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Cypress Semiconductor 10-Q 2005 Table of ContentsUNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended October 2, 2005
OR
Commission file number 1-10079
CYPRESS SEMICONDUCTOR CORPORATION (Exact name of registrant as specified in its charter)
198 Champion Court, San Jose, California 95134 (Address of principal executive offices and zip code)
(408) 943-2600 (Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The total number of outstanding shares of the registrant’s common stock as of October 31, 2005 was 135,532,810.
Table of ContentsINDEX
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Table of ContentsPART I – FINANCIAL INFORMATION
Forward-Looking Statements
The discussion in this Quarterly Report on Form 10-Q contains statements that are not historical in nature, but are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that involve risks and uncertainties, including, but not limited to, statements as to our projected segment and overall revenue and gross margin expectation for the fourth quarter of fiscal 2005; our ability to develop and bring to market new products; the rate of customer acceptance of Cypress and its subsidiaries’ products and our resulting market share; the general economy, including specifically the holiday demand, and its impact on the markets we serve; the changing environment and/or cycles of the semiconductor and solar power industries; the successful integration and achievement of the objectives of acquired businesses; competitive pricing; our ability to utilize and manage the wafer capacity in our manufacturing facilities; cost goals emanating from manufacturing efficiencies; the availability of raw materials, such as polysilicon, used in the manufacture of SunPower products; the financial and operational performance of our subsidiaries; the adequacy of cash and working capital; risks related to investing in development stage companies; our management of the risk related to our outstanding employee loans; our ability to manage our interest rate and exchange rate exposure; and other liquidity risks. We use words such as “anticipates,” “believes,” “expects,” “future,” “intends” and similar expressions to identify forward-looking statements. Such forward-looking statements are made as of the date hereof and are based on our current expectations, information, beliefs or intentions regarding future events and our financial performance. Except as required by law, we assume no responsibility to update any such forward-looking statements. Our actual results could differ materially from those expected, discussed or projected in the forward-looking statements for any number of reasons, including, but not limited to, the materialization of one or more of the risks set forth above or in the “Risk Factors” section in this Quarterly Report on Form 10-Q.
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Table of ContentsITEM 1. FINANCIAL STATEMENTS
CYPRESS SEMICONDUCTOR CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands, except per-share amounts) (Unaudited)
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.
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Table of ContentsCYPRESS SEMICONDUCTOR CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per-share amounts) (Unaudited)
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.
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Table of ContentsCYPRESS SEMICONDUCTOR CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited)
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.
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Table of ContentsCYPRESS SEMICONDUCTOR CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Fiscal Years
Cypress Semiconductor Corporation (“Cypress” or the “Company”) reports on a fiscal-year basis and ends its quarters on the Sunday closest to the end of the applicable calendar quarter, except in a 53-week fiscal year, in which case the additional week falls into the fourth quarter of that fiscal year. Fiscal 2005 is a 52-week year and fiscal 2004 was a 53-week year. The third quarter of fiscal 2005 ended on October 2, 2005 and the third quarter of fiscal 2004 ended on September 26, 2004.
Basis of Presentation
In the opinion of the management of the Company, the accompanying unaudited condensed consolidated financial statements contain all adjustments (consisting solely of normal recurring adjustments) necessary to state fairly the financial information included therein. The Company believes that the disclosures are adequate to make the information not misleading. However, this financial data should be read in conjunction with the audited consolidated financial statements and related notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended January 2, 2005.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
The results of operations for the three and nine months ended October 2, 2005 are not necessarily indicative of the results to be expected for the full fiscal year.
Recent Accounting Pronouncements
In May 2005, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 154, “Accounting Changes and Error Corrections,” which changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS No. 154 replaces Accounting Principles Board (“APB”) Opinion No. 20, “Accounting Changes,” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statement.” It requires retrospective application to prior period’s financial statements of a voluntary change in accounting principle unless it is impracticable. In addition, under SFAS No. 154, if an entity changes its method of depreciation, amortization, or depletion for long-lived, non-financial assets, the change must be accounted for as a change in accounting estimate effected by a change in accounting principle. SFAS No. 154 applies to accounting changes and error corrections made in fiscal years beginning after December 15, 2005. The Company does not expect the adoption of SFAS No. 154 in the first quarter of fiscal 2006 will have a material impact on its consolidated results of operations and financial condition.
In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations.” Interpretation No. 47 clarifies that an entity must record a liability for a “conditional” asset retirement obligation if the fair value of the obligation can be reasonably estimated. Interpretation No. 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. Interpretation No. 47 is effective no later than the end of the fiscal year ending after December 15, 2005. The Company is currently evaluating the provision and does not expect the adoption of Interpretation No. 47 in the fourth quarter of fiscal 2005 will have a material impact on its results of operations or financial condition.
In March 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 107, which provides guidance on the implementation of SFAS No. 123(R), “Share-Based Payment” (see discussion below). In particular, SAB No. 107 provides key guidance related to valuation methods (including assumptions such as expected volatility and expected term), the accounting for income tax effects of share-based payment arrangements upon adoption of SFAS No. 123(R), the modification of employee share options prior to the adoption of SFAS No. 123(R), the classification of compensation expense, capitalization of compensation cost related to share-based payment arrangements, first-time adoption of SFAS No. 123(R) in an interim period, and disclosures in Management’s Discussion and Analysis subsequent to the adoption of SFAS No. 123(R). SAB No. 107 became effective on March 29, 2005. It did not have a material impact on the Company’s financial statements.
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Table of ContentsIn December 2004, the FASB issued SFAS No. 123(R), which replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Under SFAS No. 123(R), companies are required to measure the compensation costs of share-based compensation arrangements based on the grant-date fair value and recognize the costs in the financial statements over the period during which employees are required to provide services. Share-based compensation arrangements include stock options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. In April 2005, the SEC postponed the implementation date to the fiscal year beginning after June 15, 2005. The Company will adopt SFAS No. 123(R) in the first quarter of fiscal 2006. SFAS No. 123(R) permits public companies to adopt its requirements using one of two methods. The Company is currently evaluating which method to adopt. The adoption of SFAS No. 123(R) will have a significant adverse impact on the Company’s results of operations, although it will have no impact on its overall financial position. The precise impact of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the Company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized for such excess tax deductions was zero for the nine months ended October 2, 2005 and September 26, 2004.
In December 2004, the FASB issued FASB Staff Position (“FSP”) No. 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004.” The American Jobs Creation Act introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to U.S. companies, provided certain criteria are met. FSP No. 109-2 provides accounting and disclosure guidance on the impact of the repatriation provision on a company’s income tax expense and deferred tax liability. The Company is currently studying the impact of the one-time foreign dividend provision and intends to complete the analysis by the end of fiscal 2005. Accordingly, the Company has not adjusted its income tax expense or deferred tax liability to reflect the tax impact of any repatriation of non-U.S. earnings it may make.
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Table of ContentsAccounting for Stock-Based Compensation
The Company has a number of stock-based employee compensation plans and accounts for these plans under the recognition and measurement principles of APB Opinion No. 25 and the related interpretation. In certain instances, the Company reflects stock-based employee compensation cost in net income (loss). If there is any compensation under APB Opinion No. 25, the expense is amortized using an accelerated method prescribed under the rules of FASB Interpretation No. 28, “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans.” The following table illustrates the effect on net income (loss) and related per-share amounts if the Company had applied the fair value recognition provisions of SFAS No. 123 to all stock-based employee awards:
Change in Accounting Estimate
During the first quarter of fiscal 2005, the Company determined that the useful lives of certain equipment and production assets used in certain of its manufacturing operations were longer than historically estimated. Accordingly, the Company revised the useful lives of the newly acquired equipment from 5 years to 7 years and the production assets from 10 months to 2 years beginning in the first quarter of fiscal 2005. Useful lives for those equipment and production assets acquired prior to the first quarter of fiscal 2005 remained unchanged. The impact of the revised useful lives resulted in a decrease of approximately $1.2 million and $2.7 million in depreciation for the three and nine months ended October 2, 2005, respectively.
NOTE 2 — BUSINESS COMBINATION
SMaL Camera Technologies, Inc. (“SMaL”)
On February 14, 2005, the Company completed the acquisition of SMaL, a company specializing in the digital imaging solutions for a variety of business and consumer applications, such as digital still cameras, automotive vision systems and mobile phone cameras. SMaL is part of the Company’s Memory and Imaging Division segment (see Note 14).
The fair value of assets acquired and liabilities assumed was recorded in the Company’s consolidated balance sheet as of February 14, 2005, the effective date of the acquisition, and the results of operations of SMaL were included in the Company’s consolidated results of operations subsequent to February 14, 2005. There were no significant differences between the accounting policies of the Company and SMaL.
The Company acquired 100% of the outstanding capital stock of SMaL in exchange for $42.5 million in cash. In addition, the Company assumed SMaL’s outstanding stock options and, in exchange, issued approximately 319,000 Cypress stock options with a fair value of $3.2 million. The fair value of the Cypress stock options was determined using the Black-Scholes model with the following assumptions: volatility of 75%, expected life of 1 to 3.75 years, and risk-free interest rate of 3.14%.
Of the total number of Cypress stock options issued, approximately 166,000 were unvested. In accordance with FASB Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation,” the intrinsic value of these unvested options, totaling $0.8 million, was excluded from the purchase consideration and accounted for as deferred stock-based compensation, which is being amortized over the remaining vesting periods.
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Table of ContentsThe following table summarizes the total purchase consideration:
The allocation of the purchase consideration was as follows:
Net tangible assets consisted of the following:
In addition to the purchase consideration, the terms of the acquisition include contingent consideration of up to approximately $22.5 million in cash through fiscal 2006. Of this amount, $1.7 million is based on employment and the achievement of certain individual performance milestones and $20.8 million is based on the achievement of certain sales milestones and employment. Such payments will be accounted for as compensation and expensed in the appropriate periods. See Note 7 for the discussion of the status of the contingent consideration.
Acquired Identifiable Intangible Assets:
The fair value of patents was determined using the royalty savings approach method, which calculated the present value of the royalty savings related to the intangible assets using a royalty rate of 5% and a discount rate of 38%. The fair value of patents is being amortized over 6 years on a straight-line basis.
The fair value attributed to purchased technology was determined using the income approach method, which was based on a discounted forecast of the estimated net future cash flows to be generated from the technology using discount rates ranging from 25% to 30%. The fair value of purchased technology is being amortized over 4 years on a straight-line basis.
The fair value attributed to customer contracts was determined using a cost approach method with a discount rate of 28%. The fair value of customer contracts is being amortized over 6 years on a straight-line basis.
The fair value attributed to non-compete agreements was determined using the income approach method, which was based on a discounted forecast of the estimated net future cash flows associated with the savings resulting from having the agreements in place, using a discount rate of 30%. The fair value of non-compete agreements is being amortized over 2 years on a straight-line basis.
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Table of ContentsIn-Process Research and Development:
The Company identified in-process research and development projects in areas for which technological feasibility had not been established and no alternative future use existed. These in-process research and development projects include the development of first generation automotive cameras and mobile phone sensors.
In assessing the projects, the Company considered key characteristics of the technology as well as its future prospects, the rate technology changes in the industry, product life cycles, and various projects’ stage of development. The Company allocated $12.3 million of the purchase price to the in-process research and development projects and wrote off the amount in the first quarter of fiscal 2005.
The value of in-process research and development was determined using the income approach method, which calculated the sum of the discounted future cash flows attributable to the projects once commercially viable using discount rates ranging from 35% to 45%, which were derived from a weighted-average cost of capital analysis and adjusted to reflect the stage of completion of the projects and the level of risks associated with the projects. The percentage of completion for each project was determined by identifying the research and development expenses invested in the project as a ratio of the total estimated development costs required to bring the project to technical and commercial feasibility. The following table summarizes certain information of each significant project as of the acquisition date:
Goodwill:
SMaL offers industry-leading digital imaging solutions for a variety of business and consumer applications. The acquisition will significantly accelerate the Company’s entry into the high-volume complimentary metal oxide semiconductor image sensor business, and SMaL’s product line will complement new mobile phone products introduced by FillFactory NV, which the Company acquired in fiscal 2004. The result could position the Company to have the broadest line of image sensors currently available for the mobile phone market. These factors primarily contributed to a purchase price which resulted in goodwill. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill is not amortized but is tested for impairment at least annually. Goodwill from the SMaL acquisition is not expected to be deductible for tax purposes.
Combined Pro Forma Information
In addition to the acquisition of SMaL during the first quarter of fiscal 2005, the Company completed the acquisition of FillFactory NV during the third quarter of fiscal 2004 and the buy-out of the minority interests in SunPower during the fourth quarter of fiscal 2004. The following unaudited pro forma financial information presents the combined results of operations of the Company, SMaL and FillFactory NV as if the acquisitions had occurred as of the beginning of the periods presented. The historical results of operations of SunPower have already been consolidated into the Company’s results beginning in fiscal 2003.
The unaudited pro forma financial information presented above should not be taken as representative of the future consolidated results of operations or financial condition of the Company.
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Table of ContentsNOTE 3 — GOODWILL AND PURCHASED INTANGIBLE ASSETS
Goodwill
During the first quarter of fiscal 2005, the Company changed its internal organization and identified five new reportable business segments (see Note 14). The following table presents the changes in the carrying amount of goodwill under the reportable business segments:
Goodwill of $21.0 million acquired during fiscal 2005 was related to SMaL (see Note 2).
Purchased Intangible Assets
The following table presents details of the Company’s total purchased intangible assets:
The estimated future amortization expense of purchased intangible assets as of October 2, 2005 was as follows:
NOTE 4 — RESTRUCTURING
Overview
The semiconductor industry has historically been characterized by wide fluctuations in demand for, and supply of, semiconductors. In some cases, industry downturns have lasted more than a year. Prior experience has shown that restructuring of operations, resulting in significant restructuring charges, may become necessary if an industry downturn persists. In addition, events and circumstances specific to the Company may result in restructuring charges.
The Company initiated a restructuring plan in the first quarter of fiscal 2005 (“Fiscal 2005 Restructuring Plan”). In addition, the Company had one other restructuring plan initiated in the fourth quarter of fiscal 2002 (“Fiscal 2002 Restructuring Plan”). The Fiscal 2002 Restructuring Plan has been substantially completed with reserves remaining for lease payments for restructured facilities. During the third quarter of fiscal 2005, the Company completed the restructuring plan initiated in the third quarter of fiscal 2001 (“Fiscal 2001 Restructuring Plan”).
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Table of ContentsFiscal 2005 Restructuring Plan
During the first quarter of fiscal 2005, management implemented the Fiscal 2005 Restructuring Plan aimed to reorganize its internal structure and reduce operating costs as the Company continued to experience softness in demand in the semiconductor industry. The Fiscal 2005 Restructuring Plan primarily includes the following initiatives:
The Company recorded total restructuring charges of $22.7 million in the first quarter of fiscal 2005, consisting of $8.8 million associated with property and equipment and $1.2 million of related selling costs, and $12.7 million associated with lease obligations and personnel costs. During the second quarter of fiscal 2005, the Company recorded additional provisions of $5.0 million, consisting of $0.1 million related to property and equipment and $4.9 million associated with lease obligations, personnel costs and other items. During the third quarter of fiscal 2005, the Company recorded additional provisions of $1.0 million, consisting of $0.9 million related to property and equipment and $0.1 million related to personnel costs.
Restructuring reserves related to lease obligations, personnel costs and other items from inception to the end of the third quarter of fiscal 2005 are summarized as follows:
Property and Equipment:
The restructuring charge of $8.8 million recorded in the first quarter of fiscal 2005 consisted of:
During the first quarter of fiscal 2005, the Company recorded charges of $5.2 million related to the write-down of property and equipment that were removed from operations, resulting in a new cost basis of $1.3 million. In addition, the Company recorded selling costs of $0.4 million. These assets consisted primarily of manufacturing and test equipment located in the Company’s manufacturing facility in Minnesota, as well as manufacturing and test equipment and prototype tools previously used in operations by Silicon Light Machines and SunPower, two subsidiaries of Cypress. As management has committed to plans to dispose of the assets by sale, the Company classified the assets as held for sale and recorded the assets at the lower of their carrying amount or fair value less costs to
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Table of Contentssell. Fair value was determined by market prices estimated by a third party that specializes in sales of used equipment. The assets were originally purchased based on internal forecast of growth in demand that subsequently did not materialize. Prior to the Company’s restructuring announcement, the Company did not determine the assets were impaired as assets to be held and used. The Company used a contra account to record the adjustment to reflect the assets held for sale at their new cost basis. The contra account was included within property and equipment in the Condensed Consolidated Balance Sheets, thereby adjusting the assets held for sale to fair value less costs to sell, and not as a liability within the restructuring reserves. The Company expects to complete the disposal of the restructured assets by the first quarter of fiscal 2006.
During the second quarter of fiscal 2005, the Company closed a design center in Europe and recorded a charge of $0.1 million related to the write-down of certain property and equipment that were removed from operations. During the third quarter of fiscal 2005, the Company recorded an additional charge of $0.9 million related to certain property and equipment that were removed from operations.
Termination of SMS Operations:
During the first quarter of fiscal 2005, management approved a plan to cease operations of SMS, a subsidiary specializing in magnetic random access memories. SMS generated no revenues historically and as of the end of fiscal 2004, total assets, which primarily consisted of property and equipment, were less than 1% of the Company’s consolidated total assets.
As a result of management’s decision to cease operations, the Company had committed to a plan to dispose of the assets by sale during the first quarter of fiscal 2005 and recorded charges of $3.6 million related to the write-down of the assets, resulting in a new cost basis of $3.2 million. In addition, the Company recorded selling costs of $0.8 million. These assets consisted primarily of manufacturing and test equipment. The Company classified the assets as held for sale and recorded the assets at the lower of their carrying amount or fair value less costs to sell. Fair value was determined by market prices estimated by a third party that specializes in sales of used equipment. Prior to the Company’s restructuring announcement, the Company did not determine the assets were impaired as assets to be held and used. The Company expects to complete the disposal of the restructured assets by the first quarter of fiscal 2006.
In addition, SMS had 29 employees, which were less than 1% of the Company’s total headcount. The Company re-assigned twenty employees to other functions within the organization and terminated nine employees.
Leased Facilities:
During the first quarter of fiscal 2005, the Company recorded charges totaling $0.9 million for exiting leases related to a design center and a sales office in the United States. During the second quarter of fiscal 2005, the Company closed one additional design center in Europe as a result of the Fiscal 2005 Restructuring Plan and recorded additional charges of $0.3 million related to the lease and certain closing costs. The Company estimated the costs of exiting leases based on the contractual terms of the agreements, the current real estate market condition and the assumptions of sublease rental income, if applicable. Amounts related to the lease expense will be paid over the respective lease terms through fiscal 2007.
Personnel:
During the first quarter of fiscal 2005, the Company incurred charges of $11.8 million consisting of: (1) severance and benefits of $8.1 million associated with the reduction of the global workforce, and (2) a non-cash compensation charge of $3.7 million associated with the modification of stock option agreements for certain terminated employees. During the second quarter of fiscal 2005, the Company recorded an additional provision of $3.9 million consisting of: (1) severance and benefits of $0.9 million as the Company identified and terminated additional employees, and (2) a non-cash compensation charge of $3.0 million associated with the modification of stock option agreements for certain terminated employees. During the third quarter of fiscal 2005, the Company recorded an additional provision of $0.1 million related to severance and benefits as the Company identified and terminated additional employees.
The Company identified and terminated 219 employees in the first quarter of fiscal 2005, 35 employees in the second quarter of fiscal 2005 and 6 employees in the third quarter of fiscal 2005. In total, the reduction in workforce included 260 employees, of which 78 employees were engaged in manufacturing, 126 employees in research and development, and 56 employees in selling, general and administrative functions. Geographically, the reduction in workforce included 215 employees located in the U.S., 22 employees in the Philippines, and 23 in other countries. Of the 260 terminated employees, 259 employees have left the Company as of October 2, 2005. The Company expects the majority of the payments related to severance and benefits to be completed by the end of fiscal 2005.
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Table of ContentsOther:
During the second quarter of fiscal 2005, the Company recorded a charge of $0.7 million associated with the termination of a contract with a sales representative in Europe as part of the reorganization of the worldwide sales force under the Fiscal 2005 Restructuring Plan. The termination fee is expected to be paid by the end of fiscal 2005.
Fiscal 2002 Restructuring Plan and Fiscal 2001 Restructuring Plan
During the third quarter of fiscal 2005, the Company completed the Fiscal 2001 Restructuring Plan. As of October 2, 2005, restructuring reserves under the Fiscal 2002 Restructuring Plan remained only for leased facilities, which will decrease over time as the Company continues to make lease payments. See the 2004 Annual Report on Form 10-K for a detailed discussion of the Fiscal 2002 Restructuring Plan and the Fiscal 2001 Restructuring Plan.
The following table summarizes the activities associated with the Fiscal 2002 Restructuring Plan and the Fiscal 2001 Restructuring Plan:
During the third quarter of fiscal 2005, the Company completed the lease obligations under the Fiscal 2001 Restructuring Plan and recorded a benefit of $0.3 million for the remaining unused balance, as the actual lease obligations were lower than the Company had originally estimated.
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Table of ContentsReconciliation
The following table reconciles the restructuring charges (credits) recognized in the Condensed Consolidated Statements of Operations:
NOTE 5 — BALANCE SHEET COMPONENTS
Accounts Receivable, Net
Inventories
Other Current Assets
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Table of ContentsOther Assets
Other Current Liabilities
Deferred Income Taxes and Other Tax Liabilities
NOTE 6 — FINANCIAL INSTRUMENTS
Available-for-sale securities were as follows:
As of October 2, 2005:
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Table of ContentsAs of January 2, 2005:
The Company classifies all available-for-sale securities that are intended to be available for use in current operations as either cash equivalents or short-term investments.
During the fourth quarter of fiscal 2004, the Company reclassified all auction rate securities from cash equivalents to short-term investments. The reclassification had no impact on the Condensed Consolidated Statements of Operations for the three and nine months ended September 26, 2004. The impact on the Condensed Consolidated Statements of Cash Flows was a decrease of $2.8 million in cash used in investing activities for the nine months ended September 26, 2004.
As of October 2, 2005, contractual maturities of the Company’s short-term investments were as follows:
Realized losses were zero and $0.3 million for the three and nine months ended October 2, 2005, respectively, and zero for the three and nine months ended September 26, 2004.
Proceeds from sales and maturities of available-for-sale investments were $135.6 million and $58.6 million for the nine months ended October 2, 2005 and September 26, 2004, respectively.
Fair Value of Debt Instruments
The estimated fair values of the Company’s debt instruments have generally been determined using available market information. However, considerable judgment is required in interpreting market data to develop the estimates of fair values. Accordingly, the estimates presented are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies could have a material effect on the estimated fair value amounts.
The carrying amounts and estimated fair values were as follows:
The Company’s liabilities for all periods were presented at the carrying values, not the estimated fair values.
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Table of ContentsNOTE 7 — COMMITMENTS AND CONTINGENCIES
Guarantees and Product Warranties
The Company applies the disclosure provisions of FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others,” to its agreements that contain guarantee or indemnification clauses. These disclosure provisions expand those required by SFAS No. 5, “Accounting for Contingencies,” by requiring that guarantors disclose certain types of guarantees, even if the likelihood of requiring the guarantor’s performance is remote. As of October 2, 2005, Cypress has accrued its estimate of liability incurred under these indemnification arrangements and guarantees, as applicable. The Company maintains self-insurance for certain liabilities of its officers and directors.
Indemnification Obligations:
The Company is a party to a variety of agreements pursuant to which it may be obligated to indemnify the other party with respect to certain matters. Typically, these obligations arise in the context of contracts entered into by the Company, under which the Company customarily agrees to hold the other party harmless against losses arising from a breach of representations and covenants related to such matters as title to assets sold, certain intellectual property rights, specified environmental matters and certain income taxes. In these circumstances, payment by the Company is customarily conditioned on the other party making a claim pursuant to the procedures specified in the particular contract, which procedures typically allow the Company to challenge the other party’s claims. Further, the Company’s obligations under these agreements may be limited in terms of time and/or amount, and in some instances, the Company may have recourse against third parties for certain payments made by it under these agreements.
It is not possible to predict the maximum potential amount of future payments under these or similar agreements due to the conditional nature of the Company’s obligations and the unique facts and circumstances involved in each particular agreement. Historically, payments made by the Company under these agreements have not had a material effect on its business, financial condition or results of operations. The Company believes that if it were to incur a loss in any of these matters, such loss would not have a material effect on its business, financial condition, cash flows or results of operations, although there can be no assurance of this.
Product Warranties:
The Company estimates its warranty costs based on historical warranty claim experience and applies this estimate to the revenue stream for products under warranty. The estimated future warranty obligations related to product sales are recorded in the period in which the related revenue is recognized. The warranty accrual is reviewed quarterly to verify that it properly reflects the remaining obligations based on the anticipated expenditures over the balance of the obligation period. Adjustments are made when actual warranty claim experience differs from estimates.
The following table presents the Company’s warranty reserve activities:
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Table of ContentsAcquisition-Related Contingent Compensation
The Company recorded acquisition-related contingent compensation charges of $0.6 million and $2.8 million for the three and nine months ended October 2, 2005, respectively, and $1.3 million and $4.6 million for the three and nine months ended September 26, 2004, respectively. Substantially all acquisition-related contingent compensation charges were recorded as research and development expenses. The status of the acquisition-related contingent compensation is as follows:
SMaL:
The terms of the acquisition include contingent consideration of up to approximately $22.5 million in cash through fiscal 2006. Of this amount, $1.7 million is based on employment and the achievement of certain individual performance milestones and $20.8 million is based on the achievement of certain sales milestones and employment. When the contingency is based on milestone achievements and employment conditions, no charge is recognized until it is probable that the milestone conditions will be reached at which point any contingent consideration will be recognized over the employment-vesting period. Such payments will be accounted for as compensation and expensed in the appropriate periods. The Company recorded charges of $0.1 million and $0.4 million in the third quarter and first nine months of fiscal 2005, respectively, related to the achievement of individual performance milestones and employment. As of October 2, 2005, no payment has been made and an accrual of $0.4 million remained outstanding.
Cascade Semiconductor Corporation:
The terms of the acquisition include contingent consideration of approximately $9.4 million payable to employees based on either revenue milestone achievement and employment conditions, or employment conditions alone, through January 2007. When the contingency is based on milestone achievements and employment conditions, no charge is recognized until it is probable that the milestone conditions will be reached at which point any contingent consideration will be recognized over the employment-vesting period. Employment-only contingent consideration is recognized over the employment-vesting period.
To date, the Company recorded total charges of $6.6 million related to the contingent consideration, of which $0.3 million and $1.8 million were recorded in the third quarter and first nine months of fiscal 2005, respectively, and $4.8 million was recorded in fiscal 2004. Payments related to the $6.6 million charges consisted of the following:
Sahasra Networks:
The terms of the acquisition include provisions for contingent cash payments to employees and third parties of up to $2.3 million through December 2005 based on the amount of revenues generated by certain products in future periods. Cash payments to third parties based solely on product revenues will be recorded as an increase in the purchase price, if paid. Cash payments to employees for achievement of revenue targets require that individuals remain employed by the Company and are accounted for as compensation for services and expensed in the appropriate periods. To date, no charges have been recorded as achievements of product revenue targets have not been met.
In addition, the agreement includes provisions for the contingent issuance to employees of up to 259,000 shares of the Company’s common stock based on the achievement of certain product development milestones. Issuance of shares to employees upon successful completion of product milestones requires that individuals remained employed by the Company and are accounted for as compensation for services and expensed in the appropriate periods.
To date, the Company recorded total charges of $3.3 million related to the contingent consideration, of which $0.2 million and $0.6 million were recorded in the third quarter and first nine months of fiscal 2005, respectively, $0.2 million was recorded in fiscal 2004, and $2.5 million was recorded prior to fiscal 2004. Payments related to the $3.3 million charges consisted of the following:
Synthetic Lease
On June 27, 2003, the Company entered into an operating lease agreement, commonly known as a synthetic lease, for manufacturing and office facilities located in Minnesota and California. A synthetic lease obligation of $62.7 million with restricted cash collateral was established as of the second quarter of fiscal 2003. The synthetic lease requires the Company to purchase the
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Table of Contentsproperties or to arrange for the properties to be acquired by a third party at lease expiration, which is June 2008. In addition, the Company may extend the lease if the lessor allows. If the Company had exercised its right to purchase all the properties subject to the synthetic lease at October 2, 2005, the Company would have been required to make a payment totaling $62.7 million (the “Termination Value”). If the Company exercised its option to sell the properties to a third party, the proceeds from such a sale could be less than the properties’ Termination Value, and the Company would be required to pay the difference up to the guaranteed residual value of $54.5 million (the “Guaranteed Residual Value”).
In accordance with FASB Interpretation No. 45, the Company determined that the fair value associated with the Guaranteed Residual Value embedded in the synthetic operating lease was $2.0 million, which was recorded in other assets and other long-term liabilities in the Condensed Consolidated Balance Sheets.
The Company is required to evaluate periodically the expected fair value of the properties at the end of the lease term. In the event the Company determines that it is estimable and probable that the expected fair value of the properties at the end of the lease term will be less than the Termination Value, the Company will ratably accrue the loss over the remaining lease term. During fiscal 2004, the Company performed the analysis and accrued a loss contingency of approximately $1.8 million in other long-term liabilities in the Condensed Consolidated Balance Sheets relating to the potential decline in the fair value of the facilities in California. The loss contingency was determined by management with the assistance of a market analysis performed by an independent appraisal firm. During the third quarter and first nine months of fiscal 2005, the Company accrued an additional $0.3 million and $0.9 million, respectively, related to the loss contingency. As of October 2, 2005, the accrued loss contingency totaled $2.7 million.
The Company is required to maintain restricted cash or investments to serve as collateral for this lease. As of October 2, 2005, the balance of restricted cash and accrued interest was $62.9 million and was classified in other assets in the Condensed Consolidated Balance Sheets.
During the first quarter of fiscal 2005, the Company amended its synthetic lease agreement, whereby amounts due under the Company’s convertible subordinated notes are excluded from certain financial covenant calculations under the amended agreement. As of October 2, 2005, the Company was in compliance with the financial covenants.
Litigation and Asserted Claims
In January 1998, an attorney representing the estate of Mr. Jerome Lemelson contacted the Company and charged that the Company infringed certain patents owned by Mr. Lemelson and/or a partnership controlled by Mr. Lemelson’s estate. On February 26, 1999, the Lemelson Partnership sued the Company and 87 other companies in the United States District Court for the District of Arizona for infringement of 16 patents. In May 2000, the Court stayed litigation on 14 of the 16 patents in view of concurrent litigation in the United States District Court, District of Nevada, on the same 14 patents. On January 23, 2004, the Nevada Court held, in favor of plaintiffs, that all asserted claims of the 14 patents are unenforceable, invalid, and not infringed. The Nevada ruling is now being appealed, and the 14 patents remain stayed as to the Company during the appeal. In October 2001, the Lemelson Partnership amended its Arizona complaint to add allegations that two more patents were infringed. Therefore, there are currently four patents that are not stayed in this litigation. The case is in the “claim construction” (i.e., patent claim interpretation) phase on the four non-stayed patents. The claim construction hearing concluded on December 10, 2004, and the Company is awaiting the Judge’s order. The Company has reviewed and investigated the allegations in both Lemelson’s original and amended complaints. The Company believes that it has meritorious defenses to these allegations and will vigorously defend itself in this matter. However, because of the nature and inherent uncertainties of litigation, should the outcome of this action be unfavorable, the Company’s business, financial condition, results of operations or cash flows could be materially and adversely affected.
The Company is currently a party to various other legal proceedings, claims, disputes and litigation arising in the ordinary course of business, including those noted above. The Company currently believes that the ultimate outcome of these proceedings, individually and in the aggregate, will not have a material adverse effect on its financial position, results of operation or cash flows. However, because of the nature and inherent uncertainties of litigation, should the outcome of these actions be unfavorable, the Company’s business, financial condition, results of operations or cash flows could be materially and adversely affected.
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Table of ContentsNOTE 8 — DEBT AND EQUITY TRANSACTIONS
Line of Credit
In September 2003, the Company entered into a $50.0 million, 24-month revolving line of credit with a major financial institution. In December 2004, this line of credit was extended to December 2006 and the total amount was increased to $70.0 million. As of October 2, 2005 and January 2, 2005, the outstanding balance related to the line of credit was zero and $4.0 million, respectively. In addition, as of October 2, 2005 and January 2, 2005, $0.3 million and $0.4 million were outstanding, respectively, related to a standby letter of credit. Loans made under the line of credit bear interest based upon the Wall Street Journal Prime Rate or LIBOR plus a spread at the Company’s election. The line of credit agreement includes a variety of covenants including restrictions on the incurrence of indebtedness, incurrence of loans, the payment of dividends or distribution on its capital stock, and transfers of assets and financial covenants with respect to tangible net worth and a quick ratio. As of October 2, 2005, the Company was in compliance with all of the financial covenants. The Company’s obligations under the line of credit are guaranteed and collateralized by the common stock of certain of the Company’s subsidiaries. The Company intends to use the line of credit on an as-needed basis to fund working capital and capital expenditures.
Equity Option Contracts
As of October 2, 2005, the Company had outstanding a series of equity options on its common stock with an initial cost of $26.0 million that were originally entered into in fiscal 2001. These options were included in stockholders’ equity in the Condensed Consolidated Balance Sheets. The contracts require physical settlement and will expire in November 2005. Upon expiration of the options, if the Company’s stock price is above the threshold price of $21 per share, the Company will receive a settlement value totaling $30.3 million in cash. If the Company’s stock price is below the threshold price of $21 per share, the Company will receive 1.4 million shares of its common stock. Alternatively, the contracts may be renewed and extended.
The Company received total premiums of zero and $1.8 million during the three and nine months ended September 26, 2004, respectively, upon extensions of the contracts. The Company received no premiums for the three and nine months ended October 2, 2005. The premiums were recorded in additional paid-in capital in the Condensed Consolidated Balance Sheets.
Stock-Based Compensation
Stock-based compensation expense generally includes the amortization of deferred stock-based compensation related to the Company’s acquisitions. Deferred stock-based compensation is amortized on an accelerated basis over the vesting periods of the individual stock options or restricted stock, generally a period of four to five years, in accordance with FASB Interpretation No. 28.
The following table summarizes the stock-based compensation expense recorded in the Condensed Consolidated Statements of Operations:
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Table of ContentsNOTE 9 — ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) AND COMPREHENSIVE INCOME (LOSS)
The components of accumulated other comprehensive income (loss), net of tax, were as follows:
The components of comprehensive income (loss), net of tax, were as follows:
NOTE 10 — FOREIGN CURRENCY DERIVATIVES
The Company operates and sells products in various global markets and purchases capital equipment using foreign currencies. Additionally, the Company is exposed to risks associated with changes in foreign currency exchange rates. The Company may use various hedge instruments from time to time to manage the exposures associated with purchases of foreign sourced equipment, net asset or liability positions of its subsidiaries and forecasted revenues and expenses. The Company does not enter into foreign currency derivative financial instruments for speculative or trading purposes.
As of October 2, 2005, the Company’s hedge instruments consisted entirely of forward contracts for its subsidiary SunPower. The Company calculates the fair value of its forward contracts based on spot rates and interest differentials from published sources.
Under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” the Company accounts for its hedges of forecasted foreign currency revenues as cash flow hedges and hedges of firmly committed purchase contracts denominated in foreign currency as fair value hedges.
Cash flow hedges: Hedges of forecasted foreign currency denominated revenues are designated as cash flow hedges and changes in fair value of the effective portion of hedge contracts are recorded in accumulated other comprehensive income (loss) in stockholders’ equity in the Condensed Consolidated Balance Sheets. Amounts deferred in accumulated other comprehensive income (loss) are reclassified into the Condensed Consolidated Statements of Operations in the periods in which the related revenue is recognized. The effective portion of unrealized gains (losses) recorded in accumulated other comprehensive income (loss), net of tax, was $1.2 million and $(1.4) million as of October 2, 2005 and January 2, 2005, respectively. As of October 2, 2005 and January 2, 2005, the Company had outstanding forward contracts with an aggregate notional value of $34.4 million and $34.0 million, respectively. All outstanding contracts will mature by July 2006.
Fair value hedges: On occasion, the Company commits to purchase equipment in foreign currency, predominantly Euro. When these purchases are hedged and qualify as firm commitments under SFAS No. 133, they are designated as fair value hedges and changes in fair value of the derivative contract are recognized in the Condensed Consolidated Statements of Operations. Under fair value hedge treatment, the changes in the firm commitment on a spot-to-spot basis are recorded in property, plant and equipment, net, in the Condensed Consolidated Balance Sheets and in other income (expense), net, in the Condensed Consolidated Statements of Operations. As of October 2, 2005 and January 2, 2005, the Company had outstanding forward contracts with an aggregate notional value of $9.5 million and zero, respectively. All outstanding contracts will mature by December 2005.
Both cash flow hedges and fair value hedges are tested for effectiveness each period on a spot-to-spot basis using the dollar-offset method and both the excluded time value and any ineffectiveness are recorded in other income (expense), net, in the Condensed Consolidated Statements of Operations. The changes in excluded time value were immaterial for all periods presented. No ineffectiveness was recorded for any periods presented.
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Table of ContentsBalance sheet hedges: The Company records its hedges of foreign currency denominated monetary assets and liabilities at fair value with the related gains or losses recorded in other income (expense), net, in the Condensed Consolidated Statements of Operations. The gains or losses on these contracts are substantially offset by transaction gains or losses on the underlying balances being hedged. As of October 2, 2005 and January 2, 2005, the Company had outstanding forward contracts with an aggregate notional value of $23.3 million and $0.7 million, respectively, to hedge the risks associated with Euro foreign currency denominated assets and liabilities. All outstanding contracts will mature by December 2005.
NOTE 11 — BENEFIT FROM INCOME TAXES
The Company’s effective rate of income tax benefit was 1.5% and 0.3% for the three and nine months ended October 2, 2005, respectively. The Company’s effective rate of income tax benefit was 119.5% and 78.7% for the three and nine months ended September 26, 2004, respectively. The tax benefit for fiscal 2005 was attributable to income earned in certain countries that is not offset by current year net operating losses in other countries. The tax benefit for fiscal 2004 is attributable to income earned in certain countries that is not offset by current year net operating losses in other countries, and a favorable adjustment to income tax liabilities. The future tax benefit of certain losses is not currently recognized due to management’s assessment of the likelihood of realization of these benefits. The Company’s effective tax rate may vary from the U.S. statutory rate primarily due to utilization of future benefits, the earnings of foreign subsidiaries taxed at different rates, tax credits, and other business factors.
NOTE 12 — 2001 EMPLOYEE STOCK PURCHASE ASSISTANCE PLAN
On May 3, 2001, the Company’s stockholders approved the adoption of the 2001 employee stock purchase assistance plan (“SPAP”). The SPAP became effective on May 3, 2001 and will terminate on the earlier of May 3, 2011, or such time as determined by the Board of Directors. The SPAP allowed for loans to employees to purchase shares of the Company’s common stock on the open market. Employees of the Company and its subsidiaries, including executive officers but excluding the chief executive officer and the Board of Directors, were allowed to participate in the SPAP. The loans were granted to executive officers prior to Section 402 of the Sarbanes-Oxley Act of 2002, effective July 30, 2002, which prohibits loans to executive officers of public corporations. As of October 2, 2005, loans to executive officers represented approximately 2.6% of the total outstanding loan balance. Each loan was evidenced by a full recourse promissory note executed by the employee in favor of the Company and was secured by a pledge of the shares of the Company’s common stock purchased with the proceeds of the loan. If a participant sells the shares of the Company’s common stock purchased with the proceeds from the loan, the proceeds of the sale must first be used to repay the interest and then the principal on the loan before being received by the participant. The loans are callable and currently bear interest at a minimum rate of 4.0% per annum compounded annually, except for loans to executive officers, whose loans bear interest at the rate of 5.0% per annum compounded annually. As the loans are at interest rates below the estimated market rate, the Company records compensation expense to reflect the difference between the rate charged and an estimated market rate for each loan outstanding. Compensation expense was $0.5 million and $1.5 million for the three and nine months ended October 2, 2005, respectively, and $0.5 million and $1.4 million for the three and nine months ended September 26, 2004, respectively.
The following table summarizes the components of the outstanding loan balance:
The outstanding loan balance, net of allowance for potential uncollectible accounts, is classified as a current asset in the Condensed Consolidated Balance Sheets.
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Table of ContentsThe allowance for potential uncollectible accounts represents an amount for estimated potential uncollectible balances, with changes in the allowance for potential uncollectible accounts recognized in selling, general and administrative expenses in the Condensed Consolidated Statements of Operations. In determining the allowance for potential uncollectible accounts, management considered various factors, including a review of borrower demographics (including geographic location and job grade), loan quality and a fair value analysis of the loans and the underlying collateral. The allowance was determined by management with the assistance of an analysis performed by an independent appraisal firm. To date, write-offs totaled less than $10 thousand.
In the first quarter of fiscal 2004, the Company instituted a program directed at minimizing losses resulting from these employee loans. Under this program, employees other than executive officers were required to execute either a sell limit order or a stop loss order on the collateral common stock that will be triggered once the common stock price exceeds the employee’s break-even point. Executive officers were precluded from participating in the stop loss program as a result of Section 402 of the Sarbanes-Oxley Act of 2002, which prohibits material modifications to any term of a loan to an executive officer. If the common stock price declines to the stop loss price, the collateral stock is sold and the proceeds are used to repay the employee’s outstanding loan to the Company. The employee loans remain callable and the Company is willing to pursue every available avenue, including those covered under the Uniform Commercial Code, to recover these loans by pursuing employees’ personal assets should the employees not repay these loans.
NOTE 13 — NET INCOME (LOSS) PER SHARE
Basic net income (loss) per common share is computed using the weighted-average common shares outstanding for the period. Diluted net income per common share is computed using the weighted-average common shares outstanding plus any potentially dilutive securities, except when their effect is anti-dilutive. Diluted net loss per common share is computed using the weighted-average common shares outstanding for the period and excludes all potentially dilutive securities because the Company is in a net loss position and their inclusion would have been anti-dilutive. The following table sets forth the computation of basic and diluted net income (loss) per share:
Convertible Subordinated Notes:
1.25% Convertible Subordinated Notes (“1.25% Notes”):
For the three and nine months ended October 2, 2005, and for the three months ended September 26, 2004, 33.1 million shares of common stock issuable upon the assumed conversion of the 1.25% Notes were excluded from the calculation of diluted net income (loss) per share as the effect was anti-dilutive.
For the nine months ended September 26, 2004, diluted net income per share included 33.1 million shares assuming conversion of the 1.25% Notes and payment of the $300 portion of each note in cash rather than common stock. Each $1,000 principal value 1.25%
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Table of ContentsNotes is convertible at any time prior to maturity into 55.172 shares of common stock, subject to certain adjustments, plus $300 of cash. The Company, at its option, may pay the $300 in shares of common stock, subject to certain conditions. The Company currently intends to pay the $300 in cash rather than shares of common stock. As a result, for purposes of determining the Company’s diluted net income per share calculation, it is presumed that the $300 payment will be settled in cash. Therefore, net income in the diluted computation was adjusted by 70% of the interest expense and bond issuance costs.
3.75% Convertible Subordinated Notes (“3.75% Notes”):
For the three and nine months ended September 26, 2004, 1.1 million shares of common stock issuable upon the assumed conversion of the 3.75% Notes were excluded from the calculation of diluted net income per share as the effect was anti-dilutive.
The Company redeemed all of the 3.75% Notes in the fourth quarter of fiscal 2004.
Stock Options:
For the three and nine months ended October 2, 2005, all outstanding options were excluded from the calculation of diluted net loss per share as the Company was in a net loss position and therefore, their inclusion would have been anti-dilutive. As of October 2, 2005, total outstanding options to purchase common stock were 41.5 million.
For the three and nine months ended September 26, 2004, the Company excluded 25.0 million and 17.7 million, respectively, of the outstanding stock options from the calculation of diluted net income per share because the exercise prices of the stock options were greater than or equal to the average share price for the periods, and therefore, their inclusion would have been anti-dilutive.
NOTE 14 — SEGMENT, GEOGRAPHICAL AND CUSTOMER INFORMATION
The Company designs, develops, manufactures and markets a broad range of solutions for various markets including consumer, computation, data communications, automotive, industrial and solar power. The Company evaluates its reportable business segments in accordance with SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” During the first quarter of fiscal 2005, in conjunction with the Fiscal 2005 Restructuring Plan, the Company redefined its internal organizational structure and identified five reportable business segments based on the criteria of SFAS No. 131. The five reportable business segments are as follows:
Information for the three and nine months ended September 26, 2004 has been restated to conform with the current-period presentation. The Company does not allocate restructuring, acquisition-related costs, interest income and expense, other income and expense and income taxes to its segments. In addition, the Company does not allocate assets to the segments as the Company does not manage its business this way.
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Table of ContentsThe following tables set forth information relating to the reportable business segments:
Revenues:
Income (Loss) Before Income Taxes:
Geographical Information:
International revenues accounted for approximately 72% and 68% of total revenues for the three and nine months ended October 2, 2005, respectively, and approximately 65% and 66% of total revenues for the three and nine months ended September 26, 2004, respectively.
Customer Information:
Sales to U.S. and non-U.S. based distributors accounted for approximately 54% and 51% of total revenues for the three and nine months ended October 2, 2005, respectively, and approximately 46% and 50% of total revenues for the three and nine months ended September 26, 2004, respectively.
The following table presents certain information on the Company’s significant customers, including distributors, who accounted for 10% or greater of total revenues:
NOTE 15 – SUNPOWER INITIAL PUBLIC OFFERING
During the third quarter of fiscal 2005, SunPower filed an S-1 registration statement with the Securities and Exchange Commission for the initial public offering of its class A common stock. Following the initial public offering, SunPower will have two classes of authorized common stock: class A common stock and class B common stock. The Company will hold in the aggregate approximately 52.0 million shares of class B common stock, representing approximately 87% of SunPower’s total outstanding shares
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Table of Contentsof common stock. At that time, the Company is expected to hold 98% of the voting power of SunPower’s outstanding capital stock. The Company does not have any current plans to distribute to its stockholders the shares of SunPower’s class B common stock that it beneficially owns, although it may elect to effect such a distribution in the future.
As part of the spin-off, SunPower entered into various separation agreements with the Company, including a master separation agreement, an employee matters agreement, a tax sharing agreement, a master transition services agreement, a wafer manufacturing agreement, a lease for certain manufacturing assets, an investor rights agreement, and an indemnification and insurance matters agreement. These agreements will become effective upon completion of its initial public offering, except for the tax sharing agreement and the lease for manufacturing assets which are currently effective. SunPower also entered into an agreement with the Company to extend its lease in the Philippines for an additional 15 years with a right to purchase the facility.
NOTE 16 – SUBSEQUENT EVENTS
SunPower 2005 Stock Unit Plan
In October 2005, SunPower adopted the 2005 Stock Unit Plan in which all of SunPower’s employees except its executive officers and directors are eligible to participate, although SunPower currently intends to limit participation to those of its non-US employees who are not senior managers. Under this plan, SunPower’s board of directors awards participants the right to receive cash payments from SunPower in an amount equal to the appreciation in SunPower’s stock between the award date and the date the employee redeems the award. The right to redeem the award typically vests in the same manner as options vest under the 2005 Stock Incentive Plan. To date, SunPower has granted 11,450 units to approximately 120 of its Philippines employees. A maximum of 100,000 stock units may be subject to stock unit awards granted under this plan.
Acquisition of Minority Interests in Cypress MicroSystems (“CMS”)
In October 2005, the Company’s Board of Directors approved a plan to acquire the minority interests in CMS, a subsidiary of Cypress, for approximately $14.8 million in cash. The Company expects to complete the transaction in the fourth quarter of fiscal 2005.
Internal Revenue Service (“IRS”) Audit
In October 2005, the IRS notified the Company that it will begin an audit of the Company’s 2003 federal income tax return.
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Table of ContentsITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 that involve risks and uncertainties, which are discussed in the “Forward-Looking Statements” section under Part I of this Quarterly Report on Form 10-Q.
Executive Summary
We design, develop, manufacture and market a broad range of silicon-based products and solutions for various markets including consumer, computation, data communications, automotive, industrial and solar power. Our product portfolio includes a selection of wired and wireless universal serial bus (“USB”) devices, complementary metal oxide semiconductor image sensors, timing solutions, network search engines, specialty memories, high-bandwidth synchronous and micropower memory products, optical solutions, reconfigurable mixed-signal arrays and solar cells and modules.
During the first quarter of fiscal 2005, in conjunction with our restructuring plan, we reorganized our internal structure and identified five new business segments: Computation and Consumer Division (“CCD”), Data Communications Division (“DCD”), Memory and Imaging Division (“MID”), SunPower Corporation (“SunPower”), and Other:
The goals of the reorganization are to achieve the following objectives:
During the first quarter of fiscal 2005, we completed the acquisition of SMaL Camera Technologies, Inc. (“SMaL”). SMaL offers industry-leading digital imaging solutions for a variety of business and consumer applications. The acquisition will significantly accelerate our entry into the high-volume complimentary metal oxide semiconductor image sensor business, and SMaL’s product line will complement new mobile phone products introduced by FillFactory NV, which we acquired in fiscal 2004.
Revenues for the three months ended October 2, 2005 were $227.1 million, an increase of $7.5 million compared to the three months ended September 26, 2004. Strong acceptance of our PSoC family of mixed signal arrays in consumer applications and overall strength in our CCD segment, coupled with the growth in SunPower, drove the increase in revenues and offset weaknesses in our MID and DCD segments. Our revenue growth in the third quarter of fiscal 2005 was constrained by manufacturing capacity limitations that were further exacerbated by power outages that shut down each of our manufacturing plants for a day or more during the quarter.
The following outlook constitutes forward-looking statements that are hereby subject to risks and uncertainties. See the “Risk Factors” section.
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Table of ContentsWe currently anticipate revenues for the fourth quarter of fiscal 2005 to be in the range of $234 million to $241 million with the following expectations:
We currently expect gross margin percentage in the fourth quarter of fiscal 2005 to increase sequentially to the range of 43% to 44%, primarily due to the increased volumes in the CCD segment, continued improvement in SunPower and increased fab utilization. The gains in these segments are expected to be partially offset by the decline in volumes in the DCD and MID segments.
From a liquidity and capital resources standpoint, our long-term strategy is to maintain a minimum amount of cash and cash equivalents for operational purposes and to invest the remaining amount of our cash in interest bearing and highly liquid cash equivalents and debt securities. As of the end of the third quarter of fiscal 2005, total cash, cash equivalents, short-term investments and restricted cash were $272.7 million, a $34.9 million reduction from the end of fiscal 2004.
Results of Operations
Revenues
CCD:
For the three months ended October 2, 2005, revenues from the sales of CCD products increased $24.6 million, or 43%, compared to the same prior-year period. The increase was primarily attributable to an increase of approximately $12.0 million in sales of our PSoC products, driven by a major ramp in consumer applications, including MP3 players, set-top boxes and gaming, and continued expansion in computation platforms with the major personal computer original equipment manufacturers. In addition, continued adoption of our family of USB products contributed an increase of approximately $8.7 million in revenues.
For the nine months ended October 2, 2005, revenues from the sales of CCD products decreased $3.2 million, or 1%, compared to the same prior-year period. This decrease was primarily attributable to the decline of approximately $19.8 million in sales of our USB and clock products as a result of softness in demand, partially offset by an increase of approximately $15.8 million in sales of our PSoC products driven by demand in consumer applications.
DCD:
For the three months ended October 2, 2005, revenues from the sales of DCD products decreased $16.3 million, or 31%, compared to the same prior-year period. This decrease was primarily attributable to the decline of approximately $7.8 million in sales of our PLD products as they are in an end-of-life cycle. In addition, softness in demand for our specialty memories and network search engine products contributed a decline of approximately $5.1 million in revenues.
For the nine months ended October 2, 2005, revenues from the sales of DCD products decreased $46.6 million, or 28%, compared to the same prior-year period. This decrease was primarily attributable to the decline of approximately $17.6 million in sales of our PLD products as they are in an end-of-life cycle. In addition, softness in demand for our specialty memories and network search engine products contributed a decline of approximately $19.8 million in revenues.
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Table of ContentsMID:
For the three months ended October 2, 2005, revenues from the sales of MID products decreased $16.0 million, or 17%, compared to the same prior-year period. The decrease was attributable to a decrease of approximately $17.6 million in sales of our memory products, offset by an increase of approximately $1.6 million in sales of our image sensor products. The decrease in our memory products was primarily attributable to a decline in sales of our pseudo-SRAM products, partially offset by an increase in sales of our synchronous SRAM products. The increase in sales of our image sensor products was primarily due to a full-quarter revenue contribution from FillFactory and SMaL, which we acquired during the third quarter of fiscal 2004 and the first quarter of fiscal 2005, respectively.
For the nine months ended October 2, 2005, revenues from the sales of MID products decreased $71.4 million, or 23%, compared to the same prior-year period. The decrease was attributable to a decrease of approximately $90.4 million in sales of our memory products, offset by an increase of approximately $19.0 million in sales of our image sensor products. The decrease in our memory products was primarily attributable to a decline in sales of our pseudo-SRAM and micropower products, partially offset by an increase in sales of our synchronous SRAM products. The increase in sales of our image sensor products was primarily due to a nine-month period of revenue contribution from FillFactory and a seven-month period of revenue contribution from SMaL during fiscal 2005.
During the third quarter of fiscal 2005, we entered into an agreement with a customer with respect to the development of certain products and recorded $1.8 million in revenues in the MID segment, consisting of $2.4 million in license fee for granting the customer a license of our intellectual property used in developing the products, which was partially offset by a credit memo of $1.0 million issued to the customer in consideration of a yield drop resulting from certain retesting activities. In addition, the customer agreed to pay us $0.8 million in exchange for design services, of which $0.4 million has been earned by us in the third quarter of fiscal 2005 and the remaining amount will be earned in the fourth quarter of fiscal 2005.
SunPower:
For the three months ended October 2, 2005, revenues from the sales of SunPower products increased $19.4 million, or 775%, compared to the same prior-year period. For the nine months ended October 2, 2005, revenues from the sales of SunPower products increased $43.3 million, or 704%, compared to the same prior-year period. The increase for both the three and nine-month periods was primarily attributable to increased production coupled with higher demand for its solar cells and panels driven by the continued strong global solar market.
Other:
For the three months ended October 2, 2005, revenues decreased $4.1 million, or 30%, compared to the same prior-year period. This decrease was primarily attributable to a decrease of $3.5 million in revenues generated by our subsidiary Silicon Light Machines (“SLM”). For the nine months ended October 2, 2005, revenues decreased $12.5 million, or 32%, compared to the same prior-year period. The decrease was primarily attributable to a decrease of $11.5 million in revenues generated by SLM. The decrease in revenues generated by SLM for both the three and nine-month periods was primarily due to the decline in royalty revenues from Sony as the use of certain of SLM’s technology by Sony came to an end in the fourth quarter of fiscal 2004.
Cost of Revenues/Gross Margin
For the three and nine months ended October 2, 2005, gross margin benefited by increased volumes and the cost savings measures implemented under our restructuring plan in the first quarter of fiscal 2005, which was partially offset by lower average selling prices and increased spending due to losses from the power outages in our manufacturing plants during the third quarter of fiscal 2005. In addition, changes in product mix had a less than favorable impact on gross margin as our SunPower segment with lower margins became a larger portion of our business and volumes from our DCD segment with higher margins declined.
Our gross margin has been impacted by the timing of inventory adjustments related to inventory write-downs and the subsequent sale of these written-down products caused by the general state of our business including our inventory profile. During the three and
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Table of Contentsnine months ended October 2, 2005, the net impact of the inventory adjustments was a charge of $4.3 million and $11.5 million, respectively. During the three and nine months ended September 26, 2004, the net impact of the inventory adjustment was a charge of $1.0 million and a credit of $3.5 million, respectively. The inventory reserve balance was $32.5 million and $29.4 million as of October 2, 2005 and January 2, 2005, respectively.
We record inventory write-downs as a result of our normal analysis of demand forecasts and the aging profile of the inventory. We record charges to cost of goods sold to write down the carrying values of our inventories when their estimated market values are less than their carrying values. The inventory write-downs reflect estimates of future market pricing relative to the costs of production and inventory carrying values and projected timing of product sales. The semiconductor industry has historically been highly cyclical and volatile. In recent years, a combination of global economic conditions and a slowing growth rate in the demand for semiconductors, coupled with worldwide increases in semiconductor production capacity, caused significant declines in demand and average selling prices for semiconductor components. These trends could continue in the future and could cause us to re-evaluate our inventory costs, which could result in additional inventory reserves.
In reviewing our inventory reserves, we follow methodologies that are consistent with those used by other companies within the semiconductor industry. At the time of an inventory write-down, we make a determination, based on demand forecasts and the aging profile of the inventory, that there is a very high probability that the inventory that was reserved would not be sold. Once the inventory is written down, a new cost basis is established; however, for tracking purposes, the write-down is recorded as a reserve on the balance sheets. In accordance with Staff Accounting Bulletin No. 100, the contra asset account is relieved at the time the inventory is either sold or scrapped. At October 2, 2005, the remaining inventory reserve represented excess and obsolete inventories that have not been scrapped or sold.
Research and Development
For the three months ended October 2, 2005, research and development (“R&D”) expenses decreased $8.7 million compared to the same prior-year period. The decrease in R&D expenditures was due to a decrease of approximately $4.7 million in employee-related compensation expenses and depreciation, which was primarily attributable to the restructuring measures implemented during the first quarter of fiscal 2005. In addition, R&D expenditures decreased approximately $4.3 million for SunPower primarily due to the completion of certain R&D efforts related to a product line in the fourth quarter of fiscal 2004. The decrease in R&D expenditures was partially offset by an increase of approximately $1.6 million in purchases of R&D-related supplies.
For the nine months ended October 2, 2005, R&D expenses decreased $23.6 million compared to the same prior-year period. The decrease in R&D expenditures was due to a decrease of approximately $18.3 million in employee-related compensation expenses and depreciation, which was primarily attributable to the restructuring measures implemented during the first quarter of fiscal 2005. The decrease in employee-related compensation expenses included a credit of approximately $1.9 million as a result of the reversal of the unamortized deferred compensation balance associated with terminated employees. In addition, R&D expenditures decreased approximately $10.3 million for SunPower primarily due to the completion of certain R&D efforts related to a product line in the fourth quarter of fiscal 2004. The decrease in R&D expenditures was partially offset by an increase of approximately $7.4 million in purchases of R&D-related supplies.
Selling, General and Administrative
For the three months ended October 2, 2005, selling, general and administrative (“SG&A”) expenses increased $2.8 million compared to the same prior-year period. The increase in SG&A expenditures was primarily due to a stock-based compensation charge of $1.6 million related to our subsidiary Cypress MicroSystems (“CMS”) and an increase of approximately $0.5 million in advertising expenses. The stock-based compensation charge primarily resulted from unvested options exercised with notes, for which we have the right to purchase unvested shares upon employee termination at the original cost.
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Table of ContentsFor the nine months ended October 2, 2005, SG&A expenses increased $10.5 million compared to the same prior-year period. The increase in SG&A expenses was primarily attributable to a benefit of $7.7 million related to the reduction in the loan reserves of our employee stock purchase assistance plan recorded in the first nine months of fiscal 2004. In addition, the increase in SG&A expenses was attributable to a stock-based compensation charge of $1.6 million related to CMS and an increase of approximately $1.9 million in advertising expenses, partially offset by a decrease of approximately $1.9 million in employee-related compensation expense primarily resulting from the restructuring measures implemented during the first quarter of fiscal 2005.
Restructuring
The semiconductor industry has historically been characterized by wide fluctuations in demand for, and supply of, semiconductors. In some cases, industry downturns have lasted more than a year. Prior experience has shown that restructuring of operations, resulting in significant restructuring charges, may become necessary if an industry downturn persists. In addition, events and circumstances specific to us may result in restructuring charges.
We initiated a restructuring plan in the first quarter of fiscal 2005 (“Fiscal 2005 Restructuring Plan”). In addition, we had one other restructuring plan initiated in the fourth quarter of fiscal 2002 (“Fiscal 2002 Restructuring Plan”). The Fiscal 2002 Restructuring Plan has been substantially completed with reserves remaining for lease payments for restructured facilities. During the third quarter of fiscal 2005, we completed the restructuring plan initiated in the third quarter of fiscal 2001 (“Fiscal 2001 Restructuring Plan”). For additional information on these events, refer to Note 4 of Notes to Condensed Consolidated Financial Statements.
In January 2005, we announced a plan to reduce costs and losses by approximately $19.0 million per quarter. This plan included (1) restructuring activities implemented under the Fiscal 2005 Restructuring Plan, and (2) various other initiatives to reduce discretionary spending and reduce our losses. As of the end of the second quarter of fiscal 2005, we had realized these savings as described below.
The initiatives implemented under our Fiscal 2005 Restructuring Plan were intended to generate savings by reducing employee-related costs, disposing of excess equipment thereby reducing depreciation costs, reducing certain facility costs by existing certain facilities and ceasing operations of our subsidiary Silicon Magnetic Systems (“SMS”). During the second quarter of fiscal 2005, we had realized these savings as follows: approximately $5.7 million in employee-related compensation expenses due to the termination of employees, $1.0 million in depreciation as a result of the removal of equipment from operations, $0.1 million in rent expense due to the closure of facilities, and $1.3 million as a result of discontinuing the operations of SMS.
The initiatives to reduce the amount of discretionary spending and reduce our losses were intended to generate savings of approximately $10.9 million. We achieved these savings as of the end of the second quarter of fiscal 2005.
Amortization of Intangible Assets
Intangible assets are amortized using the straight-line method over their useful lives ranging from 2 to 6 years.
For the three months ended October 2, 2005, amortization was $6.5 million compared with $9.7 million during the corresponding fiscal 2004 period. The decrease was primarily attributable to a $3.9 million decrease in amortization of purchased technology and non-compete agreements, partially offset by an increase of $0.6 million in amortization of patents, customer contracts, licenses and trademarks.
For the nine months ended October 2, 2005, amortization was $22.0 million compared with $29.5 million during the corresponding fiscal 2004 period. The decrease was primarily attributable to an $11.1 million decrease in amortization of purchased technology and non-compete agreements, partially offset by an increase of $3.5 million in amortization of patents, customer contracts, licenses and trademarks.
In-Process Research and Development Charges
For the nine months ended October 2, 2005, we recorded $12.3 million of in-process research and development charges relating to our acquisition of SMaL. For the three and nine months ended September 26, 2004, we recorded $15.6 million of in-process research and development charges relating to our acquisition of FillFactory. See our 2004 Annual Report on Form 10-K for the discussion of our FillFactory acquisition.
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Table of ContentsIn-process research and development projects related to SMaL include the development of first generation automotive cameras and mobile phone sensors. In assessing the projects, we considered key characteristics of the technology as well as its future prospects, the rate of technology changes in the industry, product life cycles, and various projects’ stage of development. We allocated $12.3 million of the purchase price to the in-process research and development projects and wrote off the amount in the first quarter of fiscal 2005 as technology feasibility has not been established and no alternative future uses existed.
The value of in-process research and development was determined using the income approach method, which calculated the sum of the discounted future cash flows attributable to the projects once commercially viable using discount rates ranging from 35% to 45%, which were derived from a weighted-average cost of capital analysis and adjusted to reflect the stage of completion of the projects and the level of risks associated with the projects. The percentage of completion for each project was determined by identifying the research and development expenses invested in the project as a ratio of the total estimated development costs required to bring the project to technical and commercial feasibility. The following table summarizes certain information of each significant project as of the acquisition date:
Status of In-Process Research and Development Projects:
The status of in-process research and development projects associated with our acquisitions is as follows:
SMaL:
To date, there have been no significant differences between the actual and estimated results of the in-process research and development projects. As of October 2, 2005, we have incurred total post-acquisition costs of approximately $3.4 million related to the in-process research and development projects and estimate that an additional investment of approximately $5.7 million will be required to complete the projects. We expect to complete the projects by March 2006, which is within the timeframe as we had originally estimated.
FillFactory NV:
To date, there have been no significant differences between the actual and estimated results of the in-process research and development projects. As of October 2, 2005, we have incurred total post-acquisition costs of approximately $7.8 million related to the in-process research and development projects and estimate that an additional investment of approximately $0.5 million will be required to complete the projects. The industrial, medical and high-end photography projects have all been completed during the second quarter of fiscal 2005. We expect to complete the digital still and wireless terminal camera projects by November 2005, which has been delayed by one quarter from the original estimate, and the automotive projects by January 2006, which is within the timeframe as we had originally estimated.
The development of these technologies remains a significant risk due to factors including the remaining efforts to achieve technical viability, rapidly changing customer markets, uncertain standards for new products, and competitive threats. The nature of the efforts to develop these technologies into commercially viable products consists primarily of planning, designing, experimenting, and testing activities necessary to determine that the technologies can meet market expectations, including functionality and technical requirements. Failure to bring these products to market in a timely manner could result in a loss of market share or a lost opportunity to capitalize on emerging markets and could have a material adverse impact on our business and operating results.
Interest Income
Interest income consists primarily of interest earned on cash equivalents, short-term investments and restricted cash. In addition, interest income includes interest earned on our loans to employees under the employee stock purchase assistance plan.
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Table of ContentsFor the three months ended October 2, 2005, interest income was $3.1 million compared with $2.7 million for the same prior-year period. The increase in interest income was primarily attributable to an increase of $0.4 million in interest earned on our cash and investments as a result of higher interest rates.
For the nine months ended October 2, 2005, interest income was $8.2 million compared with $8.0 million for the same prior-year period. The increase in interest income was primarily attributable to an increase of $0.5 million in interest earned on our cash and investments as a result of higher interest rates, partially offset by a decrease of $0.3 million in interest earned on our loans to employees under the employee stock purchase assistance plan due to lower outstanding loan balances.
Interest Expense
Interest expense is primarily associated with our convertible subordinated notes.
For the three months ended October 2, 2005, interest expense was $2.0 million compared with $2.8 million during the same prior-year period. The decrease in interest expense was primarily attributable to a decrease of $0.6 million in interest expense associated with the 3.75% convertible subordinated notes (“3.75% Notes”), as we redeemed all of the outstanding 3.75% Notes during the fourth quarter of fiscal 2004.
For the nine months ended October 2, 2005, interest expense was $6.3 million compared with $8.3 million during the same prior-year period. The decrease in interest expense was primarily attributable to a decrease of $1.9 million in interest expense associated with the 3.75% Notes, as we redeemed all of the outstanding 3.75% Notes during the fourth quarter of fiscal 2004.
As of October 2, 2005, $600.0 million of our 1.25% convertible subordinated notes (“1.25% Notes”) remained outstanding.
Other Income (Expense), Net
For the three months ended October 2, 2005, other income, net, was $0.7 million, compared with other expense, net, of $2.4 million during the same prior-year period. For the nine months ended October 2, 2005, other expense, net, was $3.1 million, compared with other expense, net, of $3.6 million during the same prior-year period. The following table summarizes the components of other income (expense), net:
Deferred Compensation Plan:
In fiscal 1995, we adopted a deferred compensation plan, which provides certain key employees with the option to defer the receipt of compensation in order to accumulate funds for retirement. As of October 2, 2005, the deferred compensation plan assets of $23.3 million and liabilities of $27.8 million were recorded in other assets and other current liabilities, respectively, in the Condensed Consolidated Balance Sheets.
We account for the deferred compensation plan in accordance with Emerging Issues Task Force (“EITF”) No. 97-14, “Accounting for Deferred Compensation Arrangements Where Amounts Earned Are Held in a Rabbi Trust and Invested.” In accordance with EITF No. 97-14, the liabilities associated with the other diversified assets and the investment in our common stock is being marked to market, with the offset being recorded as compensation expense to the extent there is an increase in the value or a reduction of operating expense to the extent there is a decrease in the value. The other diversified assets are marked to market with the offset being recorded as other income (expense), net. No entries are recorded for the amounts invested in our common stock since this is accounted for in treasury stock.
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Table of ContentsAll amounts associated with the changes in fair values of the deferred compensation plan assets and liabilities were recorded in the following line items in the Condensed Consolidated Statements of Operations:
Benefit from Income Taxes
Our effective rate of income tax benefit was 1.5% and 0.3% for the three and nine months ended October 2, 2005, respectively. Our effective rate of income tax benefit was 119.5% and 78.7% for the three and nine months ended September 26, 2004, respectively. The tax benefit for fiscal 2005 was attributable to income earned in certain countries that is not offset by current year net operating losses in other countries. The tax benefit for fiscal 2004 is attributable to income earned in certain countries that is not offset by current year net operating losses in other countries, and a favorable adjustment to income tax liabilities. The future tax benefit of certain losses is not currently recognized due to management’s assessment of the likelihood of realization of these benefits. Our effective tax rate may vary from the U.S. statutory rate primarily due to utilization of future benefits, the earnings of foreign subsidiaries taxed at different rates, tax credits, and other business factors.
Liquidity and Capital Resources
The following table summarizes information regarding our cash and investments, working capital and long-term debt:
Key Components of Cash Flows:
During the nine months ended October 2, 2005, net cash generated from operations was $62.9 million, compared to $134.1 million generated from operations during the same prior-year period. The $71.2 million decrease was primarily attributable to a net loss of $90.0 million incurred during the current nine-month period compared with net income of $52.8 million generated in the same prior-year period, adjusted for certain non-cash items including restructuring costs and changes in operating assets and liabilities.
During the nine months ended October 2, 2005, investing activities used cash of $66.6 million, compared to $193.3 million used during the same prior-year period. During the nine months ended October 2, 2005, we used $95.7 million for the acquisitions of property and equipment and $39.6 million for the acquisition of SMaL, net of cash received. These uses of cash were partially offset by proceeds of $71.4 million from sales and maturities of investments, net of purchases. During the nine months ended September 26,
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Table of Contents2004, we used $89.5 million for the acquisitions of property and equipment and $42.0 million for the purchases of investments, net of proceeds from sales and maturities. In addition, we used $89.9 million, net of cash received, for the acquisitions of Cascade and FillFactory. These uses of cash were partially offset by proceeds of $28.4 million from the collection of our loans to employees under the employee stock purchase assistance plan.
During the nine months ended October 2, 2005, net cash generated from financing activities was $39.7 million, compared to $28.7 million during the same prior-year period. During the nine months ended October 2, 2005, we received proceeds of $49.1 million from the issuance of shares upon exercise of stock options by employees and used $9.3 million for the repayment of debt. During the nine months ended September 26, 2004, we received proceeds of $32.2 million from the issuance of shares upon exercise of stock options by employees and used $5.3 million for the repayment of debt.
Liquidity:
The Board of Directors has approved programs authorizing the repurchase of our common stock or convertible subordinated notes in the open market or in privately negotiated transactions. The actual total amount that can be repurchased is limited to $15.0 million.
We have $600.0 million of aggregate principal amount in the 1.25% Notes that are due in June 2008. The 1.25% Notes are subject to compliance with certain covenants that do not contain financial ratios. As of October 2, 2005, we were in compliance with these covenants. If we failed to be in compliance with these covenants beyond any applicable grace period, the trustee of the 1.25% Notes, or the holders of a specific percentage thereof, would have the ability to demand immediate payment of all amounts outstanding.
On June 27, 2003, we entered into a synthetic operating lease agreement for U.S. manufacturing and office facilities. The lease agreement requires us to purchase the properties or to arrange for the properties to be acquired by a third party at lease expiration. If we had exercised our right to purchase all the properties subject to these leases at October 2, 2005, we would have been required to make a payment and record assets totaling $62.7 million. We are required to maintain restricted cash or investments to serve as collateral for this lease. As of October 2, 2005, the amount of restricted cash and accrued interest was $62.9 million, which was classified as a non-current asset in the Condensed Consolidated Balance Sheets.
In September 2003, we entered into a $50.0 million, 24-month revolving line of credit with a major financial institution. In December 2004, this line of credit was extended to December 2006 and the total amount was increased to $70.0 million. As of October 2, 2005, no amount was outstanding. Loans made under the line of credit bear interest based upon the Wall Street Journal Prime Rate or LIBOR plus a spread at our election. The line of credit agreement includes a variety of covenants including restrictions on the incurrence of indebtedness, incurrence of loans, the payment of dividends or distribution on our capital stock, and transfers of assets and financial covenants with respect to tangible net worth and a quick ratio. As of October 2, 2005, we were in compliance with all of the covenants. Our obligations under the line of credit are guaranteed and collateralized by the common stock of certain of our subsidiaries. We intend to use the line of credit on an as-needed basis to fund working capital and capital expenditures.
During fiscal 2003, we entered into certain long-term loan agreements primarily with two lenders with an aggregate principal amount equal to $24.7 million. These agreements are collateralized by specific equipment located at our U.S. manufacturing facilities. Principal amounts are to be repaid in monthly installments inclusive of accrued interest, over a three to four-year period. The applicable interest rates are variable based on changes to LIBOR rates. The loans are subject to financial and non-financial covenants. As of October 2, 2005, the outstanding principal balance was $8.6 million and we were in compliance with the covenants.
In February 2005, we completed the acquisition of 100% of the outstanding capital stock of SMaL. We acquired SMaL for a total cash consideration of $39.6 million, net of cash received.
Several of our acquisitions obligate us to pay certain contingent compensation in cash based on continued employment and meeting certain milestones. As of October 2, 2005, total outstanding contingent compensation that could be paid in cash under our agreements, assuming all contingencies are met, was $29.5 million.
Capital Resources and Financial Condition:
Our long-term strategy is to maintain a minimum amount of cash and cash equivalents for operational purposes and to invest the remaining amount of our cash in interest-bearing and highly liquid cash equivalents and debt securities. Accordingly, at the end of the third quarter of fiscal 2005, in addition to $102.6 million in cash and cash equivalents, we had $107.2 million invested in short-term investments that are available for current operating, financing and investing activities, for a total liquid cash and investment position
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Table of Contentsof $209.8 million. We had an additional $62.9 million of restricted cash related to our synthetic lease for a total cash, short-term investments and restricted cash position of $272.7 million. As of October 2, 2005, we had outstanding $600.0 million in principal amount of our 1.25% Notes. Historically, we have funded the capital expenditures of SunPower internally. In the future, we anticipate to fund SunPower through either debt or equity financings.
We believe that liquidity provided by existing cash, cash equivalents, investments, and our borrowing arrangements described above will provide sufficient capital to meet our requirements for at least the next twelve months. However, should prevailing economic conditions and/or financial, business and other factors beyond our control adversely affect our estimates of our future cash requirements (including our debt obligations), we would be required to fund our cash requirements by alternative financing. There can be no assurance that additional financing, if needed, would be available on terms acceptable to us or at all.
We may choose at any time to raise additional capital to strengthen our financial position, facilitate growth, and provide us with additional flexibility to take advantage of business opportunities that arise.
Off-Balance Sheet Arrangement:
Synthetic Lease
On June 27, 2003, we entered into a synthetic operating lease agreement for manufacturing and office facilities located in Minnesota and California. The synthetic lease enables us to lease rather than acquire the facilities. This results in improved cash flow through lower lease payments compared to expending much more cash in a direct acquisition of the properties. The synthetic lease requires us to purchase the properties or to arrange for the properties to be acquired by a third party at lease expiration, which is in June 2008. In addition, we may extend the lease if the lessor allows. If we had exercised our right to purchase all the properties subject to the synthetic lease at October 2, 2005, we would have been required to make a payment totaling $62.7 million (the “Termination Value”). If we had exercised our option to sell the properties to a third party, the proceeds from such a sale could be less than the properties’ Termination Value, and we would be required to pay the difference up to the guaranteed residual value of $54.5 million.
We are required to evaluate periodically the expected fair value of the properties at the end of the lease term. In the event we determine that it is estimable and probable that the expected fair value of the properties at the end of the lease term will be less than the Termination Value, we will ratably accrue the loss over the remaining lease term. During fiscal 2004, we performed the analysis and accrued a loss contingency of approximately $1.8 million in other long-term liabilities in the Condensed Consolidated Balance Sheets relating to the potential decline in the fair value of the facilities in California. The loss contingency was determined by management with the assistance of a market analysis performed by an independent appraisal firm. During the third quarter and first nine months of fiscal 2005, we accrued an additional $0.3 million and $0.9 million, respectively, related to the loss contingency. As of October 2, 2005, the accrued loss contingency totaled $2.7 million.
We are required to maintain restricted cash or investments to serve as collateral for this lease. As of October 2, 2005, the balance of restricted cash and accrued interest was $62.9 million and was classified in other assets in the Condensed Consolidated Balance Sheets.
During the first quarter of fiscal 2005, we amended the synthetic lease agreement, whereby amounts due under our 1.25% Notes are excluded from certain financial covenant calculation under the revised agreement. As of October 2, 2005, we were in compliance with the financial covenants.
Equity Option Contracts
At October 2, 2005, we had outstanding a series of equity options on our common stock with an initial cost of $26.0 million which is classified in stockholders’ equity in the Condensed Consolidated Balance Sheets. The contracts require physical settlement and will expire in November 2005. Upon expiration of the options, if our stock price is above the threshold price of $21 per share, we will receive a settlement value totaling $30.3 million. If our stock price is below the threshold price of $21 per share, we will receive 1.4 million shares of our common stock. Alternatively, the contracts may be renewed and extended.
During the three and nine months ended September 26, 2004, we received total premiums of zero and $1.8 million, respectively, upon extensions of the contracts. We received no premiums during the three and nine months ended October 2, 2005. The premiums were recorded in additional paid-in capital in the Condensed Consolidated Balance Sheets.
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Table of ContentsRecent Accounting Pronouncements
In May 2005, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 154, “Accounting Changes and Error Corrections,” which changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS No. 154 replaces Accounting Principles Board (“APB”) Opinion No. 20, “Accounting Changes,” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statement.” It requires retrospective application to prior period’s financial statements of a voluntary change in accounting principle unless it is impracticable. In addition, under SFAS No. 154, if an entity changes its method of depreciation, amortization, or depletion for long-lived, non-financial assets, the change must be accounted for as a change in accounting estimate effected by a change in accounting principle. SFAS No. 154 applies to accounting changes and error corrections made in fiscal years beginning after December 15, 2005. We do not expect the adoption of SFAS No. 154 in the first quarter of fiscal 2006 will have a material impact on our consolidated results of operations and financial condition.
In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations.” Interpretation No. 47 clarifies that an entity must record a liability for a “conditional” asset retirement obligation if the fair value of the obligation can be reasonably estimated. Interpretation No. 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. Interpretation No. 47 is effective no later than the end of the fiscal year ending after December 15, 2005. We are currently evaluating the provision and do not expect the adoption of Interpretation No. 47 in the fourth quarter of fiscal 2005 will have a material impact on our results of operations or financial condition.
In March 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 107, which provides guidance on the implementation of SFAS No. 123(R), “Share-Based Payment” (see discussion below). In particular, SAB No. 107 provides key guidance related to valuation methods (including assumptions such as expected volatility and expected term), the accounting for income tax effects of share-based payment arrangements upon adoption of SFAS No. 123(R), the modification of employee share options prior to the adoption of SFAS No. 123(R), the classification of compensation expense, capitalization of compensation cost related to share-based payment arrangements, first-time adoption of SFAS No. 123(R) in an interim period, and disclosures in Management’s Discussion and Analysis subsequent to the adoption of SFAS No. 123(R). SAB No. 107 became effective on March 29, 2005. It did not have a material impact on our financial statements.
In December 2004, the FASB issued SFAS No. 123(R), which replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.” Under SFAS No. 123(R), companies are required to measure the compensation costs of share-based compensation arrangements based on the grant-date fair value and recognize the costs in the financial statements over the period during which employees are required to provide services. Share-based compensation arrangements include stock options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. In April 2005, the SEC postponed the implementation date to the fiscal year beginning after June 15, 2005. We will adopt SFAS No. 123(R) in the first quarter of fiscal 2006. SFAS No. 123(R) permits public companies to adopt its requirements using one of two methods. We are currently evaluating which method to adopt. The adoption of SFAS No. 123(R) will have a significant adverse impact on our results of operations, although it will have no impact on our overall financial position. The precise impact of adoption of SFAS No. 123(R) cannot be predicted at this time because it will depend on levels of share-based payments granted in the future. SFAS No. 123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While we cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), the amount of operating cash flows recognized for such excess tax deductions was zero for the nine months ended October 2, 2005 and September 26, 2004.
In December 2004, the FASB issued FASB Staff Position (“FSP”) No. 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004.” The American Jobs Creation Act introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to U.S. companies, provided certain criteria are met. FSP No. 109-2 provides accounting and disclosure guidance on the impact of the repatriation provision on a company’s income tax expense and deferred tax liability. We are currently studying the impact of the one-time foreign dividend provision and intend to complete the analysis by the end of fiscal 2005. Accordingly, we have not adjusted our income tax expense or deferred tax liability to reflect the tax impact of any repatriation of non-U.S. earnings we may make.
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Table of ContentsRisk Factors
We face significant volatility in supply and demand conditions for our products and this volatility, as well as any failure by us to accurately forecast future supply and demand conditions, could materially and negatively impact our business.
The semiconductor industry has historically been characterized by wide fluctuations in the demand for, and supply of, semiconductors. Demand for our products depends in large part on the continued growth of various electronics industries that use our products, including:
In addition, certain of our products, including USB micro-controllers and high-frequency clocks, are incorporated into computer and computer-related products, which have historically experienced, and may in the future experience, significant fluctuations in demand. Any downturn or reduction in the growth of these industries could seriously harm our business, financial condition and results of operations.
We order materials and build our products based primarily on our internal forecasts and secondarily on existing orders, which may be cancelled under many circumstances. Because our markets are volatile, as discussed above, and subject to rapid technological and price changes, our forecasts may be wrong causing us to make too many or too few of certain products. Also, our customers frequently place orders requesting product delivery almost immediately after the order is made, which makes forecasting customer demand even more difficult, particularly when supply is abundant. In addition, we have in the past spent, and will continue to spend, significant amounts of money to upgrade and increase our wafer fabrication, assembly and test manufacturing capability and capacity. If we experience inadequate demand or a significant shift in the mix of product orders that makes our existing capacity and capability inadequate, our fixed costs per semiconductor produced will increase, which will harm our financial condition and results of operations. Alternatively, if we should experience a sudden increase in demand, we will need to quickly ramp our inventory and/or manufacturing capacity to adequately respond to our customers. If we are unable to ramp our inventory or manufacturing capacity in a timely manner or at all, we risk losing our customer’s business, which could have a negative impact on our financial performance and reputation.
In some cases, such downturns have lasted more than a year. Prior experience has shown that restructuring of our operations, resulting in significant restructuring charges, may become necessary if an industry downturn persists. During the second half of fiscal 2004 and continuing into the first quarter of fiscal 2005, we experienced a rapid decline of demand for our products that may represent a period of industry over-supply. While we experienced sequential increase in sales in the second and third quarters of fiscal 2005, no assurance can be given that such increase is an indication of the beginning of a long-term recovery for us or the semiconductor industry.
Our subsidiary SunPower is currently facing an industry-wide shortage of polysilicon. The prices that SunPower pays for polysilicon have increased recently and SunPower expects these price increases to continue, which may constrain SunPower’s revenue growth and decrease its gross margins and profitability.
Polysilicon is an essential raw material in SunPower’s production of photovoltaic, or solar, cells. There is currently an industry-wide shortage of polysilicon, which has resulted in significant price increases. Based on its experience, SunPower believes that the average price of polysilicon has continued to increase. Increases in polysilicon prices have in the past increased SunPower’s manufacturing costs and may impact its manufacturing costs and operating results in the future. As demand for solar cells has increased, many of SunPower’s principal competitors have announced plans to add additional manufacturing capacity. As this manufacturing capacity becomes operational, it will increase the demand for polysilicon and further exacerbate the current shortage. Polysilicon is also used in the semiconductor industry generally and any increase in demand from that sector will compound the shortage. The production of polysilicon is capital intensive and adding additional capacity requires significant lead time. While SunPower is aware that several new facilities for the manufacture of polysilicon are under construction, it does not believe that the supply imbalance will be remedied in the near term. SunPower expects that polysilicon demand will continue to outstrip supply for the foreseeable future.
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Table of ContentsThere are a limited number of polysilicon suppliers. Since SunPower has only been purchasing polysilicon in bulk for less than a year, its competitors may have longer and perhaps stronger relationships with the suppliers than SunPower does. Some of SunPower’s competitors also have inter-locking board members with their polysilicon suppliers. In addition, since some of the arrangements are with suppliers who do not themselves manufacture polysilicon but instead purchase their requirements from other vendors, it is possible that these suppliers will not be able to obtain sufficient polysilicon to satisfy their contractual obligations to SunPower.
Although SunPower has purchase orders and contracts for what it believes will be an adequate supply of silicon ingots through 2006, its estimates regarding the supply needs may not be correct, its purchase orders may be cancelled, or the volume or pricing terms may be changed by the suppliers. Based on market conditions, SunPower’s purchase orders are generally non-binding in nature.
The inability to obtain sufficient polysilicon at commercially reasonable prices or at all would adversely affect SunPower’s ability to meet customer demand for its products, which could cause SunPower to lose customers, market share and revenue, thereby seriously harming SunPower’s and our business, financial condition and results of operations.
Our stock price may experience increased volatility as a result of SunPower’s planned initial public offering.
During the third quarter of fiscal 2005, our subsidiary SunPower has filed a registration statement for the initial public offering of its class A common stock. As the majority holder of SunPower’s capital stock, our stock price may experience increased volatility as SunPower progresses through the offering process. In addition, if SunPower’s initial public offering is cancelled, our stock could be negatively impacted.
Our ability to meet our cash requirements depends on a number of factors, many of which are beyond our control.
Our outstanding debt obligations primarily include $600.0 million of aggregate principal amount of the 1.25% convertible subordinated notes (“1.25% Notes”) that are due in June 2008. As of October 2, 2005, our total cash, cash equivalents and short-term investments excluding restricted cash were $209.8 million, which was less than our outstanding indebtedness if it were currently due.
In addition, each holder of our 1.25% Notes is permitted at any time prior to maturity to redeem his or her 1.25% Notes into 55.172 shares of our common stock plus a cash payment of $300. If all of the holders of our 1.25% Notes were to elect to convert their 1.25% Notes to shares of our common stock and cash, we would be required to issue approximately 33.1 million additional shares of common stock, which could have a dilutive impact on any future earnings per share, as well as making cash payments of approximately $180 million.
Our ability to meet our cash requirements (including our debt service obligations) is dependent upon our future performance, which will be subject to financial, business and other factors affecting our operations, many of which are beyond our control. We cannot guarantee that our business will generate sufficient cash flows from operations to fund our cash requirements or to meet our debt service obligations. If we are unable to meet our cash requirements from operations, we would be required to fund these cash requirements by alternative financing. The degree to which we may be leveraged could materially and adversely affect our ability to obtain financing for working capital, acquisitions or other purposes, could make us more vulnerable to industry downturns and competitive pressures or could limit our flexibility in planning for, or reacting to, changes and opportunities in our industry, which may place us at a competitive disadvantage. There can be no assurance that we would be able to obtain alternative financing, that any such financing would be on acceptable terms or that we will be permitted to do so under the terms of our existing financing arrangements. In the absence of such financing, our ability to respond to changing business and economic conditions, make future acquisitions, react to adverse operating results, meet our debt service obligations, or fund required capital expenditures may be adversely affected.
Our business, financial condition and results of operations will be seriously harmed if we fail to compete successfully in our highly competitive industry and markets.
The semiconductor industry is intensely competitive. This intense competition results in a difficult operating environment that is marked by erosion of average selling prices over the lives of each product and rapid technological change resulting in limited product life cycles. In order to offset selling price decreases, we attempt to decrease the manufacturing costs of our products and to introduce new, higher priced products that incorporate advanced features. If these efforts are not successful or do not occur in a timely manner, or if our newly introduced products do not gain market acceptance, our business, financial condition and results of operations could be
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Table of Contentsseriously harmed. Furthermore, we expect our competitors to invest in new manufacturing capacity and achieve significant manufacturing yield improvements in the future. These developments could dramatically increase the worldwide supply of competitive products and result in further downward pressure on prices.
A primary cause of this highly competitive environment is the strength of our competitors. The industry consists of major domestic and international semiconductor companies, many of which have substantially greater financial, technical, marketing, distribution and other resources than we do. We face competition from other domestic and foreign high-performance integrated circuit manufacturers, many of which have advanced technological capabilities and have increased their participation in markets that are important to us. We believe that there is a variety of competing technologies under development by other companies that could result in lower manufacturing costs than those expected for our products. Our development efforts may be rendered obsolete by the technological advances of others, and other technologies may prove more advantageous for the commercialization of solar power products and semiconductors generally.
Our ability to compete successfully in the rapidly evolving high performance portion of the semiconductor technology industry depends on many factors, including:
Although we believe we currently compete effectively in the above areas to the extent they are within our control, given the pace of change in the industry, our current abilities are not a guarantee of future success. If we are unable to compete successfully in this environment, our business, financial condition and results of operations will be seriously harmed.
Our financial results could be adversely impacted if we fail to develop, introduce and sell new products or fail to develop and implement new technologies.
Like many semiconductor companies, which frequently operate in a highly competitive, quickly changing environment marked by rapid obsolescence of existing products, our future success depends on our ability to develop and introduce new products that customers choose to buy. We introduce significant numbers of products each year, which are important sources of revenue for us. If we fail to introduce new product designs in a timely manner or are unable to manufacture products according to the requirements of these designs, or if our customers do not successfully introduce new systems or products incorporating our products, or market demand for our new products does not exist as anticipated, our business, financial condition and results of operations could be seriously harmed.
For us and many other semiconductor companies, introduction of new products is a major manufacturing challenge. The new products the market requires tend to be increasingly complex, incorporating more functions and operating at faster speeds than prior products. Increasing complexity generally requires smaller features on a chip. This makes manufacturing new generations of products substantially more difficult than prior generations. Ultimately, whether we can successfully introduce these and other new products depends on our ability to develop and implement new ways of manufacturing semiconductors. If we are unable to design, develop, manufacture, market and sell new products successfully, our business, financial condition and results of operations would be seriously harmed.
We must spend heavily on equipment to stay competitive and will be adversely impacted if we are unable to secure financing for such investments.
In order to remain competitive, semiconductor manufacturers generally make significant investments in capital equipment to maintain or increase technology and design development and manufacturing capacity and capability. This is particularly true as companies develop technologies that would allow for fabrication of products using smaller geometries in order to increase performance of those products and also to reduce cost. In addition, certain technology breakthroughs may only be supported by
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Table of Contents300mm equipment. This technology change would most likely necessitate migrating our production into 300mm wafers versus our existing 200mm capability, which could be prohibitively expensive for us and could cause us to change our business model. We anticipate significant continuing capital expenditures in subsequent years. In the past, we have reinvested a substantial portion of our cash flows from operations in technology, design development and capacity expansion and improvement programs.
If we are unable to decrease costs for our products at a rate at least as fast as the rate of the decline in selling prices for such products, we may not be able to generate enough cash flows from operations to maintain or increase manufacturing capability and capacity as necessary. In such a situation, we would need to seek financing from external sources to satisfy our needs for manufacturing equipment and, if cash flows from operations declines too much, for operational cash needs as well. Such financing, however, may not be available on terms that are satisfactory to us or at all, in which case our business, financial condition and results of operations would be seriously harmed.
The complex nature of our manufacturing activities makes us highly susceptible to manufacturing problems and these problems can have a substantial negative impact on us when they occur.
Making semiconductors is a highly complex and precise process, requiring production in a tightly controlled, clean environment. Even very small impurities in our manufacturing materials, difficulties in the wafer fabrication process, defects in the masks used to print circuits on a wafer or other factors can cause a substantial percentage of wafers to be rejected or numerous chips on each wafer to be non-functional. We may experience problems in achieving an acceptable success rate in the manufacture of wafers and the likelihood of facing such difficulties is higher in connection with the transition to new manufacturing methods. The interruption of wafer fabrication or the failure to achieve acceptable manufacturing yields at any of our facilities would seriously harm our business, financial condition and results of operations. We may also experience manufacturing problems in our assembly and test operations and in the introduction of new packaging materials.
Problems in the performance or availability of other companies we hire to perform certain manufacturing and transport tasks can seriously harm our financial performance.
A high percentage of our products are fabricated in our manufacturing facilities located in Texas, Minnesota and the Philippines. However, we also rely on independent contractors to manufacture some of our products. If market demand for our products exceeds our internal manufacturing capacity, we may seek additional foundry manufacturing arrangements. A shortage in foundry manufacturing capacity, which is more likely to occur at times of increasing demand, could hinder our ability to meet demand for our products and therefore adversely affect our operating results.
While a high percentage of our products are assembled, packaged and tested at our manufacturing facility located in the Philippines, we rely on independent subcontractors to assemble, package and test the balance of our products. We cannot be certain that these subcontractors will continue to assemble, package and test products for us on acceptable economic and quality terms or at all and it might be difficult for us to find alternatives if they do not do so.
We also rely on independent carriers and freight haulers to move our products between manufacturing plants and our customers. Transport or delivery problems due to their error or because of unforeseen interruptions in their business due to factors such as strikes, political instability, terrorism, natural disasters or accidents could seriously harm our business, financial condition and results of operations and ultimately impact our relationship with our customers.
If the market for solar power products takes longer to develop than we anticipate or does not develop at all, or if we fail to compete successfully in the solar power market, our revenue and profitability could be adversely affected.
The market for solar power products manufactured by SunPower is emerging and rapidly evolving. If solar power technology proves unsuitable for widespread commercial deployment or if demand for SunPower’s products or solar power products generally fails to develop sufficiently or at all, our revenues and profitability could be affected adversely. In addition, demand for solar power products in the markets and geographic regions we target may develop more slowly than we anticipate or not at all. The solar cell market has not historically been a part of our core semiconductor business. If we are unable to keep pace with this rapidly evolving industry, our results of operations could suffer. Many factors will influence the adoption of solar power technology as well as our ability to compete in the solar power products market, including:
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Because SunPower has fixed-price agreements with two of its largest customers and operates on a purchase order basis with its third largest customer, its financial results, and therefore ours, may suffer if its manufacturing costs were to increase or purchase orders were changed or cancelled.
SunPower’s agreements with Conergy and Solon provide that they will purchase products from SunPower on a fixed-price basis. The agreement with Conergy expires at the end of this year and SunPower is currently in negotiations with them regarding a new agreement. The agreement with Solon provides for a fixed-price basis for the first two years of the agreement, which expires in 2010. However, SunPower’s manufacturing costs, including the cost of polysilicon, are variable. If SunPower’s manufacturing costs increase, it would be unable to raise its prices to these customers, which in turn would negatively impact its margins and operating results. SunPower does not have a long-term agreement with Plexus but instead operates on a purchase order basis. Although SunPower believes that cancellations to date have been insignificant, its customers may cancel or reschedule purchase orders on relatively short notice. Cancellations or rescheduling of customer orders could result in the delay or loss of anticipated sales without allowing SunPower sufficient time to reduce, or delay the incurrence of, corresponding inventory and operating expenses. If SunPower’s operating expenses were to increase or if it were to lose expected sales, its financial performance could be negatively impacted which could also affect our results of operations.
Any guidance that we may provide about our business or expected future results may prove to differ from actual results.
From time to time we have shared our views in press releases or SEC filings, on public conference calls and in other contexts about current business conditions and our expectations as to potential future results. Identifying correctly the key factors affecting business conditions and predicting future events is inherently an uncertain process. Our analyses and forecasts have in the past and, given the complexity and volatility of our business, will likely in the future, prove to be incorrect. We offer no assurance that such predictions or analysis will ultimately be accurate, and investors should treat any such predictions or analyses with appropriate caution.
In addition, because we recognize revenues from sales to certain distributors only when these distributors make a sale to customers, we are highly dependent on the accuracy of their resale estimates. The occurrence of inaccurate estimates also contributes to the difficulty in predicting our quarterly revenue and results of operations and we can fail to meet expectations if we are not accurate in our estimates.
We consolidate SunPower’s financial results in the results of operation we report to the public in press releases and our SEC filings. SunPower’s financial performance may be affected by a number of factors, including, but not limited to:
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Any analysis or forecast that we make which ultimately proves to be inaccurate may adversely affect our stock price.
We may be unable to protect our intellectual property rights adequately and may face significant expenses as a result of ongoing or future litigation.
Protection of our intellectual property rights is essential to keeping others from copying the innovations that are central to our existing and future products. Consequently, we may become involved in litigation to enforce our patents or other intellectual property rights, to protect our trade secrets and know-how, to determine the validity or scope of the proprietary rights of others or to defend against claims of invalidity. We are also from time to time involved in litigation relating to alleged infringement by us of others’ patents or other intellectual property rights.
Intellectual property litigation is frequently expensive to both the winning party and the losing party and could take up significant amounts of management’s time and attention. In addition, if we lose such a lawsuit, a court could find that our intellectual property rights are invalid, enabling our competitors to use our technology, or require us to pay substantial damages and/or royalties or prohibit us from using essential technologies. For these and other reasons, this type of litigation could seriously harm our business, financial condition and results of operations. Also, although in certain instances we may seek to obtain a license under a third party’s intellectual property rights in order to bring an end to certain claims or actions asserted against us, we may not be able to obtain such a license on reasonable terms or at all.
For a variety of reasons, we have entered into technology license agreements with third parties that give those parties the right to use patents and other technology developed by us and/or give us the right to use patents and other technology developed by them. Historically, these arrangements have not been a material source of revenue to the Company. We anticipate that we will continue to enter into these kinds of licensing arrangements in the future. It is possible, however, that licenses we want will not be available to us on commercially reasonable terms or at all. If we lose existing licenses to key technology, or are unable to enter into new licenses that we deem important, our business, financial condition and results of operations could be seriously harmed.
It is critical to our success that we are able to prevent competitors from copying our innovations. Therefore, we intend to continue to seek intellectual property protection for our technologies. The process of seeking patent protection can be long and expensive and we cannot be certain that any currently pending or future applications will actually result in issued patents, or that, even if patents are issued, they will be of sufficient scope or strength to provide meaningful protection or any commercial advantage to us. Furthermore, others may develop technologies that are similar or superior to our technology or design around the patents we own.
We also rely on trade secret protection for our technology, in part through confidentiality agreements with our employees, consultants and third parties. However, these parties may breach these agreements and we may not have adequate remedies for any breach. Also, others may | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||