Silicon Image (SIMG)

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

 

Form 10-K

 

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

 

For the fiscal year ended December 31, 2005

 

Commission file number 000-26887

 

 

 

Silicon Image, Inc.
(Exact name of registrant as specified in its charter)

 

 

1060 East Arques Avenue
Sunnyvale, CA 94085
(Address of principal executive offices and zip code)

 

(Registrant’s telephone number, including area code)
(408) 616-4000

 

Securities registered pursuant to section 12(g) of the Act:
Common Stock, $0.001 par value

 

 

 

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

 

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

 

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 þ     No o

 

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

 

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):

Large accelerated filer o     Accelerated filer þ     Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ

 

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $683,741,554 as of the last business day of the registrant’s most recently completed second fiscal quarter, based upon the closing sale price on the Nasdaq National Market reported for such date. Shares of common stock held by each officer and director and by each person who owned 5% or more of the outstanding Common Stock (based upon Schedule 13G filings made prior to such date) have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

 

The number of shares of the Registrant’s common stock outstanding as of February 28, 2006 was 81,145,950.

 

Portions of the Proxy Statement for the 2006 Annual Meeting of Stockholders to be held on May 23, 2006, are incorporated by reference in Part III of this Form 10-K.

 

 

TABLE OF CONTENTS

 

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. These forward-looking statements involve a number of risks and uncertainties, including those identified in the section of this Annual Report on Form 10-K entitled “Factors Affecting Future Results,” that may cause actual results to differ materially from those discussed in, or implied by, such forward-looking statements. Forward-looking statements within this Annual Report on Form 10-K are identified by words such as “believes,” “anticipates,” “expects,” “intends,” “may,” “will”, “can”, “should”, “could”, “estimate”, based on”, “intended”, “would”, “projected”, “forecasted” and other similar expressions. However, these words are not the only means of identifying such statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. We undertake no obligation to publicly release the results of any updates or revisions to these forward-looking statements that may be made to reflect events or circumstances occurring subsequent to the filing of this Form 10-K with the Securities and Exchange Commission (SEC). Our actual results could differ materially from those anticipated in, or implied by, forward-looking statements as a result of various factors, including the risks outlined elsewhere in this report. Readers are urged to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the SEC that attempt to advise interested parties of the risks and factors that may affect our business.

PART I

 

Our mission is to be the market leader in the secure storage, distribution and presentation of high definition content in the consumer environment. To ensure that rich digital content is available across devices, whether consumer electronics (CE), personal computers and displays (PC) or storage devices, they must be architected for content compatibility and interoperability.

 

Our strategy entails establishing industry-standard, high-speed digital, secure interfaces and building market momentum and leadership through our first-to-market, standards-based semiconductor products. Further leveraging our IP portfolio, we broaden market adoption of the Digital Visual Interface (DVI), High-Definition Multimedia Interface^tm (HDMI^tm) and Serial ATA (SATA) interfaces by licensing our proven IP cores to companies interested in promoting products complementary to our own. Licensing, in addition to creating revenue and return on engineering investment in market segments we choose not to address, creates products complementary to our own that expand the markets for our products and help to improve industry wide interoperability.

 

We are a leader in the global PC and digital display arena with our innovative PanelLink branded digital interconnect technology, which enables an all-digital connection between PC host systems, such as PC motherboards, graphics add-in boards and notebook PCs and digital displays such as LCD monitors, plasma displays and projectors. Our PanelLink solutions are the most popular DVI implementations in their market, with more than 75 million units shipped to date.

 

Our CE products offer a secure interface for transmission of digital video and audio to consumer devices, such as digital TVs, HDTVs, A/V receivers, set-top boxes (STBs) and DVD players. Leveraging our core technology and standards-setting expertise, we are a leading force in advancing the adoption of HDMI, the digital audio and video interface standard for the CE market. Introduced in 2003 by founders Hitachi Ltd. (Hitachi), Matsushita Electric Industrial Co. (MEI or Panasonic), Philips Consumer Electronics International B.V. (Philips), Silicon Image, Sony Corporation (Sony), Thomson Multimedia, S.A. (Thomson or Thomson RCA) and Toshiba Corporation (Toshiba), HDMI enables the distribution of uncompressed, high-definition video and multi-channel audio in a single, all-digital interface that dramatically improves quality and simplifies cabling. Based on the same core technology used by the DVI standard, our HDMI technology is also marketed under the PanelLink brand and includes High-bandwidth Digital Content Protection (HDCP), which is supported by some Hollywood studios as the technology of choice for the secure distribution of premium content over uncompressed digital connections. We shipped the first HDMI-compliant silicon to the market and currently remain the market leader for HDMI functionality, with more than 35 million units shipped to date.

 

In the storage market, we have assumed a leadership role in SATA, the high-bandwidth, point-to-point interface that is replacing parallel ATA in desktop storage and making inroads in the enterprise arena due to its improved price/performance ratio. We are a leading supplier of discrete SATA devices with multiple motherboard and add-in-card design wins. Our SATALink^tm branded solutions are fully SATA-compliant and offer advanced features and capabilities such as 3Gb/s support Native Command Queuing, port multiplier capability and ATAPI support. We continue to supply high-performance, low-power Fibre Channel Serializer/Deserializer (SerDes) to leading switch manufacturers. In 2004, we shipped our first products based on the SteelVine^tm storage architecture that is expected to serve the storage needs of the home consumer and consumer electronics markets with a system- on-a-chip implementation that includes a high-speed switch, a custom designed dual instruction RISC (reduced instruction set computer) micro-processor, firmware and the SATA interface, among other features.

 

In 2004, we launched PanelLink Cinema Partners^tm, LLC, a wholly-owned subsidiary of ours which was formally changed to Simplay Labs, LLC (Simplay) in December 2005. Simplay operates and markets the Simplay HD^tm Testing Program. This testing program is primarily designed for consumer electronics (CE) manufacturers, CE retailers and technology providers. Current members of the program include Hitachi, LG, Mitsubishi, Samsung, Sony, TTE, Tweeter and others. The Simplay HD Testing Program is open to all manufacturers of consumer electronics devices implementing HDMI/HDCP including HDTV’s, DTV’s, Set-Top Boxes (STB’s), DVD players, A/V receivers and cables. The program also maintains broad industry support from a variety of leading digital content providers including The Walt Disney Company, Fox, Universal and Warner Bros.

The Simplay HD^tm Testing Program is designed to help consumers know that the digital entertainment devices that they purchase have been tested according to specifications aimed at maximizing the delivery of HD content. The program consists of testing, branding and awareness initiatives directed at retailers as well as consumers. At its core, the program is based on the Simplay HD Compatibility Test Specification (CTS) for device manufacturers. Testing encompasses HDCP functionality in conjunction with HDMI, as well as compatibility (“plug-testing”), between devices from different manufacturers. Products that pass have been verified to meet the Simplay HD^tm Testing Program requirements and are licensed to use the Simplay HD logo, enabling consumers to purchase digital entertainment devices with the confidence that they will be able to receive and play the latest digital content with state of the art technology. Leveraging this branding component, the Simplay HD^tm Testing Program will be providing education to retailers on the importance of Simplay HD verification.

 

Markets and Customers

 

We focus our sales and marketing efforts on achieving design wins with leading original equipment manufacturers (OEMs) of CE, PC, and storage products. In many cases, these OEMs outsource manufacturing functions to third parties. In these cases, once our product is designed into an OEM’s product, we typically work with the OEM’s third-party manufacturer to facilitate the design for production. After the design is complete, we sell our products to these third-party manufacturers either directly or indirectly through distributors.

 

Historically, a relatively small number of customers and distributors have generated a significant portion of our revenue. Our top five customers, including distributors, generated 54%, 47%, and 41%, of our revenue in 2005, 2004 and 2003, respectively. The increase in 2005 from 2004 and 2003 levels can be attributed to the increased level of purchasing activities with these distributors. Additionally, the percentage of revenue generated through distributors tends to be significant, since many OEMs rely upon third-party manufacturers or distributors to provide purchasing and inventory management functions. Our revenue, generated through distributors, was 52%, 45% and 42% of our total revenue in 2005, 2004 and 2003, respectively. World Peace Inc., comprised 17.2%, 15.0% and 13.6% of our revenue in 2005, 2004 and 2003 respectively. Microtek comprised 10.6%, 12.0% and 11.2% of our revenue in 2005, 2004 and 2003 respectively. Our licensing revenue is not generated through distributors, and to the extent licensing revenue increases, we would expect a decrease in the percentage of our revenue generated through distributors. A substantial portion of our business is conducted outside the United States; therefore, we are subject to foreign business, political and economic risks. Nearly all of our products are manufactured in Asia and for the years ended December 31, 2005, 2004, and 2003, 74%, 72%, and 74% of our revenue, respectively, was generated from customers and distributors located outside the United States, primarily in Asia.

 

Products

 

Our mission is to be the market leader in the secure storage, distribution and presentation of high definition content in the consumer environment. To ensure that rich digital content is available across devices, consumer electronics, PC and storage devices must be architected for content compatibility and interoperability. Our industry and the markets we serve are characterized by rapid technological advancement. We constantly strive for innovation in our product offerings. We introduce products to address markets or applications that we have not previously addressed, and to replace our existing products with products that are based on more advanced technology that incorporate new or enhanced features. We market products to the CE, PC/display, and storage markets. We expect to continue integrating more functionality into our existing products in order to enhance their performance and capabilities.

 

When we introduce replacement products, we notify our customers in advance, work with our customers to qualify and migrate to our newer products and accept final orders for replaced products, thereby enabling us to eventually discontinue production and support for older, less advanced products. We may decide to phase out products for reasons other than new product introductions. Such reasons could include failure of products to achieve market acceptance, changing market conditions and changes in business strategy.

Consumer Electronics

 

Developed by Sony, Hitachi, Thomson (RCA), Philips, Matsushita (Panasonic), Toshiba and Silicon Image as the digital interface standard for the consumer electronics market, the HDMI specification combines uncompressed high-definition video and multi-channel audio in a single digital interface to provide digital quality over a single cable.

 

Our Transition Minimized Differential Signaling TMDS^® technology serves as the basis for HDMI, as well as for the Digital Visual Interface (DVI) standard designed for PC applications.

 

Fully backward-compatible with products incorporating DVI (also pioneered by Silicon Image), HDMI offers additional consumer enhancements such as automatic format adjustment to match content to its preferred viewing format, and the ability to build in intelligence so one remote click can configure an entire HDMI-enabled system. HDMI has the support of major Hollywood studios and offers significant advantages over analog A/V interfaces, including the ability to transmit uncompressed, high-definition digital video and multi-channel digital audio over a single cable.

 

Silicon Image’s HDMI products are branded under the PanelLink product family and have been selected by many of the world’s leading CE companies.

 

PanelLink HDMI Transmitters.  Our PanelLink HDMI transmitter products reside on host systems, such as DVD players, DVD recorders, A/V receivers, STBs, PVRs and D-VHS players. PanelLink HDMI transmitters encrypt digital video and audio from a source device, combine it in a single, HDMI-compliant stream and transmit the secure content to a HDMI receiver in a display. Our PanelLink HDMI transmitter products include:

 

PanelLink HDMI Transmitters

 

 

PanelLink HDMI Receivers.  Our PanelLink HDMI receiver products reside in display systems, such as DTVs, HDTVs, plasma TVs, LCD TVs, rear-projection TVs and front projectors, as well as A/V receivers. PanelLink HDMI receivers decode and decrypt an incoming HDMI/HDCP stream and deliver YPbPr or analog RGB video along with digital audio. Our PanelLink HDMI receiver products include:

 

PanelLink HDMI Receivers

 

Digital Video Processors.  Our digital video processor products are high-quality, digital video format converters that convert any standard-definition interlaced video signal to a non-interlaced signal, resulting in higher-definition images. These products are suitable for DTVs, HD-ready TVs or monitors, LCD TV, LCD, or digital light processing projection DTVs, projectors, or progressive scan DVD players. We have recently introduced dual mode DVI/HDMI transmitters to the market to facilitate PC connections to advanced TV displays with HDMI connections. Our digital video processor products include:

 

Digital Video Processors

 

 

PCs and Displays

 

Pioneered by Silicon Image and introduced by the Digital Display Working Group (DDWG), DVI is the digital standard for connecting PCs to digital displays. DVI defines a robust, high-speed serial communication link between host systems and displays — enabling sharper, crystal-clear images and lower cost designs. Accommodating bandwidth in excess of 165 MHz, DVI provides UXGA support with a single-link interface.

 

Silicon Image’s DVI products are branded under the PanelLink product family with well over 75 million DVI-based units shipped into PC and digital display applications.

 

PanelLink DVI Transmitters.  Our PanelLink DVI transmitter products reside on host systems, such as PC motherboards, graphics add-in boards and notebook PCs. Transmitters take a stream of digital data from a graphics source, convert it to DVI-compliant digital output and transmit that output to a receiver in a display. Our PanelLink DVI and DVI/HDMI transmitter products include:

 

PanelLink DVI Transmitters

 

 

PanelLink DVI Receivers.  Our PanelLink receiver products reside in display systems, such as flat panel displays and projectors. Receivers receive DVI-compliant digital input and restore the video data format. Our

receivers also contain functionality that simplifies the design of digital displays. Our PanelLink DVI receiver products include:

 

PanelLink DVI Receivers

 

 

PanelLink DVI Controllers.  Our PanelLink controller products are suitable for display systems such as flat panel displays and digital televisions. Our PanelLink controller products include:

 

PanelLink DVI Controllers

 

Intelligent Panel Controllers.  Our Intelligent Panel Controller (IPC) products are programmable controllers with integrated timing controllers that reside on the LCD display module. These products receive digital input, restore the video data format and directly interface with the LCD module electronics. Our IPC products include:

 

Intelligent Panel Controllers

 

 

Storage

 

Silicon Image sells a variety of storage products that facilitate today’s demanding storage applications. One of these products is our SteelVine product line, which is designed to integrate functionality typically associated with a redundant array of independent disks (RAID) into a single chip and significantly lower the cost of highly reliable storage solutions for the home consumer and for newly emerging CE applications like DVR and Media PC’s.

 

Silicon Image continues to introduce higher levels of SATA integration, driving higher SATA performance and functionality, and delivering a family of SATA system-on-a-chip solutions and systems for the consumer electronics environment.

 

Serial ATA offers a number of benefits over parallel ATA interfaces, including higher bandwidth, scalability, lower voltage and narrower cabling. As a result, SATA is expected to become the standard drive interface for desktop and notebook PCs and is expected to establish a significant presence in both enterprise storage and CE applications through external SATA (e-SATA) connections.

 

Silicon Image’s new SteelVine storage architecture enables a new class of storage systems solutions available to the home consumer and consumer electronics markets. SteelVine-based systems deliver enterprise-class features such as virtualization, RAID, hot-plug and hot spare, in appliance-like solutions that are simple, reliable, affordable and scalable. The first system implementation of the SteelVine architecture, the SV2000^tm, is a reference design that leverages a standard SATA interface to provide a sophisticated RAID solution that does not require special OS drivers or RAID software to load or configure.

SteelVine Storage Reference Systems.  The products in our SteelVine storage reference systems family include a 5-drive SATA-II array as well as a 2-drive SATA-II array and a two and four external port host bus adapter that maximize the performance of the SV2000 and SV1000. Customers have the option of going to production directly with Silicon Image reference designs to achieve time to market objectives or have the option of purchasing SteelVine ICs. Our storage reference systems products and IC products include:

 

SteelVine Storage Reference Systems

 

 

SteelVine Storage ICs

 

 

Silicon Image’s proven multi-layer approach to providing robust, cost-effective, multi-gigabit semiconductor solutions on a single chip for high-bandwidth applications, lends itself well to SATA storage market applications.

 

Silicon Image has assumed a leadership role in driving SATA adoption across desktop and enterprise platforms. Silicon Image’s SATA semiconductor products are branded under the SATALink product family.

 

SATALink Serial ATA Host Controllers and Device Bridges.

 

The products in our SATALink family include six host controllers, and two bridge ICs that enable customers to begin to incorporate SATA while they transition from parallel ATA. Our SATA controller, and device bridge products are based on the SATA specifications published by the Serial ATA International Organization (SATA-IO) and include:

 

SATALink Serial ATA Controllers and Device Bridges

 

 

Parallel ATA Controller.  Our parallel ATA controller serves products incorporating the parallel ATA interface such as motherboards, add-in cards and embedded systems. Our parallel ATA controller product is:

 

Parallel ATA Controllers

 

Fibre Channel SerDes.  Our Fibre Channel Serializer/Deserializer (SerDes) products are low-power, high-quality (low-jitter), cost-effective solutions for applications such as host bus adapters (HBAs) and switches that connect PCs and servers to large storage banks. Our Fibre Channel products include:

 

Fibre Channel SerDes

 

 

Promotion of Industry Standards

 

A key element of our business strategy is the development and promotion of industry standards in our target markets. Current standards efforts include:

 

High-Definition Multimedia Interface (HDMI)

 

We, together with Sony, Matsushita (Panasonic), Philips, Thomson (RCA), Hitachi and Toshiba, entered into a Founder’s Agreement and formed a working group to develop a specification for a next-generation digital interface for consumer electronics. In December 2002, the final specification for High-Definition Multimedia Interface (HDMI^tm) 1.0 was released. In May 2004, the HDMI specification was modified (HDMI 1.1) to include DVD audio-related capabilities. In August 2005, the HDMI specification was modified (HDMI 1.2) to include SACD audio-related capabilities, and to improve support for PC monitor resolutions.

 

The HDMI 1.2 specification is based on our TMDS^® technology, the underlying technology for DVI 1.0, and has received strong support from Fox and Universal Studios (now NBC Universal), DirecTV and Echostar. Because of the number of devices and the dynamic nature of the consumer electronics market it is expected that the HDMI standard will evolve further over time. As an HDMI Founder, we have actively participated in the evolution of the HDMI specification. Additionally, the HDMI standard has been approved as a digital connection by the Federal Communications Commission (FCC) and DVD Forum for use in TVs and STBs and for use in DVD players. This is discussed in more detail below. In December 2005, the HDMI specification was modified (HDMI 1.2a) to include the full specification of CEC features and compliance tests as well as additional cable and connector testing requirements.

 

As of December 31, 2005, there were 313 companies that had signed HDMI Adopters Agreements, and are granted a standard license to the HDMI specification and necessary patents. We expect HDMI to proliferate and become the standard digital interface for consumer electronics products that carry digital audio and video signals.

 

As a requirement under the HDMI specification, manufacturers are required to test their first product in each of four product categories at an independent HDMI Authorized Testing Center (ATC). We operate several HDMI ATCs that tests manufacturer products for conformance to the HDMI specification. Our first HDMI ATC opened in August of 2003. We charge a per product fee for testing in the following categories: (i) source devices, such as DVD players, (ii) sink devices, such as televisions, (iii) repeater devices, such as AV receivers, and (iv) HDMI cables.

 

In the United States, the FCC issued its Plug and Play order in October 2003. In November 2003 and March 2004, these rules, known as the Plug & Play Final Rules (Plug & Play Rules), became effective. The Plug and Play Rules are relevant to DVI and HDMI with respect to high definition set-top boxes and the labeling of digital cable ready televisions.

 

Regarding high-definition set-top boxes, the FCC stated that, as of July 1, 2005, all high definition set-top boxes acquired by cable operators for distribution to subscribers would need to include either a Digital Visual Interface (DVI) or High-Definition Multimedia Interface (HDMI) with HDCP.

Regarding digital cable ready televisions, the FCC stated that a unidirectional digital cable television may not be labeled or marketed as digital cable ready unless it includes the following interfaces according to the following schedule:

 

(i) For 480p grade unidirectional digital cable televisions, either a DVI/HDCP, HDMI/HDCP, or 480p Y,Pb,Pr (analog) interface:

 

(A) Models with screen sizes 36 inches and above: 50% of a manufacturer’s or importer’s models manufactured or imported after July 1, 2004; 100% of such models manufactured; or

 

(B) Models with screen sizes 32 to 35 inches: 50% of a manufacturer’s or importer’s models manufactured or imported after July 1, 2005; 100% of such models manufactured or imported after July 1, 2006.

 

(ii) For 720p/1080i grade unidirectional digital cable televisions, either a DVI/HDCP or HDMI/HDCP interface:

 

(A) Models with screen sizes 36 inches and above: 50% of a manufacturer’s or importer’s models manufactured or imported after July 1, 2004; 100% of such models manufactured or imported after July  1, 2005;

 

(B) Models with screen sizes 25 to 35 inches: 50% of a manufacturer’s or importer’s models manufactured or imported after July 1, 2005; 100% of such models manufactured or imported after July 1, 2006; or

 

(C) Models with screen sizes 13 to 24 inches: 100% of a manufacturer’s or importer’s models manufactured or imported after July 1, 2007.

 

In the past, the FCC has made modifications to its rules and timetable for the digital television transition and it may do so in the future.

 

In January 2005, the European Industry Association for Information Systems, Communication Technologies and Consumer Electronics (EICTA) issued its “Conditions for High Definition Labeling of Display Devices” which requires all HDTVs using the “HD Ready” logo to have either an HDMI or DVI input with HDCP. In August 2005, EICTA issued its “Minimum Requirements for HD Television Receivers” which requires HD Receivers without an integrated display (e.g. HD STBs) utilizing the “HDTV” logo and intended for use with HD sources (e.g. television broadcasts), some of which require content protection in order to permit HD quality output, to have either a DVI or HDMI output with HDCP.

 

In August 2005, the Cable and Satellite Broadcasting Association of Asia (CASBAA) issued a series of recommendations in its “CASBAA Principles for Content Protection in the Asia-Pacific Pay-TV Industry” for handling digital output from future generations of set-top boxes for VOD, PPV, Pay-TV and other encrypted digital programming applications. These recommendations include the use of one or more HDMI with HDCP or DVI with HDCP digital outputs for set-top boxes capable of outputting uncompressed high-definition content.

 

High-bandwidth Digital Content Protection (HDCP)

 

In 2000, the High-bandwidth Digital Content Protection (HDCP) specification HDCP 1.0 was published by Intel, with contributions by Silicon Image, acknowledged in the specification. The specification was developed to provide a content-protected link from host devices, such as PCs, set-top boxes and DVD and D-VHS players, to displays such as computer monitors, HDTVs and digital TVs. This technology has support from certain members of the Motion Picture Industry Association and aims to prevent high-definition movie content from being copied when transmitted over a digital link. In 2003, the HDCP specification was modified and made available for use over HDMI interfaces.

DVD Copy Control Association

 

In addition, the DVD Copy Control Association, responsible for licensing CSS (Content Scramble System) to manufacturers of DVD hardware, discs and related products, has approved HDMI for use in DVD players as an authorized digital output of CSS protected content.

 

Digital Visual Interface (DVI)

 

In 1998, we, together with Intel, Compaq, IBM, Hewlett-Packard, NEC and Fujitsu, announced the formation of the Digital Display Working Group (DDWG). Subsequently, these parties entered into a Promoter’s Agreement in which they agreed to:

 

 

In 1999, the DDWG published the DVI 1.0 specification, which defines a high-speed serial data communication link between computers and digital displays. Today, over 100 companies, including systems manufacturers, graphics semiconductor companies and monitor manufacturers have participated in DDWG activities, and many are developing hardware and software products designed to be compliant with the DVI specification. The DVI 1.0 standard remains in effect and has not changed from its release in 1999.

 

As noted above, the FCC in the Plug & Play Rules included DVI/HDCP and HDMI/HDCP requirements for high-definition STBs acquired by cable operators for distribution to cable subscribers and for use of the “digital cable ready” label for televisions. In the past, the FCC has made modifications to its rules and timetables for digital television transition and may continue to do so in the future.

 

Serial ATA Working Group

 

During 2000, we acquired Zillion Technologies, a developer of high-speed transmission technology for data storage applications. Zillion contributed in drafting the preliminary SATA 1.0, published in 2001 which was being promoted as a successor to parallel bus technology. We were a contributor to the SATA working group, which includes, Dell, Intel, Maxtor, Seagate, and Vitesse among its promoters. In February 2002, we joined the SATA II Working Group, the successor to SATA working group, as a contributor. The SATA II working group released “Extensions to Serial ATA 1.0 Specifications” in October 2002 and “Extensions to Serial ATA 1.0a rev. 1.1” in November of 2003, to enhance the existing SATA 1.0 specification for the server and network storage markets. The SATA II working group has also released specifications for SATA port multipliers and SATA port selectors.

 

In 2004, the SATA II working group released specifications for the next-generation SATA speed of 3 Gb/s and external cabling for SATA.

 

In July 2004, a new organization, the Serial ATA International Organization, (SATA-IO), was formed as the successor to the SATA II working group. This organization provides the industry with guidance and support for implementing the SATA specification. We are a member of the SATA-IO, which has a current membership of over 100 companies including its current board members, Dell, Intel, Maxtor, Seagate and Vitesse. Under the SATA-IO committee, a revised 2.5 specification has been released. Silicon Image continues to be an active member in the Serial-IO group.

 

Incits T-13 Committee

 

In 2003, Silicon Image joined the Incits T-13 technical committee (T-13 Committee) as a contributor. The T-13 Committee is responsible for publishing the ATA specification and is currently working to make improvements to the ATA specification, including the incorporation of the Serial ATA 1.0a specification into their next revision of the

ATA specification, ATA-7. Members of the T-13 Committee include Hitachi, Intel, Seagate, Phoenix Technologies, Maxtor, Microsoft, Fujitsu and nVidia among others.

 

UDI Working Group

 

In May 2005, we entered into the Unified Display Interface Specification Promoters Agreement (UDI Promoters Agreement) with Intel and National Semiconductor, since joined by Apple Computer, LG Electronics, and Samsung Electronics, to develop and promote the Unified Display Interface specification that is intended to serve as the next-generation digital display interface standard for PCs and provide compatibility with Consumer Electronics devices. UDI is targeted to become the new display interface for desktop PCs, workstations, notebook PCs and PC monitors, replacing the aging VGA analog standard and providing guidelines to ensure backward compatibility with today’s DVI standard. Further, the UDI specification is planned to be fully compatible with HDMI and advanced CE displays. It is also intended that UDI will be able to use High-bandwidth Digital Content Protection (HDCP) technology

 

We intend to continue to be involved and actively participate in other standard setting initiatives.

 

Silicon Image Technology

 

Multi-Layer Systems Approach to Solving High-Speed Interconnect Problems

 

We invented technology upon which the DVI and HDMI specifications are based and have substantial experience in the design, manufacture and deployment of semiconductor products incorporating this high-speed data communications technology. The advanced nature of our high-speed digital design allows us to integrate significant functionality with multiple high-speed communication channels using industry-standard, low-cost complementary metal oxide semiconductor (CMOS) manufacturing processes. At the core of our innovation is a multi-layered approach to providing multi-gigabit semiconductor solutions.

 

The three layers of our Multi-layer Serial Link (MSL) architecture include the physical, coding and protocol layers. Serial link technology is the basis for the physical layer, which performs electrical signaling in several data communication protocols, including DVI 1.0, HDMI 1.2, Serial ATA and Fibre Channel. This technology converts parallel data into a serial stream that is transmitted sequentially at a constant rate and then reconstituted into its original form. Our high-speed serial link technology includes a number of proprietary elements designed to address the significant challenge of ensuring that data sent to a display or a storage device can be accurately recovered after it has been separated and transmitted in serial streams over multiple channels. In order to enable a display or a storage device to recognize data at the proper time and rate, our digital serial link technology uses a digital phase-locked loop combined with a unique phase detecting and tracking method to monitor the timing of the data.

 

At the coding layer, we have developed substantial intellectual property in data coding technology for high-speed serial communication. Our TMDS^® coding technology simplifies the protocol for high-speed serial communication and allows tradeoffs to be made in physical implementation of the link, which in turn reduces the cost of bandwidth and simplifies the overall system design. In addition, we have ensured direct current balanced transmission and the ability to use TMDS^® to keep electromagnetic emissions low and to enable connection to fiber optic interconnects without use of additional components.

 

PanelLink HDMI

 

Our PanelLink HDMI technology sends protected high-fidelity digital audio and high-definition video across the HDMI link for use in the consumer electronics market. Combining digital video and multi-channel digital audio transmissions in a single interconnect system simplifies and reduces the cost of the connection between consumer electronics devices, while maintaining high quality and content protection. PanelLink HDMI technology is fully compliant with the HDMI 1.2 specification.

 

We have assembled a team of engineers and technologists with extensive experience in the areas of high-speed interconnect architecture, circuit design, digital video/audio processor architecture, storage architecture, logic design/verification, firmware/software, flat panel displays, digital video/audio systems, and storage systems. Our

engineering team includes a group of consultants in Asia that focuses primarily on advanced technology development.

 

From our inception until 1998, our internal research and development efforts focused primarily on the development of our core PanelLink technology, our initial transmitter and receiver products, and our first intelligent panel controller product. In 1999, we improved our PanelLink technology and developed new transmitter and receiver products, focusing on providing both higher speeds and improved ease of use. We also began development of our PanelLink architecture for digital displays. In 2000, we focused our internal research and development efforts on integrating our PanelLink receiver technology with additional functionality, such as digital audio and HDCP, for flat panel displays, digital CRTs and the consumer electronics industry. In 2001, we diversified our research and development efforts by increasing our investment in storage semiconductor development and by adding storage system architecture and software development expertise through our acquisition of CMD Technology. In 2002 and 2003, our research and development efforts focused primarily on technology and applications for the consumer electronics and storage markets, including the development of HDMI and SATA technologies.

 

Research and Development

 

Our research and development efforts continue to focus on developing higher bandwidth links and links with higher levels of integrated features and functions for use in various CE, PC, and storage applications. By utilizing our patented data coding technology and different clocking methodologies, we believe our high-speed link can scale with advances in semiconductor manufacturing process technology, simplify system design, and be combined with other functionality to provide new innovative solutions for our customers.

 

We have invested, and expect that we will continue to invest, significant funds for research and development activities. Our research and development expenses (including stock compensation expense of $3.9 million, $16.6 million, and $6.9 million for 2005, 2004 and 2003, respectively) were approximately $44.9 million, $61.5 million, and $43.4 million in 2005, 2004 and 2003, respectively.

 

Sales and Marketing

 

We sell our products to distributors and OEMs throughout the world using a direct sales force with field offices located in North America, Taiwan, Europe, Japan and Korea, and indirectly through a network of distributors and manufacturer’s representatives located throughout North America, Asia and Europe.

 

Our sales strategy for all products is to achieve design wins with key industry leaders in order to grow the markets in which we participate and to promote and accelerate the adoption rate for industry standards (such as DVI, HDMI and SATA) that we support or are developing. Our sales personnel and applications engineers provide a high-level of technical support to our customers. Our marketing efforts focus primarily on promoting adoption of the DVI, HDMI and SATA standards, participating in industry trade shows and forums, entering into branding relationships such as PanelLink for DVI, HDMI and SATALink for SATA to build awareness of our brands, and bringing new solutions to market.

 

Manufacturing

 

Wafer Fabrication

 

Our semiconductor products are fabricated using standard CMOS processes, which permit us to engage independent wafer foundries to fabricate our semiconductors. By outsourcing our manufacturing requirements, we are able to avoid the high-cost of owning and operating a semiconductor wafer fabrication facility, take advantage of these suppliers’ high-volume economies of scale and it also gives us direct and timely access to advancing process technology. This allows us to focus our resources on the innovation or design and quality of our products. Our devices are currently fabricated using 0.35 micron, 0.25 micron and 0.18 micron processes. We have conducted research and development projects for our licensees that have involved 0.13 micron and 0.90 nm designs. We continuously evaluate the benefits, primarily improved performance and costs, and feasibility of migrating our products to smaller geometry process technologies. We rely almost entirely on Taiwan Semiconductor Manufacturing Company (TSMC), an outside foundry, to produce all of our CE, PC, SATA and Fibre Channel products. We

also rely on other outside foundries, such as Kawasaki and Atmel, to produce our parallel ATA products. We do not have long-term supply agreements with Kawasaki or Atmel and therefore cannot be assured of sufficient capacity availability or future prices. Because of the cyclical nature of the semiconductor industry, capacity availability can change quickly and significantly. We attempt to optimize wafer availability by continuing to use less advanced wafer geometries, such as 0.5 micron, 0.35 micron, 0.25 micron and 0.18 micron, for which foundries generally have more available capacity.

 

Assembly and Test

 

After wafer fabrication, die (semiconductor devices) are assembled into packages and the finished products are tested. Our products are designed to use low-cost standard packages and to be tested with widely available semiconductor test equipment. We outsource all of our packaging and the majority of our test requirements to Amkor Technology in Korea, Advanced Semiconductor Engineering in Taiwan, Malaysia and the United States, and Fujitsu and Kawasaki in Japan. This enables us to take advantage of these subcontractors’ high-volume economies of scale and supply flexibility, and gives us direct and timely access to advancing packaging and test technologies. We test a small portion of our products in-house.

 

The high-speed nature of our products makes it difficult to test our products in a cost-effective manner prior to assembly. Since the fabrication yields of our products have historically been high and the costs of our packaging have historically been low, we test our products after they are assembled. Our operations personnel closely review the process, control and monitor information provided to us by our foundries. To ensure quality, we have established firm guidelines for rejecting wafers that we consider unacceptable. To date, not testing our products prior to assembly has not caused us to experience unacceptable failures or yields. However, lack of testing prior to assembly could have adverse effects if there are significant problems with wafer processing. Additionally, for newer products and products for which yield rates have not stabilized, we may conduct bench testing using our personnel and equipment, which is more expensive than fully automated testing.

 

Quality Assurance

 

We focus on product quality through all stages of the design and manufacturing process. Our designs are subjected to in-depth circuit simulation at temperature, voltage and processing extremes before being fabricated. We pre-qualify each of our subcontractors through an audit and analysis of the subcontractor’s quality system and manufacturing capability. We also participate in quality and reliability monitoring through each stage of the production cycle by reviewing data from our wafer foundries and assembly subcontractors. We closely monitor wafer foundry production to ensure consistent overall quality, reliability and yields. Our independent foundries, assembly and test subcontractors have achieved International Standards Organization (ISO) 9001 certification.

 

Intellectual Property

 

Our success and future revenue growth will depend, in part, on our ability to protect our intellectual property. We rely on a combination of patent, copyright, trademark and trade secret laws, as well as nondisclosure agreements, licenses, and methods, to protect our proprietary technologies. As of December 31, 2005, we have been issued over 70 United States patents and have in excess of 55 United States patent applications pending. Our issued patents expire in 2014 or later, subject to our payment of periodic maintenance fees. We cannot assure you that any valid patent will be issued as a result of any applications or, if issued, that any claims allowed will be sufficiently broad to protect our technology, or that any patent will be upheld in the event of a dispute. In addition, we do not file patent applications on a worldwide basis, meaning we do not have patent protection in some jurisdictions. We also generally control access to and distribution of our documentation and other proprietary information. Despite our precautions, it may be possible for a third-party to copy or otherwise obtain and use our products or technology without authorization, develop similar technology independently or design around our patents. It is also possible that some of our existing or new licensing relationships will enable other parties to use our intellectual property to compete against us. Legal actions to enforce intellectual property rights tend to be lengthy and expensive, and the outcome often is not predictable, and the relief available may not compensate for the harm caused.

Our participation in the DDWG requires that we grant others the right to use specific elements of our intellectual property in implementing the DVI specification in their products, at no cost, in exchange for an identical right to use specific elements of their intellectual property for this purpose. We agreed to grant rights to the DDWG members and other adopters of the DVI specification in order to promote the adoption of our technology as an industry standard. We thereby limited our ability to rely on intellectual property law to prevent the adopters of the DVI specification from using certain specific elements of our intellectual property for certain purposes for free. This reciprocal free license covers the connection between a computer and a digital display. It does not, however, extend to the internal methods by which such performance is created. Although the DVI specification is an open industry standard, we have developed proprietary methods of implementing the DVI specification. The intellectual property that we have agreed to license defines the logical structure of the interface, such as the number of signal wires, the signaling types, and the data encoding method for serial communication. Our implementation of this logical structure in integrated circuits remains proprietary, and includes our techniques to convert data to and from a serial stream, our signal recovery algorithms and our circuits to reduce electromagnetic interference (EMI). Third parties may develop proprietary intellectual property relating to DVI implementations that would prevent us from developing or enhancing our DVI implementation in conflict with those rights. Third parties may also develop equivalent or superior implementations of the DVI specification and we cannot guarantee that we will succeed in protecting our intellectual property rights in our proprietary implementation. Third parties may have infringed or be infringing our intellectual property rights, or may do so in the future, and we may not discover that fact in a timely or cost-effective manner. Moreover, the cost of pursuing an intellectual property infringement may be greater than any benefit we would realize.

 

Our participation as a founder of the HDMI specification requires that we grant others the right to use specific elements of our intellectual property in implementing the HDMI specification in their products, in exchange for a license. This license bears an annual fee and royalties that are payable to HDMI Licensing, LLC, a wholly-owned subsidiary of ours. There can be no assurance that such license fees and royalties will adequately compensate us for having to license our intellectual property. The license, with restrictions, generally covers the patent claims necessary to implement the specification of an interface for CE devices, and does not extend to the internal methods by which such performance is created. Although the HDMI specification is a proposed industry standard, we have developed proprietary methods of implementing the HDMI specification. The intellectual property that we have agreed to license defines the logical structure of the interface, such as the number of signal wires, the signaling types, and the data encoding method for serial communication. Our implementation of this logical structure in integrated circuits remains proprietary, and includes our techniques to convert data to and from a serial stream, our signal recovery algorithms, our implementation of audio and visual data processing, and our circuits to reduce EMI. Third parties may also develop intellectual property relating to HDMI implementations that would prevent us from developing or enhancing our HDMI specification in conflict with those rights. Third parties may also develop equivalent or superior implementations of the HDMI specification and we cannot guarantee that we will succeed in protecting our intellectual property rights in our proprietary implementation. Third parties may have infringed or be infringing our intellectual property rights, or may do so in the future, and we may not discover that fact in a timely or cost-effective manner. Moreover, the cost of pursuing an intellectual property infringement may be greater than any benefit we would realize. In addition, third parties may not pay the prescribed license fees and royalties, in which case we may become involved in infringement or collection actions, or we may determine that the cost of pursuing such matters may be greater than any benefit we would realize. We agreed to grant rights to the founders and adopters of the HDMI specification in order to promote the adoption of our technology as an industry standard. We thereby limited our ability to rely on intellectual property law to prevent the founders and adopters of the HDMI specification from using certain specific elements of our intellectual property for certain purposes in exchange for a portion of the specified royalties.

 

We entered into a patent cross-license agreement with Intel in which each of us granted the other a license to use certain of the grantor’s existing and future patents, including certain future patents, with specific exclusions related to the grantor’s current and anticipated future products and network devices. Products excluded include our digital receivers, discrete digital transmitters and discrete display controllers, and Intel’s processors, chipsets, graphics controllers and flash memory products. This cross-license does not require delivery of any masks, designs, software or any other item evidencing or embodying such patent rights, thus making “cloned” products no easier to create. The cross-license agreement expires when the last licensed patent expires, anticipated to be no earlier than

2016, subject to the right of either party to terminate the agreement earlier upon material breach by the other party, or a bankruptcy, insolvency or change of control of the other party. We have forfeited, however, our ability to rely on intellectual property law to prevent Intel from using our patents within the scope of this license. To date, we are not aware of any use by Intel of our patent rights that negatively impacts our business.

 

Pursuant to the UDI Promoters Agreement, we agreed, subject to conditions stipulated in such agreement, to license certain specific elements of our TMDS and panel interface logic intellectual property to adopters of the UDI specification on a reciprocal, royalty-free basis. We agreed to grant rights to the UDI Promoters and future adopters of the UDI specification in order to promote the adoption of our technology as an industry standard. We thereby limited our ability to rely on intellectual property law to prevent the adopters of the UDI specification from using certain specific elements of our intellectual property for certain purposes for free.

 

The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights or positions, which can result in significant, protracted litigation. We have brought a patent infringement suit against Genesis Microchip, which is described in further detail below in the section entitled “Legal Proceedings.”

 

Competition

 

The markets in which we compete are intensely competitive and are characterized by rapid technological change, evolving standards, short product life cycles and decreasing prices. We believe that some of the key factors affecting competition in our markets are levels of product integration, compliance with industry standards, time-to-market, cost, product capabilities, system design costs, intellectual property, customer support, quality and reputation.

 

In the PC market, our products face competition from a number of sources including analog solutions, DVI-compliant solutions, dual-interface solutions and other digital interface solutions.

 

 

The market for our intelligent panel controller products is also very competitive. Some of our intelligent panel controller products are designed to be functionally interchangeable with similar products sold by National Semiconductor, Texas Instruments, Samsung Semiconductor, Novatek and Thine.

 

In the consumer electronics market, our digital interface products are used to connect new cable set-top boxes, satellite set-top boxes and DVD players to digital televisions. These products incorporate DVI and HDCP, or HDMI with HDCP support. Companies that have announced or are shipping competing DVI-HDCP solutions include Analog Devices, Texas Instruments, Thine, Broadcom, Conexant, Mstar, and Genesis Microchip. In addition, our video processor products face competition from products sold by AV Science, Broadcom, Focus Enhancements, Genesis Microchip, Mediamatics, Micronas Semiconductor, Oplus, Philips Semiconductor, Pixelworks, ATI, and

Trident. We also compete in some instances against in-house processing solutions designed by large consumer electronics OEMs. While we have experienced only modest competition for HDMI products in 2004 and 2005, we expect increased competition for HDMI products beginning in 2006, from the other HDMI founders and adopters, including Hitachi, Matsushita, Philips, Sony, Thomson and Toshiba as well as several other companies.

 

In the storage market, our Fibre Channel products face competition from companies selling similar discrete products, including Agilent Technologies, Mindspeed Technologies, PMC-Sierra, Serverworks and Vitesse, from other Fibre Channel SerDes providers who license their core technology, such as LSI Logic, and from companies that sell HBA controllers with integrated SerDes, such as QLogic and Agilent.

 

Our serial ATA products compete with similar products from Marvell Technology, VIA Technologies, Silicon Integrated Systems, J-Micron, Atmel and Promise Technology. In addition, other companies, such as APT, Intel, LSI Logic, ServerWorks and Vitesse, have developed or announced intentions to develop SATA products. We also are likely to compete against Intel, nVidia, VIA Technologies, Silicon Integrated Systems, ATI Technologies and other motherboard chip-set makers that have or have announced intentions to integrate SATA functionality into their chipsets.

 

Many of our competitors have longer operating histories and greater presence in key markets, greater name recognition, access to larger customer bases and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other resources than we do. As a result, they may be able to adapt more quickly to new or emerging technologies and customer requirements, or devote greater resources to the promotion and sale of their products. In particular, well-established semiconductor companies, such as Analog Devices, Intel, National Semiconductor and Texas Instruments, and consumer electronics manufacturers, such as Hitachi, Matsushita, Philips, Sony, Thomson and Toshiba, may compete against us in the future. We cannot assure you that we can compete successfully against current or potential competitors, or that competition will not seriously harm our business.

 

Employees

 

As of December 31, 2005, we had a total of 384 employees, including 37 located outside of the United States. None of our employees are represented by a collective bargaining agreement, nor have we experienced any work stoppages. We consider our relations with our employees to be good. We depend on the continued service of our key technical, sales and senior management personnel, and our ability to attract and retain additional qualified personnel. If we are unable to hire and retain qualified personnel, our business will be seriously harmed.

 

Available Information

 

Our Internet website address is www.siliconimage.com. We make available free of charge through our Internet website our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.

Item 1A.  Risk Factors

 

You should carefully consider the following risk factors, together with all other information contained or incorporated by reference in this filing, before you decide to purchase shares of our common stock. These factors could cause our future results to differ materially from those expressed in or implied by forward-looking statements made by us. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also harm our business. The trading price of our common stock could decline due to any of these risks, and you may lose all or part of your investment.

 

We operate in rapidly evolving markets, which makes it difficult to evaluate our future prospects.

 

The revenue and income potential of our business and the markets we serve are early in their lifecycle and are difficult to predict. The Digital Visual Interface (DVI) specification, which is based on technology developed by us

and used in many of our products, was first published in April 1999. We completed our first generation of consumer electronics and storage IC products in mid-to-late 2001. The preliminary serial ATA specification was first published in August 2001. The High Definition Multimedia Interface (HDMI) specification was first released in December 2002. Our SteelVine^tm storage architecture was first released in September 2004. Accordingly, we face risks and difficulties frequently encountered by companies in new and rapidly evolving markets. If we do not successfully address these risks and difficulties, our results of operations could be negatively affected.

 

We have a history of losses and may not sustain profitability.

 

For the year ended December 31, 2005, we generated net income of $49.5 million. However, prior to 2005, we incurred net losses in each fiscal year since our inception, including net losses of $0.3 million and $12.8 million for the years ended December 31, 2004 and 2003, respectively. Accordingly, we may not sustain profitability.

 

Our annual and quarterly operating results may fluctuate significantly and are difficult to predict.

 

Our annual and quarterly operating results are likely to vary significantly in the future based on a number of factors over which we have little or no control. These factors include, but are not limited to:

 

 

Because we have little or no control over these factors and/or their magnitude, our operating results are difficult to predict. Any substantial adverse change in any of these factors could negatively affect our business and results of operations.

Our future annual and quarterly operating results are highly dependent upon how well we manage our business.

 

Our annual and quarterly operating results may fluctuate based on how well we manage our business. Some of these factors include the following:

 

 

If we fail to effectively manage our business, this could adversely affect our results of operations.

 

The licensing component of our business strategy increases business risk and volatility.

 

Part of our business strategy is to license certain of our technology to companies that address markets in which we do not want to directly participate. We signed our first license contract in December 2001 and have limited experience marketing and selling our technology on a licensing basis. There can be no assurance that additional companies will be interested in licensing our technology on commercially favorable terms or at all. We also cannot ensure that companies who license our technology will introduce and sell products incorporating our technology, will accurately report royalties owed to us, will pay agreed upon royalties, will honor agreed upon market restrictions, will not infringe upon or misappropriate our intellectual property and will maintain the confidentiality of our proprietary information. Licensing contracts are complex and depend upon many factors including completion of milestones, allocation of values to delivered items, and customer acceptances. Many of these factors require significant judgments. Licensing revenue could fluctuate significantly from period to period because it is heavily dependent on a few key deals being completed in a particular period, the timing of which is difficult to predict and may not match our expectations. Because of its high margin content, licensing revenue can have a disproportionate impact on gross profit and profitability. Also, generating revenue from licensing arrangements is a lengthy and complex process that may last beyond the period in which efforts begin, and once an agreement is in place, the timing of revenue recognition may be dependent on customer acceptance of deliverables, achievement of milestones, our ability to track and report progress on contracts, customer commercialization of the licensed technology, and other factors. Licensing that occurs in connection with actual or contemplated litigation is subject to risk that the adversarial nature of the transaction will induce non-compliance or non-payment. The accounting rules associated with recognizing revenue from licensing transactions are increasingly complex and subject to interpretation. Due to these factors, the amount of license revenue recognized in any period may differ significantly from our expectations.

We face intense competition in our markets, which may lead to reduced revenue from sales of our products and increased losses.

 

The CE, PC and storage markets in which we operate are intensely competitive. These markets are characterized by rapid technological change, evolving standards, short product life cycles and declining selling prices. We expect competition for many of our products to increase, as industry standards become widely adopted and as new competitors enter our markets.

 

Our products face competition from companies selling similar discrete products, and from companies selling products such as chipsets with integrated functionality. Our competitors include semiconductor companies that focus on the display, CE or storage markets, as well as major diversified semiconductor companies, and we expect that new competitors will enter our markets. Current or potential customers, including our own licensees, may also develop solutions that could compete with us, including solutions that integrate the functionality of our products into their solutions. In addition, potential OEM customers may have internal semiconductor capabilities, and may develop their own solutions for use in their products rather than purchasing them from companies such as us. Some of our competitors have already established supplier or joint development relationships with current or potential customers and may be able to leverage their existing relationships to discourage these customers from purchasing products from us or persuade them to replace our products with theirs. Many of our competitors have longer operating histories, greater presence in key markets, better name recognition, access to larger customer bases and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other resources than we do As a result, they may be able to adapt more quickly to new or emerging technologies and customer requirements, or devote greater resources to the promotion and sale of their products. In particular, well-established semiconductor companies, such as Analog Devices, Intel, National Semiconductor and Texas Instruments, and consumer electronics manufacturers, such as Hitachi, Matsushita, Philips, Sony, Thomson and Toshiba, may compete against us in the future. Some of our competitors could merge, which may enhance their market presence. Existing or new competitors may also develop technologies that more effectively address our markets with products that offer enhanced features and functionality, lower power requirements, greater levels of integration or lower cost. Increased competition has resulted in, and is likely to continue to result in price reductions and loss of market share in certain markets. We cannot assure you that we can compete successfully against current or potential competitors, or that competition will not reduce our revenue and gross margins.

 

Our success depends in part on demand for our new SteelVine storage products.

 

Our growth depends in part on market acceptance of our new product offerings based on our SteelVine architecture. These products may not achieve the desired level of market acceptance in the anticipated timeframes. We anticipate that the products based upon our SteelVine architecture will be sold into markets where we have limited experience. Furthermore, there is no established market for these products. There can be no assurance that we will be able to successfully market and sell the products based upon the SteelVine architecture and failure to do so would adversely affect our business.

 

Our success depends in part on the success of our new integrated HDMI DTV products.

 

Our future growth depends in part on the success of our highly integrated Digital TV System On a Chip solutions currently sampling in the market and which may or may not contribute significantly to our overall CE revenue. These products are subject to significant competition from established companies that have been selling these kinds of products for longer periods of time than Silicon Image.

 

Demand for our consumer electronics products is dependent on the adoption and widespread use of the HDMI specification.

 

Our success in the consumer electronics market is largely dependent upon the rapid and widespread adoption of the HDMI specification, which combines high-definition video and multi-channel audio in one digital interface and uses our patented underlying transition minimized differential signaling (TMDS^®) technology, and optionally Intel’s HDCP technology, as the basis for the interface. Version 1.0 of the specification was published for adoption in December 2002, Version 1.1 of the specification was published for adoption in May 2004, and Versions 1.2 and

1.2a were published for adoption in August and December 2005, respectively. We cannot predict the rate at which manufacturers will adopt the HDMI specification. Adoption of the HDMI specification may be affected by the availability of consumer products, such as DVD players and televisions, and of computer components that implement this new interface. Other competing specifications may also emerge that could adversely affect the acceptance of the HDMI specification. Delays in the widespread adoption of the HDMI specification could reduce acceptance of our products, limit or reduce our revenue growth and increase our losses.

 

We believe that the adoption of our CE products may be affected in part by U.S. and international regulations relating to digital television, cable, satellite and over-the-air digital transmissions, specifically regulations relating to the transition from analog to digital television. The FCC has adopted rules governing the transition from analog to digital television, which include rules governing the requirements for television sets sold in the United States designed to speed the transition to digital television. The FCC has delayed such requirements and timetables for phasing in digital television in the past. We cannot predict whether the FCC will further delay its rules relating to the digital television requirements and timetables. In the event that additional regulatory activities, either in the United States or internationally, delay or postpone the transition to digital television beyond the anticipated time frame, that could reduce the demand for our CE products.

 

In addition, we believe that the rate of HDMI adoption may be accelerated by FCC rules and EICTA (Europe) and CASBAA (Asia) recommendations discussed in the “Promotion of Industry Standards” section above. However, in the case of the FCC, we cannot predict whether these rules will be amended prior to completion of the phase-in dates or that such phase-in dates will not be delayed. In addition, we cannot guarantee that the FCC will not in the future reverse these rules or adopt rules requiring or supporting different interface technologies, either of which would adversely affect our business. In the case of the EICTA and CASBAA recommendations, we cannot predict the rate at which manufacturers will implement the HDMI-related recommendations in their products.

 

Transmission of audio and video from source devices (such as a DVD player or STB) to sink devices (such as an HDTV) over HDMI with HDCP represents a combination of new technologies working in concert. Cable and satellite system operators are just beginning to require transmissions of digital video with HDCP between source and sink devices in consumer homes, and DVD players incorporating this technology have only recently come to market. Complexities with these technologies and the variability in implementations between manufacturers may cause some of these products to work incorrectly, or for the transmissions to not occur correctly, or for certain products not to be interoperable. Also, the user experience associated with audiovisual transmissions over HDMI with HDCP is unproven, and users may reject products incorporating these technologies or they may require more customer support than expected. Delays or difficulties in integration of these technologies into products or failure of products incorporating this technology to achieve market acceptance could have an adverse effect on our business.

 

Our success depends in part on strategic relationships.

 

We have entered into strategic partnerships with third parties. For example, we have entered into a relationship with Sunplus which includes licensing and development agreements. Under these agreements, Sunplus licenses our technology and we and Sunplus jointly develop products.

 

While these strategic partnerships are designed to drive revenue growth and adoption of our technologies and industry standards promulgated by us and also reduce our research and development expenses, there is no guarantee that these strategic partnerships will be successful. Negotiating and performing under these strategic partnerships involves significant time and expense; we may not realize anticipated increases in revenue, standards adoption or cost savings; and these strategic partnerships may make it easier for the third parties to compete with us; any of which may have a negative effect our business and results of operations.

 

We do not have long-term commitments from our customers and we allocate resources based on our estimates of customer demand.

 

Substantially all of our sales are made on the basis of purchase orders, rather than long-term agreements. In addition, our customers may unilaterally cancel or reschedule purchase orders. We purchase inventory components and build our products according to our estimates of customer demand. This process requires us to make multiple assumptions, including volume and timing of customer demand for each product, manufacturing yields and product

quality. If we overestimate customer demand or product quality or under estimate manufacturing yields, we may build products that we may not be able to sell at an acceptable price, when we expect or at all. As a result, we would have excess inventory, which would increase our losses. As an example, we may be expected to purchase inventory components and contract for services for a unique product design for a customer that may not ever be put into production by that potential customer or may be put into production later or in smaller quantities than we anticipate. Additionally, if we underestimate customer demand or if sufficient manufacturing capacity is unavailable, we could forego revenue opportunities or incur significant costs for rapid increases in production, lose market share and damage our customer relationships.

 

Our lengthy sales cycle can result in a delay between incurring expenses and generating revenue, which could harm our operating results.

 

Because our products are based on new technology and standards, a lengthy sales process, typically requiring several months or more, is often required before potential customers begin the technical evaluation of our products. This technical evaluation can exceed nine months before the potential customer informs us whether we have achieved a design win, which is not a binding commitment to purchase our products. After achieving a design win, it can then be an additional nine months before a customer commences volume shipments of systems incorporating our products, if at all. Given our lengthy sales cycle, we may experience a delay between the time we incur expenditures and the time we generate revenue, if any. As a result, our operating results could be seriously harmed if a significant customer reduces or delays orders, or chooses not to release products incorporating our products.

 

We depend on a few key customers and the loss of any of them could significantly reduce our revenue.

 

Historically, a relatively small number of customers and distributors have generated a significant portion of our revenue. For the year ended December 31, 2005, shipments to World Peace International, an Asian distributor, generated 17.2% of our revenue and shipments to Microtek, a distributor, generated 10.6% of our revenue. For the year ended December 31, 2004, shipments to World Peace International generated 15% of our revenue, and shipments to Microtek generated 12% of our revenue. In addition, an end-customer may buy through multiple distributors, contract manufacturers, and/or directly, which could create an even greater concentration. We cannot be certain that customers and key distributors that have accounted for significant revenue in past periods, individually or as a group, will continue to sell our products and generate revenue. As a result of this concentration of our customers, our results of operations could be negatively affected if any of the following occurs:

 

 

Due to our participation in multiple markets, our customer base has broadened significantly and we therefore anticipate being less dependent on a relatively small number of customers to generate revenue. However, as product mix fluctuates from quarter to quarter, we may become more dependent on a small number of customers or a single customer for a significant portion of our revenue in a particular quarter, the loss of which could adversely affect our operating results.

 

We sell our products through distributors, which limits our direct interaction with our customers, therefore reducing our ability to forecast sales and increasing the complexity of our business.

 

Many original equipment manufacturers rely on third-party manufacturers or distributors to provide inventory management and purchasing functions. Distributors generated 52% of our revenue for the year ended December 31, 2005, 45% of our revenue for the year ended December 31, 2004, and 42% of our revenue for the year ended December 31, 2003. Selling through distributors reduces our ability to forecast sales and increases the complexity of our business, requiring us to:

 

 

 

Since we have limited ability to forecast inventory levels at our end customers, it is possible that there may be significant build-up of inventories in the retail channel, with the OEM or the OEM’s contract manufacturer. Such a buildup could result in a slowdown in orders, requests for returns from customers, or requests to move out planned shipments. This could adversely impact our revenues and profits.

 

Any failure to manage these challenges could disrupt or reduce sales of our products and unfavorably impact our financial results.

 

Our success depends on the development and introduction of new products, which we may not be able to do in a timely manner because the process of developing high-speed semiconductor products is complex and costly.

 

The development of new products is highly complex, and we have experienced delays, some of which exceeded one year, in the development and introduction of new products on several occasions in the past. We have recently introduced new storage products for the consumer and small to medium business markets and we expect to introduce new consumer electronics, storage and PC products in the future. As our products integrate new, more advanced functions, they become more complex and increasingly difficult to design, manufacture and debug. Successful product development and introduction depends on a number of factors, including, but not limited to:

 

 

Accomplishing all of this is extremely challenging, time-consuming and expensive and there is no assurance that we will succeed. Product development delays may result from unanticipated engineering complexities, changing market or competitive product requirements or specifications, difficulties in overcoming resource limitations, the inability to license third-party technology or other factors. Competitors and customers may integrate the functionality of our products into their products that would reduce demand for our products. If we are not able to develop and introduce our products successfully and in a timely manner, our costs could increase or our revenue could decrease, both of which would adversely affect our operating results. In addition, it is possible that we may experience delays in generating revenue from these products or that we may never generate revenue from these products. We must work with a semiconductor foundry and with potential customers to complete new product development and to validate manufacturing methods and processes to support volume production and potential re-work. Each of these steps may involve unanticipated difficulties, which could delay product introduction and reduce

market acceptance of the product. In addition, these difficulties and the increasing complexity of our products may result in the introduction of products that contain defects or that do not perform as expected, which would harm our relationships with customers and our ability to achieve market acceptance of our new products. There can be no assurance that we will be able to achieve design wins for our planned new products, that we will be able to complete development of these products when anticipated, or that these products can be manufactured in commercial volumes at acceptable yields, or that any design wins will produce any revenue. Failure to develop and introduce new products, successfully and in a timely manner, may adversely affect our results of operations.

 

We have made acquisitions in the past and may make acquisitions in the future, if advisable, and these acquisitions involve numerous risks.

 

Our growth depends upon market growth and our ability to enhance our existing products and introduce new products on a timely basis. One of the ways we develop new products and enter new markets is through acquisitions. In 2001, we completed the acquisitions of CMD and SCL. In April 2003, we acquired Transwarp Networks, Inc. (TWN). We may acquire additional companies or technologies. Acquisitions involve numerous risks, including, but not limited to, the following:

 

 

No assurance can be given that our prior acquisitions or our future acquisitions, if any, will be successful or provide the anticipated benefits, or that they will not adversely affect our business, operating results or financial condition. Failure to manage growth effectively and to successfully integrate acquisitions made by us could materially harm our business and operating results.

 

The cyclical nature of the semiconductor industry may create constrictions in our foundry, test and assembly capacity.

 

The semiconductor industry is characterized by significant downturns and wide fluctuations in supply and demand. This cyclicality has led to significant fluctuations in product demand and in the foundry, test and assembly capacity of third-party suppliers. Production capacity for fabricated semiconductors is subject to allocation, whereby not all of our production requirements would be met. This may impact our ability to meet demand and could also increase our production costs. Cyclicality has also accelerated decreases in average selling prices per unit. We may experience fluctuations in our future financial results because of changes in industry-wide conditions.

 

We depend on third-party sub-contractors to manufacture, assemble and test nearly all of our products, which reduce our control over the production process.

 

We do not own or operate a semiconductor fabrication facility. We rely on third party semiconductor manufacturing companies overseas to produce the vast majority all of our semiconductor products. We also rely on outside assembly and test services to test all of our semiconductor products. Our reliance on independent foundries, assembly and test facilities involves a number of significant risks, including, but not limited to:

 

 

 

In addition, our semiconductor products are assembled and tested by several independent subcontractors. We do not have a long-term supply agreement with all of our subcontractors, and instead obtain production services on a purchase order basis. Our outside sub-contractors have no obligation to supply products to us for any specific period of time, in any specific quantity or at any specific price, except as set forth in a particular purchase order. Our requirements represent a small portion of the total production capacity of our outside foundries, assembly and test facilities and our sub-contractors may reallocate capacity to other customers even during periods of high demand for our products. These foundries may allocate or move production of our products to different foundries under their control, even in different locations, which may be time consuming, costly, and difficult, have an adverse affect on quality, yields, and costs, and require us and/or our customers to re-qualify the products, which could open up design wins to competition and result in the loss of design wins and design-ins. If our subcontractors are unable or unwilling to continue manufacturing our products in the required volumes, at acceptable quality, yields and costs, and in a timely manner, our business will be substantially harmed. As a result, we would have to identify and qualify substitute contractors, which would be time-consuming, costly and difficult. This qualification process may also require significant effort by our customers, and may lead to re-qualification of parts, opening up design wins to competition, and loss of design wins and design-ins. Any of these circumstances could substantially harm our business. In addition, if competition for foundry, assembly and test capacity increases, our product costs may increase and we may be required to pay significant amounts or make significant purchase commitments to secure access to production services.

 

The complex nature of our production process, which can reduce yields and prevent identification of problems until well into the production cycle or, in some cases, after the product has been shipped.

 

The manufacture of semiconductors is a complex process, and it is often difficult for semiconductor foundries to achieve acceptable product yields. Product yields depend on both our product design and the manufacturing process technology unique to the semiconductor foundry. Since low yields may result from either design or process difficulties, identifying problems can often only occur well into the production cycle, when an actual product exists that can be analyzed and tested.

 

Further, we only test our products after they are assembled, as their high-speed nature makes earlier testing difficult and expensive. As a result, defects often are not discovered until after assembly. This could result in a substantial number of defective products being assembled and tested or shipped, thus lowering our yields and increasing our costs. These risks could result in product shortages or increased costs of assembling, testing or even replacing our products.

 

Although we test our products before shipment, they are complex and may contain defects and errors. In the past we have encountered defects and errors in our products. Because our products are sometimes integrated with products from other vendors, it can be difficult to identify the source of any particular problem. Delivery of products with defects or reliability, quality or compatibility problems, may damage our reputation and our ability to retain existing customers and attract new customers. In addition, product defects and errors could result in additional development costs, diversion of technical resources, delayed product shipments, increased product returns, warranty and product liability claims against us that may not be fully covered by insurance. Any of these circumstances could substantially harm our business.

 

We face foreign business, political and economic risks because a majority of our products and our customers’ products are manufactured and sold outside of the United States.

 

A substantial portion of our business is conducted outside of the United States. As a result, we are subject to foreign business, political and economic risks. Nearly all of our products are manufactured in Taiwan or elsewhere in Asia, and for the years ended December 31, 2005, 2004 and 2003, 74%, 72%, and 74% of our revenue respectively was generated from customers and distributors located outside of the United States, primarily in Asia.

We anticipate that sales outside of the United States will continue to account for a substantial portion of our revenue in future periods. Accordingly, we are subject to international risks, including, but not limited to:

 

 

These risks could adversely affect our business and our results of operations. In addition, original equipment manufacturers that design our semiconductors into their products sell them outside of the United States. This exposes us indirectly to foreign risks. Because sales of our products are denominated exclusively in United States dollars, relative increases in the value of the United States dollar will increase the foreign currency price equivalent of our products, which could lead to a change in the competitive nature of these products in the marketplace. This in turn could lead to a reduction in sales and profits.

 

The success of our business depends upon our ability to adequately protect our intellectual property.

 

We rely on a combination of patent, copyright, trademark, mask work and trade secret laws, as well as nondisclosure agreements and other methods, to protect our proprietary technologies. We have been issued patents and have a number of pending patent applications. However, we cannot assure you that any patents will be issued as a result of any applications or, if issued, that any claims allowed will protect our technology. In addition, we do not file patent applications on a worldwide basis, meaning we do not have patent protection in some jurisdictions. It may be possible for a third-party, including our licensees, to misappropriate our copyrighted material or trademarks. It is possible that existing or future patents may be challenged, invalidated or circumvented and effective patent, copyright, trademark and trade secret protection may be unavailable or limited in foreign countries. It may be possible for a third-party to copy or otherwise obtain and use our products or technology without authorization, develop similar technology independently or design around our patents in the United States and in other jurisdictions. It is also possible that some of our existing or new licensing relationships will enable other parties to use our intellectual property to compete against us. Legal actions to enforce intellectual property rights tend to be lengthy and expensive, and the outcome often is not predictable. As a result, despite our efforts and expenses, we may be unable to prevent others from infringing upon or misappropriating our intellectual property, which could harm our business. In addition, practicality also limits our assertion of intellectual property rights. Patent litigation is expensive and its results are often unpredictable. Assertion of intellectual property rights often results in counterclaims for perceived violations of the defendant’s intellectual property rights and/or antitrust claims. Certain parties after receipt of an assertion of infringement will cut off all commercial relationships with the party making the assertion, thus making assertions against suppliers, customers, and key business partners risky. If we forgo making such claims, we may run the risk of creating legal and equitable defenses for an infringer.

Our participation in the Digital Display Working Group requires us to license some of our intellectual property for free, which may make it easier for others to compete with us in the DVI PC market.

 

We are a promoter of the DDWG, which published and promotes the DVI specification. Our strategy includes establishing the DVI specification as the industry standard, promoting and enhancing this specification and developing and marketing products based on this specification and future enhancements. As a result:

 

 

Accordingly, companies that implement the DVI specification in their products can use specific elements of our intellectual property for free to compete with us.

 

Our participation as a founder in the working group developing HDMI requires us to license some of our intellectual property, which may make it easier for others to compete with us in the market.

 

In April 2002, together with Sony, Philips, Thomson, Toshiba, Matsushita and Hitachi, we announced the formation of a working group to define the next-generation digital interface specification for consumer electronics products. Version 1.0 of the specification was published for adoption on December 9, 2002. The HDMI specification combines high-definition video and multi-channel audio in one digital interface and uses Silicon Image’s patented underlying TMDS^® technology, optionally, along with Intel’s HDCP as the basis for the interface. The founders of the working group have signed a founder’s agreement in which each commits to license certain intellectual property to each other, and to adopters of the specification.

 

Our strategy includes establishing the HDMI specification as the industry standard, promoting and enhancing this specification and developing and marketing products based on this specification and future enhancements. As a result:

 

 

Accordingly, companies that implement the HDMI specification in their products can use specific elements of our intellectual property to compete with us. Although there will be license fees and royalties associated with the adopters agreements, there can be no assurance that such license fees and royalties will adequately compensate us for having to license our intellectual property. Fees and royalties received during the early years of adoption will be used to cover costs we incur to promote the HDMI standard and to develop and perform interoperability tests; in addition, after an initial period, the HDMI founders may reallocate the license fees and royalties amongst themselves to reflect each founder’s relative contribution of intellectual property to the HDMI specification.

 

Our success depends on managing our relationship with Intel.

 

Intel has a dominant role in many of the markets in which we compete, such as PCs and storage, and is a growing presence in the CE market. We have a multi-faceted relationship with Intel that is complex and requires significant management attention, including:

 

 

 

Our cooperation and competition with Intel can lead to positive benefits, if managed effectively. If our relationship with Intel is not managed effectively, it could seriously harm our business, negatively affect our revenue, and increase our operating expenses.

 

We have granted Intel rights with respect to our intellectual property, which could allow Intel to develop products that compete with ours or otherwise reduce the value of our intellectual property.

 

We entered into a patent cross-license agreement with Intel in which each of us granted the other a license to use the patents filed by the grantor prior to a specified date, except for identified types of products. We believe that the scope of our license to Intel excludes our current products and anticipated future products. Intel could, however, exercise its rights under this agreement to use our patents to develop and market other products that compete with ours, without payment to us. Additionally, Intel’s rights to our patents could reduce the value of our patents to any third-party who otherwise might be interested in acquiring rights to use our patents in such products. Finally, Intel could endorse competing products, including a competing digital interface, or develop its own proprietary digital interface. Any of these actions could substantially harm our business and results of operations.

 

We have been and may continue to become the target of securities class action suits and derivative suits which could result in substantial costs and divert management attention and resources.

 

Securities class action suits and derivative suits are often brought against companies, particularly technology companies, following periods of volatility in the market price of their securities. Defending against these suits, even if meritless, can result in substantial costs to us and could divert the attention of our management. We and certain of our officers and directors, together with certain investment banks, have been named as defendants in a securities class action suit filed against us on behalf of purchasers of our securities between October 5, 1999 and December 6, 2000. It is alleged that the prospectus related to our initial public offering was misleading because it failed to disclose that the underwriters of our initial public offering had solicited and received excessive commissions from certain investors in exchange for agreements by investors to buy our shares in the aftermarket for predetermined prices. Due to inherent uncertainties in litigation, we cannot accurately predict the outcome of this litigation; however, a proposed settlement has been negotiated and has received preliminary approval by the Court. This settlement will not require Silicon Image to pay any settlement amounts nor issue any securities. In the event that the settlement is not granted final approval, we believe that these claims are without merit and we intend to defend vigorously against them.

 

We and certain of our officers were named as defendants in a securities class action captioned “Curry v. Silicon Image, Inc., Steve Tirado, and Robert Gargus,” commenced on January 31, 2005. Plaintiffs filed the action on behalf of a putative class of shareholders who purchased Silicon Image stock between October 19, 2004 and January 24,

2005. The lawsuit alleged that we and certain of our officers and directors made alleged misstatements of material facts and violated certain provisions of Sections 20(a) and 10(b) of the Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. On April 27, 2005, the Court issued an order appointing lead plaintiff and approving the selection of lead counsel. On July 27, 2005, plaintiffs filed a consolidated amended complaint (“CAC”). The CAC no longer named Mr. Gargus as an individual defendant, but added Dr. David Lee as an individual defendant. The CAC also expanded the class period from June 25, 2004 to April 22, 2005. Defendants filed a motion to dismiss the CAC on September 26, 2005. Plaintiffs subsequently received leave to file, and did file, a second consolidated amended complaint (“Second CAC”) on December 8, 2005. The Second CAC extends the end of the class period from April 22, 2005 to October 13, 2005 and adds additional factual allegations under the same causes of action against us, Mr. Tirado and Dr. Lee. The complaint also adds a new plaintiff, James D. Smallwood. Defendants filed a motion to dismiss the Second CAC on February 9, 2006 and that motion is currently scheduled to be heard on June 9, 2006.

 

We are currently engaged in intellectual property litigation that is time-consuming and expensive to prosecute. We may become engaged in additional intellectual property litigation that could be time-consuming, may be expensive to prosecute or defend, and could adversely affect our ability to sell our product.

 

In recent years, there has been significant litigation in the United States and in other jurisdictions involving patents and other intellectual property rights. This litigation is particularly prevalent in the semiconductor industry, in which a number of companies aggressively use their patent portfolios to bring infringement claims. In addition, in recent years, there has been an increase in the filing of so-called “nuisance suits,” alleging infringement of intellectual property rights. These claims may be asserted as counterclaims in response to claims made by a company alleging infringement of intellectual property rights. These suits pressure defendants into entering settlement arrangements to quickly dispose of such suits, regardless of merit. In addition, as is common in the semiconductor industry, from time to time we have been notified that we may be infringing certain patents or other intellectual property rights of others. Responding to such claims, regardless of their merit, can be time consuming, result in costly litigation, divert management’s attention and resources and cause us to incur significant expenses. As each claim is evaluated, we may consider the desirability of entering into settlement or licensing agreements. No assurance can be given that settlements will occur or that licenses can be obtained on acceptable terms or that litigation will not occur. In the event there is a temporary or permanent injunction entered prohibiting us from marketing or selling certain of our products, or a successful claim of infringement against us requiring us to pay damages or royalties to a third-party, and we fail to develop or license a substitute technology, our business, results of operations or financial condition could be materially adversely affected.

 

In 2001, we filed a suit in the U.S. District Court for the Eastern District of Virginia against Genesis Microchip Corp. and Genesis Microchip, Inc. (collectively, “Genesis”) for infringement of our U.S. patent number 5,905,769 (Case No.: CA-01-266-R). In 2002, we added a claim for infringement of our U.S. patent number 5,974,464. In December 2002, the parties entered into an agreement that apparently settled the case. The agreement was reflected in a Memorandum of Understanding (MOU), which contemplated, among other things, the execution of a more detailed “definitive agreement” by December 31, 2002. Disputes arose, however, regarding the interpretation of certain terms of the MOU, and the parties were unable to conclude a definitive agreement. The parties’ disputes were brought before the court, and on July 15, 2003, the court held that the MOU constituted a binding settlement agreement, and that our interpretation of the MOU was correct. Thereafter, the court ordered Genesis to make certain payments described in the MOU to the Court’s escrow account, and on December 19, 2003, the court entered judgment based on its July 15, 2003 ruling.

 

Genesis appealed the judgment to the U.S. Court of Appeals for the Federal Circuit on January 16, 2004. On January 28, 2005, the Federal Circuit dismissed Genesis’ appeal for lack of jurisdiction, holding that the judgment below was not final and appealable. Specifically, the Court of Appeals found that the parties’ agreement to settle the case, as embodied in the MOU, required that Genesis pay us, rather than the district court’s escrow account, certain of the payments described in the MOU.

 

The case was remanded to the district court, where the parties subsequently agreed to a stipulated order whereby the funds held by the district court were transferred to Silicon Image, under restrictions, until appeals are exhausted. On July 22, 2005, based on the stipulated order, the court dismissed the case with prejudice. Genesis filed

a renewed appeal to the Federal Circuit, asserting among other things that the district court erred in its interpretation of the MOU, that the MOU (as interpreted by the court) constitutes patent misuse, and that the district court erred in construing certain claim terms in the asserted patents. A hearing on that appeal is scheduled for April 5, 2006, and a ruling is expected within two to three months thereafter.

 

Any potential intellectual property litigation against us could also force us to do one or more of the following:

 

 

If we take any of these actions, we may be unable to manufacture and sell our products. We may be exposed to liability for monetary damages, the extent of which would be very difficult to accurately predict. In addition, we may be exposed to customer claims, for potential indemnity obligations, and to customer dissatisfaction and a discontinuance of purchases of our products while the litigation is pending. Any of these consequences could substantially harm our business and results of operations.

 

We have entered into, and may again be required to enter into, patent or other intellectual property cross-licenses.

 

Many companies have significant patent portfolios or key specific patents, or other intellectual property in areas in which we compete. Many of these companies appear to have policies of imposing cross-licenses on other participants in their markets, which may include areas in which we compete. As a result, we have been required, either under pressure of litigation or by significant vendors or customers, to enter into cross licenses or non-assertion agreements relating to patents or other intellectual property. This permits the cross-licensee, or beneficiary of a non-assertion agreement, to use certain or all of our patents and/or certain other intellectual property for free to compete with us.

 

We must attract and retain qualified personnel to be successful, and competition for qualified personnel is increasing in our market.

 

Our success depends to a significant extent upon the continued contributions of our key management, technical and sales personnel, many of who would be difficult to replace. The loss of one or more of these employees could harm our business. Although we have entered into a limited number of employment contracts with certain executive officers, we generally do not have employment contracts with our key employees. We do not have key person life insurance for any of our key personnel. Our success also depends on our ability to identify, attract and retain qualified technical, sales, marketing, finance and managerial personnel. Competition for qualified personnel is particularly intense in our industry and in our location. This makes it difficult to retain our key personnel and to recruit highly qualified personnel. We have experienced, and may continue to experience, difficulty in hiring and retaining candidates with appropriate qualifications. To be successful, we need to hire candidates with appropriate qualifications and retain our key executives and employees. Replacing departing executive officers and key employees can involve organizational disruption and uncertain timing.

 

The volatility of our stock price has had an impact on our ability to offer competitive equity-based incentives to current and prospective employees, thereby affecting our ability to attract and retain highly qualified technical personnel. If these adverse conditions continue, we may not be able to hire or retain highly qualified employees in the future and this could harm our business. In addition, regulations adopted by The NASDAQ National Market requiring shareholder approval for all stock option plans, as well as regulations adopted by the New York Stock Exchange prohibiting NYSE member organizations from giving a proxy to vote on equity compensation plans unless the beneficial owner of the shares has given voting instructions, could make it more difficult for us to grant options to employees in the future. In addition, SFAS No. 123R, Share Based Payments, which comes into effect on January 1, 2006, will require us to record compensation expense for options granted to employees. To the extent that new regulations make it more difficult or expensive to grant options to employees, we may incur increased cash

compensation costs or find it difficult to attract, retain and motivate employees, either of which could harm our business.

 

We use contractors to provide services to us, which often involves contractual complexity, tax and employment law compliance, and being subject to audits and other governmental actions. We have been audited for our contracting policies in the past, and may be in the future. Burdening our ability to freely use contractors to provide services to us may increase the expense of obtaining such services, and/or require us to discontinue using contractors and attempt to find, interview, and hire employees to provide similar services. Such potential employees may not be available in a reasonable time, or at all, or may not be hired without undue cost.

 

We have experienced transitions in our management team, our board of directors and our independent registered public accounting firm in the past and may continue to do so in the future.

 

We have experienced a number of transitions with respect to our board of directors, executive officers, and our independent registered public accounting firm in recent quarters, including the following:

 

 

 

Such past and future transitions may continue to result in disruptions in our operations and require additional costs.

 

Industry cycles may strain our management and resources.

 

Cycles of growth and contraction in our industry may strain our management and resources. To manage these industry cycles effectively, we must:

 

 

If we cannot manage industry cycles effectively, our business could be seriously harmed.

 

Our operations and the operations of our significant customers, third-party wafer foundries and third-party assembly and test subcontractors are located in areas susceptible to natural disasters.

 

Our operations are headquartered in the San Francisco Bay Area, which is susceptible to earthquakes, and the operations of CMD, which we acquired, are based in the Los Angeles area, which is also susceptible to earthquakes. TSMC, the outside foundry that produces the majority of our semiconductor products, is located in Taiwan. Advanced Semiconductor Engineering, or ASE, one of the subcontractors that assembles and tests our semiconductor products, is also located in Taiwan. For the years ended December 31, 2005, 2004 and 2003 customers and distributors located in Taiwan generated 25%, 25% and 34% of our revenue, respectively, and customers and distributors located in Japan generated 22%, 20%, and 15% of our revenue, respectively. Both Taiwan and Japan are susceptible to earthquakes, typhoons and other natural disasters.

 

Our business would be negatively affected if any of the following occurred:

 

 

Changes in environmental rules and regulations could increase our costs and reduce our revenue.

 

Several jurisdictions are considering whether to implement rules that would require that certain products, including semiconductors, be made lead-free. We anticipate that some jurisdictions may finalize and enact such requirements. Some jurisdictions are also considering whether to require abatement or disposal obligations for products made prior to the enactment of any such rules. Although several of our products are available to customers in a lead-free condition, most of our products are not lead-free. Any requirement that would prevent or burden the development, manufacture or sales of lead-containing semiconductors would likely reduce our revenue for such products and would require us to incur costs to develop substitute lead-free replacement products, which may take time and may not always be economically or technically feasible, and may require disposal of non-compliant inventory. In addition, any requirement to dispose or abate previously sold products would require us to incur the costs of setting up and implementing such a program.

 

Provisions of our charter documents and Delaware law could prevent or delay a change in control, and may reduce the market price of our common stock.

 

Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. These provisions include:

 

 

Provisions of Delaware law also may discourage, delay or prevent someone from acquiring or merging with us.

 

The price of our stock fluctuates substantially and may continue to do so.

 

The stock market has experienced extreme price and volume fluctuations that have affected the market valuation of many technology companies, including Silicon Image. These factors, as well as general economic and political conditions, may materially and adversely affect the market price of our common stock in the future. The market price of our common stock has fluctuated significantly and may continue to fluctuate in response to a number of factors, including, but not limited to:

 

 

Due to these factors, the price of our stock may decline. In addition, the stock market experiences volatility that is often unrelated to the performance of particular companies. These market fluctuations may cause our stock price to decline regardless of our performance.

 

Continued terrorist attacks or war could lead to further economic instability and adversely affect our operations, results of operations and stock price.

 

The United States has taken, and continues to take, military action against terrorism and has engaged in war with Iraq and currently has an occupation force there and in Afghanistan. In addition, the current nuclear arms crises in North Korea and Iran could escalate into armed hostilities or war. Acts of terrorism or armed hostilities may disrupt or result in instability in the general economy and financial markets and in consumer demand for the OEM’s products that incorporate our products. Disruptions and instability in the general economy could reduce demand for our products or disrupt the operations of our customers, suppliers, distributors and contractors, many of whom are located in Asia, which would in turn adversely affect our operations and results of operations. Disruptions and instability in financial markets could adversely affect our stock price. Armed hostilities or war in South Korea could disrupt the operations of the research and development contractors we utilize there, which would adversely affect our research and development capabilities and ability to timely develop and introduce new products and product improvements.

 

We indemnify certain of our licensing customers against infringement.

 

We indemnify certain of our licensing agreements customers for any expenses or liabilities resulting from third-party claims of infringements of patent, trademark, trade secret, or copyright rights by the technology we license. Certain of these indemnification provisions are perpetual from execution of the agreement and, in some instances; the maximum amount of potential future indemnification is not limited. To date, we have not paid any such claims or been required to defend any lawsuits with respect to any claim. In the event that we were required to defend any lawsuits with respect to our indemnification obligations, or to pay any claim, our results of operations could be materially adversely affected.

 

If we are unable to successfully address the material weakness in our internal controls as described in Item 9A in this Annual Report on Form 10-K, our ability to report our financial results on a timely and accurate basis may be adversely affected.

 

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we are required to furnish a report by our management on our internal control over financial reporting. Such report must contain, among other matters, an assessment of the effectiveness of our internal control over financial reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management. Such report must also contain a statement that our auditors have issued an attestation report on management’s assessment of such internal controls. Management’s report is included in this Annual Report on Form 10-K under Item 9A.

 

As of December 31, 2005, management concluded that a material weakness exists as we did not maintain effective controls to correctly compute the excess tax benefit relating to stock options exercised, which resulted in us recording a material adjustment in the 2005 financial statements that affected the provision for income taxes and stockholders’ equity. Because of this material weakness, management concluded that we did not maintain effective internal control over financial reporting as of December 31, 2005. Management has identified the steps necessary to address the material weaknesses described above, and has begun to execute remediation plans, as discussed in Item 9A of this Annual Report on Form 10-K. If we are unable to successfully address the material weakness in our internal controls, our ability to report our financial results on a timely and accurate basis may be adversely affected. As a result, current and potential stockholders and other third parties could lose confidence in our financial reporting which could have a material adverse effect on our business, operating results and stock price.

 

Not applicable.

 

Our principal operating facility, consisting of approximately 110,000 square feet of space in Sunnyvale, California, is leased through July 31, 2010. We also have approximately 29,000 square feet of space in Irvine, California, which is leased through November 2008. Until January 2006, we also leased approximately 8,000 square feet of space in Milpitas, California, which we did not occupy in 2005. In Taiwan, we lease office space consisting of approximately 6,500 square feet for a period of three years. We also lease office space in Japan, Korea, China and the United Kingdom. We believe that our facilities are adequate to meet our operational requirements at least through the end of 2006.

 

In 2001, we filed a suit in the U.S. District Court for the Eastern District of Virginia against Genesis Microchip Corp. and Genesis Microchip, Inc. (collectively, “Genesis”) for infringement of our U.S. patent number 5,905,769 (Case No.: CA-01-266-R). In 2002, we added a claim for infringement of our U.S. patent number 5,974,464. In December 2002, the parties entered into an agreement that apparently settled the case. The agreement was reflected in a Memorandum of Understanding (MOU), which contemplated, among other things, the execution of a more detailed “definitive agreement” by December 31, 2002. Disputes arose, however, regarding the interpretation of certain terms of the MOU, and the parties were unable to conclude a definitive agreement. The parties’ disputes were brought before the court, and on July 15, 2003, the court held that the MOU constituted a binding settlement agreement, and that our interpretation of the MOU was correct. Thereafter, the court ordered Genesis to make certain payments described in the MOU to the Court’s escrow account, and on December 19, 2003, the court entered judgment based on its July 15, 2003 ruling.

 

Genesis appealed the judgment to the U.S. Court of Appeals for the Federal Circuit on January 16, 2004. On January 28, 2005, the Federal Circuit dismissed Genesis’ appeal for lack of jurisdiction, holding that the judgment below was not final and appealable. Specifically, the Court of Appeals found that the parties’ agreement to settle the case, as embodied in the MOU, required that Genesis pay us, rather than the district court’s escrow account, certain of the payments described in the MOU.

 

The case was remanded to the district court, where the parties subsequently agreed to a stipulated order whereby the funds held by the district court were transferred to Silicon Image, under restrictions, until appeals are exhausted. On July 22, 2005, based on the stipulated order, the court dismissed the case with prejudice. Genesis filed a renewed appeal to the Federal Circuit, asserting among other things that the district court erred in its interpretation of the MOU, that the MOU (as interpreted by the court) constitutes patent misuse, and that the district court erred in construing certain claim terms in the asserted patents. A hearing on that appeal is scheduled for April 5, 2006, and a ruling is expected within two to three months thereafter.

 

We and certain of our officers and directors, together with our underwriters, have been named as defendants in a securities class action lawsuit captioned Gonzales v. Silicon Image, et al., No. 01 CV 10903 (SDNY 2001) pending in Federal District Court for the Southern District of New York. The lawsuit alleges that all defendants were part of a scheme to manipulate the price of Silicon Image’s stock in the aftermarket following our initial public offering in October 1999. Response to the complaint and discovery in this action on behalf of Silicon Image and individual defendants has been stayed by order of the court. The lawsuit is proceeding as part of a coordinated action of over 300 such cases brought by plaintiffs in the Southern District of New York. Pursuant to a tolling agreement, individual defendants have been dropped from the suit for the time being. In February 2003, the Court denied motions to dismiss brought by the underwriters and certain issuers and ordered that the case may proceed against certain issuers including against Silicon Image. A proposed settlement has been negotiated and has received preliminary approval by the Court. In the event that the settlement is granted final approval, we do not expect it to have a material effect on our results of operations or financial position. This settlement will not require Silicon Image to pay any settlement amounts nor issue any securities. In the event that the settlement is not finally approved, we cannot accurately predict the outcome of the litigation, but we intend to defend this matter vigorously.

We and certain of our officers were named as defendants in a securities class action captioned “Curry v. Silicon Image, Inc., Steve Tirado, and Robert Gargus,” commenced on January 31, 2005. Plaintiffs filed the action on behalf of a putative class of shareholders who purchased Silicon Image stock between October 19, 2004 and January 24, 2005. The lawsuit alleged that Silicon Image and certain of our officers and directors made alleged misstatements of material facts and violated certain provisions of Sections 20(a) and 10(b) of the Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. On April 27, 2005, the Court issued an order appointing lead plaintiff and approving the selection of lead counsel. On July 27, 2005 plaintiffs filed a consolidated amended complaint (“CAC”). The CAC no longer named Mr. Gargus as an individual defendant, but added Dr. David Lee as an individual defendant. The CAC also expanded the class period from June 25, 2004 to April 22, 2005. Defendants filed a motion to dismiss the CAC on September 26, 2005. Plaintiffs subsequently received leave to file, and did file, a second consolidated amended complaint (“Second CAC”) on December 8, 2005. The Second CAC extends the end of the class period from April 22, 2005 to October 13, 2005 and adds additional factual allegations under the same causes of action against Silicon Image, Mr. Tirado and Dr. Lee. The complaint also adds a new plaintiff, James D. Smallwood. Defendants filed a motion to dismiss the Second CAC on February 9, 2006 and that motion is currently scheduled to be heard on June 9, 2006.

 

On January 14, 2005, we received a preliminary notification that the Securities and Exchange Commission had commenced a formal investigation involving trading in our securities. On February 14, 2005, through our legal counsel, we received a formal notification of that investigation and associated subpoenas. We are fully cooperating with the SEC in this matter.

 

In addition, we have been named as defendants in a number of judicial and administrative proceedings incidental to our business and may be named again from time to time.

 

We intend to defend such matters vigorously, and although adverse decisions or settlements may occur in one or more of such cases, the final resolution of these matters, individually or in the aggregate, is not expected to have a material adverse effect on our results of operations, financial position or cash flows.

 

Not applicable.

PART II

 

Our common shares have been traded on the NASDAQ Stock Market since our initial public offering on October 6, 1999. Our common shares trade under the symbol “SIMG”. Our shares are not listed on any other markets or exchanges. The following table shows the high and low closing prices for our common shares as reported by the NASDAQ Stock Market:

 

As February 28, 2006, we had approximately 142 holders of record of our common stock. Because many of such shares are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders.

 

We have never declared or paid cash dividends on shares of our capital stock. We intend to retain any future earnings to finance growth and do not anticipate paying cash dividends.

 

In December 2005, we repurchased 143,350 shares of restricted stock at an aggregate price of $573 from a former employee. These shares were originally issued in connection with our acquisition of Transwarp Networks, Inc. in April 2003.

 

The following selected financial data should be read in connection with our consolidated financial statements and notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual Report on Form 10-K. Historical results of operations are not necessarily indicative of future results.

 

 

Overview

 

Prior to 2000, we focused most of our efforts on the sale and development of PanelLink DVI transmitters, receivers and controllers for the PC and display market. In 2000, in order to decrease our dependence on the PC business, we began focusing our resources on entering two new markets, CE and storage, which we believed would grow significantly and in which we could apply our technology and expertise in high-speed serial interfaces. During 2000, we acquired DVDO, a provider of digital video processing systems for the CE market and Zillion, a developer of high-speed transmission technology for data storage applications. In 2001, we focused on accelerating our entry into the CE and storage markets, leveraging our IP into licensing revenue, and restructuring the company to improve profitability. During 2001, we acquired CMD, a provider of storage subsystems and semiconductors designed for storage area networks, and SCL, a provider of mixed-signal and high-speed circuit designs. From 2002 through 2005, we focused on our diversification strategy and the continued expansion of our presence in the CE and storage markets, including the introduction of our first HDMI products for the CE market in 2003, as well as continuing to leverage our intellectual property to generate revenue. We also focused on improving our profitability and reducing our cash usage throughout this period.

 

From 2002 through 2004, we achieved solid revenue growth, resulting in revenue of $81.5 million, $103.5 million, and $173.2 million for the fiscal years ended December 31, 2002, 2003, and 2004, respectively. We were also able to successfully leverage our intellectual property to generate $6.7 million, $14.2 million, and $20.8 million of development, licensing and royalty revenue for the fiscal years ended December 31, 2002, 2003, and 2004, respectively. During 2005 we continued this strong performance, achieving $212.4 million of revenue (representing a 22.7% increase compared to 2004), $49.5 million of net income (compared to a net loss of $324,000 for 2004), an increase in cash and short-term investments of $58.0 million (compared to an increase of $56.3 million in 2004), and $18.5 million of development, licensing and royalty revenue (compared to $20.8 million of this type of revenue in 2004).

 

Products sold into the PC market have been declining as a percentage of our total revenues and generated 23.2% of our revenue in 2005, 23.8% of our revenue in 2004, and 32.0% of our revenues in 2003. If we include licensing revenues, these percentages would be 23.8%, 24.0%, and 34.9% for the years ended December 31, 2005, 2004, and 2003, respectively. In the PC market, during 2005, our business was favorably impacted by the continued market share growth of Intel’s PCI Express integrated graphic chipsets (IGCs). All desktop and notebook PC platforms based on Intel IGCs require the use of a discrete SDVO transmitter for supporting DVI or HDMI functionality, and we continue to maintain strong market share in the discrete DVI transmitter market. Our transmitter business was also positively impacted by increasing OEM demand for the DVI dual link feature in desktop and notebook PCs, a market where we are the only provider of discrete DVI dual link transmitters. Finally, our business in the PC market was favorably impacted by demand for our integrated panel controllers that are incorporated into LCD panels used in digital LCD monitors. This demand led to 19.4% sales growth in PC integrated circuits from 2004 to 2005. The PC market saw DVI adoption expand significantly. In addition, we generated licensing revenue in 2005 by licensing certain technology to companies for use in making products for the dual-mode interface market.

 

When Intel moved from PCI to PCI Express on the Grantsdale platform, it changed the interface for DVI transmitters and moved from the Digital Video Output (DVO) interface to the new Serial Digital Video Output (SDVO) interface. Our DVI transmitter was designed to work with Intel’s SDVO port in the Intel Grantsdale platform, and sales of this transmitter will continue to be driven by the success of the Grantsdale platform where DVI is offered. We expect DVI adoption rates to continue to expand over the next two years as the market moves away from analog and dual-mode (combination of analog and digital) solutions to all-digital, higher quality and lower-cost solutions. Correspondingly, we expect the prices of digital displays to continue to decrease and drive increased demand for digital only displays that incorporate DVI transmitters and panel controllers such as those sold by us. We continued to grow our next generation of integrated controller panel (IPC) product line in 2005 with the introduction of two customer specific IPCs.

 

Generally, our transmitter products continued to experience competitive pressure in 2005, primarily from integration by the graphics chip suppliers such as ATI Technologies and nVidia. Explore Technologies, Chrontel Thine Electronics and Texas Instruments also remain competitors. Because of this increased competition there were

lower average selling prices for these products during 2005. We expect graphics card manufacturers to continue to integrate a transmitter into their graphics chip, thus eliminating the need for a discrete transmitter device in many host products. Solutions that utilize the integrated graphics supplied by the Intel chipset and that wish to connect to the LCD monitor via DVI will be the primary focus of our transmitter business. In addition, we generated licensing revenue by licensing certain technology to companies for use in making products for the dual mode monitor interface market.

 

Products sold into the CE market have been increasing as a percentage of our total revenues and generated 51.2%, 41.2% and 24.9% of our total revenues for the years ended December 31, 2005, 2004 and 2003, respectively. If we include licensing revenues, these numbers would be 55.8%, 48.8%, and 32.2% for the years ended December 31, 2005, 2004, and 2003, respectively. Demand for our products will be driven primarily by the adoption rate of the HDMI standard within these product categories.

 

Products sold into the storage market, as a percentage of our total revenues, generated 16.9%, 23.0%, and 29.4% of our revenue for the years ended December 31, 2005, 2004, and 2003, respectively. If we include storage related licensing revenues, these numbers were 20.4%, 27.1%, and 32.9%, for the years ended December 31, 2005, 2004, and 2003, respectively. Demand for our storage semiconductor products is dependent upon the rate at which interface technology transitions from parallel to serial, market acceptance of our SteelVine architecture, and the extent to which SATA and Fibre Channel functionality are integrated into chipsets and controllers offered by other companies, which would make our discrete devices unnecessary. In 2006, we anticipate our legacy storage semiconductor business, Fibre Channel, and parallel ATA revenues to continue decreasing as our SteelVine revenues are projected to increase.

 

In the storage market, we had a number of new and advanced product offerings during 2005. We were able to achieve numerous design wins with our SATALink products. In particular, there was widespread market acceptance of the PCI-e to two-port SATA solutions for the PC market and a number of major manufacturers incorporated our products into their motherboards. We expect to leverage our storage expertise in the new and rapidly growing area for CE storage devices through our SteelVine architecture. We anticipate that many next-generation consumer devices such as set-top boxes, Personal Video Recorders (PVRs) and media PCs are likely to have one or more external SATA ports. Demand declined throughout 2005 for our parallel ATA products as the market continued to transition from these technologies to serial ATA. We expect demand for these legacy products to continue to decrease significantly throughout 2005 and beyond.

 

Our licensing activity is complementary to our product sales and it helps us to monetize our intellectual property and accelerate market adoption curves associated with our technology. Most of our licenses include a field of use restriction that prevents the licensee from building a chip in direct competition with those market segments we have chosen to pursue. Revenue from development for licensees, licensing and royalties accounted for 8.7%, 12.0% and 13.7% of our revenues for the years ended December 31, 2005, 2004 and 2003, respectively. Licensing contracts are complex and depend upon many factors including completion of milestones, allocation of values to delivered items, and customer acceptances. Although we attempt to make these factors predictable, many of these factors require significant judgments.

 

In 2004, we launched PanelLink Cinema Partners^tm, LLC a wholly-owned subsidiary of Silicon Image, Inc., which was formally changed to Simplay Labs, LLC (Simplay) in December 2005. Simplay operates and markets the Simplay HD^tm Testing Program, a consumer electronics testing program designed for leading consumer electronics (CE) manufacturers and technology providers. Current members of the program include Hitachi, LG, Mitsubishi, Samsung, Sony, TTE and others. The Simplay HD Testing Program is open to all manufacturers of consumer electronics devices implementing HDMI/HDCP including HDTV’s, DTV’s, Set-Top Boxes (STB’s), DVD players, A/V receivers and cables. The program also maintains broad industry support from a variety of leading digital content providers including The Walt Disney Company, Fox, Universal and Warner Bros.

 

The Simplay HD^tm Testing Program is designed to help consumers know that the digital entertainment devices that they purchase have been tested according to specifications aimed at maximizing the delivery HD content. The program consists of testing, branding and awareness initiatives directed at retailers as well as consumers. At its core, the program is based on the Simplay HD Compatibility Test Specification (CTS) for device manufacturers. Testing encompasses HDCP functionality in conjunction with HDMI, as well as compatibility (“plug-testing”) between

devices from different manufacturers. Products that pass have been verified to meet the Simplay HD Testing Program requirements and are licensed to use the Simplay HD logo, enabling consumers to purchase digital entertainment devices with the confidence that they will be able to receive and play the latest digital content with state of the art technology. Leveraging this branding component, the Simplay HD Testing Program will be providing education to retailers on the importance of Simplay HD verification.

 

During 2005, we also focused on improving our profitability and cash flows. Our cash and short-term investments increased by $58.0 million in 2005, versus an increase of $56.3 million in 2004. Our net income for the year ended December 31, 2005, was $49.5 million compared to a net loss of $324,000 for the year ended December 31, 2004.

 

Commitments, Contingencies and Concentrations

 

Historically, a relatively small number of customers and distributors have generated a significant portion of our revenue. For instance, our top five customers, including distributors, generated 54%, 47%, and 41% of our revenue in 2005, 2004, and 2003, respectively. The increase in 2005 from 2004 and 2003 levels can be attributed to the geographical concentration of our revenue as these customers are primarily in Asia. Additionally, the percentage of revenue generated through distributors tends to be significant, since many OEM’s rely upon third-party manufacturers or distributors to provide purchasing and inventory management functions. In 2005, 52% of our revenue was generated through distributors, compared to 45% in 2004 and 42% in 2003. World Peace Inc., comprised 17.2%, 15.0% and 13.6% of our revenue in 2005, 2004 and 2003 respectively. Microtek comprised 10.6%, 12.0% and 11.2% of our revenue in 2005, 2004 and 2003 respectively. Our licensing revenue is not generated through distributors, and to the extent licensing revenue increases, we would expect a decrease in the percentage of our revenue generated through distributors.

 

A significant portion of our revenue is generated from products sold overseas. Sales (including licensing) to customers in Asia, including distributors, generated 74%, 67%, and 69% of our revenue in 2005, 2004, and 2003, respectively. The reason for our geographical concentration in Asia is that most of our products are part of flat panel displays, graphic cards and motherboards, the majority of which are manufactured in Asia. The percentage of our revenue derived from any country is dependent upon where our end customers choose to manufacture their products. Accordingly, variability in our geographic revenue is not necessarily indicative of any geographic trends, but rather is the combined effect of new design wins and changes in customer manufacturing locations. All revenue to date has been denominated in U.S. dollars.

 

Critical Accounting Policies

 

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect amounts reported in our consolidated financial statements and accompanying notes. We base our estimates on historical experience and all known facts and circumstances that we believe are relevant. Actual results may differ materially from our estimates. We believe the following accounting policies to be most critical to an understanding of our financial condition and results of operations because they require us to make estimates, assumptions and judgments about matters that are inherently uncertain:

 

Revenue recognition

 

For products sold directly to end-users, or to distributors that do not receive price concessions and do not have rights of return, we recognize revenue upon shipment and title transfer if we believe collection is reasonably assured. Reserves for sales returns are estimated based primarily on historical experience and are provided at the time of shipment. The amount of sales returns and allowances has not been, and is not expected to be, material.

 

The majority of our products are sold to distributors with agreements allowing for price concessions and product returns. We recognize revenue based on our best estimate of when the distributor sold the product to its end customer based on point of sales reports received from our distributors. Due to the timing of receipt of these reports, we recognize distributor sell-through using information that lags quarter end by one month. Revenue is not recognized upon shipment since, due to various forms of price concessions; the sales price is not substantially fixed

or determinable at that time. Price concessions are recorded when incurred, which is generally at the time the distributor sells the product to an end-user. Additionally, these distributors have contractual rights to return products, up to a specified amount for a given period of time. Revenue is earned when the distributor sells the product to an end-user, at which time our sales price to the distributor becomes fixed. Our revenue is highly dependent on receiving pertinent and accurate data from our distributors in a timely fashion. Distributors provide us periodic data regarding the product, price, quantity, and end customer shipments as well as the quantities of our products they still have in stock. In determining the appropriate amount of revenue to recognize, we use this data and apply judgment in reconciling differences between their reported inventories and activities. If distributors incorrectly report their inventories or activities, or if our judgment is in error, it could lead to inaccurate reporting of our revenues and income. We have controls in place to minimize the likelihood of this occurrence, but there is no absolute assurance that this will not occur.

 

License revenue is recognized when an agreement with a licensee exists, the price is fixed or determinable, delivery or performance has occurred, and collection is reasonably assured. Generally, we expect to meet these criteria and recognize revenue at the time we deliver the agreed-upon items. However, we may defer recognition of revenue until either cash is received if collection is not reasonably assured at the time of delivery or, in the event that the arrangement includes undelivered elements for which the fair value cannot be determined, until the earlier of such time that the fair value can be determined or the elements are delivered. The fair value of undelivered elements is generally based upon the price charged when the elements are sold separately. A number of our license agreements require customer acceptance of deliverables, in which case we would defer recognition of revenue until the licensee has accepted the deliverables and either payment has been received or is expected within 90 days of acceptance. Certain licensing agreements provide for royalty payments based on agreed upon royalty rates. Such rates can be fixed or variable depending on the terms of the agreement. The amount of revenue we recognize is determined based on a time period or on the agreed-upon royalty rate, extended by the number of units shipped by the customer. To determine the number of units shipped, we rely upon actual royalty reports from our customers when available, and rely upon estimates in lieu of actual royalty reports when we have a sufficient history of receiving royalties from a specific customer for us to make an estimate based on available information from the licensee such as quantities held, manufactured and other information. These estimates for royalties necessarily involve the application of management judgment. As a result of our use of estimates, period-to-period numbers are “trued-up” in the following period to reflect actual units shipped. To date, such “true-up” adjustments have not been significant. In cases where royalty reports and other information are not available to allow us to estimate royalty revenue, we recognize revenue only when royalty reports are received. Development revenue is recognized when a project is completed and accepted by the other party to the development agreement, and collection is reasonably assured. In certain instances, we recognize development revenue using the lesser of non-refundable cash received or the results of using a proportional performance measure, based on the achievement of project milestones. Our license revenue recognition depends upon many factors including completion of milestones, allocation of values to delivered items and customer acceptances.

 

Allowance for Doubtful Accounts

 

We review collectibility of accounts receivable on an on-going basis and provide an allowance for amounts we estimate will not be collectible. During our review, we consider our historical experience, the age of the receivable balance, the credit-worthiness of the customer, and the reason for the delinquency. Write-offs to date have not been material. At December 31, 2005, we had $30.6 million of gross accounts receivable and an allowance for doubtful accounts of $417,000. While we endeavor to accurately estimate the allowance, we may record unanticipated write-offs in the future.

 

Inventories

 

We record inventories at the lower of actual cost, determined on a first-in first-out (FIFO) basis, or market. Actual cost approximates standard cost and standard cost variances. Provisions are recorded for excess and obsolete inventory, and are estimated based on a comparison of the quantity and cost of inventory on hand to management’s forecast of customer demand. Customer demand is dependent on many factors and requires us to use significant judgment in our forecasting process. We must also make assumptions regarding the rate at which new products will

be accepted in the marketplace and at which customers will transition from older products to newer products. Generally, inventories in excess of six months demand are written down to zero and the related provision is recorded as a cost of revenue. While we endeavor to accurately predict demand and stock commensurate inventory levels, we may record unanticipated material inventory write-downs in the future, which may negatively impact our operating results.

 

Goodwill and intangible assets

 

We adopted the Statement of Financial Accounting Standard No. 142 (SFAS No. 142), Goodwill and Other Intangible Assets on January 1, 2003. This standard requires that goodwill no longer be amortized, and instead, be tested for impairment on a periodic basis. The process of evaluating the potential impairment of goodwill is highly subjective and requires significant management judgement to forecast future operating results, projected cash flows and current period market capitalization levels. In estimating the fair value of the business, we make estimates and judgments about the future cash flows. Although our cash flow forecasts are based on assumptions that are consistent with the plans and estimates we are using to manage our business, there is significant judgment in determining such future cash flows. We also consider market capitalization (adjusted for unallocated monetary assets such as cash, marketable debt securities and debt) on the date we perform the analysis. Based on our annual impairment test performed for 2005, we concluded that there was no impairment of goodwill. However, there can be no assurance that we will not incur charges for impairment of goodwill in the future, which could adversely affect our earnings.

 

Deferred Tax Assets

 

We account for income taxes using an asset and liability approach, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements, but have not been reflected in our taxable income. A valuation allowance is established to reduce deferred tax assets to their estimated realizable value. Therefore, we provide a valuation allowance to the extent we do not believe it is more likely than not that we will generate sufficient taxable income in future periods to realize the benefit of our deferred tax assets. To date, as a result of our uncertainty regarding the realizability of our deferred tax assets, we have recorded a 100% valuation allowance. A significant element of our deferred tax assets are the benefits received from employee stock transactions for excess tax deductions. If these stock transactions are realized, such benefits will be recorded as a reduction of income taxes payable, with a corresponding increase in stockholders’ equity.

 

Accrued Liabilities

 

Certain of our accrued liabilities are based largely on estimates. For instance, we record a liability on our consolidated balance sheet each period for the estimated cost of goods and services rendered to us, for which we have not received an invoice. Additionally, a component of our restructuring accrual related to a loss we expect to incur for excess leased facility space is based on numerous assumptions and estimates, such as the market value of the space and the time it will take to sublease the space. Our estimates are based on historical experience, input from sources outside the company, and other relevant facts and circumstances. Actual amounts could differ materially from these estimates.

 

Certain of our licensing agreements indemnify our customers for expenses or liabilities resulting from claimed infringements of patent, trademark or copyright by third parties related to intellectual property content of our products. Certain of these indemnification provisions are perpetual from execution of the agreement and, in some instances; the maximum amount of potential future indemnification is not limited. To date, we have not paid any such claims or been required to defend any lawsuits with respect to a claim.

 

Stock-Based Compensation Expense

 

We are required to determine the fair value of stock option grants to non-employees, and to record the amount as an expense over the period during which services are provided to us. Management calculates the fair value of these stock option grants using the Black-Scholes model, which requires us to estimate the life of the stock option,

the volatility of our stock, an appropriate risk-free interest rate, and our dividend yield. We also fair-value certain repriced options. The calculation of fair value is highly sensitive to the expected life of the stock option and the volatility of our stock, both of which we estimate based primarily on historical experience.

 

Legal Matters

 

We are subject to various legal proceedings and claims, either asserted or unasserted. We evaluate, among other factors, the degree of probability of an unfavorable outcome and reasonably estimate the amount of the loss. Significant judgment is required in both the determination of the probability and as to whether an exposure can be reasonably estimated. When we determine that it is probable that a loss has been incurred, the effect is recorded promptly in the consolidated financial statements. Although the outcome of these claims cannot be predicted with certainty, we do not believe that any of the existing legal matters will have a material adverse effect on our financial condition and results of operations. However, significant changes in legal proceedings and claims or the factors considered in the evaluation of those matters could have a material adverse effect on our business, financial condition and results of operations.

 

Recent Accounting Pronouncements

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 153, Exchanges of Nonmonetary Assets, (SFAS No. 153) which eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. SFAS No. 153 will be effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of SFAS No. 153 did not have a material impact on our financial position, results of operations, or cash flows.

 

In December 2004, the FASB issued Statement No. 123R, Share-Based Payment (SFAS No. 123R), which requires companies to measure and recognize compensation expense for all stock-based payments at fair value. SFAS No. 123R eliminates the alternative of applying the intrinsic value measurement provisions of APB No. 25 to stock compensation awards issued to employees. Rather, the new standard requires enterprises to measure the cost of employee services received in exchange for an award of equity instruments based on the grant date fair value of the award. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award, known as the requisite service period (usually the vesting period). SFAS No. 123R will be effective for our fiscal quarter beginning January 1, 2006, and requires the use of the Modified Prospective Application Method. Under this method, SFAS No. 123R is applied to new awards and to awards modified, repurchased, or cancelled after the effective date. Additionally, compensation cost for the portion of the awards for which the requisite service has not been rendered (such as unvested options) that is outstanding as of the date of adoption shall be recognized as the remaining services are rendered. The compensation cost relating to unvested awards at the date of adoption shall be based on the grant-date fair value of those awards as calculated for pro forma disclosures under the original SFAS No. 123. The actual effects of adopting SFAS No. 123R will be dependent on numerous factors including, but not limited to, the valuation model chosen by us to value stock-based awards and the assumed award forfeiture rates. We have not determined the full impact of SFAS No. 123R, however we do anticipate that its adoption could have a material impact on our financial position and results of operations in 2006.

 

In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (SFAS No. 154) which replaces APB Opinion No. 20 Accounting Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statement — An Amendment of APB Opinion No. 28. SFAS No. 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principal unless it is not practicable. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005 and we are required to adopt it starting with the quarter ending March 31, 2006. Although we continually evaluate accounting policies, we do not believe adoption of SFAS No. 154 will have a material impact on the our financial position, results of operations, or cash flows.

 

On March 29, 2005, the SEC issued SAB No. 107, which provides guidance on the interaction between SFAS No. 123R, and certain SEC rules and regulations. SAB No. 107 provides guidance that may simplify some of the SFAS No. 123R’s implementation challenges.

In November 2004, the FASB issued SFAS No. 151 (SFAS No. 151), Inventory Costs, an amendment of ARB No. 43 Chapter 4. This statement amends the guidance in ARB No. 43, Chapter 4 Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). This Statement requires those items to be excluded from the cost of inventory and expensed when incurred. In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. This Statement is effective for companies at the beginning of the first interim or annual period beginning after June 15, 2005. The adoption of SFAS No. 151 did not have a material effect on our financial position, results of operations, or cash flows.

 

Reclassifications

 

Patent assertion cost of $519,000 and $2,152,000 for the years ended December 31, 2004 and 2003, respectively, have been reclassified from a stand-alone caption in the accompanying Consolidated Statements of Operations, to selling, general and administrative expense to be consistent with the current year presentation. Patent assertion costs included within selling, general and administrative expense for the year ended December 31, 2005 totaled $326,000. The reclassifications had no effect on previously disclosed net loss, cash flow or stockholders’ equity.

 

Annual Results of Operations

 

REVENUE

 

 

REVENUE (with development, licensing and royalty revenues (collectively, “licensing revenue”), by product line)

 

 

Total revenue for 2005 was $212.4 million and represented a sequential growth of 22.7% over 2004. The increase in the CE product revenue was primarily due to strong sales volumes of HDMI receivers and transmitters reflecting the overall success and market acceptance of our technologies, and HDMI in particular. The growth in PC product revenue was driven primarily by our new PC transmitters that incorporate our DVI technology and our intelligent panel controllers, which are key components in LCD displays, partially offset by erosion in the average selling prices of products. The decrease in storage product revenue was due to the trend of declining sales of our legacy storage systems products and Fibre Channel SerDes, which are being phased out of customer applications, partially offset by contributions from our new SATA and Steelvine products. We license our technology in each of our areas of business, but usually limit the scope of the license to market areas that are complementary to our

product sales and do not directly compete with our direct product offerings. The decrease in licensing revenues in 2005 relative to 2004, was attributable primarily to the deferral of revenue for certain development projects.

 

Total revenues for 2004 were $173.2 million and represented a sequential growth of 67.3% over 2003. During 2004, all elements of revenue grew, compared to 2003. The increases in the revenue for CE and storage products were attributable to our new product offerings at the time, adoption of our technologies, as well as the continued overall growth of these markets, resulting in increased volumes. The growth in revenue for PC products was driven primarily by the adoption of DVI and a slightly better than expected ramp in Intel’s Grantsdale platform, partially offset by lower average selling prices and the continued softness in the overall growth rate of the PC market in general. The increase in storage product revenue was due to new product offerings was offset by a trend of declining contributions from our legacy storage systems products, which are being phased out of customer applications over time. The increase in licensing revenues during 2004, relative to 2003, was attributable primarily to licensing revenues associated with HDMI.

 

COST OF REVENUE AND GROSS MARGIN

 

 

Cost of revenue consists primarily of costs incurred to manufacture, assemble and test our products, as well as related overhead costs. Gross margin (revenue minus cost of revenue), as a percentage of revenue was 60.9%, 60.4%, and 54.4% for 2005, 2004 and 2003, respectively. The increase in gross margin from 2004 to 2005 was due to $4.2 million less in stock compensation expense partially offset by $2.3 million less in licensing revenue, which have a disproportionate impact on gross profit compared to product sales, erosion in the selling prices of our products, and higher overhead expenses. In 2006, we expect an increase in the erosion of our average selling prices as a result of increased competition. We plan to offset this average selling price erosion through cost savings and new product launches.

 

The increase in gross margin from 2003 to 2004 was attributable primarily to increased licensing revenues, manufacturing cost reductions, and improved mix whereby higher margin CE products represented a increased proportion of revenue relative to lower margin PC and storage products. These factors were offset by lower average product pricing, higher overhead costs related to increased headcount in operations areas and a $2.2 million increase in stock compensation expense.

OPERATING EXPENSES

 

 

Research and Development.  R&D expense consists primarily of compensation and related costs for employees, fees for independent contractors, the cost of software tools used for designing and testing our products and costs associated with prototype materials. R&D expense, including non-cash stock compensation expense, was $44.9 million, or 21.1% of revenue, for 2005, compared to $61.5 million, or 35.5% of revenue, for 2004, and $43.4 million, or 41.9% of revenue, for 2003. The decrease in 2005 was primarily due to the $20.5 million decrease in stock compensation expense related to R&D functions as well as the benefit from a credit to expense of approximately $1.8 million related to three engineering projects that are being funded by outside parties, irrespective of the results of the projects. These items were partially offset by an increase in the number of R&D projects as well higher salaries and wages resulting from an increased number of engineers on staff. Additional costs are also attributable to the increasing level of complexity in our new products. The increase in 2004, relative to 2003, was primarily due to an increase in the number of R&D projects to support the multiple markets in which we operate, as well as additional personnel, including a full year of expense relating to personnel who joined Silicon Image from TransWarp. Non-cash stock compensation expense (benefit) for R&D activities was $(3.9) million for 2005, $16.6 million for 2004 and $6.9 million for 2003.

 

Selling, General and Administrative.  SG&A expense consists primarily of employee compensation and benefits, sales commissions, and marketing and promotional expenses. Including non-cash stock compensation expense, SG&A expense was $32.0 million, or 15.1% of revenue for 2005, $42.7 million, or 24.7% of revenue for 2004, and $23.1 million, or 22.3% of revenue for 2003. The decrease in SG&A expense for 2005 was due to the $16.7 million decrease in stock compensation expense and a significant decrease in legal costs relating to corporate governance issues. These items were partially offset by higher salaries and wages, higher fees for consulting and professional services, and higher commissions on higher sales. We expect selling, general and administrative expenses to increase in 2006 due to increased marketing activities and our expansion into international markets. The increase during 2004, as compared to 2003, primarily resulted from increased headcount to support our increased rate of growth, approximately $1.0 million incurred during the first half of 2004 relating to costs associated with the Audit Committee examination, and $1.2 million relating to our preparation for Sarbanes-Oxley Section 404. Non-cash stock compensation expense (benefit) for SG&A activities was $(3.3) million for 2005, $13.4 million for 2004 and $2.5 million for 2003.

 

Stock Compensation.  Total stock compensation expense (benefit) was $(8.5) million or (4.0)% of revenue for 2005, $32.8 million or 18.9% of revenue for 2004, and $10.0 million or 9.6% of revenue for 2003. The decrease in the stock compensation expense in 2005 as compared to 2004 is attributable primarily to a decrease in our stock

price during 2005. The average stock price for 2005 was $10.58 as compared to $12.13 for 2004. The increase in total stock compensation expense from 2003 to 2004 can be attributed primarily to a increase in the price of our stock during stock during 2004. The change in fair value of our common stock affects our stock compensation expense (benefit) primarily because of the impact of variable accounting applied to certain option grants that were repriced in prior years. On December 22, 2000, we implemented an option exchange program to allow employees and certain consultants to exchange approximately 3,000,000 stock options with a weighted average exercise price of $25.39 for new options with an exercise price of $5.63 (the fair market value on that date). On April 4, 2001, this program was extended to executives at the December 22, 2000 price (which was greater than the fair market value of our stock on April 4, 2001). Under this program, new options vest over a four-year period and expire in six years. Compensation expense associated with the option exchange program will be recorded until the options are exercised or expire. The compensation expense or benefit for the increase or decrease, respectively, in the fair market value of our common stock in excess of the option’s exercise price is recognized immediately for vested options and is recognized over the vesting period using an accelerated method for unvested employee options.

 

Amortization of Goodwill and Intangible Assets.  During 2005, we recorded $1.1 million of amortization of intangible assets, compared to $1.3 million and $1.1 million of expense for the amortization of intangible assets for 2004 and 2003, respectively. The amortization expense recorded related to intangible assets acquired in connection with the acquisition of Transwarp Networks. The decrease in 2005 was due to the portion of intangible assets related to assembled workforce, which was amortized over eighteen months, being fully amortized at the end of 2004.

 

In-process Research and Development.  In-process research and development represents technology that has not reached technological feasibility and that has no alternative future use as of the acquisition date.

 

Transwarp Networks, Inc. (TWN).  During the quarter ended June 30, 2003, we completed the acquisition of the assets of TWN and recorded a one-time expense of $5.5 million for in-process research and development. As of the acquisition date, there was one identified development project that met the necessary criteria — “Polaris”. The value of this project was determined by estimating the future cash flows from the time it was expected to be commercially feasible, discounting the net cash flows to present value, and applying a percentage of completion to the calculated values. The net cash flows from the identified project were based on estimates of revenue, cost of revenue, research and development expenses, selling, general and administrative expenses and applicable income taxes. The technology related to the Polaris project was incorporated into our Steelvine product line, which began generating revenue in 2004 and is expected to continue. We based our revenue projections on estimates of market size and growth, expected trends in technology and the expected timing of new product introductions by our competitors and us. The discount rate used for this project was 30%, which we believe was appropriate based on the risk associated with technology that was not yet commercially feasible. The percentage of completion for this project was based on research and development expenses incurred immediately prior to the acquisition as a percentage of the total estimated research and development expenses required to bring this project to technological feasibility. As of the date of the acquisition, we estimated that Polaris was 17% complete, with total projected costs of approximately $3.3 million. Shipments of this product commenced during 2004.

 

Impairment of Intangible Assets.  Based on our annual impairment test performed for 2005, in accordance with SFAS No. 142, we concluded that there was no impairment of our goodwill and intangible assets in fiscal 2005. The impairment analysis was based on our estimates of forecasted discounted cash flows as well as our market capitalization at that time.

 

Restructuring.  In March 2003, we reorganized parts of the marketing and product engineering activities of the Company into lines of business for personal computer (PC), consumer electronics (CE) and storage products to enable us to better manage our long-term growth potential. In connection with this reorganization, we reduced our workforce by 27 people, or approximately 10%.These reductions were primarily in engineering and operations functions. Because of this workforce reduction, we recorded restructuring expense of $1.0 million in the first quarter of 2003, consisting of cash severance-related costs of $340,000 and non-cash severance-related costs of $646,000, representing the intrinsic value of modified stock options.

 

Severance related costs were determined based on the amount of pay people received that was not for services performed and by measuring the intrinsic value of stock options that were modified to the benefit of terminated

employees. For those employees terminated in the three-month period ending March 31, 2003, the remaining service period from the communication date did not exceed 60 days.

 

Severance and benefits payments are substantially complete. The following table presents restructuring activity for 2003 through December 31, 2005 (in thousands):

 

 

Interest Income.  Interest income was $3.6 million, $945,000, and $498,000 for 2005, 2004 and 2003, respectively. The increases in interest income from 2004 to 2005, and from 2003 to 2004 were attributable primarily to the increased cash and investment balances and higher interest rates.

 

Interest Expense and Other Net.  Net interest expense and other was $195,000, $227,000, and $207,000 for 2005, 2004, and 2003, respectively.

 

Gain on investment security.  In 2005, we recorded a net gain of $1.3 million from the mark to market and subsequent sale of our holdings in Leadis Technology, Inc (“Leadis”). In 2004, we recorded a net gain of $926,000 related to this investment. These holdings related to equity we acquired in a transaction with Leadis. As of December 31, 2005 our investment in Leadis was fully liquidated. Our typical practice is not to hold equity shares for investment purposes.

 

Provision for Income Taxes.  For the year ended December 31, 2005, we recorded a provision of $6.7 million for income tax expense. This amount included a $5.4 million non-cash charge associated with stock option exercises. The remaining $1.3 million was primarily for taxes in certain foreign jurisdictions and estimated provision for U.S. alternative minimum taxes for the fiscal year ended December 31, 2005. The income tax provision of $1.0 million recorded in 2004 was primarily for foreign withholding taxes payable in connection with our licensing contracts, other foreign taxes where we recently commenced operations, and an estimated provision for U.S. alternative minimum taxes. Due to our loss in 2003, no provision for income taxes was recorded in that year.

 

At December 31, 2005, we had a net operating loss (NOL) carryforward for federal income tax purposes of approximately $67.6 million that expires through 2024. In the event of a cumulative ownership change greater than 50%, as defined, over a three year period, the availability of net operating losses to offset future taxable income may be limited.

 

Gain on escrow settlement, net.  During the quarter ended March 31, 2003, we recognized a net gain of $4.6 million associated with the settlement of an escrow claim against the selling shareholders of CMD. There were no similar transactions in 2005 or 2004.

 

Earnings per share.  In our press release dated February 16, 2006 announcing our financial position as of December 31, 2005 and our results of operations for the year then ended, we calculated our diluted earnings per share under the treasury stock method using our effective tax rate to determine the amount of tax benefits from the assumed exercise of stock options. Subsequent to the issuance of our press release and prior to the issuance of this Annual Report on Form 10-K we revised our calculation of diluted earnings per share by using our statutory tax rate instead of our effective tax rate to determine to amount of the tax benefits from the assumed exercise of stock

options. As a result, our diluted earnings per share increased from $0.57 as previously reported in the press release to $0.59 as reported in this Annual Report on Form 10-K.

 

Liquidity and Capital Resources

 

 

Since our inception, we have financed our operations through a combination of private sales of convertible preferred stock, our initial public offering, lines of credit, capital lease financings, and operating cash flows. At December 31, 2005, we had $152.2 million of working capital and $151.6 million of cash, cash equivalents and short-term investments. If we are not able to generate cash from operating activities, we will liquidate short-term investments or, to the extent available, utilize credit arrangements to meet our cash needs.

 

Operating activities

 

Operating activities provided $55.6 million of cash during 2005. Increases in accounts receivable, inventories, accounts payable, accrued liabilities, deferred license revenue, and deferred margin on sales to distributors and decreases in prepaid assets and other current assets used $2.4 million in cash.

 

Net accounts receivable increased to $30.1 million at December 31, 2005 from $19.4 million at December 31, 2004. The increase was primarily due to increased sales volume and the days of sales outstanding (44 days at December 31, 2005, compared to 38 days at December 31, 2004).

 

Inventories increased to $17.1 million at December 31, 2005 from $13.9 million at December 31, 2004. The increase is attributable primarily to increased sales during the year 2005 and to support future projected sales activity. Our inventory turns increased to 6.0 at December 31, 2005 from 4.8 at December 31, 2004. Inventory turns are computed on an annualized basis, using the most recent quarter results, and are a measure of the number of times inventory is replenished during the year.

 

Accounts payable and accrued liabilities increased to $13.4 million and $14.0 million, respectively, at December 31, 2005 from $6.8 million and $13.4 million, respectively, at December 31, 2004. The increase in accounts payable was due to the timing of when certain accounts payables became due, and the increase in accrued liabilities was primarily due to various activities at the end of 2005.

 

Deferred margin on sales to distributors increased to $13.8 million at December 31, 2005 from $10.0 million at December 31, 2004. The increase is principally due to the effect of increased distributor related shipments at December 31, 2005 as compared to December 31, 2004.

We expect our sales through distributors to increase as a percentage of our total product sales. Accordingly, we expect our inventory and deferred margin on sales to distributors to increase as well.

 

Investing and financing activities

 

We used $12.2 million of cash in our investing activities in 2005. We used $6.2 million for the purchase of property and equipment and a net $8.2 million to purchase short-term investments, which were partially offset by the proceeds use from the sale of our investment in Leadis Technology, Inc. We expect capital spending to increase in 2006 as we invest in additional testing resources.

 

We generated $11.2 million from financing activities in 2005. This included $11.4 million in proceeds received from issuances of common stock from stock option exercises and ESPP purchases, offset by $259,000 for the repayment of debt.

 

Debt and Lease Obligations

 

In October 2002, we entered into a $3.6 million term loan to refinance $3.1 million of debt acquired in connection with our acquisition of CMD and $500,000 of other bank debt. This loan bore interest at prime plus 0.25% and required monthly payments through its maturity of October 1, 2004. This loan was repaid in full during fiscal 2004. During the three months ended March 31, 2003, we borrowed $383,000 to finance certain capital equipment during fiscal 2004. This term loan bears interest at 5% and requires monthly payments through its maturity in February 2004. As of December 31, 2004, $48,000 was outstanding under these term loans.

 

In November 2004, we leased certain capital equipment under a lease arrangement accounted for as a capital lease. The principal balance outstanding under this lease arrangement as of December 31, 2005 and 2004 was approximately $230,000 and $441,000, respectively.

 

In December 2002, we entered into a non-cancelable operating lease renewal for our principal operating facility, including an additional 30,000 square feet of space in an adjacent building, that commenced in August 2003 and expires in July 2010. In June 2004, the lease terms were amended and we leased approximately 28,000 square feet of additional space (for a total leased area of approximately 109,803 square feet). The revised agreement provides for a rent free period for the additional space and thereafter initial base monthly rental payments of $107,607 and provides for annual increases of 3% thereafter. As a result of the lease modification we recorded an adjustment of $220,000 to the restructuring accrual with an offsetting reduction of our operating expense for the year ended December 31, 2005.

 

In June 2001, in connection with our acquisition of CMD, we acquired the lease of an operating facility in Irvine, California with average monthly rental payments of approximately $100,000 through November 2005. We subleased parts of this facility to three separate third parties. These sublease agreements were co-terminous leases and expired in November 2005. These subleases collectively generated monthly sublease income of approximately $40,000 to offset our payments. Effective December 2005, the original lease was terminated and we entered into a new non-cancelable operating lease agreement. Under the terms of the new agreement, base monthly rental lease payments of $42,000 are required and increases annually 3% thereafter.

 

Additionally, in connection with our acquisition of SCL in July 2001, we acquired the lease of a facility in Milpitas, California with average monthly rental payments of approximately $18,000 per month which expires in January 2006. We do not occupy the Milpitas facility and therefore are accounting for the remaining monthly payments in the restructuring reserve as described in Note 3 to the Consolidated Financial Statements.

 

We also lease office space in China, Taiwan, Korea, United Kingdom and Japan.

 

Rent expense totaled $1.7 million, $1.8 million, and $1.9 million in 2005, 2004 and 2003, respectively. Future minimum lease payments under operating leases have not been reduced by expected sublease rental income or by the amount of our restructuring accrual that relates to leased facilities.

Future minimum payments for our operating leases, capital lease obligations, inventory and other purchase commitments and minimum royalty obligations to a related party at December 31, 2005 are as follows (in thousands):