The flash memory market is primarily comprised of NOR and NAND technologies. NOR is traditionally used for code storage and is characterized by fast read speeds with generally higher costs per megabyte and lower storage capacities than
NAND. NAND flash memory is traditionally used for embedded and removable data storage and is characterized by fast write speeds, high capacity and lower manufacturing cost than NOR flash memory. We are focused on NAND-based products.
Our Primary Markets. We currently focus on four primary markets:
| • | Consumer. We make and sell flash storage cards that address multiple consumer markets. Certain flash storage cards are used as the film for all major brands of digital cameras. Our cards are also used to store video in solid-state digital camcorders and to store digital data in many other devices including maps in global positioning system devices, or GPS, and personal data in personal digital assistants, or PDAs. In addition, portable game consoles now include advanced features and functionality, including storage of game results, digital audio, video playback and photo viewing. These features demand high capacity memory storage cards. We manufacture brightly colored SD and Memory Stick PRO Duo™ cards for use in gaming devices such as the Sony PSP®, Nintendo® Wii™ and Microsoft xBox®. Our Cruzer® CrossFire™ line of USB drives are geared toward the PC gaming market. Primary card formats for consumer devices include CF, SD, Memory Stick® and xD-Picture Card™. | ||
| • | Computing. We provide multiple flash storage devices and solutions for a variety of computing, industrial and enterprise markets. USB flash drives allow consumers to store computer files on keychain-sized devices and then quickly and easily transfer these files between laptops, desktops and other devices. USB flash drives are fast and easy to use, they have replaced floppy disks and other types of external storage media, and are evolving into intelligent storage devices. NAND flash memory-based data storage allows industrial customers and PC manufacturers to offer systems with solid state drives in lieu of traditional magnetic disk-based drives. In January 2007, we introduced our first 32 gigabyte solid state drive in a 1.8 inch form factor for the notebook PC market. | ||
| • | Mobile Phones. We provide embedded, semi-removable and removable storage for mobile phones. We are a leading supplier of microSD, miniSD, SD and Memory Stick PRO Duo removable storage cards used in mobile phones. Multimedia features in mobile phones, such as camera functionality, audio/MP3, games, video or internet access, have been increasing in popularity. These features require additional storage capacity in the mobile phone and transferability of data to and from other devices. | ||
| • | Digital Audio and Video Players. Digital audio players allow consumers to download, store and play music. We sell a broad line of digital audio players with both embedded and removable memory under our Sansa® brand. We have also launched our first digital video player under the Sansa brand. |
Our Sales Channels. Our products are delivered to end-users through more than 200,000 worldwide retail storefronts and also by bundling data storage cards with host products or by embedding our data storage products in host devices sold by our OEM customers.
Our sales are made through the following channels:
| • | Retail. We ship SanDisk brand name products directly to consumer electronics stores, office superstores, photo retailers, mobile phone stores, mass merchants, catalog and mail order companies, internet and e-commerce retailers, drug stores, supermarkets and convenience stores. We also sell our products to smaller or regional retailers through distributors. | ||
| We have a separate distribution network focused on the mobile phone market. Our distributors provide us access to mobile network operator branded storefronts as well as other retailers with significant mobile communications offerings. We intend to continue to emphasize offering our products throughout the mobile communication retail community as an important driver of our planned growth in that market. | |||
| We support our retail sales channels with both direct sales representatives and independent manufacturers’ representatives. We have multiple domestic retail sales offices and have organized our sales efforts in the rest of the world around three regional territories: Europe, Middle East and Africa, or EMEA, Japan and non-Japan Asia/Pacific, which we refer to as Asia Pacific. Information regarding our sales by geography is included in Note 6 to our consolidated financial statements included in Item 8 of this report. |
• OEM . Our OEM customers include manufacturers of mobile phones, digital cameras and other digital consumer devices, such as GPS. Our products are sold directly to OEMs and through distributors. We support our OEM customers with both direct sales representatives and independent manufacturers’ representatives.
As of the end of fiscal years 2006 and 2005, our backlog was $177.0 million and $105.7 million, respectively. Due to industry practice that allows customers to change or cancel orders with limited advance notice prior to shipment, we do not believe that backlog as of any particular date is indicative of future sales.
Our revenues are seasonally higher in our fourth quarter due to the holiday buying season. Our first and third quarters have sometimes been seasonally lower than the preceding quarters.
Our Customers. In fiscal years 2006, 2005 and 2004, revenues from our top 10 customers and licensees accounted for approximately 52%, 50% and 55% of our revenues, respectively. In fiscal years 2006 and 2004, no single customer or licensee accounted for greater than 10% of our revenues. In fiscal year 2005, Best Buy accounted for 11% of our revenues. The composition of our major customer base has changed over time, and we expect this pattern to continue as our markets and strategies evolve. Sales to our customers are generally made pursuant to purchase orders rather than long-term contracts.
Our Products. Our products are sold under the SanDisk brand in a wide variety of form factors and include the following:
| • | Removable Cards. Our removable data storage solutions are available in almost every major form factor in our primary markets. For example, our CompactFlash removable cards, available in capacities up to 16 gigabytes, are well-suited for a range of consumer applications, including digital cameras. Our professional products include the SanDisk Ultra® and SanDisk Extreme® product lines which are designed with additional performance and reliability. As another example, our ultra-small microSD removable cards, available in capacities up to 4 gigabytes, are designed for use in mobile phones. | ||
| • | USB Drives. Our Cruzer® line of USB drives, available in capacities up to 8 gigabytes, are highly-reliable and high-performance. USB Flash Drives, or UFDs, are used in the computing and consumer markets. A number of our Cruzers ship with U3™ smart technology which gives the user the ability to carry files and application software on a secure USB drive. Also, our Cruzer Crossfire USB Flash Drives are specially designed to make console or PC gaming experience portable. Using our USB flash drives, gamers can save game data, download portable games and demos and save game replays. | ||
| • | Embedded. Our embedded products are a set of reliable, high-capacity, high performance and cost-effective embedded flash memory drive, or EFD, solutions for both data and code storage. Ranging in capacities from 128 megabytes to 8 gigabytes, these products are designed to respond to the increasing demand for embedded storage for mobile phones and other portable devices. We also offer high-capacity solid-state drives targeted for the personal computing market in capacities up to 32 gigabytes. | ||
| • | MP3. The Sansa is our branded line of flash-based MP3 players for the digital audio and video player market. Many of our Sansa models offer a removable card slot for easy transportability of music between devices and storage capacity expansion. The Sansa MP3 players also feature built-in FM tuning for non-European models and voice recording capabilities and are compatible with a variety of music download and subscription services. Sansa is available in capacities ranging from 256 megabytes to 8 gigabytes. |
Technology. Since our inception, we have focused our research, development and standardization efforts on developing highly reliable, high-performance, small form factor and cost-effective flash memory storage products to address a variety of emerging markets. We have been actively involved in all aspects of this development, including flash memory process development, module integration, chip design, controller development and system-level integration to ensure the creation of fully-integrated, broadly interoperable products that are compatible with both existing and newly developed system platforms. We are investing to extend our 2-bits/cell memory storage technology to 3-bits/cell, or X3, and 4-bits/cell, or X4, storage technologies. In addition, we are also investing in three-dimensional memory architecture with re-write capabilities. We believe our core technical competencies are in:
• high-density flash memory process, module integration, device design and reliability;
| • | securing data on a flash memory device; | ||
| • | controller design; | ||
| • | system-level integration; | ||
| • | compact packaging; and | ||
| • | low-cost system testing. |
We have also initiated, defined and developed standards to meet new market needs and to promote wide acceptance of the standards through interoperability and ease-of-use.
To achieve compatibility with various electronic platforms regardless of the host processors or operating systems used, we developed new capabilities in flash memory chip design and created intelligent controllers. We also developed an architecture that can leverage advances in process technology designed for scaleable, high-yielding, cost-effective and highly reliable manufacturing processes. We design our products to be compatible with industry-standard interfaces used in standard operating systems for personal computers, mobile phones, gaming devices, music players and other consumer and industrial products.
Our patented intelligent controller technology with its advanced defect management system permits our flash storage card products to achieve a high level of reliability and longevity. Each one of our flash devices contains many millions of flash memory cells. For example, our 4 gigabyte cards may contain as many as 35 billion storage cells. A failure in any one of these cells or in a group or block of cells can result in loss of data such as picture files, and this can occur several years into the life of a flash storage card. The controller chip inside our cards is designed to detect such defects and recover data under most standard conditions.
Patents and Licenses. We rely on a combination of patents, trademarks, copyright and trade secret laws, confidentiality procedures and licensing arrangements to protect our intellectual property rights. See Item 1A, “Risk Factors.”
In 1988, we developed the concept of emulation of a hard disk drive with flash solid-state memory. The first related patents were filed by our chief executive officer, Dr. Eli Harari and exclusively licensed to us. As of the end of fiscal year 2006, we owned or had rights to more than 600 United States patents and more than 300 foreign patents, have more than 1,100 patent applications pending in the United States, and have foreign counterparts pending on many of the applications in multiple jurisdictions. We continually seek additional international and United States patents on our technology.
Through our acquisitions of Matrix Semiconductor, Inc., or Matrix, in early fiscal year 2006 and msystems in late fiscal year 2006, we have acquired access to fundamental patents on three-dimensional, or 3-D, memory architecture and X4 data storage technologies, respectively. Patents transferred to us upon completion of the Matrix acquisition included 124 United States patents, approximately 14 foreign patents, and approximately 141 patent applications pending in the United States. Patents transferred to us upon completion of the msystems acquisition included 54 United States patents, approximately 66 foreign patents, and approximately 201 patent applications pending in the United States. In addition, through these acquisitions, we have foreign counterparts pending on many of the applications in multiple jurisdictions
We have various patent licenses with several companies including, among others, Intel Corporation, or Intel, Lexar Media, Inc., or Lexar, a subsidiary of Micron Technology, Inc., or Micron, Matsushita, Renesas Technology Corporation, or Renesas, Samsung, Sharp Electronics KK, or Sharp, Sony and Toshiba. From time-to-time, we have also entered into discussions with other companies regarding potential license agreements for our patents.
Trade secrets and other confidential information are also important to our business. We protect our trade secrets through confidentiality and invention assignment agreements.
Supply Chain. Our supply chain is an important competitive advantage.
| • | Silicon Sourcing. All of our flash memory card products require silicon chips for the memory and controller components. The majority of our memory is supplied from our ventures with Toshiba and our Toshiba foundry relationship. This represents captive memory supply and we are obligated to take the output from the ventures with Toshiba. See “— Ventures With Toshiba.” In fiscal year 2006, we purchased non-captive memory supply primarily from Samsung. We are guaranteed a certain amount of the total output from Samsung and Hynix Semiconductor Inc., or Hynix, but we are not obligated to use the guaranteed supply until we give them an order for future purchases. Our controller wafers are currently supplied by Tower Semiconductor Ltd., or Tower, and United Microelectronics Corporation, or UMC. We have a foundry agreement with Tower on a purchase order basis. See Item 1A, “Risk Factors.” | ||
| • | Testing and Assembly. We sort and test our wafers at Toshiba in Yokkaichi, Japan, and Ardentec Corp. in Taiwan. Our tested wafers are then shipped to our third-party memory assembly subcontractors, including StatsChipPAC Ltd., or StatsChipPAC, in China, Silicon Precision Industries Co., Ltd., or SPIL, in Taiwan, and Sharp and Mitsui & Co., Ltd., both in Japan. Our packaged memory final test, card assembly and card test is performed at subcontractors such as ASE Group, DataFab Systems, Inc., or DataFab, SPIL and United Test and Assembly Center, in Taiwan, and Beautiful Enterprise Co., Ltd., DataFab, Flextronics International, Ltd., or Flextronics, Global Brands Manufacturing Ltd. and StatsChipPAC, in China. We believe our use of subcontractors reduces the cost of our operations and gives us access to increased production capacity. On November 29, 2006, we entered into a 50-year land lease in the Zizhu Science-Based Park near Shanghai, China, and we are constructing a captive assembly and test manufacturing facility to provide in-house manufacturing capacity for a portion of our card assembly and test needs. See Item 1A, “Risk Factors” and Item 7, “Liquidity.” |
Ventures with Toshiba
We and Toshiba have entered into several business ventures. In May 2000, we invested in the FlashVision Ltd., or FlashVision, venture, which operated in Manassas, Virginia, until May 2002. In April 2002, we and Toshiba agreed to consolidate the NAND wafer fabrication manufacturing operations in Fabs 1 and 2 of Toshiba’s Yokkaichi, Japan operations. FlashVision produces 200-millimeter NAND flash wafers using both owned and leased equipment. In September 2004, we and Toshiba formed the Flash Partners Ltd., or Flash Partners, venture pursuant to which a wafer fabrication facility, Fab 3, was constructed at Toshiba’s Yokkaichi, Japan operations. Flash Partners purchases and leases semiconductor manufacturing equipment for Fab 3, which produces 300-millimeter NAND flash wafers. Toshiba began production for Flash Partners in Fab 3 in the third quarter of fiscal 2005 and expects to achieve 135,000 wafers per month by the end of fiscal year 2007. In July 2006, we and Toshiba formed Flash Alliance Ltd., or Flash Alliance, to build Fab 4, a new 300-millimeter wafer fabrication facility, at Toshiba’s Yokkaichi, Japan operations. Fab 4 is under construction and initial NAND production at Fab 4 is currently scheduled for the end of fiscal year 2007. We currently expect to expand Fab 4 to approximately 67,500 wafers per month by the end of fiscal year 2008, and the capacity of Fab 4 at full expansion is currently expected to be approximately 150,000 wafers per month, with the timeframe to reach full capacity to be mutually agreed by the parties. We hold a 49.9% ownership position in each venture entity.
With these ventures, we and Toshiba collaborate in the development and manufacture of NAND flash memory products. These NAND flash memory products are manufactured by Toshiba at Toshiba’s Yokkaichi, Japan operations using the semiconductor manufacturing equipment owned or leased by FlashVision, Flash Partners or, once Fab 4 comes online, Flash Alliance. Each venture entity purchases wafers from Toshiba at cost and then resells those wafers to us and Toshiba at cost plus a mark-up. We are committed to purchase, and entitled to, half of each venture’s NAND wafer supply and are committed to fund 49.9% of each venture’s costs to the extent that the venture’s revenues from wafer sales to us and Toshiba are insufficient to cover these costs. The investments in each venture entity are shared 50/50 between us and Toshiba. In addition, we purchase wafers from Toshiba on a foundry basis.
We assumed msystems’ ownership interest in its venture with Toshiba, TwinSys Data Storage Limited Partnership, or TwinSys, which was designed to enable the parties to benefit from a portion of each party’s respective sales of USB flash drives. As of December 31, 2006, we had a 50.1% beneficial ownership in TwinSys, consisting of (i) 49.9% ownership in TwinSys and (ii) 0.2% interest held by Twinsys Ltd., in which we have a 51% ownership interest. We and Toshiba are currently negotiating the mutual closure of this venture by the first half of fiscal year 2007. However, no written agreement has been reached.
Competition
We face competition from numerous semiconductor manufacturers and manufacturers and resellers of flash memory cards, USB drives, digital audio players and other consumer electronic devices. We also face competition from manufacturers of hard disk drives and from new technologies. See Item 1A, “Risk Factors.”
Key Competitive Advantages. Our key competitive advantages are:
| • | we have a tradition of innovation and standards creation which provides us with strength in growing the overall market for NAND memory; | ||
| • | our intellectual property ownership, in particular our patent claims and MLC manufacturing know-how, provides us certain cost advantages; | ||
| • | our fab ventures with Toshiba provide us with an attractive cost structure; | ||
| • | we market and sell a broader range of card formats than any of our competitors, which gives us an advantage in obtaining strong retail and OEM distribution; and | ||
| • | we have leading market share with number 1 worldwide market share in removable flash cards and USB flash drives and number 2 market share in U.S. flash-based digital audio players. |
Semiconductor Manufacturers. Our primary semiconductor competitors currently include Samsung, Toshiba, Hynix, IM Flash Technologies, LLC, or IM Flash (a company formed by Micron and Intel), Micron, and STMicroelectronics N.V., or STMicro. If the NAND industry increases memory output faster than the increase in demand it will likely result in industry margin compression as the price decline rates exceed normal cost declines.
Flash Memory Card and USB Drive Manufacturers. Our primary competitors currently include, among others, A-Data Technology Co., Ltd., or A-Data, Buffalo Technology, FUJIFILM Corporation, or Fuji, Hagiwara Sys-Com Co., Ltd., or Hagiwara, Hama Corporation, Inc., or Hama, I/O Data Device, Inc., or I/O Data, Kingmax, Inc., or KingMax, Kingston Technology Company, Inc., or Kingston, Eastman Kodak Company, or Kodak, Lexar, Matsushita, Micron, Netac Technology, Co., or Netac, Panasonic, PNY Technologies, Inc., or PNY, RITEK Corporation, or Ritek, Samsung, Sony, Toshiba, Tradebrands International, or Tradebrands, and Transcend Information, Inc., or Transcend.
Digital Audio Player Manufacturers. Our digital audio players face strong competition from products offered by other companies, including Apple Inc., or Apple, Creative Technologies, Ltd., or Creative, Microsoft Corporation, or Microsoft, and Samsung.
Other Technologies. Other technologies compete with our product offerings and many companies are attempting to develop memory cells that use different designs and materials in order to reduce memory costs. One example of an alternative technology is the small hard disk drive, which has a low cost per megabyte for high memory capacity but a high cost per megabyte for low capacities. Hard disk drives also have significant power requirements and they are not as rugged as flash memory. Other future competitive technologies could include different designs and materials such as phase-change technology, charge-trap flash and millipedes/probes.
Employees
As of December 31, 2006, we had 2,586 full-time employees, including 1,081 in research and development, 527 in sales and marketing, 422 in general and administration and 556 in operations. None of our employees is represented by a collective bargaining agreement and we have never experienced any work stoppage. We believe that our employee relations are satisfactory.
Executive Officers
Our executive officers, who are elected by and serve at the discretion of our Board of Directors, are as follows (all ages are as of February 15, 2007):
| Name | Age | Position | ||
Eli Harari |
61 | Chairman of the Board and Chief Executive Officer | ||
Sanjay Mehrotra |
48 | President and Chief Operating Officer | ||
Judy Bruner |
48 | Executive Vice President, Administration and Chief Financial Officer | ||
Randhir Thakur |
44 | Executive Vice President, Technology and Worldwide Operations | ||
Yoram Cedar |
54 | Executive Vice President, Handset Business and Corporate Engineering |
Dr. Eli Harari, the founder of SanDisk, has served as Chief Executive Officer and as a director of SanDisk since June 1988. He was appointed Chairman of the Board in June 2006. Dr. Harari also served as President from June 1998 to June 2006. Dr. Harari founded Waferscale Integration, Inc., a privately held semiconductor company, in 1983 and was its President and Chief Executive Officer from 1983 to 1986, and Chairman and Chief Technical Officer from 1986 to 1988. From 1973 to 1983, Dr. Harari held various management positions with Honeywell Inc., Intel Corporation and Hughes Microelectronics Ltd. Dr. Harari holds a Ph.D. in Solid State Sciences from Princeton University and has more than 100 patents issued in the field of non-volatile memories and storage systems. In December 2006, Dr. Harari, along with SanDisk’s co-founders Sanjay Mehrotra and Jack Yuan, received the 2006 IEEE Reynold B. Johnson Data Storage Device Technology Award “For leadership in the development and commercialization of Flash EEPROM-based data storage products.” Dr. Harari is a board member of Tower.
Sanjay Mehrotra co-founded SanDisk in 1988 and has been our President since June 2006. He continues to serve as our Chief Operating Officer, a position he has held since 2001, and he has previously served as our Executive Vice President, Vice President of Engineering, Vice President of Product Development, Director of Memory Design and Product Engineering. Mr. Mehrotra has more than 25 years of experience in the non-volatile semiconductor memory industry including engineering and engineering management positions at Intel Corporation, Seeq Technology, Integrated Device Technology and Atmel Corporation. Mr. Mehrotra earned B.S. and M.S. degrees in Electrical Engineering and Computer Sciences from the University of California, Berkeley. He also holds several patents and has published articles in the area of non-volatile memory design and flash memory systems. In December 2006, Mr. Mehrotra, along with SanDisk’s co-founders Dr. Eli Harari and Jack Yuan, received the 2006 IEEE Reynold B. Johnson Data Storage Device Technology Award “For leadership in the development and commercialization of Flash EEPROM-based data storage products.”
Judy Bruner has been our Chief Financial Officer and Executive Vice President Administration since June 2004. She served as a member of our board of directors from July 2002 to July 2004. Ms. Bruner has over 25 years of financial management experience, including serving as Senior Vice President and Chief Financial Officer of Palm, Inc., a provider of handheld computing and communications solutions, from September 1999 until June 2004. Prior to Palm, Inc., Ms. Bruner held financial management positions with 3Com Corporation, Ridge Computers and Hewlett-Packard Company. Ms. Bruner also serves on the board of directors of Ciphergen Biosystems, Inc. Ms. Bruner holds a B.A. degree in Economics from the University of California, Los Angeles and an M.B.A. degree from Santa Clara University.
Dr. Randhir Thakur has been our Executive Vice President, Technology and Worldwide Operations since October 2005. Prior to joining us, Dr. Thakur was group Vice President and General Manager of the Front End Products Group at Applied Materials, Inc. He joined Applied Materials in 2000 as Chief Technical Officer of the Transistor and Capacitor Products Business Group. Previously, from 1997 to 2000, Dr. Thakur was Vice President of Research and Development at AG Associates and Chief Technology Officer and General Manager at Steag Electronic Systems after its acquisition of AG Associates. He also held various technical and management positions at Micron Technology from 1991 to 1997. Dr. Thakur has extensive experience in semiconductor manufacturing, holds more than 250 patents and has published more than 200 technical publications. Dr. Thakur
received his B.S. degree (honors) in Electronics and Telecommunications Engineering from the Regional Engineering College, Kurukshetra, India, and an M.S. degree in Electrical Engineering from the University of Saskatchewan, Canada. Dr. Thakur received his Ph.D. in Electrical Engineering from the University of Oklahoma.
Yoram Cedar is our Executive Vice President, Mobile Business and Corporate Engineering. Prior to October 2005, Mr. Cedar served as our Senior Vice President of Engineering and Emerging Market Business Development. Mr. Cedar began his career at SanDisk in 1998 when he joined as Vice President of Systems Engineering. He has extensive experience working in product definition, marketing and development of systems and embedded flash-based semiconductors. Prior to SanDisk, he was the Vice President of New Business Development at Waferscale Integration and has more than 27 years of experience in design and engineering management of electronic systems. Mr. Cedar earned B.S. and M.S. degrees in Electrical Engineering and Computer Architecture from Technion, Israel Institute of Technology, Haifa, Israel.
Item 1A. Risk Factors
Our operating results may fluctuate significantly, which may adversely affect our operations and our stock price . Our quarterly and annual operating results have fluctuated significantly in the past and we expect that they will continue to fluctuate in the future. This fluctuation could result from a variety of factors, including, among others:
| • | average selling prices, net of promotions, declining at a faster rate than cost reduction for our products due to industry or SanDisk excess supply and competitive pricing pressures; | ||
| • | addition of new competitors, expansion of supply from existing competitors and ourselves creating excess market supply, which could cause our average selling prices to decline faster than our costs decline; | ||
| • | impairment of goodwill, business integration and other challenges related to our acquisition of msystems and Matrix; | ||
| • | timing, volume and cost of wafer production from the FlashVision, Flash Partners and Flash Alliance ventures as impacted by fab start-up delays and costs, technology transitions, yields or production interruptions due to natural disasters, power outages, equipment failure or other factors; | ||
| • | disruption in the manufacturing operations of suppliers, including suppliers of sole-sourced components; | ||
| • | unpredictable or changing demand for our products, particularly demand for certain types or capacities of our products or demand for our products in certain markets or geographies; | ||
| • | excess supply from captive sources due to output increasing faster than the growth in demand resulting in excess inventory; | ||
| • | insufficient supply from captive and non-captive sources or insufficient capacity from our test and assembly subcontractors to meet demand; | ||
| • | reduction in price elasticity of demand related to pricing changes for some of our more mature markets for NAND flash memory; | ||
| • | potential delays in the emergence of new markets and products for NAND flash memory and acceptance of our products in these markets; | ||
| • | our license and royalty revenues may decline significantly in the future as our existing license agreements and key patents expire; | ||
| • | timing of sell-through by our distributors and retail customers; | ||
| • | increased purchases of flash memory products from our non-captive sources, which typically cost more than products from our captive sources; | ||
| • | difficulty in forecasting and managing inventory levels, particularly due to noncancelable contractual obligations to purchase materials such as flash memory and controllers, and the need to build finished product in advance of customer purchase orders; | ||
| • | errors or defects in our products caused by, among other things, errors or defects in the memory or controller components, including memory and non-memory components we procure from third-party suppliers; | ||
| • | write-downs of our investments in fabrication capacity, equity investments and other assets; | ||
| • | estimates used in calculating share-based compensation expense; and | ||
| • | the other factors described under “Risk Factors” and elsewhere in this report. |
Our average selling prices, net of promotions, may decline faster than cost reductions due to industry or SanDisk excess supply, competitive pricing pressures or strategic price reductions initiated by us or our competitors. The market for NAND flash products is competitive and characterized by rapid price declines. Price declines may be influenced by, among other factors, supply in excess of demand, technology transitions, including adoption of MLC technology by other competitors, new technologies or other strategic actions by competitors to gain market share. If our technology transitions take longer or are more costly than anticipated to complete, our cost reductions fail to keep pace with the rate of price declines or our price decreases fail to generate sufficient additional demand, our gross margin and operating results will be negatively impacted which could generate quarterly or annual net losses.
Sales to a small number of customers represent a significant portion of our revenues and, if we were to lose one of our major licensees or customers or experience any material reduction in orders from any of our customers, our revenues and operating results would suffer . Sales to our top 10 customers and licensees accounted for more than 52%, 50%, and 55% of our total revenues during the fiscal years 2006, 2005 and 2004, respectively. No customer exceeded 10% of total revenues in any of these periods except Best Buy, which accounted for 11% of our total revenues in fiscal 2005. If we were to lose one of our major licensees or customers or experience any material reduction in orders from any of our customers or in sales of licensed products by our licensees, our revenues and operating results would suffer. Additionally, our license and royalty revenues may decline significantly in the future as our existing license agreements expire. Our sales are generally made from standard purchase orders rather than long-term contracts. Accordingly, our customers may generally terminate or reduce their purchases from us at any time without notice or penalty. In addition, the composition of our major customer base changes from year-to-year as we enter new markets making our revenues from several customers somewhat less predictable from year-to-year.
Our business depends significantly upon sales of products in the highly competitive consumer market, a significant portion of which are made to retailers and through distributors, and if our distributors, and, retailers are not successful in this market, we could experience substantial product returns, which would negatively impact our business, financial condition and results of operations. A significant portion of our sales are made through retailers, either directly or through distributors. Sales through these channels typically include rights to return unsold inventory and protection against price declines. As a result, we do not recognize revenue until after the product has been sold through to the end user, in the case of sales to retailers, or to our distributors’ customers, in the case of sales to distributors. If our distributors and retailers are not successful, we could experience reduced sales as well as substantial product returns or price protection claims, which would harm our business, financial condition and results of operations. Availability of sell-through data varies throughout the retail channel, which makes it difficult for us to forecast retail product revenues. Our arrangements with our customers also provide them price protection against declines in our recommended selling prices, which has the effect of reducing our deferred revenue and eventually our revenue. Except in limited circumstances, we do not have exclusive relationships with our retailers or distributors, and therefore, must rely on them to effectively sell our products over those of our competitors.
Our revenue depends in part on the success of products sold by our OEM customers. An increasing portion of our sales are to OEMs, which can either bundle or embed our flash memory products with their products, such as cameras or mobile phones. Our sales to these customers are dependent upon the OEMs choosing our products over those of our competitors and on the OEMs’ ability to create, introduce, market and sell its products successfully in their markets. Should our OEM customers be unsuccessful in selling their current or future products that include our products, or should they decide to discontinue utilizing our products, our results of operation and financial condition could be harmed. Our future OEM revenues may be significantly impacted by our decision to de-emphasize the former msystems private label USB business and focus on our branded business.
The continued growth of our business depends on the development of new markets and products for NAND flash memory and continued elasticity in our existing markets . Over the last several years, we derived the majority of our revenues from the digital camera market. This market continues to experience slower growth rates and continues to represent a declining percentage of our total revenue, and therefore, our growth will be increasingly dependent on the development of new markets, new applications and new products for NAND flash memory. For example, in fiscal 2006, our revenue from the digital camera market grew by only 2% over the prior year, and it is possible that our revenue from this market could decline in future years. Newer markets for flash memory include digital audio and video players, mobile phones and solid state drives. There can be no assurance that new markets and products will develop and grow fast enough, or that new markets will adopt NAND flash technologies in general or our products in particular, to enable us to continue our growth. There can be no assurance that the increase in average product capacity and unit demand in response to price reductions will continue to generate revenue growth for us as it has in the past.
We continually seek to develop new applications, products, technologies and standards, which may not be widely adopted by consumers or, if adopted, may reduce demand by consumers for our older products . We continually seek to develop new
applications, products and standards and enhance existing products and standards with higher memory capacities and other enhanced features. Any new applications, products, technologies, standards or enhancements we develop may not be commercially successful. New applications, such as the adoption of flash memory cards in mobile phones, can take several years to develop. Early success in working with mobile phone manufacturers to add card slots to their mobile phones does not guarantee that consumers will adopt memory cards used for storing songs, images and other content in mobile phones. Our new products, such as Sansa ® View, pre-recorded flash memory cards and solid state drives, may not gain market acceptance and we may not be successful in penetrating the new markets that we target. As we introduce new standards or technologies, such as TrustedFlash, it can take time for these new standards or technologies to be adopted, for consumers to accept and transition to these new standards or technologies and for significant sales to be generated from them, if this happens at all. Moreover, broad acceptance of new standards, technologies or products by consumers may reduce demand for our older products. If this decreased demand is not offset by increased demand for our other form factors or our new products, our results of operations could be harmed.
We face competition from numerous manufacturers and marketers of products using flash memory, as well as from manufacturers of new and alternative technologies, and if we cannot compete effectively, our results of operations and financial condition will suffer . Our competitors include many large domestic and international companies that have greater access to advanced wafer manufacturing capacity and substantially greater financial, technical, marketing and other resources than we do, which allows them to produce flash memory chips in high volumes at low costs and to sell these flash memory chips themselves or to our flash card competitors at a low cost. Some of our competitors may sell their flash memory chips at or below their true manufacturing costs to gain market share and to cover their fixed costs. Such practices have been common in the DRAM industry during periods of excess supply, and have resulted in substantial losses in the DRAM industry. Our primary semiconductor competitors include Samsung, Toshiba, Hynix, IM Flash and STMicro. Samsung, in addition to ramping its overall NAND output, continues to ramp its MLC output. In addition, Hynix, is aggressively ramping NAND output and IM Flash, is expected to produce significant NAND output in the future. All leading suppliers, including ourselves, have been substantially increasing NAND capacity, which is resulting in prices declining at a faster rate than cost reductions. We cannot predict when the balance between supply and demand will be achieved. In addition, current and future competitors produce or could produce alternative flash memory technologies that compete against our NAND flash memory technology which may reduce demand or accelerate price decline for NAND. If the balance between supply and demand is not achieved or if pricing continues to decline at a rate faster than cost reduction, our results of operations and financial condition could be harmed.
We also compete with flash memory card manufacturers and resellers. These companies purchase, or have a captive supply of, flash memory components and assemble memory cards. Our primary competitors currently include, among others, A-Data, Buffalo Technology, Fuji, Hagiwara, Hama, I/O Data, KingMax, Kingston, Kodak, Lexar, Matsushita, Micron, Netac, Panasonic, PNY, Ritek, Samsung, Sony, Toshiba, Tradebrands and Transcend.
Some of our competitors have substantially greater resources than we do, have well recognized brand names or have the ability to operate their business on lower margins than we do. The success of our competitors may adversely affect our future sales revenues and may result in the loss of our key customers. For example, Toshiba and other manufacturers have recently increased their market share in the mobile market, including the microSD card, which has been a significant driver of our growth. In the digital audio market, we face competition from well established companies such as Apple and Microsoft. In the USB market we face competition from a large number of players including Kingston, Lexar, Memorex and PNY, among others.
Furthermore, many companies are pursuing new or alternative technologies, such as phase-change technology, charge-trap flash and millipedes/probes, which may compete with flash memory. For example, two of our competitors are advocating charge-trap flash technology, which if successful and if we are unable to scale our technology on an equivalent basis, could provide an advantage to these competitors.
These new or alternative technologies may provide smaller size, higher capacity, reduced cost, lower power consumption or other advantages. If we cannot compete effectively, our results of operations and financial condition will suffer.
We have patent cross-license agreements with several of our leading competitors. Under these agreements, we have enabled competitors to manufacture and sell products that incorporate technology covered by our patents. If we continue to license our patents to our competitors, competition may increase and may harm our business, financial condition and results of operations.
We believe that our ability to compete successfully depends on a number of factors, including:
| • | price, quality and on-time delivery to our customers; | ||
| • | product performance, availability and differentiation; | ||
| • | success in developing new applications and new market segments; | ||
| • | sufficient availability of supply; | ||
| • | efficiency of production; | ||
| • | timing of new product announcements or introductions by us, our customers and our competitors; | ||
| • | the ability of our competitors to incorporate standards or develop formats which we do not offer; | ||
| • | the number and nature of our competitors in a given market; | ||
| • | successful protection of intellectual property rights; and | ||
| • | general market and economic conditions. |
While we believe we are well-positioned to compete in the marketplace, there can be no assurance that we will be able to compete successfully in the future.
The semiconductor industry is subject to significant downturns that have harmed our business, financial condition and results of operations in the past and may do so in the future . The semiconductor industry is highly cyclical and is characterized by constant and rapid technological change, rapid product obsolescence and price declines, evolving standards, short product life cycles and wide fluctuations in product supply and demand. The industry has experienced significant downturns, often in connection with, or in anticipation of, maturing product cycles of both semiconductor companies’ and their customers’ products and declines in general economic conditions. These downturns have been characterized by diminished product demand, production overcapacity, high inventory levels and accelerated declines in selling prices. We have experienced these conditions in our business in the past and may experience such downturns in the future.
Our business and the markets we address are subject to significant fluctuations in supply and demand and our commitments to our ventures with Toshiba may result in periods of significant excess inventory . With the ramp to volume production at Fab 3 in fiscal 2006, our captive memory supply increased substantially more than in either of the last two years. Our obligation to purchase 50% of the supply from FlashVision, Flash Partners and Flash Alliance, the ventures with Toshiba, could harm our business and results of operations if our committed supply exceeds demand for our products. The adverse effects could include, among other things, significant decreases in our product prices, significant excess, obsolete or lower of cost or market inventory write-downs and the impairment of our investments in the ventures with Toshiba. For example, in the fourth quarter of fiscal 2006, over 90% of our NAND memory wafer purchases were from our ventures with Toshiba. These effects will be magnified once the Flash Alliance venture commences production. Any future excess supply could have a material adverse effect on our business, financial condition and results of operations.
We depend on third-party foundries for silicon supply and any shortage or disruption in our supply from these sources will reduce our revenues, earnings and gross margins. All of our flash memory card products require silicon supply for the memory and controller components. The substantial majority of our flash memory is currently supplied by our ventures with Toshiba and by Toshiba pursuant to our foundry agreement, and to a lesser extent by Samsung and Hynix. Any disruption in supply of flash memory from our captive or non-captive sources would harm our operating results. We intend to increase production at Fab 3, commence production at Fab 4 and continue to procure wafers from non-captive sources. If the Fab 3 production ramp does not increase as anticipated, we fail to commence production at Fab 4 as planned, Fab 4 does not meet anticipated manufacturing output, or our non-captive sources fail to supply wafers in the amounts and at the times we expect, we may not have sufficient supply to meet demand and our operating results could be harmed. Currently, our controller wafers are only manufactured by Tower and UMC, and some of these controllers are sole-sourced at either UMC or Tower. Any disruption in the manufacturing operations of Tower or UMC would result in delivery delays, would adversely affect our ability to make timely shipments of our products and would harm our operating results until we could qualify an alternate source of supply for our controller wafers,
which could take three or more quarters to complete. In times of significant growth in global demand for flash memory, demand from our customers may outstrip the supply of flash memory and controllers available to us from our current sources. If our silicon vendors are unable to satisfy our requirements on competitive terms or at all due to lack of capacity, technological difficulties, natural disaster, financial difficulty, power failure, labor unrest, their refusal to do business with us, their relationships with our competitors or other causes, we may lose potential sales and our business, financial condition and operating results may suffer. In addition, these risks are magnified at Toshiba’s Yokkaichi, Japan operations, where the current ventures are operated, Fab 4 is being constructed, and Toshiba’s foundry capacity is located. Earthquakes and power outages have resulted in production line stoppage and loss of wafers in Yokkaichi and similar stoppages and losses may occur in the future. For example, in the first quarter of fiscal 2006, a brief power outage in Fab 3 resulted in a loss of wafers and significant costs associated with bringing the fab back on line. Also, the Tower fabrication facility, from which we source controller wafers, is facing financial challenges and is located in Israel, an area of political and military turmoil. Any disruption or delay in supply from our silicon sources could significantly harm our business, financial condition and results of operations.
If actual manufacturing yields are lower than our expectations, this may result in increased costs and product shortages . The fabrication of our products requires wafers to be produced in a highly controlled and ultra clean environment. Semiconductor manufacturing yields and product reliability are a function of both design technology and manufacturing process technology and production delays may be caused by equipment malfunctions, fabrication facility accidents or human errors. Yield problems may not be identified or improved until an actual product is made and can be tested. As a result, yield problems may not be identified until the wafers are well into the production process. We have from time-to-time experienced yields that have adversely affected our business and results of operations. We have experienced adverse yields on more than one occasion when we have transitioned to new generations of products. If actual yields are low, we will experience higher costs and reduced product supply, which could harm our business, financial condition and results of operations. For example, if the production ramp and/or yield of the 56-nanometer, 300-millimeter Flash Partners’ wafers do not increase as expected, we may not have enough supply to meet demand and our cost competitiveness, business, financial condition and results of operations will be harmed.
We depend on our third-party subcontractors and our business could be harmed if our subcontractors do not perform as planned . We rely on third-party subcontractors for our wafer testing, IC assembly, packaged testing, product assembly, product testing and order fulfillment. From time-to-time, our subcontractors have experienced difficulty in meeting our requirements. If we are unable to increase the capacity of our current subcontractors or qualify and engage additional subcontractors, we may not be able to meet demand for our products. We do not have long-term contracts with our existing subcontractors nor do we expect to have long-term contracts with any new subcontract suppliers. We do not have exclusive relationships with any of our subcontractors, and therefore, cannot guarantee that they will devote sufficient resources to manufacturing our products. We are not able to directly control product delivery schedules. Furthermore, we manufacture on a turnkey basis with some of our subcontract suppliers. In these arrangements, we do not have visibility and control of their inventories of purchased parts necessary to build our products or of the progress of our products through their assembly line. Any significant problems that occur at our subcontractors, or their failure to perform at the level we expect, could lead to product shortages or quality assurance problems, either of which would have adverse effects on our operating results.
We are constructing a captive assembly and test manufacturing facility in China. The Chinese government recently approved a 50-year lease by us of a piece of land to construct and equip a captive assembly and test manufacturing facility in the Zizhu Science-Based Park near Shanghai, China. Our anticipated expenditure for this project is approximately $170 million, of which approximately $150 million is expected to be paid in fiscal 2007. Any delays in the construction and equipping of the facility would harm our results of operations and financial condition. Once constructed, this facility is only intended to replace a portion of our test and assembly needs and therefore, we will continue to depend on our third-party subcontractors for a majority of our test and assembly needs.
In transitioning to new processes, products and silicon sources, we face production and market acceptance risks that have caused, and may in the future continue to cause significant product delays that could harm our business . Successive generations of our products have incorporated semiconductors with greater memory capacity per chip. The transition to new generations of products, such as the 56-nanometer 8 and 16 gigabit MLC chip, which we expect to begin shipping in volume in fiscal 2007, is highly complex and requires new controllers, new test procedures and modifications of numerous aspects of manufacturing, as well as extensive qualification of the new products by both us and our OEM customers. In addition, Flash Partners is currently ramping the 56-nanometer 8 gigabit MLC chip in the Yokkaichi, Japan 300-millimeter fab and this transition is subject to yield, quality and output risk. Furthermore, procurement of MLC wafers from non-captive sources requires us to develop new controller technologies and may result in inadequate quality or performance in our products that integrate these MLC components. Any material delay in a development or qualification schedule could delay deliveries and adversely impact our
operating results. We periodically have experienced significant delays in the development and volume production ramp-up of our products. Similar delays could occur in the future and could harm our business, financial condition and results of operations.
Our products may contain errors or defects, which could result in the rejection of our products, product recalls, damage to our reputation, lost revenues, diverted development resources and increased service costs and warranty claims and litigation. Our products are complex, must meet stringent user requirements, may contain errors or defects and the majority of our products are warrantied for one to five years. Errors or defects in our products may be caused by, among other things, errors or defects in the memory or controller components, including components we procure from non-captive sources such as the MLC products we procure from a third-party supplier. In addition, in the fourth quarter of fiscal year 2006, over 90% of our NAND memory purchases were from our captive ventures with Toshiba and if the wafers contain errors or defects, our overall supply could be adversely affected. These factors could result in the rejection of our products, damage to our reputation, lost revenues, diverted development resources, increased customer service and support costs and warranty claims and litigation. We record an allowance for warranty and similar costs in connection with sales of our product, but actual warranty and similar costs may be significantly higher than our recorded estimate and result in an adverse effect on our results of operations and financial condition.
Our new products have from time-to-time been introduced with design and production errors at a rate higher than the error rate in our established products. We must estimate warranty and similar costs for new products without historical information and actual costs may significantly exceed our recorded estimates. Underestimation of our warranty and similar costs would have an adverse effect on our results of operations and financial condition.
We and Toshiba plan to continue to expand the wafer fabrication capacity of the Flash Partners business venture and have formed a new venture, Flash Alliance, for which we will make substantial capital investments and incur substantial start-up and tool relocation costs, which could adversely impact our operating results. We and Toshiba are making, and plan to continue to make, substantial investments in new capital assets to expand the wafer fabrication capacity of our Flash Partners business venture in Japan. We and Toshiba intend to invest $1.76 billion to continue expansion at Fab 3 to bring wafer capacity to 135,000 wafers per month by the end of fiscal year 2007 and are cooperating in the construction of an additional 300-millimeter NAND wafer fabrication facility, Fab 4, to produce NAND flash memory products for the parties under the Flash Alliance venture. We and Toshiba intend to invest 300 billion Japanese yen, or approximately $2.5 billion, based on the exchange rate at December 31, 2006, in the construction and equipping of Fab 4. Moreover, each time that we and Toshiba add substantial new wafer fabrication capacity, we will experience significant initial design and development and start-up costs as a result of the delay between the time of the investment and the time qualified products are manufactured and sold in volume quantities. For several quarters, we will incur initial design and development costs and start-up costs and pay our share of ongoing operating activities even if we do not achieve the planned output volume or utilize our full share of the expanded output, and these costs will impact our gross margins, results of operations and financial condition.
There is no assurance that Flash Partners’ 300-millimeter NAND flash memory facility will perform as expected, in particular as we transition to new lithography feature sizes . The Flash Partners’ 300-millimeter fab, Fab 3, is currently transitioning from 70-nanometer to 56-nanometer feature sizes. There can be no assurance that this transition will occur on schedule or at the yields or costs that we anticipate. This technology transition is difficult and subject to significant risks in terms of schedule, yield and cost. If Flash Partners, or in the future, Flash Alliance, encounters difficulties in transitioning to new technologies, our cost per megabyte may not remain competitive with the costs achieved by other NAND flash memory producers. Also, Samsung is licensed under our patents to use MLC technology, which enhances its manufacturing capabilities. Samsung began shipping NAND/MLC products in the third quarter of fiscal year 2005 and may be able to produce product at a lower cost than we can and increase their market share, thus adversely affecting our operating results and financial condition.
We have a contingent indemnification obligation and guarantee obligations related to the ventures with Toshiba. Toshiba has guaranteed FlashVision’s lease arrangement with third-party lessors. The total minimum remaining lease payments as of December 31, 2006 were 5.8 billion Japanese yen, or approximately $48.6 million based upon the exchange rate at December 31, 2006. If Toshiba makes payments under its guarantee, we have agreed to indemnify Toshiba for 49.9% of its costs, subject to certain limitations and exclusions.
In December 2004, December 2005, June 2006 and September 2006, Flash Partners entered into four separate equipment lease facilities totaling approximately 215.0 billion Japanese yen, or approximately $1.8 billion based upon the exchange rate at December 31, 2006, of which, as of December 31, 2006, 144.0 billion Japanese yen, or approximately $1.2 billion based upon the exchange rate at December 31, 2006, net of accumulated lease payments, had been drawn down. As of December 31, 2006, our cumulative guarantee under the equipment leases, net of cumulative lease payments, was approximately 72.0 billion Japanese yen, or approximately $605 million based on the exchange rate at December 31, 2006. On January 10, 2007, Flash Partners drew down the remaining balance of the September 2006 master lease agreement in the amount of approximately 52.0 billion Japanese yen, or approximately $437 million, based on the exchange rate at December 31, 2006, of which we guaranteed 26.0 billion Japanese yen, or approximately $218 million based upon the exchange rate at December 31, 2006. These leases contain default clauses which, if triggered, could cause us to repay the amounts due under our guarantees. If our corporate rating is significantly downgraded by any rating agency, it may impair the ability of our ventures with Toshiba to obtain future equipment lease financings on terms consistent with current leases and would cause a default under certain current leases, either of which could harm our business and financial condition.
We and Toshiba have also agreed to mutually contribute to, and indemnify each other, Flash Partners and Flash Alliance for environmental remediation costs or liability resulting from Flash Partners’ and Flash Alliance’s manufacturing operations in certain circumstances. In addition, we and Toshiba entered into a Patent Indemnification Agreement under which in many cases we will share in the expenses associated with the defense and cost of settlement associated with such claims. This agreement provides limited protection for us against third-party claims that NAND flash memory products manufactured and sold by Flash Partners or Flash Alliance infringe third-party patents.
None of the foregoing obligations are reflected as liabilities on our consolidated balance sheets. If we have to perform our obligations under these agreements, our business will be harmed and our financial condition and results of operations will be adversely affected.
Seasonality in our business may result in our inability to accurately forecast our product purchase requirements . Sales of our products in the consumer electronics market are subject to seasonality. For example, sales have typically increased significantly in the fourth quarter of each year, sometimes followed by declines in the first quarter of the following year. This may become more pronounced as sales of our Sansa digital audio player have become a larger portion of our product mix. This seasonality increases the complexity of forecasting our business. If our forecasts are inaccurate, we can lose market share or procure excess inventory or inappropriately increase or decrease our operating expenses, any of which could harm our business, financial condition and results of operations. This seasonality also may lead to higher volatility in our stock price, the need for significant working capital investments in receivables and inventory and our need to build inventory levels in advance of our most active selling seasons.
From time-to-time, we overestimate our requirements and build excess inventory, and underestimate our requirements and have a shortage of supply, both of which harm our financial results . The majority of our products are sold into consumer markets, which are difficult to accurately forecast. Also, a substantial majority of our quarterly sales are from orders received and fulfilled in that quarter. Additionally, we depend upon timely reporting from our retail and distributor customers as to their inventory levels and sales of our products in order to forecast demand for our products. Our international customers submit these reports on a monthly, not weekly, basis making it more difficult to accurately forecast demand. We have in the past significantly over-forecasted and under-forecasted actual demand for our products. The failure to accurately forecast demand for our products will result in lost sales or excess inventory both of which will have an adverse effect on our business, financial condition and results of operations. In addition, at times inventory may increase in anticipation of increased demand or as captive wafer capacity ramps. If demand does not materialize, we may be forced to write-down excess inventory which may harm our financial condition and results of operations.
Under conditions of tight flash memory supply, we may be unable to adequately increase our production volumes or secure sufficient supply in order to maintain our market share. If we are unable to maintain market share, our results of operations and
financial condition could be harmed. Conversely, during periods of excess supply in the market for our flash memory products, we may lose market share to competitors who aggressively lower their prices.
Our ability to respond to changes in market conditions from our forecast is limited by our purchasing arrangements with our silicon sources. These arrangements generally provide that the first three months of our rolling six-month projected supply requirements are fixed and we may make only limited percentage changes in the second three months of the period covered by our supply requirement projections.
We are sole-sourced for a number of our critical components and the absence of a back-up supplier exposes our supply chain to unanticipated disruptions. We rely on our vendors, some of which are a sole source of supply, for many of our critical components. We do not have long-term supply agreements with most of these vendors. Our business, financial condition and operating results could be significantly harmed by delays or reductions in shipments if we are unable to develop alternative sources or obtain sufficient quantities of these components.
We are exposed to foreign currency risks. Our purchases of NAND flash memory from the Toshiba ventures and our investments in those ventures are denominated in Japanese yen. Our sales, however, are primarily denominated in U.S. dollars or other foreign currencies. Additionally, we expect over time to increase the percentage of our sales denominated in currencies other than the U.S. dollar. This exposes us to significant risk from foreign currency fluctuations. Management of these foreign exchange exposures and the foreign currency forward contracts used to mitigate these exposures is complex and if we do not successfully manage our foreign exchange exposures, our business, results of operations and financial condition could be harmed.
Terrorist attacks, war, threats of war and government responses thereto may negatively impact our operations, revenues, costs and stock price . Terrorist attacks, U.S. military responses to these attacks, war, threats of war and any corresponding decline in consumer confidence could have a negative impact on consumer retail demand, which is the largest channel for our products. Any of these events may disrupt our operations or those of our customers and suppliers and may affect the availability of materials needed to manufacture our products or the means to transport those materials to manufacturing facilities and finished products to customers. Any of these events could also increase volatility in the U.S. and world financial markets, which could harm our stock price and may limit the capital resources available to us and our customers or suppliers or adversely affect consumer confidence. In November 2006, we acquired msystems, which is headquartered and has substantial operations in Israel, and we have a development center in Northern Israel, near the border with Lebanon, areas that have recently experienced significant violence and political unrest. Continued turmoil and unrest in this area could cause delays in the development of our products. This could harm our business and results of operations.
Natural disasters or epidemics in the countries in which we or our suppliers or subcontractors operate could negatively impact our operations. Our operations, including those of our suppliers and subcontractors, are concentrated in Milpitas, California; Yokkaichi, Japan; Hsinchu and Taichung, Taiwan; and Dongguan, Shanghai and Shenzen, China. In the past, these areas have been affected by natural disasters such as earthquakes, tsunamis and typhoons, and some areas have been affected by epidemics, such as avian flu. If a natural disaster or epidemic were to occur in one or more of these areas, our operations could be significantly impaired and our business may be harmed. This is magnified by the fact that we do not have insurance for most natural disasters, including earthquakes. This could harm our business and results of operations.
We may be unable to protect our intellectual property rights, which would harm our business, financial condition and results of operations. We rely on a combination of patents, trademarks, copyright and trade secret laws, confidentiality procedures and licensing arrangements to protect our intellectual property rights. In the past, we have been involved in significant and expensive disputes regarding our intellectual property rights and those of others, including claims that we may be infringing third-parties’ patents, trademarks and other intellectual property rights. We expect that we may be involved in similar disputes in the future. We cannot assure you that:
| • | any of our existing patents will not be invalidated; | ||
| • | patents will be issued for any of our pending applications; | ||
| • | any claims allowed from existing or pending patents will have sufficient scope or strength; |
| • | our patents will be issued in the primary countries where our products are sold in order to protect our rights and potential commercial advantage; or | ||
| • | any of our products or technologies do not infringe on the patents of other companies. |
In addition, our competitors may be able to design their products around our patents and other proprietary rights.
Several companies have recently entered or announced their intentions to enter the flash memory market, and we believe these companies may require a license from us. Enforcement of our rights may require litigation. If we bring a patent infringement action and are not successful, our competitors would be able to use similar technology to compete with us. Moreover, the defendant in such an action may successfully countersue us for infringement of their patent or assert a counterclaim that our patents are invalid or unenforceable. If we did not prevail as a defendant in patent infringement case, we could be required to pay substantial damages, cease the manufacture, use and sale of infringing products, expend significant resources to develop non-infringing technology, discontinue the use of specific processes or obtain licenses to the infringing technology.
We may be unable to license intellectual property to or from third-parties as needed, or renew existing licenses, which could expose us to liability for damages reduce our royalty revenues, increase our costs or limit or prohibit us from selling products. If we incorporate third-party technology into our products or if we are found to infringe others’ intellectual property, we could be required to license intellectual property from a third party. We may also need to license some of our intellectual property to others in order to enable us to obtain important cross-licenses to third-party patents. We cannot be certain that licenses will be offered when we need them, or that the terms offered will be acceptable, or that these licenses will help our business. If we do obtain licenses from third-parties, we may be required to pay license fees or royalty payments. In addition, if we are unable to obtain a license that is necessary to the manufacture of our products, we could be required to suspend the manufacture of products or stop our product suppliers from using processes that may infringe the rights of third-parties. We may not be successful in redesigning our products, the necessary licenses may not be available under reasonable terms, our existing licensees may not renew their licenses upon expiration and we may not be successful in signing new licensees in the future.
We are currently and may in the future be involved in litigation, including litigation regarding our intellectual property rights or those of third parties, which may be costly, may divert the efforts of our key personnel and could result in adverse court rulings, which could materially harm our business . We are involved in a number of lawsuits, including among others, several cases involving our patents and the patents of third-parties. We are the plaintiff in some of these actions and the defendant in other of these actions. Some of the actions could seek injunctions against the sale of our products and/or substantial monetary damages, which if granted or awarded, could have a material adverse effect on our business, financial condition and results of operations.
Litigation is subject to inherent risks and uncertainties that may cause actual results to differ materially from our expectations. Factors that could cause litigation results to differ include, but are not limited to, the discovery of previously unknown facts, changes in the law or in the interpretation of laws, and uncertainties associated with the judicial decision-making process. If we receive an adverse judgment in any litigation, we could be required to pay substantial damages and/or cease the manufacture, use and sale of products. Litigation, including intellectual property litigation, can be complex, can extend for a protracted period of time, and can be very expensive. Litigation initiated by us could also result in counter-claims against us, which could increase the costs associated with the litigation and result in our payment of damages or other judgments against us. In addition, litigation may divert the efforts and attention of some of our key personnel.
We have been, and expect to continue to be, subject to claims and legal proceedings regarding alleged infringement by us of the patents, trademarks and other intellectual property rights of third-parties. From time-to-time we have sued, and may in the future sue, third-parties in order to protect our intellectual property rights. Parties that we have sued and that we may sue for patent infringement may countersue us for infringing their patents. If we are held to infringe the intellectual property of others, we may need to spend significant resources to develop non-infringing technology or obtain licenses from third-parties, but we may not be able to develop such technology or acquire such licenses on terms acceptable to us or at all. We may also be required to pay significant damages and/or discontinue the use of certain manufacturing or design processes. In addition, we or our suppliers could be enjoined from selling some or all of our respective products in one or more geographic locations. If we or our suppliers are enjoined from selling any of our respective products or if we are required to develop new technologies or pay significant monetary damages or are required to make substantial royalty payments, our business would be harmed.
Moreover, from time-to-time we agree to indemnify certain of our suppliers and customers for alleged patent infringement. The scope of such indemnity varies but generally includes indemnification for direct and consequential damages and expenses, including attorneys’ fees. We may from time-to-time be engaged in litigation as a result of these indemnification obligations. Third-party claims for patent infringement are excluded from coverage under our insurance policies. A future obligation to indemnify our customers or suppliers may have a material adverse effect on our business, financial condition and results of operations. For additional information concerning legal proceedings, see Part I, Item 3, “Legal Proceedings.”
Because of our international business and operations, we must comply with numerous international laws and regulations, and we are vulnerable to political instability, currency fluctuations and other risks related to international operations. Currently, all of our products are produced overseas in China, Israel, Japan, South Korea and Taiwan. We are, therefore, affected by the political, economic and military conditions in these countries.
Specifically, China does not currently have a comprehensive and highly developed legal system, particularly with respect to the protection of intellectual property rights. This results, among other things, in the prevalence of counterfeit goods in China. The enforcement of existing and future laws and contracts remains uncertain, and the implementation and interpretation of such laws may be inconsistent. Such inconsistency could lead to piracy and degradation of our intellectual property protection. Although we have increased our efforts to prevent counterfeit products from entering the market, those efforts may not be successful. Our results of operations and financial condition could be harmed by the sale of counterfeit products.
Our international business activities could also be limited or disrupted by any of the following factors:
| • | the need to comply with foreign government regulation; | ||
| • | general geopolitical risks such as political and economic instability, potential hostilities and changes in diplomatic and trade relationships; | ||
| • | natural disasters affecting the countries in which we conduct our business, particularly Japan, such as the earthquakes experienced in Taiwan in 1999, in Japan in 2004, 2003 and previous years, and in China in previous years; | ||
| • | reduced sales to our customers or interruption to our manufacturing processes in the Pacific Rim that may arise from regional issues in Asia; | ||
| • | imposition of regulatory requirements, tariffs, import and export restrictions and other barriers and restrictions; | ||
| • | imposition of additional duties, charges and/or fees related to customs entries for our products, which are all manufactured offshore; | ||
| • | inability to successfully manage our foreign exchange exposures; | ||
| • | longer payment cycles and greater difficulty in accounts receivable collection; | ||
| • | adverse tax rules and regulations; | ||
| • | weak protection of our intellectual property rights; and | ||
| • | delays in product shipments due to local customs restrictions. |
Tower Semiconductor’s Financial Situation is Challenging. Tower supplies a significant portion of our controller wafers from its Fab 2 facility and is currently a sole source of supply for some of our controllers. Tower’s Fab 2 is operational and in the process of expanding capacity and our ability to continue to obtain sufficient supply on a cost-effective basis may be dependent upon completion of this capacity expansion. Tower’s continued expansion of Fab 2 requires sufficient funds to operate in the short-term and raising the funds required to implement the current ramp-up plan. If Tower fails to comply with the financial ratios and covenants contained in the amended credit facility agreement with its banks, fails to attract additional customers, fails to operate its Fab 2 facility in a cost-effective manner, fails to secure additional financing, fails to meet the conditions to receive government grants and tax benefits approved for Fab 2, or fails to obtain the approval of the Israeli Investment Center for a new
expansion program, Tower’s continued operations could be at risk. If this occurs, we will be forced to source our controllers from another supplier and our business, financial condition and results of operations may be harmed. Specifically, our ability to supply a number of products would be disrupted until we were able to transition manufacturing and qualify a new foundry with respect to controllers that are currently sole sourced at Tower, which could take three or more quarters to complete.
We have recognized cumulative losses of approximately $54.1 million as a result of the other-than-temporary decline in the value of our investment in Tower ordinary shares, $12.2 million as a result of the impairment in value on our prepaid wafer credits and $1.3 million of losses on our warrant to purchase Tower ordinary shares as of December 31, 2006. We are subject to certain restrictions on the transfer of our approximately 12.8 million Tower ordinary shares including certain rights of first refusal, and through January 2008, have agreed to maintain minimum shareholdings. It is possible that we will record further write-downs of our investment, which was carried on our consolidated balance sheet at $17.5 million at December 31, 2006, which would harm our results of operations and financial condition.
Our stock price has been, and may continue to be, volatile, which could result in investors losing all or part of their investments . The market price of our stock has fluctuated significantly in the past and may continue to fluctuate in the future. We believe that such fluctuations will continue as a result of many factors, including future announcements concerning us, our competitors or principal customers regarding financial results or expectations, technological innovations, industry supply dynamics, new product introductions, governmental regulations, the commencement or results of litigation or changes in earnings estimates by analysts. In addition, in recent years the stock market has experienced significant price and volume fluctuations and the market prices of the securities of high technology and semiconductor companies have been especially volatile, often for reasons outside the control of the particular companies. These fluctuations as well as general economic, political and market conditions may have an adverse affect on the market price of our common stock as well as the price of our outstanding convertible notes and could impact the likelihood of those notes being converted into our common stock, which would cause further dilution to our stockholders.
We may make acquisitions that are dilutive to existing stockholders, result in unanticipated accounting charges or otherwise adversely affect our results of operations, and result in difficulties in assimilating and integrating the operations, personnel, technologies, products and information systems of acquired companies or businesses. We continually evaluate and explore strategic opportunities as they arise, including business combinations, strategic partnerships, collaborations, capital investments and the purchase, licensing or sale of assets. If we issue equity securities in connection with an acquisition, the issuance may be dilutive to our existing stockholders. Alternatively, acquisitions made entirely or partially for cash would reduce our cash reserves.
Acquisitions may require significant capital infusions, typically entail many risks and could result in difficulties in assimilating and integrating the operations, personnel, technologies, products and information systems of acquired companies. In order to realize the intended benefits of our recent acquisitions of msystems and Matrix, we will have to successfully integrate and retain key msystems and Matrix personnel. We may experience delays in the timing and successful integration of acquired technologies and product development through volume production, unanticipated costs and expenditures, changing relationships with customers, suppliers and strategic partners, or contractual, intellectual property or employment issues. In addition, key personnel of an acquired company may decide not to work for us. The acquisition of another company or its products and technologies may also result in our entering into a geographic or business market in which we have little or no prior experience. These challenges could disrupt our ongoing business, distract our management and employees, harm our reputation, subject us to an increased risk of intellectual property and other litigation and increase our expenses. These challenges are magnified as the size of the acquisition increases, and we cannot assure you that we will realize the intended benefits of any acquisition. Acquisitions may require large one-time charges and can result in increased debt or contingent liabilities, adverse tax consequences, substantial depreciation or deferred compensation charges, the amortization of identifiable purchased intangible assets or impairment of goodwill, any of which could have a material adverse effect on our business, financial condition or results of operations.
Mergers and acquisitions of high-technology companies are inherently risky and subject to many factors outside of our control, and no assurance can be given that our previous or future acquisitions will be successful and will not materially adversely affect our business, operating results, or financial condition. Failure to manage and successfully integrate acquisitions could materially harm our business and operating results. Even when an acquired company has already developed and marketed products, there can be no assurance that such products will be successful after the closing, will not cannibalize sales of our existing products, that product enhancements will be made in a timely fashion or that pre-acquisition due diligence will have
identified all possible issues that might arise with respect to such company. See “There are numerous risks associated with our acquisition of msystems.”
Our success depends on key personnel, including our executive officers, the loss of whom could disrupt our business . Our success greatly depends on the continued contributions of our senior management and other key research and development, sales, marketing and operations personnel, including Dr. Eli Harari, our founder, president and chief executive officer. We do not have employment agreements with any of our executive officers and they are free to terminate their employment with us at any time. Our success will also depend on our ability to recruit additional highly skilled personnel. We may not be successful in hiring or retaining key personnel and our key personnel may not remain employed with us.
To manage our growth, we may need to improve our systems, controls and procedures and relocate portions of our business to new or larger facilities . We have experienced and may continue to experience rapid growth, which has placed, and could continue to place a significant strain on our managerial, financial and operations resources and personnel. Our number of employees, including management-level employees, has increased significantly, due to our acquisition of msystems. We must continue to improve our operational, accounting and financial systems and managerial controls and procedures, including fraud procedures, and we will need to continue to expand, as well as, train and manage our workforce. From time-to-time, we may need to relocate portions of our business to new or larger facilities, which could result in disruption of our business or operations. For example, in May 2006, we relocated our corporate headquarters and significant engineering operations, including labs and data centers, to new facilities in Milpitas, California. If we do not manage our growth effectively, including transitions to new or larger facilities, our business could be harmed.
We may need to raise additional financing, which could be difficult to obtain, and which if not obtained in satisfactory amounts may prevent us from funding the ventures with Toshiba, increasing our wafer supply, developing or enhancing our products, taking advantage of future opportunities, growing our business or responding to competitive pressures or unanticipated industry changes, any of which could harm our business . We currently believe that we have sufficient cash resources to fund our operations as well as our investments in the ventures with Toshiba for at least the next twelve months; however, we may in the future raise additional funds, including funds to meet our obligations with respect to Flash Partners and Flash Alliance, and we cannot be certain that we will be able to obtain additional financing on favorable terms, if at all. From time-to-time, we may decide to raise additional funds through public or private debt, equity or lease financings. If we issue additional equity securities, our stockholders will experience dilution and the new equity securities may have rights, preferences or privileges senior to those of existing holders of common stock. If we raise funds through debt or lease financing, we will have to pay interest and may be subject to restrictive covenants, which could harm our business. If we cannot raise funds on acceptable terms, if and when needed, we may not be able to develop or enhance our products, fulfill our obligations to Flash Partners and Flash Alliance, take advantage of future opportunities, grow our business or respond to competitive pressures or unanticipated industry changes, any of which could have a negative impact on our business.
Anti-takeover provisions in our charter documents, stockholder rights plan and in Delaware law could discourage or delay a change in control and, as a result, negatively impact our stockholders. We have taken a number of actions that could have the effect of discouraging a takeover attempt. For example, we have a stockholders’ rights plan that would cause substantial dilution to a stockholder, and substantially increase the cost paid by a stockholder, who attempts to acquire us on terms not approved by our board of directors. This could discourage an acquisition of us. In addition, our certificate of incorporation grants our board of directors the authority to fix the rights, preferences and privileges of and issue up to 4,000,000 shares of preferred stock without stockholder action (2,000,000 of which have already been reserved under our stockholder rights plan). Issuing preferred stock could have the effect of making it more difficult and less attractive for a third party to acquire a majority of our outstanding voting stock. Preferred stock may also have other rights, including economic rights senior to our common stock that could have a material adverse effect on the market value of our common stock. In addition, we are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law. This section provides that a corporation may not engage in any business combination with any interested stockholder during the three-year period following the time that a stockholder became an interested stockholder. This provision could have the effect of delaying or discouraging a change of control of SanDisk.
Unanticipated changes in our tax provisions or exposure to additional income tax liabilities could affect our profitability. We are subject to income taxes in the United States and numerous foreign jurisdictions. Our tax liabilities are affected by the amounts we charge for inventory, services, licenses, funding and other items in intercompany transactions. We are subject to ongoing tax audits in various jurisdictions. Tax authorities may disagree with our intercompany charges or other matters and assess additional taxes. We regularly assess the likely outcomes of these audits in order to determine the appropriateness of our tax provision. However, there can be no assurance that we will accurately predict the outcomes of these audits, and the actual
outcomes of these audits could have a material impact on our net income or financial condition. In addition, our effective tax rate in the future could be adversely affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, changes in tax laws and the discovery of new information in the course of our tax return preparation process. In particular, the carrying value of deferred tax assets, which are predominantly in the United States, is dependent on our ability to generate future taxable income in the United States. Any of these changes could affect our profitability. Furthermore, our tax provisions could be adversely affected as a result of any new interpretative accounting guidance related to accounting for uncertain tax provisions.
Changes in securities laws and regulations have increased our costs; further, in the event we are unable to satisfy regulatory requirements relating to internal control, or if our internal control over financial reporting is not effective, our business could suffer . The Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley, that became law in July 2002 required changes in our corporate governance, public disclosure and compliance practices. The number of rules and regulations applicable to us has increased and will continue to increase our legal and financial compliance costs, and has made some activities more difficult, such as approving new or amendments to our option plans. In addition, we have incurred and expect to continue to incur significant costs in connection with compliance with Section 404 of Sarbanes-Oxley regarding internal control over financial reporting. In 2007, we will incur additional costs integrating msystems into our internal control systems and procedures. These laws and regulations and perceived increased risk of liability could make it more difficult for us to attract and retain qualified members of our board of directors, particularly to serve on our audit committee, and qualified executive officers. We cannot estimate the timing or magnitude of additional costs we may incur as a result.
In connection with our certification process under Section 404 of Sarbanes-Oxley, we have identified in the past and will from time-to-time identify deficiencies in our internal control over financial reporting. We cannot assure you that individually or in the aggregate these deficiencies would not be deemed to be a material weakness. Furthermore, we may not be able to implement enhancements on a timely basis, including any enhancements necessary to integrate msystems operations, in order to prevent a failure of our internal controls or enable us to furnish future unqualified certifications. A material weakness or deficiency in internal control over financial reporting could materially impact our reported financial results and the market price of our stock could significantly decline. Additionally, adverse publicity related to the disclosure of a material weakness or deficiency in internal controls could have a negative impact on our reputation, business and stock price. Any internal control or procedure, no matter how well designed and operated, can only provide reasonable assurance of achieving desired control objectives and cannot prevent intentional misconduct or fraud.
Our debt service obligations may adversely affect our cash flow. While the 1% Notes due 2013 and the 1% Notes due 2035, are outstanding, we will have debt service obligations on the holders of the 1% Notes due 2013 and the 1% Notes due 2035 of approximately $12.3 million per year in interest payments. If we issue other debt securities in the future, our debt service obligations will increase. If we are unable to generate sufficient cash to meet these obligations and must instead use our existing cash or investments, we may have to reduce, curtail or terminate other activities of our business. We intend to fulfill our debt service obligations from cash generated by our operations, if any, and from our existing cash and investments. We may also in the future enter into other financial instruments that could increase our debt service obligations.
Our indebtedness could have significant negative consequences. For example, it could:
| • | increase our vulnerability to general adverse economic and industry conditions; | ||
| • | limit our ability to obtain additional financing; | ||
| • | require the dedication of a substantial portion of any cash flow from operations to the payment of principal of, and interest on, our indebtedness, thereby reducing the availability of such cash flow to fund our growth strategy, working capital, capital expenditures and other general corporate purposes; | ||
| • | limit our flexibility in planning for, or reacting to, changes in our business and our industry; and | ||
| • | place us at a competitive disadvantage relative to our competitors with less debt. |
We have significant financial obligations related to our ventures with Toshiba, which could impact our ability to comply with our obligations under our 1% Notes due 2013 and our 1% Notes due 2035 . We have entered into agreements to guarantee,
indemnify or provide financial support with respect to lease and certain other obligations of our ventures with Toshiba in which we have a 49.9% ownership interest. In addition, we may enter into future agreements to increase manufacturing capacity, including further expansion of Fab 3 and start-up of Fab 4. As of December 31, 2006 we had unfunded commitments of approximately $877 million to fund our various obligations under the FlashVision and Flash Partners ventures with Toshiba. As of December 31, 2006, we had indemnification and guarantee obligations for these ventures of approximately $653 million. Due to these and our other commitments, we may not have sufficient funds to make payments under or repurchase the notes.
The net share settlement feature of the 1% Notes due 2013 may have adverse consequences. The 1% Notes due 2013 are subject to net share settlement, which means that we will satisfy our conversion obligation to holders by paying cash in settlement of the lesser of the principal amount and the conversion value of the 1% Notes due 2013 and by delivering shares of our common stock in settlement of any and all conversion obligations in excess of the daily conversion values.
Our failure to convert the 1% Notes due 2013 into cash or a combination of cash and common stock upon exercise of a holder’s conversion right in accordance with the provisions of the indenture would constitute a default under the indenture. We may not have the financial resources or be able to arrange for financing to pay such principal amount in connection with the surrender of the 1% Notes due 2013 for conversion. While we currently only have debt related to the 1% Notes due 2013 and the 1% Notes due 2035 and we do not have other agreements that would restrict our ability to pay the principal amount of the 1% Notes due 2013 in cash, we may enter into such an agreement in the future, which may limit or prohibit our ability to make any such payment. In addition, a default under the indenture could lead to a default under existing and future agreements governing our indebtedness. If, due to a default, the repayment of related indebtedness were to be accelerated after any applicable notice or grace periods, we may not have sufficient funds to repay such indebtedness and amounts owing in respect of the conversion of any 1% Notes due 2013.
The convertible note hedge transactions and the warrant option transactions may affect the value of the notes and our common stock . We have entered into convertible note hedge transactions with Morgan Stanley & Co. International Limited and Goldman, Sachs & Co., or the dealers. These transactions are expected to reduce the potential dilution upon conversion of the notes. We used approximately $67.3 million of the net proceeds of funds received from the 1% Notes due 2013 to pay the net cost of the convertible note hedge in excess of the warrant transactions. These transactions were accounted for as an adjustment to our stockholders’ equity. In connection with hedging these transactions, the dealers or their affiliates:
| • | have entered into various over-the-counter cash-settled derivative transactions with respect to our common stock, concurrently with, and shortly after, the pricing of the notes; and | ||
| • | may enter into, or may unwind, various over-the-counter derivatives and/or purchase or sell our common stock in secondary market transactions following the pricing of the notes, including during any observation period related to a conversion of notes. |
The dealers or their affiliates are likely to modify their hedge positions from time-to-time prior to conversion or maturity of the notes by purchasing and selling shares of our common stock, other of our securities or other instruments they may wish to use in connection with such hedging. In particular, such hedging modification may occur during any observation period for a conversion of the 1% Notes due 2013, which may have a negative effect on the value of the consideration received in relation to the conversion of those notes. In addition, we intend to exercise options we hold under the convertible note hedge transactions whenever notes are converted. To unwind their hedge positions with respect to those exercised options, the dealers or their affiliates expect to sell shares of our common stock in secondary market transactions or unwind various over-the-counter derivative transactions with respect to our common stock during the observation period, if any, for the converted notes.
The effect, if any, of any of these transactions and activities on the market price of our common stock or the 1% Notes due 2013 will depend in part on market conditions and cannot be ascertained at this time, but any of these activities could adversely affect the value of our common stock and the value of the 1% Notes due 2013 and, as a result, the amount of cash and the number of shares of common stock, if any, holders will receive upon the conversion of the notes.
There are numerous risks associated with our acquisition of msystems . On November 19, 2006, we acquired msystems. There are numerous risks associated with our acquisition of msystems, including the risks described below.
Although we expect that the merger will result in benefits to us, those benefits may not occur because of integration and other challenges, and failure to realize the benefits of the merger may result in the dilution of our per share operating results . Achieving the expected benefits of the merger will depend on the timely and efficient integration of our and msystems’ technology, product lines, operations, business culture and personnel. This will be particularly challenging due to the fact that msystems is headquartered in Israel and we are headquartered in California. The integration may not be completed as quickly as expected, and if we fail to effectively integrate the companies or the integration takes longer than expected, we may not achieve the expected benefits of the merger. The challenges involved in this integration include, among others:
| • | retaining the customers and sales distribution channels of both companies; | ||
| • | maintaining employee morale and retaining key employees; | ||
| • | retaining key sources of supply; | ||
| • | incorporating msystems’ technology and products into our business and future product lines; | ||
| • | integrating msystems’ sales force into our worldwide product sales network; | ||
| • | demonstrating to msystems’ customers that the merger will not result in adverse changes in pricing, customer service standards or product support; | ||
| • | coordinating research and development activities to enhance introduction of new products and technologies; | ||
| • | integrating msystems’ internal control over financial reporting with our internal control over financial reporting; | ||
| • | migrating both companies to a common enterprise resource planning information system to integrate all operations, sales and administrative activities for the combined companies in a timely and cost effective way; | ||
| • | integrating msystems’ international operations with ours; | ||
| • | integrating the business cultures of both companies; and | ||
| • | ensuring there are no delays in releasing new products to market. |
This integration effort will be international in scope, complex, time consuming and expensive, and may disrupt our respective businesses or result in the loss of customers or key employees or the diversion of the attention of management. Neither msystems nor we have experience in integrating businesses and operations of this magnitude and scope. Integration will be particularly difficult because certain key members of msystems’ senior management are no longer with the combined company. In addition, the integration process may strain our financial and managerial controls and reporting systems and procedures. This may result in the diversion of management and financial resources from our core business objectives. There can be no assurance that we and msystems will successfully integrate our respective businesses or that we will realize the anticipated benefits of the merger. If we do not realize the expected benefits of the merger, including the achievement of operating synergies, the merger could result in a reduction of our per share earnings as compared to the per share earnings that would have been achieved by us had the merger not occurred.
In addition, msystems’ headquarters and significant operations are located in Israel. Therefore, political, economic and military conditions in Israel directly affect its business and operations. We cannot predict the effect of continued or increased violence in Lebanon or Gaza, or the effect of military action elsewhere in the Middle East. Continued armed conflicts or political instability in the region would harm business conditions and could adversely affect the combined company’s results of operations. Furthermore, several countries continue to restrict or ban business with Israel and Israeli companies. These restrictive laws and policies may limit the combined company’s ability to make sales in those countries.
The merger may result in a loss of customers . We and msystems operate in a highly competitive industry, and our future performance will be affected by our ability to retain each company’s existing customers. Some of msystems’ customers are our competitors or work with our competitors and may reduce or terminate their business relationships with the combined company as
a result of the merger. msystems sells its products through OEM distribution channels, while we primarily sell our products through retail channels. msystems has a broad base of OEM customers and has substantial experience selling to those customers. In order to achieve the expected benefits of the merger, we must continue to sell, and expand sales levels, to OEM customers. We may not be able to successfully continue or expand sales through OEM channels, particularly because some of msystems’ OEM customers are competitors of ours.
We and msystems currently sell to several of the same large customers. Our ability to maintain the current level of sales of each company to these common customers may be limited by the desire of these customers to minimize their dependence on a single supplier. If common customers seek alternative suppliers for at least a portion of the products currently provided by both us and msystems, our business may be harmed.
Third-parties may terminate, alter or litigate under existing contracts or relationships with the combined company. Third-parties, including suppliers, distributors, customers, licensors, licensees and other business partners, have contracts with msystems. In addition, third-parties with whom msystems or we currently have relationships, including suppliers, distributors, customers, licensors, licensees and other business partners, may terminate, otherwise adversely modify their relationship with the combined company or enter into litigation with the combined company or msystems as a result of the merger. Among other things, this may result in the combined company suffering damages or a loss of potential future revenue and possibly losing rights that are material to our business. In order to achieve the expected benefits of the merger, we may seek to renegotiate contracts with some of msystems’ and our suppliers, distributors, customers, licensors, licensees, other business partners and other third-parties, and there is no assurance that such negotiations will be successful or that costly litigation may be avoided.
General uncertainty related to the merger could harm us . Our or msystems’ existing customers may, in response to the merger, reduce future orders, pursue other sources of supply, or delay or defer purchasing decisions. If any of the foregoing occurs, the revenues of the combined company could be lower than expected and market share could be lost. In addition, the merger may create uncertainty among important suppliers, which might lead suppliers to reduce supply or adversely modify pricing to us or msystems. Any of the foregoing could have an adverse effect on our revenues, margins and profitability which, in turn, could cause our results to be substantially below the expectations of market analysts and have an adverse impact on our stock price.
Furthermore, our and msystems’ employees may experience or perceive uncertainty about their future roles with the combined company. This may harm our and msystems’ ability to attract and retain key management, marketing, sales, technical and research and development personnel.
There is pending litigation . Actions purporting to be class and derivative actions on behalf of msystems and its shareholders were filed against us and msystems prior to the closing of the merger. See Part I, Item 3, ''Legal Proceedings.’’ We may be required to expend significa