Annual Reports

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  • 10-K (Mar 2, 2010)
  • 10-K (Apr 30, 2009)

 
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Electronics for Imaging 10-K 2007
Form 10-K
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM 10-K

(Mark One)

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

For the fiscal year ended December 31, 2006

 

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

Commission File Number: 000-18805

 


ELECTRONICS FOR IMAGING, INC.

(Exact name of registrant as specified in its charter)

 

Delaware   94-3086355

(State or other Jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

303 Velocity Way, Foster City, CA 94404
(Address of principal executive offices) (Zip Code)

(650) 357-3500

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

 

Title of Each Class

 

Name of Exchange on which Registered

Common Stock, $.01 Par Value   The NASDAQ Stock Market LLC

 

Securities registered pursuant to Section 12(g) of the Act:

   None   

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

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

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  ¨    No  x

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act).

Large accelerated filer  x                        Accelerated filer  ¨                        Non-accelerated filer  ¨

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 aggregate market value of the voting and non-voting common stock held by non-affiliates of the registrant computed by reference to the price at which the common stock was last sold on June 29, 2007 and June 30, 2006 was $1,008,125,241 and $733,833,446, respectively.** The number of shares outstanding of the registrant’s common stock, $.01 par value per share, as of October 15, 2007 was 57,530,227.

DOCUMENTS INCORPORATED BY REFERENCE

None.

** Based upon the last trade price of the Common Stock reported on the NASDAQ Global Select Market on June 29, 2007 and June 30, 2006, the last business day of the registrant’s second quarter of the 2007 and 2006 fiscal year, respectively. Excludes approximately 21,828,291 shares of common stock held by Directors, Officers and holders known to the Registrant to hold 5% or more of the Registrant’s outstanding Common Stock on December 31, 2006, in that such persons may be deemed to be affiliates. Exclusion of shares held by any person should not be construed to indicate that such person possesses the power, direct or indirect, to direct or cause the direction of the management or policies of the Registrant, or that such person is controlled by or under common control with the Registrant.

 



Table of Contents

TABLE OF CONTENTS

 

EXPLANATORY NOTE

  
PART I   

ITEM 1

   Business    1

ITEM 1A

   Risk Factors    10

ITEM 1B

   Unresolved Staff Comments    26

ITEM 2

   Properties    27

ITEM 3

   Legal Proceedings    27

ITEM 4

   Submission of Matters to a Vote of Security Holders    31
PART II   

ITEM 5

   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities    32

ITEM 6

   Selected Financial Data    34

ITEM 7

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    36

ITEM 7A

   Quantitative and Qualitative Disclosures about Market Risk    59

ITEM 8

   Financial Statements and Supplementary Data    61

ITEM 9

   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure    120

ITEM 9A

   Controls and Procedures    120

ITEM 9B

   Other Information    121
PART III   

ITEM 10

   Directors, Executive Officers and Corporate Governance    122

ITEM 11

   Executive Compensation    126

ITEM 12

   Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters    142

ITEM 13

   Certain Relationships and Related Transactions, and Director Independence    145

ITEM 14

   Principal Accountant Fees and Services    146
PART IV   

ITEM 15

  

Exhibits and Financial Statement Schedules and Reports on Form 8-K

   147

SIGNATURES

   152

EXHIBIT INDEX

  

EXHIBIT 12.1

  

EXHIBIT 21

  

EXHIBIT 31.1

  

EXHIBIT 31.2

  

EXHIBIT 32.1

  


Table of Contents

EXPLANATORY NOTE

We are restating the following consolidated financial statements and related disclosures in this Annual Report on Form 10-K:

(1) our consolidated balance sheet as of December 31, 2005 and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the two years in the period ended December 31, 2005;

(2) “Selected Consolidated Financial Data” in Part II, Item 6 as of and for the fiscal years ended December 31, 2005, 2004, 2003, and 2002;

(3) “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 as of and for the fiscal years ended December 31, 2005 and 2004; and

(4) our unaudited quarterly financial information for the first two quarters in our fiscal year ended December 31, 2006 and for all quarters in our fiscal year ended December 31, 2005 located at the end of Item 8 in this Annual Report on Form 10-K.

Previously filed Annual Reports on Form 10-K and Quarterly Reports on Form 10-Q, and all earnings press releases and similar communications issued by us, relating to the period 1992 through June 30, 2006 have been affected by the restatement, have not been amended and should not be relied on. Additionally any similar earnings releases or communications issued prior to this restatement should not be relied on.

For more information regarding the restatement, please see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and Note 2, “Restatement of Consolidated Financial Statements” of the Notes to the Consolidated Financial Statements in Item 8, Financial Statements and Supplementary Data.


Table of Contents

PART I

This Annual Report on Form 10-K includes certain registered trademarks and trade names of Electronics For Imaging, Inc., its subsidiaries (collectively, “EFI” or the “Company”) and others. Best, Digital StoreFront, DocStream, EDOX, EFI, Fiery, Jetrion, Logic, MicroPress, OneFlow, Printcafe, Splash, and VUTEk are trademarks of the Company. All other terms and product names may be registered trademarks or trademarks of their respective owners, and are hereby acknowledged.

Certain of the information contained in this Annual Report on Form 10-K, including without limitation, statements made under this Part I, Item 1 “Business” and Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 7A, “Quantitative and Qualitative Disclosures about Market Risk” which are not historical facts, may include “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended and is subject to risks and uncertainties and actual results or events may differ materially. When used herein, the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” “may,” “should,” “plan,” “potential,” “seek,” “continue” and similar expressions as they relate to the Company or its management are intended to identify such statements as “forward-looking statements.” Such statements reflect the current views of the Company and its management with respect to future events and are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, the Company’s actual results, performance or achievements could differ materially from the results expressed in, or implied by, these forward-looking statements. Important factors that could cause the Company’s actual results to differ materially from those included in the forward-looking statements made herein include, without limitation, those factors discussed in Item 1 “Business” in Item 1A “Risk Factors” and elsewhere in this Annual Report on Form 10-K and in the Company’s other filings with the Securities and Exchange Commission, including the Company’s most recent Quarterly Report on Form 10-Q and current reports on Form 8-K, and any amendments thereto. The Company assumes no obligation to revise or update these forward-looking statements to reflect actual results, events or changes in factors or assumptions affecting such forward-looking statements.

Item 1: Business

Filings

We file annual reports, quarterly reports, proxy statements and other documents with the Securities and Exchange Commission (SEC) under the Securities Exchange Act of 1934 (Exchange Act). The public may read and copy any materials that we file with the SEC at the SEC’s Public Reference Room at Room 1580, 100 F Street, N.E., Washington, D.C. 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains an Internet website that contains reports, proxy and information statements and other information regarding issuers, including EFI, that file electronically with the SEC. The public can obtain any documents that we file with the SEC at http://www.sec.gov.

We also make available free of charge through our Internet website (http://www.efi.com) our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and, if applicable, amendments to those reports filed or furnished pursuant to the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.

General

EFI was incorporated in Delaware in 1989 and in 1992 we made our initial public offering of common stock. Our common stock is traded on the NASDAQ Global Select Market under the symbol EFII. Our corporate offices are located at 303 Velocity Way, Foster City, California 94404.

 

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We are the world leader in color digital print controllers, super-wide format printers and inks, and print management solutions. Our award-winning technologies offer integrated document management tools from creation to print, including high fidelity color Fiery print controllers that can output up to 2,000 pages per minute; VUTEk super-wide digital inkjet printers and UV and solvent inks capable of printing on flexible and rigid substrates; powerful print production workflow and management information software solutions for increased performance and cost efficiency; Jetrion industrial inkjet printers, inks and custom printing systems for the label and packaging industries; and corporate printing solutions. Our integrated solutions and award-winning technologies are designed to automate print and business processes, streamline workflow, provide profitable value-added services and produce accurate digital output.

Products and Services

Controllers

Headlined by EFI’s flagship Fiery brand, our core controller technologies transform digital copiers and printers into networked printing devices. Once networked, EFI-powered printers and copiers can be shared across workgroups, departments, the enterprise and the Internet to quickly and economically produce high-quality color and black & white documents. Our color digital print controllers provide solutions for a broad range of the printing market—from entry-level desktop printers to production-level digital copiers. Our color digital print controller line of products are sold to original equipment manufacturers (OEMs) for sale to customers, and consist of: (i) stand-alone print controllers which are connected to digital copiers and other peripheral devices and (ii) embedded and design-licensed solutions which are used in digital copiers, desktop laser printers and multifunctional devices.

Our main controller solutions, primary OEMs and user environments are as follows:

 

Platform

  

Primary OEM

  

User environment

Fiery external print servers    Canon, Fuji Xerox, IKON, Konica Minolta, Oce´, Ricoh, Sharp, Toshiba, Xerox    Print for Pay, Corporate Reprographic Departments, Graphic Arts, Advertising Agencies, Transactional Printers, Commercial Printers
Fiery embedded servers (boards and chipsets)    Canon, Fuji Xerox, IKON, Konica Minolta, Oce´, Ricoh, Sharp, Toshiba, Xerox    Office Environments
Splash    Xerox    Graphic Arts, Advertising Agencies
Micropress    Canon, Danka, IKON, Konica Minolta, Ricoh    Corporate Reprographic Departments, Commercial Printers

Inkjet Products

Our industry-leading VUTEk super-wide format digital inkjet printers and inks are used by billboard graphics printers, commercial photo labs, large sign shops, graphic screen printers and digital graphics providers to print billboards, building wraps, banners, art exhibits, point of purchase signage and other large displays.

 

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The VUTEk printers are divided into two categories, printers using solvent inks and those using UV (ultra violet) curable inks. In 2006, we introduced two new super-wide printing platforms, the QS series of high speed, high resolution printers and the modular VUTEk 3360. Some of our more popular printers and features are as follows:

 

Printer Type

  

Models

  

Capabilities

  

Applications

Solvent   

UltraVU Series

VUTEk 3360

  

Printing widths of 1.5 to 5.0 meters

Four, six and eight colors

Flexible substrates

Solvent ink

  

Banners

Billboards

Exhibition signage

Building Wraps

Flags

UV   

PressVu Series

QS Series

  

Printing widths up to 2.0 to 3.2 meters

Four, six and seven colors

Flexible and rigid substrates

UV curable inks

  

Point of purchase signage

Point of purchase signage

Backlit displays

Exhibition signage

Photo-quality graphics

On October 31, 2006, we acquired Jetrion LLC (Jetrion), which specializes in digital printing and provides a complete spectrum of industrial inkjet systems, custom high-performance integration solutions and specialty inks to the converting, packaging and direct mail industries. To further expand our industrial inkjet leadership, we have recently announced plans for a full color UV inkjet label press.

We also manufacture the inks used in our inkjet printers. Each of our inks is customized for each of our printers to provide optimum performance on that printer. In addition, we manufacture and sell private label inks to third-party inkjet printer manufacturers.

Advanced Professional Print Software

To provide our customers with print solutions, we have developed technology that enhances printing workflow and makes printing operations more powerful, productive and easier to manage from one centralized user interface. Most of the our software solutions have been developed with the express goal of automating print processes and streamlining workflow via open, integrated and interoperable EFI products, services and solutions.

Our enterprise resource planning (ERP) and collaborative supply chain software print management solutions are designed to enable printers and print buyers to improve productivity and customer service while reducing costs. Procurement applications for print buyers and print producers facilitate web-based collaboration across the print supply chain. Customers recognize that print management information systems, or PMIS, are essential to improving their business practices and profitability and we are continuing to focus on making our PMIS solutions the global industry standard.

 

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Our software offerings currently include:

 

Product Name

  

Description

  

User

Colorproof XF proofing software    Digital color proofing solutions offering fast, flexible workflow, power, and expandability    Digital, commercial and hybrid printers, prepress providers, publishers, creative agencies and photographers
EFI Hagen, EFI Logic, EFI PSI, EFI PrintSmith print management information systems    Collect, organize, and present critical information to improve process control and profit potential    Commercial, publishing, digital, in-plant, print for pay, large format and specialty printers
Digital StoreFront, PrinterSite web-based order entry and order management systems    Web interface to manage print transactions between customer and printer    Commercial, publishing, digital, in-plant, print for pay, large format and specialty printers

Growth and Expansion Strategies

Our overall objective is to continue to introduce new generations of digital print controllers as well as expand our offerings in inkjet, professional printing software applications, and in other new product lines related to digital printing, workflow and print management. With respect to our current products, our primary goal is to offer best of breed solutions that are interoperable and conform to open standards, which will allow customers to configure the most efficient solution for their business. Our strategy to accomplish these goals consists of four key elements: proliferate and expand product lines; develop and expand relationships with key industry participants; establish enterprise coherence and leverage industry standardization; and leverage technology and industry expertise to expand the scope of products, channels and markets. Each of these items is discussed below.

Proliferate and Expand Product Lines

We intend to continue to develop new digital print controllers that are “scalable”, meaning products that continue to meet the changing needs of the user as their business grows. Our products offer a broad range of features and functionality when connected to, or integrated with, digital color and black-and-white copiers, as well as desktop color laser printers.

We intend to continue our development of platform enhancements that advance the performance and usability of our software applications in order to provide cohesive, integrated solutions for our customers.

In 2006, we introduced a new generation of our Fiery product line, Fiery System 8, which provides enhanced workflow and production management tools and new variable data printing capabilities to provide customers with more efficient workflow, more accurate color and greater control over and visibility into their business. We also launched the new Color Profiler Suite profiling solution designed to ensure total color quality control in the color printing workflow for graphic arts professionals.

Our expansion of product lines includes our acquisition of Jetrion, a leading innovator of inkjet printers, inks and custom printing systems for the label and packaging industries. This acquisition expanded our presence in the industrial inkjet market.

In 2006, we introduced two new VUTEk super-wide UV printing platforms that provide the speed, quality and configurability necessary to better enable our customers to meet the growing needs of their customers. The new 2.0 meter QS2000 and 3.2 meter QS3200 UV inkjet printers provide both high speed and high resolution quality for rigid or flexible substrates. The new enhanced VUTEk 3360 solvent printer platform provides customers with an entry-level configuration that makes it easier for customers to acquire VUTEk quality and add functionality as needed to meet the needs of their customers.

 

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In 2006, we introduced our BioVu ink, the first ink for super-wide format printers made from a renewable resource, corn. As a result of its environmental signature, BioVu will help improve working conditions within our customers’ production facilities as well as helping our customers meet their customers’ growing need for environmental sustainability in the printed products they purchase.

We also continue to explore acquisition possibilities as a way to expand our product lineup and customer base. Although there can be no assurance that acquisitions will be successful, acquisitions have allowed us to broaden our product lines.

Develop and Expand Relationships with Key Industry Participants

Our customer relationships are one of our most important assets. We have established relationships with leading printer and copier industry companies, including Canon, Fuji Xerox, Konica Minolta, Oki, Océ, Ricoh, Sharp, Toshiba and Xerox, which we collectively refer to as our OEM customers.

Our relationships with our OEM customers are based upon business relationships we have established over time. However, our agreements with such OEM customers generally do not require them to make any future purchases from us, and our OEM customers are generally free to purchase products from our competitors or build their own and cease purchasing our products at any time, for any reason or no reason.

Additionally, we have established relationships with many leading distribution companies in the office, graphic arts and commercial print industries such as IKON, Presstek, Fujifilm Graphic Systems, Pitman, Nazdar and 3M. We seek to establish new relationships in pursuit of the goal of offering our controller line of products as well as our software technology for optimizing the management and creation of documents in a variety of print environments.

We also have established relationships with many of the leading print providers globally, such as R.R. Donnelley, Consolidated Graphics and Cenveo Anderson Lithograph. These direct sales relationships, along with dealer arrangements, are vital for our understanding of the end markets for our products and serve as a source of future product development ideas. In many cases our products are customized for the needs of large customers yet maintain the common intuitive interfaces that EFI is known for around the world.

Our Advanced Professional Print Software and Inkjet products are sold both direct and via distribution arrangements to all sizes of print providers.

Establish Enterprise Coherence and Leverage Industry Standardization

In our development of new products and platforms, we seek to establish coherence across our entire product line by designing products that provide a consistent “look and feel” to the end-user. We believe cross-product coherence can create higher productivity levels as a result of shortened learning curves. Additionally, we believe the integrated coherence that end-users can achieve using EFI products for all of their digital printing and imaging needs leads to a lower total cost of ownership. We also advocate open architecture utilizing industry-established standards to provide inter-operability across a range of digital printing devices and software applications, ultimately providing end-users more choice and flexibility in their selection of products. For example in 2006, we introduced enhanced integration between our web-based Digital StoreFront application, our Fiery, our Logic SQL print MIS application and Canon’s new production print engine, the Canon imagePress 7000VP, leveraging the industry standard Job Definition Format (JDF).

Leverage Technology and Industry Expertise to Expand the Scope of Products, Channels and Markets

We have assembled, organically and through acquisitions, an experienced team of technical and sales and marketing personnel with backgrounds in color reproduction, digital pre-press, image processing, management

 

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information systems, networking and software and hardware engineering as well as market knowledge of enterprise printing, graphic arts and commercial printing. By applying our expertise in these areas, we expect to continue to expand the scope and sophistication of our products and gain access to new markets and channels of distribution.

Significant Relationships

We have established and continue to build and expand relationships with our OEMs and distributors of digital printing technology in order to benefit from their products, distribution channels and marketing resources. Our customers include domestic and international manufacturers, distributors and sellers of color and black-and-white digital copiers, wide-format printers and desktop color printers. We work closely with our OEM customers with the aim of developing solutions that incorporate leading technology, and that work optimally in conjunction with such companies’ products. The top 7 revenue-generating OEMs or distributors, in alphabetical order, that we sold products to in 2006 were Canon, Fuji Xerox, IKON Office Solutions, Konica Minolta, Océ, Ricoh and Xerox. Together, sales to Canon and Xerox accounted for approximately 34% of our 2006 revenue, with sales to each of these two customers accounting for more than 10% of our revenue. Because sales of our printer and copier-related products constitute a significant portion of our controller revenues and there are a limited number of OEMs producing copiers and printers in sufficient volume to be attractive customers for us, we expect that we will continue to depend on a relatively small number of OEM customers for a significant portion of our revenues in future periods. Accordingly, if we lose or experience reduced sales to an important OEM, we will have difficulty replacing the revenue traditionally generated from such OEM with sales to new or existing OEMs and our revenues may decline.

We customarily enter into development and distribution agreements with our OEM customers. These agreements can be terminated under a range of circumstances and often upon relatively short notice. The circumstances under which an agreement can be terminated vary from agreement to agreement and there can be no assurance that our OEM customers will continue to purchase products from us in the future, despite such agreements. Furthermore, our agreements with our OEM customers generally do not commit such customers to make future purchases from us and they could decline to purchase products from us in the future and could purchase products from our competitors, or build the products themselves. We recognize the importance of, and work hard to maintain, our relationships with our customers. However, our relationships with our customers are affected by a number of factors including, among others: competition from other suppliers, competition from internal development efforts by the customers themselves and changes in general economic, competitive or market conditions such as changes in demand for our or the OEM’s products, or fluctuations in currency exchange rates. There can be no assurance that we will continue to maintain or build the relationships we have developed to date. See Item 1A—We face competition from other suppliers as well as our own OEM customers and if we are not able to compete successfully our business may be harmed.

We have a continuing relationship pursuant to a license agreement with Adobe and license PostScript® software from Adobe for use in many of our controller solutions. This relationship is important because each of our controller solutions requires page description language software such as that provided by Adobe in order to operate. Adobe’s PostScript® software is widely used to manage the geometry, shape and typography of hard copy documents and Adobe is a leader in providing page description software. Although to date we have successfully obtained licenses to use Adobe’s PostScript® software when required, Adobe is not required to and we cannot be certain that Adobe will, grant future licenses to Adobe PostScript® software on reasonable terms, in a timely manner, or at all. In addition, in order to obtain licenses from Adobe, Adobe requires that we obtain from them quality assurance approvals for our products that use Adobe software. If Adobe does not grant us such licenses or approvals, if the Adobe licenses are terminated, or if our relationship with Adobe is otherwise materially impaired, we would likely be unable to sell products that incorporate Adobe PostScript® software. If that occurred, we would have to license, acquire, develop or reestablish our own competing software as a viable alternative for Adobe Postscript and our financial condition and results of operations could be significantly harmed for a period of time.

 

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Our inkjet printers are constructed with inkjet print heads which are manufactured by a limited number of suppliers. If we were to experience difficulty obtaining print heads, our production of inkjet printers would be limited and our revenues would be harmed. We manufacture inks for use in our printers and rely upon a limited number of suppliers for certain pigments used in our inks. Our ink sales would decline significantly if we were unable to obtain the pigments as needed. In addition, since the warranties on the ink delivery systems of our inkjet printers are voided if our inks are not used, our printer sales and customer relationships could be harmed.

Distribution and Marketing

Our primary distribution method for our controller line of products is to sell them to our OEMs. Our OEMs in turn sell these products to OEM-affiliated and independent distributors/dealers/resellers and end-users for use with the OEM’s copiers or printers as part of an integrated printing system. See Item 1A—We rely on sales to a relatively small number of OEM customers and the loss of any of these OEM customers could substantially decrease our revenues.

Our primary distribution method for our MicroPress controllers, our EFI Proofing Solutions and our EFI Workflow software products is to sell directly to our authorized distributors, dealers, and resellers who in turn sell the solutions to end users either in a stand alone form or bundled with other solutions they offer. Primary customers with whom we have established distribution agreements include Enovation, Fujifilm Graphic Systems, Pitman and other sales companies. There can be no assurance that we will continue to successfully distribute our products through these channels.

Our Print Management Information Solutions are primarily sold directly to the end user by EFI’s own sales force. To distribute our VUTEk printers and ink, we utilize a direct sales force in North America and Europe and principally distributors for the rest of our global distribution. Any interruption of the distribution methods could negatively impact us in the future.

We promote all of our products through public relations, direct mail, advertising, promotional material, trade shows and ongoing customer communication programs. The majority of the sales leads for inkjet printer sales are generated from tradeshows and any interruption in our tradeshow participation could materially impact our revenue and profitability.

Research and Development

Research and development costs for 2006, 2005 and 2004 were $127.9 million, $110.1 million and $112.3 million, respectively. As of December 31, 2006, 885 of our 1,889 full-time employees were involved in research and development. We believe that development of new products and enhancement of existing products are essential to our continued success, and management intends to continue to devote substantial resources to research and new product development. We expect to make significant expenditures to support our research and development programs for the foreseeable future.

We are developing products to support additional color and black-and-white printing devices including desktop printers, high-end color copiers, digital black-and-white copiers and multifunctional devices. We are also developing new software applications designed to maximize workflow efficiencies and to meet the needs of the graphic arts and commercial print professional, including proofing solutions and print management information systems solutions. We also expect to continue to develop new platforms of inkjet print technologies in order to meet the needs of existing and future markets. We have research and development sites in nine U.S. locations, as well as in Israel, India, Japan and Europe. See “Growth and Expansion Strategies—Proliferate and Expand Product Lines” above. Substantial additional work and expense will be required to complete and bring to market each of the products currently being developed by us.

 

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Manufacturing

We utilize sub-contractors to manufacture our controller line of products. These sub-contractors work closely with us to promote low costs and high quality in the manufacture of our products. Sub-contractors purchase components needed for our products from third parties. We are completely dependent on the ability of our sub-contractors to produce products sold by us and although we supervise our sub-contractors, there can be no assurance that such sub-contractors will perform efficiently or effectively. A significant amount of our controller line of products are manufactured at a single sub-contractor, Celestica Inc., located in Toronto, Canada. Should Celestica experience any inability or unwillingness to manufacture or deliver product from this location, our business, financial condition and operations could be harmed. Since we do not maintain long-term agreements with our sub-contractors, any of our sub-contractors could enter into agreements with our competitors that might restrict or prohibit such sub-contractors from manufacturing our products or could otherwise lead to an inability of such sub-contractor from filling our orders in a timely manner. See Item 1A— We are dependent on a limited number of subcontractors, with whom we do not have long-term contracts, to manufacture and deliver products to our customers and the loss of any of these subcontractors could adversely affect our business.

Our VUTEk printers and ink are manufactured at our Meredith, New Hampshire facility. Meredith is not located in a major metropolitan area, and we have encountered difficulties in hiring and retaining adequate skilled labor and management. We also face the risk of our New Hampshire labor force unionizing. Most of the components used in the manufacturing of the printers and the inks are available from multiple suppliers, except for the inkjet print heads and the pigments for our inks. Although typically in low volumes, many key components are sourced from single vendors. If we were unable to obtain the print heads currently used, we would be required to redesign our printers to use different print heads. If we were to change pigments, we would be required to reformulate and test the inks. In two of our locations we use hazardous materials to formulate solvent-based inks. The storage, use and disposal of those materials must meet various environmental regulations.

A significant number of the components necessary for the manufacture of our controller line of products are obtained from a sole supplier or a limited group of suppliers. These include processors from Intel and other related semiconductor components. We depend largely on the following sole and limited source suppliers for our components and manufacturing services:

 

Supplier

  

Components

Intel

   Central processing units, or CPUs; chip sets

Toshiba

   ASICs

LSI Logic

   ASICs

Texas Instruments

   Digital signal processors, or DSPs

Celestica Inc.

   Contract manufacturing

We do not maintain long-term agreements with any of our suppliers of components and primarily conduct our business with such suppliers solely on a purchase order basis. If any of our sole or limited source suppliers were unwilling or unable to supply us with the components for which we rely on them, we may be unable to continue manufacturing our products utilizing such components.

The absence of agreements with most of our suppliers also subjects us to fluctuations in pricing, a factor we believe is partially offset by the fact that our suppliers benefit from selling as many components to us as possible. Many of our components are similar to those used in personal computers, and the demand and price fluctuations of personal computer components could affect our component costs. Because the purchase of key components involves long lead times, in the event of unanticipated volatility in demand for our products, we may be unable to manufacture certain products in a quantity sufficient to meet end user demand, or we may hold excess quantities of inventory. We maintain an inventory of components for which we are dependent upon sole or limited source suppliers and of components with prices that fluctuate significantly. We cannot ensure that at any given time we will have sufficient inventory to enable us to meet demand for our products, which would harm our financial results. As a result of our acquisition of VUTEk in 2005, our inventory has increased; however, it still represents

 

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less than 4% of our total assets as of December 31, 2006. See Item 1A—We depend upon a limited group of suppliers for key components in our products and the loss of any of these suppliers could adversely affect our business.

Human Resources

As of December 31, 2006, we employed 1,889 full time employees. Approximately 441 were in sales and marketing, 229 were in general and administrative, 334 were in manufacturing and 885 were in research and development. Of the total number of employees, we had approximately 1,413 employees located in U.S. and Canadian offices and 476 employees located in offices outside of North America. Our employees are not represented by any collective bargaining organization and we have never experienced a work stoppage. However, there can be no assurance that collective bargaining, work stoppage or other employment related issues will not arise, particularly at our New Hampshire manufacturing facilities.

Competition

Competition in our markets is intense and involves rapidly changing technologies and frequent new product introductions. To maintain and improve our competitive position, we must continue to develop and introduce on a timely and cost-effective basis new products and features that keep pace with the evolving needs of our customers. The principal competitive factors affecting the markets for our controller solutions include, among others, customer service and support, product reputation, quality, performance, price and product features such as functionality, scalability, ability to interface with OEM products and ease of use. We believe we have generally been able to compete effectively in the past against product offerings of our competitors on the basis of such factors. However, there can be no assurance that we will continue to be able to compete effectively in the future based on these or any other competitive factors.

Our primary competitor for third-party stand-alone color controllers is Kodak. However, Kodak currently sells to a limited number of OEMs. Our OEM customers themselves are the principal competitors for the embedded and design-licensed color solutions. Our digital black-and-white solutions face competition from our OEM customers. Our market position vis-à-vis internally-developed controllers is small, however, as we are the largest third party controller vendor. We believe that our advantages include our continuously advancing technology, time-to-market, brand recognition, end-user loyalty, sizable installed base, number of products supported, price driven by lower developmental costs and market knowledge. A significant disadvantage is our lack of control of the distribution channels and direct connections with our end-users. We do, however, provide a variety of features as well as a unique “look and feel” to our OEMs’ products to differentiate our customers’ products from those of their competitors.

The VUTEk line of super-wide inkjet printers competes with printers produced by Durst, Gandi, Hewlett-Packard, Inca, NUR and Scitex Vision, throughout most of the world. There are Chinese and Korean printer manufacturers in the marketplace, but their products are typically sold in their domestic markets and are not perceived as alternatives in most other markets. Although we recommend that our inks be used in the VUTEk printers, users can purchase solvent-based inks from other ink manufacturers. The third-party inks are typically priced at a lower price than our proprietary inks. However, these third-party inks may not provide the same quality. In addition, the use of third-party inks with our printer products may void the ink delivery system warranty on the printer. We believe that our broad product line and leading technology provide a competitive advantage.

Our Advanced Professional Print Software category, which includes our Workflow, Proofing, Print Management Information Software and Web Submission Tools, faces competition from software application vendors that specifically target the printing industry. These vendors are typically small, privately-owned companies. We also face competition from larger vendors that currently offer or are seeking to develop printer-focused enterprise resource planning products. We believe the principal competitive factor affecting our markets is the market rates for new printing technology.

 

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There can be no assurance that we will be able to continue to advance our technology and products or to compete effectively against other companies’ product offerings and any failure to do so could have a material adverse effect upon our business, operating results and financial condition.

Intellectual Property Rights

We rely on a combination of patent, copyright, trademark and trade secret laws, non-disclosure agreements and other contractual provisions to establish, maintain and protect our intellectual property rights, all of which afford only limited protection. As of December 31, 2006, the Company had 172 issued U.S. patents, up from 165 at December 31, 2005, 87 pending U.S. patent applications and various foreign counterpart patents and applications. There can be no assurance that patents will be issued from these pending applications or from any future applications or that, if issued, any claims allowed will be sufficiently broad enough to protect our technology. In 2006, 5 new patent applications were filed, up from 2 in 2005. In addition, 1 patent expired with the remaining issued U.S. patents expiring between January 13, 2009 and August 20, 2024. Our failure to obtain or maintain patent protection may make it easier for our competitors to offer equivalent or superior technology. In addition, third parties may independently develop similar technology without misappropriation of our trade secrets or breach of other proprietary rights. Any failure by us to take all necessary steps to protect our trade secrets or other intellectual property rights and failure to enforce these rights may have a material adverse effect on our ability to compete in our markets. See Item 1A—We may be unable to adequately protect our proprietary information and may incur expenses to defend our proprietary information.

Certain trademarks are registered in the United States and/or in foreign jurisdictions. Additionally, applications for registration of certain additional trademarks are also pending, in the United States and/or in foreign jurisdictions. We will continue to evaluate the registration of additional trademarks as appropriate. Any failure by us to properly register or maintain our trademarks or to otherwise take all necessary steps to protect our trademarks may diminish the value associated with our trademarks. Our products include software sold pursuant to “shrink wrap” licenses that are not signed by the end user and, therefore, may be unenforceable under the laws of certain jurisdictions. In addition, the laws of some foreign countries, including several in which we operate or sell our products, do not protect intellectual property and proprietary rights to as great an extent as do the laws of the United States.

From time to time, litigation may be necessary to defend and enforce our proprietary rights. Such litigation, whether or not concluded successfully for us, could involve significant expense and the diversion of management’s attention and other resources. See Item 1A—We may be unable to adequately protect our proprietary information and may incur expenses to defend our proprietary information.

Financial Information about Foreign and Domestic Operations and Export Sales

See Note 15 of the Notes to Consolidated Financial Statements. See also Item 1A—We face risks from our international operations and We face risks from currency fluctuations.

Item 1A: Risk Factors

The matters relating to the Special Committee’s review of our historical stock option investigation practices and the restatement of our consolidated financial statements have required us to incur substantial expenses for accounting, legal and other professional services, have diverted our management’s attention from our business and have had and may continue to have a material adverse effect on our financial performance.

On October 24, 2006, we announced that a Special Committee of our Board of Directors had commenced an independent investigation of our historical stock option grants. On May 7, 2007, we announced that, based on information obtained by the Special Committee relating to a portion of the historical option grants under review, we believed that the actual measurement dates for certain stock option grants made during the period under

 

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review differed from the recorded grant dates used for financial accounting and reporting purposes for such options. Based on information obtained by the Special Committee, we concluded that the Company’s financial statements, earnings releases and similar communications relating to the period 1992 through June 30, 2006 should no longer be relied upon. On June 29, 2007, we announced the completion of the independent investigation by the Special Committee, and the remedial actions being taken in response to the findings and recommendations of the Special Committee. The Special Committee investigation and findings relating to stock option practices, the restatement and remedial measures adopted by our Board of Directors as a result of the investigation are described in further detail in Note 2 of the Notes to Consolidated Financial Statements, “Restatement of Consolidated Financial Statements,” Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and Part II, Item 9A, “Controls and Procedures.”

The independent investigation of our historical stock option practices and resulting restatement activities have required us to expend significant management time and incur significant accounting, legal and other expenses totaling $4.0 million in 2006, and we expect to incur additional costs in the future periods.

As a result of the events described above, we have become subject to a number of significant risks, each of which could have an adverse effect on our business, financial condition and results of operations, described below. See Item 1A—We face risks related to possible SEC and regulatory actions regarding our historical stock option grant practices, which could require significant management time and attention, and could require us to pay fines or other penalties; We face litigation risks relating to our stock option grant practices that could have a material adverse effect on the Company; Because of the delayed filing of our periodic reports, we face delisting from The Nasdaq Global Select Market. Delisting would adversely affect the trading price of our common stock; Because of the delayed filing of our periodic reports, we are ineligible to register our securities on Form S-3, which may increase our transaction costs and delay our ability to quickly access the capital markets; Alleged defaults of our convertible senior debentures, if not cured, may result in an acceleration of the debentures.

We face risks related to possible SEC and regulatory actions regarding our historical stock option grant practices, which could require significant management time and attention, and could require us to pay fines or other penalties.

In connection with the Special Committee investigation of our historical stock option grant practices and related informal inquiry by the Securities and Exchange Commission (“SEC”), we have voluntarily continued to keep the SEC advised of the issues identified during the investigation, its progress and our conclusions. Although no formal inquiry has been made by any regulatory agency with respect to the investigation and the related restatement, we are unable to predict whether any such formal inquiry will be initiated or what consequences, if any, that any such further inquiry may have on us. Any regulatory inquiry could result in substantial legal expenses, divert management’s attention from other business concerns and harm our business. If a regulatory agency were to commence legal action, it is possible that we could be required to pay significant penalties and/or fines and could become subject to administrative orders. Any regulatory action could result in the filing of additional restatements of our prior financial statements or require that we take other actions.

While we believe that we have made appropriate judgments in determining the revised measurement dates for option grants, the SEC may disagree with the manner in which we have accounted for and reported, or not reported, the financial impact of past option grant measurement date adjustments, and there is a risk that any SEC inquiry could lead to circumstances in which we may have to further restate our prior financial statements, amend prior filings with the SEC or otherwise take other actions not currently contemplated. In addition, the SEC may issue additional guidance on disclosure requirements related to the financial impact of past option grant measurement date adjustments that may require us to amend this filing or prior filings with the SEC to provide additional disclosures pursuant to this guidance. Any such circumstance could also lead to future delays in filing our subsequent SEC reports and delisting of our common stock from The Nasdaq Global Select Market. See Item 1A—Because of the delayed filing of our periodic reports, we face delisting from The Nasdaq Global Select Market. Delisting would adversely affect the trading price of our common stock. Furthermore, if we are subject to

 

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adverse findings in any of these matters, we could be required to pay damages or penalties or have other remedies imposed upon us which could harm our business, financial condition, results of operations and cash flows. See Note 2, “Restatement of Consolidated Financial Statements” of the Notes to Consolidated Financial Statements for further information.

We face litigation risks relating to our stock option grant practices that could have a material adverse effect on the Company.

A number of purported shareholder derivative complaints have been filed against us in connection with our historical stock option grant practices. The complaints allege, among other things, that certain of our current and past officers and directors breached their fiduciary duty to the Company by improperly backdating certain grants of stock options to officers and directors of the Company and violating the terms of our stock option plans, violating generally accepted accounting practices and producing and disseminating statements that improperly accounted for the options and concealed the alleged backdating. See Part I, Item 3, “Legal Proceedings,” for a further description of these proceedings.

The defense of these lawsuits has resulted, and will likely result in the future, in significant expense and the continued diversion of management’s time and attention from the operation of our business, which could impede our ability to achieve our business objectives. An unfavorable outcome in any of these lawsuits could have a material adverse effect on our business, financial condition, results of operations and cash flows. Additionally, any amount that we may be required to pay to satisfy a judgment or settlement of these lawsuits may not be covered by insurance. Under the bylaws, charter and indemnification agreements that we have entered into with our officers and directors, we are required, subject to certain limited qualifications, to indemnify, and advance expenses to, our current and former executive officers and directors in connection with their participation in proceedings arising out of their service to us. There can be no assurance that such payments in connection with the derivative actions will not be material. Additionally, in the future, we may be the subject of additional private or government actions related to our option grant practices. Litigation is time-consuming, expensive and disruptive to normal business operations, and the outcome of litigation, as well as its costs, are difficult to predict and could have a material adverse effect on our business, financial condition, results of operations and cash flows.

Because of the delayed filing of our periodic reports, we face delisting from The Nasdaq Global Select Market. Delisting would adversely affect the trading price of our common stock.

As a result of the delayed filing of our periodic reports with the SEC, on November 15, 2006, we received a Nasdaq staff determination notice stating that we were not in compliance with Nasdaq Marketplace Rule 4310(c)(14) due to our failure to timely file our Quarterly Report on Form 10-Q for the period ended September 30, 2006, and that our common stock is, therefore, subject to delisting from The Nasdaq Global Select Market. We received additional Nasdaq staff determination notices with respect to our failure to timely file our Annual Report on Form 10-K for the year ended December 31, 2006 and our Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2007 and June 30, 2007.

We requested and subsequently attended a hearing before the Nasdaq Listing Qualifications Panel (the “Panel”) to appeal the staff determination and presented a plan to cure the filing deficiencies and regain compliance. The Panel granted our request for continued listing on The Nasdaq Global Select Market, subject to certain conditions which we were unable to meet because of the then-ongoing independent investigation of our historical stock option grants. As a result, the Panel notified us that it had determined to delist our securities, which ordinarily would have resulted in the suspension of our securities effective on May 17, 2007. However, the Nasdaq Listing and Hearing Review Council (the “Listing Council”), pursuant to its discretionary authority under Marketplace Rule 4807(b), called for review the decision of the Panel regarding our case and stayed any action by the Panel to suspend our securities from trading on The Nasdaq Global Select Market pending further action by the Listing Council.

 

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On July 2, 2007, we provided the Listing Council with an additional submission for its consideration, and requested that the Listing Council exercise its discretionary authority, pursuant to Marketplace Rule 4802(b), in favor of granting us an additional extension to regain compliance with Nasdaq’s filing requirement, as set forth in Marketplace Rule 4310(c)(14).

On August 23, 2007, the Listing Council notified us that it had determined to exercise its discretionary authority, under Nasdaq Marketplace Rule 4802(b), to grant us an exception to demonstrate compliance with all of The Nasdaq Global Select Market continued listing requirements through October 22, 2007. If we do not become current in our public filings with the SEC by October 22, 2007, our securities will be suspended from trading on The Nasdaq Global Select Market at the opening of business on October 24, 2007.

If the Panel determines that we have not demonstrated compliance with all of the Nasdaq listing requirements, our common stock will be delisted from The Nasdaq Global Select Market. If we are delisted, our common stock would subsequently be transferred to the National Quotation Service Bureau, or “Pink Sheets.” The trading of our common stock on the Pink Sheets may reduce the price of our common stock and the levels of liquidity available to our stockholders. In addition, the trading of our common stock on the Pink Sheets will materially adversely affect our access to the capital markets and our ability to raise capital through alternative financing sources on terms acceptable to us, or at all. Securities that trade on the Pink Sheets are no longer eligible for margin loans, and a company trading on the Pink Sheets cannot avail itself of federal preemption of state securities or “blue sky” laws, which adds substantial compliance costs to securities issuances, including pursuant to employee option plans, stock purchase plans and private or public offerings of securities. If we are delisted in the future from The Nasdaq Global Select Market and transferred to the Pink Sheets, there may also be other negative implications, including the potential loss of confidence by suppliers, customers and employees and the loss of institutional investor interest in our company.

Alternatively, we may apply for listing on another exchange. However, there is no assurance that we will meet the requirements for initial listing or maintain compliance with the continued listing requirements of such an exchange.

Because of the delayed filing of our periodic reports, we are ineligible to register our securities on Form S-3, which may increase transaction costs and delay our ability to quickly access the capital markets.

As a result of the delayed filing of our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2006, Annual Report on Form 10-K for the year ended December 31, 2006 and Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2007 and June 30, 2007, we will be ineligible to register our securities on Form S-3 for sale by us or resale by others until we have timely filed all periodic reports under the Securities and Exchange Act of 1934 for a period of twelve months and any portion of a month from the due date of the last untimely report. We may use Form S-1 to raise capital or complete acquisitions, but doing so could increase transaction costs and adversely impact our ability to raise capital or complete certain acquisitions of other companies in a timely manner.

Alleged defaults of our convertible senior debentures, if not cured, may result in an acceleration of the debentures.

In June 2003, we issued $240 million in 1.50% convertible senior debentures due in 2023. We have received notices from the trustee under the indenture governing the debentures regarding certain requirements to file with the trustee copies of annual and quarterly reports that we are required to file with the SEC. Most recently, we received a notice from the trustee asserting that, because we did not file our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2006 within 60 days of receiving a previous notice from the trustee, an “Event of Default” has occurred and is continuing under the indenture. This notice further asserted that, if the deficiency related to the filing of our Annual Report on Form 10-K for the fiscal year ended December 31, 2006 and Quarterly Report on Form 10-Q for the quarterly periods ended March 31, 2007 and June 30, 2007 is not

 

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cured within 60 days, additional “Events of Default” will occur under the indenture. Under the terms of the indenture, we have 60 days to cure a default. If we do not cure a default within that period, either the trustee or the holders of at least 25% of the aggregate principal amount of outstanding debentures may accelerate the maturity of the debentures, causing the outstanding principal amount plus accrued interest to be immediately due and payable; to date, none has done so. The trustee has not accelerated the maturity of the debentures, but reserved the right to seek the remedies allowed in the indenture.

As of June 30, 2007, we had approximately $517.4 million of cash and investments. Accordingly, we believe that, if the debentures were accelerated, we will have adequate financial resources to pay any unpaid principal and interest due on the debentures. We believe that as a result of the filing of our periodic reports on October 22, 2007, any purported default under the Debentures has been fully cured and is no longer continuing, and neither the trustee nor any holders of the Debentures will have any ability to accelerate the maturity of the Debentures from and after October 22, 2007.

We rely on sales to a relatively small number of OEM customers and the loss of any of these OEM customers could substantially decrease our revenues.

A significant portion of our revenues are and have been generated by sales of our printer and copier related products to a relatively small number of OEMs. For example, Canon and Xerox each contributed over 10% of our revenues for the year ended December 31, 2006 and together accounted for approximately 34% of those revenues during the same period. During the fiscal year ended December 31, 2005, Canon, Xerox, and Konica Minolta each contributed over 10% of our revenues and together accounted for approximately 48% of our revenues for the year. Because sales of our printer and copier-related products constitute a significant portion of our revenues and there is a limited number of OEMs producing copiers and printers in sufficient volume to be attractive customers for us, we expect that we will continue to depend on a relatively small number of OEM customers for a significant portion of our controller revenues in future periods. In addition, our OEM customers have developed, and may continue to develop, their own controller products, which may compete directly with our product, which may adversely affect our revenues. Accordingly, if we lose or experience reduced sales to an important OEM customer, we will have difficulty replacing the revenue previously generated from such customers with sales to new or existing OEM customers and our controller revenue will likely decline significantly.

The market for our super-wide-format printers is very competitive.

The printing equipment industry is extremely competitive. Our VUTEk products compete against several companies that market digital printing systems based on electrostatic, drop-on-demand and continuous drop-on-demand inkjet, airbrush and other technologies and printers utilizing solvent and UV curable ink. Two of our largest competitors, Scitex Vision and Inca, were recently acquired by Hewlett Packard (“HP”) and Dai Nippon Screen (“Screen”), respectively. Both HP and Screen have greater resources to develop new products and technologies and market those products, as well as acquire or develop critical components at lower costs, which would provide a competitive advantage. They could also exert downward pressure on product pricing to gain market share.

We have also witnessed the recent growth of local Chinese and Korean markets where local competitors are developing, manufacturing and selling inexpensive printers, mainly to the local Chinese and Korean markets. These Chinese and Korean manufacturers have also begun penetrating the international market and have partnered with other super-wide format printer manufacturers. Our ability to compete depends on factors both within and outside of our control, including the price, performance and acceptance of our current printers and any products we develop in the future. We also face competition from existing conventional wide format and super-wide format printing methods, including screen printing and offset printing. Our competitors could develop new products, with existing or new technology, that could be more competitive in our market than our printers. We cannot assure you that we can compete effectively with any such products.

 

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We face strong competition in the market for printing supplies such as ink.

We compete with independent manufacturers in the ink market. We cannot guarantee that we will be able to remain the exclusive or even principal ink supplier for our printers. The loss of ink sales to our installed base of printers could adversely impact our revenues and gross margins. We could also experience an overall reduction in price within the ink markets, which would also adversely affect our gross margins. While solvent inks are relatively easy to replicate and additional manufacturers could increase pricing competition or divert customers away from us, we believe our UV curable ink is more difficult to replicate and also represents a superior long term growth opportunity.

We do not typically have long term purchase contracts with our OEM customers and our OEM customers have in the past and could at any time in the future, reduce or cease purchasing products from us, harming our operating results and business.

With the exception of certain minimum purchase obligations, we typically do not have long-term volume purchase contracts with our OEM customers, including Canon, Xerox and Konica Minolta and they are not obligated to purchase products from us. Accordingly, our customers could at any time reduce their purchases from us or cease purchasing our products altogether. In the past, some of our OEM customers have elected to develop products on their own, rather than purchase our products and we expect that customers will continue to make such elections in the future. In addition, because our OEM customers incorporate our products into products they manufacture and sell, any decline in demand for copiers or laser printers and any other negative developments affecting our major customers or the computer industry in general, including reduced demand for the products sold by our OEM customers, would likely harm our results of operations. For example, several of our customers have in the past experienced serious financial difficulties which led to a decline in sales of our products to these customers. If any significant customers should face such difficulties in the future, our operating results could be harmed through, among other things, decreased sales volumes and write-offs of accounts receivables and inventory related to products we have manufactured for these customers’ products.

In addition, a significant portion of our operating expenses are fixed in advance based on projected sales levels and margins, sales forecasts from our OEM customers and product development programs. A substantial portion of our backlog is scheduled for delivery within 90 days or less and our customers may cancel orders and change volume levels or delivery times for product they have ordered from us without penalty. Accordingly, if sales to our OEM customers are below expectations in any given quarter, the adverse impact of the shortfall in revenues on operating results may be increased by our inability to adjust spending in the short term to compensate for this shortfall.

We rely on our OEM customers to develop and sell products incorporating our controller technologies and if they fail to successfully develop and sell these products, or curtail or cease the use of our technologies in their products, our business will be harmed.

We rely upon our OEM customers to develop new products, applications and product enhancements utilizing our controller technologies in a timely and cost-effective manner. Our continued success in the controller industry depends upon the ability of these OEM customers to utilize our technologies while meeting changing end-user customer needs and responding to emerging industry standards and other technological changes. However, we cannot provide assurance that our OEM customers will effectively meet these challenges. These OEM customers are generally not obligated to purchase products from us and we cannot provide assurance that they will continue to carry our products. For example, our OEM customers have incorporated into their products the technologies of other companies or internally developed technologies in addition to, or instead of, our technologies and will likely continue to do so in the future. If our OEM customers do not effectively and successfully market products containing our technologies, our revenue will likely be materially and adversely affected.

Our OEM customers work closely with us to develop products that are specific to each OEM customer’s copiers and printers. Many of the products and technologies we are developing require that we coordinate development, quality testing, marketing and other tasks with our OEM customers. We cannot control our OEM customers’

 

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development efforts or the timing of these efforts and coordinating with our OEM customers may cause delays in our own product development efforts that are outside of our control. If our OEM customers delay the release of their products, our revenue and results of operations may be adversely affected. In addition, our revenue and results of operations may be adversely affected if we cannot meet our OEM customers’ product needs for their specific copiers and printers, as well as successfully manage the additional engineering and support effort and other risks associated with such a wide range of products.

Ongoing economic uncertainty has had and may continue to have a negative effect on our business.

The revenue growth and profitability of our business depends significantly on the overall demand for information technology products such as ours that enable printing of digital data, which in turn depends on a variety of macro- and micro-economic conditions. In addition, our revenue growth and profitability in our Inkjet business depends on demand and spending for advertising and marketing products and programs, which also depends on a variety of macro- and micro-economic conditions. Delays or reductions in information technology spending, which has occurred in the past, could cause a decline in demand for our products and services and consequently harm our business, operating results, financial condition, prospects and stock price.

Our operating results may fluctuate based upon many factors, which could adversely affect our stock price.

Stock prices of high technology companies such as ours tend to be volatile as a result of various factors, including variations in operating results and, consequently, fluctuations in our operating results could adversely affect our stock price. Factors that have caused our operating results and share price to fluctuate in the past and that may cause future fluctuations include:

 

   

varying demand for our products, due to seasonality, OEM customer product development and marketing efforts, OEM customer financial and operational condition and general economic conditions;

 

   

shifts in customer demand to lower cost products;

 

   

success and timing of new product introductions by us and our OEM customers and the performance of our products generally;

 

   

success and timing of new inkjet product introductions;

 

   

volatility in foreign exchange rates, changes in interest rates and availability of bank or financing credit to consumers of digital copiers and printers;

 

   

price reductions by us and our competitors, which may be exacerbated by competitive pressures caused by economic conditions generally;

 

   

substitution of third-party inks for our own ink products by users of our super-wide format inkjet printers;

 

   

delay, cancellation or rescheduling of orders or projects;

 

   

availability of key components and licenses, including possible delays in deliveries from suppliers, the performance of third-party manufacturers and the status of our relationships with our key suppliers;

 

   

potential excess or shortage of employees and location of research and development centers;

 

   

changes in our product mix such as shifts from higher revenue or gross margin products to lower revenue or gross margin products such as our inkjet products;

 

   

costs associated with complying with any applicable governmental regulations;

 

   

cost associated with possible SEC and regulatory actions regarding our historical stock option granting practices and remedial measures we are taking with respect to our historical stock option granting practices;

 

   

acquisitions and integration of new businesses;

 

   

costs related to our entry into new markets, such as commercial printing and office equipment service automation;

 

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general economic conditions;

 

   

commencement of litigation or adverse results in pending litigation, including the shareholder derivative suits related to our historical stock option granting practices; and

 

   

other risks described herein.

We face competition from other suppliers as well as our own OEM customers and if we are not able to compete successfully our business may be harmed.

The digital printing marketplace is highly competitive and is characterized by rapid technological changes. We compete against a number of other suppliers of imaging products and technologies, including our OEM customers themselves. Although we attempt to develop and support innovative products that end customers demand, products or technologies developed by competing suppliers, including our own OEM customers, could render our products or technologies obsolete or noncompetitive.

While many of our OEM customers incorporate our technologies into their end products on an exclusive basis, we do not have any formal agreements that prevent these OEM customers from offering alternative products that do not incorporate our technologies. If, as has occurred in the past, an OEM customer offers products incorporating technology from alternative suppliers instead of, or in addition to, products incorporating our technologies, our market share could decrease, which would likely reduce our revenue and adversely affect our financial results.

In addition, many OEMs in the printer and copier industry, including most of our OEM customers, internally develop and sell products that compete directly with our current products. These OEMs have significant investments in their existing solutions and have substantial resources that may enable them to develop or improve, more quickly than us, technologies similar to ours that are compatible with their own products. Our OEM customers have in the past marketed and likely will continue in the future to market, their own internal technologies and solutions in addition to ours, even when their technologies and solutions are less advanced, have lower performance or cost more than our products. Given the significant financial, marketing and other resources of our larger OEM customers and other significant OEMs in the imaging industry who are not our customers, we may not be able to successfully compete against these OEMs selling similar products that they develop internally. If we cannot compete successfully against the OEMs’ internally developed products, we will lose sales and market share in those areas where the OEMs choose to compete and our business will be harmed.

Entry into new markets or distribution channels could result in higher operating expenses that may not be offset by increased revenue.

We continue to explore opportunities to develop or acquire product lines different from our current controllers, such as print management software, document scanning solutions and inkjet printers. We expect to continue to invest funds to develop new distribution and marketing channels for these and additional new products and services, which will increase our operating expenses. We do not know if we will be successful in developing these channels or whether the market will accept any of our new products or services or if we will generate sufficient revenues from these activities to offset the additional operating expenses we incur. In addition, even if we are able to introduce new products or services, if customers do not accept these new products or services or if we are not able to price such products or services competitively, our operating results will likely suffer.

We license software used in most of our products from Adobe Systems Incorporated and the loss of this license would prevent us from shipping these products.

Most of our current products include software that we must license from Adobe. Specifically, we are required to obtain separate licenses from Adobe for the right to use Adobe PostScript® software in each type of copier or printer used with a Fiery Controller. Although to date we have successfully obtained licenses to use Adobe’s PostScript® software when required, Adobe is not required to and we cannot be certain that Adobe will, grant

 

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future licenses to Adobe PostScript® software on reasonable terms, in a timely manner, or at all. In addition, in order to obtain licenses from Adobe, Adobe requires that we obtain from them quality assurance approvals for our products that use Adobe software. Although to date we have successfully obtained such quality assurances from Adobe, we cannot be certain Adobe will grant us such approvals in the future. If Adobe does not grant us such licenses or approvals, if the Adobe licenses are terminated, or if our relationship with Adobe is otherwise materially impaired, we would likely be unable to sell products that incorporate Adobe PostScript® software and our financial condition and results of operations would be significantly harmed.

We depend upon a limited group of suppliers for key components in our products and the loss of any of these suppliers could adversely affect our business.

Certain components necessary for the manufacture of our products are obtained from a sole supplier or a limited group of suppliers. These include processors from Intel and other related semiconductor components and inkjet print heads for our super-wide format printers. We do not maintain long-term agreements with any of our component suppliers and conduct our business with such suppliers solely on a purchase order basis. If we are unable to continue to procure these sole-sourced components from our current suppliers, we will have to qualify other sources, if possible, or design our products so that they no longer require these components. In addition, these suppliers may be concentrated within similar industries or geographic locations, which could potentially exacerbate these risks. We cannot provide assurance that other sources of these components exist or will be willing to supply us on reasonable terms or at all, or that we will be able to design around these components. Therefore any unavailability of supply of these components could harm our business. Because the purchase of certain key components involves long lead times, in the event of unanticipated volatility in demand for our products, we have been in the past and may in the future be unable to manufacture certain products in a quantity sufficient to meet demand. Further, as has occurred in the past, in the event that anticipated demand does not materialize, we may hold excess quantities of inventory that could become obsolete. In order to meet projected demand, we maintain an inventory of components for which we are dependent upon sole or limited source suppliers and components with prices that fluctuate significantly. As a result, we are subject to a risk of inventory obsolescence, which could adversely affect our operating results and financial condition. Additionally, the market prices and availability of certain components, particularly memory and Intel-designed components, which collectively represent a substantial portion of the total manufactured cost of our products, have fluctuated significantly in the past. Such fluctuations in the future could have a material adverse effect on our operating results and financial condition including a reduction in gross margins.

We are dependent on a limited number of subcontractors, with whom we do not have long-term contracts, to manufacture and deliver products to our customers and the loss of any of these subcontractors could adversely affect our business.

We subcontract with other companies to manufacture our products and we do not have long-term agreements with these subcontractors. We rely on the ability of our subcontractors to produce products to be sold to our customers and while we closely monitor our subcontractors’ performance we cannot assure you that such subcontractors will continue to manufacture our products in a timely and effective manner. In the past a weakened economy led to the dissolution, bankruptcy or consolidation of some of the subcontractors who are able to manufacture our products, decreasing the available number of subcontractors. If the available number of subcontractors were to again decrease, it is possible that we would not be able to secure appropriate subcontractors to fulfill our demand in a timely manner or at all, particularly if demand for our products increases. The existence of fewer subcontractors may also reduce our negotiating leverage potentially resulting in higher product costs. Difficulties experienced by our subcontractors, including financial problems and the inability to make or ship our products or fix quality assurance problems, could harm our business, operating results and financial condition. If we decide to change subcontractors, we could experience delays in finding, qualifying and commencing business with new subcontractors which would result in both delay in delivery of our products and also potentially the cancellation of orders for our products. A high concentration of our Fiery controllers is manufactured at a single subcontractor location, Celestica in Toronto, Ontario, Canada. Should

 

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Celestica experience any inability to, or refuse to manufacture or deliver product from this location our business, financial condition and operations could be harmed. Since we do not maintain long-term agreements with our subcontractors, any of our subcontractors could enter into agreements with our competitors that might restrict or prohibit such subcontractors from manufacturing our products or could otherwise lead to an inability of such subcontractors from filling our orders in a timely manner. In such event, we may not be able to find suitable replacement subcontractors and our business, financial condition and operations would likely be harmed.

We may face increased risk of inventory obsolescence related to our super-wide format inkjet printers and ink.

We procure raw materials and build our super-wide printers and ink products based on our sales forecasts. If we do not accurately forecast demand for our products we may end up with excess inventory, or we may lose sales because we do not have the correct products available for sale. If we have excess printers or other products we may have to lower prices to stimulate demand. We may also run the risk that our inventory of raw materials may become obsolete. Our ink products have a defined shelf life. If we do not sell the ink before the end of its shelf life it will no longer be sellable and will have to be expensed.

If we are not able to hire and retain skilled employees, we may not be able to develop products or meet demand for our products in a timely fashion.

We depend upon skilled employees, such as software and hardware engineers, quality assurance engineers and other technical professionals with specialized skills. We are headquartered in the Silicon Valley and additionally have research and development offices in India. Competition in both locations has historically been intense amongst companies hiring engineering and technical professionals. In times of professional labor imbalances, it has in the past and is likely in the future to be difficult for us to locate and hire qualified engineers and technical professionals and for us to retain these people. There are many technology companies located near our corporate offices in the Silicon Valley and our operations in India that may try to hire our employees. The movement of our stock price may also impact our ability to hire and retain employees. If we do not offer competitive compensation, we may not be able to recruit or retain employees.

We offer a broad-based equity compensation plan based on granting options and restricted stock from stockholder-approved plans in order to be competitive in the labor market. If we cannot offer equity awards when necessary to enable us to offer compensation competitive with those offered by other companies seeking the same employees, it may be difficult for us to hire and retain skilled employees.

With the January 1, 2006 adoption of the Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment (Revised 2004)” (“SFAS 123(R)”), which requires the measurement and recognition of compensation expense for all equity awards made to our employees and directors, including employee stock options, restricted stock and employee stock purchase plans related to all our stock-based compensation plans based on estimated fair values, we anticipate a non-cash reduction to net income after income taxes that might limit our ability to successfully hire, compensate, and retain employees which could affect our ability to develop products, meet demand for existing products, or in other ways harm the results of operations.

On November 1, 2006, we notified participants under our equity compensation plans of the potential suspension of our registration statements on Form S-8 covering the securities issued under these plans as of November 10, 2006. During the suspension period, participants have not been able to exercise options granted or purchase employee stock or have payroll deductions made under the Company’s 2000 Employee Stock Purchase Plan.

Our acquisition of VUTEk in June 2005 increased the chance that we will experience additional bad debt expense.

Our OEM customers are typically large profitable customers who present little credit risk to us. Our APPS and Inkjet business sells via a direct sales force to a broader base of customers, many of whom are smaller and

 

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potentially less credit worthy. In addition, many of these customers are located overseas in many countries where it may be hard to enforce our legal rights should collection issues arise.

Because of our recent acquisitions we now sell our products directly to distributors and to the end-user. If we are unable to effectively manage a direct sales force, sales and revenues could decline.

We have traditionally sold our products to our OEM partners, who in turn sold the product to the end-user. Our marketing focused on manufacturers and distributors of the manufacturers’ equipment, not on the end-user of the product. We now sell our professional printing applications and our inkjet printers and ink to the end-user. If we are unable to effectively manage a direct sales force and develop a marketing program that can reach the end-users, we are likely to see a decline in revenues from those products.

We have made acquisitions that are dilutive to existing stockholders. Acquisitions may result in unanticipated accounting charges or otherwise adversely affect our results of operations and result in difficulties in assimilating and integrating the operations, personnel, technologies, products and information systems of acquired companies or businesses.

We seek to develop new technologies and products from both internal and external sources. As part of this effort, we have in the past made, and will likely continue to make, acquisitions of other companies or other companies’ assets. Acquisitions involve numerous risks, such as:

 

   

if we issue equity securities in connection with an acquisition, the issuance may be dilutive to our existing stockholders, alternatively, acquisitions made entirely or partially for cash (such as our acquisition of VUTEk) will reduce our cash reserves;

 

   

difficulties in integration of operations, employees, technologies, or products and the related diversion of management time and effort to accomplish successful integration;

 

   

risks of entering markets in which we have little or no prior experience, or entering markets where competitors have stronger market positions;

 

   

possible write-downs of impaired assets;

 

   

potential loss of key employees of the acquired company;

 

   

possible expense overruns;

 

   

an adverse reaction by customers, suppliers or partners of the acquired company or EFI;

 

   

the risk of changes in ratings by stock analysts;

 

   

potential litigation surrounding transactions or the prior actions of the acquired company, such as the Printcafe litigation;

 

   

the inability to protect or secure technology rights; and

 

   

increases in operating costs.

Mergers and acquisitions of companies are inherently risky and we cannot provide assurance that our previous or future acquisitions will be successful or will not harm our business, operating results, financial condition, or stock price.

We face risks from currency fluctuations.

Approximately $260.7 million and $208.6 million of our revenue from the sale of products for the years ended December 31, 2006 and 2005, respectively, came from sales outside the Americas, primarily to Europe and Japan. We expect that sales outside the Americas will continue to represent a significant portion of our total revenue.

 

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Given the significance of our non-US sales to our total product revenue, we face a continuing risk from the fluctuation of the US dollar versus the Japanese yen, the Euro and other major European currencies and numerous Southeast Asian currencies. We typically invoice our customers in US dollars and this may result in our products becoming more expensive in the local currency of our customers, thereby reducing our ability to sell our products. When we do invoice our customers in local currencies, our cash flows and earnings are exposed to fluctuations in interest rates and foreign currency exchange rates between the currency of the invoice and the US dollar. In addition, we have a substantial number of international employees which creates material operating costs denominated in foreign currencies. In Europe, where we have a significant presence, our sales and marketing expenses and general and administrative expenses have risen in part due to the weakened US dollar. We have attempted to limit or hedge these exposures through operational strategies where we have considered it appropriate in the past, although no hedging activities occurred in 2006. Our efforts to reduce the risk from our international operations and from fluctuations in foreign currencies or interest rates may not be successful, which could harm our financial condition and operating results. In 2006, the impact from currency exchange differences was not material.

We face risks from our international operations.

We are subject to certain risks because of our international operations. Changes to and compliance with a variety of foreign laws and regulations that may increase our cost of doing business and our inability or failure to obtain required approvals could harm our international and domestic sales. Trade legislation in either the United States or other countries, such as a change in the current tariff structures, export compliance laws or other trade policies, could adversely affect our ability to sell or to manufacture in international markets. Some of our sales to international customers are made under export licenses that must be obtained from the United States Department of Commerce (DOC) and certain transactions require prior approval of the DOC. Changes in governmental regulation and our inability or failure to obtain required approvals, permits or registrations could harm our international and domestic sales and adversely affect our revenues, business and operations. Any violations could result in fines and penalties, including prohibiting us from exporting our products to one or more countries, and could materially and adversely affect our business.

Moreover, local laws and customs in many countries differ significantly from those in the United States. We incur additional legal compliance costs associated with our international operations and could become subject to legal penalties in foreign countries if we do not comply with local laws and regulations, which may be substantially different from those in the United States. In many foreign countries, particularly in those with developing economies, it may be common to engage in business practices that are prohibited by United States regulations applicable to us such as the Foreign Corrupt Practices Act. Although we implement policies and procedures designed to ensure compliance with these laws, there can be no assurance that all of our employees, contractors and agents, as well as those companies to which we outsource certain of our business operations, including those based in or from countries where practices which violate such United States laws may be customary, will not take actions in violation of our policies. Any such violation, even if prohibited by our policies, could have a material adverse effect on our business.

Other risks include natural disasters and political or economic conditions in a specific country or region. In addition, many countries in which we derive revenues do not currently have comprehensive and highly developed legal systems, particularly with respect to the protection of intellectual property rights, which, among other things, can result in the prevalence of infringing products and counterfeit goods in certain countries, which could harm our business and reputation.

We may be unable to adequately protect our proprietary information and may incur expenses to defend our proprietary information.

We rely on a combination of copyright, patent, trademark and trade secret protection, nondisclosure agreements and licensing and cross-licensing arrangements to establish, maintain and protect our intellectual property rights, all of which afford only limited protection. We have patents and pending patent applications in the United States and in various foreign countries. There can be no assurance that patents will issue from our pending applications

 

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or from any future applications, or that, if issued, any claims allowed will be sufficiently broad to protect our technology. Any failure to adequately protect our proprietary information could harm our financial condition and operating results. We cannot be certain that any patents that have been or may in the future be issued to us, or which we license from third parties, or any other of our proprietary rights will not be challenged, invalidated or circumvented. In addition, we cannot be certain that any rights granted to us under any patents, licenses or other proprietary rights will provide adequate protection of our proprietary information. In addition, as different areas of our business change or mature, from time to time we evaluate our patent portfolio and make decisions either to pursue or not to pursue specific patents and patent applications related to such areas. Choosing not to pursue certain of our patents, patentable applications and failing to file applications for potentially patentable inventions, may harm our business by, among other things, enabling our competitors to more effectively compete with us, reducing the potential claims we can bring against third parties for patent infringement and limiting our potential defenses to intellectual property claims brought by third parties.

Litigation has been and may continue to be necessary to defend and enforce our proprietary rights. Such litigation, whether or not concluded successfully for us, could involve significant expense and the diversion of our attention and other resources, which could harm our financial condition and operating results.

We face risks from third party claims of infringement and potential litigation.

Third parties have claimed in the past and may claim in the future that our products infringe, or may infringe, their proprietary rights. Such claims have in the past resulted in lengthy and expensive litigation and could do so in the future. Such claims and any related litigation, whether or not we are successful in the litigation, could result in substantial costs and diversion of our resources, which could harm our financial condition and operating results. Although we may seek licenses from third parties covering intellectual property that we are allegedly infringing, we cannot assure you that any such licenses could be obtained on acceptable terms, if at all.

We may be subject to environmental related liabilities due to our use of hazardous materials and solvents.

We conduct our business operations that involve the use of certain hazardous materials at two separate locations. At these facilities, we mix ink used in some of our printers with solvents and other hazardous materials. Those materials are subject to various governmental regulations relating to their transfer, handling, packaging, use and disposal. We store the ink at warehouses worldwide, including Europe and the United States, and shipping companies ship it at our direction. We face potential responsibility for problems such as spills that may arise when we ship the ink to customers. While we customarily obtain insurance coverage typical for this kind of risk, if we fail to comply with these laws or an accident involving our ink waste or solvents occurs, then our business and financial results could be harmed.

Future sales of our hardware products in European Union member nations (EU) could be limited due to the enactment of the EU Restriction of Hazardous Substances in Electrical and Electronic Equipment (ROHS).

Since July 1, 2006 forward, new electrical and electronic equipment sold into EU nations must not contain lead, mercury, cadmium, hexavalent chromium, polybrominated biphenyls (PBBs) or polybrominated diphenyl ethers (PBDEs). These must be replaced by other non- or less than-toxic substances. Manufacturers must comply with significant, and potentially costly, compliance requirements in order to meet the ROHS deadline. Some of our products may not have been converted before the deadline. As a result, we may not be allowed to sell those products in the EU until the products are made fully compliant, which could harm our business and financial results We could also incur additional costs and liabilities in connection with non-compliant product recalls, regulatory fines and exclusion of non-compliant products from certain markets.

Our products may contain defects which are not discovered until after shipping.

Our products consist of hardware and software developed by ourselves and others. Our products may contain undetected errors and we have in the past discovered software and hardware errors in certain of our products after

 

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their introduction, resulting in warranty expense and other expenses incurred in connection with rectifying such errors. Errors could be found in new versions of our products after commencement of commercial shipment and any such errors could result in a loss or delay in market acceptance of such products and thus harm our reputation and revenues. In addition, errors in our products (including errors in licensed third party software) detected prior to new product releases could result in delays in the introduction of new products and our incurring additional expense, which could harm our operating results.

Actual or perceived security vulnerabilities in our products could adversely affect our revenues.

Maintaining the security of our software and hardware products is an issue of critical importance to our customers and for us. There are individuals and groups who develop and deploy viruses, worms and other malicious software programs that could attack our products. Although we take preventative measures to protect our products, and we have a response team that is notified of high-risk malicious events, these procedures may not be sufficient to mitigate damage to our products. Actual or perceived security vulnerabilities in our products could lead some customers to seek to return products, to reduce or delay future purchases or to purchase competitive products. Customers may also increase their expenditures on protecting their computer systems from attack, which could delay or reduce purchases of our products. Any of these actions or responses by customers could adversely affect our revenues.

System failures or system unavailability could harm our business.

We rely on our network infrastructure, internal technology systems and our internal and external websites for our development, marketing, operational, support and sales activities. Our hardware and software systems related to such activities are subject to damage from malicious code released into the public Internet through recently discovered vulnerabilities in popular software programs. These systems are also subject to acts of vandalism and to potential disruption by actions or inactions of third parties. Any event that causes failures or interruption in our hardware or software systems could harm our business, financial condition and operating results.

The location and concentration of our facilities subjects us to the risk of earthquakes, floods or other natural disasters and public health risks.

Our corporate headquarters, including most of our research and development facilities, are located in the San Francisco Bay Area, an area known for seismic activity. This area has also experienced flooding in the past. In addition, many of the components necessary to supply our products are purchased from suppliers based in areas including the San Francisco Bay Area, Taiwan and Japan and are therefore subject to risk from natural disasters. A significant natural disaster, such as an earthquake, flood or typhoon, could harm our business, financial condition and operating results.

Our employees, suppliers and customers are located worldwide. We face the risk that our employees, suppliers, or customers, either through travel or contact with other individuals, could become exposed to contagious diseases endemic to particular regions of the world. In addition, governments in those regions have from time-to-time imposed quarantines and taken other actions in response to contagious diseases that could affect our operations. If a significant number of employees, suppliers, or customers were unable to fulfill their obligations, due to contagious diseases, actions taken in response to contagious diseases, or other reasons, our business, financial condition and operating results could be harmed.

We are subject to numerous federal and state employment laws and may face claims in the future under such laws.

EFI is subject to numerous federal and state employment laws, and from time to time EFI faces claims by its employees and former employees under such laws. In addition, the number of cases involving alleged violations of the Fair Labor Standards Act and state wage and hour laws has recently increased in the software industry. The outcome of these types of cases is highly fact specific and the law, particularly in California, is still evolving. Although there are no pending or threatened claims under wage and hour laws against EFI, we cannot assure you

 

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that claims under such laws or other employment-related laws will not be attempted in the future against EFI, nor can we predict the likely impact of any such claims on EFI, or that, if asserted, EFI would be able to successfully resolve any such claims without incurring significant expenses.

We may be subject to the risk of loss due to fire because the materials we use in the manufacturing process of our inks are flammable.

We use flammable materials in the manufacturing processes of our inks and may therefore be subject to the risk of loss arising from fires. The risk of fire associated with these materials cannot be completely eliminated. We own certain facilities that manufacture our inks, which increases our exposure to such risk in case these facilities are destroyed. We maintain insurance policies to reduce losses caused by fire, including business interruption insurance. If one or more of these facilities is damaged or otherwise ceases operations as a result of a fire, it would reduce manufacturing capacity and, consequently, may reduce revenues and adversely affect our business.

The value of our investment portfolio is subject to interest rate volatility.

We have an investment portfolio of mainly fixed income securities classified as available-for-sale securities. As a result, our investment portfolio is subject to volatility if market interest rates fluctuate. We attempt to limit this exposure to interest rate risk by investing in securities with maturities of less than three years; however, we may be unable to successfully limit our risk to interest rate fluctuations and this may cause volatility in our investment portfolio value.

Our stock price has been volatile historically and may continue to be volatile.

The market price for our common stock has been and may continue to be volatile. For example, during the twelve-month period ended December 31, 2006, the price of our common stock as reported on The NASDAQ Global Select Market ranged from a low of $19.13 to a high of $29.18. We expect our stock price to be subject to fluctuations as a result of a variety of factors, including factors beyond our control. These factors include:

 

   

actual or anticipated variations in our quarterly or annual operating results;

 

   

our failure to meet analyst expectations;

 

   

announcements of technological innovations or new products or services by us or our competitors;

 

   

announcements relating to strategic relationships, acquisitions or investments;

 

   

announcements by our customers regarding their businesses or the products in which our products are included;

 

   

changes in financial estimates or other statements by securities analysts;

 

   

changes in general economic conditions;

 

   

terrorist attacks and the effects of military engagements or natural disasters;

 

   

changes in the rating of our debentures or other securities;

 

   

changes in the economic performance and/or market valuations of other software and high-technology companies;

 

   

commencement of litigation or adverse results in pending litigation, including shareholder derivative suits related to our historical stock option practices;

 

   

commencement of possible SEC and regulatory actions regarding our historical stock option grant practices; and

 

   

a potentially high volume of sales of our stock by our employees once we have filed all periodic reports with the SEC resulting from an expected demand to sell equity held by employees, and the prior unavailability of an effective registration statement covering the issuance of such employee equity.

 

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Because of this volatility, we may fail to meet the expectations of our stockholders or of securities analysts from time-to-time and the trading prices of our securities could decline as a result. In addition, the stock market has experienced significant price and volume fluctuations that have particularly affected the trading prices of equity securities of many high-technology companies. These fluctuations have often been unrelated or disproportionate to the operating performance of these companies. Any negative change in the public’s perception of high-technology companies could depress our stock price regardless of our operating results.

Our stock repurchase program could affect our stock price and add volatility.

Any repurchases pursuant to our stock repurchase program could affect our stock price and add volatility. There can be no assurance that the repurchases will be made at the best possible price. The existence of a stock repurchase program could also cause our stock price to be higher than it would be in the absence of such a program and could potentially reduce the market liquidity for our stock. Additionally, we are permitted to and could discontinue our stock repurchase program at any time and any such discontinuation could cause the market price of our stock to decline. For example, we suspended our stock repurchase program in connection with our investigation of our historical stock option grant practices.

Under regulations required by the Sarbanes-Oxley Act of 2002, an adverse opinion on internal controls over financial reporting could be issued by our auditors, and this could have a negative impact on our stock price.

Section 404 of the Sarbanes-Oxley Act of 2002 requires that we establish and maintain an adequate internal control structure and procedures for financial reporting and assess on an on-going basis the design and operating effectiveness of our internal control structure and procedures for financial reporting. Our auditors, an independent registered public accounting firm, are required to attest to and audit both the design and operating effectiveness of our internal controls over financial reporting and management’s assessment of the design and the effectiveness of its internal controls for financial reporting. Although no known material weaknesses are believed to exist at this time, it is possible that material weaknesses could be identified. If we are unable to remediate the weaknesses, our management would be required to conclude that our internal controls over financial reporting were not effective and our auditors would be required to issue an adverse opinion on our internal controls over financial reporting. It is uncertain what impact an adverse opinion would have on our stock price. In addition to their inherent limitations, internal controls over financial reporting and the audit of such controls by our auditors may not prevent or detect misstatements, errors, omissions, or fraud.

A reduction in our net income as reported on our financial statements could increase the likelihood of identifying a material weakness in our internal controls.

The threshold for determining whether or not we have a material weakness in our internal controls and procedures as defined by the Sarbanes-Oxley Act is, in part, based on our generally accepted accounting principles, or GAAP, net income. Lowered GAAP net income, with an associated lowered materiality threshold, may increase our risk of having to disclose control weaknesses. For example, continued acquisitions, and the associated amortization of intangibles, will increase our amortization expenses and in the future may lower our GAAP earnings which would result in a lower materiality threshold for internal control testing. A lower materiality threshold requires us to test more areas of the business. As the number of areas tested increases, the statistical chance of discovering a material weakness increases.

Our debt service obligations may adversely affect our cash flow.

In June 2003, we issued $240 million in 1.50% convertible senior debentures due in 2023. During the period the debentures are outstanding, we will have debt service obligations on the debentures of approximately $3.6 million per year in interest payments, payable semi-annually. In addition, beginning June 1, 2008, we could be required to pay contingent interest of 0.35% if during any six-month period from June 1 to November 30 and

 

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December 1 to May 31, the average market price of the debentures for the five trading days ending on the third trading day immediately preceding the first day of the relevant nine-month period equals 120% or more of the principal amount of the debentures. Due to our failure to timely file our Quarterly Reports on Form 10-Q for the quarterly periods ended September 30, 2006, March 31, 2007 and June 30, 2007 and this Annual Report on Form 10-K, we received notices of default of certain covenants of the indenture. For a more detailed description of the default, see Item 1A—Alleged defaults of our convertible senior debentures, if not cured, may result in acceleration of the debentures.

Our debt service obligations related to the debentures include the following redemption and repurchase terms that could also affect our cash position:

 

   

On or after June 1, 2008, we may redeem the debentures for cash at any time as a whole, or from time to time in part, at a price equal to 100% of the principal amount of the debenture to be redeemed plus any accrued and unpaid interest, including contingent interest, if any;

 

   

On June 1, 2008 a holder may require us to repurchase all or a portion of that holder’s debentures at a repurchase price equal to 100% of the principal amount of those debentures plus accrued and unpaid interest, including contingent interest, if any, to, but not including, the date of repurchase in cash; and

 

   

A holder may require us to repurchase all or a portion of that holder’s debentures if a fundamental change, as defined in the indenture, occurs prior to June 1, 2008 at 100% of their principal amount, plus any accrued and unpaid interest, including contingent interest, if any to, but not including, the repurchase date. We may choose to pay the repurchase price in cash.

If we issue other debt securities in the future, our debt service obligations will increase. We intend to fulfill our debt service obligations from cash generated by our operations, if any, and from our existing cash and investments. If we are unable to generate sufficient cash to meet these obligations and must instead use our existing cash or investments, we may have to reduce, curtail or terminate other activities of our business. We may add lines of credit and obtain other long-term debt and mortgage financing to finance capital expenditures in the future.

Our indebtedness could have significant negative consequences. For example, it could:

 

   

increase our vulnerability to general adverse economic and industry conditions, as we are required to make interest payments and maintain compliance with financial covenants contained in the debentures regardless of such external conditions;

 

   

limit our ability to obtain additional financing due to covenants contained in the debentures and the existing leverage evidenced by the debentures;

 

   

require the dedication of a substantial portion of any cash flow from operations to the payment of principal of and interest on, our indebtedness, thereby reducing the availability of such cash flow to fund our growth strategy, working capital, capital expenditures and other general corporate purposes;

 

   

limit our flexibility in planning for, or reacting to, changes in our business and our industry by restricting the funds available for use in addressing such changes; and

 

   

place us at a competitive disadvantage relative to our competitors with less debt.

Item 1B: Unresolved Staff Comments

None.

 

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Item 2: Properties

The following table sets forth the location, size and use of each of our principal facilities:

 

Location

   Square
footage
   Leased or
owned
   

Principal uses

Foster City, California

   458,000    Leased (1)  

Corporate offices, design and engineering, product testing, customer service

Meredith, New Hampshire

   163,000    Owned    

Manufacturing (VUTEk printers and ink), design and engineering, sales, customer service

Norcross, Georgia

   111,000    Leased (2)  

Design and engineering

Bangalore, India

   69,167    Leased    

Design and engineering, sales, administrative and support services

Minneapolis, Minnesota

   69,523    Owned    

Design and engineering, customer service, software engineering

Ypsilanti, Michigan

   70,138    Leased    

Manufacturing (ink), design and engineering, sales, customer service

Scottsdale, Arizona

   29,232    Leased (3)  

Administrative services, customer service

Ratingen, Germany

   27,438    Leased    

Software engineering, sales, customer service

Pittsburgh, Pennsylvania

   25,997    Leased    

Software engineering, sales

Lebanon, New Hampshire

   17,683    Leased    

Software engineering

Schiphol-Rijk, The Netherlands

   16,695    Leased    

European corporate offices, sales, support services

Parsippany, New Jersey

   11,960    Leased    

Design and engineering

Tokyo, Japan

   6,405    Leased    

Sales, design and engineering


(1)

Approximately 47,139 square feet are sub-leased.

(2)

Approximately 59,000 square feet are sub-leased.

(3)

Approximately 12,700 square feet are sub-leased.

Our Foster City offices are located on approximately 35 acres of real property which we own. We also lease a number of additional domestic and international sales offices. For additional information on our lease obligations see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”

We believe that our facilities, in general, are adequate for our present needs. We do not expect that, if the need arises, we would experience difficulties in obtaining additional space at favorable rates.

Item 3: Legal Proceedings

Legal Proceedings

As more fully discussed below, from time to time we may be involved in a variety of claims, lawsuits, investigations and proceedings relating to contractual disputes, securities law, intellectual property, employment matters and other claims or litigation matters relating to various claims that arise in the normal course of our business. We determine whether an estimated loss from a contingency should be accrued by assessing whether a loss is deemed probable and can be reasonably estimated. We assess our potential liability by analyzing our specific litigation and regulatory matters using available information. We develop our views on estimated losses in consultation with inside and outside counsel, which involves a subjective analysis of potential results and outcomes, assuming various combinations of appropriate litigation and settlement strategies. Because of the uncertainties related to both the amount and ranges of possible loss on the pending litigation matters, we are unable to predict with certainty the precise liability that could finally result from a range of possible unfavorable outcomes. However, taking all of the above factors into account, we reserve an amount that we could reasonably expect to pay for the cases discussed. However, our estimates could be wrong, and we could pay more or less

 

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than our current accrual. Litigation can be costly, diverting management’s attention and could, upon resolution, have a material adverse effect on our business, results of operations, financial condition and cash flow.

Leggett & Platt, Inc. and L&P Property Management Company v. VUTEk, Inc.:

In May 2005, prior to EFI’s acquisition of VUTEk, Leggett & Platt, Inc. (“L&P’), and its patent holding subsidiary brought a patent infringement action against VUTEk in the United States District Court in the Eastern District of Missouri. After conducting extensive discovery, EFI moved for summary judgment that the asserted patent is invalid and not infringed. After several months of reviewing the evidence, on December 26, 2006, the Court granted EFI’s summary judgment motion and ruled that all of L&P’s asserted patent claims were invalid on multiple grounds. The Court found that each asserted patent claim was obvious and already disclosed in VUTEk’s own prior patents. In addition to those two grounds for invalidity, the Court also found L&P’s patent claims invalid because the L&P patent claims were vague and indefinite in view of the patent claim interpretations suggested by L&P. The Court also granted EFI’s motion to recover its costs from L&P. L&P filed a notice of appeal, and EFI moved to dismiss the appeal for lack of proper certification from the trial court. The Court of Appeals for the Federal Circuit in Washington, D.C. granted EFI’s motion and dismissed L&P’s first appeal. After obtaining a final certification from the trial court, L&P filed a new notice of appeal. EFI will continue to vigorously contest L&P’s second attempt at an appeal.

Bureau of Industry and Security (BIS) Export Investigation:

In January 2005, prior to EFI’s acquisition of VUTEk, the U.S. Commerce Department’s Bureau of Industry and Security (BIS) initiated an investigation of VUTEk relating to VUTEk’s alleged failure to comply with U.S. export regulations in connection with several export sales to Syria in 2004. EFI self-initiated an internal compliance review of historical export practices for both VUTEk and EFI. Potential violations uncovered during our compliance review were voluntarily disclosed to BIS in November 2006 (for VUTEk) and December 2006 (for EFI). Additionally, we provided BIS with detailed reports of our compliance review findings and supplemental information in March 2007 (for VUTEk) and May 2007 (for EFI). The areas of possible non-compliance found in the internal review relate to: (1) deemed exports of controlled encryption source code and/or technology to foreign nationals of Syria and Iran, (2) exports of printers and other products with encryption functionality before completion of encryption reviews by BIS and (3) statistical reporting errors on some export declarations. At present, we believe that these matters will be resolved solely with administrative penalties. However, there is no assurance that these matters will not have an unforeseen outcome that could impair our ability to export product outside of the United States and Canada.

Purported Derivative Shareholder Lawsuits:

On August 16, 2006, a purported derivative shareholder complaint was filed in the Superior Court of the State of California for the County of San Mateo captioned Parish v. Avida et al., No. CIV 457013. A substantively identical complaint was filed in the same court on September 11, 2006 captioned Fennimore v. Avida et al., No. CIV 457566. These actions were consolidated as In re Electronics For Imaging, Inc. Derivative Litigation, Master File No. 457013. The consolidated complaint filed December 18, 2006, alleged claims—derivatively and on behalf of the Company as nominal defendant—against certain of the Company’s current and former officers and/or directors and sought redress for alleged breaches of fiduciary duty by and unjust enrichment of the individual defendants. Plaintiffs claimed that, from 1994 to 2003, the defendants colluded to improperly backdate stock option grants to various officers and directors in violation of the Company’s stock option plans. Further, Plaintiffs claimed that the individual defendants colluded to improperly record and account for the allegedly backdated options in violation of Generally Accepted Accounting Principles, and to produce and disseminate statements that improperly recorded and accounted for the options and concealed the allegedly improper backdating. According to plaintiffs, the Company has suffered damage as a result of the individual defendants’ alleged misconduct, and the recipients of the options have allegedly garnered unlawful profits. On January 30, 2007 the court entered a stipulated order dismissing the consolidated action and, on February 2, 2007, plaintiffs

 

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filed a similar complaint in the United States District Court for the Northern District of California captioned Parish et al. v. Avida et al., No. C07-00698.

On November 22, 2006, another purported derivative shareholder complaint was filed in the Superior Court of the State of California for the County of San Mateo captioned City of Ann Arbor Employees’ Retirement Association v. Gecht et al., No. CIV 459145. The complaint asserted derivative claims against certain of the Company’s current and former officers and/or directors, alleging that the director defendants breached their fiduciary duty by improperly manipulating certain stock option grants between 1996 and 2003, thereby violating the terms of the Company’s stock option plan, causing the Company to issue false and misleading financial statements and proxy statements, and unjustly enriching the executives who received the subject option grants. The complaint also purported to be brought on behalf of a class consisting of all others similarly situated and alleges a class claim for breach of the fiduciary duty of disclosure. On December 5, 2006 the case was removed to the United States District Court for the Northern District of California and, on March 9, 2007, the court denied plaintiff’s motion to remand the case back to state court. On April 3, 2007 the court granted plaintiff’s motion to voluntarily dismiss its complaint. Plaintiff re-filed its complaint in Delaware Chancery Court on April 9, 2007.

On November 27, 2006 a purported derivative shareholder complaint was filed in the United States District Court for the Northern District of California captioned Indiana State District Council of Laborers and Hod Carriers Pension Fund v. Gecht et al., No. C-06-7274(EMC). Similar to the derivative allegations asserted in the previously-filed complaints, the plaintiff alleges that, between 1997 and 2006, the individual defendants improperly manipulated the grant date of certain stock option grants and made false or misleading statements regarding such grants. Plaintiff claims that the individual defendants’ alleged misconduct violated the Securities Exchange Act of 1934, as well as California and Delaware law. On March 22, 2007, the court issued an Order consolidating this action with the Parish action. On April 12, 2007 Parish and Fennimore were appointed lead plaintiffs and their attorneys lead counsel. On July 25, 2007 the Court granted plaintiffs’ unopposed motion to stay the action in deference to the litigation pending in Delaware (described below).

On March 15, 2007 a complaint was filed in Delaware Chancery Court captioned Denver Employees Retirement Plan v. Gecht et al., No. 2797. The complaint asserts derivative claims against certain of the Company’s current and former officers and/or directors, alleging that the director defendants breached their fiduciary duty by improperly manipulating certain stock option grants between 1996 and 2003, thereby violating the terms of the Company’s stock option plan, causing the Company to issue false and misleading financial statements and proxy statements, and unjustly enriching the executives who received the subject option grants. The complaint also purported to be brought on behalf of a class consisting of all others similarly situated and alleges a class claim for breach of the fiduciary duty of disclosure. On May 9, 2007, the court granted the parties’ proposed order consolidating the Denver and Ann Arbor cases, designating the Denver complaint as the operative complaint, and appointing the named plaintiffs lead plaintiffs and their counsel lead counsel. Defendants have moved to dismiss the action.

Durst Fototechnik Technology GmbH v. Electronics for Imaging, GmbH et al.:

On February 23, 2007, Durst brought a patent infringement action against EFI GmbH in the Mannheim District Court in Germany. On May 10, 2007, EFI GmbH filed its Statement of Defenses. These defenses include lack of jurisdiction, non-infringement, invalidity and unenforceability based on Durst’s improper actions before the German patent office. EFI Inc. filed its Statement of Defense on August 29, 2007. EFI Inc.’s defenses include those for EFI GmbH as well as an additional defense for prior use based on EFI’s own European patent rights. Trial has been set in Mannheim for November 30, 2007. EFI will continue to defend itself vigorously.

Acacia Patent Litigation

On August 8, 2007, Screentone Systems Corporation, a subsidiary of Acacia Technologies Group, initiated litigation against several defendants, including Konica Minolta Printing Solutions, Canon USA, and Ricoh

 

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Americas, for infringement of a patent related to apparatus and methods of digital halftoning in the United States District Court for the Eastern District of Texas. Konica Minolta, Canon and Ricoh are EFI customers. While the complaint does not identify any accused products nor reference EFI directly, at least one defendant has notified EFI that Acacia representatives have communicated that at least one basis for its infringement claim is based on certain EFI Fiery products. EFI has contractual obligations to indemnify its customers to varying degrees and subject to various circumstances. At least one defendant has written requesting indemnification for any EFI products that allegedly infringe these patents. While EFI does not believe that its products infringed this patent, due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of this litigation.

Tesseron Patent Litigation

On September 26, 2007, Tesseron, Ltd. initiated litigation against Konica Minolta Business Solutions USA, Konica Minolta Business Technologies and Konica Minolta Holdings for infringement of eight patents related to variable printing technology in the United States District Court for the Northern District of Ohio, Eastern Division. Konica Minolta is an EFI customer and the complaint references EFI Fiery variable data enabled printer controllers. Additionally, Tesseron has on multiple occasions over the past 4 years sent threatening letters to EFI. However, Tesseron failed to reply to each of EFI’s requests for a dialogue. EFI has contractual obligations to indemnify its customers to varying degrees and subject to various circumstances. Konica Minolta has written requesting indemnification for any EFI products that allegedly infringe these patents. While EFI does not believe that its products infringed any of these patents, due to the inherent uncertainties of litigation, we cannot accurately predict the ultimate outcome of this litigation.

Nasdaq Delisting Proceedings:

Due to the Special Committee investigation, we were unable to file on a timely basis with the SEC our Quarterly Report on Form 10-Q for the period ended September 30, 2006, our Annual Report on Form 10-K for the year ended December 31, 2006, our Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2007 and our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2007. On November 15, 2006, we received a Nasdaq staff determination notice stating that we were not in compliance with Nasdaq Marketplace Rule 4310(c)(14) due to our failure to timely file our Quarterly Report on Form 10-Q for the period ended September 30, 2006, and that our securities are, therefore, subject to delisting from The Nasdaq Global Select Market. We received additional Nasdaq staff determination notices with respect to our failure to timely file our Annual Report on Form 10-K for the year ended December 31, 2006 and our Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2007 and June 30, 2007.

We requested and subsequently attended a hearing before the Nasdaq Listing Qualifications Panel (the “Panel”) to appeal the staff determination and presented a plan to cure the filing deficiencies and regain compliance. The Panel granted our request for continued listing on The Nasdaq Global Select Market, subject to certain conditions which we were unable to meet because of the then-ongoing independent investigation of our historical stock option grants. As a result, the Panel notified us that it had determined to delist our securities, which ordinarily would have resulted in the suspension of our securities effective on May 17, 2007. However, the Nasdaq Listing and Hearing Review Council (the “Listing Council”), pursuant to its discretionary authority under Marketplace Rule 4807(b), called for review the decision of the Panel regarding our case and stayed any action by the Panel to suspend our securities from trading on The Nasdaq Global Select Market pending further action by the Listing Council.

On July 2, 2007, we provided the Listing Council with an additional submission for its consideration, and requested that the Listing Council exercise its discretionary authority, pursuant to Marketplace Rule 4802(b), in favor of granting us an additional extension to regain compliance with Nasdaq’s filing requirement, as set forth in Marketplace Rule 4310(c)(14).

 

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On August 23, 2007, the Listing Council notified us that it had determined to exercise its discretionary authority, under Nasdaq Marketplace Rule 4802(b), to grant us an exception to demonstrate compliance with all of The Nasdaq Global Select Market continued listing requirements through October 22, 2007.

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

None.

 

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PART II

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

Our common stock has traded on the NASDAQ National Market (now The NASDAQ Global Select Market) under the symbol EFII since October 2, 1992. The table below lists the high and low sales price during each quarter the stock was traded in 2006 and 2005.

 

     2006    2005
     Q1    Q2    Q3    Q4    Q1    Q2    Q3    Q4

High

   29.41    29.85    24.23    27.07    18.14    21.43    25.37    28.55

Low

   25.39    19.85    19.11    21.59    16.07    16.12    19.50    21.48

As of September 28, 2007 there were 381 stockholders of record. Because many of such shares are held by brokers and other institutions on behalf of stockholders, we are unable to provide the actual number of stockholders represented by these record holders.

We have never paid cash dividends on our capital stock. We currently anticipate that we will retain all available funds for our business and will not pay any cash dividends in the foreseeable future.

Equity Compensation Plan Information

Information regarding our equity compensation plans may be found in Item 12 of this Annual Report on Form 10-K and is incorporated herein by reference.

Repurchases of Equity Securities

In August 2004, our Board of Directors authorized $100.0 million to be used for the repurchase of our outstanding common stock. A total of 53 thousand shares were repurchased under this program in 2004 and an additional 2,263 thousand shares were purchased under a previous Board of Directors authorization of $50.0 million which was completed in 2004. No shares were repurchased in 2005 and 1,523 thousand shares were repurchased in 2006. Our buyback program is limited by the SEC regulations and by trading windows set by the Company’s policy. The $100.0 million repurchase program was intended to partially offset the exercise of common stock options by employees and the distribution of common stock through the 2000 Employee Stock Purchase Plan. Approximately $65.1 million remains under the program to purchase shares at December 31, 2006. In connection with our investigation of our historical stock option practices, we suspended our buyback program in August 2006.

 

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Purchases of equity securities during the twelve months ended December 31, 2006 were (in thousands except for per share amounts):

 

Fiscal month

   (a)
Total number of
shares purchased
  

(b)
Average price

paid per share

   (c)
Cumulative total
number of shares
purchased as
part of publicly
announced plans
   (d)
Approximate dollar
value of shares that
may yet be
purchased under
the plans

January 2006

         53    $ 98,937

February 2006

   274    $ 26.0371    327    $ 91,814

March 2006

         327    $ 91,814

April 2006

         327    $ 91,814

May 2006

   75    $ 24.2436    402    $ 89,985

June 2006

   926    $ 21.5329    1,328    $ 70,065

July 2006

   160    $ 19.7692    1,488    $ 66,899

August 2006

   88    $ 19.9360    1,576    $ 65,147

September 2006

         1,576    $ 65,147

October 2006

         1,576    $ 65,147

November 2006

         1,576    $ 65,147

December 2006

         1,576    $ 65,147
             

Total

   1,523    $ 22.1990      
             

Comparison of Cumulative Total Return among Electronics for Imaging, Inc., Nasdaq Composite and Nasdaq Computer Manufacturers Index

The stock price performance graph below includes information required by the SEC and shall not be deemed incorporated by reference by any general statement incorporating by reference this Annual Report into any filing under the Securities Act of 1933 as amended or under the Securities Exchange Act of 1934 as amended (the “Exchange Act”), except to the extent the Company specifically incorporates this information by reference, and shall not otherwise be deemed soliciting material or filed under such Acts or subject to the liabilities of Section 18 of the Exchange Act.

 

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The following graph demonstrates a comparison of cumulative total returns based upon an initial investment of $100 in the Company’s Common Stock as compared with the NASDAQ Composite and the NASDAQ Computers and Manufacturers Index. The stock price performance shown on the graph below is not necessarily indicative of future price performance and only reflects the Company’s relative stock price for the five-year period ending on December 31, 2006. All values assume reinvestment of dividends and are calculated at December 31 of each year.

LOGO

Item 6: Selected Financial Data

All amounts in this item are in thousands, except per share amounts and ratios.

The following table summarizes selected consolidated financial data as of and for the five years ended December 31, 2006. This information should be read in conjunction with Item 7: “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the audited consolidated financial statements and related notes thereto. The information presented in the following tables has been adjusted to reflect the restatement of our financial results. For a more detailed description, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and Note 2: “Restatement of Consolidated Financial Statements.”

 

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    For the year ended December 31,  
    2006     2005     2004     2003     2002  
(in thousands, except per
share amounts and ratios)
        As
restated(1)
    As
restated(1)
    As
previously
reported(1)
    Adjustments(1)     As
restated(1)
    As
previously
reported(1)
    Adjustments(1)     As
restated(1)
 

Operations

                 

Revenue

  $ 564,611     $ 467,117     $ 394,604     $ 379,587     $ —       $ 379,587     $ 350,185     $ —       $ 350,185  

Cost of revenue

    229,441       178,665       138,491       148,054       265       148,319       167,685       409       168,094  
                                                                       

Gross Profit

    335,170       288,452       256,113       231,533       (265 )     231,268       182,500       (409 )     182,091  
Operating expenses:                  

Research and development

    127,900       110,086       112,254       96,697       3,174       99,871       89,973       4,312       94,285  

Sales and marketing

    99,838       82,039       75,050       61,597       611       62,208       50,624       802       51,426  

General and administrative

    47,857       35,856       28,613       21,690       2,502       24,192       21,778       3,505       25,283  

Restructuring charges

    —         2,685       —         —         —         —         —         —         —    

Real estate related charges

    —         —         14,394       —         —         —         —         —         —    

Amortization of identified intangibles

    35,514       26,434       13,690       6,450       —         6,450       4,391       —         4,391  

Acquired in-process research and development(2)

    8,500       45,300       1,000       13,220       —         13,220       —         —         —    
                                                                       

Total operating expenses

    319,609       302,400       245,001       199,654       6,287       205,941       166,766       8,619       175,385  
Income (loss) from operations     15,561       (13,948 )     11,112       31,879       (6,552 )     25,327       15,734       (9,028 )     6,706  
Interest and other income, net:                  

Interest and other income (expense), net

    24,002       14,489       12,779       11,489       —         11,489       11,540       —         11,540  

Interest expense

    (5,027 )     (5,010 )     (5,632 )     (2,886 )     —         (2,886 )     (54 )     —         (54 )

Gain on sale of product line, net

    6,995       —         2,994       —         —         —         —         —         —    

Litigation settlement income, net

    —         —         58       2,408       —         2,408       (4,409 )     —         (4,409 )

Loss on equity investment

    —         —         —         (1,562 )     —         (1,562 )     —         —         —    
                                                                       

Total interest and other income, net

    25,970       9,479       10,199       9,449       —         9,449       7,077       —         7,077  
                                                                       
Income (loss) before income taxes     41,531       (4,469 )     21,311       41,328       (6,552 )     34,776       22,811       (9,028 )     13,783  
(Provision for) benefit from income taxes     (41,714 )     (711 )     14,254       (14,820 )     2,148       (12,672 )     (6,843 )     2,612       (4,231 )
                                                                       

Net income (loss)

  $ (183 )   $ (5,180 )   $ 35,565     $ 26,508     $ (4,404 )   $ 22,104     $ 15,968     $ (6,416 )   $ 9,552  
                                                                       

Earnings per share

                 
Net income (loss) per basic common share   $ (0.00 )   $ (0.10 )   $ 0.66     $ 0.49       $ 0.41     $ 0.29       $ 0.18  
                                                           
Net income (loss) per diluted common share   $ (0.00 )   $ (0.10 )   $ 0.60     $ 0.47       $ 0.40     $ 0.29       $ 0.17  
                                                           
Shares used in basic per-share calculation     56,559       54,425       53,898       53,789         53,789       54,256         54,256  
                                                           
Shares used in diluted per-share calculation     56,559       54,425       63,979       60,138         60,272       54,852         54,808  
                                                           

 

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    For the year ended December 31,
    2006   2005   2004   2003   2002
(in thousands, except
per share amounts
and ratios)
      As
restated(1)
  As
restated(1)
  As
previously
reported(1)
  Adjustments(1)     As
restated(1)
  As
previously
reported(1)
  Adjustments(1)   As
restated(1)

Financial Position

                 
Cash, cash equivalents and short-term investments   $ 510,171   $ 469,616   $ 659,559   $ 624,112   $ —       $ 624,112   $ 498,370   $ —     $ 498,370

Working capital

    261,774     459,077     617,076     665,193     (947 )     664,246     470,054     —       470,054

Total assets

    1,144,651     1,088,438     1,025,323     1,013,661     8,737       1,022,398     727,106     9,375     736,481
Senior convertible debentures     240,000     240,000     240,000     240,000     —         240,000     —       —       —  

Stockholders’ equity

    751,578     710,739     674,026     654,813     7,790       662,603     634,067     9,375     643,442

(1)

See Note 2, “Restatement of Consolidated Financial Statements” to Consolidated Financial Statements.

(2)

We expensed acquired in-process research and development costs of $8.5 million, $45.3 million and $1.0 million for the years ended December 31, 2006, 2005, and 2004, respectively. See Note 4 of Notes to Consolidated Financial Statements.

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

The following discussion and analysis should be read in conjunction with the audited consolidated financial statements and related notes thereto included in this Annual Report on Form 10-K.

All assumptions, anticipations, expectations and forecasts contained herein are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21 E of the Securities Exchange Act of 1934, as amended, that involve risks and uncertainties. Forward-looking statements include, among others, those statements including the words “expects,” “anticipates,” “intends,” “believes” and similar language. Our actual results could differ materially from those discussed here. For a discussion of the factors that could impact our results, readers are referred to Item 1A “Risk Factors” in Part I of this Annual Report and to our other reports filed with the Securities and Exchange Commission. We do not assume any obligation to update the forward-looking statements provided to reflect events that occur or circumstances that exist after the date on which they were made.

Restatement of Consolidated Financial Statements and Special Committee Investigation

We are restating the following consolidated financial statements and related disclosures in this Annual Report on Form 10-K:

(1) our consolidated balance sheet as of December 31, 2005 and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the two years in the period ended December 31, 2005;

(2) “Selected Consolidated Financial Data” in Part II, Item 6 as of and for the fiscal years ended December 31, 2005, 2004, 2003, and 2002;

(3) “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 as of and for the fiscal years ended December 31, 2005 and 2004; and

(4) our unaudited quarterly financial information for the first two quarters in our fiscal year ended December 31, 2006 and for all quarters in our fiscal year ended December 31, 2005 located at the end of Item 8 in this Annual Report on Form 10-K.

 

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The restatements result from an independent investigation by a special committee of the Company’s Board of Directors (the “Special Committee”) into our historical stock option granting practices. Information relating to the Special Committee investigation has been disclosed in Current Reports on Form 8-K filed on October 24, 2006 and June 29, 2007 with the Securities and Exchange Commission (“SEC”).

Special Committee Investigation of Historical Stock Option Practices

In May 2006, Citigroup published a number of reports, one of which identified us as having well-timed option grants among seven companies in our sector, and therefore, as being at risk for greater scrutiny of our option granting practices. The report identified certain stock options granted to executive officers of the Company on selected dates during the years 1996, 1998, 1999 and 2001.

On August 16, 2006, the first of several shareholder derivative suits was filed, alleging that certain of our current and former officers and directors breached their fiduciary duty in connection with the administration and accounting associated with stock option grants to officers.

On October 20, 2006, our management reviewed information compiled by our litigation counsel, Wilson Sonsini Goodrich and Rosati (“WSGR”) and discussed the matter with the Chairman of the Audit Committee of the Board of Directors. The Board of Directors’ Special Committee, consisting of directors selected to carry out an independent investigation of our historical stock option granting practices, retained independent counsel and forensic accounting advisors to assist with their investigation.

Completion of Special Committee Investigation of Historical Stock Option Practices

On June 25, 2007, the Special Committee, with its independent counsel and forensic accountants, reported their completion of the investigation to management and the Board of Directors.

The Special Committee investigation focused on our historical stock option granting practices from the Company’s initial public offering on October 2, 1992 through 2006. In particular, they reviewed in detail 22 unique company-wide grant dates and developed observations related to each of the grants on those specific dates.

The Special Committee’s advisors worked in excess of a collective 30,000 professional hours. The work included:

 

   

Conducting 46 interviews of 27 current and former directors, officers, employees, and advisors to the Company.

 

   

Collecting documents from 28 current and former directors, officers, and employees, files from certain Company servers, and documents from outside legal counsel, among other sources. In total, the Special Committee collected approximately 9.5 million pages of hard copy and electronic documents.

 

   

Reviewing approximately 4.5 million pages of hard copy and electronic documents.

 

   

Analyzing each option grant based on its price, the number of options, and other relevant information.

 

   

Performing extensive analytics.

The Special Committee found that a substantial number of the grants to existing officers, directors and employees were priced on dates coinciding with our low stock price for the month, and, in some instances, the quarter. Information collected during the investigation suggests that, prior to 2004, many such option grants were priced with the benefit of a “look back” at historical stock prices, with such “look backs” ranging up to several weeks. The Special Committee found that grants to newly-hired employees, dated April 1994 through October 2003, were typically priced with an effective date coinciding with a low stock price for a given period.

 

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Based on its investigation, the Special Committee concluded, among other things, that we lacked contemporaneous evidence supporting a number of the recorded option grant dates. The affected grants included grants to (1) newly hired employees, (2) employees joining EFI in connection with one or more acquisition, and (3) existing employees, officers, and directors.

Management’s Review of the Investigative Forensic Evidence provided by the Special Committee

The Special Committee provided to management forensic evidence collected during the investigation in order for us to reassess the original measurement dates selected for accounting purposes. To review the forensic evidence, a systematic approach was developed for evaluating the historical measurement dates for new hire grants (including grants to new hires related to acquisitions) and company-wide (“broad-based”) grants to existing employees, officers, and directors and for determining the revised measurement date, if a revision was warranted. On grant dates where we lacked strong contemporaneous evidence supporting the original grant date; our approach was subject to judgment and in some cases multiple reasonable assumptions were considered and multiple measurement dates could have been supported by the documents available to management.

We hired experienced accountants and financial reporting consultants to assist in management’s review of the documentation provided by the Special Committee and to expand our review to all stock options and restricted stock awards granted in the review period. Our consultants worked collectively in excess of 11,000 hours.

In addition to the materials provided by the Special Committee, management conducted its own review of the following: 757 individual personnel and stock option files which we determined to be of interest; accounting records for fiscal years 1992-2006 and supporting reports for stock-based compensation; 1992-2006 Board of Director and committee documentation and minutes; emails and the stock-based compensation accounting database.

We have determined there were 756 unique grant dates that required review as a result of the observations by the Special Committee. Those unique grant dates can be classified as 718 grant dates for newly hired employees (including new hires related to acquisitions) and 38 broad-based grant dates.

Based on the results of this review, we concluded that the original measurement date used for accounting purposes required revision in a number of cases. This created a non-cash intrinsic value equaling the difference between the exercise price (fair market value of our stock on the original measurement date) and the fair market value of our stock on the revised measurement date.

 

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The table and chart below illustrate the total gross non-cash intrinsic value in each year for which a revised measurement date was required (amortization of the intrinsic value is not reflected in the table); these amounts are higher than the amounts ultimately recorded as compensation expense in the financial statements because they do not reflect reductions due to the accounting for forfeitures, cancellations, and income tax effects.

Gross non-cash intrinsic values for stock options (in millions)

 

    Broad-based
grants
  Modifications   New hire
grants
  Total
1992   $ —     $ 1.1   $ 0.1   $ 1.2
1993     0.2     0.2     0.1     0.5
1994     2.5     0.0     0.2     2.7
1995     3.5     0.7     1.8     6.0
1996     4.8     0.0     2.3     7.1
1997     6.6     1.5     1.4     9.5
1998     14.5     3.0     0.3     17.8
1999     29.5     0.0     1.6     31.1
2000     72.2     30.7     3.3     106.2
2001     4.0     0.0     1.8     5.8
2002     0.0     0.0     0.3     0.3
2003     2.8     0.2     0.2     3.2
2004     0.0     0.0     0.0     0.0
2005     0.0     0.0     0.0     0.0
2006     0.0     0.0     0.0     0.0
                       
        Totals   $ 140.6   $ 37.4   $ 13.4   $ 191.4
                       

LOGO

 

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The original new hire measurement dates were evaluated based on the employee hire date and the specific “look back” period convention used to determine the original exercise price. The revised measurement date was determined, with judgment by us, to be the last day of the “look back” period since it appeared from the available evidence that the number of shares and exercise price were both known on that date. Beginning in October 2003, we modified our procedures to no longer use a “look back” period convention to determine the exercise price for new hire stock option grants and, as such, there were no material adjustments to the original measurement dates for new hires after that date.

The revised measurement dates for new hire grants resulted in approximately $13.4 million of incremental gross non-cash intrinsic value (before accounting for forfeitures, cancellations, and the related income tax effects); all of which relates to measurement date revisions originating in periods prior to January 2004.

Broad-based grants to employees, directors, and officers were evaluated using all available evidence to systematically evaluate the appropriateness of previously determined measurement dates. We then applied judgment in determining whether the measurement dates of any of the unique grant dates under review required revision. The revised measurement dates for broad-based grants resulted in approximately $140.6 million of incremental gross non-cash intrinsic value (before accounting for forfeitures, cancellations, and related tax effects); this entire amount relates to measurement date revisions originating in periods prior to January 2004.

We applied Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees,” and its related interpretations beginning in 1989 through our fiscal year ended December 31, 2005 and provided the required pro forma disclosures under Statement of Financial Accounting Standards No. 123 (“SFAS 123”), “Accounting for Stock-Based Compensation,” beginning in 1996 through our fiscal year ended December 31, 2005. Under APB 25 (intrinsic value model), non-cash stock-based compensation expense (“non-cash intrinsic value”) was required to be recognized for any option in which the exercise price was below the market price of our stock on the measurement date. If, after our review and the revision of certain measurement dates, our stock options had an exercise price below the market price of our stock on the revised measurement date, we have recognized in the restated financial statements stock-based compensation expense for the options under APB 25 equal to the number of option shares, multiplied by the difference between the exercise price and the market price of our stock on the revised measurement date. That expense has been recognized over the vesting periods of the options on a straight-line basis. If a stock option was forfeited prior to vesting, the compensation expense recorded in the consolidated statements of operations in prior periods was reversed, as was any remaining unamortized unearned stock-based compensation associated with the forfeited stock options.

We also reviewed the accounting treatment for stock options related to employee terminations and separation agreements and other possible modification conditions.

Prior to 2006, modifications were accounted for under the provisions of Financial Accounting Standards Board Interpretation No. 44 (“FIN 44”) “Accounting for Certain Transactions Involving Stock Compensations”, which required that an award be re-measured at the modification date and to record any incremental increase in intrinsic value as a compensation charge. For modifications made in conjunction with employment terminations, the compensation charge was recognized immediately since the shares were fully vested and no additional services were required.

We evaluated modifications in relation to the original grant terms and changes to employee status to determine if modifications had been accounted for appropriately in our consolidated statement of operations, and determined that incremental gross compensation charges of $37.4 million (before income tax effect) should be recorded related to modifications in or prior to 2001. In the past, we elected to modify the terms of stock option awards to certain employees, including officers, in a manner that provided the employee with a greater benefit than in the original award. These modifications occurred on termination of employment to allow for additional vesting and/or extension beyond our plan’s standard exercise period of three (3) months after termination. Of these charges, $30.6 million involved a separation agreement executed in 2000 between us and our former Chief Executive

 

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Officer and Chairman of the Board of Directors. Another $3.0 million involved a separation agreement in 1998 with a former vice president. These two officer modifications accounted for $33.6 million or approximately 89% of the total modifications.

Summary of Adjustments for Stock-Based Compensation

While the chart and table above illustrate the gross intrinsic value before forfeitures, cancellations and related income tax effects, the table below illustrates the stock-based compensation expense impact to the consolidated statement of operations and the associated income tax provision (benefit) in the periods in which they were recorded. We used a straight-line method to amortize the gross intrinsic value over the vesting period and accounted for forfeitures and cancellations in the period they occurred. In the aggregate, we recorded additional stock-based compensation expense for the period 1992 through 2005 of approximately $151.7 million with associated income tax benefits of $53.0 million for a net expense of $98.7 million related to stock-based compensation.

Statement of operations incremental impact for stock-based compensation expense and other adjustments (in thousands):

 

Year   Date Adj
related to
SBC
  Modification
and other
adj related
to SBC
    Total
pre-tax
adj related
to SBC
  Adjustment
to tax
provision
(benefit)
    Total adj
related
to SBC,
net of tax
  Other
adj,
net of
tax
  Total
adj, net
of tax
1992   $ 24   $ 1,077     $ 1,101   $ (12 )   $ 1,089   $ —     $ 1,089
1993     44     166       210     (17 )     193     —       193
1994     196     21       217     (70 )     147     —       147
1995     1,011     661       1,672     (633 )     1,039     —       1,039
1996     2,348     —         2,348     (849 )     1,499     —       1,499
1997     3,272     1,501       4,773     (1,756 )     3,017     —       3,017
1998     7,561     3,013       10,574     (3,849 )     6,725     —       6,725
1999     11,646     49       11,695     (3,881 )     7,814     —       7,814
2000     22,300     30,971       53,271     (19,264 )     34,007     —       34,007
2001     46,498     103       46,601     (17,535 )     29,066     —       29,066
2002     9,072     (44 )     9,028     (2,613 )     6,415     —       6,415
2003     6,105     447       6,552     (2,148 )     4,404     —       4,404
                                             
Cummulative
through
December 31, 2003
    110,077     37,965       148,042     (52,627 )     95,415     —       95,415
                                             
2004     2,949     (32 )     2,917     (463 )     2,454     —       2,454
2005     735     —         735     86       821     292     1,113
                                             
  $ 113,761   $ 37,933     $ 151,694   $ (53,004 )   $ 98,690   $ 292   $ 98,982
                                             

Abbreviations:

Stock based compensation (“SBC”)

Measurement date (“date”)—Note: measurement date revisions relate to broad-based and new hire grants

Incremental expense adjustment (“Adj”)

Income tax (“tax”)

Summary of Other Accounting Adjustments

As part of our restatement, we also recorded additional non-cash adjustments for previously identified adjustments that at the time were considered to be immaterial. These adjustments primarily related to the timing of revenue recognized for certain VUTEk contracts during 2005. The contract revenue and related costs of sales

 

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($1.4 million and $0.9 million, respectively) originally recognized in 2005 were deferred at December 31, 2005 as part of the restatement resulting in an adjustment, net of taxes, of $0.3 million in our statement of operations. The contract revenue and related costs were subsequently recognized in 2006.

For additional information regarding the restatement, please see Note 2, “Restatement of Consolidated Financial Statements” of the Notes to the Consolidated Financial Statements.

Related Tax Matters

We also considered the application of Section 409A of the Internal Revenue Code to certain stock option grants where, under APB No. 25, intrinsic value existed at the time of grant. Holders of options with revised measurement dates granted by us may be subject to adverse tax consequences, including a penalty tax under Section 409A of the Internal Revenue Code and, as applicable, similar penalty taxes under California and other state tax laws. On July 2, 2007, we paid $0.56 million under Internal Revenue Service and California compliance programs on behalf of certain option holders who had already exercised affected options during 2006 for the additional taxes incurred under Section 409A of the Internal Revenue Code. We also remitted an additional $0.54 million to the Internal Revenue Service and state tax agencies to cover any tax liabilities of our employees resulting from our payment of Section 409A taxes on July 2, 2007 on their behalf.

We also considered the application of Section 162(m) of the Internal Revenue Code to stock option exercises by certain executive officers where, under APB No. 25, intrinsic value existed at the time of grant. Section 162(m) limits the corporate tax deduction to $1.0 million annually for any non-performance based compensation paid to an affected executive officer. The exercise of those options with intrinsic value at the time of grant will be considered non-performance based compensation, and the resulting gains have been disallowed as a corporate tax deduction to the extent these amounts, when combined with all other non-performance based compensation paid annually, exceed the annual $1.0 million Section 162(m) limitation. We have recorded a charge of approximately $1.3 million related to Section 162(m) disallowances for the tax years 2003 to 2006.

Related Proceedings

For information on related proceedings see Item 3—Legal Proceedings.

Overview

Key financial results for 2006 were as follows:

 

   

Our consolidated revenues increased by approximately 21%, or $97.5 million, from $467.1 million in 2005 to $564.6 million for the year ended December 31, 2006. This was due primarily to the addition of the VUTEk product line in mid-2005, which contributed $92.0 million of the increase, and the October, 2006 addition of Jetrion revenues. Those increases were offset by slight decreases in revenue from our Controllers product revenues and the sale of the Mobile Workforce Automation (MWA) business in June 2006.

 

   

Gross margins decreased to 59% in 2006 versus 62% in 2005 due to the inclusion of the VUTEk product line for a full year in 2006 versus seven months in 2005, offsetting higher margins on our Controllers line of products.

 

   

Operating expenses as a percent of revenues decreased from 65% in 2005 to 57% in 2006 due to decreases in in-process research and development (IPR&D) expense recorded in connection with the acquisition of VUTEk and Jetrion. IPR&D costs totaled 2% and 10% of revenue for 2006 and 2005, respectively. After excluding IPR&D, operating expenses remained at 55% of revenues.

 

   

Interest and other income increased from 2% of revenue in 2005 to 5% of revenue in 2006 due to higher interest rates and higher invested balances and a $7 million gain on sale of the MWA business.

 

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Our tax provision increased from 16% of operating income in 2005 to 100% of operating income in 2006 primarily due to a one-time charge related to the migration of the non-North American chipset product lines to our European headquarters.

Results of Operations

The following table sets forth items in our consolidated statements of operations as a percentage of total revenue for 2006, 2005 and 2004. These operating results are not necessarily indicative of results for any future period.

 

     Years ended December 31,  
     2006     2005
As restated(1)
    2004
As restated(1)
 

Revenue

   100 %   100 %   100 %

Gross Profit

   59 %   62 %   65 %

Operating expenses:

      

Research and development

   23 %   24 %   28 %

Sales and marketing

   18 %   18 %   19 %

General and administrative

   8 %   8 %   7 %

Restructuring charges

   0 %   1 %   0 %

Real estate related charges

   0 %   0 %   4 %

Amortization of identified intangibles

   6 %   6 %   3 %

Acquired in-process research and development

   2 %   10 %   0 %
                  

Total operating expenses

   57 %   65 %   62 %
                  

Income (loss) from operations

   2 %   -3 %   3 %

Interest and other income, net

   5 %   2 %   2 %
                  

Income (loss) before income taxes

   7 %   -1 %   5 %

(Provision for) benefit from income taxes

   -7 %   0 %   4 %
                  

Net income (loss)

   0 %   -1 %   9 %
                  
 
 

(1)

See Note 2, “Restatement of Consolidated Financial Statements” to Consolidated Financial Statements.

Revenue

For 2006, we group our revenues as derived from three major categories. The first category, “Controllers”, is primarily made up of stand-alone controllers, which connect digital copiers with computer networks, and embedded desktop controllers, bundled solutions and design-licensed solutions primarily for the office market and commercial printing. This category includes our Fiery, Splash, Edox, and MicroPress color and black and white controller product line and also includes spares, scanning solutions, and field dispatching solutions previously considered a separate miscellaneous category. The second category, “Inkjet Products”, consists of sales of the super-wide format inkjet printers and inks, and parts and services revenue from our VUTEk and Jetrion product lines which were acquired June 2, 2005 and October 31, 2006, respectively. The third category, “Advanced Professional Print Software”, or (APPS), consists of software technology focused on printing workflow, print management information systems, proofing and web submission and job tracking tools.

 

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Our revenues by product category for the years ended December 31, 2006, 2005 and 2004 were as follows (in thousands):

 

     Years ended December 31,     % change  

Revenue

   2006    

2005

As restated(1)

   

2004

As restated(1)

    2006
over
2005
As restated
    2005
over
2004
As restated
 

Controller

   $ 306,688    54 %   $ 310,213    67 %   $ 326,120    83 %   (1 )%   (5 )%

Inkjet Products

     180,203    32       85,530    18       —      —       111     100  
Advanced Professional Printing Software      77,720    14       71,374    15       68,484    17     9     4  
                                           

Total revenue

   $ 564,611    100 %   $ 467,117    100 %   $ 394,604    100 %   21     18  
                                           

(1)

See Note 2, “Restatement of Consolidated Financial Statements” to Consolidated Financial Statements.

Overview

Revenue was $564.6 million in 2006, compared to $467.1 million in 2005 and $394.6 million in 2004, which resulted in a 21% increase in 2006 versus 2005 and an 18% increase in 2005 compared to 2004. The $97.5 million increase in 2006 compared to 2005 was primarily due to a $94.7 million increase in inkjet product revenues and a $6.3 million increase in APPS revenues, offset by a $3.5 million decrease in controllers revenues. Inkjet revenue growth is from year-over-year growth of the business and also from the inclusion of a full year’s results for VUTEk in 2006 versus only a partial-year’s results in 2005.

Controller Revenues

In our controller category, the decrease in 2006 versus 2005 of $3.5 million was primarily due to the sale of the MWA business in the second quarter of 2006 which contributed a $4.5 million decline in revenue year over year.

The controller product revenues decreased $15.9 million in 2005 as compared to 2004 due to the timing of product introductions by our OEM’s in the second half of 2005. Our controller product revenues are heavily dependent on when OEM’s introduce and ship their products since our controllers are part of the printing equipment they sell. Though 2005 revenue was lower than 2004, the second half revenues in 2005 actually increased over the second half revenues of 2004.

Inkjet Products Revenues

Inkjet revenues were $180.2 million in 2006 as compared to $85.5 million in 2005. Our 2005 results include seven months of VUTEk revenues since its acquisition in June 2005 and our 2006 results include 2 months of Jetrion revenues and a full year of VUTEk revenues. Inkjet revenues would have increased 26% on a pro forma basis if 2005 revenues included VUTEk pre-acquisition revenues.

Approximately $51.7 million of 2006 inkjet product revenues were generated from ink sales versus $26.1 million in 2005.

Advanced Professional Print Software Revenues

The Advanced Professional Print Software category increased 9% in 2006 over 2005 primarily due to a $6.2 million increase in revenues from packaged software solutions, which are sold with new controllers and to existing customers. Within this category are the products we acquired from Printcafe and Best GmbH as well as

 

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certain software products that were developed by EFI to enhance our controller products, such as our Graphic Arts Package and products to optimize the workflow in print shops such as Oneflow and Balance. The software applications in this category generate higher margins, favorably impacting our margins. We continue to see strong market acceptance of these products and we believe we will experience further incremental growth.

We believe that price reductions for all of our products may affect revenues in the future. We have made and may in the future make price reductions for our products in order to drive demand and remain competitive. Depending upon the price-elasticity of demand for our products, the pricing and quality of competitive products and other economic and competitive conditions, such price reductions may have an adverse impact on our revenues and profits. If we are not able to compensate for lower gross margins that may result from price reductions with an increased volume of sales, our results of operations could be adversely affected.

Revenues by geographic area for the years ended December 31, 2006, 2005 and 2004 were as follows (in thousands):

 

     For the years ended December 31,     % change  
     2006     2005
As restated(1)
    2004
As restated
    2006
over
2005
As restated(1)
    2005
over
2004
As restated
 

Americas

   $ 303,931    54 %   $ 258,543    55 %   $ 217,069    55 %   18 %   19 %

Europe

     175,037    31       139,165    30       105,168    27     26     32  

Japan

     63,248    11       47,125    10       56,799    14     34     (17 )
Other international locations      22,395    4       22,284    5       15,568    4     0     43  
                                           

Total

   $ 564,611    100 %   $ 467,117    100 %   $ 394,604    100 %   21     18  
                                           

(1)

See Note 2, “Restatement of Consolidated Financial Statements” to Consolidated Financial Statements.

Revenues from each geographic area represented a roughly equal percentage of total revenues for 2006 versus 2005. Revenue growth in both 2006 and 2005 across all geographic regions was primarily driven by the addition of the VUTEk portion of the Inkjet Products line in June 2005 and to a lesser extent, industrial inkjet products from the acquisition of Jetrion. In the individual regions, Inkjet Product revenues in 2006 represented 30%, 45%, 3% and 38% of revenue in the Americas, Europe, Japan and other international locations, respectively. Overall revenue in the Americas and Europe regions increased in 2006 versus 2005, due to the inclusion of VUTEk for the full year of 2006 versus seven months in 2005, and stronger demand for our Controller product lines in these regions.

Japan region had strong 2006 growth due to strong design license sales to OEM customers. Americas region was negatively impacted by the sale of the Mobile Workforce Automation (“MWA”) product line in the second quarter of 2006.

Shipments to some of our US OEM customers are made to centralized purchasing and manufacturing locations, which in turn sell through to other locations. We believe that non-U.S. sales of our products into each region may differ from what is reported because accurate data is difficult to obtain. We expect that non-U.S. sales will continue to represent a significant portion of our total revenue.

A substantial portion of our revenue over the years has been attributable to sales of products through our OEM customers and independent distributor channels. For the year ended December 31, 2006, two customers—Canon and Xerox—each provided more than 10% of our revenue individually and approximately 34% of revenue in the aggregate. For the year ended December 31, 2005, Canon, Konica-Minolta and Xerox each provided more than 10% of our revenue individually and approximately 48% of revenue in the aggregate. We have shown a continued decrease in our dependency on the OEM business and in the fourth quarter of 2006, 52% of our revenues were from non-OEM sources.

 

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The decreasing trend in OEM dependency is attributable to the addition of the Inkjet Products business where most of the revenue is generated from sales to distributors and direct customers. No assurance can be given that our relationships with distributors and direct customers will continue or that we will be successful in maintaining or increasing the number of our OEM customers or the size of our existing OEM relationships. Several of our OEM customers have reduced their purchases from us at various times in the past and any customer could do so in the future as there are no contractual obligations by most of our OEMs to purchase our products at all, or in significant amounts. Such reductions have occurred in the past and could in the future have a significant negative impact on our consolidated financial position and results of operations. We expect that if we increase our revenues from VUTEk and our Advance Professional Print Software, the percentage of our revenue that comes from individual OEMs will continue to decrease.

We continue to develop new products and technologies for each of our product lines including new generations of controllers and controller products and other new product lines and to distribute those new products to or through current and new OEM customers, distribution partners, and end-users in 2007 and beyond. No assurance can be given that the introduction or market acceptance of current or future products will be successful.

To the extent sales of our products do not grow over time in absolute terms, or if we are not able to meet demand for higher unit volumes, it could have a material adverse effect on our operating results. There can be no assurance that any products that we introduce in the future will successfully compete, be accepted by the market, or otherwise effectively replace the volume of revenue and/or income from our older products. Market acceptance of our software products, products acquired through acquisitions and other products cannot be assured.

We also believe that in addition to the factors described above, price reductions for all of our products will affect revenues in the future. We have previously reduced and in the future will likely reduce prices for our products. Depending upon the price-elasticity of demand for our products, the pricing and quality of competitive products, and other economic and competitive conditions, such price reductions have had and may in the future have an adverse impact on our revenues and profits.

Gross Margins

Our gross margins were 59%, 62% and 65% for 2006, 2005 and 2004, respectively. The decrease in gross margin from 2005 to 2006 was due primarily to the acquisition of VUTEk in 2005 which has lower gross margins than our other categories. Gross margins decreased in 2005 versus 2004 primarily due to the acquisition of VUTEk starting June of 2005. Our inkjet printers have a lower gross margin than our Controllers and Advanced Professional Print Software product lines. Product mix is a significant driver in our gross margins and we cannot predict the impact that product mix will have on future gross margin results.

Gross margins on our inkjet products have a lower gross margin than our traditional controller business. Our ink sales represent a continuing revenue stream to existing customers that will increase if our inkjet customers’ production increases. Ink margins are typically higher than overall inkjet margins. Our inkjet product line is growing as a percentage of revenue which decreases gross margin percentage. For 2006 inkjet revenues were 32% of total revenue as compared to 18% of total revenues in 2005.

If our product mix changes significantly, our gross margins will fluctuate. In addition, gross margins can be impacted by a variety of other factors. These factors include the market prices that can be achieved on our current and future products, the availability and pricing of key components (including DRAM, Processors, print heads and PostScript® interpreter software), third party manufacturing costs, product, channel and geographic mix, the success of our product transitions and new products, competition and general economic conditions in the United States and abroad. Consequently, gross margins may fluctuate from period to period. In addition to the factors affecting revenue described above, if we reduce prices, gross margins for our products could be lower.

 

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Our print controllers are manufactured by third-party manufacturers who purchase most of the necessary components. If our third-party manufacturers cannot obtain the necessary components at favorable prices, we could experience an increase in our product costs. We purchase certain parts directly, including processors, memory, certain ASICs and software licensed from various sources, including PostScript® interpreter software, which we license from Adobe Systems Incorporated.

Operating Expenses

Operating expenses increased by 6% in 2006 over 2005 and increased by 23% in 2005 over 2004. Operating expenses as a percentage of revenue totaled 57%, 65%, and 62% for 2006, 2005, and 2004, respectively. The decrease in operating expenses as a percentage of revenue in 2006 versus 2005 was primarily due to a decrease in in-process research and development expense (IPR&D) from $45.3 million in 2005 relating to the VUTEk acquisition to $8.5 million in 2006 relating to the Jetrion acquisition. Excluding the impact of IPR&D, operating expenses increased by $54.0 million mainly due to increases in stock-based compensation of $20.8 million, amortization expense of $9.1 million, VUTEk full year operating expenses in 2006, and increases in research and development and sales and marketing expenses due primarily to higher operating expenses from higher headcount from last year.

Research and Development

Expenses for research and development consist primarily of personnel-related and facility expenses and, to a lesser extent, consulting, depreciation and costs of prototype materials. Research and development expenses were $127.9 million or 23% of revenue in 2006 compared to $110.1 million or 24% of revenue in 2005 and $112.3 million or 28% of revenue in 2004. The increase of $17.8 million in 2006 versus 2005 was primarily due to an increase in stock-based compensation of $7.8 million, higher personnel and other related costs due to higher headcount, and higher spending due to Inkjet research and development. Research and development headcount was 885 and 781 as of December 31, 2006 and 2005, respectively.

We believe that the development of new products and the enhancement of existing products are essential to our success and we intend to continue to devote substantial resources to research and new product development efforts. Accordingly, we expect that our research and development expenses may increase in absolute dollars and also as a percentage of revenue in future periods. A reduction in prototype expenses also contributed to the decrease in research and development expenses in 2005 from 2004.

As part of our operational practices, we review all projects on a periodic basis for estimated return on investment. Those projects that do not meet certain criteria may be changed or halted.

Sales and Marketing

Sales and marketing expenses include personnel-related expenses, costs for trade show related expenses, marketing programs and promotional materials, sales commissions, travel and entertainment expenses, depreciation and costs associated with sales offices in the United States, Europe, Japan and other locations around the world. Sales and marketing expenses for 2006 were $99.8 million or 18% of revenue compared to $82.0 million or 18% of revenue in 2005 and $75.0 million or 19% of revenue in 2004.

The $17.8 million increase in expenses in 2006 versus 2005 primarily related to the acquisition of VUTEk, which is included in the full year results for 2006 and for seven months in 2005. VUTEk sells directly to end user customers which results in a higher level of sales expense compared to our OEM customers. VUTEk sales and marketing expenses increased by $14.5 million in 2006 from 2005. The remaining increases consisted of a $3.1 increase in stock-based compensation expense, from $0.2 million in 2005 to $3.2 million in 2006. Sales and marketing headcount was 441 and 399 as of December 31, 2006 and 2005, respectively.

 

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The $7.0 million increase in expenses in 2005 versus 2004 was primarily related to the $14.1 million in VUTEk-related marketing expenses, offset primarily by $4.4 million in employee-related cost reductions due to the reduction in workforce in the first quarter of 2005, and $1.9 million in lower tradeshow expenses. Drupa, a leading print industry exposition in Europe which occurs every four years in Europe, increased trade show expenses in 2004.

We expect that our sales and marketing expenses may increase in absolute dollars and possibly also as a percentage of revenue as we continue to actively promote our products, launch new products and services, and continue to build our sales and marketing organization, particularly in Europe and Asia Pacific, and as we grow our software solutions and other new product lines which require greater sales and marketing support from us. We also expect that if the US dollar remains volatile against the Euro or other currencies, sales and marketing expenses reported in US dollars could fluctuate. Approximately 40% of our sales and marketing expenses are incurred from offices outside the United States.

General and Administrative

General and administrative expenses consist primarily of personnel-related expenses and, to a lesser extent, depreciation and facility costs, bad debt, professional fees and other costs associated with public companies. General and administrative expenses were $47.9 million or 8% of revenue in 2006, compared to $35.9 million or 8% of revenue in 2005 and $28.6 million or 7% of revenue in 2004. The $12.0 million increase in 2006 versus 2005 principally consists of an increase of stock-based compensation of $8.3 million from $2.1 million in 2005 to $10.4 million in 2006, and $4.0 million incurred in 2006 for accounting and legal fees relating to our independent investigation into past stock option practices.

The increase in general and administrative expenses in 2005 of $7.2 million as compared to 2004 principally consists of increases in overall expenses related to our June 2005 acquisition of VUTEk of $5 million, rent increases of $1.1 million and increased litigation-related fees.

Real estate related charges

In 2004, we incurred expenses of $14.4 million related to an $11.4 million fair market adjustment on our building at 301 Velocity Way and a $3.0 million write off of capitalized lease and development costs related to our building and land at our Foster City headquarters. The fair market value adjustment was required as part of a valuation completed in 2004 as part of our amended financing arrangement entered into in September 2004 for that building. Under the original lease of $43 million, we guaranteed the lessor an 82% residual value in the building upon the termination of the original lease. The valuation provided a value of approximately $31.7 million for the building, and we paid the lessor $11.4 million and recorded a one-time loss associated with the original lease in September 2004.

Restructuring Charges

During the first quarter of 2005 we incurred severance costs of approximately $2.7 million related to a headcount reduction of 65 employees.

Amortization of Identified Intangibles

Amortization of acquisition-related intangibles was $35.5 million or 6% of revenue in 2006 versus $26.4 or 6% of revenue in 2005. The increase of $9.1 million in 2006 versus 2005 is primarily due to the inclusion of amortization of VUTEk intangible assets for a full year in 2006 versus seven months in 2005. We acquired VUTEk on June 2, 2005.

 

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Acquired In-process Research and Development

At the time of acquisition of each of Jetrion and VUTEk, we expensed acquired in-process research and development of $8.5 million for Jetrion in 2006 and $45.3 million for VUTEk in 2005.

Interest and Other Income, Net

Interest and other income

Interest income was $24.0 million in 2006 and increased by 66% from $14.5 million in 2005. Interest and other income increased $1.7 million in 2005 versus 2004. Both yearly increases reflect rising interest rates and higher invested balances. We had realized losses on our marketable securities of $0.2 million and $0.8 million in 2006 and 2005, respectively.

Interest expense

Interest expense is recognized ratably over the life of our debentures at a rate of 1.5% per annum when we amortize debt issuance costs related to the convertible debentures. Interest expense including debt amortization totaled $5.0 million for each of the years ended December 31, 2006 and 2005, respectively, and $5.6 million in 2004.

Gain on Sale of Product Line

During the second quarter of 2006 we sold our inventory and intangible assets related to our MWA line of products. Gross proceeds from the sale were $10.0 million and we recognized a gain of $7.0 million.

In 2004, we recognized approximately $3.0 million from the sale of our Unimobile product line, consisting of a customer base, research and development and sales employees, and intangible assets.

Income Taxes

In 2006, we recorded a tax provision of $41.7 million on a pre-tax operating income of $41.5 million, compared to a tax provision of $0.7 million recorded in 2005 on pre-tax operating loss of $4.5 million and a tax benefit of $14.3 million recorded in 2004 on pre-tax operating income of $21.3 million. In each of these years, we benefited from research and development credits and benefits derived from the extra-territorial income exclusion. In 2005 and 2004, our taxes also decreased due to lower taxes on foreign income. Our taxes increased in 2006 and 2005 due to non-deductible stock compensation charges, and in 2005 and 2004 due to in-process research and development write-offs related to the VUTEk acquisition in 2005 and the ADS acquisition in 2004. As a result of discrete tax adjustments, our taxes in 2006 were reduced by $0.9 million as a result of the expiration of the statute of limitations for state income tax purposes and $0.4 million due to a reassessment of tax contingency reserves related to the filing of foreign income tax returns, and were increased by $34.9 million due to the migration of the non-North American and chipset product lines to our European headquarters and $2.9 million related to sales of the MWA assets. As a result of discrete tax adjustments, our taxes for 2005 were reduced by $6.2 million due to a reassessment of tax contingency reserves related to the filing of US and foreign income tax returns and $1.1 million as a result of the expiration of the statute of limitations for state income tax purposes.

In the second quarter of 2005, pursuant to the American Jobs Creation Act of 2004, we made the decision to repatriate $60.0 million of earnings, which had previously been permanently invested outside the United States, and we recorded a tax charge associated with repatriating these earnings of $3.2 million in the second quarter. Of this $3.2 million tax charge, $2.3 million related to earnings accumulated prior to 2005 and was recorded in the second quarter of 2005. The remaining tax charge of $0.9 million related to 2005 foreign earnings and was reflected in the 2005 effective tax rate beginning in the second quarter. In the fourth quarter, we repatriated $70.0 million of earnings (the $60.0 million decided upon in Q2 plus an additional $10.0 million) to the US, which resulted in an additional tax charge of $0.3 million in the fourth quarter.

 

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During the third quarter of 2004, we reached a settlement with the Internal Revenue Service for the federal income tax returns filed for the years 1999 through 2001. As a result of the settlement, the third quarter’s tax benefit in 2004 was increased by the reassessment of tax contingency reserves resulting in a favorable adjustment of $18.9 million. This favorable adjustment was related to the profitability of foreign operations in 1999 through 2003 and foreign sales corporation and research and development credit benefits.

Critical Accounting Policies

The preparation of the consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. We evaluate our estimates, including those related to bad debts, inventories, intangible assets, income taxes, warranty obligations, purchase commitments, revenue recognition and contingencies. The estimates are based upon historical experience and on various other assumptions that are believed to be reasonable under the circumstances at the time of the estimate, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

The following are believed to be our critical accounting policies and estimates:

 

   

revenue recognition;

 

   

estimating allowance for doubtful accounts, inventory and litigation accruals;

 

   

accounting for stock-based compensation;

 

   

accounting for income taxes;

 

   

valuation analyses for intangible assets and goodwill;

 

   

business combinations; and

 

   

the determination of functional currencies for the purposes of consolidating our international operations.

Revenue recognition. We derive our revenue primarily from product revenue, which includes hardware (controllers, design-licensed solutions, and inkjet printers and ink), software and royalties. We also receive services and support revenue from software license maintenance agreements, customer support and training and consulting. As described below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period. Material differences could result in the amount and timing of our revenue for any period if our management made different judgments or utilized different estimates.

We recognize revenue in accordance with the provisions of SEC Staff Accounting Bulletin 104 “Revenue Recognition” (“SAB104”) and, when applicable, Emerging Issues Task Force 00-21, “Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”), for the sale of controllers, printers, and ink. As such, revenue is generally recognized when persuasive evidence of an arrangement exists, the product has been delivered or services have been rendered, the fee is fixed or determinable and collection of the resulting receivable is reasonably assured.

We use either a purchase order or signed contract as evidence of an arrangement. Sales through some of our OEMs are evidenced by a master agreement governing the relationship together with purchase orders on a transaction-by-transaction basis. Our arrangements do not generally include acceptance clauses. Delivery for hardware generally is complete when title and risk of loss is transferred at point of shipment from manufacturing facilities. In some instances, we also sell products and services in which the terms included in sales arrangements result in different timing for revenue recognition. We assess whether the fee is fixed or determinable based on the terms of the contract or purchase order. We assess collection based on a number of factors, including past transaction history with the customer and the credit-worthiness of the customer. We may not request collateral

 

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from our customers. If we determine that collection of a fee is not reasonably assured, we defer the fee and recognize revenue at the time collection becomes reasonably assured, which is generally upon receipt of cash.

We license our software primarily under perpetual licenses. Revenue from software consists of software licensing, post-contract customer support and professional consulting. We apply the provisions of Statement of Position 97-2, “Software Revenue Recognition” (“SOP 97-2”), as amended by Statement of Position 98-9, “Modification of SOP 97-2, Software Recognition”, with respect to certain transactions, and if applicable, SAB 104 and EITF 00-21 to all transactions involving the sale of software products and hardware transactions where the software is not incidental.

When several elements, including software licenses, post-contract customer support and professional services, are sold to a customer through a single contract, the revenue from such multiple-element arrangements are allocated to each element using the residual method in accordance with SOP 98-9. Revenue is allocated to the support elements and professional service elements of an agreement using vendor specific objective evidence of fair value (“VSOE”) and to the software license portion of the agreements using the residual method. We have established VSOE of the fair value of our professional services based on the rates charged to our customers in stand alone orders. We have also established VSOE of fair value for post-contract customer support based on substantive renewal rates. Accordingly, software license fees are recognized under the residual method for arrangements in which the software is licensed with maintenance and/or professional services, and where the maintenance and professional services are not essential to the functionality of the delivered software. Revenue allocated to software licenses is recognized when the following four basic criteria are met: persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable and collectibility is probable. Revenue allocated to post-contract support is recognized ratably over the term of the support contract, assuming the four basic criteria are met. We also have subscription arrangements where the customer pays a fixed fee and receives services over a period of time. We recognize revenue from the subscriptions ratably over the service period. Any upfront setup fees associated with our subscription arrangements are recognized ratably, generally over one year.

Allowances for doubtful accounts, inventory and litigation accruals. To determine the need for an allowance for doubtful accounts, management must make estimates of the collectibility of our accounts receivables. To do so, management analyzes accounts receivable and historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Our accounts receivable balance was $96.3 million, net of allowance for doubtful accounts and sales returns of $7.9 million as of December 31, 2006.

Similarly, management must make estimates of potential future inventory obsolescence and purchase commitments to measure the need for inventory reserves. Management analyzes current economic trends, changes in customer demand and the acceptance of our products when evaluating the adequacy of such allowances. Significant management judgments and estimates must be made and used in connection with establishing the allowances and reserves in any accounting period. Material differences may result in changes in the amount and timing of our income for any period if management made different judgments or utilized different estimates. Our inventory balance was $35.2 million, net of inventory reserves of $10.8 million, as of December 31, 2006.

We accrue for estimated legal expenses, including potential regulatory fines when the likelihood of the incurrence of the related costs is probable and management has the ability to estimate such costs. Until both of these conditions are met, the related legal expenses are recorded as incurred. The material assumptions we use to estimate the amount of legal expenses include:

 

   

the monthly legal expense incurred by our external attorneys on the particular case being evaluated;

 

   

communication between our external attorneys and us on the expected duration of the lawsuit and the estimated expenses during that time;

 

   

our strategy regarding the lawsuit;

 

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the deductible amounts under the insurance policies; and

 

   

past experiences with similar lawsuits.

The outcome of any particular lawsuit cannot be predicted, and if the outcome is different than expected, our income could be materially impacted, either positively or negatively.

We have from time to time set up allowances or accruals for uncertainties related to revenues and for potential unfavorable outcomes from disputes with customers or vendors. Management bases its estimates for the allowances or accruals on historical experience and on various other assumptions believed to be applicable and reasonable under the circumstances.

Accounting for stock-based compensation. We account for stock-based compensation in accordance with SFAS 123(R), “Share-Based Payment”. We must use our judgment in determining and applying the assumptions needed for the valuation of stock options, issuances under our Employee Stock Purchase Plan, and stock awards. We also are required to apply a forfeiture rate to reflect what we believe will be our final expense related to stock-based compensation. The amounts to be recorded as stock-based compensation expense expected in the future are subject to change if our assumptions for the variables used in determining the fair value of the instruments and the forfeiture rates are revised.

Accounting for income taxes. In preparing our consolidated financial statements we are required to estimate our income taxes in each of the jurisdictions in which we operate. We estimate our actual current tax expense and the temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and book accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income. If we believe that recovery of these deferred assets is not likely, we must establish a valuation allowance. To the extent we either establish or increase a valuation allowance in a period, we must include an expense within the tax provision in the statement of operations.

Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance recorded against our net deferred tax assets. We have maintained a valuation allowance of $5.9 million as of December 31, 2006 for foreign tax credits resulting from the 2003 acquisition of Best and compensation deductions potentially limited by U.S. Internal Revenue Code Section 162(m). If actual results differ from these estimates or we adjust these estimates in future periods, we may need to establish an additional valuation allowance that could materially impact our financial position and results of operations.

Net deferred tax assets as of December 31, 2006 were $9.4 million.

Valuation analyses of intangible assets and goodwill. In 2002 we adopted SFAS 142, “Goodwill and Other Intangible Assets” (SFAS 142). In lieu of amortization, we are required to perform an annual impairment review of our goodwill. We completed our annual review in the third quarter of 2006, based upon June 30, 2006 balances, with no impairment of goodwill indicated as a result of the review. We assess the impairment of identifiable intangibles and long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable or that the life of the asset may need to be revised. Factors we consider important which could trigger an impairment review include the following:

 

   

significant changes in the manner of our use of the acquired assets or the strategy for our overall business;

 

   

significant negative industry or economic trends;

 

   

significant decline in our stock price for a sustained period; and

 

   

our market capitalization relative to net book value.

 

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When we determine that the carrying value of goodwill, intangibles or long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. Net intangible assets and goodwill totaled $333.0 million as of December 31, 2006. No adjustments to the lives of the other intangible assets have been made since the adoption of SFAS 142.

Business combinations. We allocate the purchase price of acquired companies to the tangible and intangible assets acquired, liabilities assumed, as well as in-process research and development based on their estimated fair values. We engage independent third-party appraisal firms to assist in determining the fair values of intangible assets acquired. Such a valuation requires management to make significant estimates and assumptions, especially with respect to intangible assets.

Management makes estimates of fair value based upon assumptions believed to be reasonable. These estimates are based on historical experience and information obtained from the management of the acquired companies. Critical estimates in valuing certain of the intangible assets include but are not limited to: future expected cash flows; acquired developed technologies and patents; expected costs to develop the in-process research and development into commercially viable products and estimating cash flows from the projects when completed; the acquired company’s brand awareness and market position, as well as assumptions about the period of time the acquired brand will continue to be used in the combined company’s product portfolio; and discount rates. These estimates are inherently uncertain and unpredictable. Assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur which may affect the accuracy or validity of such assumptions, estimates or other actual results.

Other estimates associated with the accounting for acquisitions include severance costs and the costs of vacating duplicate facilities. These costs are based upon estimates made by management and are subject to refinement. We estimate the future costs to operate and eventually vacate duplicate facilities. Estimated costs may change as additional information becomes available regarding the assets acquired and liabilities assumed and as management continues its assessment of the pre-merger operations.

Our financial projections may ultimately prove to be inaccurate and unanticipated events and circumstances may occur. Therefore, no assurance can be given that the underlying assumptions used to forecast revenues and costs to develop such projects will transpire as projected.

Determining functional currencies for the purpose of consolidating our international operations. We have a number of foreign subsidiaries which together account for approximately 46% of our net revenues, approximately 22% of our total assets and approximately 64% of our total liabilities as of December 31, 2006. We primarily quote and bill our international customers in United States dollars.

Based on our assessment of the factors discussed below, we consider the United States dollar to be the functional currency for each of our international subsidiaries except for our Japanese subsidiaries, EFI K.K., and Electronics for Imaging Japan YK, for which we consider the Japanese yen to be the subsidiary’s functional currency and our German subsidiary, Electronics for Imaging GmbH, for which we consider the Euro to be the subsidiary’s functional currency.

In preparing our consolidated financial statements, we are required to translate the financial statements of the foreign subsidiaries from the currency in which they keep their accounting records, generally the local currency, into United States dollars. This process results in exchange gains and losses which, when the transactions are not denominated in the functional currency, are included within the statement of operations or, if the transactions are denominated in the functional currency, are included as a separate component of stockholders’ equity under the caption “Accumulated other comprehensive income.”

 

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Under the relevant accounting guidance the treatment of these translation gains or losses is dependent upon our management’s determination of the functional currency of each subsidiary. The functional currency is determined based on management judgment and involves consideration of all relevant economic facts and circumstances affecting the subsidiary. Generally, the currency in which the subsidiary transacts a majority of its transactions, including billings, financing, payroll and other expenditures would be considered the functional currency but any dependency upon the parent company and the nature of the subsidiary’s operations must also be considered. If any subsidiary’s functional currency is deemed to be the local currency, then any gain or loss associated with the translation of that subsidiary’s financial statements is included in stockholders’ equity. However, if the functional currency is deemed to be the United States dollar then any gain or loss associated with the translation of the subsidiary’s financial statements would be included within our consolidated statement of operations. If we dispose of any of our subsidiaries, any cumulative translation gains or losses would be realized in our consolidated statement of operations. If we determine that there has been a change in the functional currency of a subsidiary to the United States dollar, any translation gains or losses arising after the date of change would be included within our consolidated statement of operations.

Recent Accounting Pronouncements

See Note 1 of our Notes to Consolidated Financial Statements for a full description of recent accounting pronouncements including the respective expected dates of adoption.

Liquidity and Capital Resources

 

(in thousands)    2006     2005
As restated(1)
    2004
As restated(1)
 

Cash and cash equivalents

   $ 166,996     $ 182,039     $ 156,322  

Short term investments

     343,175       287,577       503,237  
                        

Total cash, cash equivalents and short term investments

   $ 510,171     $ 469,616     $ 659,559  
                        

Net cash provided by operating activities

   $ 66,871     $ 62,883     $ 59,677  

Net cash (used in) provided by investing activities

     (94,140 )     (71,726 )     12,194  

Net cash provided by (used in) financing activities

     12,381       34,720       (28,766 )

(1)

See Note 2, “Restatement of Consolidated Financial Statements” to Consolidated Financial Statements.

Overview

Cash and cash equivalents and short term investments increased $40.6 million to $510.2 million as of December 31, 2006 from $469.6 million as of December 31, 2005. The increase is primarily due to cash generated by operations of $66.9 million and cash received from employees for purchases of common stock under our ESPP and through exercise of employee stock options totaling $42.3 million offset by the acquisition of treasury shares of $33.9 million and the October 2006 purchase of Jetrion for $41.4 million in cash.

Operating Activities

Net cash provided by operating activities in 2006, 2005 and 2004 of $66.9 million, $62.9 million and $ 59.7 million, respectively, was primarily the result of net income (loss) adjusted for non-cash items such as depreciation and amortization, acquired in-process research and development, deferred income taxes, stock compensation and changes in various assets and liabilities such as accounts payable, accounts receivable and other current assets.

Our historical and primary source of operating cash flow is the collection of accounts receivable from our customers and the timing of payments to our vendors and service providers. One measure of the effectiveness of our collection efforts is average days sales outstanding (“DSO”) for accounts receivable. DSOs were 58 days, 43

 

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days, and 46 days at December 31, 2006, 2005 and 2004 respectively. We calculate accounts receivable DSO by dividing the net accounts receivable balance at the end of the quarter by the amount of revenue recognized for the quarter multiplied by the total days in the quarter. We expect DSOs to vary from period to period because of changes in quarterly mix of business between our direct and OEM customers, and the effectiveness of our collection efforts. Our accounts receivable DSO trended upward in 2006 reflecting the longer invoice terms offered with our Inkjet and APPS products, which represented a higher portion of our sales in those years. DSO may trend upwards in future quarters as a greater portion of our revenues will come from direct sales of printers and software which traditionally carry longer terms.

Our operating cash flows are impacted by the timing of payments to our vendors for accounts payable and by our accrual of liabilities. In 2006, the change in accounts payable and accrued liabilities increased our cash flows by approximately $7.9 million compared to a decrease in cash flows in 2005 of $4.8 million. In 2006, the change in income taxes payable increased our cash flows by $3.9 million compared to a decrease in cash flows in 2005 of $11.2 million.

Our working capital, defined as current assets minus current liabilities, was $261.8 million and $459.1 million at December 31, 2006 and 2005, respectively. The cause of the decrease in working capital of approximately $197.3 million is principally related to our acquisition of Jetrion of $41.4 million and the classification of $240.0 million in convertible debt obligations as short-term liabilities. These reductions in working capital were offset in part by cash provided from operations.

We expect to meet our obligations as they become due through available cash and internally generated funds. We expect to generate positive working capital through our operations. However, we cannot predict whether current trends and conditions will continue, or the effect on our business from the competitive environment in which we operate. We believe the working capital available to us will be sufficient to meet our cash requirements for at least the next 12 months.

Investing Activities

A summary of our investing activities at December 31, 2006, 2005 and 2004 follows. The detail of these line items can be seen in our consolidated statement of cash flows.

Investing Activity

(in thousands)    2006     2005     2004  

Purchases of short-term investments

   $ (323,590 )   $ (525,809 )   $ (225,576 )
Proceeds from sales and maturities of short-term investments      271,624       741,709       264,951  
Net purchases of restricted cash, cash equivalents and short-term investments      —         —         (472 )
Transfers of investments between restricted and available-for-sale      —         —         34,119  
Net purchases of restricted investments      —         —         (45,500 )
Purchases, net of proceeds from sales, of property and equipment      (9,318 )     (5,627 )     (2,297 )
Proceeds from sale of product line      10,000       —         —    
Businesses acquired, net of cash received      (41,427 )     (281,755 )     (11,550 )

Purchases of other investments

     (1,429 )     (244 )     (1,481 )
                        
Net cash (used for) provided by investing activities    $ (94,140 )   $ (71,726 )   $ 12,194  
                        

 

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Acquisitions

Below is a summary of our acquisitions for the last three fiscal years:

Jetrion: On October 31, 2006, we purchased Jetrion LLC for approximately $41.4 million in cash. Jetrion sells its Industrial inkjet printers and inks to label printing companies.

VUTEk: On June 2, 2005, we acquired VUTEk for $281.8 million, net of cash received of $7.4 million. VUTEk’s super-wide digital inkjet printers and Solvent and UV inks allows us to offer print shops a diversified product portfolio and the ability to better integrate our products.

ADS Technology: On February 19, 2004, we purchased ADS for $11.6 million, net of cash received of $0.3 million. We purchased ADS Technology to enhance our software offerings to the copier dealer channels. In the second quarter of 2006, we sold WMA (formerly named ADS Technology) for $10.0 million.

We may buy or invest in complementary companies, products and technologies within the print industry. Our available cash and equity may be used to acquire or invest in companies or products, possibly resulting in significant acquisition-related charges to earnings and dilution to our stockholders.

Property and Equipment

Our net equipment purchases totaled $9.3 million, $5.6 million, and $2.3 million in 2006, 2005, and 2004, respectively. Our property and equipment additions have been funded from operations.

We anticipate that we will continue to purchase property and equipment necessary in the normal course of our business. The amount and timing of these purchases and the related cash outflows in future periods is difficult to predict and is dependent on a number of factors including our hiring of employees, the rate of change in computer hardware/software used in our business, our business outlook, and decisions to invest or expand business sites.

Investments

We made net purchases of marketable securities in 2006 of $52.0 million. In 2005, we received net proceeds from our marketable securities of $215.9 million, reflecting the liquidation of marketable securities for the purchase of VUTEk. In 2004, we received net proceeds of $39.4 million resulting from the liquidation of marketable securities to fund the collateral accounts for our synthetic leases. We have classified our investment portfolio as “available for sale,” and our investments are made with a policy of capital preservation and liquidity as the primary objectives. We generally hold investments in corporate bonds and U. S. government agency securities to maturity; however, we may sell an investment at any time if the quality rating of the investment declines, the yield on the investment is no longer attractive or we are in need of cash. Because we invest only in investment securities that are highly liquid with a ready market, we believe that the purchase, maturity or sale of our investments has no material impact on our overall liquidity.

Restricted Investments

We have restricted investments classified as non-current assets in connection with the synthetic leases for our Foster City offices. We are required to maintain cash in LIBOR-based interest-bearing accounts which fully collateralized our synthetic lease. We now have $88.6 million in collateral accounted for as restricted investments. For further information on these transactions, see the discussion at “Off Balance Sheet Financing.”

Financing Activities

Historically, our recurring cash flows provided by financing activities have been from the receipt of cash from the issuance of common stock from the exercise of stock options and employee stock purchase plans. We

 

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received cash proceeds from these plans in the amount of $42.3 million, $34.7 million and $26.9 million in 2006, 2005 and 2004, respectively. The lower proceeds in 2004 are reflective of our lower stock price during that period. If our stock price rises, more employees’ options are “in the money”, and the employees are more likely to exercise their options, generating cash proceeds to the Company. If our stock price decreases, more of our employees’ options are “out of the money” or “under water”, and therefore, the employees will be unlikely to exercise options, which results in no cash received by us. While we expect to continue to receive these proceeds in future periods, the timing and amount of such proceeds are difficult to predict and is contingent on a number of factors including the price of our common stock, the number of employees participating in the plans and general market conditions. Under FAS 123(R) we are required to expense the fair market value of stock-based compensation. We have decided to change and will continue to assess the term, number and types of equity awards we issue. This may result in less cash received from issuance of equity awards in the future.

The primary use of funds for financing activities in 2006 and 2004 was the use of $33.9 million and $55.6 million, respectively, of cash to repurchase outstanding shares of our common stock. No shares were repurchased during 2005. See Item 5—Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities for further discussion of our programs to repurchase our common stock.

The synthetic lease agreements for our corporate headquarters provide for residual value guarantees. Under FIN 45, the fair value of a residual value guarantee in lease agreements entered into after December 31, 2002, must be recognized as a liability on our consolidated balance sheet. We have determined that the guarantees have no material value as of December 31, 2006 and therefore have not recorded any liability.

Other Commitments

Our inventory consists primarily of inkjet products and finished goods, memory subsystems, processors and ASICs for our controller line of products, which are sold to third-party contract manufacturers responsible for manufacturing our products and inkjet printheads, frames and other components related to our manufacturer of inkjet printers. Should we decide to purchase components and do our own manufacturing of controllers, or should it become necessary for us to purchase and sell components other than the processors, ASICs or memory subsystems for our contract manufacturers, inventory balances and potentially property and equipment would increase significantly, thereby reducing our available cash resources. Further, the inventory we carry could become obsolete, thereby negatively impacting our financial condition and results of operations. We are also reliant on several sole-source suppliers for certain key components and could experience a further significant negative impact on our financial condition and results of operations if such supply were reduced or not available. Should our volumes increase materially on our inkjet printers, our purchases of inkjet printheads, frames and other components will also increase correspondingly.

We may be required to compensate our sub-contract manufacturers for components purchased for orders subsequently cancelled by us. We periodically review the potential liability and the adequacy of the related allowance. Our financial condition and results of operations could be negatively impacted if we were required to compensate the sub-contract manufacturers in amounts in excess of the accrued liability.

Legal Proceedings

In addition to the matters discussed under Item 3, Legal Proceedings, we are involved from time to time in litigation relating to claims arising in the normal course of our business.

 

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Contractual Obligations

The following table summarizes our significant contractual obligations at December 31, 2006 and the effect such obligations are expected to have on our liquidity and cash flows in future periods. This table excludes amounts already recorded on our balance sheet as current liabilities at December 31, 2006 except for $240.0 million in senior convertible debentures which is reported as current.

 

     Payments due by period
(in thousands)    Total    Less than
1 year
   1-3 years    3-5 years    More than
5 years

Operating lease obligations(1)

   $ 52,586    $ 10,836    $ 16,861    $ 11,625    $ 13,264
Interest payments on 1.50% senior convertible debentures(2)      66,300      3,600      7,200      7,200      48,300

Senior convertible debentures

     240,000      240,000      —        —        —  
                                  

Total(3)

   $ 358,886    $ 254,436    $ 24,061    $ 18,825    $ 61,564
                                  

(1) Lease obligations related to the principal corporate facilities are estimated and are based on current market interest rates (LIBOR). See Off-Balance Sheet Financing.
(2) See Note 7 of the Notes to the Consolidated Financial Statements for additional information regarding our 1.50% Senior Convertible Debentures.
(3) Total does not include contractual obligations recorded on the balance sheet as current liabilities, or certain purchase obligations as discussed below.

Purchase orders or contracts for the purchase of raw materials and other goods and services are not included in the table above. We are not able to determine the aggregate amount of such purchase orders that represent contractual obligations, as purchase orders may represent authorizations to purchase rather than binding agreements. For the purposes of this table, contractual obligations for purchase of goods or services are defined as agreements that are enforceable and legally binding on EFI and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Our purchase orders are based on our current manufacturing needs and are fulfilled by our vendors within short time horizons. We do not have significant agreements for the purchase of raw materials or other goods specifying minimum quantities or set prices that exceed our expected requirements for three months. We also enter into contracts for outsourced services; however the obligations under these contracts were not significant and the contracts generally contain clauses allowing for cancellation without significant penalty.

The expected timing of payment of the obligations discussed above is estimated based on current information. Timing of payments and actual amounts paid may be different depending on the time of receipt of goods or services or changes to agreed-upon amounts for some obligations.

Off-Balance Sheet Financing

All amounts in this section are presented (in thousands, except for per share amounts).

Synthetic Lease Arrangements

We are a party to two synthetic leases (the “301 Lease” and the “303 Lease”, together “Leases”) covering our Foster City facilities located at 301 and 303 Velocity Way, Foster City, California. These leases provide a cost effective means of providing adequate office space for our corporate offices. Both Leases expire in July 2014. We may, at our option, purchase the facilities during or at the end of the term of the leases for the amount expended by the lessor to purchase the facilities ($56.9 million for the 303 Lease and $31.7 million for the 301 Lease). We have guaranteed to the lessor a residual value associated with the buildings equal to 82% of their funding of the respective Leases. Under the financial covenants, we must maintain a minimum net worth and a minimum tangible net worth as of the end of each quarter. There is an additional covenant regarding mergers. We

 

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were in compliance with all such financial and merger related covenants as of December 31, 2006. We are liable to the lessor for the financed amount of the buildings if we default on our covenants. We obtained limited and conditional waivers from the lessor regarding any event of default that should occur solely as a result of an event of default on other indebtedness caused by our failure to comply with covenants relating to the filing and delivery of our periodic reports.

We have assessed our exposure in relation to the first loss guarantees under the Leases and believe that there is no deficiency to the guaranteed value at December 31, 2006. If there is a decline in value, we will record a loss associated with the residual value guarantee. The funds pledged under the Leases ($56.9 million for the 303 Lease and $31.7 million for the 301 Lease at December 31, 2006 for a total of $88.6 million) are in LIBOR-based interest bearing accounts and are restricted as to withdrawal at all times.

In conjunction with the Leases, we leased the land on which the buildings are located to the lessor of the buildings. These separate ground leases are for approximately 30 years.

We are treated as the owner of these buildings for federal income tax purposes.

Effective July 1, 2003, we applied the accounting and disclosure rules set forth in Interpretation No. 46 Consolidation of Variable Interest Entities, as revised (“FIN 46R”) for variable interest entities (“VIEs”). We have evaluated our synthetic lease agreements to determine if the arrangements qualify as variable interest entities under FIN 46R. We have determined that the synthetic lease agreements do qualify as VIEs; however, because we are not the primary beneficiary under FIN 46R we are not required to consolidate the VIEs in our financial statements.

Item 7A: Quantitative and Qualitative Disclosures about Market Risk

All amounts in this section are presented in thousands, except for per share amounts.

Market Risk

We are exposed to various market risks, including changes in foreign currency exchange rates. Market risk is the potential loss arising from adverse changes in market rates and prices, such as foreign currency exchange and interest rates. We do not enter into derivatives or other financial instruments for trading or speculative purposes. We may enter into financial instrument contracts to manage and reduce the impact of changes in foreign currency exchange rates. The counterparties to such contracts are major financial institutions.

Interest Rate Risk

Marketable Securities

We maintain an investment portfolio of short-term investments of various holdings, types and maturities. These short-term investments are generally classified as available-for-sale and consequently, are recorded on the balance sheet at fair value with unrealized gains and losses reported as a separate component of accumulated other comprehensive income (loss). At any time, a sharp rise in interest rates could have a material adverse impact on the fair value of our investment portfolio. Conversely, declines in interest rates could have a material impact on interest earnings for our portfolio. We do not currently hedge these interest rate exposures.

The following table presents the hypothetical change in fair values in the financial instruments held by us at December 31, 2006 that are sensitive to changes in interest rates. The modeling technique used measures the change in fair values arising from selected potential changes in interest rates. Market changes reflect immediate hypothetical parallel shifts in the yield curve of plus or minus 100 basis points (BPS) over a twelve-month time horizon.

 

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This table estimates the fair value of the portfolio at a twelve-month time horizon (in thousands):

 

Valuation of
securities given an
interest rate
decrease of 100
basis points
  No change in
interest rates
  Valuation of
securities given an
interest rate
increase of 100
basis points
$ 358,861   $ 353,608   $ 350,456

Convertible Debentures

The fair value of our convertible debt was estimated to be $264.6 million as of December 31, 2006 and the carrying value was $240.0 million. The fair market value of our convertible senior debentures was estimated based upon quoted market prices.

Derivatives

We do not use any derivatives for trading or speculative purposes.

Financial Risk Management

The following discussion about our risk management activities includes “forward-looking statements” that involve risks and uncertainties. Actual results could differ materially from those projected in the forward-looking statements.

As a global concern, we face exposure to adverse movements in foreign currency exchange rates. These exposures may change over time as business practices evolve and could have a material adverse impact on our financial results. Our primary exposures are related to non-U.S. dollar-denominated sales in Japan and Europe and operating expenses in Germany, India, Japan and the Netherlands. At the present time, we do not hedge against these currency exposures, but as these exposures grow we may consider hedging against currency movements.

We maintain investment portfolio holdings of various issuers, types and maturities, typically U.S. Treasury and Agencies securities, corporate debt instruments, and asset-backed instruments. These short-term investments are classified as available-for-sale and consequently are recorded on the balance sheet at fair value with unrealized gains and losses reported as a separate component of accumulated other comprehensive income (loss). These securities are not leveraged and are held for purposes other than trading.

 

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Item 8: Financial Statements and Supplementary Data

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

     Page
Report of Independent Registered Public Accounting Firm    62
Consolidated Balance Sheets as of December 31, 2006 and 2005 (As restated)    64
Consolidated Statements of Operations for the Years Ended December 31, 2006, 2005 (As restated) and 2004 (As restated)    65
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2006, 2005 (As restated) and 2004 (As restated)    66
Consolidated Statements of Cash Flows for the Years Ended December 31, 2006, 2005 (As restated) and 2004 (As restated)    67
Notes to Consolidated Financial Statements    68
Unaudited Quarterly Consolidated Financial Information    112

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of Electronics For Imaging, Inc.:

We have completed integrated audits of Electronics For Imaging, Inc.’s consolidated financial statements and of its internal control over financial reporting as of December 31, 2006 in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

Consolidated financial statements and financial statement schedule

In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Electronics For Imaging, Inc. and its subsidiaries at December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

As discussed in Note 2 to the consolidated financial statements, the Company has restated its 2005 and 2004 consolidated financial statements.

As discussed in Note 1 to the consolidated financial statements, the Company changed the manner in which it accounts for stock-based compensation in 2006.

Internal control over financial reporting

Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2006 based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

 

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A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

/s/    PricewaterhouseCoopers LLP

San Jose, California

October 19, 2007

 

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Electronics For Imaging, Inc.

Consolidated Balance Sheets

 

     December 31,  
(in thousands)    2006    

2005

As restated(1)

 

Assets

    

Current assets:

    

Cash and cash equivalents

   $ 166,996     $ 182,039  

Short-term investments, available for sale

     343,175       287,577  

Accounts receivable, net of allowance for doubtful accounts of $7.9 million and $4.3 million respectively

     96,252       67,926  

Inventories

     35,225       26,770  

Other current assets

     13,199       32,464  
                

Total current assets

     654,847       596,776  

Property and equipment, net

     52,646       49,600  

Restricted investments

     88,580       88,580  

Goodwill

     212,992       189,667  

Intangible assets, net

     120,030       153,722  

Other assets

     15,556       10,093  
                

Total assets

   $ 1,144,651     $ 1,088,438  
                

Liabilities and Stockholders’ Equity

    

Current liabilities:

    

Accounts payable

   $ 41,834     $ 30,937  

Convertible debt

     240,000       —    

Accrued and other liabilities

     62,954       64,415  

Deferred revenue

     26,461       25,004  

Income taxes payable

     21,824       17,343  
                

Total current liabilities

     393,073       137,699  

Convertible debt

     —         240,000  
                

Total liabilities

     393,073       377,699  
                

Commitments and contingencies (Note 10)

    

Stockholders’ equity:

    

Preferred stock, $0.01 par value; 5,000 shares authorized; none issued and outstanding

     —         —    

Common stock, $0.01 par value; 150,000 shares authorized; 57,614 and 56,249 shares outstanding, respectively

     691       662  

Additional paid-in capital

     577,997       511,951  

Deferred Compensation

     —         (5,550 )

Treasury stock, at cost, 11,490 and 9,964 shares, respectively

     (248,631 )     (214,722 )

Accumulated other comprehensive income (loss)

     1,237       (2,069 )

Retained earnings

     420,284       420,467  
                

Total stockholders’ equity

     751,578       710,739  
                

Total liabilities and stockholders’ equity

   $ 1,144,651     $ 1,088,438  
                

(1)

See Note 2, “Restatement of Consolidated Financial Statements”.

See accompanying notes to consolidated financial statements.

 

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Electronics For Imaging, Inc.

Consolidated Statements of Operations

 

     For the years ended December 31,  
(in thousands, except per share amounts)    2006     2005
As restated(2)
    2004
As restated(2)
 

Revenue

   $ 564,611     $ 467,117     $ 394,604  

Cost of revenue(1)

     229,441       178,665       138,491  
                        

Gross Profit

     335,170       288,452       256,113  
                        

Operating expenses:

      

Research and development(1)

     127,900       110,086       112,254  

Sales and marketing(1)

     99,838       82,039       75,050  

General and administrative(1)

     47,857       35,856       28,613  

Restructuring charges

     —         2,685       —    

Real estate related charges

     —         —         14,394  

Amortization of identified intangibles

     35,514       26,434       13,690  

Acquired in-process research and development

     8,500       45,300       1,000  
                        

Total operating expenses

     319,609       302,400       245,001  
                        

Income (loss) from operations

     15,561       (13,948 )     11,112  

Interest and other income, net:

      

Interest and other income (expense), net

     24,002       14,489       12,837  

Gain on sale of product line, net

     6,995       —         2,994  

Interest expense

     (5,027 )     (5,010 )     (5,632 )
                        

Total interest and other income, net

     25,970       9,479       10,199  
                        

Income (loss) before income taxes

     41,531       (4,469 )     21,311  

(Provision for) benefit from income taxes

     (41,714 )     (711 )     14,254  
                        

Net income (loss)

   $ (183 )   $ (5,180 )   $ 35,565  
                        

Net income (loss) per basic common share

   $ (0.00 )   $ (0.10 )   $ 0.66  
                        

Shares used in basic per-share calculation

     56,559       54,425       53,898  
                        

Net income (loss) per diluted common share

   $ (0.00 )   $ (0.10 )   $ 0.60  
                        

Shares used in diluted per-share calculation

     56,559       54,425       63,979  
                        

(1)      Includes stock-based compensation expense as follows:

      
     2006    

2005

As restated(2)

   

2004

As restated(2)

 

Cost of revenue

   $ 1,725     $ 106     $ 109  

Research and development

     8,346       561       1,120  

Sales and marketing

     3,248       185       339  

General and administrative

     10,427       2,076       1,797  

 

(2)

See Note 2, “Restatement of Consolidated Financial Statements”.

See accompanying notes to consolidated financial statements.

 

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Electronics For Imaging, Inc.

Consolidated Statements of Stockholders’ Equity

 

    Common stock   Additional
paid-in capital
    Deferred
compensation
    Treasury stock    

Other

comprehensive
income (Loss)

    Retained
earnings
   

Total

stockholders’
equity

 
(in thousands)   Shares     Amount       Shares     Amount        

Balances as of December 31, 2003 (As previously reported)

  62,044     $ 620   $ 328,358     $ (1,597 )     (7,648 )   $ (159,077 )   $ 1,012     $ 485,497       654,813  

Cumulative effect of restatement on prior years

  —         —       106,616       (3,411 )     —         —         —         (95,415 )     7,790  
                                                                   

Balances as of December 31, 2003 (As restated)(1)

  62,044       620     434,974       (5,008 )     (7,648 )     (159,077 )     1,012       390,082       662,603  
                                                                   

Net income (As restated)(1)

                  35,565    

Other comprehensive income (loss), net of tax:

                 

Currency translation adjustment

                392      

Market valuation on short-term investments

                (2,616 )    
                             

Comprehensive income (As restated)(1)

                (2,224 )     35,565       33,341  

Repurchase of common stock

            (2,316 )     (55,645 )         (55,645 )

Exercise of common stock options

  1,385       14     21,951                 21,965  

Cancellation of options and restricted stock awards (As restated)(1)

  (5 )     —       (429 )     303               (126 )

Stock-based compensation (As restated)(1)

        409       2,956               3,365  

Stock issued pursuant to ESPP

  368       4     5,036                 5,040  

Tax benefit related to stock plans (As restated)(1)

        3,483                 3,483  
                                                                   

Balances as of December 31, 2004 (As restated)(1)

  63,792       638     465,424       (1,749 )     (9,964 )     (214,722 )     (1,212 )     425,647       674,026  
                                                                   

Net loss (As restated)(1)

                  (5,180 )  

Other comprehensive income (loss), net of tax:

                 

Currency translation adjustment

                (1,000 )    

Market valuation on short-term investments(1)

                143      
                             

Comprehensive loss (As restated)(1)

                (857 )     (5,180 )     (6,037 )

Exercise of common stock options

  1,698       17     29,434                 29,451  

Cancellation of options and restricted stock awards (As restated)(1)

        (268 )     268               —    

Restricted stock grants (As restated)(1)

  357       4     6,553       (6,557 )             —    

Stock-based compensation (As restated)(1)

        443       2,488               2,931  

Stock issued pursuant to ESPP

  366       3     5,266                 5,269  

Tax benefit related to stock plans (As restated)(1)

  —         —       5,099                 5,099  
                                                                   

Balances as of December 31, 2005 (As restated)(1)

  66,213       662     511,951       (5,550 )     (9,964 )     (214,722 )     (2,069 )     420,467       710,739  
                                                                   

Net income

                  (183 )  

Other comprehensive income (loss), net of tax:

                 

Currency translation adjustment

                1,199      

Market valuation on short-term investments

                2,107      
                             

Comprehensive loss

                3,306       (183 )     3,123  

Exercise of common stock options

  2,006       20     36,111                 36,131  

Elimination of deferred stock-based compensation in connection with the adoption of SFAS 123(R)

        (5,550 )     5,550               —    

Restricted stock grants

  470       5     (5 )               —    

Stock-based compensation

        23,746                 23,746  

Stock repurchase

            (1,526 )     (33,909 )         (33,909 )

Stock issued pursuant to ESPP

  415       4     6,122                 6,126  

Tax benefit related to stock plans

  —         —       5,622       —         —         —         —         —         5,622  
                                                                   

Balances as of December 31, 2006

  69,104     $ 691   $ 577,997     $ —       $ (11,490 )   $ (248,631 )   $ 1,237     $ 420,284     $ 751,578  
                                                                   

(1)

See Note 2, “Restatement of Consolidated Financial Statements”.

See accompanying notes to consolidated financial statements.

 

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Electronics For Imaging, Inc.

Consolidated Statements of Cash Flows

 

     For the years ended December 31,  

(in thousands)

   2006    

2005

As restated(1)

   

2004

As restated(1)

 

Cash flows from operating activities:

      

Net income (loss)

   $ (183 )   $ (5,180 )   $ 35,565  

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

      

Depreciation and amortization

     45,085       35,610       23,524  

Acquired in-process research & development

     8,500       45,300       1,000  

Deferred taxes

     22,666       1,622       (12,151 )

Provision for allowance for bad debts and sales-related allowances

     5,997       6,890       1,288  

Tax benefits from employee stock plans

     5,622       5,099       3,483  

Excess tax benefit from stock-based compensation

     (4,033 )     —         —    

Gain on sale of product line

     (6,995 )     —         50  

Provision for inventory obsolescence

     1,563       1,954       308  

Stock-based compensation

     23,746       2,928       3,365  

Changes in operating assets and liabilities, net of effect of acquired companies:

      

Accounts receivable

     (32,093 )     (11,853 )     12,197  

Inventories

     (8,460 )     (4,506 )     2,167  

Receivables from sub-contract manufacturers

     450       (72 )     (439 )

Other current assets

     (6,800 )     1,120       524  

Accounts payable and accrued liabilities

     7,928       (4,846 )     (1,421 )

Income taxes payable

     3,878       (11,183 )     (9,783 )
                        

Net cash provided by operating activities

     66,871       62,883       59,67