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SiRF Technology Holdings 10-Q 2006 Table of ContentsUNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
FORM 10-Q
(Mark one)
For the quarterly period ended June 30, 2006 OR
For the transition period from to Commission File Number 000-50669
SiRF TECHNOLOGY HOLDINGS, INC. (Exact name of registrant as specified in its charter)
(408) 392-8300 (Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.): Yes ¨ No x 51,700,974 shares of the Registrant’s common stock were outstanding as of July 31, 2006.
Table of ContentsTABLE OF CONTENTS
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Table of ContentsItem 1. Financial Statements SiRF TECHNOLOGY HOLDINGS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands)
See accompanying Notes to Condensed Consolidated Financial Statements.
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Table of ContentsSiRF TECHNOLOGY HOLDINGS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts) (Unaudited)
See accompanying Notes to Condensed Consolidated Financial Statements.
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Table of ContentsSiRF TECHNOLOGY HOLDINGS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited)
See accompanying Notes to Condensed Consolidated Financial Statements.
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Table of ContentsNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Note 1. Organization and Summary of Significant Accounting Policies Organization SiRF Technology Holdings, Inc., or SiRF or the Company, is the holding company for SiRF Technology, Inc., or SiRF Technology, which develops and markets semiconductor products designed to enable location awareness in high-volume mobile consumer devices and commercial applications. SiRF Technology was incorporated in the state of California in February 1995 and reincorporated in the state of Delaware in September 2000. SiRF was incorporated in the state of Delaware in June 2001 when all of SiRF Technology’s capital was exchanged for SiRF capital. Basis of Presentation The accompanying unaudited condensed consolidated financial statements have been prepared by SiRF and reflect all adjustments which are, in the opinion of management, necessary for a fair presentation of the interim periods presented. Such adjustments are of a normal recurring nature. The condensed consolidated results of operations for the interim periods presented are not necessarily indicative of the results for any future interim period or for the entire fiscal year. Certain information and footnote disclosures normally included in the annual consolidated financial statements prepared in accordance with United States, or U.S., generally accepted accounting principles have been condensed or omitted pursuant to the U.S. Securities and Exchange Commission, or SEC, rules and regulations regarding interim financial statements. The information included in this Quarterly Report on Form 10-Q should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Quantitative and Qualitative Disclosures About Market Risk” and the Consolidated Financial Statements and notes thereto included in Items 7, 7A and 8, respectively, of SiRF’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005. The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. Unless otherwise specified, references to the Company are references to the Company and its consolidated subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Use of Estimates The preparation of consolidated financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Such management estimates include, but are not limited to, recognition of revenue, provision for inventory write-downs, allowance for doubtful accounts, valuation of stock options, provision for warranty claims, valuation of goodwill and long-lived assets and valuation of deferred tax assets. Actual results could differ from those estimates. Reclassifications Certain reclassifications have been made to prior period amounts to conform to current period presentation. Rebate reserves to be paid to indirect customers previously included as a reduction in net accounts receivable in the quarterly balance sheets during fiscal 2005, have been separately presented in the balance sheet as a liability under the caption ‘Rebates payable to customers’ as of December 31, 2005, along with their related impact on the statement of cash flows for the six months ended June 30, 2005. Revenue Recognition SiRF derives revenue primarily from sales of semiconductor chip sets and licenses of its intellectual property and premium software products. As business activities related to licenses of intellectual property and premium software products are not considered significant to SiRF’s consolidated operating results, SiRF operates as a single operating segment and thus does not present discrete financial information for business activities related to this component of our business. Revenue is recognized when persuasive evidence of a sales arrangement exists, transfer of title and acceptance, where applicable, occurs, the sales price is fixed or determinable and collection is probable. Transfer of title occurs based on defined terms in customer purchase orders. The Company records reductions to revenue for expected product returns based on the Company’s historical experience. SiRF defers the recognition of revenue and the related cost of revenue on shipments to distributors that have rights of return and price protection privileges on unsold merchandise until the merchandise is sold by the distributor to its customers. Price protection rights grant distributors the right to credit in the event of decreases in the price of SiRF’s products. SiRF enters into co-branding rebate agreements with certain customers and provides marketing incentives to certain distributors. Payments made under such agreements and marketing incentives are recorded as a reduction of revenue in accordance with Emerging Issues Task Force, or EITF, Issue No. 01-09, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products). SiRF records rebate reserves for both direct and indirect customers. Rebates to direct customers are presented in the consolidated balance sheet as a reduction of accounts receivables as the rebates are offset against amounts owed from direct customers and rebates to indirect customers are separately presented in the consolidated balance sheet as rebates payable to customers.
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Table of ContentsSiRF licenses rights to use its intellectual property to allow licensees to integrate GPS technology into their products. SiRF also licenses rights to use its premium software products to licensees to enable SiRF chip sets to provide enhanced functionality in specific applications. Licensees pay ongoing royalties based on defined terms in software license agreements. Payments are generally made based on licensees’ sales of their products incorporating the licensed intellectual property or premium software. Royalty revenue is generally recognized at the time products containing the licensed intellectual property or premium software are sold by the licensees based on quarterly reports received from licensees detailing the number of chip sets shipped by licensees into which SiRF’s intellectual property or premium software was embedded. For certain licensees, or Estimated Licensees, the Company estimates and records the royalty revenue earned in the quarter in which such sales occur, but only when reasonable estimates of such amounts can be made. Estimates of royalty revenue for the Estimated Licensees are based on forecasts provided by Estimated Licensees, an analysis of the Company’s sales of chip sets to Estimated Licensees and historical attach rates, historical royalty data for Estimated Licensees and current market and economic trends. Once royalty reports are received from the Estimated Licensees, the variance between such reports and the estimate is recorded as royalty revenue in the quarter in which the reports are received. To date, such variances have been insignificant. Subsequent to the sale, SiRF has no obligation to provide any modification, customization, upgrades, or enhancements. The cost of revenue associated with licenses is insignificant. Inventory The Company records a reserve for inventories which have become obsolete or are in excess of anticipated demand or net realizable value. SiRF performs a detailed review of inventory each period that considers multiple factors including demand forecasts, market conditions, product life cycle status, product development plans and current sales levels. If future demand or market conditions for the Company’s products are less favorable than forecasted or if unforeseen technological changes negatively impact the utility of component inventory, SiRF may be required to record additional write-downs which would negatively impact gross margins in the period when the write-downs are recorded. If actual market conditions are more favorable, SiRF may have higher gross margins when products incorporating inventory that was previously reserved are sold. Accounts Receivable Allowance The Company makes estimates of the collectibility of accounts receivable. The Company regularly reviews the adequacy of its allowance for doubtful accounts after considering the amount of aged accounts receivable, each customer’s ability to pay, and the Company’s collection history with each customer. The Company reports charges to the allowance for doubtful accounts as a portion of selling, general and administrative costs. The Company regularly reviews past due invoices to determine if an allowance is appropriate based on the risk category using the factors discussed above. In addition, the Company maintains a reserve by applying a percentage to aging categories based on historical experience. Assumptions and judgments regarding collectibility of accounts could differ from actual events. While SiRF’s credit losses have historically been within its expectations and the allowance established, the Company may not continue to experience the same credit loss rates that it has in the past. The Company’s receivables are concentrated in a relatively few number of customers. As of June 30, 2006, 49% of our receivables were concentrated in two customers, which each accounted for 10% or more of our net receivables. Therefore, a significant change in the liquidity or financial position of any of these customers could make it more difficult for the Company to collect its accounts receivable and may require the Company to record additional charges that could adversely affect its operating results. Assessment of Long-Lived and Other Intangible Assets and Goodwill The Company is required to assess the potential impairment of identified intangible assets, long-lived assets and goodwill on an annual basis, and potentially more frequently if events or changes in circumstances indicate that the carrying value may not be recoverable. Factors the Company considers important which could trigger an impairment review include the following:
When it is determined that the carrying value of intangible assets, long-lived assets or goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we test for recoverability based on an estimate of future undiscounted cash flows as compared to the long-lived assets or goodwill’s carrying value. If the initial test for recovery fails, measurement of impairment is based on the Company’s projected discounted cash flow, which
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Table of Contentsrequires the Company to make significant estimates and assumptions regarding future revenue and expenses, projected capital expenditures, changes in the Company’s working capital and the relevant discount rate. Should actual results differ significantly from current estimates, impairment charges may result. Income Taxes The Company accounts for income taxes under the provisions of Statement of Financial Accounting Standards, or SFAS, No. 109, Accounting for Income Taxes. Under this method, the Company determines deferred tax assets and liabilities based upon the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. The tax consequences of most events recognized in the current year’s financial statements are included in determining income taxes payable. However, because tax laws and financial accounting standards differ in their recognition and measurement of assets, liabilities, equity, revenue, expenses, gains and losses, differences arise between the amount of taxable income and pretax financial income and between the tax bases of assets or liabilities and their reported amounts in the financial statements. Because it is assumed that the reported amounts of assets and liabilities will be recovered and settled, respectively, a difference between the tax basis of an asset or a liability and its reported amount in the balance sheet will result in a taxable or a deductible amount in some future years when the related liabilities are settled or the reported amounts of the assets are recovered, resulting in a deferred tax liability or deferred tax asset. In preparing condensed consolidated financial statements, the Company assesses the likelihood that deferred tax assets will be realized from future taxable income. The Company establishes a valuation allowance if the Company determines that it is more likely than not that some portion of the deferred tax assets will not be realized. Changes in the valuation allowance, when recorded, would be included in the Company’s consolidated statements of operations as a provision for (benefit from) income taxes. SiRF exercises significant judgment in regards to estimates of future market growth, forecasted earnings and projected taxable income, in determining provision for income taxes, deferred tax assets and liabilities for purposes of assessing the Company’s ability to utilize any future tax benefit from deferred tax assets. Net Income (Loss) Per Share Basic net income (loss) per share is calculated by dividing net income by the weighted average number of common shares outstanding, excluding the weighted average unvested common shares subject to repurchase. Diluted net income (loss) per share is computed giving effect to all potential dilutive common stock including stock options, stock warrants, common stock subject to repurchase, restricted stock units and potential shares associated with employee stock purchase plan withholding. The reconciliation of the numerators and denominators used in computing basic and diluted net income (loss) per share for the three and six months ended June 31, 2006 and 2005 is as follows:
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Table of ContentsThe net loss for the three months ended March 31, 2006 was $11.0 million, as previously disclosed in SiRF’s March 31, 2006 Form 10-Q. The net loss per diluted common share should have been disclosed as $0.22 per diluted share based on 50,179,000 weighted average shares outstanding, which is equivalent to the reported net loss per basic common share. This corrected presentation of diluted earnings per share is necessitated by generally accepted accounting principles, which excludes the effects of anti-dilution when calculating diluted earnings per share. The following table presents a numerical comparison of the amounts and shares previously reported as compared to the corrected presentation for the three months ended March 31, 2006:
The following common stock equivalents, which could potentially dilute basic net income per share in future periods, were excluded from the computation of diluted net income (loss) per share in the periods presented, as their effect would have been anti-dilutive:
Research and Development and Software Development Costs Research and development expense is charged to operations as incurred. To the extent research and development costs include the development of embedded software, the Company believes that software development is an integral part of the semiconductor design and such costs are expensed as incurred until technological feasibility has been established, at which time any additional costs would be capitalized in accordance with SFAS No. 86, Computer Software To Be Sold, Leased or Otherwise Marketed. The costs to develop such software have not been capitalized as the current software development process is essentially completed concurrent with the establishment of technological feasibility and the time period between the establishment of technological feasibility and product release is relatively short.
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Table of ContentsSiRF generates engineering services income with various commercial customers thereby enabling them to accelerate their product development efforts. SiRF retains ownership of the technology developed under these arrangements. Such development income has moderately contributed to the funding of SiRF’s product development activities. Development costs related to the underlying contracts are classified as research and development expense, and any income generated is classified as a reduction of research and development expense. Engineering services are billed in accordance with the terms and conditions of the related contracts, which may allow progress billings upon costs incurred, completion, or other billing arrangements. Engineering services income is recognized as a reduction of research and development expense only if the customer accepts the delivery of a given milestone, and collectibility is probable. Advance contract billings include amounts that have been invoiced, for which SiRF has not yet received acceptance of the deliverable from the customer, and result in the deferral of income until such time that specified milestones are accepted. The following table summarizes these services:
Indemnifications From time to time the Company enters into types of contracts that contingently require SiRF to indemnify parties against third party claims. These contracts primarily relate to: (i) real estate leases, under which the Company may be required to indemnify property owners for environmental and other liabilities, and other claims arising from use of the applicable premises; (ii) agreements with the Company’s officers, directors and employees, under which SiRF may be required to indemnify such persons from liabilities arising out of their employment relationship; and (iii) agreements with customers to purchase chip sets and to license the Company’s IP core technology or embedded software, under which the Company may indemnify customers for intellectual property infringement claims, product liability claims or recall campaign claims related specifically to the Company’s products. As for indemnifications related to intellectual property, these guarantees generally require the Company to compensate the other party for certain damages and costs incurred as a result of third party intellectual property claims alleged against the Company’s products. As for indemnifications related to product liability claims, these guarantees generally require the Company to compensate the other party for death or destruction stemming from use of the Company’s products. As for indemnifications related to recall campaigns, these guarantees generally require the Company to compensate the other party for costs related to the repair or replacement of defective products. The nature of the intellectual property indemnification, the product liability indemnification, and the recall campaign indemnification prevents the Company from making a reasonable estimate of the maximum potential amount it could be required to pay to its customers and suppliers in the event the Company is required to meet its contractual obligations. Historically, the Company has not made any significant indemnification payments under such agreements and no amount has been accrued in the accompanying condensed consolidated financial statements with respect to these indemnification obligations. Foreign Currency During the fourth quarter of 2005, SiRF reevaluated its functional currency determination due to acquisitions that occurred during fiscal year 2005 and growth of the foreign subsidiaries in both volume and size. As a result, SiRF changed the functional currency for all its foreign subsidiaries to the US dollar. Previously, the functional currency of SiRF’s foreign subsidiaries’ was deemed to be the local currency, with all translation adjustments included as a separate component of stockholders’ equity within ‘Accumulated other comprehensive loss’ on the balance sheet. At the time the original determination of functional currency was made, there were only two foreign subsidiaries which were not material to SiRF and resulting effects of foreign currency translation were insignificant. This policy change did not have a material effect on SiRF’s results of operations or financial position. Product Warranty SiRF provides for the estimated cost of product warranties at the time revenue is recognized. SiRF continuously monitors chip set returns for product failures and maintains a warranty reserve for the related expenses based on historical experience of similar products, as well as other assumptions that SiRF believes to be reasonable under the circumstances. SiRF’s product warranty reserve includes specific accruals for known product issues and an accrual for an estimate of incurred but unidentified product issues based on historical activity. SiRF’s warranty accrual is based on historical activity and the related expense was not significant for the periods presented.
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Table of ContentsSegment Reporting SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, or SFAS No. 131, establishes standards for the reporting of information about operating segments, including related disclosures about products and services, geographic areas and major customers. Based on the criteria stated in SFAS No. 131 for determining separately reportable operating segments, SiRF determined it operates as a single operating and reportable segment under SFAS No. 131. Recent Accounting Pronouncements Accounting for Sabbatical Leave and Other Similar Benefits In June 2006, the Financial Accounting Standards Board, or FASB, ratified Emerging Issues Task Force, or EITF, Issue No. 06-02, “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43, Accounting for Compensated Absences,” or EITF 06-02. A sabbatical leave is a benefit provided to employees whereby the employee is entitled to time off with pay, over and above routine vacation time, after working for a specified period of time. EITF 06-02 concluded that an employee’s right to a compensated absence under a sabbatical or similar benefit arrangement does accumulate pursuant to FASB Statement No. 43, “Accounting for Compensated Absences” and therefore, a liability should be accrued over the service period in which employees earn the right to sabbatical leave. EITF 06-02 is effective for fiscal years beginning after December 15, 2006, and may be applied by recognizing a cumulative effect of the change in accounting principle recorded as an adjustment to the beginning balance of retained earnings or through retrospective application. Currently, SiRF has accrued for the expense related to sabbatical leave when the employee fully vests. SiRF plans to implement EITF 06-02 by recognizing a cumulative effect of the change accounting principle recorded as an adjustment to the beginning balance of retained earnings at January 1, 2007 and is still evaluating the impact of the adoption of EITF 06-02; however, it will likely have a material impact on the Company’s consolidated results of operations, financial position and statement of cash flows, as the Company would be required to recognize an additional liability and corresponding operating expense for its existing sabbatical program. Accounting for Uncertainty in Income Taxes In July 2006, the FASB issued Financial Accounting Standards Interpretation, or FIN, No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109,” or FIN 48. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 utilizes a two-step approach for evaluating tax positions. Step one, Recognition, occurs when a company concludes that a tax position is more likely than not to be sustained upon examination. Step two, Measurement, is based on the largest amount of benefit, which is more likely than not to be realized on ultimate settlement. FIN 48 is effective for fiscal years beginning after December 15, 2006, with the cumulative effect of the change in accounting principle recorded as an adjustment to the beginning balance of retained earnings. The Company is currently assessing FIN 48 and has not determined the impact, if any, that the adoption of FIN 48 will have on its results of operations. Share-Based Payment Effective January 1, 2006, SiRF adopted SFAS No. 123R, Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock-Based Compensation. SFAS No. 123R supersedes Accounting Principles Board, or APB, Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. In March 2005, the SEC issued Staff Accounting Bulletin, or SAB, No. 107, regarding the SEC’s interpretation of SFAS No. 123R and the valuation of share-based payments for public companies. SFAS No. 123R permits public companies to adopt its requirements using one of two methods: the modified-prospective method or the modified-retrospective method. Under SFAS No. 123R, the pro-forma disclosures previously permitted will no longer be an alternative to financial statement recognition. Upon adoption of SFAS No. 123R in the first quarter of fiscal 2006, SiRF has applied the Black-Scholes option pricing model to determine the fair value of share-based payments to employees and have elected to apply the modified prospective method, which requires that compensation expense be recorded for all unvested stock options, restricted stock and restricted stock units, for all new stock options, restricted stock and restricted stock unit grants and elimination of any deferred stock compensation recorded in the balance sheet as of January 1, 2006.
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Table of ContentsSFAS No. 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under previous accounting literature. This requirement has reduced net operating cash flows and increased net financing cash flows for the six months ended June 30, 2006 by approximately $17.4 million. Prior to the adoption of SFAS No. 123R, SiRF accounted for share-based payments to employees using APB Opinion No. 25’s intrinsic value method and, as such, generally recognized no compensation cost for employee stock options. During the three and six months ended June 30, 2006, SiRF recognized approximately $6.9 million and $11.6 million, respectively, of total employee stock-based compensation. The requirements of SFAS No. 123R and SAB No. 107 had a material adverse impact on SiRF’s condensed consolidated results of operations and earnings per share. See Note 3, Stock-Based Compensation, below for further discussion of SiRF’s SFAS No. 123R adoption and the corresponding impact on our financial results. Note 2. Acquisitions Development-Stage Company On March 14, 2006, SiRF acquired TrueSpan Incorporated, or TrueSpan, a development-stage company specializing in systems communication. The aggregate purchase consideration for this acquisition was approximately $18.0 million, which includes direct transaction costs and cash acquired and excludes the fair value of assumed unvested TrueSpan stock options, issuance of unvested SiRF restricted stock units and future contingent payments. Such contingent payments will be made to certain former TrueSpan employees contingent upon their continued employment with SiRF and will not exceed $3.0 million. These contingent payments will result in compensation expense amortized on a straight-line basis over the related two-year service period. TrueSpan did not have a developed product, had no customers and was not generating revenue. Accordingly, the Company concluded the TrueSpan acquisition did not met the criteria to be accounted for as an acquisition of a “business” under the requirements of SFAS No. 141, Business Combinations, as TrueSpan did not possess the ability to generate outputs in order to continue normal operations and generate a revenue stream by providing its products to customers. The negative excess of the fair value of the net assets acquired over purchase consideration was allocated on a proportionate basis to reduce the fair value of non-monetary assets acquired. The total fair value of net assets acquired, as adjusted for the allocation of excess fair value over purchase consideration, consisted of current assets of $1.2 million, property and equipment of $0.2 million, identified amortizable intangible assets of $1.0 million, net deferred tax assets of $3.4 million, less current liabilities assumed of $0.9 million and recognition of $13.3 million of charges for acquired in-process research and development. The in-process research and development projects had not yet reached technological feasibility at the time of acquisition. These projects will require substantial additional investment relative to the fair value of the transferred set of assets acquired and were at least a year away from commercial viability. The acquisition of TrueSpan, a technology company with significant communications systems expertise, is intended to add to SiRF’s systems expertise as the Company expands its offerings to include complex multifunction and location technology platform solutions. In connection with the TrueSpan acquisition, SiRF issued 214,931 restricted stock units, which are contingent upon the continued employment of the recipients, with the contingency being released over four years. SiRF also issued of 53,791 restricted stock units, which are contingent upon the achievement of specified milestones and the continued employment of the recipients over a period of two years. The fair value of the restricted stock units is approximately $10.0 million based upon the average SiRF stock price a few days before and after the acquisition announcement date on March 16, 2006 in accordance with EITF 99-12, Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination, which will be amortized as compensation expense on a straight-line basis over the service period. SiRF has concluded that this acquisition is insignificant in accordance with the SEC’s Regulation S-X requirements and therefore has not presented pro-forma financial information with respect to this acquisition. SiRF included the results of operations of this transaction prospectively from the date of transaction closing. Businesses In fiscal 2005, we acquired Kisel Microelectronics, AB, a privately held limited liability company, or Kisel, based in Stockholm, Sweden, the GPS chip set product line of Motorola, Inc., a Delaware corporation, or Motorola, and Impulsesoft, a privately held software company based in Bangalore, India. SiRF has concluded that these acquisitions were insignificant on an individual basis and on an aggregate basis in accordance with the SEC’s Regulation S-X requirements and therefore has not presented pro-forma financial information with respect to these acquisitions.
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Table of ContentsIn connection with the Kisel acquisition on April 28, 2005, SiRF issued 784,926 shares of common stock which are contingent upon the continued employment of the recipients, with the contingency being released over four years. The approximate $8.9 million fair value related to these shares of common stock is being amortized as compensation expense over the service period using the accelerated method prescribed by the Financial Accounting Standards Board Interpretation, or FIN, No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans. Certain adjustments to the aggregate purchase consideration for Kisel will be recorded in future periods as contingent cash payments are made to certain former Kisel shareholders upon achievement of certain milestones. Such contingent payments will not exceed $3.7 million and will result in an increase in goodwill related to this acquisition. During the second quarter of fiscal 2006, SiRF recorded approximately $1.8 million in contingent cash payments to certain former Kisel shareholders upon achievement of certain milestones, which resulted in an increase in goodwill related to this acquisition. In connection with the acquisition of Motorola’s GPS chip set product line on June 1, 2005, SiRF issued options to purchase 465,500 shares of SiRF common stock and 142,000 restricted stock units. The approximate $2.2 million fair value related to these restricted stock units is being amortized as compensation expense over the service period using the accelerated method prescribed by FIN No. 28. These common stock options and restricted stock units are contingent upon the continued employment of the recipients, with the contingency being released over four years. During the second quarter of fiscal 2006, SiRF recorded a purchase accounting adjustment to de-recognize a portion of an acquisition related prepaid asset that was no longer realizable, which resulted in an increase of approximately $0.3 million in goodwill related to this acquisition. In connection with the acquisition of Impulsesoft on December 24, 2005, SiRF issued 119,134 restricted stock units, with an approximate fair value of $3.5 million, which is being amortized as compensation expense over the service period using the accelerated method prescribed by FIN No. 28. The restricted stock units are contingent upon the continued employment of the recipients, with the contingency being released over four years. In addition, future contingent payments will be made to certain former Impulsesoft shareholders contingent upon their continued employment with SiRF, which will not exceed $2.2 million and will result in compensation expense recorded over the related two-year service period. Note 3. Stock-Based Compensation On January 1, 2006, SiRF adopted the provisions of SFAS No. 123R. SFAS No. 123R establishes accounting for stock-based awards exchanged for employee services. Accordingly, stock-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized as expense over the requisite service period. SiRF accounts for equity instruments issued to non-employees in accordance with EITF Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. Under EITF Issue No. 96-18, compensation expense for non-employee stock options is calculated using the Black-Scholes option pricing model and is recorded as the shares underlying the options are earned. The unvested shares underlying the options are subject to periodic revaluation over the remaining vesting period, as these options have similar characteristics to our employee options. Prior to the adoption of SFAS No. 123R Prior to the adoption of SFAS No. 123R, SiRF applied the intrinsic-value-based method prescribed in APB Opinion No. 25 in accounting for employee stock option plans, our 2004 Employee Stock Purchase Plan, or the Purchase Plan, rights and other stock-based compensation, and complied with the disclosure provisions of SFAS No. 123, as amended by SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosures. Under APB Opinion No. 25, SiRF recognized compensation expense when it issued equity awards such as restricted stock and restricted stock units or granted common stock options with a discounted exercise price, and recognized any resulting compensation expense over the associated service period, which was generally the award or option vesting term. SiRF recognized compensation expense related to restricted stock, restricted stock units and common stock options using a multiple option valuation approach in accordance with FIN No. 28. Prior to there being a public market for SiRF’s common stock, the Board of Directors determined the deemed fair value of the Company’s common stock based on factors such as the sale of SiRF’s preferred stock, results of operations and consideration of the fair value of comparable publicly traded companies. Prior to the adoption of SFAS No. 123R, SiRF provided the disclosures required under SFAS No. 123. The pro forma effect on net income and net income per share as if the fair value of stock-based compensation had been recognized as compensation expense for the three and six months ended June 30, 2005 was as follows:
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The information above regarding net income and net income per share was prepared in accordance with SFAS No. 123 and has been determined as if SiRF accounted for employee stock options and purchase rights under the 2004 Employee Stock Purchase Plan, or the Purchase Plan, under the fair value method prescribed by SFAS No. 123, and provisions of FASB Technical Bulletin 97-1, Accounting under Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option. For purposes of pro forma disclosures, the estimated fair value of the Purchase Plan rights is amortized over the individual accumulation periods comprising the offering period, subject to modification on the date of purchase, on an accelerated basis, in accordance with FIN No. 28. The fair value for options granted prior to February 10, 2004, SiRF’s initial filing date of its Form S-1 with the Securities and Exchange Commission, was estimated at the date of grant using the minimum value method. Options granted on or after February 10, 2004 have been valued using the Black-Scholes option pricing model. Adoption of SFAS No. 123R SiRF elected to adopt the modified prospective application method as provided by SFAS No. 123R. Accordingly, during the second quarter and first half of fiscal 2006, SiRF recorded stock-based compensation cost totaling the amount that would have been recognized had the fair value method been applied since the effective date of SFAS No. 123. Previously reported financial statements have not been restated. The effect of recording employee stock-based compensation for the second quarter and first half of fiscal 2006 were as follows:
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Table of ContentsThe fair value of SiRF’s stock options and the Purchase Plan rights was estimated using a Black-Scholes option pricing model. This model requires the input of highly subjective assumptions, along with certain policy elections in adopting and implementing SFAS No. 123R, including the options’ expected life and the price volatility of the Company’s underlying stock. Actual volatility, expected lives, and interest rates may be different than the Company’s assumptions which would result in an actual value of the options being different than estimated. The fair value of stock-based awards is amortized over the requisite service period of the award using the straight-line attribution method for awards granted after the adoption of SFAS No. 123R and continue to use the multiple option valuation approach for awards granted prior to the adoption of SFAS No. 123R. Expected Term: SiRF’s expected term represents the period that SiRF’s stock options are expected to be outstanding and was determined based on the accounting guidance provided within SAB No. 107. SAB No. 107 provides a simplified method for determining the expected term of “plain vanilla” options, as defined by SAB No. 107, under certain circumstances. As SiRF’s options are considered “plain vanilla” and no awards have been issued with a market condition, SiRF has elected to use this simplified method as it has limited historical exercise data or alternative information to reasonably estimate an expected term assumption. The simplified method assumes that all options will be exercised midway between the vesting date and the contractual term of the option. SiRF will utilize this simplified method as provided within SAB No. 107 only for stock option grants through December 31, 2007 (the maximum allowed transition period per SAB No. 107). During the transition period, SiRF will evaluate its expected term assumption to consider among other things, historical exercise patterns, the contractual terms of the stock-based awards, vesting schedules and expectations of future employee behavior. During the second quarter and first half of fiscal 2006, SiRF’s estimated expected term was approximately 4.57 and 4.97 years, respectively, based upon the simplified method provided by SAB No. 107, as compared to approximately 2.96 years during the second quarter and first half of fiscal 2005, which was estimated utilizing a weighted average calculated based on the vesting term of the underlying options. Expected Volatility: SiRF utilized its own historical and implied volatility in valuing its stock option grants. SiRF also evaluated the historical and implied volatility of “guideline” companies selected based on similar industry and product focus whose share or option prices have been publicly traded for a longer period of time as a baseline volatility benchmark to evaluate the reasonableness of its volatility assumption. During the second quarter of fiscal 2006, the volatility used to value employee stock options was 50% and the volatility used to value the purchase rights under the Purchase Plan was 55%. Expected Dividend: The Black-Scholes option pricing model calls for a single expected dividend yield as an input. SiRF has not issued any dividends, nor does it expect to issue dividends in the near future; therefore, a dividend yield of zero was used. Risk-Free Interest Rate: SiRF bases the risk-free interest rate used in the Black-Scholes option pricing model on the implied yield currently available on U.S. Treasury zero-coupon issues with an equivalent expected term. Estimated Pre-vesting Forfeitures: SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised if necessary in subsequent periods if actual forfeitures differ from those estimates. SiRF has considered historical termination behavior, as well as retention related incentives in its forfeiture estimation process. The fair value of stock options and new ESPP purchase rights were estimated with the following weighted-average assumptions:
The weighted average fair value of options granted with an exercise price equal to the deemed fair value of common stock utilizing the Black-Scholes option pricing model during the second quarter of fiscal 2006 and 2005, was $16.03 and $5.47, respectively. The weighted average fair value of options granted with an exercise price equal to the deemed fair value of common stock utilizing the Black-Scholes option pricing model during the first half of fiscal 2006 and 2005, was $16.56 and $5.25, respectively. No options were granted in the second quarter or first half of fiscal 2006 or 2005 with exercise prices below the deemed fair value of common stock.
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Table of ContentsThe estimated fair value of ESPP purchase rights is amortized over the individual accumulation periods comprising the offering period. The weighted average fair value of new ESPP purchase rights was $14.35 during the second quarter and first half of fiscal 2006. Stock Option and Employee Stock Purchase Plans 1995 Stock Plan In March 1995, SiRF adopted the 1995 Stock Plan, or the 1995 Plan, to provide incentive and non-statutory stock options to purchase shares of common stock to employees and independent contractors. Under the 1995 Plan, the exercise price for incentive stock options is at least 100% of the stock’s fair market value on the date of grant for employees owning 10% or less of the voting power of all classes of stock, and at least 110% of the fair market value on the date of grant for employees owning more than 10% of the voting power of all classes of stock. For non-statutory stock options, the exercise price is at least 110% of the fair market value on the date of grant for employees owning more than 10% of the voting power of all classes of stock and no less than 85% for employees owning 10% or less of the voting power of all classes of stock. The 1995 Plan was terminated upon the completion of SiRF’s initial public offering in April 2004. No shares of the Company’s common stock remain available for issuance under the 1995 Plan other than for satisfying exercises of stock options granted under this plan prior to its termination. As of June 30, 2006, no shares of common stock have been reserved for issuance under the 1995 Plan and options to purchase a total of 3,959,960 shares of common stock were outstanding. Options generally vest over a period of four years, generally become exercisable beginning six months from the date of employment or grant and expire ten years from the date of grant. Unvested common stock issued to employees, directors and consultants under stock purchase agreements is subject to repurchase at the Company’s option upon termination of employment or services at the original purchase price. This right to repurchase expires ratably over the vesting period. 2004 Stock Incentive Plan In March 2004, SiRF adopted the 2004 Stock Incentive Plan, or the 2004 Plan, and on April 22, 2004, the remaining 19,558 stock options not granted under the 1995 Plan were cancelled. Under the 2004 Plan, 5,000,000 shares of common stock were reserved for issuance upon the completion of the Company’s initial public offering. On January 1 of each year, starting in 2005, the aggregate number of shares reserved for issuance under the 2004 Plan increase automatically by the lesser of (i) 5,000,000 shares, (ii) 5% of the total number of shares of common stock outstanding at that time, or (iii) a number of shares determined by the Board of Directors. Forfeited options or awards generally become available for future awards. Under the 2004 Plan, the exercise price for incentive stock options is at least 100% of the stock’s fair market value on the date of grant for employees owning 10% or less of the voting power of all classes of stock, and generally not available to employees owning more than 10% of the voting power of all classes of common stock. For non-statutory stock options, the exercise price is no less than 85% of the stock’s fair market value on the date of grant. Under the 2004 Plan, options generally expire between seven and ten years. However, the term of the options may be limited to five years if the optionee owns stock representing more than 10% of the voting power of all classes of stock. Vesting periods are determined by the Company’s Board of Directors and generally provide for shares to vest ratably over a four-year period. As of June 30, 2006, 4,391,721 options to purchase common stock and 777,454 unvested shares granted were outstanding and 4,379,963 options were available for issuance under the 2004 Plan. 2004 Employee Stock Purchase Plan In March 2004, SiRF adopted the 2004 Employee Stock Purchase Plan, or the Purchase Plan. Under the Purchase Plan, 1,000,000 shares were reserved for issuance upon the Company’s completion of the initial public offering. On January 1 of each year, starting in 2005, the number of shares reserved for issuance automatically increase by the lesser of (i) 750,000 shares, (ii) 1.5% of issued and outstanding shares of common stock on the last day of the immediately preceding fiscal year, or (iii) a number of shares determined by the Board of Directors. Eligible employees are allowed to have salary withholdings of up to 15% of cash compensation to purchase shares of common stock at a price equal to 85% of the lower of the fair market value of the stock on the first trading day of the offering period or the fair market value on the purchase date. The initial offering period commenced on April 22, 2004, the effective date for the initial public offering of SiRF’s common stock. There were 147,232 shares of common stock issued under the Purchase Plan with weighted-average purchase price of $11.52 during the second quarter of fiscal 2006. As of June 30, 2006, there were 1,999,561 shares available for issuance under the Purchase Plan.
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Table of ContentsTrueSpan 2004 Stock Incentive Plan In March 2006, in conjunction with the acquisition of TrueSpan, SiRF assumed the existing TrueSpan 2004 Stock Incentive Plan, or the TrueSpan Plan. All unvested options granted under the TrueSpan Plan were assumed by SiRF as part of the acquisition. All contractual terms of the assumed options remain the same, except for the converted number of shares and exercise price based on an exchange ratio determined as part of the acquisition. As of June 30, 2006, no additional options can be granted under the TrueSpan Plan and options to purchase a total of 29,032 shares of common stock were outstanding. Outstanding Stock Options The following table summarizes information about options granted and outstanding under the 2004 Plan, 1995 Plan and the TrueSpan Plan at June 30, 2006:
The aggregate intrinsic value in the table above is based on SiRF’s closing stock price of $32.22 as of June 30, 2006, which would have been received by the option holders had all option holders exercised their options as of that date. The weighted average remaining contractual term of options exercisable at June 30, 2006 was approximately 6.27 years. A summary of stock option activity as of June 30, 2006 is presented below:
As of June 30, 2006, there was approximately $30.6 million of total unrecognized compensation cost related to unvested stock options granted and outstanding with a weighted average remaining vesting period of 2.1 years. Net cash proceeds from the exercise of stock options were approximately $7.2 million and $3.0 million for first half of fiscal 2006 and 2005, respectively. The aggregate intrinsic value of options exercised during the first half of fiscal 2006 based on the aggregate weighted average exercise price and SiRF’s closing stock price of $32.22 as of June 30, 2006, was approximately $38.8 million.
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Table of ContentsA summary of restricted stock unit activity as of June 30, 2006 is presented below:
The fair value of the Company’s acquisition related restricted stock units was calculated based upon the fair market value of the Company’s stock at the date of grant or as determined under EITF 99-12, Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination. As of June 30, 2006, there was $23.7 million of total unrecognized compensation cost related to unvested restricted stock units granted, which is expected to be recognized over a weighted average period of 3.1 years. As of June 30, 2006, there was $0.9 million of total unrecognized compensation cost related to the Purchase Plan rights that is expected to be recognized over the remaining accumulation periods comprising the offering periods. Deferred Stock Compensation SiRF recorded deferred stock compensation of approximately $14.6 million for the year ended December 31, 2005 in connection with the acquisition of Kisel, Motorola’s GPS chipset product line and Impulsesoft. No deferred stock compensation was recorded in 2005 in connection with options granted to employees to purchase common stock. See Note 2, Acquisitions, above for further discussion of the stock-based awards issued in conjunction with these acquisitions. In connection with the acquisition of TrueSpan, SiRF issued 214,931 restricted stock units, which are contingent upon the continued employment of the recipients, with the contingency being released over four years. SiRF also issued 53,791 restricted stock units, which are contingent upon the achievement of specified milestones and the continued employment of the recipients over a period of two years. The fair value of the restricted stock issuance is approximately $10.0 million based upon the average SiRF stock price a few days before and after the acquisition announcement date on March 16, 2006 in accordance with EITF 99-12, Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination, which will be amortized as compensation expense on a straight-line basis over the service period. There was no deferred stock compensation recorded after the adoption of SFAS No. 123R. Prior to the adoption of SFAS No. 123R, the deferred charges for common stock, restricted stock units and employee common stock options were amortized as compensation expense over the service period, using a multiple option valuation approach, on an accelerated basis in accordance with FIN No. 28. Upon the adoption of SFAS No. 123R, SiRF reversed the remaining previously recorded deferred stock compensation expense of approximately $11.7 million to additional paid-in capital. The remaining stock compensation expense associated with equity awards units granted prior to the adoption of SFAS No. 123R will continue to be recorded as compensation expense over the service period, using a multiple option valuation approach, on an accelerated basis in accordance with FIN No. 28. The stock compensation expense associated with equity awards granted after the adoption of SFAS No. 123R will be recorded as compensation expense over the service period, on a straight-line basis. Note 4. Inventories Inventories consist of the following:
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Table of ContentsNote 5. Segment and Geographical Information As discussed in Note 1, SFAS No. 131 establishes standards for the reporting by business enterprises of information about operating segments, products and services, geographic areas, and major customers. The standard for determining what information to report is based on available financial information that is regularly reviewed and used by SiRF’s chief operating decision maker in evaluating our financial performance and resource allocation. SiRF’s chief operating decision-maker is considered to be the chief executive officer, or CEO. Based on the financial information available to and reviewed by the CEO, the Company has determined that it operates in a single operating segment. Geographic Information The following table summarizes net revenue by geographic region:
The Company determines geographic location of its revenue based upon the destination of shipment for all original equipment manufacturers and value-added manufacturer customers, and based upon distributor location for all its distributor customers. Note 6. Customer Concentration The following table summarizes net revenue as a percentage of total net revenue and accounts receivable as a percentage of total accounts receivable for customers that accounted for 10% or more of net revenue or net accounts receivable:
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Table of ContentsNote 7. Identified Intangible Assets Identified intangible assets at June 30, 2006, consist of the following:
As discussed in Note 2, SiRF acquired a development stage company in the first quarter of fiscal 2006, resulting in an increase in acquisition-related intangible assets. Identified intangible assets at December 31, 2005, consist of the following:
Amortization expense of acquisition-related intangible assets was $1.4 million and $2.7 million for the three and six months ended June 30, 2006, respectively, and $1.3 million and $2.4 million for the three and six months ended June 30, 2005, respectively. Amortization of intellectual property assets was $0.2 million and $0.3 million for the three and six months ended June 30, 2006, respectively, and $0.1 million and $0.2 million for the three and six months ended June 30, 2005, respectively, and was included in research and development expense. Estimated future amortization expense related to identified intangible assets at June 30, 2006 is as follows:
Note 8. Deferred Margin on Shipments to Distributors Revenue on shipments made to distributors under agreements allowing right of return and price protection is deferred until the distributors sell the merchandise. Deferred revenue under these agreements and deferred cost of sales related to inventories held by distributors are as follows:
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Table of ContentsNote 9. Comprehensive Income (Loss) The Components of comprehensive income (loss), net of tax, are as follows:
Note 10. Long-Term Obligations The Company maintains a short-term revolving line of credit under which it may borrow up to $5.0 million, including $5.0 million in the form of letters of credit, with an interest rate equal to the greater of (i) 1% percentage point above the prime rate (8.25% of June 30, 2006) or (ii) 5.25%. The line of credit is available through February 2007 and is secured by substantially all of SiRF’s assets. There were no borrowings under the line of credit as of June 30, 2006 or December 31, 2005. There were no letters of credit collateralized by the line of credit as of June 30, 2006 or December 31, 2005. Note 11. Related Party Transactions Certain customers and/or suppliers of the Company, who are also common stockholders and/or have a common board member, are considered as related parties. The Company entered into an agreement with Skyworks Solutions, Inc., or Skyworks, to manufacture some of its chip set products. One of SiRF’s board members, Moiz Beguwala, is also a board member of Skyworks. In the three and six months ended June 30, 2006, SiRF purchased zero products from Skyworks. In the three and six months ended June 30, 2005, SiRF purchased approximately $0.1 million and $0.3 million of product from Skyworks, respectively. As of June 30, 2006, SiRF did not have any trade payables to Skyworks and had approximately $0.2 million of non-cancelable purchase orders with Skyworks. As of December 31, 2005, SiRF did not have any trade payables to Skyworks and had an insignificant amount of non-cancelable purchase orders with Skyworks. As discussed above in Note 2, Acquisitions, during the first quarter of fiscal 2006, SiRF acquired TrueSpan, a development-stage company specializing in systems communication. One of SiRF’s board members, Diosdado P. Banatao, is a founder of Tallwood Venture Capital, or Tallwood, a venture capital firm focusing on semiconductors and semiconductor related technologies. Tallwood was an investor in TrueSpan and owned 4.0 million shares of preferred stock at the time of acquisition. Diosdado P. Banatao recused himself from the Company’s decision to acquire TrueSpan. There was no preferential treatment given to Tallwood as part of this acquisition, the preferred stock owned by Tallwood was purchased at the same payout rate as other holders of preferred stock. Note 12. Commitments and Contingencies SiRF may be subject to claims, legal actions and complaints, including patent infringement, arising in the normal course of business. The likelihood and ultimate outcome of such an occurrence is not presently determinable; however there can be no assurance that SiRF will not become involved in protracted litigation regarding alleged infringement of third party intellectual property rights or litigation to assert and protect the Company’s patents or other intellectual property rights. Any litigation relating to patent infringement or other intellectual property matters could result in substantial cost and diversion of SiRF’s resources that could materially and adversely affect the Company’s business and operating results. On August 5, 2005, SiRF’s subsidiary, SiRF Technology, Inc., filed a complaint against u-Nav Microelectronics, or u-Nav, in the United States District Court for the Central District of California. The complaint alleges infringement by u-Nav of three patents assigned to SiRF Technology, Inc. and seeks both monetary damages and an injunction to prevent further infringement. In January 2006, u-Nav counterclaimed by alleging that one of its patents was infringed by SiRF’s subsidiary. On June 6, 2006, SiRF Technology, Inc. filed a second amended complaint with the Court adding four additional patents to its claims of infringement against u-Nav, and u-Nav counterclaimed on the same day alleging that our subsidiary infringed a second patent. Discovery in this case is continuing, and a trial date has been set for July 24, 2007. The outcome of any litigation, including the lawsuit against u-Nav, is uncertain and either favorable or unfavorable outcomes could have a material impact.
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Table of ContentsLeases The Company leases facilities and certain equipment under operating lease agreements, which require payment of property taxes, insurance and normal maintenance costs. Many of the Company’s facility leases contain renewal options, which provide the option to extend its lease based upon the terms of the agreement. These renewal options do not represent a future commitment on behalf of the Company. In conjunction with the acquisition and other facility lease renewals during the first and second quarters of fiscal 2006, the Company’s future minimum rental payments required under capital and operating leases and the present value of annual minimum lease payments under capital leases are as follows:
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Table of ContentsItem 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations This report on Form 10-Q contains forward-looking statements, including, but not limited to, statements about our operating segment, our expectations regarding the amount of our net revenue from sales to the Asia/Pacific region, our belief that a significant amount of the systems designed and manufactured by customers in the Asia/Pacific region are subsequently sold to original equipment manufacturers outside of that region, the expected growth of the LBS market and its impact on our business, our dependency on establishing and maintaining relationships with established providers and industry leaders, increases in research and development costs, sales and marketing expenses and general and administrative expenses, stock-based compensation charges and amortization of intangible assets, our granting of stock options, adjustments for our tax liability, expansion of our engineering group, expansion of our product lines, enhancing our efficiencies in logistic management, anticipated benefits of our recent acquisitions, the success of SiRFStarIII and SiRFLoc and the importance of their success on our revenue growth, our ability to meet market demand for low power and small size GPS functionality products, impact from changes in interest rates, our profitability, our critical accounting policies and impact of recent accounting pronouncements, our gross margins, our expenses, our revenues and sources of revenues, our anticipated cash needs, our estimates regarding our capital requirements, our needs for additional financing, price reductions, our dependency on relationships with and concentration of our customers, costs of being a public company, our disclosure controls and procedures, future acquisitions or investments, competition and our competitive position, our intellectual property including our ability to obtain patents in the future and protection of intellectual property in foreign countries and potential legal proceedings. These statements may be identified by such terms as “anticipate,” “believe,” “may,” “might,” “expect,” “will,” “intend,” “could,” “can,” or the negative of those terms or similar expressions intended to identify forward-looking statements. These forward-looking statements are subject to risks and uncertainties which may cause actual results to differ materially from those expressed or implied by the forward-looking statements. These risks and uncertainties include, but are not limited to, the development of the market for GPS-based location awareness technology, factors affecting our quarterly results, our sales cycle, price reductions, our dependence on and qualification of foundries to manufacture our products, production capacity, our ability to adequately forecast demand for our products, our customer relationships, our ability to compete successfully, our product warranties, the impact of our intellectual property indemnification practices and other risks discussed in “Risk Factors” in this report. These forward-looking statements represent our estimates and assumptions only as of the date of this report. Unless required by law, we undertake no responsibility to update these forward-looking statements. The following discussion of our financial condition and results of operations should be read together with the financial statements and related notes in this report. This discussion may contain forward-looking statements based upon current expectations that involve risks and uncertainties. These risks and uncertainties may cause actual results to differ materially from those discussed in the forward-looking statements. Overview We are a leading semiconductor supplier of Global Positioning System, or GPS, based location technology solutions designed to provide location awareness capabilities in high-volume mobile consumer and commercial systems. Our products have been integrated into mobile consumer devices such as mobile phones, automobile navigation systems, personal digital assistants, handheld navigation devices and GPS-based peripheral devices, and into commercial systems such as fleet management and road-tolling systems. As of June 30, 2006, we had an intellectual property portfolio of 136 patents granted in the United States and 39 patents granted in foreign countries. We market and sell our products to original equipment manufacturers, or OEMs, of three target platforms: wireless handheld devices, such as mobile phones; automotive electronics systems, including navigation and telematics systems; and consumer and compute devices, including personal digital assistants, notebook computers, recreational GPS handhelds, mobile gaming machines, digital cameras and watches. As we supply products that support multiple applications within these three target platforms, we do not have the ability to discreetly track separate financial information for each of these three target platforms. Additionally, we market and sell our products to value-added manufacturers, or VAMs, who typically provide GPS modules or sub-systems to the OEMs, and through intellectual property partners, who integrate our core technology into their products. Intellectual property partners are typically large semiconductor companies. As usage of GPS technology for high volume applications is generally in early stages of deployment, it is difficult to predict market growth or growth drivers reliably. While some of the applications, such as OEM automotive navigation systems, are well developed, most high-growth applications are just starting to emerge. In fiscal 2004, we saw the emergence of portable navigation systems as a new growth driver and in 2005 and in 2006 it continues to be a major driver in our growth. While the location based services, or LBS, market for wireless operators is in its early stages, we expect it to become a growth driver for our business starting the first half of 2007. Our long term growth depends on maintaining a leadership
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Table of Contentsposition in such markets and enabling multiple growth drivers across our target platforms. We are currently focusing significant efforts on enabling the end-to-end platform for successful LBS deployment by wireless operators and for other consumer applications. Successful alliances with wireless operators and service providers, mobile phone vendors, location based content providers and wireless platform providers are critical to our success in this emerging market. On March 14, 2006, we acquired TrueSpan Incorporated, or TrueSpan, a privately-held Delaware corporation, formed in August 2004 located in Long Beach, California and in Bangalore, India. The acquisition of TrueSpan, a technology company with significant communications systems expertise, is intended to add to our systems expertise as we expand our offerings to include complex multifunction and location technology platform solutions. We concluded the TrueSpan acquisition did not meet the criteria to be accounted for as an acquisition of a “business” under the requirements of SFAS No. 141, Business Combinations, as TrueSpan did not possess the ability to generate outputs in order to continue normal operations and generate a revenue stream by providing its products to customers. As such, we recognized $13.3 million of charges for acquired in-process research and development, which were projects that had not yet reached technological feasibility at the time of acquisition. These projects will require substantial additional investment relative to the fair value of the transferred set of assets acquired and were at least a year away from commercial viability at the time of acquisition. In fiscal 2005, we acquired Kisel Microelectronics, AB, a privately held limited liability company, or Kisel, based in Stockholm, Sweden, the GPS chip set product line of Motorola, Inc., a Delaware corporation, or Motorola, and Impulsesoft, a privately held software company based in Bangalore, India. The acquisition of Kisel on April 28, 2005, a company with extensive expertise in complex integrated transceiver designs, is intended to complement our existing RF engineering group as the design of RF transceivers is a critical core technology and is an essential element in complex multi-radio system solutions. The acquisition of Motorola’s GPS chip set product line on June 1, 2005, is intended to provide broader product offerings and better overall support infrastructure to serve Motorola and SiRF’s other customers worldwide, through the acquisition of a team with a critical mass of GPS expertise, product lines that complement our existing products and a strong customer base. As part of the Motorola acquisition we recognized $0.8 million of charges for acquired in-process research and development, which related to a project that had not yet reached technological feasibility at the time of acquisition. The acquisition of Impulsesoft on December 24, 2005, an expert in Bluetooth stereo solutions and embedded software, is intended to provide users of Bluetooth technology with a rich audio experience and deliver and support value-added embedded software solutions to complement our chip set offerings. In 2005, we launched a range of new products including: (a) the GSC3 family, our highly integrated, low-power GPS products, which are based on the SiRFstarIII architecture that combine radio frequency integrated circuit and a digital signal processing circuit in a single 7 mm x 10 mm package and (b) the GSC2 family, which combines radio frequency integrated circuit and a digital signal processing circuit in a single package with one third the power and half the size of it’s predecessor. In the second quarter of 2005, we started to ramp-up the first product line based on our SiRFstarIII architecture in volume production and now the SiRFstarIII architecture based products are the primary contributors to our revenue stream as we continue to see customers migrate from products based on our SiRFstarII architecture to products based on our SiRFstarIII architecture. Our SiRFLoc server platform is key to our success in penetrating the market for wireless operators and in the third quarter of 2005, one of our operator customers commenced deployment of our SiRFLoc server platform in their network and during the first half of fiscal 2006, another operator customer commenced deployment. Our SiRFSoft product family is not yet in high-volume commercial production. During the first half of fiscal 2006, we announced four new products: (a) SiRFLink, our first multifunction architecture and product line that utilizes the synergies between GPS and Bluetooth for a range of consumer platforms and accessories, (b) SiRFInstantFix, our unique service that minimizes the start-up wait time for GPS systems, (c) SiRFstarIII-LT, our most power-efficient and the smallest version of our flagship SiRFstarIII architecture ideal for a wide range of GPS enabled consumer mobile devices and (d) GSCi-5000, our extremely small multimode A-GPS chip, based on a new architecture, and optimized to address the space and cost constraints of cellular handsets. None of these product lines are in volume production as yet and we do not expect any significant revenue contribution from these product lines until late 2006. Strong interest and design win activity for these products, especially the SiRFstarIII based products are important for our revenue growth in 2006 and beyond. Our ability to develop and deliver new products successfully depends on a number of factors, including our ability to predict market requirements, anticipate changes in technology standards, and develop and introduce new products that meet market needs in a timely manner. We are seeing significant demand in the market for low power and small size GPS functionality. Our ability to meet these market requirements is a key element for our revenue growth. If we do not deliver new products on a timely basis or if these products do not achieve market acceptance, the variability of our revenue may increase and our revenue, earnings and stock price may decline.
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Table of ContentsOur markets are becoming more competitive resulting in increased pricing pressure on our products. While we believe that we have leading edge technology, our ability to compete and maintain current product margin levels depends on faster design cycle time and lower cost structure. In the first quarter of 2006 and in fiscal 2005, we acquired one development stage company and three businesses, respectively, intended to complement our existing engineering group and expand our product offerings. We also continue to enhance our efficiencies in logistics management and work with our semiconductor fabrication, packaging and testing vendors to reduce product costs, in an effort to maintain our overall cost structure. Our operations are directly impacted by cyclicality in the semiconductor industry, which is characterized by wide fluctuations in product supply and demand. This cyclicality could cause our operating results to decline dramatically from one period to the next. In addition to the sale of chip sets, our business depends on the volume of production by our technology licensees, which in turn, depend on the current and anticipated market demand for semiconductors and products that use semiconductors. For example, in the fourth quarter of 2004, our results were impacted by cyclicality of consumer demand, delay in production release of our first SiRFstarIII-based products, as well as lower than expected licensing revenues. If we are unable to control expenses adequately in response to lower revenue from our chip set customers and technology licensees, our financial condition and results of operations may be negatively impacted. We currently rely, and expect to continue to rely, on a limited number of customers for a significant portion of our net revenue. In the second quarter of 2006, we had three customers that each accounted for 10% or more of our net revenue, which collectively accounted for approximately 68% of our net revenue. In the first half of fiscal 2006, we had three customers that each accounted for 10% or more of our net revenue, which collectively accounted for approximately 65% of our net revenue. If we fail to successfully sell our products to one or more of our significant customers in any particular period, or if a large customer purchases fewer of our products, defers orders or fails to place additional orders with us, our net revenue could decline, and our operating results may not meet market expectations. In the first quarter of 2006, we adopted Statement of Financial Accounting Standards, or SFAS, No. 123R, Share-Based Payment, which requires us to record the expense associated with the fair value of employee stock option grants and other equity incentives within our financial statements. We may have significant and ongoing accounting charges resulting from employee stock option grants and other equity incentive expensing that could reduce our overall net income. SiRF®, SiRFstar®, SiRFXTrac®, SiRFDRive®, SiRFLoc®, SoftGPS® and the SiRF name and orbit design logo are our registered trademarks. The following are trademarks of SiRF Technology, Inc., some of which are pending registration as intent-to-use applications: SiRFstarIII™, SiRFSoft™, SiRFstarII™, SiRFNav™, SnapLock™, SnapStart™, FoliageLock™, SingleSat™, TricklePower™, Push-to-Fix™, SiRF Powered™, SiRFLink™ and Multimode Location Engine™. This quarterly report on Form 10-Q also includes trade names, trademarks and service marks of other companies and organizations. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations are based on our consolidated financial statements, which have been prepared in accordance with United States, or U.S., generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used or changes in the accounting estimate that are reasonably likely to occur could materially change the financial statements. Our most critical accounting policies include: (a) revenue recognition, which impacts the recording of revenue; (b) valuation of inventories, which impacts cost of revenue and gross margin; (c) stock-based compensation, which impacts cost of revenue, gross margin and operating expenses, as well as footnote disclosure; (d) accounts receivable allowance, which impacts general and administrative expense; (e) product warranty, which impacts cost of revenue and gross margin; (f) the assessment of recoverability of long-lived assets including goodwill and other intangible assets, the potential impairment of which impacts operating expenses; and (e) income taxes which impacts provision for income taxes and our deferred tax assets and liabilities. We also have other key accounting policies that are less subjective, and therefore, their application would not have a material impact on our reported results of operations. The following is a discussion of our most critical policies, as well as the estimates and judgments involved. Revenue Recognition. We recognize revenue from sales to our direct customers, both OEMs and VAMs, when the earnings process is complete, as evidenced by an agreement with the customer, transfer of title, as well as fixed or
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Table of Contentsdeterminable pricing and probable collectibility. Transfer of title occurs based on defined terms in customer purchase orders for all shipments. We assess the need for allowances at the time of sale to our direct customers for estimated sales returns. We determine these allowances based upon historical rates of returns. Sales to distributors are made under agreements providing price protection and rights of return under certain circumstances. We defer the recognition of revenue and the related cost of revenue on shipments to distributors that have rights of return and price protection privileges on unsold merchandise until the merchandise is sold by the distributors to their customers. Accounts receivable from distributors are recognized and inventory is released upon shipment as title to inventories generally transfers upon shipment at which point we have a legally enforceable right to collection under normal payment terms. Revenue recognition depends on notification from the distributor that the product has been sold to the end customer. Information reported to us by the distributor includes quantity and end-customer shipment information, as well as monthly inventory on hand at the distributor. Distributor month-end inventory quantities are subsequently reconciled to related deferred distributor revenue balances. We license rights to use our intellectual property to allow licensees to integrate our GPS technology into their products. We also license rights to use our premium software products to licensees to enable our chip sets to provide enhanced functionality in specific applications. We recognize software product revenue in accordance with Statement of Position (“SOP”) 97-2, Software Revenue Recognition. Licensees pay ongoing royalties based on defined terms in software license agreements. Payments are generally made based on licensees’ sales of their products incorporating the licensed intellectual property or premium software. Royalty revenue is generally recognized at the time products containing the licensed intellectual property or premium software are sold by the licensees based on quarterly reports received from licensees detailing the number of chip sets shipped by licensees into which our intellectual property or premium software was embedded. For certain licensees, or Estimated Licensees, we estimate and record the royalty revenue earned in the quarter in which such sales occur, but only when reasonable estimates of such amounts can be made. Estimates of royalty revenue for the Estimated Licensees are based on forecasts provided by Estimated Licensees, an analysis of our sales of chip sets to Estimated Licensees and historical attach rates, historical royalty data for Estimated Licensees and current market and economic trends. Once we receive royalty reports from the Estimated Licensees, we record the variance between such reports and the estimate as royalty revenue in the quarter in which we receive the reports. To date, such variances have not been significant. Subsequent to the sale, we have no obligation to provide any modification, customization, upgrades, or enhancements. The cost of revenue associated with licenses is insignificant. Inventory. We record a reserve for inventories which have become obsolete or are in excess of anticipated demand or net realizable value. We perform a detailed review of inventory each period that considers multiple factors including demand forecasts, market conditions, product life cycle status, product development plans and current sales levels. If future demand or market conditions for our products are less favorable than forecasted or if unforeseen technological changes negatively impact the utility of component inventory, we may be required to record additional write-downs which would negatively impact gross margins in the period when the write-downs are recorded. If actual market conditions are more favorable, we may have higher gross margins when products incorporating inventory that was previously reserved are sold. Stock-Based Compensation. Beginning on January 1, 2006 we account for our employee stock options and the purchase rights under the 2004 Employee Stock Purchase Plan, or the Purchase Plan, under the provisions of SFAS No. 123R and U.S. Securities and Exchange Commission, or SEC, Staff Accounting Bulletin, or SAB, No. 107. SFAS No. 123R requires stock-based compensation cost to be measured at grant date, based on the fair value of the award and is recognized as expense over the requisite service period. We adopted the modified prospective application method as provided by SFAS No. 123R. Under the modified-prospective method compensation cost is recognized beginning with the effective date (a) based on the requirements of SFAS No. 123R for all share-based payments granted after the effective date and (b) based on the requirements of SFAS No. 123, Accounting for Stock-Based Compensation, for all awards granted to employees prior to the effective date of SFAS No. 123R that remain unvested on the effective date. Previously reported financial statements have not been restated and pro forma disclosures previously required by SFAS No. 123 continue to be required. The fair value of our restricted stock units was calculated based upon the fair market value of our stock at the date of grant or as determined under EITF 99-12, Determination of the Measurement Date for the Market Price of Acquirer Securities Issued in a Purchase Business Combination, for our acquisition related restricted stock units. The fair value of our stock options and our Purchase Plan rights was estimated using a Black-Scholes option pricing model. The Black-Scholes option pricing model requires the input of highly subjective assumptions, as disclosed in Note 3 of our condensed consolidated financial statements, and elections in adopting and implementing SFAS No. 123R, including the option’s expected term and the price volatility of the underlying stock. We have elected to use this simplified method as prescribed by the SEC’s Staff Accounting Bulletin, or SAB, No. 107, to estimate the option’s expected term as we have limited historical exercise data or alternative information to estimate a reasonable expected term assumption. Our options are considered “plain vanilla” as defined by SAB No. 107. The simplified method assumes that all options will be exercised midway between the vesting date and the contractual term of the option. We utilized our own historical and implied volatility in valuing our stock option grants. We
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Table of Contentsalso evaluated the historical and implied volatility of “guideline” companies selected based on similar industry and product focus whose share or option prices have been publicly traded for a longer period of time as a baseline volatility benchmark to evaluate the reasonableness of our volatility assumption. During the second quarter of fiscal 2006, the volatility used to value our employee stock options was 50% and the volatility used to value our purchase rights under the Purchase Plan was 55%. Actual volatility, expected lives, and interest rates may be different than our assumptions which would result in an actual value of the options being different than estimated. We have elected to use the straight-line attribution method for awards granted after the adoption of SFAS No. 123R and continue to use a multiple option valuation approach for awards granted prior to the adoption of SFAS No. 123R. Prior to the adoption of SFAS No. 123R, we elected to follow the intrinsic-value-based method prescribed by Accounting Principles Board, or APB, Opinion No. 25, Accounting for Stock Issued to Employees, in accounting for our stock option plans and our Purchase Plan rights, and complied with the disclosure provisions of SFAS No. 123, as amended by SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure. As such, prior to the adoption of SFAS No. 123R, we did not record compensation expense for stock options granted to our employees when the exercise price equals the deemed fair market value of the stock on the date of grant and the exercise price, number of shares eligible for issuance under the options and vesting period are fixed. We recognized compensation expense when we issued equity awards with a discounted exercise price, and recognized any resulting compensation expense over the associated service period, which was generally the award or option vesting term. We recognized deferred compensation expense related to our equity awards using a multiple option valuation approach in accordance with the Financial Accounting Standards Board Interpretation, or FIN, No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans. In accordance with SFAS No. 123, we disclosed our pro forma net income and net income per share as if we had expensed the fair value of the options. Accounts Receivable Allowance. We make estimates of the collectibility of accounts receivable. We regularly review the adequacy of our allowance for doubtful accounts after considering the amount of aged accounts receivable, each customer’s ability to pay, and our collection history with each customer. We report charges to the allowance for doubtful accounts as a portion of selling, general and administrative costs. We regularly review past due invoices to determine if an allowance is appropriate based on the risk category using the factors discussed above. Assumptions and judgments regarding collectibility of accounts could differ from actual events. While our credit losses have historically been within our expectations and the allowance established, we may not continue to experience the same credit loss rates that we have in the past. Our receivables are concentrated in a relatively few number of customers. As of June 30, 2006, 49% of our receivables were concentrated in two customers, which each accounted for 10% or more of our net receivables. Therefore, a significant change in the liquidity or financial position of any of these customers could make it more difficult for us to collect our accounts receivable and may require us to record additional charges that could adversely affect our operating results. Product Warranty. We provide for the estimated cost of product warranties at the time revenue is recognized. We continuously monitor chip set returns for product failures and maintain a warranty reserve for the related expenses based on historical experience of similar products, as well as other assumptions that we believe to be reasonable under the circumstances. Our product warranty reserve includes specific accruals for known product issues and an accrual for an estimate of incurred but unidentified product issues based on historical activity. Our warranty accrual is based on historical activity and the related expense was not significant for the periods presented. Assessment of Long-Lived and Other Intangible Assets and Goodwill. We are required to assess the potential impairment of identified intangible assets, long-lived assets and goodwill on an annual basis, and potentially more frequently if events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:
When we determine that the carrying value of intangible assets, long-lived assets or goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we test for recoverability based on an estimate of future undiscounted cash flows as compared to the long-lived assets or goodwill’s carrying value. If the initial test for recovery fails, measurement of impairment is based on projected discounted cash flow, which requires us to make significant estimates and assumptions regarding future revenue and expenses, projected capital expenditures, changes in our working capital and the relevant discount rate. Should actual results differ significantly from our current estimates, impairment charges may result.
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Table of ContentsIncome Taxes. We account for income taxes under the provisions of SFAS No. 109, Accounting for Income Taxes. Under this method, we determine deferred tax assets and liabilities based upon the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. The tax consequences of most events recognized in the current year’s financial statements are included in determining income taxes payable. However, because tax laws and financial accounting standards differ in their recognition and measurement of assets, liabilities, equity, revenue, expenses, gains and losses, differences arise between the amount of taxable income and pretax financial income and between the tax bases of assets or liabilities and their reported amounts in the financial statements. Because it is assumed that the reported amounts of assets and liabilities will be recovered and settled, respectively, a difference between the tax basis of an asset or a liability and its reported amount in the balance sheet will result in a taxable or a deductible amount in some future years when the related liabilities are settled or the reported amounts of the assets are recovered, resulting in a deferred tax liability or deferred tax asset. In preparing our condensed consolidated financial statements, we assess the likelihood that our deferred tax assets will be realized from future taxable income. We establish a valuation allowance if we determine that it is more likely than not that some portion of the deferred tax assets will not be realized. Changes in the valuation allowance, when recorded, would be included in our consolidated statements of operations as a provision for (benefit from) income taxes. We exercise significant judgment in determining our provisions for income taxes, our deferred tax assets and liabilities and our future taxable income for purposes of assessing our ability to utilize any future tax benefit from our deferred tax assets. During the second quarter of 2006, we assessed the need for a valuation allowance against our deferred tax assets and based on earnings history and projected future taxable income, management determined that it is more likely than not that the deferred tax assets would be realized. We calculate our current and deferred tax provision based on estimates and assumptions that could differ from the actual results reflected in income tax returns filed during the subsequent year. Adjustments based on filed returns are recorded when identified, which is generally in the third quarter of the subsequent year for U.S. federal and state provisions. In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations. We recognize liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional tax payments are probable. We believe we have adequately provided for any reasonably foreseeable adjustments to our tax liability. If we ultimately determine that payment of these amounts is unnecessary, we reverse the liability and recognize a tax benefit during the period in which we determine that the liability is no longer necessary. We record an additional charge in our provision for taxes in the period in which we determine that the recorded tax liability is less than we expect the ultimate assessment to be. Results of Operations Revenue
Net revenue increased 61% and 76% in the second quarter and first half of fiscal 2006, respectively, compared to the corresponding prior year periods due primarily to an increase in product revenue. The increase in product revenue in the second quarter and first half of 2006 as compared to the prior year periods resulted primarily from an 85% and 103% increase in unit shipments of chip sets, respectively, which was due in part to increased sales of our product line based on our SiRFStarIII architecture. This increase was partially offset by an 8% and 10% decline in average selling prices in the corresponding prior year periods, respectively. License royalty revenue decreased slightly in the second quarter of fiscal 2006 compared to the prior year period due a change in the mix of customers selling products containing SiRF’s licensed intellectual property. License royalty revenue
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Table of Contentsincreased in the first half of fiscal 2006 compared to the prior year period due primarily to an increase in licensees’ sales of products containing our licensed intellectual property during the first quarter of fiscal 2006. License royalty revenue represented 5% of our net revenue in the second quarter and first half of fiscal 2006, as compared to 8% of our net revenue in the second quarter and first half of fiscal 2005. License royalty revenue as a percentage of total net revenue declined as compared to the prior year periods primarily due to the significant growth in product revenue, although the license royalty unit volumes increased year over year. This trend is expected to continue based on our long-term business model. Export sales from the United States to customers outside the United States accounted for 85% and 81% of net revenue in the second quarter of fiscal 2006 and 2005, respectively, and 81% and 78% of net revenue in the first half of fiscal 2006 and 2005, respectively. Export sales from the United States to the Asia/Pacific region accounted for approximately 77% and 64% of net revenue in the second quarter of 2006 and 2005, respectively, and approximately 73% and 62% in the first half of fiscal 2006 and 2005, respectively. We anticipate that a significant amount of our net revenue will continue to reflect sales to customers in that region as many of our VAM and contract manufacturer customers are located in Asia. Although a large percentage of our sales are made to customers in the Asia/Pacific region, we believe that a significant amount of the systems designed and manufactured by these customers are subsequently sold through to OEMs outside of the Asia/Pacific region. All of our chip-set sales are denominated in United States dollars. Cost of Revenue and Gross Margin Cost of revenue consists primarily of finished units or silicon wafers and costs associated with the assembly, testing and inbound and outbound shipping of our chip sets, costs of personnel and occupancy associated with manufacturing support and quality assurance, all of which are associated with product revenue. As we do not have long-term, fixed supply agreements, our unit or wafer costs are subject to change based on the cyclical demand for semiconductor products. There was no cost of license royalty revenue for the periods reported. Total cost of revenue for the periods reported was as follows:
Cost of revenue increased in the second quarter and first half of fiscal 2006 as compared to the corresponding prior year periods due primarily to an increase in the volume of chip sets shipped and recognized as product revenue, partially offset by declines in per-unit materials cost. Cost of product revenue includes stock compensation expense of $0.2 million and $0.1 million for the three months ended June 30, 2006 and 2005, respectively, and $0.3 million and $0.1 million for the six months ended June 30, 2006 and 2005, respectively. Gross margin and gross margin as a percentage of net revenue for the periods reported were as follows:
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Gross margin as a percentage of net revenue remained flat in the second quarter and first half of fiscal 2006 as compared to the corresponding prior year periods. Gross margin as a percentage of net revenue was impacted by license royalty revenue becoming a smaller percentage of total net revenue and the decrease in average selling prices, which was offset by declines in per unit materials cost. Included within cost of revenue for the second quarter and first half of fiscal 2006 is approximately $0.2 million and $0.3 million of stock compensation expense, respectively, which had an insignificant impact on gross margin. Product gross margin as a percentage of net revenue increased in the second quarter and first half of 2006 as compared to the corresponding prior year periods due primarily to a decline in materials cost. In the future, our gross margin percentages may be affected by increased competition and related decreases in unit average selling prices, changes in the mix of products sold (including the extent of license royalty revenue), the availability and cost of products from our suppliers, manufacturing yields (particularly on new products), increased volume and related volume price breaks, timing of volume shipments of new products and potential delays in introductions of new products. As a result, we may experience declines in demand or average selling prices of our existing products, and our inventories on hand may become impaired, resulting in write-offs either for excess quantities or lower of cost or market considerations. Such a write-off, when determined, could have a material adverse effect on gross margins and results of operations. Operating Expenses Our results of operations for the second quarter and first half of fiscal 2006 were impacted by the adoption of SFAS No. 123R, which requires us to recognize a non-cash expense related to the estimated fair value of all our employee stock-based compensation awards. We elected to use the modified prospective transition method of adoption, which requires the inclusion of stock-based compensation expense in our results of operations beginning in the first quarter of 2006 without restating prior periods to include stock-based compensation expense. In periods prior to the adoption of SFAS No. 123R, when employee stock-based compensation awards had an exercise price equal to or higher than the market value of the underlying common stock on the date of grant, no stock-based compensation expense was recognized in statement of operations. In periods prior to the adoption of SFAS No. 123R, we recorded stock compensation expense associated with equity awards issued in conjunction with acquisitions and pre-IPO options granted at less than deemed fair market value. Of the approximately $6.9 million in total employee stock-based compensation expense recognized in the second quarter of fiscal 2006, $4.5 million is included in research and development expense, $1.0 million is included in sales and marketing expense and $1.2 million is included in general and administrative expense. Of the approximately $11.6 million in total employee stock-based compensation expense recognized in the first half of fiscal 2006, $7.8 million is included in research and development expense, $1.6 million is included in sales and marketing expense and $1.9 million is included in general and administrative expense. These amounts are depicted in the following table:
Research and Development Research and development expense consists primarily of salaries, bonuses and benefits for engineering personnel, depreciation of engineering equipment, amortization of intellectual property assets, costs of outside engineering services from contractors and consultants and costs associated with prototype wafers and mask sets. Some of our development costs are offset by income from engineering services arrangements with certain customers. Engineering services income was $0.1 million and $0.02 million in the second quarter of fiscal 2006 and 2005, respectively, and $0.3 million in both the first half of 2006 and 2005, respectively. Research and development expenses, net, for the periods reported were as follows:
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Research and development expense increased in both the second quarter and first half of fiscal 2006 as compared to the corresponding prior year periods due primarily to a 71% increase in headcount, which resulted in increases in headcount related expenses of approximately $2.8 million and $6.1 million, respectively. The increase in headcount is primarily attributable to the acquisition of Impulsesoft in 2005 and the acquisition of TrueSpan in the first quarter of 2006, as well as the overall growth of our business. In conjunction with these acquisitions during the second quarter and first half of fiscal 2006, approximately $1.1 million and $1.5 million, respectively, of acquisition-related contingent payments were recorded as compensation expense, with no similar expense in the corresponding prior year period. Additional increases in both the second quarter and first half of fiscal 2006 as compared to the corresponding prior year periods was attributed to increases in product development expenses of approximately $1.4 million and $3.3 million, respectively. The increase in research and development expense during the second quarter and first half of fiscal 2006 is further attributable to the net increase in stock compensation expense of approximately $3.5 million and $6.6 million, respectively, which is primarily associated with our recent acquisition related stock compensation awards as compared to the corresponding prior year period. Additionally, increased costs associated with physical implementation of chip designs, as well as increased depreciation and amortization of engineering equipment and licensed technology attributed to the overall increase in research and development expense. We expect our research and development costs to increase in absolute dollars as we continue to develop new products in the future. Sales and Marketing Sales and marketing expense consists primarily of salaries, bonuses, benefits and related costs for sales and marketing personnel, sales commissions, customer support, public relations, tradeshows, advertising and other marketing activities. Sales and marketing expenses for the periods reported were as follows:
Sales and marketing expense increased slightly in both the second quarter and first half of fiscal 2006 as compared to the corresponding prior year periods due primarily to the net increase in stock compensation expense of approximately $0.8 million and $1.3 million, respectively. The increase in sales and marketing expense during the second quarter and first half of fiscal 2006 is further attributable to increases in headcount related expenses of approximately $0.3 million and $0.8 million, respectively. We expect sales and marketing expense to increase in absolute dollars as we hire additional personnel, expand our sales and marketing efforts and incur higher sales commissions with the anticipated growth of our business. General and Administrative General and administrative expense consists primarily of salaries, bonuses, benefits and related costs for finance and administrative personnel, as well as outside service expenses, including legal, accounting and recruiting. General and administrative expenses for the periods reported were as follows:
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General and administrative expense increased in both the second quarter and first half of fiscal 2006 as compared to the corresponding prior year periods due primarily to increases in headcount related expenses and increased costs for legal, accounting and professional consulting services of approximately $1.0 million and $1.2 million, respectively. The increase in general and administrative expense during the second quarter and first half of fiscal 2006 is further attributable to the net increase in stock compensation expense of approximately $1.0 million and $1.5 million, respectively. The increase in general and administrative expense is primarily associated with the growth of our business, as well as our recent acquisitions. We expect general and administrative expense to increase in absolute dollars as we hire additional personnel and incur costs related to the anticipated growth of our business and investments in our information technology infrastructure. Amortization of Acquisition-Related Intangible Assets Acquired identified intangible assets other than goodwill consist of acquired developed technology, core technology, customer list, assembled workforce, patents and customer relationships. These acquired identified intangible assets are being amortized using the straight-line method over their expected useful lives, which range from two to 13 years.
Amortization of acquisition-related intangible assets increased in both the second quarter and first half of fiscal 2006 as compared to the corresponding prior year periods due primarily to increases in amortization expense for intangible assets acquired in the acquisition of TrueSpan in the first quarter of 2006 and the acquisition of Impulsesoft in the fourth quarter of 2005. During the fourth quarter of 2005, we determined it was more likely than not that certain net operating losses acquired in connection with the Enuvis acquisition will be realized and therefore recognized an associated deferred tax asset of approximately $5.0 million. Recognizing this deferred tax asset resulted in the reduction of the remaining $4.3 million unamortized cost of acquisition-related developed technology to zero. The resulting reduction in amortization of acquisition-related intangible assets for this asset, partially offset the increased intangible asset amortization associated with the TrueSpan and Impulsesoft acquisitions. Acquired in-Process Research and Development
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Table of ContentsIn connection with the acquisition of TrueSpan in the first quarter of fiscal 2006, we allocated approximately $13.3 million of the purchase price to acquired in-process research and development, or IPR&D, with no similar expense incurred during the second quarter of fiscal 2006. The corresponding prior year periods include approximately $0.8 million of acquired IPR&D associated with the acquisition of the Motorola’s GPS chipset product line in the second quarter of fiscal 2005. The amounts allocated to the acquired IPR&D were immediately expensed in the period the acquisition was completed because the associated project had not yet reached technological feasibility and no future alternative uses existed for the acquired technology. In calculating the value of the acquired IPR&D, we, with the assistance of an independent appraiser, used established valuation techniques accepted in the technology industry. This calculation gave consideration to relevant market size and growth factors, expected industry trends, the anticipated nature and timing of new product introductions by us and our competitors, product sales cycles, and the estimated life of the product derived from the underlying technology. The value of the acquired IPR&D reflects the relative value and contribution of the acquired research and development. Consideration was given to the stage of completion, the complexity of the work completed to date, the difficulty of completing the remaining development, costs already incurred, and the expected cost to complete the projects in determining the value assigned to the acquired IPR&D. Other Income, Net Other income, net, consists primarily of interest earned on our cash and investments. Other income, net, was $1.4 million and $2.7 million in the second quarter and first half of fiscal 2006, respectively, and $0.9 million and $1.8 million in the second quarter and first half of 2005, respectively. The increase in other income, net, in both periods as compared to the corresponding prior year period is attributable to the increased interest rates earned on our cash equivalents, short- and long-term investments. Provision for Income Taxes Provision for income taxes was $1.7 million and $3.3 million in the second quarter and first half of fiscal 2006, respectively, and $0.5 million and $1.2 million in the second quarter and first half of 2005, respectively. Our estimated effective tax rate was 51% and (54%) in the second quarter and first half of 2006, respectively, and 11% and 18% in the second quarter and first half of 2005. The provision for income taxes in the second quarter of 2006 differs from the amount computed by applying the statutory federal rate principally due to nondeductible stock-based compensation expense and tax benefits from disqualified dispositions of incentive stock options and our employee stock purchase plan during the quarter. The provision for income taxes in the first half of 2006 also differs from the amount computed by applying the statutory federal rate principally due to nondeductible acquired in-process research and development expense incurred as part of the TrueSpan acquisition during the first quarter of 2006. With the expiration of the federal research and development tax credit on December 31, 2005, we did not factor this credit into our effective rate calculations for the second quarter or first half of 2006. The provision for income taxes in the second quarter and first half of 2005 differs from the amount computed by applying the statutory federal rate principally due to a tax benefit from disqualified dispositions of incentive stock options and research and development tax credits. Liquidity and Capital Resources Financial Condition
Cash Flows We have historically financed our operations primarily through private sales of our common and preferred stock, and to a lesser extent, through our bank line of credit. As of June 30, 2006, we had $106.0 million in cash, cash equivalents, and marketable securities and $137.2 million in working capital, as compared to cash, cash equivalents and marketable securities
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Table of Contentsbalance of $117.9 million and $142.1 million in working capital as of December 31, 2005. As of June 30, 2006, we had $33.6 million in long-term investments, as compared to a long-term investments balance of $20.8 million as of December 31, 2005. The increase of $12.8 million in long-term investments is consistent with our investment policy to manage our working capital. Operating Activities – Net cash used in operating activities was $3.1 million in the first half of fiscal 2006, which resulted primarily from a net loss of $9.3 million, adjusted for non-cash reconciling items of approximately $16.5 million related to stock compensation expense, depreciation and amortization, acquired in-process research and development, and changes in deferred tax assets. In conjunction with the adoption of SFAS No. 123R, we present the cash retained in connection with the benefits of tax deductions in excess of recognized compensation cost as a financing cash flow, rather than as an operating cash flow as required under previous accounting literature. This requirement has reduced net operating cash flows and increased net financing cash flows during the first half of 2006 by approximately $17.4 million. Net cash used in operating activities was also partially impacted by an increase in accounts receivables of $13.4 million, an increase in prepaid expenses and other current assets of $1.3 million, offset by an increase in accounts payable and accrued payroll and related benefits of $4.3 million. Net cash provided by operating activities was $14.5 million in the first half of fiscal 2005, which resulted primarily from net income of $5.5 million, adjusted for non-cash reconciling items of $8.2 million in stock compensation expense, depreciation, amortization, acquired in-process research and development, decline in the deferred tax assets balance due to utilization of tax attributes that otherwise would have offset income taxes payable, as well as an increase in accounts payable of $3.9 million due to timing of receipt of inventories from our suppliers. Cash provided by operating activities was partially offset by increases in inventory of $1.4 million due to the above mentioned timing of receipt of inventory, as well as an increase in prepaid expenses and other current assets of $1.0 million. Investing Activities – Net cash used in investing activities was $39.6 million in the first half of fiscal 2006, which was primarily due to the acquisition of TrueSpan during the first quarter of fiscal 2006 that represented approximately $16.8 million, net of cash acquired. The cash paid in connection with the TrueSpan acquisition during the first quarter of fiscal 2006 excludes approximately $3.0 million in future contingent payments, which will be made to certain former TrueSpan employees contingent upon their continued employment with us and will result in compensation expense recorded over the related two-year service period. See Note 2 of “Notes to Condensed Consolidated Financial Statements” in Item 1 for further information. During the second quarter of fiscal 2006, SiRF paid approximately $1.8 million in contingent cash payments associated with a past acquisition, which resulted in an increase in goodwill related to this acquisition. In addition, the net expenditures from maturities and sales of available-for-sale investments of $19.0 million and to a lesser extent capital expenditures during the first half of fiscal 2006 of $1.3 million impacted net cash used in investing activities. Net cash used in investing activities was $34.4 million in the first half of 2005, which consisted primarily of our acquisitions of Kisel and the GPS chipset product line of Motorola for a total of $40.8 million, net of cash acquired and including in-process research and development expense of $0.8 million, as well as capital expenditures of $1.6 million. Net cash used in investing activities during the first half of 2005 was partially offset by maturities and sales of available-for-sale investments, net of purchases of available-for-sale investments of $8.1 million. Financing Activities – Net cash provided by financing activities was approximately $24.6 million in the first half of fiscal 2006, which was primarily due to the proceeds from stock option exercises of approximately $7.2 million and an increase in net financing cash flows of approximately $17.4 million related to the cash retained in connection with the benefits of tax deductions in excess of recognized compensation cost as required under SFAS No. 123R. Net cash provided by financing activities was $2.4 million in the first half of 2005 was driven primarily by proceeds from stock option exercises and employee purchases of common stock under our employee stock purchase plan, partially offset by payment on our litigation settlement obligation. In February 2005, we modified our short-term revolving line of credit under which we may borrow up to $5.0 million, including $5.0 million in the form of letters of credit, with an interest rate equal to the greater of (i) 1% percentage point above the prime rate (8.25% as of June 30, 2006), or (ii) 5.25%. The line of credit is available through February 2007 and is secured by substantially all of our assets. We had no borrowings under the line of credit as of June 30, 2006 or December 31, 2005. As of June 30, 2006, we were in compliance with all financial and non-financial covenants, including borrowing base requirements. We currently have no plans to obtain additional debt financing and do not foresee our bank line of credit having a significant impact on our ability to obtain equity financing. We expect to experience continued growth in our operating expenses for the foreseeable future in order to execute our business strategy. We believe that our existing cash, investments, amounts available under our bank line of credit and cash generated from operating activities will be sufficient to meet our working capital and capital expenditure requirements for the next 12 months. However, we may require additional capital resources to grow our business internally or to acquire complementary technologies and businesses at any time in the future and may seek to sell additional equity or debt securities or obtain other debt financing. The sale of additional equity or convertible debt securities could result in additional dilution to our stockholders.
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Table of ContentsItem 3. Quantitative and Qualitative Disclosures About Market Risk Interest Rate Risk Our exposure to market risks for changes in interest rates relates primarily to our investment portfolio. As of June 30, 2006, our cash equivalents and investment portfolio consisted of commercial paper, government bonds and money market funds. Our marketable securities consist of high-quality debt securities with maturities beyond 90 days at the date of acquisition, which mature within one year or less. Our long-term investments consist of high-quality debt securities with maturities beyond one year. Our investments are considered to be available-for-sale. We do not believe that an immediate 10% increase in interest rates would have a material effect on the fair market value of our portfolio primarily due to the short term nature of our investment portfolio. Since we believe we have the ability to liquidate this portfolio, we do not expect our operating results or cash flows to be materially impacted by the effect of a sudden change in market interest rates on our investment portfolio. Foreign Currency Exchange Risk Our exposure to adverse movements in foreign currency exchange rates is primarily related to our subsidiaries’ operating expenses, primarily in the United Kingdom, Japan, Taiwan, India and Sweden, denominated in the respective local currency. A hypothetical change of 10% in foreign currency exchange rates would not have a material impact on our consolidated financial statements or results of operations. All of our sales are transacted in U.S. dollars. Item 4: Controls and Procedures (a) Evaluation of disclosure controls and procedures. We maintain “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Our disclosure controls and procedures have been designed to meet reasonable assurance standards. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Based on their evaluation as of the end of the period covered by this quarterly report on Form 10-Q, our Chief Executive Officer and Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level. (b) Changes in internal control over financial reporting. There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) identified in connection with management’s evaluation during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. After the completion of our fourth fiscal quarter of 2004 and in connection with the audit of our consolidated financial statements for the year ended December 31, 2004, our independent registered public accounting firm informed members of our senior management and our Audit Committee of our Board of Directors that it considered our procedures for assessing and accounting for certain deferred tax assets to be a “significant deficiency” constituting a “material weakness” in our internal controls under standards established by the Public Company Accounting Oversight Board. Accounting for deferred tax assets is a critical accounting policy that requires our management to make various judgments. To remediate this error, in the first quarter of 2005, we engaged a new third-party tax advisor to assist in the review and preparation of our provision for income taxes, including the accounting for deferred tax assets, established formal internal procedures for the review and preparation of our provision for income taxes. Based on our assessment during the first half of 2005, we believed these measures had remediated this error; however, during the review of our quarterly financial statements for the third quarter of 2005, our independent registered public accounting firm discovered certain errors in the calculation of our benefit from income taxes and our deferred tax assets. These errors were discovered and corrected prior to the release of our
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Table of ContentsSeptember 30, 2005 financial results. Based on these findings, we revisited the measures previously taken and refined certain aspects of our internal controls around our income tax accounting process to mitigate the risk of such errors in the future, including enhancing our internal procedures for the review and preparation of our provision for income taxes, as well as the financial statements. Based on our assessment as of the end of 2005 and the first and second quarters of 2006, we believe that these refinements, together with the measures previously taken, have remediated the material weakness and that we have effective internal controls over financial reporting. The certifications of our principal executive officer and principal financial officer required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002 are attached as exhibits to this quarterly report on Form 10-Q. The disclosures set forth in this Item 4(a) contain information concerning (i) the evaluation of our disclosure controls and procedures, and changes in internal control over financial reporting, referred to in paragraph 4 of the certifications, and (ii) material weaknesses in the design or operation of our internal control over financial reporting, referred to in paragraph 5 of the certifications. Those certifications should be read in conjunction with this Item 4(a) for a more complete understanding of the matters covered by the certifications.
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Table of ContentsItem 1. Legal Proceedings During the quarter ended June 30, 2006, we were not a party to any material legal proceedings. However, we may be subject to other legal proceedings, as well as demands, claims and threatened litigation, that arise in the normal course of our business. For example, in August 2005, our subsidiary, SiRF Technology, Inc., filed a complaint against u-Nav Microelectronics, or u-Nav, in the United States District Court for the Central District of California. The complaint alleges infringement by u-Nav of three patents assigned to SiRF Technology, Inc. and seeks both monetary damages and an injunction to prevent further infringement. In January 2006, u-Nav counterclaimed by alleging that one of its patents was infringed by our subsidiary. On June 6, 2006, SiRF Technology, Inc. filed a second amended complaint with the Court adding four additional patents to its claims of infringement against u-Nav, and u-Nav counterclaimed on the same day alleging that our subsidiary infringed a second patent. Discovery in this case is continuing, and a trial date has been set for July 24, 2007. The outcome of any litigation, including the lawsuit against u-Nav, is uncertain and either favorable or unfavorable outcomes could have a material impact. Regardless of the outcome, litigation may be time-consuming and expensive and could divert management’s attention from our business. Item 1A. Risk Factors In evaluating SiRF Technology Holdings, Inc. and our business, you should carefully consider the following factors in addition to the other information in this quarterly report on Form 10-Q. Any one of the following risks could seriously harm our business, financial condition, and results of operations, causing the price of our stock to decline. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations. RISKS RELATED TO OUR BUSINESS We have a history of losses, have only become profitable since the third quarter of fiscal 2003 and may not sustain or increase profitability in the future. We have only been profitable since the third quarter of fiscal 2003 and may not sustain or increase profitability in the future. As of June 30, 2006, we had an accumulated deficit of approximately $40 million. We intend to increase our research and development, sales and marketing and general and administrative expenses. We also expect to incur substantial stock-based compensation charges and charges related to amortization of acquired intangible assets associated with the acquisition of Kisel, Motorola’s GPS chip set product line, Impulsesoft and TrueSpan. If we do not sustain or increase profitability or otherwise meet the expectations of securities analysts or investors, the market price of our common stock will likely decline. The revenue and income potential of our business and market are unproven. Our revenue may not continue to increase at historical rates. The market for Global Positioning System, or GPS-based location awareness capabilities in high-volume consumer and commercial applications is emerging, and if this market does not develop as quickly as we expect, the growth and success of our business will be limited. The market for GPS-based location awareness technology in high-volume consumer and commercial applications is new and its potential is uncertain. Many of these GPS-based applications have not been commercially introduced or have not achieved widespread acceptance. Our success depends on the rapid development of this market. We cannot predict the growth rate, if any, of this market. The development of this market depends on several factors, including government mandates such as E911 mandate in the U.S. and E110 mandate in Japan, the development of location awareness infrastructure by wireless network operators and the availability of location-aware content and services. The failure of the market for high-volume consumer and commercial GPS-based applications to develop in a timely manner would limit the growth and success of our business. If we are unable to fund the development of new products to keep pace with rapid technological change, we will be unable to expand our business. The market for high-volume consumer and commercial GPS-based applications and other technologies that we are developing is characterized by rapidly changing technology, such as low power or smaller form factors. This requires us to continuously develop new products and enhancements for existing products to keep pace with evolving industry standards and rapidly changing customer requirements. We may not have the financial resources necessary to fund future innovations. If we are unable to successfully define, develop and introduce competitive new products and enhance existing products, we may not be able to compete successfully in our markets.
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Table of ContentsIf we do not timely deliver new products or if these products do not achieve market acceptance, our reputation may suffer and our net revenue may decline Our ability to develop and deliver new products successfully will depend on various factors, including our ability to:
If we do not timely deliver new products or if these products do not achieve market acceptance, our reputation may suffer and our net revenue may decline. For example, in 2004 we introduced three new products: SiRFstarIII, SiRFSoft and SiRFLoc Server. In 2005 we launched a range of new products based on both SiRFstarII and SiRFstarIII architectures and in first quarter of 2006 we launched four new products: SiRFstarIII/LT, GSCi5000, SiRFLink and SiRFInstantFix. While some of the product lines based on our SiRFstarIII architecture are now in high-volume production, others are still in prototype or sampling stages. If these or other products we introduce do not achieve market acceptance in a timely manner, our business would suffer. Our products are becoming more complex and defects in our products could result in a decrease of customers and revenue, unexpected expenses and loss of market share. Our products are complex and must meet stringent quality requirements. With some of our recent acquisitions we are expanding into even more complex technologies that may require a significant investment of resources to be successful. Products as complex as ours may contain undetected errors or defects, especially when first introduced or when new versions are released. For example, our products may contain errors, which are not detected until after they are shipped because we cannot test for all possible scenarios. Errors or defects may not be detected until after commercial shipments. In addition, errors or defects in our server software could cause our customers to experience a loss of network service effecting end-users. As our products become more complex, such as the multifunction SiRFLink product line, which is more complex than our single function GPS products, we face significantly higher research and development risks and risk of undetected defects. In addition, as our components become more complex we may be limited in the number of products that can utilize these components. Any errors or defects in our products, or the perception that there may be errors or defects in our products, could result in customers’ rejection of our products, damage to our reputation, a decline in our stock price, lost revenue, diverted development resources and increased customer service and support costs and warranty claims. We are entering into new markets that are highly competitive with well established competitors. As a result of some of our recent acquisitions, we are entering into more complex market areas and we may need to invest a significant amount of resources to compete successfully. For example, in both the Bluetooth and mobile TV space there are a range of well established semiconductor companies, including CSR and Broadcom in the Bluetooth space and Qualcomm and Texas Instruments in the mobile TV space, as well as start-ups that have established a market presence. As new entrants into these markets, we believe that our success depends on our ability to establish relationships with leading providers and our failure to do so could harm our ability to successfully compete in these new markets. Our quarterly revenue and operating results are difficult to predict, and if we do not meet quarterly financial expectations, our stock price will likely decline. Our quarterly revenue and operating results are difficult to predict and, have in the past, and may in the future, fluctuate from quarter to quarter. It is possible that our operating results in some quarters will be below market expectations. This would likely cause the market price of our common stock to decline. Our quarterly operating results may fluctuate because of many factors, including:
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We base our planned operating expenses in part on our expectations of future revenue, and our expenses are relatively fixed in the short term. If revenue for a particular quarter is lower than we expect, we may be unable to proportionately reduce our operating expenses for that quarter, which would harm our operating results for that quarter. We have relied, and expect to continue to rely, on a limited number of customers for a significant portion of our net revenue, and our net revenue could decline due to the delay or loss of significant customer orders. We expect that a small number of customers may constitute a significant portion of our net revenue for the foreseeable future. In the second quarter of 2006, we had three customers that each accounted for 10% or more of our net revenue, which collectively accounted for approximately 68% of our net revenue. In the first half of fiscal 2006, we had three customers that each accounted for 10% or more of our net revenue, which collectively accounted for approximately 65% of our net revenue. If we fail to successfully sell our products to one or more of our significant customers in any particular period, or if a large customer purchases fewer of our products, defers orders or fails to place additional orders with us, our net revenue could decline, and our operating results may not meet market expectations. In addition, we design some of our products to incorporate customer specifications. If our customers purchase fewer products than anticipated or if we lose a customer, we may not be able to sell these products to other customers, which would result in excess inventory and could negatively impact our operating results. We have derived a substantial majority of our net revenue from sales to the automotive, mobile phone and consumer device markets. If we fail to generate continued revenue from these markets or from additional markets, our revenue could decline. We believe that over 90% of our net revenue during the first quarter of 2006 and 2005 was attributable to products which were eventually incorporated into the automotive, mobile phone and consumer device markets. Consumer spending and the demand for our products in these markets is uncertain and may decline. If we cannot sustain or increase sales of our products into these markets or if we fail to generate revenue from additional markets, our net revenue could decline. Our lengthy sales cycle makes it difficult for us to forecast revenue and increases the variability of quarterly fluctuations, which could cause our stock price to decline. We have a lengthy sales process in some of our target markets and our sales cycles typically range from six months to two years, depending on the market. We typically need to obtain a design win, where our product is incorporated into a customer’s initial product design. In some cases, due to the rapid growth of new GPS applications and products and our prospective customers’ inexperience with GPS technology, this process can be time-consuming and requires substantial investment of our time and resources. After we have developed and delivered a product to a customer, our customer often tests and evaluates our product before designing its own product to incorporate our technology. Our customers may need three to six months or longer to test and evaluate our technology and an additional 12 months or more to begin volume production of products that incorporate our technology. Because of this lengthy sales cycle, we may experience delays from the time we increase our operating expenses and our investments in committing capacity until the time that we generate revenue from these products. Also, a design win may never result in volume shipments. It is possible that we may not generate sufficient, if any, revenue from these products to offset the cost of selling and completing the design work. Our success depends upon our customers’ ability to successfully sell their products incorporating our technology. Even if a customer selects our technology to incorporate into its product, the customer may not ultimately market and sell its product successfully. A cancellation or change in plans by a customer, whether from lack of market acceptance of its products or otherwise, could cause us to lose sales that we had anticipated. Also, our business and operating results could suffer if a significant customer reduces or delays orders during our sales cycle or chooses not to release products that contain our technology.
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Table of ContentsOur operating results depend significantly on sales of our SiRFstarII and SiRFstarIII product lines and our ability to develop and achieve market acceptance of new GPS products. We currently derive most of our revenue from sales of our SiRFstarII and SiRFstarIII product lines. If we fail to develop or achieve market acceptance of new GPS products, we will continue to depend on sales of our SiRFstarII and SiRFstarIII product lines. Any decline in sales of our SiRFstarII and SiRFstarIII product lines or decreases in average selling prices will adversely affect our net revenue and operating results. The average selling prices of products in our markets have historically decreased rapidly and will likely do so in the future, which could harm our revenue and gross profits. As is typical in the semiconductor industry, the average selling price of a product historically declines significantly over the life of the product. In addition, the products we develop and sell are used for high-volume applications. In the past, we have reduced the average selling prices of our products in anticipation of future competitive pricing pressures, new product introductions by us or our competitors and other factors. We expect that we will have to similarly reduce prices in the future for mature products. Reductions in our average selling prices to one customer could also impact our average selling prices to all customers. A decline in average selling prices would harm our gross margins. Our financial results will suffer if we are unable to offset any reductions in our average selling prices by increasing our sales volumes, reducing our costs, adding new features to our existing products or developing new or enhanced products on a timely basis with higher selling prices or gross margins. We intend to evaluate acquisitions or investments in complementary technologies and businesses, and we may not realize the anticipated benefits of these acquisitions or investments. As part of our business strategy, we plan to evaluate acquisitions of, or investments in, complementary technologies and businesses. For example, on April 28 2005, we acquired Kisel, an independent European design house for complex integrated transceiver circuits. On June 1 2005, we acquired Motorola’s GPS chip set product line. Motorola has historically been one of our customers; however, we cannot be assured that they will continue to be a customer in the future. On December 24, 2005, we acquired Impulsesoft, an expert in Bluetooth stereo solutions and embedded software. On March 14, 2006, we acquired TrueSpan, a technology company with significant communications systems expertise. We may be unable to identify suitable acquisition candidates or investment opportunities in the future or be able to make these acquisitions or investments on a commercially reasonable basis, or at all. If we are unable to identify and successfully complete suitable acquisitions or investments, we may be required to expand our internal research and development efforts, which could harm our competitive position or result in negative market perception. Any future acquisitions and investments would have several risks, including:
We may not realize the anticipated benefits of any acquisition or investment. Our reliance on third-party distributors subjects us to certain risks that could negatively impact our business. We market and sell our products directly and through third-party distributors pursuant to agreements that can generally be terminated for convenience by either party upon prior notice to the other party. These agreements are non-exclusive and permit our distributors to offer our competitors’ products. In addition, our third party distributors have been a significant factor in our ability to increase sales of our products. In the second quarter and first half of fiscal 2006, one of our distributors accounted for approximately 42% of our net revenues. Accordingly, we are dependent on our distributors to supplement our direct marketing and sales efforts. If a significant distributor terminated its relationship with us or decided to market our competitors’ products over our products, this could have an adverse impact on our ability to bring our products to market.
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Table of ContentsAdditionally, distributors typically maintain an inventory of our products. In most instances, our agreements with distributors protect their inventory of our products against price reductions. Some agreements with our distributors also contain standard stock rotation provisions permitting limited levels of product returns. We defer the gross margins on our sales to distributors, resulting from both our deferral of revenue and related product costs, until the applicable products are re-sold by the distributors. However, in the event of an unexpected significant decline in the price of our products, the price protection rights we offer to our distributors could materially adversely affect us because our revenue and product margin would decline. Because competition for qualified personnel is intense in our industry and in our geographic regions, we may not be able to recruit and retain necessary personnel, which could impact the development or sales of our products. Our success will depend on our ability to attract and retain senior management, engineering, sales, marketing and other key personnel, such as GPS, radio frequency, or RF, and application-specific integrated circuit, or ASIC, engineers. Because of the intense competition for these personnel, particularly in the San Francisco Bay Area, Los Angeles Area and Phoenix Areas in the U.S. and Bangalore and Noida in India, we may be unable to attract and retain key technical and managerial personnel. If we are unable to retain our existing personnel, or attract and train additional qualified personnel, our growth may be limited due to our lack of capacity to develop and market our products. All of our key employees are employed on an “at will” basis. The loss of any of these key employees could slow our product development processes and sales efforts or harm investors’ perception of our business. We may also incur increased operating expenses and be required to divert the attention of other senior executives to recruit replacements for key personnel. Also, we may have more difficulty attracting personnel as a public company because of the perception that the stock option component of our compensation package may not be as valuable. We depend primarily on five independent foundries to manufacture substantially all of our current products, and any failure to obtain sufficient foundry capacity could significantly delay our ability to ship our products and damage our customer relationships. We do not own or operate a fabrication facility. We rely on third parties to manufacture our semiconductor products. Five outside foundries, Samsung in South Korea, IBM in the U.S., STMicroelectronics in Italy and France, SST in China and TSMC in Taiwan currently manufacture substantially all of our products. Because we rely on outside foundries, we face several significant risks, including:
The ability of each foundry to provide us with semiconductors is limited by its available capacity. We do not have a guaranteed level of production capacity with any of these foundries and it is difficult to accurately forecast our capacity needs. We do not have long-term agreements with any of these foundries and we place our orders on a purchase order basis. We place our orders on the basis of our customers’ purchase orders and sales forecasts; however, the foundries can allocate capacity to the production of other companies’ products and reduce deliveries to us on short notice. It is possible that foundry customers that are larger and better financed than we are, or that have long-term agreements with the foundries, may induce our foundries to reallocate capacity to them. Any reallocation could impair our ability to secure the supply of semiconductors that we need. Each of our semiconductor products is manufactured at only one foundry and if any one foundry is unable to provide the capacity we need, we may be delayed in shipping our products, which could damage our customer relationships and result in reduced revenue. Although we substantially use three separate foundries, each of our semiconductor products is manufactured at one of these foundries. If one of our foundries is unable to provide us with capacity as needed, we could experience significant delays delivering the semiconductor product being manufactured for us solely by that foundry. Also, if any of our foundries experiences financial difficulties, if they suffer damage to their facilities or in the event of any other disruption of foundry capacity, we may not be able to qualify an alternative foundry in a timely manner. If we choose to use a new foundry or process for a particular semiconductor product, we believe that it would take us several months to qualify the new foundry or process before we can begin shipping products. If we cannot accomplish this qualification in a timely manner, we may experience a significant interruption in supply of the affected products.
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Table of ContentsThe facilities of the independent foundries upon which we rely to manufacture all of our semiconductors are located in regions that are subject to earthquakes and other natural disasters, as well as geopolitical risk and social upheaval. The outside foundries and their subcontractors upon which we rely to manufacture most of our semiconductors are located in countries that are subject to earthquakes and other natural disasters, as well as geopolitical risks and social upheavals. Any earthquake or other natural disaster in these countries could materially disrupt these foundries’ production capabilities and could result in our experiencing a significant delay in delivery, or substantial shortage, of our products. In addition, these facilities are subject to risks associated with uncertain political, economic and other conditions in Asia, such as political turmoil in the region and the outbreak of SARS or bird flu, which could disrupt the operation of these foundries and in turn harm our business. For example, South Korea is a neighboring state to North Korea, which is currently in discussions with the United States and other countries regarding its nuclear weapons program. Any geographical or social upheaval in these countries could materially disrupt the production capabilities of our foundries and could result in our experiencing a significant delay in delivery, or a substantial shortage of our products. We place binding manufacturing orders based on our forecasts and if we fail to adequately forecast demand for our products, we may incur product shortages or excess product inventory. Our third-party manufacturers require us to provide forecasts of our anticipated manufacturing orders and place binding manufacturing orders in advance of receiving purchase orders from our customers. This may result in product shortages or excess product inventory because we cannot easily increase or decrease our manufacturing orders. Obtaining additional supply in the face of product shortages may be costly or impossible, particularly in the short term, which could prevent us from fulfilling orders. In addition, our chip sets have rapidly declining average selling prices. As a result, an incorrect forecast may result in substantial product in inventory that is aged and obsolete, which could result in write-downs of excess or obsolete inventory. Our failure to adequately forecast demand for our products could cause our quarterly operating results to fluctuate and cause our stock price to decline. We may experience lower than expected manufacturing yields, which would delay the production of our semiconductor products. The manufacture of semiconductors is a highly complex process. Minute impurities in a silicon wafer can cause a substantial number of wafers to be rejected or cause numerous die on a wafer to be nonfunctional. Semiconductor companies often encounter difficulties in achieving acceptable product yields from their manufacturers. Our foundries have from time to time experienced lower than anticipated manufacturing yields, including for our products. This often occurs during the production of new products or the installation and start-up of new process technologies. We may also experience yield problems as we migrate our manufacturing processes to smaller geometries. If we do not achieve planned yields, our product costs could increase, and product availability would decrease. The loss of any of the five primary third-party subcontractors that assemble and test all of our current products could disrupt our shipments, harm our customer relationships and reduce our sales. Five primary third-party subcontractors assemble and test all of our current chip sets either for our foundries or directly for us. As a result, we do not directly control our product delivery schedules, assembly and testing costs or quality assurance and control. If any of these subcontractors experiences capacity constraints or financial difficulties, if any subcontractor suffers any damage to its facilities or if there is any other disruption of assembly and testing capacity, we may not be able to obtain alternative assembly and testing services in a timely manner. We do not have long-term agreements with any of these subcontractors. We typically procure services from these suppliers on a per-order basis. Because of 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 semiconductor products. Any problems that we may encounter with the delivery, quality or cost of our products could damage our reputation and result in a loss of customers. We use a third party to warehouse and ship a significant portion of our products and any failure to adequately store and protect our products or to deliver our products in a timely manner could harm our business. We use a third party, JSI Shipping, located in Singapore, for a significant portion of our product warehousing and shipping. As a result, we rely on this third-party to adequately protect and ensure the timely delivery of our products. Our warehoused products are insured under a general insurance policy, including the portion of products warehoused by JSI, which may not always sufficiently cover the entire value of inventory held by JSI at any given time. If our products are not delivered in a timely manner or are not sufficiently protected prior to delivery, our business could suffer.
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Table of ContentsIf our value-added manufacturer customers do not provide sufficient support, our business could be harmed. Our products are highly technical and, as a result, may require a high level of customer support. We rely on our value-added manufacturers to support our products. If these value-added manufacturers cannot successfully support our products, which are embedded in their products, our reputation could be harmed and future sales of our products could be adversely affected. Our future success depends on building relationships with customers that are market leaders. If we cannot establish these relationships or if these customers develop their own systems or adopt competitors’ products instead of buying our products, our business may not succeed. We intend to continue to pursue customers who are leaders in our target markets. We may not succeed in establishing these relationships because these companies may develop their own systems or adopt one of our competitors’ products. These relationships often require us to develop new premium software that involves significant technological challenges. These types of customers also frequently place considerable pressure on us to meet their tight development schedules. We may have to devote a substantial amount of our limited resources to these relationships, which could detract from or delay our completion of other important development projects. Delays in development of these projects could impair our relationships with other customers and negatively impact sales of the products under development. Recent changes to our senior management could negatively effect our operations and relationships with manufacturers, customers and employees. Our previous chief financial officer retired at the end of March 2006. We have hired a new senior vice president finance who assumed the role of chief financial officer at the beginning of April 2006. This change could negatively affect our operations and our relationships with our manufacturers, third-party subcontractors, customers, employees and market leaders. If the integration of this new member to our senior management team does not go as smoothly as anticipated, it could negatively affect our business. If we fail to manage our growth, our business may not succeed. We have significantly expanded our operations in the United States and internationally, and we plan to continue to expand the geographic scope of our operations. As we continue to grow, we may be unable to expand our business at the same growth rate as we have in the past. To manage our growth, we must implement and improve additional and existing administrative, financial and operations systems, procedures and controls. Our failure to manage growth could disrupt our operations and could limit our ability to pursue potential market opportunities. The limited warranty provisions in our agreements with some customers expose us to risks from product liability claims. Our agreements with some customers contain limited warranty provisions, which provide the customer with a right to damages if a defect is traced to our products or if we cannot correct errors reported during the warranty period. If our contractual limitations are unenforceable in a particular jurisdiction or if we are exposed to product liability claims that are not covered by insurance, a successful claim could require us to pay substantial damages. We may not obtain sufficient patent protection, which could harm our competitive position and increase our expenses. Our success and ability to compete depends to a significant degree upon the protection of our proprietary technology. As of June 30, 2006, we had 136 patents granted in the United States, 114 patent applications pending in the United States, 39 patents granted in foreign countries and 159 foreign patent applications pending. Our patent applications may not provide protection of all competitive aspects of our technology or may not result in issued patents. Any patents issued may provide only limited protection for our technology and the rights that may be granted under any future patents that may be issued may not provide competitive advantages to us. Also, patent protection in foreign countries may be limited or unavailable where we need this protection. It is possible that competitors may independently develop similar technologies or design around our patents and competitors could also successfully challenge any issued patent.
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Table of ContentsWe also rely upon trademark, copyright and trade secret laws and contractual restrictions to protect our proprietary rights, and, if these rights are not sufficiently protected, it could harm our ability to compete and generate revenue. We also rely on a combination of trademark, copyright and trade secret laws, and contractual restrictions, such as confidentiality agreements and licenses, to establish and protect our proprietary rights. Our ability to compete and grow our business could suffer if these rights are not adequately protected. We seek to protect our source code for our software, and design code for our chip sets, documentation and other written materials under trade secret and copyright laws. We license our software and IP cores under signed license agreements, which impose restrictions on the licensee’s ability to utilize the software and IP cores. We also seek to avoid disclosure of our intellectual property by requiring employees and consultants with access to our proprietary information to execute confidentiality agreements. The steps taken by us to protect our proprietary information may not be adequate to prevent misappropriation of our technology. Our proprietary rights may not be adequately protected because:
The laws of other countries in which we market our products, such as some countries in the Asia/Pacific region, may offer little or no protection of our proprietary technologies. As we increase our international sales, it may be more difficult to protect our intellectual property rights. Reverse engineering, unauthorized copying or other misappropriation of our proprietary technologies could enable third parties to benefit from our technologies without paying us for doing so, which would harm our competitive position and market share. Our intellectual property indemnification practices may adversely impact our business. We have agreed to indemnify some customers for certain costs and damages of intellectual property infringement in some circumstances. This practice may subject us to significant indemnification claims by our customers or others. In addition to indemnification claims by our customers, we may also have to defend related third-party infringement claims made directly against us. In some instances, our GPS products are designed for use in devices used by potentially millions of consumers, such as cellular telephones, and our server software is placed on servers providing wireless network services to end-users, both of which could subject us to considerable exposure should an infringement claim occur. In the past we have received notice from a major customer informing us that this customer received notice from one of our competitors that the inclusion of our chip sets into our customer’s products requires the payment of patent license fees to the competitor. We may receive similar notices from our customers or directly from our competitors in the future. We cannot assure you that such claims will not be pursued or that these claims, if pursued, would not harm our business. Any potential dispute involving our patents or intellectual property could be costly, time-consuming and result in our loss of significant rights. Other parties may assert intellectual property infringement claims against us, and our products may infringe the intellectual property rights of third parties. From time to time we and our customers receive letters, including letters from various industry participants, alleging infringement of patents. For example, in September 2000, we entered into a settlement and cross-licensing agreement with a third party regarding patent infringement under which we agreed to pay approximately $5.0 million and issued a warrant to purchase shares of our preferred stock. As we increase our international sales, we may become more susceptible to these types of infringement claims. Litigation may be necessary in the future to enforce our patents or any patents we may receive and other intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity, and we may not prevail in any future litigation. Litigation, whether or not determined in our favor or settled, could be costly and time-consuming and could divert management’s attention from our business. If there is a successful claim of infringement, we may be required to pay substantial damages to the party claiming infringement, develop non-infringing technology or enter into royalty or license agreements that may not be available on acceptable terms, if at all. Our failure to develop non-infringing technologies or license the proprietary rights on a timely basis would harm our business. Also, we may be unaware of filed patent applications that relate to our products. Parties making infringement claims may be able to obtain an injunction, which could prevent us from selling our products or using technology that contains the allegedly infringing intellectual property. Parties making infringement claims may also be able to bring an action before the International Trade Commission that could result in an order stopping the importation into the United States of our products. Any intellectual property litigation could have a material adverse effect on our business, operating results or financial condition.
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Table of ContentsPart of our business uses a royalty-based business model, which has inherent risks. Although a substantial majority of our net revenue is derived from sales of our chip sets, in recent periods, we have had a portion of our net revenue from large customers in the wireless markets come from royalties paid by licensees of our technology. Royalty payments are based on the number of semiconductor chips shipped which contain our GPS technology or our premium software. We depend on our ability to structure, negotiate and enforce agreements for the determination and payment of royalties. We face risks inherent in a royalty-based business model, many of which are outside of our control, including, but not limited to, the following:
It is difficult for us to verify royalty amounts owed to us under our licensing agreements, and this may cause us to lose revenue. The standard terms of our license agreements require our licensees to document the manufacture and sale of products that incorporate our technology and report this data to us on a quarterly basis. Although our standard license terms give us the right to audit books and records of our licensees to verify this information, audits can be expensive, time-consuming and potentially detrimental to our ongoing business relationship with our licensees. As a result, to date, we have relied exclusively on the accuracy of reports supplied by our licensees without independently verifying the information in them. Any significant inaccuracy in the reporting by our licensees or our failure to audit our licensees’ books and records may result in our receiving less royalty revenue than we are entitled to under the terms of our license agreements. Some of our customers could eventually become our competitors. Many of our customers are also large integrated circuit suppliers and some of our large customers already have GPS expertise in-house. These large customers have longer operating histories, significantly greater resources and name recognition, and a larger base of customers than we do. The process of licensing our technology and support of such customers to effectuate the transfer of technology may enable them to become a source of competition to us, despite our efforts to protect our intellectual property rights. We cannot sell to some customers who compete with us. In addition, we compete with divisions within some of our customers. For example, STMicroelectronics, a customer of ours, has internally developed a GPS solution for the automotive market in which we compete. Further, each new design by a customer presents a competitive situation. We, in the past, have lost design wins to divisions within our customers and this may occur again in the future. We cannot provide assurance that these customers will not continue to compete with us, that they will continue to be our customers or that they will continue to license products from us at the same volumes. Competition could increase pressure on us to lower our prices and profit margins. Our operations are primarily located in California and, as a result, are subject to earthquakes and other catastrophes. Our business operations depend on our ability to maintain and protect our facilities, computer systems and personnel, which are primarily located in San Jose, California and in Santa Ana, California. San Jose and Santa Ana exist on or near known earthquake fault zones. Should an earthquake or other catastrophe, such as a fire, flood, power loss, communication failure or similar event, disable our facilities, we do not have readily available alternative facilities from which to conduct our business. Changes to financial accounting standards may affect our results of operations and cause us to change our business practices. We prepare our financial statements to conform with U.S. generally accepted accounting principles, or GAAP. These accounting principles are subject to interpretation by the American Institute of Certified Public Accountants, the Securities and Exchange Commission and various bodies formed to interpret and create appropriate accounting policies. A change in those policies can have a significant effect on our reported results and may affect our reporting of transactions completed before a change is announced. Changes to those rules or the questioning of current practices may adversely affect our reported financial results or the way we conduct our business. For example, accounting policies affecting many aspects of our business, including rules relating to employee stock option grants, have recently been adopted. The Financial Accounting Standards Board and other agencies have finalized changes to GAAP that now require us to record a charge to earnings for the fair value of employee stock option grants and other equity incentives. We will have significant and ongoing accounting charges resulting from option grant and other equity incentive expensing that will reduce our overall net income. In addition,
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Table of Contentssince we historically have used equity-related compensation as a component of our total employee compensation program, the accounting change could make the use of equity-related compensation less attractive to us and therefore make it more difficult to attract and retain employees. See Note 3 of the “Notes to Condensed Consolidated Financial Statements” in Item 1 for a discussion of the impact on our financial results. In connection with our equity compensation program, we have reviewed certain stock option grants and our related procedures. Although we do not believe there are any matters that could have a material effect on our financial statements, the SEC or other government agency may inquire as to our granting of equity compensation or disagree with our findings. RISKS RELATED TO OUR INDUSTRY Because many companies sell in the market for GPS-based products, we must compete successfully to gain market share. The market for our products is competitive and rapidly evolving. We expect competition to increase. Increased competition may result in price reductions, reduced margins or loss of market share. We may be unable to compete successfully against current or future competitors. Some of our customers are also competitors of ours. Within each of our markets, we face competition from public and private companies as well as our customers’ in-house design efforts. For chip sets, our main competitors include Analog Devices, Philips, QUALCOMM, Infineon, Sony, STMicroelectronics, Texas Instruments and Trimble, as well as several private companies. Some large semiconductor companies may acquire private GPS companies to gain access to their technology and become serious competitors to us in a short time. For modules based on our products, the main competitors are Furuno, JRC, Sony, u-blox and Trimble. For licensed IP cores, our competitors include QUALCOMM, Ceva and several private companies. Licensees of our competitors’ products may also compete against us. In the wireless market, we also compete against products based on alternative location technologies that do not rely on GPS, such as wireless infrastructure-based systems. These systems are based on technologies that compute a caller’s location by measuring the differences of signals between individual base stations. If these technologies become more widely adopted, market acceptance of our products may decline. Competitors in these areas include Andrew, Cambridge Positioning Systems and TruePosition. Further, alternative satellite-based navigation systems such as Galileo, which is being developed by European governments, may reduce the demand for GPS-based applications or cause customers to postpone decisions on whether to integrate GPS capabilities into their products. Many of our competitors have significantly greater financial, technical, manufacturing, marketing, sales and other resources than we do. Also, in 2005, many of our private competitors raised additional financing. We also believe that our success depends on our ability to establish and maintain relationships with established system providers and industry leaders. Our failure to establish and maintain these relationships, or the preemption of relationships by the actions of other competitors, will harm our ability to penetrate emerging markets. Cyclicality in the semiconductor industry may affect our revenue and, as a result, our operating results could be adversely affected. The semiconductor industry has historically been cyclical and is characterized by wide fluctuations in product supply and demand. From time to time, this industry has experienced significant downturns, often in connection with, or in anticipation of, maturing product and technology cycles, excess inventories and declines in general economic conditions. This cyclicality could cause our operating results to decline dramatically from one period to the next. In addition to the sale of chip sets, our business depends on the volume of production by our technology licensees, which, in turn, depends on the current and anticipated market demand for semiconductors and products that use semiconductors. As a result, if we are unable to control our expenses adequately in response to lower revenue from our chip set customers and technology licensees, our operating results will suffer and we might experience operating losses. We derive a substantial portion of our revenue from international sales and conduct some of our business internationally, and economic, political and other risks may harm our international operations and cause our revenue to decline. We derived approximately 85% and 81% of our net revenue on export sales from the United States in the second quarter of 2006 and 2005, respectively, and approximately 81% and 78% in the first half of fiscal 2006 and 2005, respectively. Export sales from the United States to the Asia/Pacific region accounted for approximately 77% and 64% of our net revenue in the second quarter of 2006 and 2005, respectively, and approximately 73% and 62% in the first half of fiscal 2006 and 2005, respectively. We maintain sales offices in Europe and the Asia/Pacific region and may expand our international operations.
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Table of ContentsA significant amount of our business is international and our products are sold into markets that are very price sensitive. Tariffs and trade restrictions that favor local competition in some countries on our products could significantly impact our business. Any increase in tariffs changes on GPS products, in countries where we do business, could negatively impact our business. Additional risks we face in conducting business internationally include:
Also, there may be reluctance in some foreign markets to purchase products based on GPS technology, due to the control of GPS by the United States government. Any of these factors could significantly harm our future international sales and operations and, consequently, our business. We may have difficulty in protecting our intellectual property rights in foreign countries, which could increase the cost of doing business or cause our revenue to decline. Our intellectual property is used in a large number of foreign countries. There are many countries, such as China, in which we have no issued patents, or that may have reduced intellectual property protection. In addition, effective intellectual property enforcement may be unavailable or limited in some foreign countries. It may be difficult for us to protect our intellectual property from misuse or infringement by other companies in these countries. For example, if our foundries lose control of our intellectual property, it would be more difficult for us to take remedial measures because our foundries are located in countries that do not have the same protection for intellectual property that is provided in the United States. Furthermore, we expect this to become a greater problem for us as our technology licensees increase their manufacturing in countries, which provide less protection for intellectual property. Our inability to enforce our intellectual property rights in some countries may harm our business. The GPS market could be subject to governmental and other regulations that may increase our cost of doing business or decrease demand for our products. GPS technology is restricted and its export is controlled. The United States government may restrict specific uses of GPS technology in some applications for privacy or other reasons. The United States government may also block the civilian GPS signal at any time or in hostile areas. In addition, the policies of the United States government for the use of GPS without charge may change. The growth of the GPS market could be limited by government regulation or other action. For example, the President of the United States authorized a new national policy on December 8, 2004 that establishes guidance and implementation actions for space-based positioning, navigation, timing programs, augmentations and activities for U.S. national and homeland security, civil, scientific, and commercial purposes. These regulations or actions could interrupt or increase our cost of doing business. Reallocation of the radio frequency bands used by GPS technology may harm the utility and reliability of our products. GPS technology uses radio frequency bands that are globally allocated for radio navigation satellite services. International allocations of radio frequency bands are made by the International Telecommunications Union, a specialized technical agency of the United Nations. These allocations are further governed by radio regulations which have treaty status
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Table of Contentsand which are subject to modification every two to three years by the World Radio Communication Conference. Any reallocation of radio frequency bands, including frequency band segmentation or spectrum sharing, may negatively affect the utility and reliability of GPS-based products. Also, unwanted emissions from mobile satellite services and other equipment operating in adjacent frequency bands or inband from licensed and unlicensed devices may negatively affect the utility and reliability of GPS-based products. The Federal Communications Commission continually receives proposals for new technologies and services which may seek to operate in, or across, the radio frequency bands currently used by the GPS and other public services. For example, in May 2000, the Federal Communications Commission issued a proposed rule for the operation of ultra-wideband radio devices on an unlicensed basis in the same frequency bands. These ultra-wideband devices might cause interference with the reception of GPS signals. This could reduce demand for GPS-based products, which could reduce our sales and revenue. Adverse decisions by the Federal Communications Commission that result in harmful interference to the delivery of the GPS signals may harm the utility and reliability of GPS-based products. Our technology relies on the GPS satellite network, and any disruption in this network would impair the viability of our business. The satellites and ground support systems that provide GPS signals are complex electronic systems subject to electronic and mechanical failures and possible sabotage. The satellites were originally designed to have lives of six to seven years and are subject to damage by the hostile space environment in which they operate. However, some of the satellites currently deployed have already been in place for 15 years. Repairing damaged or malfunctioning satellites is currently not economically feasible. If a significant number of satellites were to become inoperable, there could be a substantial delay before they are replaced with new satellites, or they may not be replaced at all. A reduction in the number of operating satellites would impair the operations or utility of GPS, which would have a material negative effect on our business. The United States government may not remain committed to the maintenance of GPS satellites over a long period. Personal privacy concerns may limit the growth of the high-volume consumer and commercial GPS-based applications and demand for our products. GPS-based consumer and commercial applications rely on the ability to receive, analyze and store location information. Consumers may not accept some GPS applications because of the fact that their location can be tracked by others and that this information could be collected and stored. Also, federal and state governments may disallow specific uses of GPS technology for privacy or other reasons or could subject this industry to regulation. If consumers view GPS-based applications as a threat to their privacy, demand for some GPS-based products could decline. We may experience a decrease in market demand due to uncertain economic conditions in the United States and in international markets, which has been further exacerbated by the concerns of terrorism, war and social and political instability. Economic growth in the United States and international markets has slowed significantly. In addition, the terrorist attacks in the United States and turmoil in the Middle East have increased the uncertainty in the United States economy and may contribute to a decline in economic conditions, both domestically and internationally. Terrorist acts and similar events, or war in general, could contribute further to a slowdown of the market demand for goods and services, including demand for our products. If the economy declines as a result of the recent economic, political and social turmoil, or if there are further terrorist attacks in the United States or elsewhere, we may experience decreases in the demand for our products, which may harm our operating results. OTHER RISKS RELATED TO US Our ability to raise capital in the future may be limited, and our failure to raise capital when needed could prevent us from executing our growth strategy. We believe that our existing cash, investments, amounts available under our bank line of credit and cash generated from operating activities, will be sufficient to meet our anticipated cash needs for at least the next 12 months. The timing and amount of our working capital and capital expenditure requirements may vary significantly depending on numerous factors, including:
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Table of ContentsIf our capital resources are insufficient to satisfy our liquidity requirements, we may seek to sell additional equity securities or debt securities or obtain other debt financing. The sale of additional equity securities or convertible debt securities would result in additional dilution to our stockholders. Additional debt would result in increased expenses and could result in covenants that would restrict our operations. We have not made arrangements to obtain additional financing, and there is no assurance that financing, if required, will be available in amounts or on terms acceptable to us, if at all. We will incur increased costs as a result of being a public company. The Sarbanes-Oxley Act of 2002, as well as rules subsequently implemented by the Securities and Exchange Commission and Nasdaq, have required changes in corporate governance practices of public companies. These rules and regulations have increased our legal and financial compliance costs, and made some activities more time-consuming and costly. We also expect these rules and regulations to make it more difficult and more expensive for us to obtain director and officer liability insurance and we may be required to accept reduced policy limits and coverage or incur substantially higher costs to obtain similar coverage. These rules and regulations could also make it may be more difficult for us to attract and retain qualified members of our board of directors, particularly to serve on our audit committee, and qualified executive officers. We are exposed to risks from legislation requiring companies to evaluate internal controls over financial reporting. Section 404 of the Sarbanes-Oxley Act of 2002 requires our management to report on, and our independent auditors to attest to, the effectiveness of our internal control structure and procedures for financial reporting. We have an ongoing program to perform the system and process evaluation and testing necessary to comply with these requirements. As a result, we have and expect to continue to incur increased expense and to devote additional management resources to Section 404 compliance. In the future, if our chief executive officer, chief financial officer or independent registered public accounting firm determine that our internal controls over financial reporting are not effective as defined under Section 404, investor perceptions of our company may be adversely affected and could cause a decline in the market price of our stock. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds (a) On the following dates we withheld the following shares of common stock pursuant to the vesting of outstanding restricted stock units to cover the withholding taxes for such shares of common stock:
Item 4. Submission of Matters to a Vote of Security Holders We held an Annual Meeting of our Stockholders on May 3, 2006, at which the following occurred: ELECTION OF CLASS I DIRECTORS TO THE BOARD OF DIRECTORS: The stockholders elected Mohanbir Gyani, Stephen Sherman and Sam Srinivasan as Class II Directors. The votes on the matters were as follows:
Other directors whose term of office as a director continued after the annual meeting were Diosdado P. Banatao, Moiz M. Beguwala, Michael L. Canning, Kanwar Chadha and James M. Smaha.
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Table of ContentsRATIFICATION OF THE SELECTION BY THE AUDIT COMMITTEE OF THE BOARD OF DIRECTORS OF ERNST & YOUNG LLP AS OUR INDEPENDENT REGISTERED PUBLIC ACCOUNTANTS: The stockholders ratified the selection by the Audit Committee of the Board of Directors of Ernst & Young LLP as our independent registered public accountants for the 2006 fiscal year. The vote on the matter was as follows:
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Table of ContentsItem 6. Exhibits
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Table of ContentsSiRF TECHNOLOGY HOLDINGS, INC. Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
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Table of ContentsExhibit Index
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