use our technology without authorization, develop similar technology independently or design around our patents. If any of our patents fails to protect our technology it would make it easier for our competitors to offer similar products. In addition, effective patent, copyright, trademark and trade secret protection may be unavailable or limited in certain countries.
Uncertainties involving litigation could adversely affect our business.
We and certain of our current and former officers and directors have been named as defendants in several purported securities class action lawsuits, which have now been consolidated into a single action. We and certain of our directors and officers have also been named as defendants in purported shareholder derivative actions. We and certain of our current and former officers and our Employee Benefits Plan Committee have also been named as defendants in a purported breach of fiduciary duties action. Although we believe that these lawsuits are without merit, an adverse determination could have a negative impact on the price of our stock. Moreover, regardless of the ultimate result, the lawsuits may divert management’s attention and resources from other matters, which could also adversely affect our business and results of operations.
Our success depends, in part, on our ability to effect suitable investments, alliances and acquisitions.
Although we invest significant resources in research and development activities, the complexity and speed of technological changes make it impractical for us to pursue development of all technological solutions on our own. On an ongoing basis, we review investment, alliance and acquisition prospects that would complement our existing product offerings, augment our market coverage or enhance our technological capabilities. However, we cannot assure you that we will be able to identify and consummate suitable investment, alliance or acquisition transactions in the future.
Moreover, if we consummate such transactions, they could result in:
| • | large initial one-time write-offs of in-process research and development; | ||
| • | the incurrence of substantial debt and assumption of unknown liabilities; | ||
| • | the potential loss of key employees from the acquired company; | ||
| • | amortization expenses related to intangible assets; and | ||
| • | the diversion of management’s attention from other business concerns. |
Integrating acquired organizations and their products and services may be expensive, time-consuming and a strain on our resources and our relationships with employees and customers, and ultimately may not be successful. The process of integrating operations could cause an interruption of, or loss of momentum in, the activities of one or more of our product lines and the loss of key personnel. The diversion of management’s attention and any delays or difficulties encountered in connection with acquisitions and the integration of multiple operations could have an adverse effect on our business, results of operations or financial condition.
We have significant goodwill and intangible assets, and future impairment of our goodwill and intangible assets could have a material negative impact on our financial condition and results of operations.
At September 29, 2006, we had $710.8 million of goodwill and $76.0 million of intangible assets, net, which together represented approximately 50% of our total assets. Approximately $616.3 million of the goodwill was generated in our merger with GlobespanVirata, Inc. in February 2004. In periods subsequent to an acquisition, at least on an annual basis or when indicators of impairment exist, we must evaluate goodwill and acquisition-related
intangible assets for impairment. When such assets are found to be impaired, they will be written down to estimated fair value, with a charge against earnings. If our market capitalization drops below our book value for a prolonged period of time, if our assumptions regarding our future operating performance change or if other indicators of impairment are present, we may be required to write-down the value of our goodwill and acquisition-related intangible assets by taking a non-cash charge against earnings. Because of the significance of our goodwill and intangible assets, any future impairment of these assets could have a material adverse effect on our financial condition and results of operations, although it would have no effect on our cash flow.
We may be liable for penalties under environmental laws, rules and regulations, which could adversely impact our business.
Our former manufacturing operations used a variety of chemicals and were subject to a wide range of environmental protection regulations in the United States and Mexico. We have been designated as a potentially responsible party and are engaged in groundwater remediation under a previously approved Consent Decree at one Superfund site located at a former silicon wafer manufacturing facility and steel fabrication plant in Parker Ford, Pennsylvania formerly occupied by us, which has been settled pursuant to a Consent Decree entered into with the EPA in August 2006. In addition, we are engaged in remediations of groundwater contamination at our former Newport Beach, California wafer fabrication facility. We estimate the remaining costs for these remediations to be approximately $2.1 million as of September 29, 2006 and have accruals for these costs in our consolidated balance sheets.
In the United States, environmental regulations often require parties to fund remedial action regardless of fault. Consequently, it is often difficult to estimate the future impact of environmental matters, including potential liabilities. While we have not experienced any material adverse effects on our operations as a result of such regulations, we cannot assure you that the costs that might be required to complete remedial actions, if any, will not have a material adverse effect on our business, financial condition and results of operations.
We may be limited in the future in the amount of net operating losses that we can use to offset taxable income.
As of September 29, 2006, we had approximately $1.2 billion of U.S. federal income tax net operating loss (NOL) carry forwards that can be used to offset taxable income in subsequent years. Approximately $455.9 million of the NOL carry forwards were acquired in the merger with GlobespanVirata and in other acquisitions. The NOL carry forwards are scheduled to expire at various dates through 2026. Section 382 of the Internal Revenue Code could limit the future use of some or all of the NOL carry forwards if the ownership of our common stock changes by more than 50 percentage points in certain circumstances over a three-year testing period. Based on information known to us, we have not undergone such a change of ownership and the merger did not constitute a change of ownership, although the shares of our common stock issued in the merger will be taken into account in any change of ownership computations. Direct or indirect transfers of our common stock, when taken together with the shift in ownership resulting from the merger, could result in a change of ownership that would trigger the Section 382 limitation. If such an ownership change occurs, Section 382 would limit our use of NOL carry forwards in each subsequent taxable year to an amount equal to a federal long-term tax-exempt rate published by the Internal Revenue Service at the time of the ownership change, multiplied by our fair market value at such time; any unused annual limitation amounts may also be carried forward. The merger resulted in a change of ownership of GlobespanVirata and the future use of GlobespanVirata’s NOL carry forwards is subject to the Section 382 limitation (or further limitation in the case of NOL carry forwards already subject to limitation as a result of previous transactions) based on the fair market value of GlobespanVirata at the time of the merger.
Provisions in our organizational documents and rights agreement and Delaware law may make it difficult for someone to acquire control of us.
We have established certain anti-takeover measures that may affect our common stock and convertible notes. Our restated certificate of incorporation, our by-laws, our rights agreement with Mellon Investor Services LLC, as rights agent, dated as of November 30, 1998, as amended, and the Delaware General Corporation Law contain several provisions that would make more difficult an acquisition of control of us in a transaction not approved by our board of directors. Our restated certificate of incorporation and by-laws include provisions such as:
| • | the division of our board of directors into three classes to be elected on a staggered basis, one class each year; | ||
| • | the ability of our board of directors to issue shares of our preferred stock in one or more series without further authorization of our shareholders; | ||
| • | a prohibition on shareholder action by written consent; | ||
| • | a requirement that shareholders provide advance notice of any shareholder nominations of directors or any proposal of new business to be considered at any meeting of shareholders; | ||
| • | a requirement that a supermajority vote be obtained to remove a director for cause or to amend or repeal certain provisions of our restated certificate of incorporation or by-laws; | ||
| • | elimination of the right of shareholders to call a special meeting of shareholders; and | ||
| • | a fair price provision. |
Our rights agreement gives our shareholders certain rights that would substantially increase the cost of acquiring us in a transaction not approved by our board of directors.
In addition to the rights agreement and the provisions in our restated certificate of incorporation and by-laws, Section 203 of the Delaware General Corporation Law generally provides that a corporation shall not engage in any business combination with any interested shareholder during the three-year period following the time that such shareholder becomes an interested shareholder, unless a majority of the directors then in office approves either the business combination or the transaction that results in the shareholder becoming an interested shareholder or specified shareholder approval requirements are met.
Item 1B. Unresolved Staff Comments
Not applicable.
