ITEM 1. BUSINESS
Staktek Holdings, Inc. was originally formed by two investment funds affiliated with Austin Ventures, L.P. in May 2003 for the purpose of acquiring Staktek Corporation (the Predecessor Company), which was incorporated in Texas in June 1990. In August 2003, we acquired by merger Staktek Corporation, which survives as our wholly owned subsidiary. We refer to our acquisition of Staktek Corporation throughout this Annual Report on Form 10-K as the “Staktek acquisition.” In addition, the terms “Staktek,” “we,” “us” and “our” refer to Staktek Holdings, Inc. and all of its subsidiaries that are consolidated in conformity with United States generally accepted accounting principles and the Predecessor Company.
Overview
We are a leading provider of intellectual property and services for next-generation, stacking and module technologies for high-speed, high-capacity systems. Our suite of memory solutions increases operational performance by doubling, tripling or quadrupling the amount of memory in the same physical footprint as required by standard packaging technology. With an IP portfolio of more than 200 patents and patent applications pending, we offer flexibility for customers, including outsourced manufacturing, technology licensing and custom engineering.
We currently apply our expertise in memory stacking as well as module solutions to provide intellectual property and services that enable our customers to cost-effectively improve the performance and reliability of their systems. By stacking industry-standard memory, our Stakpak solutions can deliver up to four times the memory capacity per memory module as compared to current-generation monolithic integrated circuits. Most of our memory stacking units contain stacked dynamic random access memory (DRAM) packages or NAND Flash memory (a type of nonvolatile memory) packages. Our advanced module technologies, ArctiCore™ and MobileStak™, deliver better capacity, reliability, electrical and thermal performance compared to conventional module technologies. In addition to memory packages, our advanced module solutions include additional active and passive components as required by the overall solution, e.g., registers, buffers or controllers.
Our customers can license our technologies for their in-house stacking of memory units, outsource their manufacturing needs to us, buy memory units from a licensee such as Qimonda A.G., Samsung Electronics Co., Ltd., SMART Modular Technologies, Inc., Southland Micro Systems, Inc., or Toshiba Corporation, or optimize their needs through a combination of these approaches.
Significant developments in 2006 included the following:
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We announced the availability of the first ArctiCore fully buffered dual in-line memory modules (FB-DIMMs), which offer up to 8GB capacity, support speeds of up to DDR2-800 and deliver excellent thermal performance for current-generation, Intel-based servers and workstations.
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We announced the availability of the first ArctiCore registered dual in-line memory modules (R-DIMMs) that utilize 72 standard 512Mb memory devices, which result in a total module capacity of 4GB of memory designed for server and workstation applications.
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We introduced the second generation of our High Performance Stakpak® chip-scale package (CSP) stacking technology, resulting in improvements in cost and manufacturability, as well as support for a larger variety of DRAM memory devices, including devices operating at DDR2-800 speeds.
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We announced the availability of the FlashStak™ X-2, a thin, small outline package (TSOP) solution that doubles the density of a single-commodity NAND device in a single TSOP footprint for high-capacity applications in consumer electronics devices, such as portable MP3 players, USB Flash drives, mobile phones and PDAs.
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We licensed our NAND Flash-memory stacking technologies to Toshiba Corporation.
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We introduced MobileStak, a chip-stacking solution that enables smaller mobile products by combining virtually any processor, controller and memory device into a single, small footprint module.
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We licensed our ArctiCore R-DIMM, small outline dual in-line memory module (SO-DIMM) and our mini-DIMM module technologies to Southland Micro Systems.
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We continued adding sales capabilities outside of the United States. We now have third-party sales agents in Hong Kong, Israel, Japan, Korea and Taiwan. We plan to take similar actions in China and throughout Europe to aid in our regional sales efforts.
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More than 200 million stacks based on Staktek’s technologies have been shipped to date.
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We shipped 2.5 million High Performance Stakpaks during 2006.
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We moved all High Performance Stakpak production to our Reynosa facility, driving significant improvements to our gross margin.
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Our cash, cash equivalents and short-term investments increased $6 million while we repurchased $8 million in stock.
Industry Trends
Demand for Memory is Growing. The introduction of computing devices with greater processing power and more advanced operating systems and applications is driving the demand for greater amounts of memory, and in particular, higher-capacity memory. In addition, the growing need for more bandwidth in storage and networking equipment, such as network servers and network transmission, is escalating the demand for greater amounts of memory with faster performance characteristics. Similarly, the proliferation of next-generation routers, which utilize advanced transmission techniques to efficiently direct information across networks, is increasing the demand for both processing power and memory within these devices.
Key Market Dynamics Are Intensifying. Original equipment manufacturers (OEMs) traditionally have sought to satisfy the need for higher capacity memory and faster memory speeds by using memory chips with higher densities and by increasing the number of connectors, or memory module sockets, in their systems to support a greater number of memory chips. However, these approaches are more difficult to implement because significant availability, pricing and performance issues slow the transition from one generation of monolithic technology to the next and increasing memory bus speed limits the number of sockets that can be connected to each memory channel.
Lagging Availability / Price-to-Performance Characteristics. In order to ensure that system parts, such as memory chips, are available to meet their production needs, OEMs typically require that parts be available from multiple suppliers in sufficient volume prior to specifying a part for use within a system. Memory chips, or monolithic DRAM, formed from a single crystal of silicon have been introduced by semiconductor manufacturers with ever-increasing memory capacity, with each new generation reflecting a doubling in available memory capacity. When first introduced, next-generation monolithic DRAM chips generally are only available in limited supply and command a significantly higher price on a per bit basis when compared to current-generation DRAM chips. Until next-generation memory technologies become readily available and cost effective, it is not feasible for OEMs to specify these technologies for use other than in their high-end, more costly systems, leaving their broader product markets underserved.
Accelerating Speeds. In order to improve system performance, OEMs are designing systems that contain multiple central processing units, or CPUs, with increasingly faster processing speeds. Since each CPU requires its own memory, systems with multiple CPUs require correspondingly more memory capacity to avoid becoming a bottleneck to overall system performance. However, since the memory chips must function at accelerated speeds to keep pace with these faster CPUs, the number of memory module sockets must be reduced to mitigate loss of signal integrity and signal path delay, thus limiting the number of memory modules that can be installed in a single system.
Shrinking Form Factors. OEMs seek to design systems with smaller form factors to meet end-user demand for advanced processing capabilities in physically smaller products, such as mobile devices and thinner, modular circuit boards that are designed to fit within a rack unit in a data center, including blade-server systems featuring high-speed interconnection to enable networking capabilities that require less desktop equipment. In addition, as OEMs design systems with greater numbers of large CPUs, more memory is required in less available space. The combination of these factors causes OEMs to seek ways to obtain greater memory capacity in less physical space.
Thermal Management Challenges. When CPUs and memory chips process information, they generate heat, which can compromise system performance and reliability if not properly managed. The denser packing of transistors in CPUs and memory chips and the increased speeds of these devices result in more heat generation. Moreover, shrinking form factors at the system level require that these heat-generating parts be placed in a smaller space with less room for fans and other cooling devices. The combination of these factors magnifies the thermal management challenges faced by OEMs.
OEM Supply Chain Demands. OEMs typically subject new products and technologies to rigorous and extensive testing and review prior to specifying them for use within their systems. This qualification process can be expensive and time consuming with no assurance for success. OEMs also require conformance with standards, such as those set by the JEDEC Solid State Technology Association and other standard-setting organizations in order to ensure consistency in design across multiple sources of packaged memory supply. Therefore, memory manufacturers must design new memory chips within strict architectural constraints, limiting flexibility in design and requiring substantial investments in process development and production facilities in advance of qualification.
The demand for high-capacity memory solutions is growing, driven by technology improvements and new applications in computing devices, but the rate of growth in demand for greater memory is outstripping the pace at which memory manufacturers are able to cost-effectively produce next-generation monolithic memory chips and reduce the cost of current-generation memory chips. OEMs are seeking solutions that allow them to more effectively manage the transition from current- to next-generation memory. Intensifying market dynamics, such as accelerating processing power, shrinking form factors, higher thermal management demands and OEM supply chain requirements, are making it more difficult to meet market needs. To meet all of these demands, memory providers and OEMs must focus on ways to obtain more memory capacity and optimize the price-to-performance attributes of their systems within the intensely competitive environment of today’s semiconductor marketplace.
Our Technologies
We design our memory solutions to be more easily accepted by OEMs by utilizing industry-standard parts to cost-effectively provide next-generation memory capacity with better size characteristics and superior thermal management design features. Although our designs are capable of supporting all major types of commercially available packaged memory, including DRAM, Flash memory and static random access memory (SRAM), historically we have focused our development of Stakpak technologies on stacking DRAM chips in leaded TSOPs and in non-leaded ball grid array (BGA) packages. In addition, we have focused our development of FlashStak technologies on stacking NAND Flash chips in TSOP packages.
Performance Stakpak®. Our Performance Stakpak utilizes a patented copper interconnect technology that provides a structure and an electrical and thermal path for standard-packaged DRAM chips. The Performance Stakpak uses primarily TSOPs in two-, three- or four-high stacked configurations. The interconnect system acts as a heat sink and heat spreader to reduce heat build-up by collecting the thermal energy and conducting it from the center of the stack to the sides, where it can be dissipated from the package. This design allows the Performance Stakpak to achieve superior heat dissipation and lower die temperatures than an unstacked TSOP.
Value Stakpak®. Our lower-priced Value Stakpak uses a simplified design and assembly process in which the interconnect consists of a singulated printed circuit board placed horizontally along the edges or leads of the
TSOP. As a result, our Value Stakpak does not dissipate heat as well as our Performance Stakpak, but can be offered to customers at lower prices than our Performance Stakpak. For this reason, our Value Stakpak is targeted at lower-priced systems utilizing high-density memory where thermal management is not as critical, such as entry-level server platforms, communications systems, set-top boxes and consumer applications.
High Performance Stakpak and High Performance Stakpak II. Our High Performance Stakpak consists of non-leaded double-data-rate (DDR) DRAM packages connected by a proprietary interconnect system to maximize interconnection signal integrity. This design supports all JEDEC-compliant DDR2 DRAM packages. The High Performance Stakpak has the same BGA footprint as the original monolithic BGA packages, reducing the need for OEMs to redesign circuit boards for their stacked non-leaded memory products. In addition, our High Performance Stakpak features our patented controlled impedance interconnect system to support the signal integrity needs of the high-speed DDR2 interface. The High Performance Stakpak II is our second generation of High Performance Stakpak, which we designed to incorporate improvements in cost, manufacturability and support for a larger variety of DRAM memory devices, including devices operating at DDR2-800 speeds.
FlashStak. Our FlashStak family consists of a number of Flash memory stacking solutions addressing the needs of high-capacity data storage devices, such as USB drives, portable MP3 players, memory cards and Flash-based solid state drives. Similar to the DRAM Stakpak products, FlashStak enables the highest-density data storage solution using lower-density commodity Flash TSOP devices. In many cases, FlashStak may be adopted in a consumer electronics device by simply replacing the existing Flash TSOP component with a stack of two components, thereby immediately achieving the doubling of capacity. FlashStak has the mechanical ruggedness and reliability of a single TSOP device while achieving a low profile dimension and attractive cost structure. Since it uses standard Flash memory parts, customers enjoy the benefits of our short product lead times, as well as the flexibility to use Flash devices from multiple suppliers. During 2006, we introduced our FlashStak X-2, which is a TSOP solution that doubles the density of a single-commodity NAND device in a single TSOP footprint for high-capacity applications in consumer electronics devices.
ArctiCore Module Technologies. ArctiCore modules are DIMMs targeted at servers, storage devices and laptops. We are exploring opportunities to extend the application of the ArctiCore technology into consumer devices, medical equipment, military equipment and mobile devices. ArctiCore utilizes a double-sided, multi-layered flexible circuit folded around a rigid aluminum core to significantly increase the area available for mounting devices. Simultaneously, ArctiCore enhances thermal management, improves reliability and may offer a thinner overall profile compared to current standard FB-DIMMs. During 2006, we announced the availability of the first ArctiCore FB-DIMMs offering up to 8 GB capacity, as well as the first R-DIMMs utilizing 72 standard memory components.
MobileStak. MobileStak is a chip-stacking solution that enables smaller mobile products by combining virtually any processor, controller and memory device into a single, small footprint module. In December 2006, we announced that we have a MobileStak reference design that is available for sampling. The MobileStak designs can integrate a variety of chip packages, as well as devices provided as bare die. This product is based on our intellectual property and know-how in producing folded-flex packaging.
The vast majority of the DRAM solutions provided by us to date has been to semiconductor manufacturers, memory module manufacturers and contract manufacturers for inclusion in mid-range and high-performance servers and storage systems products of large OEMs, such as Cisco Systems, Inc., Dell, Inc., Hewlett-Packard Company (or HP) and IBM. We have provided our Flash solutions to semiconductor manufacturers and memory solution manufacturers for inclusion in high-end consumer electronics. To a lesser extent, we sell our solutions directly to OEMs, such as HP. For our manufacturing services customers, we typically receive the silicon on a consignment basis and provide a quick turnaround service to our customers. Under this business model, we avoid taking price risk on the memory devices. Some of our customers place non-binding blanket purchase orders up to three months in advance to cover shipments for the relevant period. These purchase orders serve as forecasts for pricing, administrative and general scheduling purposes and are not binding orders. In some instances, purchase
orders from customers are received no more than a day in advance or in the same shipment as the consigned DRAM chips that are supplied to us. We have no long-term purchase agreements with any of our customers.
Our solutions provide the following benefits:
Improve Availability / Price-to-Performance Characteristics. Our memory solutions utilize readily available, lower-cost, current-generation memory chips to provide next-generation memory capacity. By doing so, we help to smooth the market transition to higher-capacity memory while production capacity for next-generation memory chips is being developed. Once next-generation chips become readily available at lower costs, they become candidates for us to deliver even greater memory capacity to OEMs.
Overcome Physical Constraints. By arranging multiple TSOPs or BGAs onto a single connection on a circuit board, our technologies enable a reduction in the number of memory module sockets and, consequently, the number of circuit boards required in a system. This approach allows OEMs to design smaller, lighter and less expensive systems.
Improve Thermal Performance. We believe that the interconnect systems featured in our Stakpak and ArctiCore technologies help deliver superior thermal performance so that systems utilizing our memory solutions reliably function according to their design specifications. We base this belief on extensive research data, which is supported by thermal modeling simulations, empirical testing and basic principles of physics.
Satisfy OEM Supply Chain Needs. Our Stakpak and ArctiCore technologies utilize widely available industry-standard components, enabling our memory stacks to fit on the same circuit board as monolithic packaged memory chips. We combine our use of standard products with highly automated manufacturing and testing to deliver our memory devices with high production yields.
Our Customers
The vast majority of the DRAM solutions provided by us to date has been to semiconductor manufacturers, memory module manufacturers and contract manufacturers for inclusion in mid-range and high-performance servers and storage systems products of large OEMs, such as Cisco Systems, Inc., Dell, Inc., HP and IBM. To a lesser extent, we sell our solutions directly to OEMs, such as HP. We have provided our Flash solutions to semiconductor manufacturers and memory solution manufacturers for inclusion in high-end consumer electronics.
We work with these and other OEMs to understand their requirements, and provide them with memory solutions that they then qualify and in some cases specify for use within their systems. While we sell directly to some OEMs, we provide our services indirectly to OEMs, via semiconductor, memory module and contract manufacturers, who in turn assemble our Stakpak products onto memory modules that they deliver to the OEMs. Our major semiconductor, memory module and contract manufacturing customers include HP, Micron Technology, Inc., Netlist, Inc., Samsung and SMART Modular.
Through our flexible business model, our customers can license our proprietary technologies. To date, we have entered into license agreements with Qimonda, Samsung, SMART Modular, Southland Micro Systems and Toshiba. Under these license arrangements, Samsung and Qimonda are licensed to manufacture and sell memory modules containing stacked chips incorporating our leaded-package stacking technologies and intellectual property, SMART Modular is licensed to manufacture and sell our ArctiCore technologies as well as our Performance, Value and High Performance Stakpak and FlashStak products, Southland Micro Systems is licensed to manufacture and sell certain of our ArctiCore technologies, and Toshiba is licensed to manufacture and sell our NAND Flash-memory FlashStak technologies. We do not expect to receive royalties for several quarters from any new license agreements while the licensees implement our technology and set up necessary production lines.
In 2006, Samsung, HP, Netlist, Micron, and SMART Modular accounted for 20%, 20%, 18%, 18% and 13%, respectively, of our total revenue. We do not have long-term contracts with any of our manufacturing services customers. Sales of our memory products are made under short-term, cancelable purchase orders that are typically received and fulfilled in the same quarter. As a result, our ability to predict future sales in any given period is limited and subject to change based on demand for a specific OEM’s systems that incorporate our memory products and an OEM’s supply-chain decisions.
Our Sales and Marketing
Historically, our sales and marketing strategy has been primarily focused on targeting large OEMs, based on the assumption that ultimate control over the selection of stacking solutions, module assembly and memory components resides with the OEMs. We have a dedicated internal sales and marketing staff responsible for maintaining continual dialogues and forging close relationships with leading OEMs. Sales of stacked memory products utilizing our licensed stacking technologies also help us to increase the rate at which OEMs specify our stacked memory technologies within their systems.
OEMs value improvements in memory capacity, speed, form factor, thermal management, price and reliability. Our marketing efforts emphasize the benefits of utilizing our memory solutions in OEMs’ systems and our ability to deliver our solutions through our high-yield manufacturing processes with short lead times. To maintain broad application for our memory technologies, we design our solutions using industry-standard memory chips and footprints. This allows us to maintain a neutral position with respect to silicon providers and memory and contract manufacturers, enabling OEMs to specify the use of standardized memory chips that are available from multiple sources in high volumes while still utilizing our technologies.
We generate new business primarily by expanding our relationships and working closely with OEMs to design products that satisfy their systems’ memory needs. OEMs determine the technical specifications and control the selection of vendors and contract manufacturers or memory manufacturers that will assemble and deliver the memory components. The typical OEM design cycle is a lengthy endeavor ranging from six months to two years, and during this process, our memory solutions are considered among other alternative solutions and undergo arduous testing and qualification.
In addition to the OEMs, we also market and sell to the semiconductor manufacturers and memory module manufacturers, since they are the ultimate supplier of the memory products to the OEMs, and we want them to be ready to provide memory products that incorporate our technologies when requested by the OEMs. Memory module manufacturers are also an important channel for our technologies to smaller OEMs that we cannot reach directly in an effective manner.
Recently, we expanded the scope of our sales and marketing efforts to include OEM and silicon providers that require increased densities in Flash solutions. With the launch of our new FlashStak product line, we are working to develop relationships with companies marketing NAND semiconductor devices, USB Flash drives, MP3 players and other consumer electronic products with space and density requirements that our FlashStak and/or MobileStak can provide.
In addition, we have been adding sales capabilities outside the United States. We have third-party sales agencies in the local markets of Hong Kong, Israel, Japan, Korea and Taiwan, and plan to take similar actions in China and throughout Europe to aid in our regional sales efforts.
Another focus of our sales and marketing efforts includes increased licensing activities.
We do not have extended agreements with supply-chain partners but instead they sell to us from time to time through purchase orders.
Our Growth Strategy
We intend to build upon our leadership position in leaded packaged memory stacking and to leverage our technologies and flexible business model to continue to grow our business and expand our market opportunities, both internally and through acquisitions. The principal elements of our growth strategy include:
Expand our DRAM Business. We believe that the strength of our intellectual property position, our superior technologies and our focused expertise uniquely position us to benefit from both the growth in the high-capacity DRAM market and the inclusion of stacked memory within that market. As monolithic memory capacity increases from 512-megabits to one-gigabit, two-gigabits and beyond, we plan to apply our technologies to each new generation of memory to allow memory manufacturers to smoothly transition from one generation to the next and to allow OEMs to more quickly bring to market systems with enhanced performance capabilities. We intend to continually identify ways to penetrate fast-growing markets for high-capacity memory. We also intend to develop memory solutions that address our customers’ particular requirements. For example, our new ArctiCore technologies enable the creation of memory modules that contain up to 72 DRAMs in standard packages all within standard DIMM outlines.
Extend Technological Leadership into New Markets. We believe that our large patent portfolio and intellectual property position us as a leader in the development of intellectual property for stacking solutions. We have introduced key innovations, such as our thermal management designs in the market for stacked, packaged memory. We have also introduced key innovations unrelated to stacking DRAM, such as our ArctiCore technologies. We intend to leverage our expertise and strong intellectual property position into markets where our technologies may have a significant impact. We also introduced MobileStak, our chip-stacking solution that enables smaller mobile products by combining virtually any processor, controller and memory device into a single, small footprint module. In addition, we are exploring other product opportunities involving memory. We believe that these technologies will have applications across a broad spectrum of complementary markets for products with high processing needs and form-factor constraints. We intend to allocate increased resources to research and development to pursue these and other market opportunities.
Leverage Strategic Relationships. To grow our business, we will continue to cultivate strong relationships with leading OEMs, memory suppliers and channel partners. We intend to continue to collaborate with leading OEMs and memory manufacturers to design more effective high-capacity memory solutions than are currently available. We intend to continue working with channel partners and third-party manufacturers to make our memory solutions widely available to OEM customers. As we expand and diversify our solutions, we intend to establish new, complementary customer and partner relationships beyond our traditional server, networking and storage markets.
Capitalize on Our Flexible Business Model. We believe that by offering our customers the option of licensing our technologies, outsourcing their manufacturing requirements to us, buying from our licensees or combining these options to best satisfy their needs, we offer advantages over companies with solely a licensing or a manufacturing business model. We intend to continue to provide high-volume manufacturing services to facilitate adoption of our technologies by our customers while aggressively pursuing new opportunities to license our technologies.
Consumer Market. We continue to pursue opportunities in the consumer electronics market, as well as key markets involving industrial, medical and military applications. Many of the same DRAM memory suppliers and memory module makers are increasingly focusing on the consumer Flash memory market, and our proven package-stacking technologies and manufacturing processes are directly applicable to Flash memory.
Our Suppliers
Customers that outsource manufacturing services to us generally supply to us the memory on a consignment basis. Once we receive the memory, we assemble it in our manufacturing facility and then ship the fully
assembled memory products back to them. Under this consignment model, we are not required to carry an inventory of memory for these customers, reducing our inventory costs and minimizing inventory risk associated with pricing, volumes and potential obsolescence. While we benefit from these minimized risks, if our customers are unable to obtain sufficient DRAM due to limited availability, they are unable to consign it to us for our services.
In order to manufacture our units, we require raw materials and components such as DRAMs, NAND Flash, flex circuits, printed circuit boards, aluminum cores, resistors, capacitors, advanced memory buffers, epoxy adhesive, solder, nitrogen, ink marking supplies and tape and reel supplies. While we generally have multiple sources of supply of these materials, we typically procure them from limited sources to take advantage of volume pricing discounts.
Our Manufacturing
We believe that our ability to deliver memory technologies in high volume and with short turnaround times distinguishes us from other similar service providers. Our sophisticated manufacturing processes combine proprietary assembly equipment with standard, back-end automation in a state-of-the-art manufacturing facility. Since we began manufacturing our products, we have been increasing the degree of automation, overall efficiency and production yields of our manufacturing processes.
Historically, we manufactured all of our stacked memory products in our facility in Austin, Texas. In November 2002, we purchased a 45,000 square foot manufacturing facility in Reynosa, Mexico with approximately 27,500 square feet of manufacturing space. We completed the transition of all of our high-volume manufacturing to the Mexico facility during 2006. For the year ended December 31, 2006, virtually all of units produced were manufactured in Mexico. For the years ended December 31, 2005 and 2004, over 95% and 80%, respectively, of our units produced were manufactured in Mexico.
We have a formal quality assurance organization in place with a strategic focus on applying process improvements to achieve overall factory quality targets. We have been ISO certified to the ISO9001:2000 standard since 2001, as assessed by Bureau Veritas Quality International (N.A.) Inc.
Our Research and Development
The market for memory is subject to rapid technological changes, product obsolescence, frequent new product introductions and enhancements, changes in end-user requirements and evolving industry standards. Our ability to continue to succeed in these markets will significantly depend upon our ability to successfully develop, introduce and sell new and enhanced products on a timely and cost-effective basis and to respond to changing customer requirements.
Since 2001, we have focused our research and development spending primarily towards the design of our Stakpak technologies and more recently, we have focused on our ArctiCore and FlashStak technologies, improving our manufacturing and industrial processes and engineering, as well as developing other new products involving memory. We also have been designing our MobileStak technologies. We believe that to be competitive and to grow, we must increase our investments in research and development with a continued focus both on designing advanced technologies and improving our manufacturing processes, quality and industrial engineering and automation. Through close integration of the product development and process automation initiatives, we seek to bring together advanced product designs with process efficiencies to reduce our time to market for new technologies and to increase our overall production.
Our Intellectual Property
Our current business and our future success depend in large part on our ability to protect our proprietary intellectual property and technologies. We do not consider our business materially dependent upon any one
patent, although taken as a whole, our rights and the products made and sold under patents are the most significant element of our business. In addition to patents, we also rely on trade secrets and trademark laws and contractual provisions to protect our intellectual property. We enter into confidentiality agreements with our employees, consultants, service providers, business partners and customers and have processes and controls in place to protect and manage access to, and distribution of, our proprietary and trade secret information.
As of January 31, 2007, we had 96 issued patents and 119 pending patent applications. The patents primarily relate to our stacking solutions and help us protect our market position. These patents expire from time to time over the next 16 years. We continue to actively pursue filing patent applications to cover our intellectual property advancements, and we may be required to spend significant resources to monitor and protect our intellectual property rights.
Our Competition
The market to provide memory solutions is intensely competitive. Within that market, we believe that we compete primarily with other providers of high-capacity technologies and services to OEMs and manufacturers of high-density memory chips. The primary factors upon which we compete are product quality and reliability, manufacturing capacity, cycle times, price and prompt and effective customer service. We believe that our technologies compete favorably in each of these factors with other competitive technologies, services and manufacturers.
We have many competitors that have developed competing technologies. For example, planar solutions allow additional memory devices to be directly attached on the printed circuit board without the need for stacking. Most of the major OEMs and DRAM suppliers currently are using planar solutions, and we expect them to continue to utilize planar solutions in legacy DDR and DDR2 technologies, as well as in next-generation DDR3 technologies with the migration to smaller footprint packages.
In addition, memory packages have been developed that place two memory chips into a single package that allows both chips to fit in the same area as a single Stakpak, reducing the need for our technology. These dual-die packages are being offered by some semiconductor manufacturers to their OEM customers. Other competitors utilize competing technologies that stack standard chips. These traditional stacking competitors include STEC (formerly SimpleTech, Inc.), Amkor Technology, Inc. and Tessera Technologies, Inc. We also could face competition from many new technologies, such as 3D memory cells, stacked wafers, stacked die and module innovations or module stacking. These and other new technologies could change the demand for or performance requirements of memory products and could provide the market with cost-effective memory solutions that outperform our solutions.
Most of our customers, including HP, Micron, Netlist, Samsung and SMART Modular, also are competitors of ours, and may have the ability to manufacture competitive products at lower costs. Our current or potential competitors may also offer bundled arrangements offering a more complete or cost-effective product despite the technical merits or advantages of our services or technologies. We also face competition from current and prospective customers that continually evaluate our capabilities against the merits of manufacturing products internally. Competition may also arise due to the development of cooperative relationships among our current and potential competitors or third parties to increase the ability of their products to address the needs of our prospective customers. In addition, we expect to face competition from existing competitors and new and emerging companies that may enter our existing or future markets with similar or alternative products, which may be less costly or provide additional features. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share.
Our Regulatory Environment
We are subject to various United States and Mexican federal, state and local laws and regulations that are administered by numerous agencies and that relate to, among other things, the protection of the environment, including those governing the discharge or disposal of pollutants and hazardous materials.
We are authorized to operate our manufacturing facility in Mexico as a Maquiladora by the Ministry of Economy of Mexico. This Maquiladora status allows us to import items into Mexico duty free, provided that such items, after processing, are re-exported from Mexico within 18 months. Our Maquiladora status is subject to various restrictions and requirements, including compliance with the terms of the Maquiladora authorization program; proper utilization of imported materials; hiring and training of Mexican personnel; compliance with tax, labor, exchange control and notice provisions and regulations; and compliance with local and national constraints. Under our Maquiladora authorization program, our Reynosa, Mexico facility is not subject to any mandatory periodic audits or inspections or any periodic evaluations of our Maquiladora status. However, various Mexican government agencies, particularly Mexico’s Ministry of Economy and Mexico’s Ministry of Treasury, which are primarily responsible for the oversight and regulation of Mexico’s Maquiladora programs, have a statutory right to conduct inspections and evaluations of our Reynosa, Mexico operations at their discretion to ensure our compliance with the Maquiladora authorization program.
Our Employees
As of March 2, 2007, we had 504 full-time employees, including 415 in operations and engineering; 34 in quality assurance; 19 in sales, general and administrative functions; 26 in research and development; and 10 in executive positions.
By region, 79 and 425 of our employees are located in the United States and in Mexico, respectively. As of March 2, 2007, 78% of our employees in Mexico were represented by a labor organization that has entered into a labor contract with us. We are not party to any collective bargaining agreements with any of our employees in the United States. We have never had a work stoppage, and we believe our relations with our employees are good.
ITEM 1A.
ITEM 1A. RISK FACTORS
Our business faces significant risks. The risk factors set forth below may not be the only ones that we face. Additional risks that we are not aware of yet or that currently are not material may adversely affect our business operations.
We may not be able to increase our revenue and our operating results are likely to fluctuate, which may cause the trading price of our common stock to decline.
We may not be able to increase revenue or generate gross profits or net income. Our revenue and operating results are likely to fluctuate, causing our stock price to fluctuate. If our revenue or operating results fall below the expectations of market analysts or investors, the market price of our common stock could decline substantially.
Factors that may contribute to fluctuations in our revenue and operating results include the risk factors discussed elsewhere in this Annual Report on Form 10-K and the following additional factors:
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the timing and volume of orders received from our customers;
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market demand for, and changes in the average sales prices of, our services and technologies;
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the rate of qualification and adoption of our services and technologies including, but not limited to, the transition from DDR-1 to DDR-2 technologies, as well as from DDR-2 to DDR-3 technologies, and from leaded to non-leaded packages;
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a shortage of memory chips, which may negatively impact our ability to fulfill customer orders;
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the impact of the ongoing transition from current-generation products to next-generation products with each transition resulting in lower unit volumes of memory products to produce the same amount of memory capacity. This is partially offset by increasing demand for memory capacity with each new generation of systems;
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the increasing adoption of planar and dual-die solutions instead of our solutions by OEMs as well as memory suppliers;
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fluctuating demand for, and life cycles of, the products and systems that incorporate our solutions;
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changes in OEMs’ memory and DIMM buying processes;
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changes in the level of our operating expenses;
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our ability to develop new products that are successfully qualified and utilized by customers;
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our ability to manufacture and ship products within a particular reporting period;
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deferrals or cancellations of customer orders in anticipation of the development and commercialization of new technologies or for other reasons;
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our ability to enter into new licensing arrangements, and the terms and conditions for payment to us of license fees under those arrangements;
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the timing and compliance with license or service agreements and the terms and conditions for payment to us of license or service fees under these agreements;
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changes in our royalties caused by changes in demand for products incorporating semiconductors that use our licensed technology;
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delays in our introduction of new technologies or market acceptance of these new technologies through new license agreements;
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changes in our services and technologies and revenue mix;
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seasonal purchasing patterns for our products with lower revenue generally occurring in the first and second quarters;
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the timing of the introduction by others of competing, replacement or substitute technologies or manufacturing services;
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our ability, or the ability of our customers, to procure or manufacture memory and other required components or fluctuations in the cost of such components;
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our ability to enforce our intellectual property rights or to defend claims that we infringe the intellectual property rights of others, and the significant costs to us of related litigation;
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cyclical fluctuations in semiconductor markets generally; and
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general economic conditions that may affect end-user demand for products that use our technologies.
Fluctuations in the demand for our solutions occur as the price of next-generation monolithic memory chips declines and as OEMs respond to demand for their products, which will contribute to volatility in our revenue and operating results and may adversely impact our stock price. The rate at which OEMs adopt our memory products using a particular generation of high-density memory chips, if they adopt our memory products at all, may affect our revenue and operating results. In the past, it has taken several quarters for new, higher-density memory chips to achieve market acceptance. Once accepted by the market, demand for our memory products using these chips can accelerate rapidly and then level off such that rapid growth in sales of these products is not indicative of continued future growth. Likewise, demand for legacy memory chips can quickly decline when a new, higher-density memory chip is introduced and receives market acceptance. Sales of our products and product lines toward the end of a product’s market life may fluctuate significantly, and the precise timing of these fluctuations is difficult, if not impossible, to predict.
In other cases, revenue may decline as customers anticipate making new product purchases. The need for continued significant expenditures for capital equipment purchases, research and development and ongoing customer service and support, among other factors, makes it difficult for us to reduce our operating expenses in
any particular period if our expectations for revenue for that period are not met. Due to the various factors mentioned above, the results of any prior quarterly or annual periods should not be relied upon as an indication of our future operating performance.
Because we do not have long-term agreements with our customers and generally do not have a significant backlog of unfilled orders, our revenue and operating results in any quarter are difficult to forecast and are substantially dependent upon customer orders received and fulfilled in that quarter.
We do not have long-term purchase agreements with customers. Our customers generally place purchase orders for deliveries no more than three months in advance and sometimes no more than a day in advance. These purchase orders generally have no cancellation or rescheduling penalty provisions. Therefore, cancellations, reductions or delays of orders from any significant customer could have a material adverse effect on our business, financial condition and results of operations.
Our business model is one in which there typically is not a backlog of unfilled orders. Rather, a majority of our revenue and earnings in any quarter depends upon customer orders for our products that we receive and fulfill in that quarter. Because our expense levels are based in part on our expectations as to future revenue and to a large extent are fixed in the short term, we likely will be unable to adjust spending on a timely basis to compensate for any unexpected shortfall in revenue. Accordingly, any significant shortfall of revenue in relation to our expectations could hurt our operating results and depress our stock price.
We depend on a limited number of customers for a substantial portion of our revenue, and the loss of, or a significant reduction in orders from, any key customer could significantly reduce our revenue.
The loss of any of our key customers, or a significant reduction in sales to any one of them, would significantly reduce our revenue and adversely affect our business. Our five largest customers accounted for 89% of our total revenue in 2006, 86% of our total revenue in 2005, and 86% of our total revenue in 2004. In particular, Samsung accounted for most of our license revenue and 20% of our total revenue in 2006, and HP, Netlist, Micron Technology and SMART accounted for 20%, 18%, 18% and 13%, respectively, of our total revenue in 2006. Most of the markets for our current services and technologies are dominated by a small number of potential customers. Therefore, our operating results in the foreseeable future will continue to depend on our ability to effect sales to these customers, as well as the ability of these customers to sell products that incorporate memory utilizing our technologies. In the future, these customers may decide not to specify products that incorporate our technologies for use in their systems, purchase fewer memory products than they did in the past or alter their purchasing patterns. In addition, we may be more likely to make concessions to these customers regarding potential returns, repairs, or other issues than we would make if they were not significant customers.
Some of our customers have sought or are seeking to design alternative solutions, either internally or through third parties, to address their need for greater memory capacity. The success of these efforts could have an adverse effect on the prices we are able to charge our customers and the volume of units that incorporate our solutions, which would negatively affect our revenue and operating results.
Consolidation in some of our customers’ industries may result in increased customer concentration and the potential loss of customers. From time to time, the composition of our major customer base has changed from quarter to quarter as the market demand for our customers’ products has changed, and we expect this variability to continue in the future. We expect that sales of our products to a limited number of customers will continue to represent a majority of our revenue in the foreseeable future. The loss of, or a significant reduction in purchases by, any of our major customers could harm our business, financial condition and results of operations.
A natural disaster, epidemic, labor strike, war or political unrest where our customers’ facilities are located could reduce our sales to such customers. For example, Samsung is based in South Korea. North Korea’s decision to withdraw from the Nuclear Non-Proliferation Treaty, as well as more recent related geopolitical
developments, have created unrest. This unrest could create economic uncertainty or instability, could escalate to war or otherwise adversely affect South Korea, and therefore, Samsung, which could have a material and adverse effect on our business, financial condition and results of operations.
If we fail to protect our proprietary rights, our customers or our competitors might gain access to our technologies, which could adversely affect our ability to sell or license our memory solutions or to compete successfully in our markets and harm our operating results.
Our solutions rely on our proprietary rights, and we believe that the strength of our intellectual property rights is, and will continue to be, critical to the success of our business. If any of our key patents or other intellectual property rights are invalidated or deemed unenforceable, or if a court limits the scope of the claims in any of our key patents or other intellectual property rights, the likelihood that companies will continue to purchase or license our memory solutions could be significantly reduced. If we fail to obtain patents or if the patents issued to us do not cover all of the claims we asserted in our patent applications, others could use portions of our intellectual property without the payment of license fees and royalties. The resulting loss in revenue could significantly harm our business, financial condition and results of operations.
We rely on a combination of license, development and nondisclosure agreements and other contractual provisions and patent, trademark and trade secret laws, and restrictions on disclosure to protect our intellectual property rights. We also enter into confidentiality agreements with our employees, consultants and third parties, and control access to and distribution of our documentation and other proprietary information. It is possible that these efforts to protect our intellectual property rights may not:
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prevent challenges to, or the invalidation or circumvention of, our existing patents;
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result in patents that lead to commercially viable products or provide competitive advantages for our products;
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prevent our competitors from independently developing similar products, duplicating our products or designing around the patents owned by us;
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prevent third-party patents from having an adverse effect on our ability to do business;
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provide adequate protection for our intellectual property rights;
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prevent disputes with third parties regarding ownership of our intellectual property rights;
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prevent disclosure of our trade secrets and know-how to third parties or into the public domain; or
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result in valid patents, including international patents, from any of our pending applications.
A court invalidation or limitation of our key patents could significantly harm our business, financial condition and results of operations.
Our patent portfolio contains some patents that are particularly significant to our ongoing revenue and business. If any of these key patents is invalidated, or if a court limits the scope of the claims in any of these key patents, the likelihood that companies will take new licenses and that current licensees will continue to agree to pay under their existing licenses could be significantly reduced. The resulting loss in license fees and royalties could significantly harm our business, financial condition and results of operations.
Our revenue may suffer if we cannot continue to license or enforce our intellectual property rights or if third parties assert that we violate their intellectual property rights.
We rely upon patent, copyright, trademark and trade secret laws in the United States and similar laws in other countries, and agreements with our employees, customers, suppliers and other parties, to establish and maintain our intellectual property rights in our technology. However, any of our direct or indirect intellectual property rights could be challenged, invalidated or circumvented. Further, the laws of certain countries do not
protect our proprietary rights to the same extent as do the laws of the United States. Therefore, in certain jurisdictions we may be unable to protect our technology adequately against unauthorized third-party use, which could adversely affect our business. Third parties also may claim that we or our customers are infringing upon their intellectual property rights. Even if we believe that the claims are without merit, the claims can be time consuming and costly to defend and divert management’s attention and resources away from our business. Claims of intellectual property infringement also might require us to enter into costly settlement or license agreements or pay costly damage awards. Some of our license agreements provide limited indemnities and we may agree to indemnify others in the future. Our indemnification obligations could result in substantial expenses. In addition to the time and expense required for us to indemnify our licensees, a licensee’s development, marketing and sales of licensed semiconductors could be severely disrupted or shut down as a result of litigation, which in turn could severely hamper our business, financial condition and results of operations. If we cannot or do not license the infringed technology at all or on reasonable terms or substitute similar technology from another source, our business could suffer.
We are subject to risks relating to product concentration and lack of revenue diversification.
To date, we have derived nearly all of our revenue from sales or licenses of our Stakpak solutions, and we expect these solutions to continue to account for substantially all of our total revenue in the near term. Continued market acceptance of these solutions is critical to our future success. As a result, our business, financial condition and results of operations could be adversely affected by:
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any decline in demand for our Stakpak solutions;
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failure of our services and technologies to achieve continued market acceptance;
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the introduction of services and technologies that can serve as a substitute for, replacement of or represent an improvement over, our services and technologies such as planar solutions for small packages or dual-die solutions that do not require stacking;
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technological innovations that we are unable to address with our services and technologies; and
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any inability by us to release new products or enhanced versions of our existing services and technologies on a timely basis or the failure of our products to achieve market acceptance.
The average selling prices of our services and technologies could decrease rapidly, which may negatively impact our revenue and gross margins.
We may experience substantial period-to-period fluctuations in our future revenue and operating results due to a decline in the average selling prices for our services and technologies. From time to time, we reduce the average unit price of our services and technologies in anticipation of future competitive pricing pressures, declining memory chip prices, introductions of new services and technologies by us or our memory suppliers and other factors. The high-density memory market is extremely cost sensitive due to potentially high-order volumes combined with memory buyers’ expectations for aggressive price reductions over time. As a consequence, the average selling prices of monolithic memory chips historically have declined as new product generations are commercialized. We expect that these factors will continue to create downward pressure on our average selling prices, which may, in turn, negatively impact our revenue and gross margins, particularly if we are unable to offset reductions in average selling prices by increasing our unit volumes or reducing our manufacturing costs. To maintain our gross margins, we will need to develop and introduce new services and technologies on a timely basis and continually reduce our costs. Our failure to do so could cause our revenue and gross margins to decline.
We are a relatively small company with limited resources compared to some of our current and potential competitors, and we may not be able to compete effectively and maintain or increase our market share.
Some of our current and potential competitors have longer operating histories, significantly greater resources and name recognition, and a larger base of customers than we have. Some of these companies are
better positioned to influence industry acceptance of a particular industry standard or competing technology than we are. These companies may also be able to devote greater resources to the development, promotion and sale of products, and may be able to deliver competitive products or technologies at a lower price. They also may be able to adopt more aggressive pricing policies than we can adopt. In addition, some of our current and potential competitors have established relationships with the decision makers at our current or potential customers. These competitors may be able to leverage their existing relationships to discourage their customers from purchasing products from us or persuade them to replace our products with their products.
In addition, some of our significant customers are competitors of ours, and may have the ability to manufacture competitive products at lower costs. Our current or potential competitors may also offer bundled arrangements offering a more complete or cost-effective product, despite the technical merits or advantages of our services or technologies. We also face competition from current and prospective customers that continually evaluate our capabilities against the merits of manufacturing products internally. Competition may also arise due to the development of cooperative relationships among our current and potential competitors or third parties to increase the ability of their products to address the needs of our prospective customers. In addition, we expect to face competition from existing competitors and new and emerging companies that may enter our existing or future markets with similar or alternative products, which may be less costly or provide additional features. Accordingly, it is possible that new competitors or alliances among competitors may emerge and rapidly acquire significant market share.
We have many competitors who have developed competing technologies. For example, planar solutions allow additional memory devices to be directly attached on the printed circuit board without the need for stacking. Some of the major OEMs and memory suppliers currently are using planar solutions and we expect them to continue to utilize planar solutions in the near future in legacy DDR technologies as well as in next-generation DDR-2 and DDR-3 technologies with the migration to smaller footprint packages.
In addition, memory packages have been developed that place multiple memory chips into a single package that allows these memory chips to fit in the same area as a single Stakpak. Other competitors utilize competing technologies that stack standard memory chips. We also could face competition from many new technologies, such as 3D memory cells, stacked wafers, stacked die and module innovations or module stacking. These and other new technologies could change the demand for or performance requirements of memory products, and could provide the market with cost-effective memory solutions that outperform our Stakpak solutions.
We expect our competitors to continue to improve the performance of their current products, reduce their prices and introduce new services and technologies that may offer greater performance and improved pricing, any of which could cause a decline in revenue or loss of market acceptance of our products. In addition, our competitors may develop enhancements to, or future generations of, competitive products that may render our services or technologies obsolete or uncompetitive. These and other competitive pressures may prevent us from competing successfully against current or future competitors, and may materially harm our business. Competition could decrease our prices, reduce our revenue, lower our gross profits or decrease our market share.
If our services and technologies are used in defective products or include defective parts, we may be subject to product liability or other claims.
If we manufacture memory products that are defective, used in defective or malfunctioning products or contain defective components, we could be subject to product liability claims and product recalls, safety alerts or advisory notices. While we have product liability insurance coverage, we cannot assume that it will be adequate to satisfy claims made against us in the future or that we will be able to obtain insurance in the future at satisfactory rates or in adequate amounts. Product liability claims or product recalls in the future, regardless of their ultimate outcome, could have a material adverse effect on our business, financial condition, results of operations and reputation, and on our ability to attract and retain licensees and customers.
We have entered into an agreement with SMART to manufacture our stacked memory products for a large services customer, which will reduce our control over the manufacturing process for that customer and may result in unforeseen manufacturing and operational problems or the loss or reduction of business from this customer.
We have entered into an agreement with SMART to produce our stacked memory products for a significant customer. Our reliance on this third-party subcontractor involves risks, such as reduced control over capacity investment, delivery schedules, quality assurance, fabrication costs and the risk of supply disruptions. If SMART is unable to manufacture our stacked memory products or fails to do so to the quality standards of this customer, our business with this customer may be significantly disrupted or harmed, resulting in our business generally being materially adversely affected. In this event, we would be required to provide the stacking services ourselves or to identify and qualify a substitute subcontractor, which could be time consuming and difficult, and may result in unforeseen manufacturing and operational problems or the loss or reduction of business from this customer.
If we acquire other businesses or technologies in the future, these acquisitions could disrupt our business and harm our business, financial condition and results of operations.
As part of our growth and product diversification strategy, we will evaluate opportunities to acquire other businesses, intellectual property or technologies that would complement our current offerings, expand the breadth of our markets or enhance our technical capabilities. Acquisitions entail a number of risks that could materially and adversely affect our business and operating results, including:
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difficulties in integrating the operations, technologies or products of the acquired companies;
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the risk of diverting management’s time and attention from the normal daily operations of the business;
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insufficient revenue to offset increased expenses associated with acquisitions;
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difficulties in retaining business relationships with suppliers and customers of the acquired companies;
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risks of entering markets in which we have no or limited direct prior experience and where competitors in such markets have stronger market positions;
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the potential loss of key employees of the acquired company; and
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the potential need to amortize intangible assets.
Future acquisitions also could cause us to incur debt or contingent liabilities or cause us to issue equity securities. These actions could negatively impact the ownership percentages of our existing stockholders, our financial condition and results of operations.
Our limited experience in acquiring other businesses, product lines and technologies may make it difficult for us to overcome problems we may encounter in connection with any acquisitions we undertake.
We continually evaluate and explore strategic opportunities as they arise, including business combinations, strategic relationships, capital investments and the purchase, licensing or sale of assets. Our experience in acquiring other businesses, product lines and technologies is very limited. The attention of our small management team may be diverted from our core business if we undertake future acquisitions. Any acquisitions may also require us to incur debt or issue equity securities that may result in dilution of existing stockholders. Potential future acquisitions also involve numerous risks, including, among others:
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problems and delays in successfully assimilating and integrating the purchased operations, personnel, technologies, products and information systems;
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unanticipated costs and expenditures associated with the acquisition, including any need to infuse significant capital into the acquired operations;
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adverse effects on existing business relationships with suppliers, customers and strategic partners;
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risks associated with entering markets and foreign countries in which we have no or limited prior experience;
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contractual, intellectual property or employment issues;
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potential loss of key employees of purchased organizations; and
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potential litigation arising from the acquired company’s operations before the acquisition.
We may make acquisitions that are dilutive to existing shareholders, result in unanticipated accounting charges or otherwise adversely affect our results of operations.
We intend to grow our business through business combinations or other acquisitions of businesses, products or technologies that allow us to complement our existing product offerings, expand our market coverage, increase our engineering workforce or enhance our technological capabilities. If we make any future acquisitions, we could issue stock that would dilute our earnings and stockholders’ percentage ownership, reduce our cash reserves, incur substantial debt, or assume contingent liabilities.
Furthermore, acquisitions may require material infrequent charges and could result in adverse tax consequences, deferred compensation charges, substantial depreciation, in-process research and development charges, the amortization of amounts related to deferred compensation and identifiable purchased intangible assets or impairment of goodwill, any of which could negatively impact our results of operations.
As our current services and technology offerings evolve, we continue to derive a material portion of our revenue from royalties, which is inherently risky.
Because we expect a material portion of our future revenue to be derived from license royalties, our future success depends on:
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our ability to secure broad patent coverage for our new technologies and enter into license agreements with potential licensees; and
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the ability of our licensees to develop and commercialize successful products that incorporate our technologies.
Although we have engaged in discussions with potential licensees for our Stakpak technologies, we historically have not devoted significant resources to licensing our technologies and currently have only five license arrangements. We face risks inherent in a royalty-based business model, many of which are outside of our control, such as the following:
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the rate of adoption of our technologies by, and the incorporation of our technologies into products of, semiconductor manufacturers and OEMs;
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the extent to which large equipment vendors and materials providers develop and supply tools and materials to enable manufacturing using our technologies on a cost-effective basis and in quantities sufficient to enable volume manufacturing;
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the willingness of our licensees and others to make investments in the manufacturing process that supports our licensed technologies, and the amount and timing of those investments;
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our licensees’ ability to design and assemble memory modules and other system parts that utilize our technologies in components qualified for use by OEMs;
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any failure by our licensees to abide by compliance and quality control guidelines with respect to our proprietary rights;
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actions by our licensees that could severely harm our ability to use our proprietary rights;
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the pricing and demand for products incorporating memory modules and other system parts that utilize our licensed technologies;
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our ability to structure, negotiate and enforce agreements for the determination and payment of royalties;
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the cyclicality of supply and demand for products using our licensed technologies; and
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competition we may face with respect to our licensees competing with our services business.
It is difficult to predict when we will enter into additional license agreements, if at all. The time it takes to establish a new licensing arrangement can be lengthy. We may also incur delays or deferrals in the execution of license agreements as we develop new technologies. The timing of our receipt of royalty payments and the timing of how we recognize license revenue under license agreements may fluctuate and significantly impact our quarterly or annual operating results. Because we may recognize a significant portion of license fee revenue in the quarter that the license is signed, the timing of signing license agreements may significantly impact our quarterly or annual operating results. Under our typical license agreements, we also receive ongoing royalty payments, and these may fluctuate significantly from period to period based on sales of products incorporating our licensed technologies.
It is difficult for us to verify royalty amounts owed to us under our license agreements, and this may cause us to lose revenue.
The standard terms of our license agreements require our licensees to document the manufacture and sale of products that incorporate our technologies and report this data to us on a quarterly basis. Although our standard license terms give us the right to audit books and records of our licensees to verify this information, audits can be expensive, time consuming and potentially detrimental to our ongoing business relationship with our licensees. As a result, to date, we have primarily relied on the accuracy of the reports themselves without independently verifying the information in them. Our failure to audit our licensees’ books and records may result in us receiving less royalty revenue than we are entitled to under the terms of our license agreements.
Because our licensing cycle is lengthy and costly, it is difficult to predict future revenue, which may cause us to miss analysts’ estimates and may result in our stock price declining.
Pursuing and entering into new license agreements generally requires significant marketing and sales efforts. The length of time it takes to establish a new licensing relationship can range from six to 12 months or longer. Because our licensing cycle is a lengthy process, the accurate prediction of future revenue from new licenses is difficult.
In addition, engineering services are dependent upon the varying level of assistance desired by licensees and, therefore, revenue from these services is also difficult to predict as it is recognized in the period in which we render service. There can be no assurance that we can accurately estimate the amount of resources required to complete projects, or that we will have, or be able to expend, sufficient resources required to complete a project. Furthermore, there can be no assurance that the product development schedule for these projects will not be changed or delayed. All of these factors make it difficult to predict future licensing revenue that may result in us missing analysts’ estimates and may cause our stock price to decline.
Our marketing and sales efforts may be unsuccessful.
We have limited sales and marketing resources. As our business evolves to become more of a royalty-based model, we may have to employ more rigorous sales and marketing efforts, hire more sales and marketing personnel and engage in lengthy negotiations to reach agreement with potential licensees. As a result, our
operating expenses may increase, and we may incur losses in periods that precede the generation of royalties under licensing agreements. If the sales and marketing efforts that we direct at potential licensees of our technologies are unsuccessful, then we may not be able to license our technologies or earn related royalties.
Our reliance on our memory manufacturer customers for the memory chips used in products that incorporate our technologies subjects us to the risk of a shortage of these chips, adversely impacting our ability to fulfill orders from other customers, risks of natural disasters and other factors that could cause disruptions in the supply of memory chips.
Our ability to fulfill customer orders is dependent on a sufficient supply of memory chips to which we apply our manufacturing services. Historically, our customers have shipped on consignment their memory chips to be stacked, which we stack and then return to them. We have no memory supply contracts under which we are currently operating. In acquiring memory chips, supply options are very limited because of the small number of memory manufacturers. Our dependence on our customers’ provision of memory chips to us on a just-in-time consignment basis, rather than through guaranteed supply contracts, subjects our business to risks associated with unforeseen disruptions in the industry availability of memory chips. In the past, there have been shortages of DRAM chips available in the market. These shortages negatively impacted our ability to fulfill customer orders, which resulted in a decrease in shipments in these quarters. Any future shortage could result in a similar decrease in shipments, which would adversely impact our financial condition and results of operations.
In addition, natural disasters or other factors could cause delays or reductions in product shipments that could negatively affect our revenue, financial condition and results of operations. Moreover, since the majority of memory chips are manufactured in the Pacific Rim region, we believe that the risk of exposure of memory suppliers to earthquakes, typhoons, political unrest, terrorist activity, infectious diseases or other similar events is of particular concern. Any unexpected interruption in the manufacture of other key electronic components used in association with products that incorporate our technologies could disrupt production of devices that use our services and technologies, thereby adversely affecting either our ability to deliver products to our customers or the customers’ demand for our services and technologies.
We have indefinite-lived intangible assets and other intangible assets that may become impaired, which could significantly affect our results of operations in the period recognized.
In accordance with generally accepted accounting principles, we evaluate the recoverability of our indefinite-lived intangible assets (goodwill and trademark) on an annual basis and periodically evaluate the recoverability of all of our intangible assets when indicators of impairment exist. The following factors may result in an impairment of goodwill or other intangible assets: significant negative industry or economic trends; disruptions to our business; declines in revenue or market capitalization; or other factors may result in an impairment of goodwill or other intangible assets. Future impairment charges could significantly affect our results of operations in the periods recognized. Please refer to Note 7 of the Notes to Consolidated Financial Statements for the gross carrying amount and accumulated amortization balances of our intangible assets as of December 31, 2006.
If we are unable to manufacture our products efficiently or we experience credit losses or other collections issues, our business, financial condition and results of operations could suffer.
We are continuously modifying our manufacturing processes in an effort to maintain satisfactory manufacturing yields and product performance, lower our costs and reduce the time it takes to design products based on our technologies. In addition, new manufacturing processes are required as we ramp high-volume production of new technologies, such as our High Performance Stakpak and ArctiCore technologies. We face increased risks with these new processes and we incur significant start-up costs associated with implementing new manufacturing technologies, methods and processes and purchasing new equipment, which could impact our gross margins. We expect to experience manufacturing delays and inefficiencies as we develop or refine new
manufacturing technologies and methods, implement them in volume production and qualify them with customers, which could cause our operating results to decline. As we manufacture more complex products, such as our High Performance Stakpak, ArctiCore and future products, the risk of encountering delays or difficulties increases.
In addition, if demand for our products increases significantly, we will need to expand our operations to manufacture sufficient quantities of products without increasing our production times or our unit costs. As a result of such expansion, we could be required to purchase new equipment, upgrade existing equipment, develop and implement new manufacturing processes and hire additional personnel. Further, new or expanded manufacturing facilities could be subject to qualification by our customers. We cannot be certain that we will be able to add required manufacturing capacity or that we will be able to maintain control over product quality, delivery schedules, manufacturing yields and costs as we increase our output. Any difficulties in expanding our manufacturing operations could cause product delivery delays and lost sales.
If demand for our products decreases, we could have excess manufacturing capacity. The fixed costs associated with excess manufacturing capacity could cause our operating results to decline. If we are unable to achieve further manufacturing efficiencies and cost reductions, particularly if we are experiencing pricing pressures in the marketplace, our financial condition and results of operations could suffer.
We have not historically recorded a bad debt allowance or established reserves for our accounts receivable because we have not had significant credit losses or other collections issues during the periods for which financial information is presented. Although we do not believe that we will incur any material credit losses in the foreseeable future, if we were to do so, our financial condition and results of operations could be harmed. Furthermore, should we face any collections issues in the future, it could become necessary to begin recording a bad debt allowance, which could negatively impact our results of operations.
If we are unable to develop new and enhanced solutions that achieve market acceptance in a timely manner, our financial condition, results of operations and competitive position could be harmed.
Our future success will be based in large part on our ability to reduce our dependence on our current Performance Stakpak solution for the majority of our revenue by increasing revenue associated with our other solutions, such as High Performance Stakpak and ArctiCore, and by developing other new technologies and enhancements that can achieve market acceptance in a timely and cost-effective manner. Successful development and introduction of new technologies on a timely basis require that we:
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identify and adjust to changing requirements of customers within the memory and semiconductor markets generally;
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identify and adapt to emerging technological trends in our target markets;
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maintain effective marketing strategies;
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timely design and introduce cost-effective, innovative and performance-enhancing features that differentiate our services and technologies from those of our competitors;
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timely qualify and certify our technologies for use in our customers’ products; and
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successfully develop our relationships with existing and potential customers, OEMs and supplier and channel partners.
Our research and development efforts are focused primarily on furthering the technologies related to our non-leaded solutions, ArctiCore, MobileStak and other new product initiatives. If the development of these technologies is delayed or abandoned, or if these new technologies fail to achieve market acceptance, our growth prospects, financial condition, results of operations and competitive position could be adversely affected. Furthermore, if markets for these new technologies develop later than we anticipate, or do not develop at all, demand for our solutions that are currently in development would suffer, resulting in lower sales of these products than we currently anticipate.
If we do not create and implement new designs to expand our licensable technology portfolio, our competitive position could be harmed or our financial condition and results of operations adversely affected.
We expect in the future to derive a significant portion of our revenue from licenses and royalties from a relatively small number of key technologies. To remain competitive, we must introduce new technologies or designs in a timely manner and the market must adopt them. Developments in these key technologies are inherently complex, and require long development cycles and a substantial investment before we can determine their commercial viability. We may not be able to develop and market new technologies in a timely or commercially acceptable fashion. Moreover, our currently issued U.S. patents expire at various times from 2010 through 2022. We need to develop and patent successful innovations before our current patents expire.
We also may attempt to expand our licensable technology portfolio and technical expertise by acquiring technologies or developing strategic relationships with others. These strategic relationships may include the right for us to sublicense technologies to others. However, we may not be able to acquire or obtain rights to licensable technologies in a timely manner or upon commercially reasonable terms. Moreover, our research and development efforts, and acquisitions and strategic relationships, may be futile if we do not accurately predict the future packaging needs of the semiconductor and consumer electronics industries. Our failure to develop or acquire new technologies could significantly harm our business, financial condition, and results of operations.
Failure by our licensees to introduce products using our technologies, as well as our licensees’ pricing policies, could limit our royalty revenue growth.
Because we expect a significant portion of our future revenue to be derived from royalties on memory products that use our licensed technology, our future success depends upon our licensees developing and introducing commercially successful products, as well as charging competitive prices for these products. Any of the following factors could limit our royalty revenue growth:
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the willingness and ability of materials and equipment suppliers to produce materials and equipment that support our licensed technologies, in a quantity sufficient to enable volume manufacturing;
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the ability of our licensees to purchase such materials and equipment on a cost-effective and timely basis;
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the willingness of our licensees and others to make investments in the manufacturing processes that support our licensed technologies, and the amount and timing of those investments;
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our licensees’ ability to design and assemble packages incorporating our technologies that are acceptable to their customers; and
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the willingness of our licensees to set competitive prices so that products using our intellectual properties sell in significant volume.
Products that incorporate our technologies generally have long sales and implementation periods, and our customers require that our technologies undergo a lengthy and expensive qualification process without any assurance of revenue.
Products that incorporate our technologies are complex and are typically intended for use in applications that may be critical to the systems being developed by our customers. Prospective customers generally must make a significant commitment of resources to test and evaluate our technologies and to integrate memory modules and other system parts into larger systems. As a result, our sales process is often subject to delays associated with lengthy approval processes that typically accompany the design, testing and adoption of new, technologically complex products. This may delay the time in which we recognize revenue and result in our investing significant resources well in advance of orders for our products.
Prior to incorporating memory products utilizing our technologies, our customers require our processes and technologies to undergo an extensive qualification process, which involves testing products utilizing our
technologies, as well as rigorous reliability testing. This qualification process may continue for six months or longer. However, qualification by a customer does not ensure any sales to that customer. Even after successful qualification and sales to a customer of products incorporating our technologies, changes in our technologies may require a new qualification process, which may result in additional delays. After our products are qualified, it can take an additional six months or more before the customer commences production of components or devices that incorporate our products. Despite these uncertainties, we devote substantial resources, including design, engineering, sales, marketing and management efforts, toward qualifying our products with customers in anticipation of sales. If we are unsuccessful or delayed in qualifying any of our products with a customer, such failure or delay would preclude or delay sales of such products to the customer, which may impede our growth and cause our business to suffer.
If the supply of materials used to manufacture our products is interrupted, or our manufacturing turnaround times are extended, our financial condition and results of operations could be adversely affected.
In order to manufacture our solutions, we require raw materials and components such as but not limited to flex circuits, printed circuit boards, aluminum cores, resistors, capacitors, advanced memory buffers, epoxy adhesive, solder, nitrogen, ink marking supplies and tape and reel supplies. We typically procure these materials from limited sources to take advantage of volume pricing discounts. Shortages in these materials may occur from time to time. In addition to shortages, we could experience quality problems with these materials, which could result in returning them to our suppliers. These shortages and returns could extend the turnaround times of our manufacturing services. If our supply of materials is interrupted for any reason, or our manufacturing turnaround times are extended, our financial condition and results of operations could be adversely affected.
We relocated virtually all of our manufacturing operations from Austin, Texas to Reynosa, Mexico; our failure to continue to manage these operations, as well as issues associated with the location of this facility, could materially and adversely affect our business.
We relocated virtually all of our manufacturing capacity from our Austin, Texas facility to our manufacturing facility in Reynosa, Mexico. We began manufacturing operations in our Mexico facility in the first quarter of 2003, and in the 12 months ended December 31, 2006, we manufactured virtually all of our units in Mexico. The relocation of our operations has placed, and any future growth of our operations may place, a significant strain on our management personnel, systems and resources. We may need to implement a variety of new and upgraded operational and financial systems, procedures and controls, including the improvement of our accounting and other internal management systems. We also expect that we will need to continue to expand, train, manage and motivate our workforce. All of these endeavors will require substantial management time and attention, and we anticipate that we will require additional management personnel and internal processes to manage these efforts. If we are unable to effectively manage our expanding operations, our business could be materially and adversely affected.
In addition, this facility is exposed to certain risks as a result of its location, including:
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changes in international trade laws, such as the North American Free Trade Agreement, or other governmental regulations or tariffs affecting our import and export activities;
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changes in labor laws and regulations affecting our ability to hire and retain employees;
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fluctuations of foreign currency and exchange controls;
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security measures at the United States-Mexico border;
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potential political instability and changes in the Mexican government;
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relations between the governments of the United States and Mexico;
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potential kidnappings of employees;
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natural disasters, such as flooding and other acts of nature;
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strikes by our union employees;
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issues relating to drug-trafficking activities in Mexico; and
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general economic conditions in Mexico.
Any of these risks could interfere with the operation of this facility or restrict or delay our ability to move components, finished products or manufacturing equipment across the United States-Mexico border and result in reduced production, increased costs, or both. In the event that this facility’s production is reduced or we encounter disruptions or delays in moving products across the border, we could fail to ship products on schedule and could face a reduction in future orders from dissatisfied customers. If our costs to operate this facility increase, our gross margins would decrease. Reduced shipments and margins would have an adverse effect on our business, financial condition and results of operations.
We operate our manufacturing facility in Mexico as a Maquiladora and any loss of this status or change in the laws affecting Maquiladoras, or disputes with the labor union in Mexico, could materially harm our business, financial condition and results of operations.
In the 12 months ended December 31, 2006, we manufactured virtually all of our memory products at our manufacturing facility in Reynosa, Mexico. This facility is authorized to operate as a Maquiladora by the Ministry of Economy of Mexico. Mexico has enacted this legislation to promote the use of such manufacturing operations by foreign companies, and continuation of these operations depends upon, among other factors, compliance with applicable laws and regulations of the United States and Mexico. Maquiladora status allows us to import items into Mexico duty-free, provided that such items, after processing, are re-exported from Mexico within 18 months. Maquiladora status is subject to various restrictions and requirements, including:
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compliance with the terms of the Maquiladora authorization program;
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proper utilization of imported materials;
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hiring and training of Mexican personnel;
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compliance with tax, labor, exchange control and notice provisions and regulations, both in the United States and in Mexico; and
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compliance with local and national constraints.
Because assembly operations in Mexico continue to be less expensive than comparable operations in the United States, in recent years many companies have established Maquiladora operations in the Reynosa area to take advantage of lower labor costs. Increasing demand for labor, particularly skilled labor and professionals, from new and existing Maquiladora operations could in the future result in increased labor costs. The loss of our Maquiladora status, changes in the Maquiladora program, the inability to recruit, hire and retain qualified employees, a significant increase in labor costs, unfavorable exchange rates or interruptions in the trade relations between the United States and Mexico could have a material adverse effect on our business, financial condition and results of operation.
While we are not party to any collective bargaining agreements with any of our employees in the United States, as of December 31, 2006, 455, or 83%, of our employees in Mexico were represented by a labor organization that has entered into a labor contract with us. As a result, our Reynosa operations are subject to union activities, including organized strikes or other work stoppages, and cost factors arising from our negotiations of employment terms with the representatives of this union. To date, we have not experienced any organized strikes or other work stoppages at our facility in Reynosa.
We derive a substantial portion of our revenue from our license agreement with Samsung. Royalties paid to us by Samsung generally have been decreasing over time and they may continue to decline as a result of Samsung not utilizing as much of our stacking technology as it utilized in the past, which could materially harm our business, financial condition and results of operations.
We receive the substantial majority of our license revenue from our license agreement with Samsung. This agreement requires that Samsung pay us royalties based on the number of stacked memory products Samsung sells or bundles within its own products. Royalties paid to us by Samsung generally have been decreasing over time and they will continue to decline as a result of Samsung not utilizing as much of our stacking technology as it has utilized in the past.
As of December 31, 2006, the remaining residual value of the customer relationship intangible asset associated with this contract was $2.9 million. The value was initially recorded based upon the projected discounted net cash flows attributable to this relationship. We may have to record an impairment charge for some or all of the value of this asset, depending upon the amount of royalties Samsung pays to us, since unanticipated reductions in the future cash flow from this contract may cause an impairment. As of December 31, 2006, no impairment had been recorded.
The consumer electronics market is a highly competitive and volatile market and if we are not successful in this or other new markets, our business, financial condition and results of operations could be adversely affected.
During 2005, we began to focus on expanding our technologies into the consumer electronics market, particularly the consumer Flash market, as well as key markets involving industrial, medical and military applications. We believe our package-stacking technologies and manufacturing processes are directly applicable to Flash memory market, but we are a recent entrant to this market, and many of the memory suppliers and memory module makers are increasingly focusing on the consumer Flash memory market. Further, the consumer market is highly competitive and is characterized by aggressive pricing practices, downward pressure on gross margins, frequent introduction of new products, short product life cycles, evolving industry standards, continual improvement in product price/performance characteristics, rapid adoption of technological and product advancements by competitors, price sensitivity on the part of consumers, dynamic customer demand patterns, seasonal revenue trends and a large number of competitors. In addition, the consumer market can be much more volatile than other segments of the memory market place. To be successful, we will need to continually introduce new products and technologies, enhance existing products in order to remain competitive, and effectively stimulate customer demand for new products and upgraded versions of our existing products. The success of new product introductions is dependent on a number of factors, including market acceptance; our ability to manage the risks associated with product transitions and production ramp issues; the availability of products in appropriate quantities to meet anticipated demand; and the risk that new products may have quality or other defects in the early stages of introduction. The gross margins in the consumer business are also lower than the other markets on which we are focused, which may adversely affect our financial performance and could lead to a decreased valuation of the Company. As a result, we cannot determine in advance the ultimate effect that new products will have on our sales, licensing or results of operations, and, as a result, if we are not successful in this or other new markets, our business, financial condition and results of operations could be adversely affected.
Austin Ventures controls us, and will continue to control us, as long as it beneficially owns a majority of our common stock.
Austin Ventures beneficially owns approximately 77% of our outstanding common stock. Because Austin Ventures and its affiliates own more than 50% of our common stock, we are considered a “controlled company” under NASD Marketplace Rule 4350(c)(5), and we are exempt from NASD rules that would otherwise require that our board of directors consist of a majority of independent directors. As a “controlled company,” we also are exempt from NASD rules that require the compensation of officers and the nomination of company directors be determined by a committee of independent directors or a majority of independent directors. Our board of directors currently consists of eight directors, of which three qualify as independent directors under NASD rules.
As long as Austin Ventures beneficially owns a majority of our outstanding common stock, Austin Ventures will continue to be able to elect all members of our board of directors. Purchasers of our common stock will not be able to affect the outcome of any stockholder vote until Austin Ventures beneficially owns less than a majority of our outstanding common stock. As a result, Austin Ventures will control all matters affecting us, including:
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the composition of our board of directors and, through it, any determination with respect to our business direction and policies, including the appointment and removal of officers;
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any determinations with respect to mergers or other business combinations;
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our acquisition or disposition of assets; and
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our corporate finance activities.
In addition, to the extent that Austin Ventures continues to beneficially own a significant portion of our outstanding common stock, although less than a majority, it will continue to have a significant influence over all matters submitted to our stockholders and to exercise significant control over our business policies and affairs. Under our certificate of incorporation, as amended, if Austin Ventures ceases to own at least 30% of our outstanding common stock, the approval of the holders of at least two-thirds of our common stock will be required for stockholders to amend our certificate of incorporation or bylaws, to increase or decrease the authorized number of shares of our capital stock or to remove a director. Furthermore, concentration of voting power could have the effect of delaying, deterring or preventing a change of control or other business combination that might otherwise be beneficial to our stockholders. This significant concentration of share ownership may also adversely affect the trading price for our common stock because investors may perceive disadvantages in owning stock in a company that is controlled by a small number of stockholders. Austin Ventures is not prohibited from selling a controlling interest in us to any third party, or from selling its shares at any time, which could adversely affect our stock price.
Austin Ventures and its designees on our board of directors may have interests that conflict with our interests.
Austin Ventures and its designees on our board of directors may have interests that conflict with, or are different from, our own. Conflicts of interest between Austin Ventures and us may arise, and such conflicts of interest may not be resolved in a manner favorable to us, including potential competitive business activities, corporate opportunities, indemnity arrangements, registration rights, sales or distributions by Austin Ventures of our common stock and the exercise by Austin Ventures of its ability to control our management and affairs. Our certificate of incorporation does not contain any provisions designed to facilitate resolution of actual or potential conflicts of interest, or to ensure that potential business opportunities that may become available to both Austin Ventures and us will be reserved for or made available to us. Pertinent provisions of law will govern any such matters if they arise. In addition, Austin Ventures and its director designees could delay or prevent an acquisition or merger even if the transaction would benefit other stockholders.
Our operations could be disrupted by power outages, political unrest, natural disasters or other disasters.
Our manufacturing facility is located in Reynosa, Mexico, and earthquakes, fires, flooding or other natural disasters in this location, or an epidemic, political unrest, war, labor strikes or work stoppages, or interruptions in supply or utilities at this location would likely result in the disruption of our manufacturing services, cause significant delays in shipments of our products and materially and adversely affect our operating results.
We intend to expand our research and development activities and other operations, and this expansion may strain our resources and increase our operating expenses.
We intend to increase our research and development activities and other operations, both in the United States and in Mexico, as we grow our business and expand our technology offerings. We may do so through both internal growth and acquisitions. We expect that this expansion could strain our systems and operational and financial controls.
Products that incorporate our technologies must conform to industry standards in order to be widely accepted by OEMs for use in their products.
Our services and technologies are used to create products that comprise only a part of a larger system. Typically, the components of these systems comply with industry standards in order to operate efficiently together. We depend on companies that provide other components of systems and devices to support prevailing industry standards. Many of these companies are significantly larger and more influential in affecting industry standards than we are. Some industry standards may not be widely adopted or implemented consistently, and competing standards may emerge that may be preferred by our customers or end users. If larger companies do not support the same industry standards that we do, or if competing standards emerge, market acceptance of our products could be adversely affected, which would harm our business.
Industry standards are continually evolving, and our ability to compete in the future will depend on our ability to identify and ensure compliance with these evolving industry standards. The emergence of new industry standards could render our products incompatible with products developed by other suppliers. As a result, we could be required to invest significant time and effort and to incur significant expense to implement new services and technologies to ensure compliance with relevant standards. If our products or those of our customers are not in compliance with prevailing industry standards for a significant period of time, we may not be able to sell our services and technologies and our financial condition and results of operations would suffer. In addition, if we do not correctly anticipate new technologies and standards, or if the products that we develop based on these new technologies and standards fail to achieve market acceptance, our competitors may be better able to address market demand than we would and our business, financial condition and results of operations would be adversely affected.
We have been in the process of obtaining adoption of our ArctiCore technologies as a standard in the electronics industry by the JEDEC Solid State Technology Association (JEDEC). JEDEC policies and procedures require that member companies disclose any intellectual property they own and of which they are aware that may infringe a proposed standard. Kentron Technologies, Inc. (Kentron) and Chris Karabatsos, a principal of Kentron, have stated that they believe our ArctiCore technologies infringe on a pending patent application they have filed with the United Stated Patent and Trademark Office, which has not been publicly disclosed, but they have refused to disclose a complete copy of this patent application to either JEDEC or to us. Their allegations cannot be evaluated without disclosure of their pending patent application. Certain members of JEDEC have expressed concern regarding these allegations, which has resulted in a delay of the standardization of our ArctiCore technologies by JEDEC. In response to their actions, on August 1, 2006, we filed an action in the U.S. District Court for the Western District of Texas, Austin Division, against Kentron and the principal. We are seeking damages and injunctive relief, and have alleged that their actions constitute unfair competition under the Lanham Act, intentional interference with prospective business relations, defamation, business disparagement and have caused actionable injury to our business reputation.
We may not be able to adequately address the issues raised by Kentron and its principal in a timely fashion, we may not succeed in our litigation, and we may be required to obtain a license from Kentron, if a license is available to us on reasonable terms. In addition, there can be no assurance that we will be able to sell or license any of our ArctiCore technologies even if JEDEC standardizes some or all of them as a standard.
We depend on a few key personnel to manage our business effectively, and if we lose the services of any of those personnel or are unable to hire additional personnel, our business could be harmed.
We believe our future success will depend in large part upon our ability to attract and retain highly skilled managerial, engineering, sales and marketing personnel. We believe that our future success will be dependent on retaining the services of our key personnel, developing their successors, modifying our internal processes to reduce our reliance on specific individuals, and on properly managing the transition of key roles should departures or additions to the management team occur. The loss of any of our key employees, or the inability to attract or retain qualified personnel, including engineers and sales and marketing personnel, could delay the development and introduction of, and negatively impact our ability to sell, our services and technologies.
We may be involved in costly legal proceedings to enforce or protect our intellectual property rights or to defend against claims that we infringe the intellectual property rights of others.
Litigation is inherently uncertain, and an adverse outcome could subject us to significant liability for damages or invalidate our proprietary rights. Legal proceedings we initiate to protect our intellectual property rights could also result in counterclaims or countersuits against us. Any litigation, regardless of its outcome, could be time consuming and expensive to resolve and could divert our management’s time and attention. Any intellectual property litigation also could force us to take specific actions, including:
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cease selling products that are claimed to be infringing a third party’s intellectual property;
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obtain licenses to make, use, sell, offer for sale or import the relevant technologies from the intellectual property’s owner, which licenses may not be available on reasonable terms, or at all;
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redesign those products that are claimed to be infringing a third party’s intellectual property; or
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pursue legal remedies with third parties to enforce our indemnification rights, which may not adequately protect our interests.
We have found it necessary to litigate against others, including our customers, to enforce our intellectual property and contractual and commercial rights, as well as to challenge the validity and scope of the proprietary rights of others and to defend against claims of infringement or invalidity.
We may be involved in costly legal proceedings involving our contracts, which could include our licensees, potential licenses or strategic partners.
We may become involved in a dispute relating to our contracts, which could include or be with a licensee, potential licensee or strategic partner. Any such dispute could cause the licensee or strategic partner to cease making royalty or other payments to us and could substantially damage our relationship with the company on both business and technical levels. Any litigation stemming from such a dispute could be very expensive. Litigation could also severely disrupt or shut down the business operations of our licensees or strategic partners, which in turn would significantly harm our ongoing relations with them and cause us to lose royalties. Any such litigation could also harm our relationships with other licensees or our ability to gain new customers, which may postpone licensing decisions pending the outcome of the litigation.
Our failure to comply with environmental laws and regulations could subject us to significant fines and liabilities, and new laws and regulations or changes in regulatory interpretation or enforcement could make compliance more difficult and costly.
We are subject to various and frequently changing federal, state and local, and foreign governmental laws and regulations relating to the protection of the environment, including those governing the discharge of pollutants into the air and water, the management and disposal of hazardous substances and wastes, the cleanup of contaminated sites and the maintenance of a safe workplace. We could incur substantial costs, including clean-up costs, civil or criminal fines or sanctions and third-party claims for property damage or personal injury, as a result of violations of or liabilities under environmental laws and regulations or non-compliance with the environmental permits required for our facilities. These laws, regulations and permits also could require the installation of costly pollution control equipment or operational changes to limit pollutant emissions or decrease the likelihood of accidental releases of hazardous substances.
In addition, new laws and regulations, stricter enforcement of existing laws and regulations, the discovery of previously unknown contamination at our sites or the imposition of new clean-up requirements could require us to curtail our operations, restrict our future expansion, subject us to liability and cause us to incur future costs that would have a negative effect on our financial condition and results of operations.
Economic, political and other risks associated with international sales and operations could adversely affect our revenue.
Since we sell our services and technologies worldwide, our business is subject to risks associated with doing business internationally. Our revenue originating outside the United States, including license revenue from Samsung and others and services revenue from our United States and Mexico manufacturing facilities derived from foreign customers, as a percentage of our total revenue, was 22% in 2006, 37% in 2005, and 59% in 2004. International turmoil, exacerbated by the war in Iraq, the escalating tensions in North Korea and violence in the Middle East, have contributed to an uncertain political and economic climate, both in the United States and globally, which may affect our ability to generate revenue on a predictable basis. In addition, terrorist attacks and the threat of future terrorist attacks both domestically and internationally have negatively impacted the worldwide economy. As we ship memory units both in the United States and internationally, the threat of future terrorist attacks may adversely affect our business. These conditions make it difficult for us and for our customers to accurately forecast and plan future business activities and could have a material adverse effect on our business, financial condition and results of operations.
A portion of our revenue is derived from customers based in Asia. The economies of Asia have been highly volatile and recessionary in the past, resulting in significant fluctuations in local currencies and other instabilities. Some countries in Asia have recently been affected by infectious diseases. These instabilities continue and may occur again in the future. Our exposure to the business risks presented by the economies of Asia will increase to the extent that we continue to expand our customer base and activities in that region. An outbreak of an infectious disease could result in reduced demand for products incorporating our technologies, extend the qualification periods for our technologies or otherwise adversely affect our business.
If industry or securities analysts do not continue to publish reports or research about our business, our stock price and trading volume could decline.
The trading market for our common stock depends on the research and reports that industry and securities analysts publish about us and our business. We do not have any control over these analysts. If one or more of the analysts who cover us downgrade our stock, our stock price would likely decline. If one or more of these analysts cease coverage of our company or fail to regularly publish reports on us, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline.
Our stock price is likely to be volatile and could drop unexpectedly.
Our common stock has been publicly traded since February 2004. The market price of our common stock has been subject to significant fluctuations since the date of our initial public offering. The stock market has from time to time experienced significant price and volume fluctuations that have affected the market prices of securities, particularly securities of technology companies. We have limited liquidity in terms of the number of outstanding shares of our common stock that are publicly traded, which may adversely affect the value of our stock. In addition, we have an ongoing stock repurchase program, which could further decrease our liquidity. As a result, the market price of our common stock may materially decline, regardless of our operating performance. In the past, following periods of volatility in the market price of a particular company’s securities, securities class action litigation has often been brought against that company. We may become involved in this type of litigation in the future. Litigation of this type is often expensive and diverts management’s attention and resources.
If Congress changes the patent laws, we could be adversely impacted.
We rely on the uniform and historically consistent application of United States patent laws and regulations. Congress is currently considering modifying the U.S. patent laws, and the Patent and Trademark Office is considering modifying certain regulations relating to filing for patent protection. Some of these modifications may not be advantageous for us, and may make it more difficult to obtain adequate patent protection or to enforce our patents against parties using them without a license or a payment of royalties. These changes could have a negative affect on our licensing program and, therefore, the royalties we would receive.
Recently enacted and proposed changes in securities laws and regulations have increased our costs.
The Sarbanes-Oxley Act of 2002 that became law in July 2002, as well as new rules and regulations subsequently implemented by the SEC, have required changes to some of our corporate governance practices. The Sarbanes-Oxley Act also requires the SEC to promulgate additional new rules on a variety of subjects. In addition to final rules and rule proposals already made by the SEC, the National Association of Securities Dealers has adopted revisions to its requirements for companies, such as us, that propose to have securities listed on the Nasdaq Stock Market. These new rules and regulations have increased our legal and financial compliance costs, and have made some activities more difficult, time consuming and costly. These new rules and regulations have made it more difficult and more expensive for us to obtain director and officer liability insurance. These new rules and regulations could also make it more difficult for us to attract and retain qualified members for our board of directors, particularly to serve on our audit committee, as well as qualified executive officers.
Available Information
We maintain a web site at www.staktek.com, which makes available free of charge our filings with the SEC. Our Quarterly Reports on Form 10-Q, Annual Report on Form 10-K, 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 and Exchange Act of 1934 are available through the Investor Relations page of our web site as soon as reasonably practicable after we electronically file this material with, or furnish it to, the SEC. Our web site and the information contained therein or connected thereto are not intended to be incorporated into this Annual Report on Form 10-K.
ITEM 2.
ITEM 2. PROPERTIES
Our principal executive offices are located at 8900 Shoal Creek Boulevard, Suite 125, Austin, Texas 78757. The facility consists of approximately 46,000 square feet of office space under lease through 2010. It houses all executive, administrative and research functions and staff. We also do limited manufacturing at this facility.
In January 2003, we commenced manufacturing operations at our new facility in Reynosa, Mexico. This facility consists of approximately 45,000 square feet, which we own. During the year ended December 31, 2006, we manufactured virtually all of our memory products at this facility.
We continue to evaluate our future real estate needs based on the current industry environment and our business requirements. We believe that these facilities are suitable and adequate to meet our current operating needs.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
Staktek Group, L.P. v. Kentron Technologies, Inc. and Chris Karabatsos
On August 1, 2006, we filed an action in the U.S. District Court for the Western District of Texas, Austin Division, against Kentron Technologies, Inc. and Chris Karabatsos, an individual. We are seeking damages and injunctive relief relating to the defendants’ false and disparaging statements regarding Staktek and our ArctiCore technologies that we are proposing to the JEDEC Solid State Technology Association for possible adoption as a standard. In particular, we have alleged that the defendants’ actions constitute unfair competition under the Lanham Act, intentional interference with prospective business relations, defamation, business disparagement and have caused actionable injury to our business reputation. While we intend to vigorously prosecute these claims, there can be no guarantee that we will ultimately prevail or that the court will award the remedies we are seeking. The defendants’ response to our lawsuit is not yet due. It is possible that the defendants could include counterclaims against us with their responsive pleadings, but we have no knowledge of any basis for such counterclaims.
Helen Holzwasser v. Staktek Holdings, Inc., James. W. Cady and William Kirk Patterson
On October 22, 2004, a class action complaint for violations of U.S. federal securities laws was filed in the U.S. District Court in New Mexico against us and two of our executive officers, one of whom is no longer an executive officer but remains on our Board of Directors (the Defendants). The plaintiff claims that the Defendants failed to disclose to the public an anticipated shortage of computer memory chips and that they knew or recklessly disregarded that the anticipated shortage would have a materially adverse impact on our revenue and earnings. In addition, the plaintiff claims that the Defendants failed to disclose to investors that the industry’s transition to a new generation of higher-capacity memory chips was causing computer makers to stockpile supplies of older memory chips, increasing the shortage. The suit covers individuals who purchased our stock between November 26, 2003 and May 19, 2004. In April 2005, the case was transferred to federal district court in Austin, Texas, and in June 2005 the plaintiff amended her complaint, adding our chairman of the board as a defendant. A class has not been certified at this time. We do not believe there is any merit to the claims asserted by the plaintiff in this complaint and plan to vigorously defend ourselves. Due to the early stage of this lawsuit, we cannot estimate the outcome of this matter or the resulting financial impact to us, if any.
As of December 31, 2006, we were not involved in any other material legal proceedings.
From time to time, we may be subject to legal proceedings, claims in the ordinary course of business, claims in foreign jurisdictions where we operate, and non-contractual customer claims or requested concessions we may agree to in the interest of maintaining business relationships.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market Information
Our common stock has been quoted on the Nasdaq National Market since February 6, 2004 under the symbol STAK. As of March 2, 2007, there were 26 holders of record of our common stock.
The following tables sets forth, for the periods indicated, the high and low sales prices per share of our common stock as reported on the Nasdaq National Market.
Dividends
We have not declared or paid cash dividends on our common stock. We expect to retain all available funds and any future earnings for use in the operation and development of our business.
Our redeemable preferred stock (the Preferred Stock) issued in August 2003 accrued a cumulative dividend at a rate of 8% per annum. In February 2004, we paid all accumulated dividends totaling $1.1 million to holders of our Preferred Stock, and all outstanding shares of our Preferred Stock were redeemed and canceled.
At December 31, 2006 and 2005 we had 5.0 million authorized shares of $0.001 par value redeemable preferred stock, none of which was issued or outstanding.
Equity Compensation Plan Information
We currently maintain three equity compensation plans: the 2003 Stock Option Plan, providing for the issuance of common stock to our employees, directors and consultants, the 2005 Employee Stock Purchase Plan and the 2006 Equity-Based Compensation Plan, providing for the issuance of restricted stock, restricted stock units, stock appreciation rights, bonus stock and other types of equity to our employees, directors and consultants. The following table provides information about the Company’s common stock that may be issued upon the exercise of options under the Company’s 2003 Stock Option Plan, upon the issuance of restricted stock units pursuant to the 2006 Equity-Based Compensation Plan, and the shares of stock issued pursuant to the 2005 Employee Stock Purchase Plan, in each case as of December 31, 2006.
(1) Excludes RSUs, which had a stock price of $6.73 on the date of issuance.
Issuer Purchases of Equity Securities
The following table provides information with respect to our purchases of our common stock during the quarter ended December 31, 2006:
(1) On February 2, 2006, our Board of Directors renewed our stock repurchase program for up to $10.0 million to purchase shares of our common stock. On November 14, 2006, our Board of Directors authorized an additional $10.0 million to purchase shares of our common stock.
(2) Excludes commissions paid.
Performance Graph
COMPARISON OF 35 MONTH CUMULATIVE TOTAL RETURN*
Among Staktek Holdings, Inc., The NASDAQ Composite Index
And The RDG Semiconductor Composite Index
* $100 invested on 2/6/04 in stock or on 1/31/04 in index-including reinvestment of dividends.
Fiscal year ending December 31.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data should be read in connection with “Item 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Cautionary Statement
The following discussion should be read along with the audited consolidated condensed financial statements and notes included in Item 8 of this Annual Report on Form 10-K. This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements regarding future events and our future results are based on current expectations, estimates, forecasts and projections, and the beliefs and assumptions of our management including, without limitation, our expectations regarding the following: the sales of our products to a limited number of customers and with a limited number of key technologies; most of our revenue coming from our Stakpak solutions; deriving a significant portion of our future revenue from license royalties; the lack of significant credit losses from our customers; manufacturing delays as we develop or refine new manufacturing technologies; our belief that our current assets, including cash, cash equivalents and investments, and expected cash flows from operating activities, will be sufficient to fund our operations; our anticipated additions to property, plant and equipment and any share repurchases under our stock repurchase program for at least the next 12 months; our belief regarding the future of planar technologies; our belief that our package-stacking technologies and manufacturing processes are directly applicable to the Flash memory market; our belief that our facilities are suitable and adequate to meet our current operating needs; our belief that a ten percent change in interest rates will not have a significant impact on our interest income; our belief that our strong patent portfolio and intellectual property position will allow us to continue to expand our business; our belief that the strength of our intellectual property rights is, and will continue to be, critical to the success of our business; our intent to grow our business through business combinations or other acquisitions; our intent to expand our research and development activities; our belief that our future success will depend upon our ability to attract and retain personnel; our belief regarding increasing our investment in research and development; our belief that the interconnect systems features in our technologies help deliver superior thermal performance; and our intent to exploit our intellectual properties and capability to establish market leadership in new technologies; our intent to devote additional personnel and other resources to research and development in future periods to address market opportunities for advanced technologies. Words such as “we expect,” “anticipate,” “target,” “project,” “believe,” “goals,” “estimate,” “potential,” “predict,” “may,” “might,” “could,” “intend,” variations of these types of words and similar expressions are intended to identify these forward-looking statements. Readers are cautioned that these forward-looking statements are predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements.
Among the important factors that could cause actual results to differ materially from those indicated by our forward-looking statements are those discussed in “Risk Factors” in Item 1A of this Annual Report on Form 10-K and elsewhere in this report. We undertake no obligation to revise or update publicly any forward-looking statement for any reason. Readers should carefully review the risk factors described in Item 1A, as well as in the documents filed by us with the SEC, specifically our Annual Report on Form 10-K for the year ended December 31, 2005 filed with the SEC on March 8, 2006 and amended on July 19, 2006, as well as our Quarterly Reports on Form 10-Q and in our other SEC filings, as they may be amended from time to time.
Overview
We are a leading provider of intellectual property and services for next-generation, stacking and module technologies for high-speed, high-capacity systems. As of December 31, 2006, our patent portfolio consisted of more than 200 patents and patent applications pending. We believe that our strong patent portfolio and intellectual property position will allow us to continue to expand our business as demand for high-density memory increases and to capitalize on emerging market opportunities. We intend to exploit our intellectual property and capabilities to establish market leadership in new technologies.
Significant developments in 2006 included the following:
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We announced the availability of the first ArctiCore FB-DIMMs, which offer up to 8GB capacity, support speeds of up to DDR2-800 and deliver excellent thermal performance for current-generation, Intel-based servers and workstations.
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We announced the availability of the first ArctiCore R-DIMMs that utilize 72 standard 512Mb memory devices, which result in a total module capacity of 4GB of memory designed for server and workstation applications.
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We introduced the second generation of our High Performance Stakpak CSP stacking technology, resulting in improvements in cost and manufacturability, as well as support for a larger variety of DRAM memory devices, including devices operating at DDR2-800 speeds.
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We announced the availability of the FlashStak X-2, a TSOP solution that doubles the density of a single-commodity NAND device in a single TSOP footprint for high-capacity applications in consumer electronics devices, such as portable MP3 players, USB Flash drives, mobile phones and PDAs.
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We licensed our NAND Flash-memory stacking technologies to Toshiba Corporation.
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We introduced MobileStak, a chip-stacking solution that enables smaller mobile products by combining virtually any processor, controller and memory device into a single, small footprint module.
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We licensed our ArctiCore R-DIMM, SO-DIMM and our mini-DIMM module technologies to Southland Micro Systems.
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We continued adding sales capabilities outside of the United States. We now have third-party sales agents in Hong Kong, Israel, Japan, Korea and Taiwan. We plan to take similar actions in China and throughout Europe to aid in our regional sales efforts.
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More than 200 million stacks based on Staktek’s technologies have been shipped to date.
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We shipped 2.5 million High Performance Stakpaks during 2006.
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We moved all High Performance Stakpak production to our Reynosa facility, driving significant improvements to our gross margin.
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Our cash, cash equivalents and short-term investments increased $6 million while we repurchased $8 million in stock.
Results of Operations
The following table presents our results of operations for the periods indicated expressed as a percentage of total revenue:
Total Revenue
Total revenue for the year ended December 31, 2006 was $55.6 million, compared to revenue of $52.5 million and $73.6 million for the years ended December 31, 2005 and 2004, respectively. Services revenue in 2006 was $43.1 million, compared to $33.6 million and $41.0 million for 2005 and 2004, respectively. License revenue in 2006 was $12.5 million, compared to $18.9 million and $32.6 million for 2005 and 2004, respectively.
Our increased services revenue during 2006 as compared to 2005 was primarily driven by an increase in demand for our High Performance Stakpak. Revenue increased as the demand for this package type expanded in the server market.
License revenue decreased $6.4 million during 2006, compared with 2005, due primarily to decreased royalty revenue from Samsung. The Samsung license is for our leaded-package technologies, which are being replaced over time by CSP technologies.
Services revenue in 2005 decreased from 2004 primarily due to a decline in our unit volume, which was primarily driven by a series of industry transitions. First, there was a transition from stacked products based on 256-megabit memory TSOPs, to next-generation stacked products based on 512-megabit memory devices. Since the next-generation devices delivered twice as many bits of memory as the current generation, the demand for stacked memory packages, as measured in megabits, was satisfied at lower levels of unit volumes. As a result, we experienced a decrease in the number of 256-megabit units, partially offset by an increase in higher-priced units
based on 512-megabit memory devices shipped during 2005 as compared to similar units shipped in 2004. In addition, a movement to non-leaded package technology, as well as the adoption of DDR-2, allowed the size of the DRAM package to vary and to more closely align with the size of the memory die in the package. This combination of industry transitions led to an increased use of planar solutions, which allowed additional memory devices to be directly attached on the printed circuit board without the need for stacking.
License revenue decreased $13.7 million during 2005, compared with 2004, due primarily to decreased royalty revenue from Samsung.
The following tables summarize sales to customers that represented 10% or more of total revenue for the periods indicated:
* Amount does not exceed 10% for the indicated period.
The following table sets forth customers, which receivable balances represented more than 10% of our accounts receivable at the dates indicated:
Looking forward, from an overall business perspective and industry overview with respect to our revenue, during the end of 2006, we began to see transitions in the industry. These included the increased use of dual-die and planar solutions; a continuing shift from DDR-1 to DDR-2, negatively impacting our legacy technologies; lower-than-expected sales of our 8GB FlashStak; our customers developing solutions internally so that they are not required to outsource stacking to us; OEMs using our competitors’ solutions instead of ours; reduced DRAM pricing due to a DRAM over supply in certain instances; as well as other transitions. Although only having a minimal impact on our business in the fourth quarter of 2006, these transitions may negatively impact the first quarter of 2007 as well as future quarters. At this time, we cannot predict when these trends may shift in a more positive direction, nor can we predict when our new product offerings will gain market traction.
Gross Profit
Gross profit for the year ended December 31, 2006 was $20.7 million, or 37.2% of total revenue. This amount represents an increase of $8.9 million, compared to gross profit of $11.8 million, or 22.4% of total revenue, for the year ended December 31, 2005. The increase in our gross profit for 2006 was primarily the result of a $6.3 million net decrease in the amortization of acquisition intangibles and stock-based compensation expense allocated to cost of revenue. Gross profit as a percentage of total revenue was reduced by 13.0 percentage points during 2006 due to the amortization of acquisition intangibles and stock-based compensation expense allocated to cost of revenue, as compared with a 25.7 percentage point impact of these items in overall
gross profit during 2005. Additionally, while license revenue, for which there was not any corresponding impact on our cost of revenue, declined by $6.4 million, services revenue increased by $9.5 million while the costs associated with services revenue increased by $0.5 million. The combination of these factors resulted in a $2.6 million increase in gross profit.
Gross profit for the year ended December 31, 2005 was $11.8 million, or 22.4% of total revenue. This amount represents a decrease of $19.3 million, compared to gross profit of $31.1 million, or 42.3% of total revenue, for the year ended December 31, 2004. The reduction in our gross profit for 2005 was primarily the result of a decrease in our total revenue. License revenue, for which there was not any corresponding impact on our cost of revenue, declined by $13.7 million. Additionally, our services revenue declined by $7.4 million while costs associated with this revenue increased $1.1 million. Manufacturing costs did not decline, due to the fixed cost nature of our production process and increased costs of temporary staffing in our Austin facility related to ramping our new High Performance Stakpak. By December 31, 2005, the manufacture of this product was largely shifted to our lower-cost facility in Reynosa, Mexico. Gross profit as a percentage of total revenue was reduced by 25.7 percentage points during 2005 due to the amortization of acquisition intangibles and stock-based compensation expense allocated to cost of revenue, as compared with a 22.2 percentage point impact of these items on overall gross profit during 2004. Our manufacturing services’ gross profit percentage, defined as gross profit calculated from services revenue and services cost of revenue, decreased by approximately 17.5 percentage points in 2005 as compared to 2004, due mainly to fixed costs being spread over fewer units and the ramp of our High Performance production, partially offset by the reduction in manufacturing costs resulting from the increased utilization of our high-volume manufacturing facility in Mexico in 2005.
Selling, General and Administrative Expenses
Selling, general and administrative expense for the year ended December 31, 2006 was $14.8 million, or 26.6% of total revenue. This amount reflected a decrease of $1.5 million, or 9.2%, as compared to selling, general and administrative expense of $16.3 million, or 31.1% of total revenue, for the year ended December 31, 2005. For the year ended December 31, 2006 and 2005, selling, general and administrative expense included stock-based compensation expense of $4.6 million and $6.2 million, respectively. The reduction in selling, general and administrative expense during 2006 relative to 2005 was primarily due to a decrease in stock-based compensation expense of $1.6 million and a reduction in directors’ and officers’ insurance costs of $0.7 million, partially offset by an increase in personnel costs of $0.9 million.
Selling, general and administrative expense for the year ended December 31, 2005 was $16.3 million, or 31.1% of total revenue. This amount reflected an increase of $3.6 million, or 28.3%, as compared to selling, general and administrative expense of $12.7 million, or 17.3% of total revenue, for the year ended December 31, 2004. For the year ended December 31, 2005 and 2004, selling, general and administrative expense included stock-based compensation expense of $6.2 million and $4.3 million, respectively. The increase in selling, general and administrative expense during 2005 relative to 2004 was primarily due to an increase in stock-based compensation expense of $1.9 million, higher personnel costs of $0.5 million and relocation costs of $0.3 million associated with our broadening sales and marketing efforts and an increase in directors’ and officers’ insurance costs of $0.3 million.
Research and Development
Research and development expense for the year ended December 31, 2006 was $8.2 million, or 14.8% of total revenue, which reflected an increase of $2.4 million, or 41.4%, as compared with research and development expense of $5.8 million, or 10.9% of total revenue for the year ended December 31, 2005. For the years ended December 31, 2006 and 2005, research and development expense included stock-based compensation expense of approximately $1.0 million and $0.4 million, respectively. The increase in costs for the year resulted from expenditures associated with the development of our non-leaded technologies, ArctiCore, MobileStak and other new product initiatives, and recording stock-based compensation of $1.0 million. We intend to devote additional
personnel and other resources to research and development in future periods to address market opportunities for advanced technologies, such as DDR-3, non-DRAM homogeneous circuits and heterogeneous circuits. Our increased spending on research and development will be used to design and develop the tooling, testing capabilities and automation equipment to position us to qualify and manufacture products based on these new technologies.
Research and development expense for the year ended December 31, 2005 was $5.8 million, or 10.9% of total revenue, which reflected an increase of $3.2 million, or 123.1%, as compared with research and development expense of $2.6 million, or 3.6% of total revenue for the year ended December 31, 2004. For the years ended December 31, 2005 and 2006, research and development expense included stock-based compensation expense of approximately $0.4 million and $63,000, respectively. The increase in costs for the year resulted from our expenditures in the development of our non-leaded technologies, ArctiCore, MobileStak and other new product initiatives.
Restructuring Expense
During the years ended December 31, 2006 and 2005, we recorded restructuring expense of $0.4 million and $1.0 million, respectively. Both restructurings were the result of the continuing transfer of manufacturing from Austin, Texas to Reynosa, Mexico and a realignment of our organizational structure to focus on our growth strategy.
There were no restructuring costs in 2004.
Amortization of Acquisition Intangibles
During the year ended December 31, 2006, we amortized $7.4 million of intangible assets resulting from the Staktek acquisition during the third quarter of 2003, with $6.6 million allocated to cost of revenue and $0.8 million to operating expenses. In 2007 we expect to incur amortization expense of $4.6 million.
During the year ended December 31, 2005, we amortized $14.0 million of intangible assets resulting from that acquisition, with $13.0 million allocated to cost of revenue and $1.0 million to operating expenses. During the year ended December 31, 2004, we amortized $17.6 million of intangible assets resulting from that acquisition, with $15.8 million allocated to cost of revenue and $1.8 million to operating expenses.
The acquisition intangibles were originally valued using a discounted cash flow methodology. As a result, each year the total annual amortization expense of these intangibles is scheduled to decline.
Interest and Other Income (Expense)
Interest and other income, net, for the year ended December 31, 2006, was $3.0 million, as compared to interest and other income, net of $1.7 million for the year ended December 31, 2005. The increase in interest and other income, net, for 2006 versus 2005 was mainly due to an improved rate of return on investments.
Interest and other income, net, for the year ended December 31, 2005, was $1.7 million, as compared to interest and other expense, net of $0.8 million for the year ended December 31, 2004. The increase in interest and other income, net, for 2005 versus 2004 was mainly due to an improved rate of return on investments, an increase in cash position and a reduction in interest expense associated with the senior and subordinating debt incurred to finance the Staktek acquisition in 2003, which was repaid following our initial public offering in February 2004.
Benefit for Income Taxes
We recorded an income tax benefit of $0.1 million and $3.1 million in the years ended December 31, 2006 and 2005, respectively. For the years ended December 31, 2006 and 2005, our effective tax rate was 22.3% and 29.1%, respectively. Management has determined that it is more likely than not that we will realize the benefit of our net deferred tax asset due to existing taxable temporary differences and carry back potential.
We recorded an income tax benefit of $3.1 million and an expense of $5.3 million in the years ended December 31, 2005 and 2004, respectively. For the years ended December 31, 2005 and 2004, our effective tax rate was 29.1% and 40.3%, respectively.
During 2006 and 2005, the effective tax rate differed from the federal statutory rate of 35%, due primarily to the impact of certain stock-based compensation expenses that were not tax deductible, in addition to other permanent items, including tax-exempt interest income
Quarterly Results of Operations
The following table presents unaudited results of operations for each of the quarters in the years ended December 31, 2006 and 2005. You should read the following table in connection with the consolidated financial statements and related notes contained in Item 8 in this Annual Report on Form 10-K. We have prepared the unaudited information on the same basis as our audited consolidated financial statements. This table includes all adjustments, consisting of normal recurring adjustments, that we consider necessary for a fair presentation of our financial position and operating results for the quarters presented. Operating results for any quarter are not necessarily indicative of results for any future quarters or for a full year.
The following table presents our historical results for the periods indicated as a percentage of total revenue:
Liquidity and Capital Resources
Our contractual future obligations at December 31, 2006 for the next five years are summarized as follows (in thousands):
Operating lease obligations above included rent commitments at December 31, 2006 for our corporate office and research and production facility located in Austin, Texas. The capital lease commitment at December 31, 2006 was for office equipment.
We believe that our cash and cash equivalents and future cash flows from operations will be sufficient to fund these obligations.
As of December 31, 2006, we had no material future sales commitments to any of our customers.
As of December 31, 2006, we had working capital of $84.5 million, including $79.7 million of cash, cash equivalents and investments, compared to working capital of $79.5 million, including $73.7 million of cash, cash equivalents and investments as of December 31, 2005.
As of December 31, 2005, we had working capital of $79.5 million, including $73.7 million of cash, cash equivalents and investments, compared to working capital of $82.0 million, including $77.4 million of cash, cash equivalents and investments as of December 31, 2004.
Net cash provided by operating activities was $14.7 million for the year ended December 31, 2006, and resulted primarily from net loss adjusted by non-cash expenses and the change in income taxes receivable/payable partially offset by the change in inventories. Net cash provided by operating activities during 2005 was $12.0 million and resulted primarily from net income adjusted by non-cash expenses, partially offset by the change in deferred income taxes and income taxes receivable. Net cash provided by operating activities were $31.1 million in 2004 and resulted mainly from net income adjusted by non-cash expenses and a decrease in accounts receivable, partially offset by a decrease in deferred tax liabilities, a reduction in accrued liabilities due to payment of accrued interest on the debt from the Staktek acquisition and a decrease in trade accounts payable.
Net cash used in investing activities was $5.0 million for the year ended December 31, 2006, compared to $3.5 million for 2005. Investing activities during 2006 consisted primarily of the purchase of investment securities of $42.0 million and additions to property, plant and equipment of $1.5 million, partially offset by sales of investment securities of $38.7 million. Net cash used in investing activities was $3.5 million for the year ended December 31, 2005, compared to $43.4 million for 2004. Investing activities during 2005 consisted primarily of the purchase of investment securities of $93.5 million and additions to property, plant and equipment of $4.4 million, partially offset by sales of investment securities of $95.1 million. Investing activities during 2004 consisted primarily of purchases of investment securities of $45.6 million, additions to property, plant and equipment of $4.8 million and the purchase of patents, patent applications and certain customer information of $0.7 million, partially offset by sales of investment securities of $8.1 million.
Net cash used in financing activities during the year ended December 31, 2006 was $6.9 million, primarily due to the purchase of our common stock as part of our stock repurchase program for $8.1 million, partially offset by the proceeds of $0.9 million received from the issuance of our common stock under our employee stock
plans. Net cash used in financing activities during the year ended December 31, 2005 was $10.4 million, primarily due to the purchase of our common stock as part of our stock repurchase program for $10.7 million. Net cash provided by financing activities during the year ended December 31, 2004 was $21.1 million, primarily due to the $145.5 million in gross proceeds received from our initial public offering, including the underwriters’ exercise of their over-allotment option, net of underwriter fees of $10.2 million and associated expenses of $1.5 million paid during the year, debt payments totaling $77.6 million and the $30.6 million redemption of the redeemable preferred stock. In the first quarter of 2004, we repaid all debt issued in connection with the Staktek acquisition, we redeemed all redeemable preferred stock previously issued, and we terminated the senior revolving credit notes. Additionally, we paid $4.3 million during 2004 to purchase our stock as part of our stock repurchase program.
On March 9, 2006, we renewed our existing unsecured revolving credit agreement with Guaranty Bank, which currently has a maturity date of June 25, 2007. We may borrow up to $20.0 million at any given time for a one-year term. This credit agreement is guaranteed by Staktek Group, L.P. The interest rate on borrowings outstanding is based on the London interbank offered rate (LIBOR), plus between 1.25% and 1.60% or the commercial-based rate minus between 0.50% and 1.00%, depending upon the amount of cash or liquid investments that we have on deposit with Guaranty Bank. We are required to maintain at least $5.0 million on deposit with Guaranty Bank during the term of this credit agreement.
The credit agreement contains customary covenants that preclude us from, among other things, making material changes to the nature and scope of our business, entering into liquidation, merger or consolidation agreements in which we would not be the surviving entity, or incurring indebtedness in excess of $10.0 million with a third party outside the scope of this agreement.
The credit agreement contains financial covenants that must be met for periods in which we have outstanding borrowings. As of December 31, 2006, we had not borrowed under this credit agreement.
We believe that our current assets, including cash and cash equivalents, investments and expected cash flow from operations, will be sufficient to fund our operations, our anticipated additions to property, plant and equipment and any share repurchases under our stock repurchase program for at least the next 12 months. However, it is possible that we may need or elect to raise additional funds to fund our activities beyond the next year or to acquire other businesses, products or technologies. We could raise these funds by borrowing money or selling more stock to the public or to selected investors. In addition, while we may not need additional funds, we may elect to sell additional equity securities or obtain credit facilities for other reasons. We cannot assure you that we will be able to obtain additional funds on commercially favorable terms, or at all. If we raise additional funds by issuing more equity or convertible debt securities, the ownership percentages of existing stockholders would be reduced. In addition, the equity or debt securities that we issue may have rights, preferences or privileges senior to those of the holders of our common stock.
Critical Accounting Estimates
Our accounting policies are more fully described in Note 2 of the Notes to the Consolidated Financial Statements. As disclosed in Note 2, the preparation of financial statements in conformity with United States generally accepted accounting principles requires that management make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe that the following discussion addresses our most critical accounting estimates, which are those that are most important to the portrayal of our financial condition and results of operations and require management’s most difficult, subjective and complex judgments.
Revenue Recognition and Presentation. We evaluate our customer arrangements for manufacturing services to determine whether revenue from these arrangements should be recorded on a gross basis or a net basis. When evaluating our customer arrangements, we determine whether the arrangement represents a
consigned inventory transaction or a purchase and resale of inventory. In making this determination, we consider the following: (1) we are only responsible for the functionality of our processes, (2) we do not select the vendor to provide the memory packages and (3) we do not set the price for the memory packages. We have determined that a net basis of revenue recognition is appropriate for our customer arrangements for manufacturing services where the customer has instructed us to purchase specified memory packages from a specified vendor for purposes of stacking and shipping to the customer. Should the considerations described above change, we may determine that future customer arrangements should be recorded on a gross basis that would result in increases in both revenue and the cost of revenue. We recognize revenue when there is persuasive evidence of an arrangement, delivery has occurred, the fee is fixed or determinable and collectibility of the resulting receivable is reasonably assured.
Initial license fees are recognized when (1) we enter into a legally binding arrangement with a customer for the license, (2) we deliver the products, (3) customer payment is deemed fixed or determinable and free of contingencies or significant uncertainties and (4) collection is reasonably assured. We may provide training and/or other assistance to our licensees under the terms of the license agreement. The amount of training or assistance provided is limited and incidental to the licensed technology. In instances where training or other assistance is provided under the terms of a license agreement, the estimated fair value of such services is deferred until these services are provided. The associated revenue is included in services revenue. In instances where we provide training or other assistance that is considered inconsequential to the license agreement, the estimated fair value of the services is recognized in connection with the initial license fee and is included in license revenue.
Royalty revenue from our license agreements is recognized in the quarter in which our licensees report royalties to us. Our licensees typically do not provide us with forward estimates or current-quarter information concerning their shipments. Because we are not able to reasonably estimate the amount of royalties earned during the period in which the licensees actually ship products using our technologies, we do not recognize royalty revenue until the royalties are reported to us and the collection of these royalties is reasonably assured.
Impairment of Assets. We evaluate the recoverability of losses on long-lived assets, such as property and equipment and intangible assets, when events or changes in circumstances indicate that the undiscounted cash flows estimated to be generated by such assets are less than the carrying value of these assets, and accordingly, all or a portion of this carrying value may not be recoverable. Impairment losses are then measured by comparing the fair value of the assets to the carrying amounts. Actual useful lives and cash flows could be different than those estimated by us.
Goodwill and our indefinite-lived intangible (trademark) are evaluated annually for impairment as of October 1 and are not amortized. The goodwill impairment test requires judgment regarding the determination of fair value of the reporting unit, which we determined to be our company as a whole, and the determination of fair value of our assets and liabilities. We periodically assess our goodwill for indications of impairment on a reporting unit level. A reporting unit is defined as a component of an entity for which the operating results are regularly reviewed by management and discrete financial information is available. The trademark impairment test requires judgment regarding the timing and amount of future cash flows.
Income Taxes. We determine deferred tax assets and liabilities based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the years in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.
Stock-Based Compensation. Effective January 1, 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 (Revised 2004), “Share-Based Payment” (SFAS 123(R)) using the modified prospective transition method and, therefore, we have not restated prior periods’ results. Under this method, we recognize compensation expense for all share-based payments granted after January 1, 2006, as well as those granted prior to but not yet vested as of January 1, 2006, in accordance
with SFAS 123(R). Under the fair value recognition provisions of SFAS 123(R), we recognize stock-based compensation net of an estimated forfeiture rate on a straight-line basis over the requisite service period of the award and only recognize compensation cost for those shares expected to vest. Prior to SFAS 123(R) adoption, we accounted for share-based payments under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25).
Determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of highly subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from the amount we have recorded in the current period.
Recent Accounting Pronouncements
In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation Number 48 “Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109”, (FIN 48). This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 defines the recognition threshold and measurement of an uncertain tax position taken or expected to be taken in a tax return and is effective for fiscal years beginning after December 15, 2006. We do not expect the adoption of FIN 48 to have a material impact on our financial position and results of operations.
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements,” (SFAS 157). This standard defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We are currently evaluating the effect the adoption of SFAS 157 will have on our financial condition and results of operations.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Currency Exchange Risk. Most of our transactions are denominated in U.S. dollars. The functional currency of our subsidiaries in Mexico is the U.S. dollar. As a result, we have very little exposure to currency exchange risks and foreign exchange losses have been minimal to date. We do not currently enter into forward exchange contracts to hedge exposure denominated in foreign currencies or any other derivative financial instruments for trading or speculative purposes. In the future, if we believe that our currency exposure has increased, we may consider entering into hedging transactions to help mitigate that risk.
Interest Rate Risk. The primary objective of our investment activities is to preserve principal while maximizing the related income without significantly increasing risk. Even so, some of the securities in which we invest may be subject to market risk. This means that a change in prevailing interest rates may cause the principal amount of the investment to fluctuate. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities and certificates of deposit. The risk associated with fluctuating interest rates is limited to our investment portfolio and we do not believe that a 10% change in interest rates will have a significant impact on our interest income. As of December 31, 2006, all of our cash was held in deposit or money market accounts, or invested in investment grade securities. At December 31, 2006 and 2005, we had amounts on deposit with financial institutions that were in excess of the federally insured limit of $100,000. We have not experienced any losses on deposits of cash and cash equivalents.
Under our credit agreement with Guaranty Bank, borrowings would expose us to risks resulting from fluctuations in the LIBOR rate on which our variable interest charge is based. The potential amount of exposure resulting from a 10% fluctuation in the LIBOR rate or the commercial-based rate would be dependent upon our outstanding borrowings. As of December 31, 2006, we had not borrowed under this credit agreement.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Set forth below are our audited consolidated financial statements for the years ended December 31, 2006, 2005 and 2004.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders of Staktek Holdings, Inc.
We have audited the accompanying consolidated balance sheets of Staktek Holdings, Inc. (the Company) as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years ended December 31, 2006, 2005 and 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Staktek Holdings, Inc. at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years ended December 31, 2006, 2005 and 2004 in conformity with U.S. generally accepted accounting principles.
As discussed in Note 16 to the financial statements, in 2006, the Company changed its method of accounting for stock-based compensation.
/s/ Ernst & Young LLP
Austin, Texas
March 5, 2007
STAKTEK HOLDINGS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)
The accompanying notes are an integral part of these consolidated financial statements.
STAKTEK HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
STAKTEK HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(in thousands, except share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
STAKTEK HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (CONTINUED)
(in thousands, except share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
STAKTEK HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
STAKTEK HOLDINGS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(in thousands)
The accompanying notes are an integral part of these consolidated financial statements.
STAKTEK HOLDINGS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
1. Description of Business
Staktek Holdings, Inc. (“we” and “our”) was originally formed by two investment funds affiliated with Austin Ventures L.P. in May 2003 for the purpose of acquiring Staktek Corporation, which was incorporated in Texas in June 1990. As a result of this merger, Staktek Corporation became our wholly owned subsidiary.
We are a provider of intellectual property and services for stacking and module technologies for high-speed, high-capacity systems. With an IP portfolio of more than 200 patents and patent applications pending, we offer outsourced manufacturing, technology licensing and custom engineering.
2. Basis of Presentation and Significant Accounting Policies
Basis of Presentation and Principles of Consolidation
The accompanying financial statements have been prepared in accordance with United States generally accepted accounting principles. Our consolidated financial statements include the accounts of Staktek Holdings, Inc. and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.
Use of Estimates
The preparation of financial statements in accordance with United States generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, as well as disclosure of assets and liabilities. Actual results could differ from those estimates.
Reclassifications
Certain reclassifications have been made to the prior years’ consolidated financial statements to conform to the current year presentation. The Securities and Exchange Commission (SEC) released Staff Accounting Bulletin No. 107, “Share-Based Payment” (SAB 107), which states that companies should present the expense related to share-based payment arrangements in the same line or lines as cash compensation paid to the same employees. Accordingly, we have reclassified share-based payments previously recorded as “amortization of deferred stock-based compensation and stock compensation expense” to the appropriate functional categories. The reclassifications had no impact on our financial position or results of operations.
Cash and Cash Equivalents
We consider all highly liquid investments with original maturities of three months or less when purchased to be cash equivalents. At December 31, 2006 and 2005, our cash equivalents included funds in demand deposit accounts, money market accounts, municipal bonds and commercial paper.
Investments
Marketable short-term investments are classified as available-for-sale. Short-term investments consist primarily of U.S. government debt securities, municipal government securities and commercial paper instruments. We classify auction rate securities and securities with hard put features and maturities in excess of one year as short-term investments.
Investments with original maturities in excess of one year may be classified as short term due to their highly liquid nature and to the fact we do not hold investments with the intent of long-term investment, but rather with the short-term objective of maximizing interest earnings on surplus cash intended for operations.
All of these investments are carried at fair value with unrealized gains and losses, if any, included as a component of accumulated other comprehensive income (loss). Fair value is determined as the market value of the security at the measurement date. Interest, dividends and realized gains and losses are included in interest and other income. Realized gains and losses are recognized based on the specific identification method.
Inventories
Inventories consist of materials purchased and labor and overhead incurred for product that has not yet been shipped. Inventories are stated at the lower of cost or market (estimated realizable value) using the first-in, first-out (FIFO) method.
Property, Plant and Equipment
We carry property, plant and equipment, including leasehold improvements, at cost less accumulated depreciation. Depreciation of property, plant and equipment is computed using the straight-line method over the useful lives of the assets, ranging from three to 20 years. We amortize leasehold improvements over the shorter of the related lease term or the estimated life of the improvements. We amortize equipment under capital leases over the lease term, and this amortization is included in the depreciation of property, plant and equipment.
Goodwill and Indefinite-Lived Intangible Assets
Goodwill represents the excess purchase price over the fair value of net assets acquired in the Staktek acquisition We have a single reporting unit at an enterprise level and allocate goodwill to this reporting unit for goodwill impairment testing.
We assess whether goodwill and indefinite-lived intangible assets (trademark) are impaired on an annual basis. Upon determining the existence of goodwill and/or trademark impairment, we measure that impairment based on the amount by which the book value of goodwill and/or trademark exceeds its fair value. Additional impairment assessments may be performed on an interim basis if we encounter events or changes in circumstances that would indicate that, more likely than not, the book value of goodwill and/or trademarks has been impaired. In connection with our annual assessment on October 1, 2006, we determined that no impairment of goodwill and/or trademark existed.
Intangible Assets
Amounts allocated to acquired technology, a customer contract and customer relationships are being amortized over the respective assets’ estimated useful lives of five to six years using a method of amortization that reflects the pattern in which their economic benefits are consumed based upon the initial estimated contribution to discounted cash flows during the period. Amounts allocated to non-compete agreements are being amortized over their estimated useful lives of four years using the straight-line method. Amortization of acquired technology and a customer contract is included in “Amortization of acquisition intangibles” in cost of revenue in the accompanying Consolidated Statements of Operations. Amortization of customer relationships and non-compete agreements is included in “Amortization of acquisition intangibles” in operating expenses in the accompanying Consolidated Statements of Operations. We periodically review the estimated useful lives of our identifiable intangible assets, taking into consideration any events or circumstances that might result in a diminished fair value or revised useful life.
We capitalize third-party costs associated with patent registration. Capitalized patent costs are amortized over the estimated useful life of 12 years beginning when the patent is issued. Amortization expense related to our patents is included in services cost of revenue or research and development expense. At the time patent registration is deemed unsuccessful, the related costs are written off.
Impairment of Long-lived Assets
Long-lived assets consist primarily of property, plant and equipment and intangible assets. We evaluate property, plant and equipment and other intangible assets held and used by us for impairment whenever events or changes in circumstances indicate that their carrying value may not be recoverable. When these factors and circumstances exist, we compare the projected undiscounted future cash flows associated with the future use and disposal of the related asset or group of assets to their respective carrying amounts. Impairment, if any, is measured as the excess of the carrying amount over the fair value, based on market value when available, or discounted expected cash flows, of those assets and is recorded in the period in which the determination is made.
Fair Value of Financial Instruments
The fair values of our cash and cash equivalents, accounts receivable, accounts payable and accrued expenses approximate their carrying values due to their short maturities.
Concentration of Credit Risk
Financial instruments that potentially subject us to significant concentrations of credit risk consist principally of cash and cash equivalents, investments and accounts receivable.
We maintain our cash and cash equivalents in accounts with five major financial institutions in the United States or in countries where our subsidiaries operate, in the form of demand deposits and money market accounts. At December 31, 2006 and 2005, we had amounts on deposit with financial institutions that were in excess of the federally insured limit of $100,000. We have not experienced any losses on deposits of cash and cash equivalents.
We believe that the concentration of credit risk in our accounts receivable is substantially mitigated by the relatively short collection terms and the high level of credit worthiness of our customers. We record an allowance for doubtful accounts specific to the accounts receivable balances outstanding based upon the results of our evaluation of our customers’ financial condition. We have not recorded an allowance for doubtful accounts for any period presented in the accompanying financial statements, since we have not realized any significant credit losses, nor do we expect any significant credit losses relating to our customers.
The following tables summarize sales to customers that represented 10% or more of consolidated total revenue for the periods indicated:
* Amount does not exceed 10% for the indicated period.
The following table sets forth customers, which receivable balances represented more than 10% of our total accounts receivable at the dates indicated:
We derive virtually all of our revenue from our Performance Stakpak and High Performance Stakpak products. During the end of 2006, we began to see transitions in the industry. These included the increased use of dual-die and planar solutions; a continuing shift from DDR-1 to DDR-2, negatively impacting our legacy technologies; our customers developing solutions internally so that they are not required to outsource stacking to us; OEMs using our competitors’ solutions instead of ours; reduced DRAM pricing due to a DRAM over supply in certain instances; as well as other transitions. A decline in demand for these products could adversely affect our results of operations.
Foreign Currency
Our foreign subsidiaries use the U.S. dollar as their functional currency. Gains or losses from foreign currency transactions are included in our results of operations. For all periods presented, these foreign currency gains or losses were not material.
Revenue Recognition
We account for our revenue under the provisions of Staff Accounting Bulletin (SAB) No. 104, “Revenue Recognition.” Under the provisions of SAB 104, we recognize revenue when there is persuasive evidence of an arrangement, delivery has occurred, the fee is fixed or determinable, and collectibility of the resulting receivable is reasonably assured. Our revenue is generated primarily from manufacturing services performed for customers using our packaged memory solutions and from license fees or royalties earned pursuant to license agreements with customers.
Services Revenue
Our manufacturing services consist of customer arrangements whereby the manufacture of our customers’ stacked memory units is outsourced to us. These customer arrangements can be categorized into two basic types. In the first arrangement, our customer consigns its memory packages to us and we stack them using our proprietary solutions. In the second arrangement, our customer prequalifies vendors for memory packages and the vendor remains the primary obligor for the functionality of the memory packages. Our customer places a purchase order with us for stacking memory packages. After we receive the purchase order from our customer, we purchase the specified memory packages and stack them using our proprietary solutions. We report revenue for memory packages purchased and sold on a net basis in accordance with Emerging Issues Task Force Issue No. 99-19. In customer arrangements for manufacturing services (i) we are responsible for the stacking process but are not the primary obligor for the memory packages that comprise substantially all of the functionality of the stacked unit, (ii) we do not earn profit on memory packages sold, since our customer arrangement specifies that these packages are to be sold at the same price paid by us, (iii) we do not bear credit risk related to the memory packages, since our customer must purchase the packages at the price paid by us or the packages can be returned to their source, (iv) we do not have latitude in establishing the price for the memory packages, and (v) we do not have discretion in the selection of the supplier of the memory packages, since the supplier is selected or specified by our customer. We have determined that a net basis of revenue recognition is appropriate for our customer arrangements for manufacturing services where the customer has instructed us to purchase specified memory packages from a specified vendor for purposes of stacking and shipping to the customer.
License Revenue
In addition to our services revenue, we also earn revenue from licensing our technology. Initial license fees are recognized when: (1) we enter into a legally binding arrangement with a customer for the license; (2) we deliver the products; (3) customer payment is deemed fixed or determinable and free of contingencies or significant uncertainties; and (4) collection is probable. We may provide training and/or other assistance to our licensees under the terms of the license agreement. The amount of training or assistance provided is limited and incidental to the licensed technology. In instances where training or other assistance is provided under the terms
of a license agreement, the estimated fair value of such services is deferred until such services are provided. The associated revenue is included in services revenue. In instances where we provide training or other assistance that is considered inconsequential to the license agreement, the estimated fair value of the services is recognized in connection with the initial license fee and is included in license revenue.
Currently we have license agreements with five customers that specify that certain royalties are earned by us upon each customer’s shipment of products utilizing our proprietary technologies. Our customers generally report shipment information 20 to 30 days after the end of the quarter in which the activity takes place and typically do not provide us with forward estimates or current-quarter information concerning their shipments. Because we are not able to reasonably estimate the amount of royalties earned during the period in which the licensee actually ship products using our technologies, we do not recognize royalty revenue until the royalties are reported to us and the collection of these royalties is considered probable.
Cost of Revenue
Cost of revenue includes the cost of labor, materials and overhead required to perform the manufacturing process. These costs are included in inventories until the product is shipped and revenue is recognized. Cost of revenue also includes the amortization of acquired technology, a customer contract and certain patents and stock-based compensation expense.
Shipping and Handling Cost
We include shipping and handling costs as part of cost of revenue as incurred.
Research and Development
We expense costs for research and development of our technologies as incurred.
Advertising Costs
We expense advertising costs as incurred. Advertising costs were not material for any periods presented.
Stock-Based Compensation
We account for our employee stock-based compensation using the fair value recognition provisions of SFAS 123(R), using the modified prospective transition method and, therefore, we have not restated prior periods’ results. Under this method, we recognize compensation expense for all share-based payments granted after January 1, 2006, as well as those granted prior to but not yet vested as of January 1, 2006, in accordance with SFAS 123(R). Under the fair value recognition provisions of SFAS 123(R), we recognize stock-based compensation net of an estimated forfeiture rate on a straight-line basis over the requisite service period of the award and only recognize compensation cost for those shares expected to vest. In addition, under SFAS 123(R), tax benefits from tax deductions in excess of the compensation cost recognized (excess tax benefits) are presented as financing cash flows in the consolidated statement of cash flows. Prior to SFAS 123(R) adoption, we accounted for share-based payments under APB 25.
Determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of highly subjective assumptions, including the expected life of the share-based payment awards and stock price volatility. The assumptions used in calculating the fair value of share-based payment awards represent management’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If our actual forfeiture rate is materially different from our estimate, the stock-based compensation expense could be significantly different from the amount we have recorded in the current period.
Equity instruments issued to non-employees are accounted for in accordance with FASB Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (SFAS 123) and Emerging Issues Task Force Issue No. 96-18, “Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.”
Income Taxes
We account for income taxes under the provisions of SFAS 109, “Accounting for Income Taxes.” Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the years in which the differences are expected to affect taxable income. We establish valuation allowances when necessary to reduce deferred tax assets to the amounts we expect to realize.
Earnings (Loss) Per Share
Basic earnings (loss) per share is computed by dividing income (loss) available to common stockholders by the weighted-average number of vested common shares outstanding for the period. Diluted earnings (loss) per share is computed under the treasury method giving effect to all potential dilutive common stock, including options, warrants and common stock subject to repurchase. For the years ended December 31, 2006 and 2005, options and common stock subject to repurchase were not included in the computation of diluted loss per share because the effect would be antidilutive.
Recent Accounting Pronouncements
In June 2006, the FASB issued FIN 48. This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS 109, “Accounting for Income Taxes.” FIN 48 defines the recognition threshold and measurement of an uncertain tax position taken or expected to be taken in a tax return and is effective for fiscal years beginning after December 15, 2006. We do not expect the adoption of FIN 48 to have a material impact on our financial position and results of operations.
In September 2006, the FASB issued SFAS 157. This standard defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years. We are currently evaluating the effect the adoption of SFAS 157 will have on our financial condition and results of operations.
3. Initial Public Offering
On February 11, 2004, we completed our initial public offering in which we sold 10 million shares of our common stock at $13.00 per share, for an aggregate public offering price of $130.0 million. On March 5, 2004, we sold an additional 1.19 million shares in connection with the underwriters’ over-allotment option, for an aggregate public offering price of approximately $15.5 million. Of the total proceeds, we applied approximately $10.2 million to underwriting discounts and commissions; $1.9 million to related costs; $78.8 million to pay in full our senior, short-term and subordinated debt (including accrued interest and fees); and $30.6 million to redeem our outstanding preferred stock. We retained approximately $24.0 million.
4. Investments
During 2006 and 2005, we invested in securities with original maturities greater than three months. These securities are classified as “available-for-sale.” The amortized cost, net unrealized gains and losses and fair value of these securities as of December 31, 2006 and 2005 were as follows (in thousands):
Net unrealized gains and losses at December 31, 2006 and 2005 were the result of fluctuations in the current market value of these securities in the marketplace.
Maturities of investment securities classified as available-for-sale at December 31, 2006 and 2005 by contractual maturity are shown below (in thousands). Expected maturities will vary from contractual maturities because borrowers may have the right to recall or prepay obligations with or without call or prepayment penalties.
We sold approximately $38.7 million and $95.1 million in investment securities held as available-for-sale in the years ended December 31, 2006 and 2005, respectively.
5. Inventories
Inventories at December 31, 2006 and 2005 consisted of the following (in thousands):
6. Property, Plant and Equipment
Property, plant and equipment at December 31, 2006 and 2005 consisted of the following (in thousands):
Amortization of the assets under capital lease was included in depreciation and was approximately $18,000, $53,000 and $113,000 for the years ended December 31, 2006, 2005 and 2004, respectively. Interest expense related to assets under capital lease was included in interest expense and was approximately $10,000, $1,000 and $9,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
In October 2004, we moved several manufacturing assets to our facility in Reynosa, Mexico. Additionally, we decided to sell certain assets, which were recorded as assets held for sale. The market value of these assets at the time we decided to sell them was approximately $59,000, which was equal to the net book value and therefore no impairment was recorded. During 2005, we sold the largest piece of this equipment with a net book value of $56,000. As of December 31, 2006, we did not have any assets recorded as assets held for sale. During 2006, we sold a piece of lab equipment for a gain of $0.2 million to SMART under the manufacturing agreement.
7. Other Intangible Assets
In June 2004, we acquired from DPAC Technologies Corp. (DPAC) its stacking patents and patent applications as well as certain customer information for $0.5 million and $0.2 million, respectively, which are being amortized over 12 and 2 years, respectively.
The gross carrying amounts and accumulated amortization of our other intangible assets and patents at December 31, 2006 and 2005 consisted of the following (in thousands):
Amortization expense for all intangibles in the years ended December 31, 2006, 2005 and 2004 was $7.4 million, $14.0 million and $17.6 million, respectively.
The following table details the estimated aggregate annual amortization expense (in thousands) for each of the five succeeding years for all of the intangibles we own that we are currently amortizing:
8. Accrued Liabilities
Accrued liabilities at December 31, 2006 and 2005 were as follows (in thousands):
Accrued severance and restructuring costs at December 31, 2006 include severance of $0.5 million for former executives.
9. Debt
On March 9, 2006, we renewed our existing unsecured revolving credit agreement with Guaranty Bank, which currently has a maturity date of June 25, 2007. We may borrow up to $20.0 million at any given time for a one-year term. This credit agreement is guaranteed by Staktek Group, L.P. The interest rate on borrowings outstanding is based on LIBOR, plus between 1.25% and 1.60% or the commercial-based rate minus between 0.50% and 1.00%, depending upon the amount of cash or liquid investments that we have on deposit with Guaranty Bank. We are required to maintain at least $5.0 million on deposit with Guaranty Bank during the term of this credit agreement.
The credit agreement contains customary covenants that preclude us from, among other things, making material changes to the nature and scope of our business, entering into liquidation, merger or consolidation agreements in which we would not be the surviving entity, or incurring indebtedness in excess of $10.0 million with a third party outside the scope of this agreement.
The credit agreement contains financial covenants that must be met for periods in which we have outstanding borrowings. As of December 31, 2006, we had not borrowed under this credit agreement.
10. Redeemable Preferred Stock
At December 31, 2006 and 2005, we had 5.0 million authorized shares of $0.001 par value redeemable preferred stock, none of which was issued or outstanding.
11. Commitments and Contingencies
At December 31, 2006, we had advance payments on assets under development of approximately $0.1 million related to the purchase of certain capital equipment and services. At December 31, 2005, advanced payments on assets under development were immaterial.
At December 31, 2006, approximately 83% of our employees in Mexico, or approximately 72% of our total employees, were represented by a labor organization that has entered into a labor contract with us.
We have indemnification agreements with our directors and executive officers. The agreements do not set monetary limits on our indemnity obligations. We have a director and officer insurance policy that enables us to recover a portion of any future amounts paid in respect of our indemnity obligations to our directors and officers.
Helen Holzwasser v. Staktek Holdings, Inc., James. W. Cady and William Kirk Patterson
On October 22, 2004, a class action complaint for violations of U.S. federal securities laws was filed in the U.S. District Court in New Mexico against us and two of our executive officers, one of whom is no longer an executive officer but remains on our Board of Directors (the Defendants). The plaintiff claims that the Defendants failed to disclose to the public an anticipated shortage of computer memory chips and that they knew or recklessly disregarded that the anticipated shortage would have a materially adverse impact on our revenue and earnings. In addition, the plaintiff claims that the Defendants failed to disclose to investors that the industry’s transition to a new generation of higher-capacity memory chips was causing computer makers to stockpile supplies of older memory chips, increasing the shortage. The suit covers individuals who purchased our stock between November 26, 2003 and May 19, 2004. In April 2005, the case was transferred to federal district court in Austin, Texas, and in June 2005, the plaintiff amended her complaint, adding our chairman of the board as a defendant. A class has not been certified at this time. We do not believe there is any merit to the claims asserted by the plaintiff in this complaint and plan to vigorously defend ourselves. Due to the early stage of this lawsuit, we cannot estimate the outcome of this matter or the resulting financial impact to us, if any.
Staktek Group, L.P. v. Kentron Technologies, Inc. and Chris Karabatsos
On August 1, 2006, we filed an action in the U.S. District Court for the Western District of Texas, Austin Division, against Kentron Technologies, Inc. and Chris Karabatsos, an individual. We are seeking damages and injunctive relief relating to the defendants’ false and disparaging statements regarding Staktek and our ArctiCore technologies that we are proposing to the JEDEC Solid State Technology Association for possible adoption as a standard. In particular, we have alleged that the defendants’ actions constitute unfair competition under the Lanham Act, intentional interference with prospective business relations, defamation, business disparagement and have caused actionable injury to our business reputation. While we intend to vigorously prosecute these claims, there can be no guarantee that we will ultimately prevail or that the court will award the remedies we are seeking. The defendants’ response to our lawsuit is not yet due. It is possible that the defendants could include counterclaims against us with their responsive pleadings, but we have no knowledge of any basis for such counterclaims.
As of December 31, 2006, we were not involved in any other material legal proceedings.
From time to time, we may be subject to legal proceedings, claims in the ordinary course of business, claims in foreign jurisdictions where we operate, and non-contractual customer claims or requested concessions we may agree to in the interest of maintaining business relationships.
12. Leases
During 2006, we leased our Austin facility under a non-cancelable operating lease agreement. During 2005 and 2004, we leased our Austin facility and certain production and office equipment under non-cancelable operating lease agreements. Total operating expense for the years ended December 31, 2006, 2005 and 2004 was approximately $0.4 million, $0.6 million, and $1.1 million, respectively. Additionally, we have office equipment under a capital lease at December 31, 2006.
Future minimum payments under capital leases and non-cancelable operating leases with initial terms of one year or more consist of the following at December 31, 2006 (in thousands):
13. Related-Party Transactions
Relationship with Austin Ventures
At December 31, 2006, Austin Ventures and its affiliates beneficially owned approximately 77% of our outstanding common stock. Set forth below is a brief description of the existing relationships and agreements between Austin Ventures and us.
Board of Directors
Joseph C. Aragona, a general partner of Austin Ventures, is chairman of our board of directors and serves as chairperson of our nominating and governance committee. Clark W. Jernigan, a principal of Austin Ventures, is one of our directors and serves as chairperson of our compensation committee. Edward E. Olkkola, an operating partner of Austin Ventures, is one of our directors.
Registration Rights
Austin Ventures has registration rights with respect to the shares of our common stock that it holds.
14. Earnings Per Share
A reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings (loss) per share follows (in thousands, except per share data):
For the years ended December 31, 2006, 2005 and 2004, we did not include approximately 5,681,000, 6,168,000 and 532,000 weighted average common stock equivalents, respectively, in the diluted earnings (loss) per share calculation because their impact would have been antidilutive.
15. Stockholders’ Equity
Common Stock
In August 2005, we reduced authorized shares from 200,000,000 to 100,000,000. Of these authorized shares, 11,030,000 shares have been reserved for the issuance of stock options. Of these options, 10,874,448 had been granted, of which 821,483 were forfeited, leaving 977,035 available for issuance at December 31, 2006. At December 31, 2005, 10,405,698 had been granted and 1,166,119 were available for issuance.
Of the 52,513,671 shares and 51,809,007 shares of common stock issued as of December 31, 2006 and 2005, respectively, 104,884 shares and 436,786 shares, respectively, were unvested and subject to rights of repurchase, at a price per share equal to the original exercise price, which repurchase rights lapse according to a time-based vesting schedule.
During 2004, our Board of Directors approved a stock repurchase program. Under this program, we could spend up to $15.0 million to purchase shares of our common stock through open market transactions or privately negotiated transactions. During 2005, we purchased 2,775,819 shares of our stock under this program at a total cost of $10.6 million. During November 2005, we completed this stock repurchase program. In February 2006, we announced that our Board of Directors renewed our stock repurchase program. Under this renewed program, we can spend up to $10.0 million to purchase shares of our common stock through open market transactions or privately negotiated transactions. In November 2006, our Board of Directors authorized an additional $10.0 million to purchase our common stock. During 2006, we purchased 1,406,683 shares of our stock under this program at a total cost of $8.1 million.
Common Stock Warrant
In October 2003, we issued a warrant to purchase 21,500 shares of common stock to a charitable foundation at $0.67 per share. The warrant is exercisable by the warrant holder at any time prior to October 24, 2010. The fair value of the warrant was estimated using the Black-Scholes pricing model with the following assumptions: expected volatility of 98.0%; expected life of 7 years; expected dividend yield of 0.0%; and the risk-free interest rate of 3.0%. During the period ended December 31, 2003, the warrant was recorded at its fair market value of approximately $225,000 and expensed to “Selling, general and administrative” expenses in the Consolidated Statement of Operations.
16. Stock-Based Compensation
In July 2003, we adopted the 2003 Stock Option Plan, which currently has 11,030,000 authorized shares. Options generally vest over a four-year period and are exercisable for a period of ten years from the date of grant.
In December 2004, the FASB issued SFAS 123(R). Under this standard, all forms of share-based payments to employees, including stock options, are treated as compensation and recognized in the income statement. Pro forma disclosure is no longer acceptable. In addition, under SFAS 123(R), tax benefits from tax deductions in excess of the compensation cost recognized (excess tax benefits) are presented as financing cash flows in the consolidated condensed statement of cash flows. Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS 123(R) and continued to use the Black-Scholes method of valuation for share-based compensation. Under the fair value recognition provisions of SFAS 123(R), we adopted the modified prospective transition method, and therefore, recognize compensation expense for all share-based payments granted after January 1, 2006, as well as those granted prior to but not yet vested as of January 1, 2006. Prior period restatement and cumulative adjustments are not required.
Prior to adopting SFAS 123(R), we presented all tax benefits of deductions resulting from the exercise of option grants as operating cash flows in the consolidated statements of cash flows. SFAS 123(R) requires the cash flows resulting from the tax benefits from tax deductions in excess of the compensation cost recognized to be classified as financing cash flows. As a result, $0.3 million of excess tax benefits for 2006 have been classified as financing cash flows. In addition, in accordance with SFAS 123(R), the approximate $6.3 million of deferred stock-based compensation recorded as a reduction to stockholders’ equity at December 31, 2005 is no longer reported as a separate component of stockholders’ equity and has been reclassified to additional paid-in capital.
Information with respect to stock option activity for the year ended December 31, 2006 was as follows:
As of December 31, 2006, there was approximately $7.5 million of unrecognized compensation cost related to outstanding stock options. For the year ended December 31, 2006, the total intrinsic value of exercised stock options was $3.3 million.
For grants issued during the three and 12 months ended December 31, 2006, the weighted average assumptions used in determining fair value under the Black-Scholes model are outlined in the following table:
The computation of expected volatility is based on historical volatility of our common stock. The expected term of options issued to employees is estimated based on the average of the vesting period and contractual term of the option. The expected term of options issued to non-employees is based on the contractual term of the option. The risk-free rate is based on U.S. Treasury yields for securities in effect at the time of grant, with terms approximating the expected term until exercise of the option. The weighted-average fair value of stock options granted during the year ended December 31, 2006 was $3.98. During the three and 12 months ended December 31, 2006, we recorded share-based compensation expense for options of approximately $1.5 million and $5.8 million, respectively.
Prior to the adoption of SFAS 123(R), we applied the intrinsic-value-based method of accounting prescribed by APB 25, and related interpretations to account for our stock options granted to employees. Under this method, we recorded compensation cost only if the market price of the underlying common stock on the grant date exceeded the exercise price. SFAS 123 established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As permitted by SFAS 123, we elected to continue to apply the intrinsic-value-based method of accounting described above, and adopted only the disclosure requirements of SFAS 123.
The following table illustrates the previously disclosed pro forma effect on net income (loss) and income (loss) per share if we had applied the fair value recognition provisions of SFAS 123 to stock-based compensation (in thousands, except per share data):
Employee Stock Purchase Plan
During the second quarter of 2005, we adopted the Staktek Holdings, Inc. 2005 Employee Stock Purchase Plan (ESPP), pursuant to which eligible employees may contribute a portion of their base compensation to
purchase shares of our common stock at a price equal to 85% of the fair market value on the date of exercise. As of December 31, 2006, we had 1.0 million authorized shares under this plan, of which approximately 56,000 shares have been issued. In accordance with SFAS 123(R), we recognize expense based on the 15% discount at purchase. For the three and 12 months ended December 31, 2006, ESPP compensation expense was approximately $5,000 and $30,000, respectively.
Restricted Stock Units
During the second quarter of 2006, we adopted the Staktek Holdings, Inc. Equity-Based Compensation Plan, which provides for granting restricted stock awards, stock appreciation rights, restricted stock units (RSUs), bonus stock and dividend equivalents to eligible employees. As of December 31, 2006, we had 800,000 authorized shares under this plan. For the 12 months ended December 31, 2006, we granted 386,610 RSUs. RSUs generally vest over a four-year period.
Information with respect to RSU activity for the year ended December 31, 2006 was as follows:
Share-based compensation related to RSUs is recorded based on our stock price as of the grant date. For the three and 12 months ended December 31, 2006, RSU compensation expense was $0.1 million and $0.4 million, respectively. As of December 31, 2006, there was approximately $1.8 million of unrecognized compensation cost related to outstanding RSUs, which we expect to recognize over a weighted average period of 3.2 years.
As a result of adopting SFAS 123(R), our loss before income taxes and net loss for the year ended December 31, 2006 were approximately $2.2 million higher and $1.7 million higher, respectively, than if we had continued to account for share-based compensation under APB 25. Basic and diluted earnings per share for the year ended December 31, 2006 were $0.04 and $0.03 lower, respectively, than if we had continued to account for shared-based compensation under APB 25.
17. Income Taxes
The components of the provision (benefit) for income taxes were as follows (in thousands):
Foreign taxes include withholdings on royalties from customers located in foreign countries.
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our deferred taxes as of December 31, 2006 and 2005 were as follows (in thousands):
During 2005, we decreased goodwill by approximately $385,000, primarily due to the tax benefits associated with tax deductible stock-based compensation costs associated with the Predecessor Company.
Undistributed earnings of our foreign subsidiaries are considered to be permanently reinvested and, accordingly, no provision for U.S. federal and/or state income taxes has been provided.
The exercise of certain of our stock options results in compensation, which is includable in the taxable income of the exercising option holder and deductible by us for federal and state income tax purposes. This compensation results from increases in the fair market value of our common stock subsequent to the date of grant of the exercised stock options. Any option-related excess tax benefits are recorded as an increase to additional paid-in capital, while option-related tax deficiencies are recorded as a decrease to additional paid-in capital to the extent of our additional paid-in capital option pool, and the remainder, if any, is taken to the income tax provision. During the years ended December 31, 2006 and 2005, our option-related excess tax deductions resulted in an increase to additional paid-in capital of approximately $0.3 million and $0, respectively, while option-related tax deficiencies resulted in a decrease to additional paid-in capital of approximately $0.2 million and $0, respectively.
Our provision for income taxes differs from the expected tax expense (benefit) amount computed by applying the statutory federal income tax rate of 35% to income (loss) before income taxes primarily as a result of the following (in thousands):
18. Employee Benefits
Full-time employees become eligible for health care benefits effective the second day of service. We offer all full-time employees partially subsidized health, dental and vision coverage. In addition, on the second day of service all full-time employees receive at our expense life insurance, accidental death coverage, worker’s compensation coverage and short- and long-term disability coverage.
401(k) Plan
We have a voluntary defined contribution retirement plan (401(k) Plan) qualifying under Section 401(k) of the Internal Revenue Code of 1986. Under the 401(k) Plan, eligible employees may defer up to 75% of their annual compensation, subject to maximum IRS limitations. Under the provisions of the 401(k) Plan, we make contributions in amounts as determined by the Board of Directors, subject to certain limitations. Our contributions related to the 401(k) Plan were approximately $0.5 million for the years ended December 31, 2006, 2005 and 2004.
Bonus Plan
We have a quarterly bonus plan under which eligible employees may receive a percentage of their base pay in additional compensation. Typically, we make these payments within 40 days after the end of the quarter in which the compensation is earned. Total expense was approximately $2.3 million, $1.9 million and $2.1 million for the years ended December 31, 2006, 2005 and 2004, respectively.
Discretionary Payment
We met 97% of our targeted annual adjusted operating income established by the Board of Directors at the beginning of 2006. As a result of this accomplishment, the Board authorized a one-time, discretionary bonus payment to employees of the Company in February 2007 based on the ratio of the full-year adjusted operating income to the adjusted operating income annual target. Total expense recorded in 2006 for this payment was approximately $0.8 million.
19. Restructuring
During 2005, we recorded a restructuring charge totaling $1.0 million resulting from workforce reductions of 76 employees. In April 2006, we recorded an additional restructuring charge of approximately $0.4 million for separation costs for a workforce reduction of 29 employees. Both restructurings were the result of the transfer of manufacturing from Austin, Texas to Reynosa, Mexico and a realignment of our organizational structure to focus on our growth strategy. The following table details the changes in the restructuring accrual (in thousands) during the year ended December 31, 2006:
As of December 31, 2006, approximately $23,000 of the restructuring accrual was included in long-term liabilities.
20. Geographic Information
We consider our business activities to constitute a single segment. Following is a summary of our revenues by geographic region (in thousands):
At December 31, 2006 and 2005, we had physical assets consisting of cash and net property, plant and equipment located at our manufacturing facility in Reynosa, Mexico as follows (in thousands):
Our manufacturing operations are concentrated in a facility located in Reynosa, Mexico. As a result of this geographic concentration, a disruption in the manufacturing process resulting from a natural disaster or other unforeseen event could have a material adverse effect on our business, financial condition or results of operations.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
The SEC defines the term “disclosure controls and procedures” to mean a company’s controls and other procedures that are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Our chief executive officer and chief financial officer have concluded, based upon the evaluation of the effectiveness of our disclosure controls and procedures by our management, as of the end of the period covered by this annual report, that our disclosure controls and procedures were effective for this purpose.
It should be noted that in designing and evaluating our disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met due to numerous factors, ranging from errors to conscious acts of an individual, or individuals acting together. In addition, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of inherent limitations in a cost-effective control system, misstatements due to error and/or fraud may occur and not be detected.
Changes in Internal Controls Over Financial Reporting
There have been no changes in our internal controls over financial reporting that occurred during the quarter ended December 31, 2006 that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information set forth in the Proxy Statement to be delivered to stockholders in connection with our Annual Meeting of Stockholders to be held on April 19, 2007 (the Proxy Statement) under the headings “Board Structure and Compensation,” “Proposal: Election of Directors,” “Executive Officers,” and “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference. In addition, the Company has adopted a Code of Conduct that applies to our directors and employees. This Code of Conduct can be found under the Investor Relations section on our web site and is included as Exhibit 14.1 to this Form 10-K.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information set forth in the Proxy Statement under the headings “Board Structure and Compensation-Director Compensation Arrangements” and “Executive Compensation” is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information set forth in the Proxy Statement under the heading “Stock Ownership” is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information set forth in the Proxy Statement under the heading “Certain Relationships and Related Transactions” is incorporated herein by reference.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information set forth in the Proxy Statement under the heading “Independent Registered Public Accounting Firm” is incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
1. Financial Statements: See Index to Consolidated Financial Statements under Item 8.
2. Financial Statement Schedules: All schedules are omitted because they are not applicable or are not required or the information required to be set forth therein is included in the consolidated financial statement or notes thereto.
3. Exhibits: The exhibits listed in the accompanying index to exhibits are filed or incorporated by reference as part of this Form 10-K.
INDEX TO EXHIBITS
* - Constitutes management contract or compensatory arrangement
** - Confidential treatment has been requested for portions of this exhibit. These portions have been omitted from this report and have been filed separately with the Securities and Exchange Commission.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
STAKTEK HOLDINGS, INC.
By:
/s/ WAYNE R. LIEBERMAN
Wayne R. Lieberman
President and Chief Executive Officer
Date: March 7, 2007
By:
/s/ W. KIRK PATTERSON
W. Kirk Patterson
Senior Vice President and Chief Financial Officer
Date: March 7, 2007
KNOW BY THESE PRESENT, that each person whose signature appears below constitutes and appoints each of Wayne R. Lieberman and W. Kirk Patterson, his attorney-in-fact, with the power of substitution, for him in any and all capacities, to sign any amendments to this report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of the attorney-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Act of 1934, as amended, this Registration Statement has been signed by the following persons in the capacities and on the dates indicated: