PMC - Sierra 10-K 2011
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended: December 26, 2010
For the transition period from: to
Commission File Number 0-19084
(Exact name of registrant as specified in its charter)
1380 Bordeaux Drive
Sunnyvale, CA 94089
(Address of principal executive offices) (Zip Code)
Registrants telephone number, including area code: (408) 239-8000
Securities registered pursuant to Section 12(b) of the Act:
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 x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrants 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. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer or a smaller reporting company. See definitions of large accelerated filer, accelerated filer, and smaller reporting company in Rule 12b-2 of the Exchange Act.
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes ¨ No x
The aggregate market value of the voting stock held by nonaffiliates of the registrant, based upon the closing sale price of the Common Stock on June 27, 2010 as reported by the NASDAQ Global Select Market, was approximately $1.1 billion. Shares of Common Stock held by each executive officer and director and by each person known to the registrant who owns 5% or more of the outstanding voting stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.
As of February 22, 2011, the registrant had 233,221,019 shares of Common Stock, $0.001 par value, outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for Registrants 2011 Annual Meeting of Stockholders are incorporated by reference into Part III of this Form 10-K Report. Such Proxy Statement will be filed with the Securities and Exchange Commission within 120 days of the registrants fiscal year ended December 26, 2010.
TABLE OF CONTENTS
Unless the context requires otherwise, PMC-Sierra, PMC, the Company, us, our or we, mean PMC-Sierra, Inc. together with our subsidiary companies.
This Annual Report on Form 10-K (this Annual Report) and the portions of our Proxy Statement incorporated by reference into this Annual Report contain forward-looking statements. We often use words such as anticipates, believes, plans, expects, future, intends, may, should, estimates, predicts, potential, continue, becoming, transitioning and similar expressions to identify such forward-looking statements.
These forward-looking statements apply only as of the date of this Annual Report. We undertake no obligation to publicly update or revise any forward-looking statements made herein or elsewhere, whether as a result of new information, future events or otherwise. Our actual results could differ materially and adversely from those anticipated in forward-looking statements, including without limitation the risks described under Item IA. Risk Factors and elsewhere in this Annual Report and our other filings with the SEC. Investors are cautioned not to place undue reliance on these forward-looking statements, which reflect managements analysis only as of the date hereof. Such forward-looking statements include statements as to, among other topics:
This Annual Report should be read in conjunction with our periodic filings made with the SEC subsequent to the date of the original filing, including any amendments to those filings, as well as any current reports filed on Form 8-K subsequent to the date of the original filing.
PMC-Sierra, Inc. (PMC or the Company) is an internet infrastructure semiconductor solutions provider. The Company designs, develops, markets and supports semiconductor solutions by integrating its mixed-signal, software and systems expertise through a network of offices in North America, Europe and Asia.
We have approximately 730 different semiconductor devices that are sold to leading equipment and design manufacturers, who in turn supply their equipment principally to service providers, carriers and enterprises globally. We provide semiconductor solutions for our customers by leveraging our intellectual property, design expertise and systems knowledge across a broad range of applications and industry protocols. PMCs portfolio of semiconductor devices are used in various applications of communications network infrastructure equipment and enable the transporting and storing of large quantities of digital data, in a secure manner.
PMC was incorporated in the state of California in 1983 and reincorporated in the state of Delaware in 1997. Our Common Stock trades on the NASDAQ Global Select Market under the symbol PMCS. Our fiscal year normally ends on the last Sunday of the calendar year. Fiscal years 2010, 2009 and 2008 consisted of 52 weeks.
The rapid growth in the digital consumer devices market continues to drive increasing demand for bandwidth and efficient networks that can manage high levels of data and video traffic. At the same time, communication service providers are seeking ways to increase their revenues by bundling and delivering a range of services to their customers in a cost-effective manner. Applications such as Video-on-Demand, Internet Protocol Television (IPTV), videoconferencing, and data-intensive mobile smartphones and tablets are causing traffic levels to increase significantly. For example, a recent study issued by Cisco Systems Inc. forecast that worldwide mobile data traffic will increase 26-fold over the next five years, reaching an annual run rate of 75 exabytes by 2015. This demand is resulting in carriers and enterprises having to upgrade and improve their network infrastructure and storage management capabilities. Enterprises, governments, corporations, small offices and home offices are expanding their networks to better capture, store and access large quantities of data and video, efficiently and securely.
MARKETS THAT WE SERVE
Our portfolio of semiconductor devices are used in various applications of communications network infrastructure equipment and enable the transporting and storing of large quantities of digital data, in a secure manner. Our semiconductor devices enable equipment primarily in five market segments: Enterprise Storage; Fiber Access; Wireless Access; Metro Transport and Aggregation; and Printer and Enterprise Networking. For information relating to our segment information, see Item 8. Financial Statements and Supplementary Data, Notes to the Consolidated Financial Statements Note 17. Segment Information.
Our products and solutions for the Enterprise Storage market segment enable high-speed communications between the servers, switches and storage devices that comprise these systems thus allowing large quantities of data to be stored, managed and moved securely. As storage demand continues to grow, managing the data becomes more critical for the operation of the entire company or service provider. Our focus in this area is in developing communication devices and controllers for high-performance storage systems in the Storage Area Network (SAN) and Network Attached Storage (NAS) markets, including 6 Gbps SAS/SATA and 8Gbps Fibre Channel (FC) controllers and expanders for this market segment. We also offer server adaptor products with high-performance Solid State Drive (SSD) caching capability that are used to configure, manage and monitor storage volumes.
We address demands for increasing bandwidth with our Fiber Access products. Passive Optical Networking (PON) is being deployed by carriers worldwide to facilitate higher speed service to residences and enterprises. Instead of copper cables, fiber is deployed to the neighborhood, the multi-dwelling unit or the residence, to deliver advanced services such as voice, video and data at faster speeds. The advantage of PON is that it provides high bandwidth without sensitivity to the distance between the central office and the subscriber.
Our product offerings in the Wireless Access market segment include devices that are used in 2G, 3G and 4G wireless base stations and mobile backhaul. We have semiconductor solutions that capture and transmit data over T/E lines, and have recently expanded our offerings into IP/Ethernet solutions through the acquisition of Wintegra, Inc. (Wintegra) in 2010. Wintegras product offerings fit strategically with our overall efforts to accelerate the transition of existing communications equipment from Time-Division Multiplexing (TDM) to converged, packet-centric solutions. Our highly integrated network processors are optimized for mobile backhaul, microwave backhaul, and cell site aggregation networks.
Our Metro Transport and Aggregation (Metro) products are used in equipment such as edge routers, multi-service provisioning platforms, and optical transport platforms where signals are gathered, processed and transmitted to the next destination as quickly and efficiently as possible in the metro area network. Next-generation networking equipment can handle multi-protocol, multi-service traffic and enable voice, video and data to be moved at high speeds over the network. For high-capacity data communication over fibre optic systems, the standard used is Synchronous Optical Networks (SONET) in North America and parts of Asia, and is Synchronous Digital Hierarchy (SDH) in the rest of the world. In addition to using SONET/SDH to increase the bandwidth or capacity of their networks, many service providers are starting to implement packet-based transport equipment using a standard called Optical Transport Network (OTN). OTN equipment is starting to be deployed in the metro and access portions of the network.
Our Printer and Enterprise Networking products provide integrated solutions for laser printers, switches, and routers that are used by enterprises and small businesses to manage their data on an inter-office and intra-office basis. We sell our standalone microprocessors and integrated system-on-chip devices primarily into the mid- to high-end and multi-function segments of that market. In addition, we have some device applications for enterprise networking equipment primarily for small and medium sized businesses.
Most of our semiconductors can be divided into broadly defined functional categories as identified below. As with descriptions of the network, particular categories may overlap and a device may be present in more than one category. In addition, some products may integrate several different functions and therefore could be classified in one or more categories. For example, some of our products convert high-speed analog signals (wired or wirelessly) to digital signals and split or combine various transmission signals.
Controllers: rapid growth in data storage is driving a need for more cost-effective and larger capacity storage systems. Controller products based on Fibre Channel, SAS and SATA enable the development of external and server-attached storage systems that meet the cost and capacity requirements of our customers.
Framers and mappers: before data can be sent to the next destination, it must be converted into a proper format for transmission in the network. For example, the framing function arranges the bits into different size formats, commonly referred to as cell or packet formats, and attaches the appropriate information to the formats to ensure they reach their destinations. In turn, this data may be inserted into other frames, such as SONET/SDH frames, for transmission across high-speed fibre optic networks.
Line interface units: these devices, also referred to as transceivers, transmit and receive signals over a physical medium such as wire, cable or fibre. The line interface unit determines the speed and timing characteristics of the signals, and may also convert them from a serial stream of data into a parallel stream before they are further processed for transmission to the next destination.
Microprocessor-based System-On-Chips (SOCs): these devices perform the high-speed computations that help identify and control the flow of signals and data in many different types of networking equipment used in the communications, storage and enterprise markets. With greater demand for integration of features and functions on a single device, more highly-integrated system-on-chip solutions are being developed.
Packet and cell processors: these devices examine the contents of cells, or packets, and perform various management and reporting functions. For instance, a switch or router may use a packet or cell processor to determine if a signal is voice or video in order to allocate the proper amount of bandwidth for transmission.
Radio Frequency (RF) transceivers: the rapid growth of mobile and nomadic data services is accelerating the need for higher bandwidth RF transceivers (a.k.a. radios). These radios transmit and receive broadband signals over the air using Orthogonal Frequency-Division Multiple Access (OFDMA) based protocols and Multiple-Input-Multiple-Output (MIMO) antenna technology.
Serializers/Deserializers: these devices convert and multiplex traffic between slower speed parallel streams and higher speed serial streams. Original Equipment Manufacturers (OEMs) use serial streams to reduce networking equipment line connections and parallel streams to allow them to apply lower cost traffic management technologies.
OUR BUSINESS FOCUS
The semiconductor solutions we develop are based on our knowledge of network applications, system requirements and networking protocols, and high-speed mixed-signal and system-on-chip design expertise. Our mission is to be the premier Internet infrastructure semiconductor solutions provider in the industry. To achieve this, while expanding our business profitably, we are focusing our efforts in the following five areas:
We work very closely with our customers to intimately understand their application and product needs. Beyond striving to deliver best-in-class products, we aim to ensure they get the best service and technical support required to assist them with their product development efforts. We have a strong history of mixed-signal and microprocessor expertise that allows PMC to integrate many of these functions and protocols into complex devices that are combined with our firmware and software for full solutions. We leverage our common technologies and intellectual property across a broad range of communications and storage equipment. Our OEM customers include Alcatel-Lucent, Cisco Systems Inc., EMC Corp., Fujitsu Ltd. (Fujitsu), Hewlett-Packard Company (H-P), Hitachi, Ltd. (Hitachi), Huawei Technologies Co., Ltd. (Huawei), LSI Logic Corp., Mitsubishi Electric Corp. (Mitsubishi Electric) and ZTE Corp (ZTE).
We continue to broaden our product line for the external and server-attached storage markets, as new standards and the level of integration continues to evolve. With growth in cloud computing services, we see increasing demand in the storage and data center market segments. Our focus remains on high-performance interconnect devices and controllers based on SAS/SATA and Fibre Channel protocol standards. We also offer controller and adaptor solutions for server-attached storage systems for OEM and Channel customers. We believe the need for faster and more complex devices will increase as next-generation storage systems are developed by our customers and deployed by enterprises worldwide.
PMC has a strong track record in developing semiconductor solutions for the access, aggregation and metro transport portion of the market. With more data and video moving on to the global network, we continue to
develop new technologies that enable higher speed, lower latency, and more efficient systems for global service providers. As next-generation Optical Transport Platforms are deployed in the Aggregation and Metro areas of the network, PMC is delivering solutions that enable this class of equipment. Carriers globally will be transitioning their networks over time to more packet-centric transport and routing platforms designed with products that meet the Optical Transport Network (OTN) protocol standard.
With the proliferation of mobile internet devicessuch as smartphones and tabletsthere are increasing requirements for carriers to capture and backhaul this traffic more efficiently. Existing mobile networks were built primarily for voice technology and therefore carriers are upgrading their wireless base stations, mobile backhaul networks, and aggregation systems to handle the increasing traffic and demand for bandwidth. We are bringing to market new devices for our OEM customers in the areas of Radio Frequency (RF) and Remote Radio Head (RRH) solutions for wireless networks as well as packet-based solutions for mobile backhaul, cell site aggregation, and access equipment.
We are working very closely with carriers and OEMs around the world to help them design and develop solutions that enable broadband access speeds of 1Gbps and 2.5Gbpsto manage the growing number of services such as videostreaming, videoconferencing, IPTV, and online gaming. We believe PON technology will continue to be deployed by carriers around the world as they move to higher-speed broadband access solutions. We are investing to maintain our leadership position in the PON market and to help accelerate the expansion of this technology globally. We are also investing in PON solutions that enable speeds of 10Gbps both upstream and downstream along the fiber optical lines to improve the efficiency of access technology.
SALES, MARKETING AND DISTRIBUTION
Our sales and marketing strategy is to have our products designed into our customers equipment by developing superior products for which we provide best-in-class service and technical support. Our marketing team is focused on developing new products and solutions that meet the needs of our customers, including OEMs and original design manufacturers. We are often involved in the early stages of design concerning our customers plans for new equipment. This helps us determine if our existing products can be used in their new equipment or if new devices need to be developed for the application. To assist us in our planning process, we are in regular contact with our key customers to discuss industry trends, emerging standards and ways in which we can assist in their new product requirements.
Our sales team is focused on selling and supporting our chips and chipsets for equipment providers who are in turn selling their products to service providers, enterprises, or consumers. To better match our available sales resources to market opportunities, we also focus our sales and support efforts on targeted customers.
We sell our products to end customers directly and through distributors and independent manufacturers representatives. In 2010, less than 30% of our orders were shipped through distributors, approximately 53% were sent by us directly to contract manufacturers selected by OEMs, and the balance were sent directly to our OEM customers.
In 2010, our largest distributor was Avnet Inc. (Avnet), which represented our products worldwide (excluding Japan, Israel, and Taiwan). In 2010, total sales shipped through Avnet worldwide were 14% of our total net revenues. Our second largest distributor is Macnica Inc. Sales shipped through this distributor in 2010 were approximately 2% of our total net revenues.
In 2010, we had one end customer, Hewlett-Packard Company, which accounted for more than 10% of our revenues.
Our sales outside of the United States, based on customer billing location, accounted for 85%, 87% and 80% of total revenue in 2010, 2009 and 2008, respectively. Our sales to customers in Asia, including Japan and China, were 77%, 84% and 73% of total revenues in 2010, 2009, and 2008, respectively.
See Item 1A. Risk Factors for further information on risks attendant to our foreign operations and dependence.
PMC-Sierra is a fabless company, meaning that we do not own or operate foundries for the production of the silicon wafers from which our products are made. Instead, we work with independent merchant foundries and chip assemblers for the manufacture of our products. We believe our fabless approach to manufacturing provides us with the benefit of superior manufacturing capability, scalability, as well as the flexibility to move wafer manufacture, assembly and test of our products to the vendors that offer the best technology and service at a competitive price.
Our lead-time, or the time required to manufacture our devices, is typically 12 to 18 weeks. Based on this lead-time, our team of production planners initiates purchase orders with our wafer suppliers and with our chip assemblers for the assembly and test of our parts so that, to the best of our ability, our products are available to meet customer demand.
We manufacture our products at independent foundries using standard Complementary Metal Oxide Semiconductor (CMOS) process techniques. We have in the past purchased silicon wafers from which we manufacture our products from Globalfoundries Inc. (previously, Chartered Semiconductor Manufacturing Ltd.), Taiwan Semiconductor Manufacturing Corporation (TSMC) and United Microelectronics Corporation (UMC). These independent foundries produce the wafers for our networking semiconductor products ranging in sizes from 0.18 micron to 40 nanometer. By using independent foundries to fabricate our wafers, we are better able to concentrate our resources on designing, developing and testing of new products. In addition, we avoid the fixed costs associated with owning and operating fabrication and chip assembly facilities and the costs associated with updating these facilities to manage constantly evolving process technologies.
We have existing, or are in the process of renewing, our supply agreements with UMC and TSMC. Generally, terms we seek, include but are not limited to, supply terms without minimum unit volume requirements for PMC, indemnification and warranty provisions, quality assurances and termination conditions.
Assembly and Test
Once our wafers are fabricated, they must be probed or inspected, to identify which individual units, referred to as die, were properly manufactured. Most wafers that we purchase are sent directly to an outside assembly house where the die are individually cut and packaged into semiconductor devices. The individual devices are then run through various electrical, mechanical and visual tests before customer delivery. PMC outsources all of its wafer probe and final testing to independent subcontractors.
The industries that we serve require high quality, reliable semiconductors for incorporation into their equipment. We pre-qualify each vendor, foundry, assembly and test subcontractor. Wafers supplied by outside foundries must meet our incoming quality and test standards. The testing function is performed predominantly by independent Asian and U.S. companies.
Since 2006, there has been an increase in the proportion of products being produced for PMC by turnkey application-specific integrated circuit (ASIC) vendors due to PMCs acquisitions of the Storage Semiconductor Business and Passave. Although PMC does not physically manage the bulk of this production, these products follow approved and audited flows conforming to PMCs Quality Assurance requirements.
Since the acquisition of the Channel Storage business from Adaptec, PMC has significant business in manufacturing and selling Printed Circuit Board (PCB) based products. These products are assembled and tested by an independent contract manufacturer before shipping to a distribution center. The design, materials, production test and packaging are specified by PMC and the manufacturing subcontractors are regularly audited and qualified by PMC.
RESEARCH AND DEVELOPMENT
Our research and development efforts are market- and customer-focused and can involve the development of both hardware and software. These devices and reference designs are targeted for use in enterprise, storage and service provider markets. Increasingly, our OEM customers that serve these end markets are demanding complete solutions with software support and complex feature sets and we are developing products to fill this need.
From time to time we announce new products to the public once development of the product is substantially completed and there are no longer significant technical risks and costs to be incurred. As we have a portfolio of approximately 730 products, we do not consider any individual new product or group of products released in a year to be material, beyond our continuing development of a portfolio of products that meet our customers future needs.
At the end of fiscal 2010, we had design centers in the United States (California, Pennsylvania, Texas, Oregon and Minnesota), Canada (British Columbia, Saskatchewan and Quebec), Israel (Herzliya and Raanana), China (Shanghai), Germany (Ismaning and Neckarsulm) and India (Bangalore).
Our research and development spending was $187.5 million in 2010, $149.2 million in 2009, and $157.6 million in 2008.
Our sales originate from customer purchase orders. However, our customers frequently revise order quantities and shipment schedules to reflect changes in their requirements. As of December 26, 2010, our backlog of products scheduled for shipment within three months totaled approximately $116.7 million. In 2009, such backlog totaled approximately $126.9 million. Unless our customers cancel or defer to a subsequent year with respect to a portion of this backlog, we expect this entire backlog to be filled in 2011.
Our backlog includes our backlog of shipments to direct customers, minor distributors and a portion of shipments by our major distributor to end customers. Our customers may cancel or defer backlog orders. Accordingly, we believe that our backlog at any given time is not a meaningful indicator of future long-term revenues. Backlog is a non-GAAP measure and may not be comparable between companies.
We typically face competition at the customer design stage when our customers are determining which semiconductor components to use in their equipment designs.
Most of our customers choose a particular semiconductor component primarily based on whether the component:
OEMs are becoming more price conscious as semiconductors sourced from third party suppliers start to comprise a larger portion of the total materials cost in OEM equipment. This price sensitivity from our customers can lead to aggressive price competition by competing suppliers that may force us to decrease our prices to win a design and therefore decrease our gross profit.
OEMs also consider the quality of the supplier when determining which component to include in a design. Many of our customers will consider the breadth and depth of the suppliers technology, as using one supplier for a broad range of technologies can often simplify and accelerate the design of next generation equipment. OEMs will also consider a suppliers design execution reputation, as many OEMs design their next generation equipment concurrently with the semiconductor component design. OEMs also consider whether a supplier has been pre-qualified, as this ensures that components made by that supplier will meet the OEMs quality standards.
We compete against established peer-group semiconductor companies that focus on the communications and storage semiconductor business. These companies include the following: Altera Corp., Applied Micro Circuits Corp.; Broadcom Corp.; Cortina Systems, Inc.; Emulex Corp.; Exar Corp.; Infineon Technologies AG; Intel Corp.; LSI Corp.; Maxim Integrated Products, Inc.; Marvell Technology Group Ltd.; Mindspeed Technologies, Inc.; QLogic Corp.; Vitesse Semiconductor; and Xilinx, Inc.. Many of these companies are well financed, have significant communications semiconductor technology assets and established sales channels, and depend on the market in which we participate for the bulk of their revenues.
Over the next few years, it is possible for additional competitors to enter the market with new products, some of which may also have greater financial and other resources than we do.
We are also continuing to expand into certain market segments, such as the Enterprise Storage market segment that have established incumbents with substantial financial and other resources. Some of these incumbents derive a majority of their earnings from these markets. We expect continued strong competition in these markets.
LICENSES, PATENTS AND TRADEMARKS
We rely in part on patents to protect our intellectual property and have a total of 530 U.S. and 87 foreign patents for circuit designs and other innovations used in the design and architecture of our products. In addition, we have 95 patent applications pending in the U.S. Patent and Trademark office. Our patents typically expire 20 years from the patent application date, with our existing patents expiring between 2011 and 2030.
We do not consider our business to be materially dependent upon any one patent. We believe that a strong portfolio of patents combined with other factors such as our ability to innovate, technological expertise and the experience of our personnel are important to compete effectively in our industry. Our patent portfolio also provides the flexibility to negotiate or cross license intellectual property with other semiconductor companies to broaden the features in our products.
We also rely on mask work protection, trademarks, copyrights, trade secret laws, employee and third-party nondisclosure agreements, and licensing arrangements to protect our intellectual property.
PMC, PMC-Sierra and our logo are registered trademarks and service marks. We own other trademarks and service marks not appearing in this Annual Report. Any other trademarks used in this Annual Report are owned by other entities.
As of December 26, 2010, we had 1,449 employees, including 880 in Research and Development, 105 in Production and Quality Assurance, 306 in Sales and Marketing and 158 in Administration. During 2010, we completed two acquisitions that increased our number of employees by 260 employees. Our employees are not represented by a collective bargaining agreement and we have never experienced any related work stoppage.
ADDITIONAL INFORMATION AND SEC REPORTS
Our principal executive offices are located at 1380 Bordeaux Drive, Sunnyvale, CA 94089. Our internet webpage is located at www.pmc-sierra.com; however, the information accessed on or through our webpage is not part of this report. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to such reports are available, free of charge, on our webpage after we electronically file or furnish such material with the Securities and Exchange Commission (SEC). The public may read and copy any materials we file with the SEC at the SECs Public Reference Room at 100F Street, NE., Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site at http://www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC.
Our company is subject to a number of risks some are normal to the fabless semiconductor industry, some are the same or similar to those disclosed in previous SEC filings, and some may be present in the future. You should carefully consider all of these risks and the other information in this report before investing in PMC. The fact that certain risks are endemic to the industry does not lessen the significance of the risk.
As a result of the following risks, our business, financial condition, operating results and/or liquidity could be materially adversely affected. This could cause the trading price of our securities to decline, and you may lose part or all of your investment.
Our global growth is subject to a number of economic risks.
In the recent past, financial markets in the United States, Europe and Asia experienced extreme disruption, including among other things, extreme volatility in security prices, severely diminished liquidity and credit availability, rating downgrades of certain investments and declining valuations of other securities. Governments took unprecedented actions intended to address extreme market conditions that include severely restricted credit and declines in real estate values.
Currently, these conditions have not impaired our liquidity for operational purposes. There can be no assurance that there will not be a further deterioration in financial markets and confidence in major economies, which may impair our liquidity in the future. The tightening of credit in financial markets adversely affects the ability of customers and suppliers to obtain financing for significant purchases and operations and could result in a decrease in or cancellation of orders for our products. Our global business is also adversely affected by decreases in the general level of economic activity, such as decreases in business and consumer spending, and in the financial strength of our customers and suppliers. We are unable to predict the likely duration and severity of the disruptions in financial markets and adverse economic conditions in the U.S. and other countries.
Finally, our ability to access the capital markets may be severely restricted at a time when we would like, or need, to access such capital markets, which could have an impact on our flexibility to pursue additional expansion opportunities and maintain our desired level of revenue growth in the future.
We are subject to rapid changes in demand for our products due to:
As a result of this uncertainty in the demand for our products, our past operating results may not be indicative of our future operating results.
Fluctuations in demand is dependent on, among other things the size of the markets for our products, the rate at which such markets develop, and the level of capital spending by end customers. We cannot assure you of the rate, or extent to which, capital spending by end customers will grow, if at all. Furthermore, industry growth rates may not be as forecast, which may result in our spending on product development being either insufficient for or in excess of actual market requirements.
Our revenues and profits may fluctuate because of factors that are beyond our control. As a result, we may fail to meet the expectations of security analysts and investors, which could cause our stock price to decline.
Our ability to project revenues is limited because a significant portion of our quarterly revenues may be derived from orders placed and shipped in the same quarter, which we call our turns business. Our turns business varies widely from quarter to quarter. Our customers may delay product orders and reduce delivery lead-time expectations, which may reduce our ability to project revenues beyond the current quarter. While we regularly evaluate end users and contract manufacturers inventory levels of our products to assess the impact of their inventories on our projected turns business, we do not have complete information on their inventories. This could cause our projections of a quarters turns business to be inaccurate, leading to lower revenues than projected.
We may fail to meet our forecasts if our customers cancel or delay the purchase of our products or if we are unable to meet their demand.
We rely on customer forecasts in order to estimate the appropriate levels of inventory to build and to project our future revenues. Many of our customers have numerous product lines, numerous component requirements for each product, sizeable and complex supplier structures, and typically engage contract manufacturers for additional manufacturing capacity. This complex supply chain creates several variables that make it complicated to accurately forecast our customers demand and accurately monitor their inventory levels of our products. If customer forecasts are not accurate, we may build too much inventory, potentially leaving us with excess and obsolete inventory, which would reduce our profit margins and adversely affect our operating results. Conversely, we may build too little inventory to meet customer demand causing us to miss revenue-generating opportunities. The cancellation or deferral of product orders, the return of previously sold products or overproduction due to the failure of anticipated orders to materialize, could result in our holding excess or obsolete inventory, which could in turn result in write-downs of inventory. This difficulty may be compounded when we sell to OEMs indirectly through distributors and other resellers or contract manufacturers, or both, as our forecasts of demand are then based on estimates provided by multiple parties.
Our customers often shift buying patterns as they manage inventory levels, market different products, or change production schedules. This makes forecasting their production requirements difficult and can lead to an inventory surplus or shortage of certain components. In addition, our products vary in terms of the profit margins they generate. If our customers purchase a greater proportion of our lower margin parts in a particular period, it would adversely impact our results of operations.
Further, our distributors provide us with periodic reports of their backlog to end customers, sales to end customers and quantities of our products that they have on hand. If the data that is provided to us is inaccurate, it could lead to inaccurate forecasting of our revenues or errors in our reported revenues, gross profit and net income.
While backlog is our best estimate of our next quarters expectations of revenues, it is industry practice to allow customers to cancel, change or defer orders with limited advance notice prior to shipment. As such, backlog may be an unreliable indicator of future revenue levels. Because a significant portion of our operating expenses is fixed, even a small revenue shortfall can have a disproportionately negative effect on our operating results.
We rely on a few customers for a major portion of our sales, any one of which could materially impact our revenues should they change their ordering pattern. The loss of a key customer could materially impact our results of operations.
We depend on a limited number of customers for large portions of our net revenues. In 2010 and 2009, we had one end customer that accounted for more than 10% of our revenues, namely Hewlett-Packard Company. In 2010, our top ten customers accounted for more than 60% of our net revenues.
In 2009, our top ten customers accounted for more than 70% of our revenues. We do not have long-term volume purchase commitments from any of our major customers. We sell our products solely on the basis of purchase orders. Those customers could decide to cease purchasing products with little or no notice and without significant penalties. A number of factors could cause our customers to cancel or defer orders, including interruptions to their operations due to a downturn in their industries, delays in manufacturing their own product offerings into which our products are incorporated, and natural disasters. Accordingly, our future operating results will continue to depend on the success of our largest customers and on our ability to sell existing and new products to these customers in significant quantities.
The loss of a key customer, or a reduction in our sales to any major customer or our inability to attract new significant customers could materially and adversely affect our business, financial condition or results of operations.
If the demand for our customers products declines, demand for our products will be similarly affected and our revenues, gross margins and operating performance will be adversely affected.
Our customers are subject to their own business cycles, most of which are unpredictable in commencement, depth and duration. We cannot accurately predict the continued demand of our customers products and the demands of our customers for our products. In the past, networking customers have reduced capital spending without notice, adversely affecting our revenues. As a result of this uncertainty, our past operating results may not be indicative of our future operating results. It is possible that, in future periods, our results may be below the expectations of public market analysts and investors. This could cause the market price of our common stock to decline.
Changes in the political and economic climate in the countries in which we do business may adversely affect our operating results.
We earn a substantial proportion of our revenues in Asia. We conduct an increasing portion of our research and development and manufacturing activities outside North America. We procure substantially all of our wafers from Taiwan and use assemblers and testers throughout Asia.
Given the depth of our sales and operations in Asia, we face risks that could negatively impact our results of operations, including economic sanctions imposed by the U.S. government, imposition of tariffs and other
potential trade barriers or regulations, uncertain protection for intellectual property rights and generally longer receivable collection periods. In addition, fluctuations in foreign currency exchange rates could adversely affect the revenues, net income, earnings per share and cash flow of our operations in affected markets. Similarly, fluctuations in exchange rates may affect demand for our products in foreign markets or our cost competitiveness and may adversely affect our profitability.
Our results of operations are increasingly dependent on our sales in China, which on a bill-to basis, accounted for over 34% of our net revenues in 2010 compared to 40% of our revenues in 2009. Government agencies in China have broad discretion and authority over all aspects of the telecommunications and information technology industry in China; accordingly their decisions may impact our ability to do business in China. Therefore, significant changes in Chinas political and economic conditions and governmental policies could have a substantial negative impact on our business. While the growth of Fiber-To-The-Home technology in China has continued to be strong, a slowdown in that growth would have an adverse impact on our operating results.
In addition to selling our products in a number of countries, an increasing portion of our research and development and manufacturing is conducted outside North America, in particular, in India and China. The geographic diversity of our business operations could hinder our ability to coordinate design, manufacturing and sales activities. If we are unable to develop systems and communication processes to support our geographic diversity, we may suffer product development delays or strained customer relationships.
The loss of key personnel could delay us from designing new products.
To succeed, we must retain and hire technical personnel highly skilled at design and test functions needed to develop high-speed networking products. The competition for such employees is intense.
We do not have employment agreements in place with many of our key personnel. As employee incentives, we issue common stock options and restricted stock grants that are subject to time vesting, and, in the case of options, have exercise prices at the market value on the grant date. As our stock price varies substantially, the equity awards to employees are effective as retention incentives only if they have economic value.
Our revenues may decline if we do not maintain a competitive portfolio of products or if we fail to secure design wins.
We are experiencing significantly greater competition in the markets in which we participate. We are expanding into market segments, such as the Wireless, and Fiber and Radio Access market segments, which have established incumbents with substantial financial and technological resources. We expect more intense competition than that which we have traditionally faced as some of these incumbents derive a majority of their earnings from these markets.
We typically face competition at the design stage, where customers evaluate alternative design approaches requiring integrated circuits. We often compete in bid selection processes to achieve design wins. These selection processes can be lengthy and can require us to invest significant effort and incur significant design and development expenditures. We may not win competitive selection processes and even if we do win such processes, we may not generate the expected level of revenue despite incurring significant design and development expenditures. Because the life cycles of our customers products can last several years and changing suppliers involves significant cost, time, effort and risk, our failure to win a competitive bid can result in our foregoing revenue from a given customers product line for the life of that product.
The markets for our products are intensely competitive and subject to rapid technological advancement in design tools, wafer manufacturing techniques, process tools and alternate networking technologies. We may not be able to develop new products at competitive pricing and performance levels. Even if we are able to do so, we
may not complete a new product and introduce it to market in a timely manner. Our customers may substitute use of our products in their next generation equipment with those of current or future competitors, reducing our future revenues. With the shortening product life and design-in cycles in many of our customers products, our competitors may have more opportunities to supplant our products in next generation systems.
Our customers are increasingly price conscious, as semiconductors sourced from third party suppliers comprise a greater portion of the total materials cost in networking equipment. We continue to experience aggressive price competition from competitors that wish to enter into the market segments in which we participate. These circumstances may make some of our products less competitive, and we may be forced to decrease our prices significantly to win a design. We may lose design opportunities or may experience overall declines in gross margins as a result of increased price competition.
Over the next few years, we expect additional competitors, some of which may also have greater financial and other resources, to enter these markets with new products. These companies, individually or collectively, could represent future competition for many design wins and subsequent product sales.
Design wins do not translate into near-term revenues and the timing of revenues from newly designed products is often uncertain.
From time to time, we announce new products and design wins for existing and new products. While some industry analysts may use design wins as a metric for future revenues, many design wins have not, and will not, generate any revenues for us, as customer projects are cancelled or unsuccessful in their end market. In the event a design win generates revenues, the amount of revenues will vary greatly from one design win to another. In addition, most revenue-generating design wins do not translate into near-term revenues. Most revenue-generating design wins take more than two years to generate meaningful revenues.
Since many of the products we develop do not reach full production sales volumes for a number of years, we may incorrectly anticipate market demand and develop products that achieve little or no market acceptance.
Our products generally take between 12 and 24 months from initial conceptualization to development of a viable prototype, and another three to 18 months to be designed into our customers equipment and sold in production quantities. We sell products whose characteristics include evolving industry standards, short product life spans and new manufacturing and design technologies. Our products often must be redesigned because manufacturing yields on prototypes are unacceptable or customers redefine their products to meet changing industry standards or customer specifications. As a result, we develop products many years before volume production and may inaccurately anticipate our customers needs. Redesigning our products is expensive and may delay production of our products. Our products may become obsolete during these delays, resulting in our inability to recoup our initial investments in product development.
We may be unsuccessful in transitioning the design of our new products to new manufacturing processes.
Many of our new products are designed to take advantage of new manufacturing processes offering smaller device geometries as they become available, since smaller geometries can provide a product with improved features such as lower power requirements, increased performance, more functionality and lower cost. We believe that the transition of our products to, and introduction of new products using, smaller device geometries is critical for us to remain competitive. We could experience difficulties in migrating to future smaller device geometries or manufacturing processes, which would result in the delay of the production of our products. Our products may become obsolete during these delays, or allow competitors parts to be chosen by customers during the design process.
The final determination of our income tax liability may be materially different from our income tax provision.
We are subject to income taxes in both the United States and international jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions where the ultimate tax determination is uncertain. Additionally, our calculations of income taxes are based on our interpretations of applicable tax laws in the jurisdictions in which we file. Although we believe our tax estimates are reasonable, there is no assurance that the final determination of our income tax liability will not be materially different than what is reflected in our income tax provisions and accruals. Should additional taxes be assessed as a result of new legislation, an audit or litigation, if our effective tax rate should change as a result of changes in federal, international or state and local tax laws, or if we were to change the locations where we operate, there could be a material effect on our income tax provision and results of operations in the period or periods in which that determination is made, and potentially to future periods as well. During the second quarter of 2008, one of our foreign subsidiaries settled several ongoing tax matters for less than had been accrued as part of its liability for unrecognized tax benefits, resulting in the recognition of tax benefits of $124.1 million. As a result of this settlement, we agreed to pay $18.0 million in cash and utilize $31.6 million in investment tax credits.
The ultimate resolution of outstanding tax matters could be for amounts in excess of our reserves established. Such events could have a material adverse effect on our liquidity or cash flows in the quarter in which an adjustment is recorded or the tax payment is due.
If foreign exchange rates fluctuate significantly, our profitability may decline.
We are exposed to foreign currency rate fluctuations because a significant part of our development, test, and selling and administrative costs are incurred in foreign currencies. The U.S. dollar has fluctuated significantly compared to other foreign currencies and this trend may continue. To protect against reductions in value and the volatility of future cash flows caused by changes in foreign exchange rates, we enter into foreign currency forward contracts. The contracts reduce, but do not eliminate, the impact of foreign currency exchange rate movements. In addition, this foreign currency risk management policy may not be effective in addressing long-term fluctuations since our contracts do not extend beyond a 12-month maturity.
We regularly limit our exposure to foreign exchange rate fluctuations from our foreign net asset or liability positions. We recorded a net $1.8 million foreign exchange loss on the revaluation of our income tax liability, net of deferred tax assets, in 2010 because of the fluctuations in the U.S. dollar against certain foreign currencies. A five percent shift in the foreign exchange rates between the U.S. and Canadian dollar would cause an approximately $3.0 million impact to our pre-tax net income.
We are exposed to the credit risk of some of our customers.
Many of our customers employ contract manufacturers to produce their products and manage their inventories. Many of these contract manufacturers represent greater credit risk than our OEM customers, who do not guarantee our credit receivables related to their contract manufacturers.
In addition, a significant portion of our sales flow through our distribution channel, this generally represents a higher credit risk. Should these companies encounter financial difficulties, our revenues could decrease, and collection of our significant accounts receivables with these companies or other customers could be jeopardized.
Our business strategy contemplates acquisition of other products, technologies or businesses, which could adversely affect our operating performance.
Acquiring products, intellectual property, technologies and businesses from third parties is a core part of our business strategy. That strategy depends on the availability of suitable acquisition candidates at reasonable prices
and our ability to resolve challenges associated with integrating acquired businesses into our existing business. These challenges include integration of product lines, sales forces, customer lists and manufacturing facilities, development of expertise outside our existing business, diversion of management time and resources, possible divestitures, inventory write-offs and other charges. We also may be forced to replace key personnel who may leave our company as a result of an acquisition. We cannot be certain that we will find suitable acquisition candidates or that we will be able to meet these challenges successfully. Acquisitions could also result in customer dissatisfaction, performance problems with the acquired company, investment, or technology, the assumption of contingent liabilities, or other unanticipated events or circumstances, any of which could harm our business. Consequently, we might not be successful in integrating any acquired businesses, products or technologies and may not achieve anticipated revenues and cost benefits.
An acquisition could absorb substantial cash resources, require us to incur or assume debt obligations, or issue additional equity. If we are not able to obtain financing, then we may not be in a position to consummate acquisitions. If we issue equity securities in connection with an acquisition, we may dilute our common stock with securities that have an equal or a senior interest in our company.
From time to time, we license, or acquire, technology from third parties to incorporate into our products. Incorporating technology into our products may be more costly or more difficult than expected, or require additional management attention to achieve the desired functionality. The complexity of our products could result in unforeseen or undetected defects or bugs, which could adversely affect the market acceptance of new products and damage our reputation with current or prospective customers.
Our current product roadmap will, in part, be dependent on successful acquisition and integration of intellectual property cores developed by third parties. If we experience difficulties in obtaining or integrating intellectual property from these third parties, it could delay or prevent the development of our products in the future.
Although our customers, our suppliers and we rigorously test our products, our highly complex products may contain defects or bugs. We have in the past experienced, and may in the future experience, defects and bugs in our products. If any of our products contain defects or bugs, or have reliability, quality or compatibility problems that are significant to our customers, our reputation may be damaged and customers may be reluctant to buy our products. This could materially and adversely affect our ability to retain existing customers or attract new customers. In addition, these defects or bugs could interrupt or delay sales to our customers.
We may have to invest significant capital and other resources to alleviate problems with our products. If any of these problems are not found until after we have commenced commercial production of a new product, we may be required to incur additional development costs and product recall, repair or replacement costs. These problems may also result in claims against us by our customers or others. In addition, these problems may divert our technical and other resources from other development efforts. Moreover, we would likely lose or experience a delay in, market acceptance of the affected product or products, and we could lose credibility with our current and prospective customers.
Industry consolidation may lead to increased competition and may harm our operating results.
There has been a trend toward industry consolidation in our markets for several years. We expect this trend to continue as companies attempt to improve the leverage of growing research and development costs, strengthen or hold their market positions in an evolving industry and as companies are acquired or are unable to continue operations. Companies that are strategic alliance partners in some areas of our business may acquire or form alliances with our competitors, thereby reducing their business with us. We believe that industry consolidation may result in stronger competitors that are better able to compete as sole-source vendors for customers. This could lead to more variability in our operating results and could have a material adverse effect on our business, operating results and financial condition.
Our business may be adversely affected if our customers or suppliers cannot obtain sufficient supplies of other components needed in their product offerings to meet their production projections and target quantities.
Some of our products are used by customers in conjunction with a number of other components, such as transceivers, microcontrollers and digital signal processors. If, for any reason, our customers experience a shortage of any component, their ability to produce the forecasted quantity of their product offerings may be affected adversely and our product sales would decline until the shortage is remedied. Such a situation could harm our operating results, cash flow and financial condition.
We rely on limited sources of wafer fabrication, the loss of which could delay and limit our product shipments.
We do not own or operate a wafer fabrication facility. In 2010, three outside wafer foundries supplied more than 95% of our semiconductor wafer requirements. Our wafer foundry suppliers also make products for other companies and some make products for themselves, thus we may not have access to adequate capacity or certain process technologies. We have less control over delivery schedules, manufacturing yields and costs than competitors with their own fabrication facilities. If the wafer foundries we use are unable or unwilling to manufacture our products in required volumes, or at specified times, we may have to identify and qualify acceptable additional or alternative foundries. This qualification process could take six months or longer. We may not find sufficient capacity quickly enough, if ever, at an acceptable cost, to satisfy our production requirements.
Some companies that supply our customers are similarly dependent on a limited number of suppliers to produce their products. These other companies products may be designed into the same networking equipment into which our products are designed. Our order levels could be reduced materially if these companies are unable to access sufficient production capacity to produce in volumes demanded by our customers because our customers may be forced to slow down or halt production on the equipment into which our products are designed.
We depend on third parties for the assembly and testing of our semiconductor products which could delay and limit our product shipments.
We depend on third parties in Asia for the assembly and testing of our semiconductor products. In addition, subcontractors in Asia assemble all of our semiconductor products into a variety of packages. Raw material shortages, political and social instability, assembly and testing house service disruptions, currency fluctuations, or other circumstances in the region could force us to seek additional or alternative sources of supply, assembly or testing. This could lead to supply constraints or product delivery delays that, in turn, may result in the loss of revenues. At times, capacity in the assembly industry has become scarce and lead times have lengthened. This may become more severe, which could in turn adversely affect our revenues. We have less control over delivery schedules, assembly processes, testing processes, quality assurances, raw material supplies and costs than competitors that do not outsource these tasks.
Due to the amount of time that it usually takes us to qualify assemblers and testers, we could experience significant delays in product shipments if we are required to find alternative assemblers or testers for our components. Any problems that we may encounter with the delivery, quality or cost of our products could damage our customer relationships and materially and adversely affect our results of operations. We are continuing to develop relationships with additional third-party subcontractors to assemble and test our products. However, even if we use these new subcontractors, we will continue to be subject to all of the risks described above.
Our business is vulnerable to interruption by earthquake, fire, power loss, telecommunications failure, terrorist activity and other events beyond our control.
We do not have sufficient business interruption insurance to compensate us for actual losses from interruption of our business that may occur, and any losses or damages incurred by us could have a material adverse effect on our business. We are vulnerable to a major earthquake and other calamities. We have operations in seismically active regions in British Columbia, Canada and California, and we rely on third-party wafer fabrication and testing facilities in seismically active regions in Asia. We have not undertaken a systematic analysis of the potential consequences to our business and financial results from a major earthquake in either region. We are unable to predict the effects of any such event, but the effects could be seriously harmful to our business.
Hostilities in the Middle East and India may have a significant impact on our Israeli and Indian subsidiaries ability to conduct their business.
We have operations, mainly research and development facilities, located in Israel and India which employ approximately 278 and 97 people, respectively. A catastrophic event, such as a terrorist attack, that results in the destruction or disruption of any of our critical business or information technology systems in Israel or India could harm our ability to conduct normal business operations and our operating results.
On an on-going basis, some of our Israeli employees are periodically called into active military duty. In the event of severe hostilities breaking out, a significant number of our Israeli employees may be called into active military duty, resulting in delays in various aspects of production, including product development schedules.
From time to time, we become defendants in legal proceedings about which we are unable to assess our exposure and which could become significant liabilities upon judgment.
We become defendants in legal proceedings from time to time. Companies in our industry have been subject to claims related to patent infringement and product liability, as well as contract and personal claims. We may not be able to accurately assess the risk related to these suits and we may be unable to accurately assess our level of exposure. These proceedings may result in material charges to our operating results in the future if our exposure is material and if our ability to assess our exposure becomes clearer.
If we cannot protect our proprietary technology, we may not be able to prevent competitors from copying or misappropriating our technology and selling similar products, which would harm our business.
To compete effectively, we must protect our intellectual property. We rely on a combination of patents, trademarks, copyrights, trade secret laws, confidentiality procedures and licensing arrangements to protect our intellectual property rights. We hold numerous patents and have a number of pending patent applications. However, our portfolio of patents includes some that expired in 2010 and are expiring in subsequent years, which could have a negative effect on our ability to prevent competitors from duplicating certain of our products.
We might not succeed in obtaining patents from any of our pending applications. Even if we are awarded patents, they may not provide any meaningful protection or commercial advantage to us, as they may not be of sufficient scope or strength, or may not be issued in all countries where our products can be sold. In addition, our competitors may be able to design around our patents.
To protect our product technology, documentation and other proprietary information, we enter into confidentiality agreements with our employees, customers, consultants and strategic partners. We require our employees to acknowledge their obligation to maintain confidentiality with respect to PMCs products. Despite these efforts, we cannot guarantee that these parties will maintain the confidentiality of our proprietary information in the course of future employment or working with other business partners. We develop,
manufacture and sell our products in Asia and other countries that may not protect our products or intellectual property rights to the same extent as the laws of the United States. This makes piracy of our technology and products more likely. Steps we take to protect our proprietary information may not be adequate to prevent theft of our technology. We may not be able to prevent our competitors from independently developing technologies that are similar to or better than ours.
Our products employ technology that may infringe on the intellectual property and the proprietary rights of third parties, which may expose us to litigation and prevent us from selling our products.
Vigorous protection and pursuit of intellectual property rights or positions characterize the semiconductor industry. This often results in expensive and lengthy litigation. We, and our customers or suppliers, may be accused of infringing patents or other intellectual property rights owned by third parties in the future. An adverse result in any litigation could force us to pay substantial damages, stop manufacturing, using and selling the infringing products, spend significant resources to develop non-infringing technology, discontinue using certain processes or obtain licenses to the infringing technology. In addition, we may not be able to develop non-infringing technology or find appropriate licenses on reasonable terms or at all.
Patent disputes in the semiconductor industry are often settled through cross-licensing arrangements. Our portfolio of patents may not have the breadth to enable us to settle an alleged patent infringement claim through a cross-licensing arrangement. We may therefore be more exposed to third party claims than some of our larger competitors and customers.
The majority of our customers are required to obtain licenses from and pay royalties to third parties for the sale of systems incorporating our semiconductor devices. Customers may also make claims against us with respect to infringement.
Furthermore, we may initiate claims or litigation against third parties for infringing our proprietary rights or to establish the validity of our proprietary rights. This could consume significant resources and divert the efforts of our technical and management personnel, regardless of the litigations outcome.
We have significant debt in the form of senior convertible notes.
At December 26, 2010, we have $61.6 million carrying value ($68.3 million of face value) of our 2.25% senior convertible notes outstanding. Our debt could materially and adversely affect our ability to obtain financing for working capital, acquisitions or other purposes, and could make us vulnerable to industry downturns and competitive pressures. Our ability to meet our debt service obligations will be dependent upon our future performance, which will be subject to financial, business and other factors affecting our operations, many of which are beyond our control. On October 15, 2025, we are obliged to repay the full remaining principal amount of the notes that have not been converted into our common stock, but we are also subject to certain triggering events that may cause the notes to be repaid earlier.
Securities we issue to fund our operations could dilute your ownership.
We may decide to raise additional funds through public or private debt or equity financing. If we raise funds by issuing equity securities, the percentage ownership of current stockholders will be reduced and the new equity securities may have priority rights to your investment. We may not obtain sufficient financing on terms that are favorable to you or us. We may delay, limit or eliminate some or all of our proposed operations if adequate funds are not available.
Our stock price has been and may continue to be volatile.
We expect that the price of our common stock will continue to fluctuate significantly, as it has in the past. In particular, fluctuations in our stock price and our price-to-earnings multiple may have made our stock attractive
to momentum, hedge or day-trading investors who often shift funds into and out of stocks rapidly, exacerbating price fluctuations in either direction particularly when viewed on a quarterly basis.
Securities class action litigation has often been instituted against a company following periods of volatility and decline in the market price of their securities. If instituted against us, regardless of the outcome, such litigation could result in substantial costs and diversion of our managements attention and resources and have a material adverse effect on our business, financial condition and operating results. In addition, we could incur substantial punitive and other damages relating to such litigation.
Provisions in Delaware law, our charter documents and our stockholder rights plan may delay or prevent another entity from acquiring us without the consent of our Board of Directors.
We adopted a stockholder rights plan in 2001, pursuant to which we declared a dividend of one share purchase right for each outstanding share of common stock. If certain events occur, including if an investor tenders for or acquires more than 15% of our outstanding common stock, stockholders (other than the acquirer) may exercise their rights and receive $650 worth of our common stock in exchange for $325 per right, or we may, at our option, issue one share of common stock in exchange for each right, or we may redeem the rights for $0.001 per right. The issuance of the rights could have the effect of delaying or preventing a change in control of us. This stockholder rights plan will expire, pursuant to its terms, on May 25, 2011.
In addition, our Board of Directors has the right to issue preferred stock without stockholder approval, which could be used to dilute the stock ownership of a potential hostile acquirer. Delaware law imposes some restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding common stock.
Although we believe these provisions of our charter documents, Delaware law and our stockholder rights plan will provide for an opportunity to receive a higher bid by requiring potential acquirers to negotiate with our Board of Directors, these provisions apply even if the offer may be considered beneficial by some stockholders.
During 2010, we leased properties in 32 locations worldwide totaling approximately 578,000 square feet. Approximately 23% of the space we leased was excess at December 26, 2010. Approximately 81% of the excess space has been subleased and we continued to actively pursue opportunities to sublease or negotiate our exit from the remaining excess facilities.
We lease approximately 108,000 square feet in Santa Clara, California, to house our U.S. design, engineering, sales and marketing operations.
Our Canadian operations are primarily located in Burnaby, British Columbia where we lease approximately 149,000 square feet of office space in two separate buildings. This location supports a significant portion of our product development, manufacturing, marketing, sales and testing activities.
In addition to the two major sites in Santa Clara and Burnaby, during 2010 we also operated thirteen additional research and development centers: two in Canada, five in the U.S., one in Bangalore, India, two in Israel, two in Germany, and one in Shanghai, China.
We have 18 sales/operations offices located in Europe, Asia, and North America.
Subsequent to the year ended December 26, 2010, PMC moved its corporate headquarters from Santa Clara, California to Sunnyvale, California, where it has leased approximately 62,000 square feet of office premise to replace the Santa Clara office space.
Stock Price Information
Our Common Stock trades on the NASDAQ Global Select Market under the symbol PMCS. The following table sets forth, for the periods indicated, the high and low closing sale prices for our Common Stock as reported by the NASDAQ Global Select Market:
To maintain consistency, the information provided above is based on the last day of the calendar quarter rather than the last day of the fiscal quarter.
As of February 22, 2011, there were 921 holders of record of our Common Stock.
We have never paid cash dividends on our Common Stock. We currently intend to retain earnings, if any, for use in our business or to fund acquisitions and do not anticipate paying any cash dividends in the foreseeable future.
Stock Performance Graph
The following graph shows a comparison of cumulative total stockholder returns for PMC, the line-of-business index for semiconductors and related devices (SIC code 3674) furnished by Research Data Group, Inc., and the S&P 500 Index. In addition, we have included the Russell 3000 Index, a broad equity market index in which we are included. We have determined that the companies included in the Russell 3000 Index more closely match our company characteristics than the companies included in the S&P 500 Index, as the Russell 3000 Index includes companies in the semiconductor industry and related industries with similar size and median market capitalization. The graph assumes the investment of $100 on December 31, 2005. The performance shown is not necessarily indicative of future performance.
SOURCE: RESEARCH DATA GROUP, INC.
The following tables set forth data from our consolidated financial statements for each of the last five fiscal years.
There were no cash dividends issued during the years ended December 26, 2010, December 27, 2009, December 28, 2008, December 30, 2007, and December 31, 2006.
The following discussion of the financial condition and results of our operations should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this Annual Report.
We generate revenues from the sale of semiconductor solutions that we have designed and developed or acquired. Almost all of our revenues in any given year come from the sale of semiconductors that are developed prior to that year. For example, 100% of our revenues in 2010 came from products developed or acquired in 2009 and earlier. After an individual product is released for production and announced it may take several years before that product generates any significant revenues.
Our current revenues are generated by a portfolio of approximately 730 products which we have designed and developed, or acquired. PMCs diverse product portfolio enables many different types of communications network infrastructure equipment. Our Enterprise Storage products enable high-speed communication servers, switches and storage devices to store, manage and move large quantities of data securely. Moving beyond data centers, our Fiber Access products are used to send data from residences and businesses to carrier back offices over fibre optic networks. Our Wireless Access solutions are used in wireless base stations, mobile backhaul, and aggregation equipment. Our Metro networking products are used in optical transport platforms, multi-services provisioning platforms, and edge routers where they gather, process and transmit disparate traffic to their next destination in the network. Our Printer and Enterprise Networking provide integrated solutions for laser printers, switches, and routers that are used by enterprises and small businesses to manage their data.
We invest a substantial amount every year for the research and development of new semiconductor solutions. We determine the amount to invest in each semiconductor development based on our assessment of the future market opportunities for those components and the estimated return on investment. To compete globally, we must invest in technologies, products and businesses that are both growing in demand and are cost competitive in the geographic markets that we serve. Going forward, we plan to continue to focus on finding innovative solutions to meet our customers needs while maintaining our operational efficiencies.
On June 8, 2010, we completed the acquisition of the Channel Storage business from Adaptec. The Channel Storage business includes Adaptecs RAID storage product line, a well-established global value added reseller customer base, and leading SSD cache performance solutions. We purchased the Channel Storage business from Adaptec because of its strategic and product fit with our existing enterprise storage products and its growth potential in the storage channel market segment.
With regard to our communications business, we continue to see the convergence of networks and build-outs by service providers who need to handle increasing levels of data and video traffic, as well as reduce their network operating costs. We are seeing growth in demand for our wireline and wireless access product, as well as our metro optical transport solutions.
On November 18, 2010, we completed the acquisition of Wintegra, a provider of highly integrated network processors optimized for mobile backhaul for 3G and 4G wireless and wireline broadband networks. The acquisition accelerates PMCs product offering in IP/Ethernet packet-based mobile backhaul equipment and fits strategically with its overall efforts to accelerate the transition of existing communications equipment to converged, packet-centric solutions.
We expect our microprocessor solutions to continue to ship into the laser printer market as well as the enterprise networking market.
RESULTS OF OPERATIONS
Overall net revenues for 2010 increased $139.0 million, or 28% compared to net revenues for 2009, primarily due to higher sales volume, including volume attributable to two acquisitions the Company completed during the year. The acquisitions of the Channel Storage business from Adaptec, Inc., and Wintegra, Inc. completed in 2010 generated additional net revenues of $40.2 million compared to 2009 and 2008.
Net revenues generated from our Enterprise Storage products and our Printer and Enterprise Networking products increased by 54% in 2010, compared to 2009. We experienced broad-based market recovery in 2010 and a corresponding positive enterprise and corporate information technology spending environment. The increase in net revenues from our enterprise storage products was mainly driven by higher demand for our 4Gbps and 8Gbps Fiber Channel products, and continued deployment of 3Gbps and 6Gbps SAS platforms. In addition, we shipped more of our 6Gbps SAS RAID-on-Chip product, which started shipping in production volumes in the second quarter of 2009.
Net revenues generated from our Enterprise-related products decreased by 2% in 2009 compared to 2008. The decline in net revenues noted was due to a 35% decline in net revenues from lower shipments of our Printer products, largely offset by a 12% increase in net revenues from our Enterprise Storage products. The lower shipment volumes of our Printer products were mainly due to the working down of inventories by our customers and the effects of the general economic slowdown on enterprise spending. The increase in our Enterprise Storage net revenues was mainly attributable to our 6 Gb/SAS RAID-on-Chip, which began shipping in production volumes in the second quarter of 2009, as well as the increased demand for our 3 Gb SAS expander products.
We generate net revenues from our Metro, Transport and Aggregation products, Fiber Access, and Wireless Access (our wired and wireless products). The demand for these products is largely driven by the capital spending by telecommunications carriers. Net revenues generated from these products increased by 5% in 2010 compared to 2009. On a year-over-year basis, we experienced growth in the North American and European geographies, partially offset by a decline in net revenues from Asia.
Net revenues generated by our wired and wireless products decreased in 2009 by 9%, compared to 2008. The decline in net revenues from these products was mainly due to consumption of excess inventory by our customers and lower levels of capital spending by carriers in those end market segments. As a partial offset to this decline in net revenues we experienced increased demand from our Chinese OEM customers related to the communications networking infrastructure build out in those market segments.
Gross profit for 2010 increased by $99.7 million over 2009. Gross profit as a percentage of net revenues was 68% in 2010 and 67% in 2009. The 1% increase in gross profit is attributable to product mix, applying fixed costs over higher sales volumes and having customer funded ASIC mask sets at zero margin during 2009, which we did not have in 2010.
Gross profit for 2009 decreased by $12.5 million over gross profit in 2008. The gross profit as a percentage of net revenues was 67% in 2009 and 65% in 2008. The 2% increase in gross profit is attributable to product mix, as well as cost reductions achieved in 2009 as compared to 2008. This was offset by an approximately 1% decrease mainly due to having customer funded ASIC mask sets at zero margin during 2009, which we did not have in 2008.
OTHER COSTS AND EXPENSES
Research and Development Expenses
Our research and development (R&D), expenses were $187.5 million in 2010. This was $38.3 million, or 26% higher compared to 2009. $8.7 million of the increase in R&D expenses was due to the Channel Storage business acquired from Adaptec during the second quarter of 2010, and Wintegra, Inc. acquired during the fourth quarter of 2010. Also, R&D expenses were higher due to an asset impairment of $4.9 million based on a determination made in the period that certain intangible assets were made redundant by assets acquired with our purchase of the Channel Storage business from Adaptec. Payroll costs increased by $16.6 million due to combination of the completion of planned hiring and other payroll related costs, and the effect of foreign exchange on our foreign operations. Total outside consultant services and material costs, including wafer and photomask costs increased by $11.4 million due to higher number of tapeouts. The remaining $3.3 million reduction in expenses relates to reduction in other expenses.
Our R&D expenses were $149.2 million in 2009. This was $8.4 million, or 5%, lower compared to 2008. Payroll costs decreased by $8.6 million mainly due to the effect of foreign exchange in our foreign operations, partially offset by an increase in headcount. Total material costs, including outside consultant services, wafer and photomask costs increased by $3.0 million mainly due to higher investment in R&D related to our storage products, partially offset by a decrease in costs related to fewer tapeouts in 2009 compared to 2008. The remaining $2.8 million reduction in expenses relates to the reduction in other expenses due to cost reduction activities.
Selling, General and Administrative Expenses
Our selling, general and administrative (SG&A) expenses increased by $19.2 million, or 23% compared to 2009. $15.2 million of this increase resulted from the two acquisitions completed during 2010, including $6.9 million in acquisition-related costs. The remainder of the increase relates to the completion of planned hiring and other payroll related costs, and the effect of foreign exchange on our foreign operations.
Our SG&A expenses were $8.6 million, or 9%, lower in 2009 compared to 2008. Payroll costs decreased by $4.9 million mainly due to the effect of foreign exchange in our foreign operations. The remaining $3.7 million reduction in expenses relates to the reduction in other expenses due to cost reduction activities.
Amortization of Purchased Intangible Assets
Amortization expense for acquired intangible assets related to developed technology, customer relationships, trademarks and backlog decreased by $9.4 million, or 24% in 2010 compared to 2009. The decrease was the result of intangibles related to the acquisition of Passave, Inc. becoming fully amortized early in the second quarter of 2010. Amortization expense for 2010 does include $2.4 million and $1.8 million of amortization related to the intangible assets identified in the preliminary purchase price allocation for our acquisitions of the Channel Storage business from Adaptec, and Wintegra, Inc., respectively.
The annual amortization of intangible assets acquired from Storage Semiconductor Business and Passave was $18.9 million and $20.4 million, respectively, for each of 2009 and 2008.
Restructuring Costs and Other Charges
We incurred restructuring costs and other charges in 2010, 2009 and 2008 of $0.4 million, $0.9 million and $0.8 million, respectively. The lower costs incurred in 2010 compared to 2009 and 2008 is due to our restructuring activities nearing completion and minor adjustments to excess facilities related assumptions of sublease income.
For details on restructuring plans, please see within Item 8. Financial Statements and Supplementary Data, the Notes to the Consolidated Financial Statements, Note 6. Restructuring and Other Costs.
OTHER INCOME AND EXPENSES
Gain on sale of investment securities
In 2010 and 2009, we realized gains of $0.2 million related to disposition of investment securities.
Amortization of debt issue costs and gain on repurchase of senior convertible notes
We recognized amortization of debt issue costs of $0.2 million, $0.2 million and $0.4 million for 2010, 2009 and 2008, respectively.
In 2005, we issued $225.0 million of 2.25% senior convertible notes. In 2008, we repurchased $156.7 million principal amount of our senior convertible notes for $138.3 million and expensed $3.2 million of related unamortized debt issue costs and transactions costs resulting in a net gain of $15.0 million.
Loss on subleased facilities
We recorded a $0.5 million loss on subleased facilities during 2009. There was no loss on subleased facilities in 2010 and 2008.
Foreign exchange (loss) gain
We have significant design presence outside the United States, especially in Canada. The majority of our operating expense exposures to changes in the value of the Canadian dollar relative to the United States dollar have been hedged in accordance with our general practice of hedging approximately three quarters in advance.
Our net foreign exchange loss was $2.4 million in 2010 and 2009 and a net foreign exchange gain of $8.1 million in 2008, which was primarily due to foreign exchange gain (loss) on the revaluation of our net foreign tax liability. We do not hedge our income tax accruals against fluctuations in foreign currency exchange rates (see Item 7A. Quantitative and Qualitative Disclosures About Market Risk). The revaluation of this foreign tax liability was required because of the foreign exchange rate fluctuations of other currencies against the United States dollar. The foreign exchange rate between the United States dollar and the currencies of countries where we have significant tax liabilities depreciated 4% during 2010, and depreciated 14% during 2009.
Interest expense, net
Our net interest expense for 2010, 2009, and 2008 was $1.2 million, $2.5 million, and $0.8 million, respectively.
In 2010, the decrease in net interest expense of $1.3 million, compared to 2009, was due to an increase of $2.3 million in interest income earned due to higher investment yields and higher cash balances, offset by $1.0 million interest expense on our short-term loan related to our acquisition of Wintegra, Inc. In 2009, the increase in net interest expense of $1.7 million, compared to 2008, was due to a decrease of $5.8 million in interest income due to lower investment yields, offset by $4.1 million decrease in interest expense relating to the senior convertible notes, which resulted from partial repurchases of the senior convertible notes in 2008.
Recovery of impairment (loss) on investment securities
At December 26, 2010, we held $22.4 million in investments in shares of the Reserve Funds, net of an impairment of $8.0 million. We recorded an impairment of $11.8 million in the third quarter of 2008, and recorded a partial recovery of $3.8 million in the fourth quarter of 2010. This recovery was recorded based on a distribution of $22.4 million received from the Reserve International Fund on December 31, 2010. See Critical Accounting Policies and EstimatesInvestments in Cash Equivalents, Short-Term Investments and Long-Term Investment Securities.
Gain on investment in Wintegra, Inc.
During the fourth quarter of 2010, we acquired Wintegra. Prior to the acquisition date, November 18, 2010, we owned 2.6% of the outstanding shares of Wintegra. Upon acquiring the remaining equity interests of Wintegra, we recorded a gain on the step-acquisition on this pre-existing investment of $4.5 million.
Recovery on investments
In 2008, we received $0.4 million from an investment in a private company, previously written off.
In 2008, we recorded $4.3 million for an asset impairment related to a supplier contract termination. There was no asset impairment in 2010 and 2009.
(Provision for) Recovery of Income Taxes
We recorded a provision for income taxes of $30.2 million and $4.2 million for 2010 and 2009, respectively, resulting in an increase in provision for income taxes of $26 million. Our effective tax rate was 27% and 8% for 2010 and 2009, respectively. During 2010, we began utilizing available stock option related loss carry-forwards. As a result we recognized $13.4 million of additional income tax provision due to the benefit of stock option related loss carry-forwards being recognized in equity. This impacted our effective tax rate by 12%. The remaining difference relates primarily to foreign exchange translation of a foreign subsidiary, and changes in accruals related to the unrecognized tax benefit liabilities.
The difference between our effective tax rates and the 35% federal statutory rate in each of 2010, 2009 and 2008, resulted primarily from foreign earnings taxed at rates lower than the federal statutory rate, permanent differences arising from stock-based compensation, foreign exchange translation of a foreign subsidiary, investment tax credits earned, non-deductible intangible asset amortization, the effect of intercompany transactions, changes in valuation allowance, and changes in accruals related to the unrecognized tax benefit liabilities.
The 2009 provision for income taxes was $4.2 million, which consisted of $9.9 million recovery associated with the change in deferred tax relating to unrealized foreign exchange loss arising from the foreign currency translation pertaining to a foreign subsidiary, $4.9 million tax expense relating to the amortization of the tax effects relating to inter-company transactions relating to sale of certain assets, as discussed below, $4.5 million tax provision relating to the liability for unrecognized tax benefits (including associated interest), $3.8 million increase in deferred income tax related to past acquisitions and $0.9 million increase in tax expense from operations, net of investment tax credits earned.
The consolidated financial statements for the 2010 and 2009, include the tax effects associated with the sale of certain assets between our wholly-owned subsidiaries. GAAP requires the tax expense associated with gains on such inter-company transactions to be recognized over the estimated life of the related assets. Accordingly prepaid tax expenses were recorded in the year ended December 27, 2009. The balance in long-term prepaid expenses as at December 26, 2010 and December 27, 2009, to be recognized in future years was $23 million and $26.2 million, respectively. The tax expense during 2010 and 2009 resulting from these transactions was $3.2 million and $4.9 million, respectively.
Our provision for income taxes for the year ended December 28, 2008 was a $70.0 million recovery, resulting in an effective tax rate of negative 120% on net income of $58.3 million. The recovery was primarily as a result of one of our foreign subsidiaries settling several ongoing tax matters for less than had been accrued as part of its liability for unrecognized tax benefits, resulting in the recognition of a $124.1 million tax benefit (see Item 8. Financial Statements and Supplementary Data, Notes to the Consolidated Financial Statements, Note 16. Income Taxes). In addition, we accrued $35.2 million (including associated interest) relating to an ongoing liability arising from the examination of our existing transfer pricing practices prior to the settlement noted above, $28.1 million of income tax from normal operations (offset by investment tax credits of $19.5 million), $5.8 million deferred tax expense from an unrealized gain arising from foreign currency translation pertaining to a foreign subsidiary, and $4.5 million increase in tax from various items, including deferred taxes, minimum taxes and revisions of prior estimates.
We expect our revenues for the first quarter of 2011 to be approximately $150 million to $160 million based on typical order patterns. As in the past, and consistent with business practice in the semiconductor industry, a portion of our revenues are likely to be derived from orders placed and shipped during the same quarter, which we call our turns business. Our turns business varies from quarter to quarter. In the fourth quarter of 2010, net orders booked and shipped within the quarter were approximately 22% of quarterly sales, and we expect the turns percentage to be similar in the first quarter of 2011 compared with the fourth quarter of 2010.
We anticipate our first quarter 2011 gross margin percentage to be in the range of 61.4% 62.8%, which includes approximately $0.2 million stock-based compensation expense and $9.0 million acquisition inventory adjustments. As in past quarters this could vary depending on the volumes of products sold, since many of our costs are fixed. Margins will also vary depending on the mix of products sold.
We expect our first quarter 2011 research and development and selling, general and administrative expenses to be approximately $90.5 million to $93.5 million, respectively including, stock-based compensation expense of approximately $5.5 million to $6.5 million, and amortization of purchased intangible assets related to our past acquisitions of $11 million.
We anticipate that net interest expense will be approximately $0.6 million in the first quarter of 2011 as interest income earned from our cash position will be offset by interest expense incurred on our outstanding senior convertible notes.
The GAAP provision for income taxes is not available on a forward looking basis without unreasonable effort.
LIQUIDITY AND CAPITAL RESOURCES
Our principal sources of liquidity are cash from operations, our short-term investments and long-term investment securities and our short-term loan. We employ these sources of liquidity to support ongoing business activities, acquire or invest in critical or complementary technologies, purchase capital equipment, repurchase and repay our senior convertible notes and finance working capital. The combination of cash, cash equivalents, short-term investments and long-term investment securities at December 26, 2010 and December 27, 2009 totaled $583.5 million and $453.4 million, respectively.
In November 2010, we obtained a short-term loan to facilitate the acquisition of Wintegra, Inc., the balance of which was $181.0 million as of December 26, 2010. We fully repaid this loan subsequent to year end. At both December 26, 2010 and December 27, 2009, we had $68.3 million of senior convertible notes outstanding. In the future, we expect our cash on hand, from operations, our short-term investments, and long-term investment securities to be our primary source of liquidity.
The composition of our cash, cash equivalents and short-term investments and long-term investment securities, as classified in our consolidated balance sheet at December 26, 2010 and at December 27, 2009 is as follows:
The investments in Reserve Funds, classified as cash and cash equivalents on the consolidated balance sheet, net of provision, totaling $22.4 million at December 26, 2010 (2009$23.2 million) relate to shares of the International Fund and the Primary Fund. As at December 26, 2010, all the underlying investments held in the Reserve Funds have matured or were sold, and securities are held only in overnight notes. Partial distributions received in 2010 from the Reserve Funds totaled $4.6 million. Subsequent to 2010, we received $22.4 million. See Critical Accounting Policies and EstimatesInvestment in Cash Equivalents, Short-Term Investments and Long-Term Investment Securities for additional information.
During 2010, we generated $183.3 million in net operating cash flows, compared to $121.8 million in 2009. This increase over 2009 is primarily attributable to earning $83.2 million of net income, which was 77% higher than the prior year, and significant non-cash addbacks of $48.1 million of depreciation and amortization and $21.9 million in stock based compensation. Changes in net working capital accounts generated $25.2 million of our net operating cash flows in 2010:
In 2010, we used $200 million to acquire Wintegra, Inc. and $34.3 million to acquire the Channel Storage Business from Adaptec, Inc. We had no acquisitions in 2009.
In 2010, we also purchased a total of $17 million (2009$7.8 million) of intangible assets and property and equipment to support ongoing operations. We also purchased investment securities of $347.6 million (2009$295.4 million) and disposed of $222.3 million (2009$59.3 million) of these securities. We also redeemed short-term investments of $4.6 million during the year (2009$186.4 million). We use these investment securities to earn a return on excess cash balances.
During 2010, we reclassified $90.3 million of our short-term and long-term investment securities to cash and cash equivalents as part of these funds were used to repay our short-term loan after December 26, 2010, and the remainder of these funds related to receiving distributions from the International Funds subsequent to our year-end. See Critical Accounting Policies and EstimatesInvestment in Cash Equivalents, Short-Term Investments and Long-Term Investment Securities for additional information.
In connection with the acquisition of Wintegra, Inc. we borrowed $220 million, $40 million of which was repaid prior to year end. The remainder was repaid shortly after year end. We also received $18.6 million from the exercise of employee stock options throughout the year.
At December 26, 2010, we had the following contractual obligations:
The Notes rank equal in right of payment with our other unsecured senior indebtedness and mature on October 15, 2025 unless earlier redeemed by us at our option, or converted or put to us at the option of the holders. Interest is payable semi-annually in arrears on April 15 and October 15 of each year, commencing on April 15, 2006. We may redeem all or a portion of the Notes at par on and after October 20, 2012. The holders may require that we repurchase Notes on October 15 of each of 2012, 2015 and 2020.
Holders may convert the Notes into the right to receive the conversion value (i) when our stock price exceeds 120% of the approximately $8.80 per share initial conversion price for a specified period, (ii) in certain change in control transactions and (iii) when the trading price of the Notes does not exceed a minimum price level. For each $1,000 principal amount of Notes, the conversion value represents the amount equal to 113.6687 shares multiplied by the per share price of our common stock at the time of conversion. If the conversion value exceeds $1,000 per $1,000 in principal of Notes, we will pay $1,000 in cash and may pay the amount exceeding $1,000 in cash, stock or a combination of cash and stock, at our election.
We entered into a Registration Rights Agreement with the holders of the Notes, under which we are required to keep the shelf registration statement effective until the earlier of (i) the sale pursuant to the shelf registration statement of all of the Notes and/or shares of common stock issuable upon conversion of the Notes and (ii) the expiration of the holding period applicable to such securities held by non-affiliates under Rule 144 under the Securities Act, or any successor provision, subject to certain permitted exceptions.
We will be required to pay liquidated damages, subject to some limitations, to the holders of the Notes if we fail to comply with our obligations to register the Notes and the common stock issuable upon conversion of the Notes or the registration statement does not become effective within the specified time periods. In no event will liquidated damages accrue after the second anniversary of the date of issuance of the Notes or at a rate exceeding 0.50% of the issue price of the Notes. We will have no other liabilities or monetary damages with respect to any registration default. If the holder has converted some or all of its Notes into common stock, the holder will not be entitled to receive any liquidated damages with respect to such common stock or the principal amount of the Notes converted.
We have a line of credit with a bank that allows us to borrow up to $0.7 million provided we maintain eligible investments with the bank equal to the amount drawn on the line of credit. At December 26, 2010, we had committed $0.6 million under letters of credit as security for office leases.
We expect to use approximately $28.7 million of cash in 2011 for capital expenditures including purchases of intellectual property. Based on our current operating prospects, we believe that existing sources of liquidity will be sufficient to satisfy our projected operating, working capital, capital expenditure, purchase obligations and remaining restructuring requirements through the end of 2011.
In addition to the amounts shown in the table above, we have recorded a $58.2 million liability for unrecognized tax benefits as of December 26, 2010 and we are uncertain as to if or when such amounts may be realized.
The Company recorded a liability for contingent consideration as part of the purchase price for the acquisition of Wintegra at the estimated fair value of $28.2 million as of December 26, 2010, which reflects the fair value of an earn-out payment that the equity holders of Wintegra may be entitled to if 2011 revenues exceed an agreed threshold. The fair value of the liability for contingent consideration arrangement of $28.2 million was estimated by applying the income approach. The measure is based on significant inputs that are unobservable in the market, which is a Level 3 input. Key assumptions include a discount rate of 4.75 percent and probability-adjusted level of quarterly revenues. The Company will perform quarterly revaluations of the liability for contingent liability and record the change as a component of operating income.
OFF-BALANCE SHEET ARRANGEMENTS
As of December 26, 2010, we had no material off-balance sheet financing arrangements.
RECENT ACCOUNTING PRONOUNCEMENTS
In December 2007, the FASB issued ASC Topic 805, the Business Combinations Topic. ASC Topic 805 changes the accounting for acquisitions that close beginning in 2009. More transactions and events qualify as business combinations and are accounted for at fair value under the new standard. ASC Topic 805 promotes greater use of fair values in financial reporting. Some of the changes introduce more volatility into earnings. ASC Topic 805 is effective for fiscal years beginning on or after December 15, 2008. The Company applied this standard for business combinations that occurred after January 1, 2009. Business combinations that were completed in 2010 were accounted for in accordance with this new standard, as a result, there was a material impact on the treatment of acquisition-related costs, accounting related to a step-acquisition, and contingent consideration (see Item 8. Financial Statements and Supplementary Data, Notes to Consolidated Financial Statements, Note 2. Business Combinations).
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Managements Discussion and Analysis of Financial Condition and Results of Operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the amounts we report as assets, liabilities, revenue and expenses, and the related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and on various other assumptions that are reasonable in the circumstances. These estimates could change under different assumptions or conditions.
Our significant accounting policies are outlined in the notes to the consolidated financial statements. In managements opinion the following critical accounting policies require the most significant judgment and involve complex estimation. We also have other policies that we consider to be key accounting policies, such as our policies of revenue recognition, including the deferral of revenues on sales to major distributors; however these policies do not meet the definition of critical accounting estimates as they do not generally require us to make estimates or judgments that are difficult or subjective.
Valuation of Goodwill and Intangible Assets
We assess the impairment of long-lived assets in the fourth quarter, or when events or changes in circumstances indicate that the carrying value of the assets or the asset grouping may not be recoverable. Factors
that we may consider when determining when to conduct an impairment test include: (i) any future declines in our operating results; (ii) a decline in the valuation of technology company stocks, including the valuation of our common stock; (iii) a further significant slowdown in the worldwide economy or the semiconductor industry; or (iv) any failure to meet the performance projections included in our forecasts of future operating results.
To determine whether impairment exists, we first compare the undiscounted cash flows of the assets to their carrying value. If the assets carrying value exceeds its estimated undiscounted cash flows, we would write the asset to its estimated fair value based on expected discounted cash flows. Significant management judgment is required in the forecasts of future operating results and discount rates used in the discounted cash flow method of valuation. It is possible, however, that the plans may change and estimates used may prove to be inaccurate. If our actual results, or the plans and estimates used in future impairment analyses, are lower than the original estimates used to assess the recoverability of these assets, we could incur additional impairment charges.
There was no impairment to goodwill or intangible assets in 2010, except for the asset impairment of $4.9 million relating to certain intangible assets that were made redundant by assets acquired with our purchase of the Channel Storage business from Adaptec. The carrying value of these assets was no longer recoverable based on expected future cash flows associated with these assets. Accordingly, the carrying value was written down to zero. This impairment charge was included in the consolidated statement of operations in research and development expenses. Changes in the estimated fair values of these assets in the future could result in significant impairment charges or changes to our expected amortization.
The aggregation of operating segments into one reportable segment requires the management to evaluate whether there are similar expected long-term economic characteristics for each operating segment, and is an area of significant judgment. If the expected long-term economic characteristics were to become dissimilar, then we could be required to re-evaluate the number of reportable segments and potentially the goodwill associated with those segments.
Since January 1, 2006, we have recognized compensation expense for all share-based payment awards. Under ASC Topic 718, CompensationStock Compensation, we measure the fair value of awards of equity instruments and recognize the cost, net of an estimated forfeiture rate, on a straight-line basis over the period during which services are provided in exchange for the award, generally the vesting period.
Calculating the fair value of stock-based compensation awards requires the input of highly subjective assumptions, including the expected life of the awards and expected volatility of our stock price. Expected volatility is a statistical measure of the amount by which a stock price is expected to fluctuate during a period. Our estimates of expected volatilities are based on a weighted historical and market-based implied volatility. In order to determine the expected life of the awards, we use historical data to estimate option exercises and employee terminations; separate groups of employees that have similar historical exercise behavior, such as directors or executives, are considered separately for valuation purposes. The expected forfeiture rate applied in calculating stock-based compensation cost is estimated using historical data and is updated annually.
The assumptions used in calculating the fair value of stock-based awards involve estimates that require management judgment. If factors change and we use different assumptions, our stock-based compensation expense could change significantly in the future. In addition, if our actual forfeiture rate is different from our estimate, our stock-based compensation expense could change significantly in the future.
In calculating the cost to dispose of our excess facilities, we had to estimate the amount to be paid in lease termination payments, the future lease and operating costs to be paid until the lease is terminated, and the
amount, if any, of sublease revenues for each location. This required us to estimate the timing and costs of each lease to be terminated, the amount of operating costs for the affected facilities and the timing and rate at which we might be able to sublease or complete negotiations of a lease termination agreement for each site. To form our estimates for these costs we performed an assessment of the affected facilities and considered the current market conditions for each site.
We believe our estimates of the obligations for the closing of sites remain sufficient to cover anticipated settlement costs. However, our assumptions on the lease termination payments, operating costs until termination, or the amounts and timing of offsetting sublease revenues may turn out to be incorrect and our actual cost may be materially different from our estimates. If our actual costs exceed our estimates, we would incur additional expenses in future periods.
PMC has operations in several tax jurisdictions, which subjects us to multiple tax rates that impact our overall effective tax rate. We use estimates and assumptions in allocating income to each tax jurisdiction. As a result of certain business activities carried out in certain countries, such as employment and capital investment activities, income earned in those countries may be subject to reduced tax rates, or exempt from tax. Material changes in business activity that we conduct in these tax jurisdictions could impact our effective tax rates.
We have recorded income tax liabilities based on our interpretation of tax regulations for the countries in which we operate. We believe that the tax return positions we have taken are fully supportable. However, our estimates are subject to review and assessment by the local tax authorities. Our tax expense and related reserves reflect amounts that we believe will be adequate if challenged or subject to income tax assessment. Management uses judgment and estimates in determining tax expense for these challenges in accordance with guidance for accounting for uncertainty in income taxes. Currently, our reserve for uncertain tax positions is attributable primarily to uncertainties related to the tax treatment of our international operations, including the allocation on income among different jurisdictions.
The timing of any such review and final assessment of our liabilities is substantially out of our control and is dependent on the actions by those local tax authorities. Any re-assessment of our tax liabilities may result in adjustments of the income taxes we pay, with a resulting impact on our tax expense, net income and cash flows. We review our reserves quarterly, and we may adjust such reserves because of changes in facts and circumstances, changes in tax regulations, negotiations between tax authorities and associated proposed tax assessments, the resolution of audits and the expiration of statutes of limitations.
We must also assess the likelihood that we will be able to recover our deferred tax assets. If recovery is not likely, we must increase our provision for taxes by recording a reserve in the form of a valuation allowance for the deferred tax assets that we estimate will not ultimately be recoverable.
We intend to reinvest all undistributed earnings of all foreign subsidiaries. Accordingly, we have not recognized deferred taxes because of the assertion that the earnings of the foreign subsidiaries are reinvested indefinitely. If our parent company were to repatriate the earnings of foreign subsidiaries, a significant tax liability may result.
Investment in Cash Equivalents, Short-Term Investments and Long-Term Investment Securities
Our cash equivalents, short-term investments and long-term investment securities are comprised of money market funds, United States Treasury and Government Agency notes, Federal Deposit Insurance Corporation (FDIC)-insured corporate notes, United States State and Municipal Securities, foreign government and agency notes and corporate bonds and notes with minimum ratings of P-1 or A3 by Moodys, or A-1 or A- by Standard and Poors, or equivalent. At December 26, 2010, these securities had an estimated fair value of $531.4 million.
Beginning in the first quarter of fiscal 2008, the assessment of fair value is based on the provisions of ASC Topic 820, the Fair Value Measurements and Disclosure Topic. We determined the fair value of our investment securities, which include money market funds, United States Treasury and Government Agency notes, Federal FDIC-insured corporate notes, United States State and Municipal Securities, foreign government and agency notes and corporate bonds and notes, using quoted prices from active markets, quoted prices for similar assets from third-party sources and by performing valuation analyses. In determining if and when a decline in market value below the carrying value of our investment securities is other-than-temporary, we evaluate on an ongoing basis the market conditions, trends of earnings, financial condition and other key measures for our investments. We assess impairment of our investment securities in accordance with GAAP.
The investments in Reserve Funds, classified as cash and cash equivalents on the consolidated balance sheet, net of provision, totaling $22.4 million at December 26, 2010 (2009$23.2 million) relate to shares of the Reserve International Liquidity Fund, Ltd. (the International Fund) and the Reserve Primary Fund (the Primary Fund, together the Reserve Funds). The Reserve Funds were AAA-rated money market funds which announced redemption delays and suspended trading in September 2008, during the severe disruption in financial markets. We assessed the fair value of its money market funds, including by consideration of Level 2 and Level 3 inputs (see Item 8. Financial Statements and Supplementary Data, the Notes to the Consolidated Financial Statements, Note 4. Fair Value Measurements) for the Reserve Funds and their underlying securities. Based on this assessment, we recorded an impairment of the Reserve Funds of $11.8 million during the third quarter of 2008, incorporating the Reserve Funds valuation at zero for debt securities of Lehman Brothers held, and a net asset value of $0.97 per share as communicated by the Primary Fund. In 2008, we reclassified our investment in shares of the Reserve Funds from Level 1 to Level 3 of the fair value hierarchy due to the inherent subjectivity and significant judgment related to the fair value of the shares of the Reserve Funds and their underlying securities. Accordingly, we changed the valuation method from a market approach to an income approach. In addition, in 2008, due to the status of the Reserve Funds, we reclassified a portion of these shares from cash and cash equivalents to short-term investments and long-term investment securities, based on the maturity dates of the underlying securities in the Reserve Funds.
As at December 26, 2010, all the underlying investments held in the Reserve Funds have matured or were sold, and securities are held only in overnight notes. Partial distributions received in 2010 from the Reserve Funds totaled $4.6 million.
During 2010, the Reserve Primary Fund entered into liquidation proceedings which were supervised by the U.S. Securities and Exchange Commission, and we received partial distributions of its holdings. During the fourth quarter of 2010, the U.S. District Court for the Southern District of New York entered into final judgment accepting a proposed settlement agreement with respect to the Reserve International Liquidity Fund, Ltd. Subsequent to the year-ended December 26, 2010, that judgment became final, as a result, we recognized recovery of impairment on investment securities of $3.8 million, based on partial distributions received based on these settlements. The courts set aside certain amounts cash held by the Reserve Funds for legal and administrative costs, and if the cash is not all consumed, we could potentially receive a further distribution.
Accordingly, we received $22.4 million on December 31, 2010. We continue to hold $8 million in shares of the Reserve International Liquidity Fund, which is fully reserved for on the balance sheet. As a result of the subsequent ruling on the Reserve International Liquidity Fund, the investments in the Reserve Funds were reclassified on the consolidated balance sheet from short-term investments to cash and cash equivalents during the fourth quarter of 2010.
The following discussion regarding our risk management activities contains forward-looking statements that involve risks and uncertainties. Actual results may differ materially from those projected in the forward-looking statements.
Cash, Cash Equivalents, Short-term Investments and Long-term Investment Securities
We regularly maintain a portfolio of short- and long-term investments comprised of various types of money market funds, United States Treasury and Government Agency notes, FDIC-insured corporate notes, United States State and Municipal Securities, foreign government and agency notes and corporate bonds and notes. Our investments are made in accordance with an investment policy approved by our Board of Directors. All investments have maturities of 36 months or less. To minimize credit risk, we diversify our investments and select minimum ratings of P-1 or A3 by Moodys, or A-1 or A- by Standard and Poors or equivalent. We classify these securities as available-for-sale and they are carried at fair market value. Our corporate policies prevent us from holding material amounts of asset-backed commercial paper.
Investments in instruments with both fixed and floating rates carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted because of a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations because of changes in interest rates, or we may suffer losses in principal if we were to sell securities that have declined in market value because of changes in interest rates.
We do not attempt to reduce or eliminate our exposure to interest rate risk through the use of derivative financial instruments.
A 1% shift in interest rates would impact our annual pre-tax income by approximately $5.5 million.
Senior Convertible Notes:
At December 26, 2010, a principal amount of $68.3 million of these Notes remained outstanding and $0.4 million of unamortized debt issue costs were included in Investments and Other Assets. The Notes were originally issued for $225 million in aggregate principal amount. During 2008, we repurchased $156.7 million principal amount of our Notes for $138.3 million and expensed $3.2 million of related unamortized debt issue costs and transaction costs resulting in a net gain of $15.0 million.
Because we pay fixed interest coupons on these Notes, market interest rate fluctuations do not impact our debt interest payments. However, the fair value of the senior convertible Notes will fluctuate as a result of changes in the price of our common stock, changes in market interest rates and changes in our credit worthiness.
Our Notes are not listed on any exchange or included in any automated quotation system but are registered for resale under the Securities Act of 1933.
The Notes rank equal in right of payment with our other unsecured senior indebtedness and mature on October 15, 2025 unless earlier redeemed by us at our option, or converted or put to us at the option of the holders. Interest is payable semi-annually in arrears on April 15 and October 15 of each year, commencing on April 15, 2006. We may redeem all or a portion of the Notes at par on and after October 20, 2012. The holders may require that we repurchase Notes on October 15 of each of 2012, 2015 and 2020.
Holders may convert the Notes into the right to receive the conversion value (i) when our stock price exceeds 120% of the approximately $8.80 per share initial conversion price for a specified period, (ii) in certain change in control transactions and (iii) when the trading price of the Notes does not exceed a minimum price
level. For each $1,000 principal amount of Notes, the conversion value represents the amount equal to 113.6687 shares multiplied by the per share price of our common stock at the time of conversion. If the conversion value exceeds $1,000 per $1,000 in principal of Notes, we will pay $1,000 in cash and may pay the amount exceeding $1,000 in cash, stock or a combination of cash and stock, at our election.
Our sales and corresponding receivables are denominated primarily in U.S. dollars. We generate a significant portion of our revenues from sales to customers located outside the United States including Canada, Europe, the Middle East and Asia. We are subject to risks typical of an international business including, but not limited to, differing economic conditions, changes in political climate, differing tax structures, other regulations and restrictions and foreign exchange rate volatility. Accordingly, our future results could be materially adversely affected by changes in these or other factors.
Through our operations in Canada and elsewhere outside the United States, we incur research and development, sales, customer support and administrative expenses in Canadian and other foreign currencies. We are exposed, in the normal course of business, to foreign currency risks on these expenditures, particularly in Canada. In our effort to manage such risks, we have adopted a foreign currency risk management policy intended to reduce the effects of potential short-term fluctuations on our operating results stemming from our exposure to these risks. As part of this risk management strategy, we enter into foreign exchange forward contracts on behalf of our Canadian subsidiary. These forward contracts offset the impact of exchange rate fluctuations on forecasted cash flows or firm commitments. We limit the forward contracts operational period to 12 months or less, and we do not enter into foreign exchange forward contracts for trading purposes. Because we do not engage in foreign exchange risk management techniques beyond these periods, our cost structure is subject to long-term changes in foreign exchange rates.
As at December 26, 2010, we had 24 currency forward contracts outstanding that qualified and were designated as cash flow hedges. The U.S. dollar notional amount of these contracts was $44.3 million and the contracts had a fair value of $1.3 million.
We attempt to limit our exposure to foreign exchange rate fluctuations from our Canadian dollar net asset or liability positions. A 5% shift in the foreign exchange rates between U.S. dollar and the Canadian dollar would impact pre-tax income by approximately $3.0 million.
Our other investments include strategic investments in privately held companies that are carried on our balance sheet at cost, net of write-downs for non-temporary declines in market value. We expect to make additional investments like these in the future. These investments are inherently risky, as they typically are comprised of investments in companies and partnerships that are still in the start-up or development stages. The market for the technologies or products that they have under development is typically in the early stages, and may never materialize. We could lose our entire investment in these companies and partnerships or may incur an additional expense if we determine that the value of these assets has been impaired. For example, in the second quarter of 2006 we recorded a charge of $3.2 million for impairment of an investment in a private company. We may record additional impairment charges should we determine that our investments have incurred a non-temporary decline in value.
The chart entitled Quarterly Data contained in Item 6 Part II hereof is hereby incorporated by reference into the Item 8 of Part II of this Form 10-K.
Schedules not listed above have been omitted because they are not applicable or are not required, or the information required to be set forth therein is included in the financial statements or the notes thereto.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of PMC-Sierra, Inc.
We have audited the accompanying consolidated balance sheets of PMC-Sierra, Inc. and subsidiaries (the Company) as of December 26, 2010 and December 27, 2009, and the related consolidated statements of operations, cash flows, and stockholders equity for each of the three years in the period ended December 26, 2010. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These consolidated financial statements and financial statement schedules are the responsibility of the Companys management. Our responsibility is to express an opinion on the consolidated financial statements and financial statement schedules based on our audits.
We conducted our audits 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 includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of PMC-Sierra, Inc. and subsidiaries as of December 26, 2010 and December 27, 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 26, 2010 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Companys internal control over financial reporting as of December 26, 2010, based on the criteria established in Internal ControlIntegrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 23, 2011 expressed an unqualified opinion on the Companys internal control over financial reporting.
CONSOLIDATED BALANCE SHEETS
(in thousands, except par value)
See notes to the consolidated financial statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except for per share amounts)
See notes to the consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to the consolidated financial statements.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
See notes to the consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of business. PMC-Sierra, Inc (the Company or PMC) designs, develops, markets and supports semiconductor solutions by integrating its mixed-signal, software and systems expertise through a network of offices in North America, Europe and Asia.
Basis of presentation. The accompanying consolidated financial statements have been prepared pursuant to the rules and regulations of the United States Securities and Exchange Commission (SEC) and United States Generally Accepted Accounting Principles (GAAP). Fiscal 2010, 2009, and 2008 consisted of 52 weeks and ended on the last Sunday in December. The Companys reporting currency is the U.S. dollar. The accompanying consolidated financial statements include the accounts of PMC-Sierra, Inc. and any of its subsidiaries or investees in which PMC exercises control. As at December 26, 2010 and December 27, 2009, all subsidiaries included in these consolidated financial statements were wholly owned by PMC. All inter-company accounts and transactions have been eliminated.
Estimates. The preparation of financial statements and related disclosures in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Estimates are used for, but not limited to, stock-based compensation, purchase accounting assumptions including those used to calculate the fair value of intangible assets and goodwill, the valuation of investments, accounting for doubtful accounts, inventory reserves, depreciation and amortization, asset impairments, sales returns, warranty costs, income taxes including uncertain tax positions, restructuring costs, assumptions used to measure the fair value of the debt component of our senior convertible notes, accounting for employee benefit plans, and contingencies. Actual results could differ from these estimates.
Cash and cash equivalents, short-term investments and long-term investment securities. At December 26, 2010, cash and cash equivalents included $0.7 million (2009$0.7 million) pledged with a bank as collateral for letters of credit issued as security for leased facilities. Cash equivalents are defined as highly liquid interest-earning instruments with maturities at the date of purchase of three months or less. Short-term investments are investments with original maturities greater than three months, but less than one year. Investments with maturities beyond one year are classified as long-term investment securities.
Management classifies investments as available-for-sale or held-to-maturity at the time of purchase and re-evaluates such designation as of each balance sheet date. Investments classified as held-to-maturity securities are stated at amortized cost with corresponding premiums or discounts amortized against interest income over the life of the investment. Marketable equity and debt securities not classified as held-to-maturity are classified as available-for-sale and reported at fair value. The cost of securities sold is based on the specific identification method. Unrealized gains and losses on these investments, net of any related tax effect are included in equity as a separate component of stockholders equity. For debt securities, if an impairment is considered other than temporary, the entire difference between the amortized cost and the fair value is recognized in earnings in the period this determination is made.
Allowance for Doubtful Accounts. The allowance for doubtful accounts is based on the Companys assessment of the collectability of customer accounts. The Company regularly reviews the allowance by considering factors such as historical experience, credit quality, age of the accounts receivable balances, and economic conditions that may affect a customers ability to pay.
Inventories. Inventories are stated at the lower of cost (first-in, first-out) or market (estimated net realizable value). Cost is computed using standard cost, which approximates actual average cost. The Company provides inventory allowances on obsolete inventories and inventories in excess of twelve-month demand for each specific part.
Inventories (net of reserves of $8.6 million and $6.8 million at December 26, 2010 and December 27, 2009, respectively) were as follows:
In 2010, the Company decreased inventory reserves by $0.8 million (2009$2.6 million, 2008$3.1 million) for inventory that was scrapped during the year.
Investments in private entities. The Company has investments in privately traded companies in which it has less than 20% of the voting rights and in which it does not exercise significant influence. The Company monitors these investments for impairment and makes appropriate reductions in carrying values when necessary. These investments are included in Investments and other assets on the Companys consolidated balance sheet and are carried at cost, net of write-downs for impairment.
Deposits for wafer fabrication capacity. The Company has wafer supply agreements with two independent foundries. Under these agreements, the Company has deposits of $5.1 million (2009$5.1 million) to secure access to wafer fabrication capacity. These are classified as long-term assets in the consolidated balance sheets. Also, see related comments under Concentrations.
Property and equipment, net. Property and equipment is stated at cost, net of write-downs for impairment, and accumulated depreciation. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets, ranging from two to five years. Leasehold improvements are capitalized and amortized over the shorter of their estimated useful lives or the lease term.
The components of property and equipment, net are as follows:
Goodwill. Goodwill is recorded when the purchase price paid for an acquisition exceeds the estimated fair value of the net identified tangible and intangible assets acquired. The Company performs a two-step process on an annual basis, or more frequently if necessary, to determine 1) whether the fair value of the relevant reporting unit exceeds the carrying value and 2) the amount of an impairment loss, if any. The Company completed this process in December 2010, 2009 and 2008, and determined that there was no impairment to goodwill.
Intangible assets, net. Intangible assets, net, consist of intangible assets acquired through business combinations, which are amortized over their estimated useful lives ranging from < 1 year to ten years or have indefinite lives, and purchased developed technology assets that are amortized over their economic lives, which are normally three years. The components of intangible assets, net are as follows: