-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, Ao7ZXv0y8810shonGwxD/FKd5qNbd6gUIVBC6pbqhqiqmWaGgzzt2L1RMVgAiAbA xy1plxDoCcqH9ZShLRoaWw== 0001012870-01-500670.txt : 20010509 0001012870-01-500670.hdr.sgml : 20010509 ACCESSION NUMBER: 0001012870-01-500670 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 20010331 FILED AS OF DATE: 20010508 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SANDISK CORP CENTRAL INDEX KEY: 0001000180 STANDARD INDUSTRIAL CLASSIFICATION: COMPUTER STORAGE DEVICES [3572] IRS NUMBER: 770191793 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-26734 FILM NUMBER: 1625963 BUSINESS ADDRESS: STREET 1: 140 CASPIAN COURT CITY: SUNNYVALE STATE: CA ZIP: 94089 BUSINESS PHONE: 4085620500 MAIL ADDRESS: STREET 1: 140 CASPIAN COURT CITY: SUNNYVALE STATE: CA ZIP: 94089 10-Q 1 d10q.txt QUARTERLY REPORT FOR PERIOD ENDED 03/31/2001 Form 10-Q SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 (Mark one) X Quarterly report pursuant to Section 13 or 15(d) of the Securities - ---------- Exchange Act of 1934 For the quarterly period ended March 31, 2001 OR Transition report pursuant to Section 13 or 15(d) of the Securities __________ Exchange Act of 1934 For the transition period from ______ to ______ Commission File Number 0-26734 ------- SanDisk Corporation (Exact name of registrant as specified in its charter) Delaware 77-0191793 -------- ---------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 140 Caspian Court, Sunnyvale, California 94089 ----------------------------------------- -------- (Address of principal executive offices) (Zip code) (408) 542-0500 -------------- (Registrant's telephone number, including area code) N/A --- (Former name, former address, and former fiscal year, if changed since last report.) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No _______ ----- Indicate the number of shares outstanding of each of the issuer's classes of common stock as of March 31, 2001 Common Stock, $0.001 par value 67,973,928 ------------------------------ ---------- Class Number of shares SanDisk Corporation Index
PART I. FINANCIAL INFORMATION Page No. ------- Item 1. Condensed Consolidated Financial Statements: Condensed Consolidated Balance Sheets March 31, 2001 and December 31, 2000................................ 3 Condensed Consolidated Statements of Operations Three months ended March 31, 2001 and 2000.......................... 4 Condensed Consolidated Statements of Cash Flows Three months ended March 31, 2001 and 2000.......................... 5 Notes to Condensed Consolidated Financial Statements.................. 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........................................... 10 Item 3. Quantitative and Qualitative Disclosures About Market Risk............ 29 PART II. OTHER INFORMATION Item 1. Legal Proceedings..................................................... 30 Item 2. Changes in Securities................................................. 30 Item 3. Defaults upon Senior Securities....................................... 30 Item 4. Submission of Matters to a Vote of Security Holders................... 30 Item 5. Other Information..................................................... 30 Item 6. Exhibits and Reports on Form 8-K...................................... 30 Signatures............................................................ 33
Page 2 PART I. FINANCIAL INFORMATION Item 1. Condensed Consolidated Financial Statements SANDISK CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands)
March 31, December 31, ----------- ------------ 2001 2000* ----------- ------------ (unaudited) ASSETS Current Assets: Cash and cash equivalents $ 77,487 $ 106,277 Short-term investments 228,954 260,462 Investment in UMC 143,851 112,854 Accounts receivable, net 71,059 104,617 Inventories 83,682 96,600 Deferred tax assets 5,637 7,066 Prepaid expenses and other current assets 17,324 9,431 ----------- ------------ Total current assets 627,994 697,307 Property and equipment, net 43,794 41,095 Investment in UMC 71,925 197,688 Investment in joint ventures 150,334 134,730 Investment in equity securities 23,340 7,200 Deposits and other assets 24,483 29,887 ----------- ------------ Total Assets $941,870 $1,107,907 =========== ============ LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities: Accounts payable $ 71,070 $ 67,112 Accrued payroll and related expenses 8,430 16,215 Income taxes payable 5,800 16,427 Other accrued liabilities 21,166 20,863 Deferred revenue 33,389 50,740 ----------- ------------ Total current liabilities 139,855 171,357 Deferred tax liability 21,268 70,000 Other liabilities 5,657 3,492 ----------- ------------ Total Liabilities 166,780 244,849 Stockholders' Equity: Common stock 571,155 567,001 Retained earnings 203,367 346,469 Accumulated other comprehensive income (loss) 568 (50,412) ----------- ------------ Total stockholders' equity 775,090 863,058 Total Liabilities and Stockholders' Equity $941,870 $1,107,907 =========== ============
______________ * Information derived from the audited Consolidated Financial Statements. The accompanying notes are an integral part of these condensed consolidated financial statements. Page 3 SANDISK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data) (Unaudited)
Three Months Ended March 31, ------------------------- 2001 2000 ----------- ---------- Revenues: Product $ 88,083 $ 97,249 License and royalty 13,244 12,120 ----------- ---------- Total revenues 101,327 109,369 Cost of sales 118,780 67,758 ----------- ---------- Gross profits (losses) (17,453) 41,611 Operating expenses: Research and development 16,353 8,769 Sales and marketing 10,218 10,544 General and administrative 4,279 4,747 ----------- ---------- Total operating expenses 30,850 24,060 Operating income (loss) (48,303) 17,551 Equity in income of joint ventures, net of equity in losses of joint ventures 634 -- Interest income 4,075 5,618 Gain (loss) on investment in foundry (179,981) 344,168 Other income (expense), net (1,783) 434 ----------- ---------- Income (loss) before taxes (225,358) 367,771 Provision for (benefit from) income taxes (82,256) 148,500 ----------- ---------- Net income (loss) $(143,102) $219,271 =========== ========== Net income (loss) per share Basic $ (2.11) $ 3.32 Diluted $ (2.11) $ 3.00 Shares used in computing net income per share Basic 67,814 66,095 Diluted 67,814 73,015
The accompanying notes are an integral part of these condensed consolidated financial statements. Page 4 SANDISK CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited)
Three Months Ended March 31, ----------------------------- 2001 2000 --------- --------- Cash flows from operating activities: Net income (loss) $(143,102) $ 219,271 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Depreciation 4,489 3,546 Deferred taxes (81,538) 138,437 Loss (Gain) on investment in foundry 179,981 (344,168) Equity in income of joint ventures (634) -- Loss on write down of fixed assets 1,887 -- Changes in operating assets and liabilities: Accounts receivable, net 33,558 (26,451) Inventories 12,918 448 Prepaid expenses and other assets (2,489) (3,559) Accounts payable 3,958 613 Accrued payroll and related expenses (7,785) (1,351) Income taxes payable (10,627) 5,873 Other accrued liabilities 303 3,952 Deferred revenue (17,351) 3,558 Other non-current liabilities 2,165 -- --------- --------- Total adjustments 118,835 (219,102) --------- --------- Net cash provided by (used in) operating activities (24,267) 169 Cash flows from investing activities: Purchases of short term investments (49,737) (114,631) Proceeds from sale of short term investments 81,245 73,453 Investment in equity securities (16,140) -- Investment in joint ventures (14,970) -- Acquisition of capital equipment (9,075) (3,676) --------- --------- Net cash used in investing activities (8,677) (44,854) Cash flows from financing activities: Sale of common stock 4,154 6,073 --------- --------- Net cash provided by financing activities 4,154 6,073 --------- --------- Net decrease in cash and cash equivalents (28,790) (38,612) Cash and cash equivalents at beginning of period 106,277 146,170 --------- --------- Cash and cash equivalents at end of period $ 77,487 $ 107,558 ========= =========
The accompanying notes are an integral part of these condensed consolidated financial statements. Page5 SANDISK CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. These interim condensed consolidated financial statements are unaudited but reflect, in the opinion of management, all normal recurring adjustments necessary to present fairly the financial position of SanDisk Corporation and its subsidiaries (the "Company") as of March 31, 2001, and the results of operations and cash flows for the three month periods ended March 31, 2001 and 2000. Because all the disclosures required by accounting principles generally accepted in the United States are not included, these interim condensed consolidated financial statements should be read in conjunction with the audited financial statements and notes thereto in the Company's annual report on Form 10-K as of, and for, the year ended December 31, 2000. The condensed consolidated balance sheet data as of December 31, 2000 was derived from the audited financial statements. The Company's results of operations and cash flows for the three month periods ended March 31, 2001 and 2000 are not necessarily indicative of results of operations and cash flows for any future period. 2. The Company's fiscal year ends on the Sunday closest to December 31, and each fiscal quarter ends on the Sunday closest to March 31, June 30, and September 30. The first fiscal quarter of 2001 and 2000 ended on April 1, 2001 and April 2, 2000, respectively. Fiscal year 2001 is 52 weeks long and ends on December 30, 2001. Fiscal year 2000 was 52 weeks long and ended on December 31, 2000. For ease of presentation, the accompanying financial statements have been shown as ending on the last day of the calendar month. 3. The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. 4. The components of inventory consist of the following: March 31, December 31, 2001 2000 --------- ------------ (in thousands) Raw materials............................ $ 44,824 $ 33,092 Work-in-process.......................... 11,950 53,921 Finished goods........................... 26,908 9,587 --------- ---------- $ 83,682 $ 96,600 ========= ========== 6 5. The following table sets forth the computation of basic and diluted earnings per share:
Three Months Ended March 31, --------------------------------- 2001 2000 --------------- ------------- (in thousands), except for per share amounts Numerator: Numerator for basic and diluted net income per share--net income (loss) $(143,102) $219,271 =============== ============= Denominator for basic net income per share: Weighted average common shares 67,814 66,095 --------------- ------------- Basic net income (loss) per share $ (2.11) $ 3.32 =============== ============= Denominator for diluted net income per share: Weighted average common shares 67,814 66,095 Employee stock options and warrants to purchase common stock --- 6,920 --------------- ------------- Shares used in computing diluted net income per share 67,814 73,015 --------------- ------------- Diluted net income (loss) per share $ (2.11) $ 3.00 =============== =============
For the three-month periods ended March 31, 2001 and 2000, options to purchase 8,558,000 and 82,000 shares of common stock, respectively, have be excluded from the earnings per share calculation, as their effect is antidilutive. 6. The Company relies on a combination of patents, trademarks, copyright trade secret laws, confidentiality procedures and licensing arrangements to protect its intellectual property rights. There can be no assurance that the will not be any disputes regarding the Company's intellectual property right Specifically, there can be no assurance that any patents held by the Company will not be invalidated, that patents will be issued for any of the Company pending applications or that any claims allowed from existing or pending patents will be of sufficient scope or strength or be issued in the primary countries where the Company's products can be sold to provide meaningful protection or commercial advantage to the Company. Additionally, competitors of the Company may be able to design around the Company's patents. To preserve its intellectual property rights, the Company believes it may be necessary to initiate litigation with one or more third parties, including but not limited to those the Company has notified of possible patent infringement. In addition, one or more of these parties may bring suit against the Company. Any litigation, whether as a plaintiff or as a defendant, would likely result in significant expense to the Company and divert the efforts of the Company's technical and management personnel, whether or not such litigation is ultimately determined in favor of the Company. On March 21, 2000, Mitsubishi Denki Co. Ltd. (Mitsubishi Electric) filed a complaint in Tokyo District Court against SanDisk K.K., SanDisk's wholly owned subsidiary in Japan. The complaint alleges that SanDisk K.K., based in Yokohama, Japan, infringes on three Mitsubishi Japanese patents, which are related primarily to the mechanical construction of memory cards. In the complaint, Mitsubishi asked the court for a preliminary injunction halting the sale of SanDisk CompactFlash and flash ATA memory cards in Japan. Mitsubishi has since dropped two of the patents from the suit. The Company and SanDisk K.K. are vigorously defending against Mitsubishi's remaining claims and believe they have meritorious defenses. Compaq Corporation has opposed in several countries, including the United States, our attempting to register CompactFlash as a trademark. We do not believe that our failure to obtain registration for the CompactFlash mark will materially harm our business. 7 In the event of an adverse result in any such litigation, the Company could be required to pay substantial damages, cease the manufacture, use and sale of infringing products, expend significant resources to develop non-infringing technology or obtain licenses to the infringing technology, or discontinue the use of certain processes. From time to time the Company agrees to indemnify certain of its suppliers and customers for alleged patent infringement. The scope of such indemnity varies but may in some instances include indemnification for damages and expenses, including attorneys' fees. The Company may from time to time be engaged in litigation as a result of such indemnification obligations. Third party claims for patent infringement are excluded from coverage under the Company's insurance policies. There can be no assurance that any future obligation to indemnify the Company's customers or suppliers will not have a material adverse effect on the Company's business, financial condition and results of operations. Litigation frequently involves substantial expenditures and can require significant management attention, even if the Company ultimately prevails. In addition, the results of any litigation matters are inherently uncertain. Accordingly, there can be no assurance that any of the foregoing matters, or any future litigation, will not have a material adverse effect on the Company's business, financial condition and results of operations. 7. Certain of the Company's balance sheet accounts and purchase commitments are denominated in Japanese Yen. The Company enters into foreign exchange contracts to hedge against changes in foreign currency exchange rates. The effects of movements in currency exchange rates on these instruments are recognized when the related operating revenues and expenses are recognized. The impact of movements in currency exchange rates on foreign exchange contracts substantially mitigates the related impact on the underlying items hedged. In the first quarter of 2001, the Company had a net foreign currency transaction loss of $1.8 million, compared to a gain of $0.5 million in the first quarter of 2000, primarily due to translation adjustments on its Japanese Yen based assets. On January 1, 2001, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities." The standard requires that all derivatives be recorded on the balance sheet at fair value and establishes criteria for designation and effectiveness of hedging relationships. The cumulative effect of adopting SFAS 133 as of January 1, 2001 was not material to the Company's consolidated financial statements. The Company is exposed to foreign currency exchange rate risk inherent in forecasted sales, cost of sales, and assets and liabilities denominated in currencies other than the U.S. dollar. The Company is also exposed to interest rate risk inherent in its debt and investment portfolios. The Company's risk management strategy provides for the use of derivative financial instruments, including foreign exchange forward contracts, to hedge certain foreign currency exposures. The Company's intent is to offset gains and losses that occur on the underlying exposures, with gains and losses on the derivative contracts hedging these exposures. The Company does not enter into any speculative positions with regard to derivative instruments. The Company enters into foreign exchange contracts to hedge against exposure to changes in foreign currency exchange rates, only when natural offsets can not be achieved. Such contracts are designated at inception to the related foreign currency exposures being hedged, which include sales by subsidiaries, and assets and liabilities that are denominated in currencies other than the U.S. dollar. The Company's foreign currency hedges generally mature within six months. The Company records all derivatives on the balance sheet at fair value. For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative instrument is recorded in accumulated other comprehensive income as a separate component of stockholders' equity and reclassified into earnings in the period during which the hedged transaction affects earnings. For derivative instruments that are designated and qualify as fair value hedges, the gain or loss on the derivative instrument, as well as the offsetting gain or loss on the hedged item attributable to the hedged risk, are recognized in earnings in the current period. For derivative instruments not designated as hedging instruments, changes in their fair values are recognized in earnings in the current period. For foreign currency forward contracts, hedge effectiveness is measured by comparing the cumulative change in the hedged contract with the cumulative change in the hedged item, both of which are based on forward rates. To the extent that the critical terms of the hedged item and the derivative are not identical, hedge ineffectiveness is 8 reported in earnings immediately. The Company estimates the fair values on derivatives based on quoted market prices or pricing models using current market rates. The Company reports hedge ineffectiveness from foreign currency derivatives for both options and forward contracts in other income or expense. Hedge ineffectiveness was not material in the first quarter of fiscal 2001. The effective portion of all derivatives is reported in the same financial statement line item as the changes in the hedged item. At March 31, 2001, the Company had $31.2 million in foreign-denominated accounts payable and open purchase orders designated as cash flow hedges or fair value hedges against foreign denominated cash holding and accounts receivable. The Company estimates the fair values on derivatives based on quoted market prices or pricing models using current market rates. At March 31, 2001, the Company had approximately $1.1 million of unrealized losses on derivative instruments, net of taxes, in accumulated other comprehensive income. 8. Accumulated other comprehensive income (loss) presented in the accompanying balance sheet consists of the accumulated unrealized gains and losses on available-for-sale marketable securities, net of the related tax effects, for all periods presented. Three Months Ended March 31, -------------------------- 2001 2000 ----------- ------------ (in thousands) Net income (loss) $(143,102) $219,271 Unrealized gain on available-for-sale securities: 370 9,807 ----------- ------------ Comprehensive income (loss) $(142,732) $229,078 =========== ============ Accumulated other comprehensive income (loss) was $0.6 million and $(50.4) million at March 31, 2001 and December 31, 2000, respectively. The balance at December 31, 2000 included unrealized losses on UMC and SmartDisk of $50.2 million and $0.4 million, respectively. Each of these losses was marked to market through the income statement in the first quarter of 2001, as each of their declines in value were believed to be other than temporary. 9. In January 2001, the Company invested the final $15 million of its $150 million commitment in cash in FlashVision, L.L.C., our joint venture with Toshiba for the development and manufacture of 512 megabit and 1 gigabit flash memory chips and Secure Digital Card controllers. On January 26, 2001, the Company guaranteed the first $20 million in equipment lease lines to equip Toshiba's Dominion Semiconductor manufacturing clean room with advanced wafer processing equipment. A total of $215 million will be guaranteed by the Company. The Company accounts for this investment under the equity method, and recorded $894,000 as equity in income of joint ventures in the first quarter of 2001. 10. On January 3, 2000, the USIC foundry in Taiwan, one of our major suppliers of semiconductor wafers, was merged into UMC. The Company had invested $51.2 million in USIC. In exchange for its USIC shares, the Company received 111 million UMC shares. These shares were valued at approximately $396 million at the time of the merger, resulting in a pretax gain of $344.2 million ($203.9 million after-tax) in the first quarter of 2000. Trading restrictions expired on one-half of the shares on July 3, 2000, and the remaining shares become available for sale over a two-year period beginning in January 2002. Due to the current weakness in the semiconductor industry, the value of the Company's UMC shares declined to $215.8 million as of March 31, 2001. The downturn in the semiconductor industry, and the economy in general, appears to be more severe than previously anticipated, and there is a great deal of uncertainty regarding when the semiconductor industry will recover from this down cycle. Because of the continued downturn in the economy, the Company believed that the decline in the market value of its investment in UMC as of March 31, 9 2001, was other than temporary as defined by accounting principles generally accepted in the United States. In the first quarter of 2001, the Company recorded a loss in other income and expense on this other than temporary decline in value of $179.6 million, or $114.0 million after taxes. This loss is included in other income and expense. If the value of the Company's UMC shares declines further, it may be required to record additional losses. In addition, in future periods, the Company may recognize a gain or loss if it sells its UMC shares due to fluctuations in the market value of UMC's stock. 11. On July 4, 2000, SanDisk entered into a share purchase agreement to make a $75 million investment in Tower Semiconductor, or Tower, in Israel, representing approximately 10% ownership of Tower. On January 26, 2001, Tower satisfied the closing conditions of the share purchase agreement, and the Company transferred the first $20 million of its investment from an escrow account to purchase 866,551 shares ordinary shares and obtain $8.8 million in pre-paid wafer credits. On March 1, 2001, the Company paid Tower an additional $11.0 million upon its completion of milestone one, to purchase 366,690 ordinary shares and obtain $6.1 million prepaid wafer credits. Additional contributions will take the form of mandatory warrant exercises for ordinary shares at an exercise price of $30.00 per share if other milestones are met. The warrants will expire five years from the date of grant, and in the event the key milestones are not achieved, the exercise of these warrants will not be mandatory. We expect first wafer production to commence at the new fabrication facility in late 2002. 12. On August 9, 2000, SanDisk entered into a joint venture, DigitalPortal Inc., or DPI, with Photo-Me International, or PMI, for the manufacture, installation, marketing, and maintenance of self-service, digital photo printing labs, or kiosks, bearing the SanDisk brand name in locations in the U.S. and Canada. Under the agreement, SanDisk and PMI will each make an initial investment of $4.0 million and secure lease financing for the purchase of the kiosks. The total value of the lease financing will depend on the number of kiosks deployed by the joint venture. The Company estimates that it will guarantee equipment lease arrangements of approximately $40.0 million over the first two years of the agreement. PMI will manufacture the kiosks for the joint venture and will install and maintain the kiosks under contract with the joint venture. The Company expects the first kiosks to be deployed in pilot programs in select retail stores in the United States starting in the third quarter of 2001. The Company accounts for this investment under the equity method, and recorded a loss of $260,000 as equity in loss of joint venture in the first quarter of 2001. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Certain statements in this discussion and analysis are forward-looking statements under Section 21E of the Securities and Exchange Act of 1934, as amended based on current our expectations, and entail various significant risks and uncertainties that could cause our actual results to differ materially from those expressed in such forward looking statements. Such risks and uncertainties are discussed below and in our Form 10-K for the year ended December 31, 2000 under the heading "Factors That May Affect Future Results." Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to update these forward-looking statements to reflect events or circumstances occurring after the date hereof. The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto. Overview SanDisk was founded in 1988 to develop and market flash data storage systems. We sell our products to the consumer electronics and industrial/communications markets. In the first three months of fiscal 2001, approximately 72% of our product sales were attributable to the consumer electronics market, particularly sales of CompactFlash and MultiMediaCard products for use in digital cameras and portable music devices. Our CompactFlash products have lower average selling prices and gross margins than our higher capacity FlashDisk and FlashDrive products. In addition, a substantial portion of our CompactFlash and MultiMediaCard products are sold into the retail channel, which usually has shorter customer order lead-times than our other channels. A majority of our sales to the retail channel are turns business, with orders received and fulfilled in the same quarter, thereby decreasing our ability to accurately forecast future production needs. We believe sales to the consumer market will continue to represent a 10 majority of our sales, and increase as a percentage of sales in future years, as the popularity of consumer applications, including digital cameras, increases. Our operating results are affected by a number of factors including the volume of product sales, competitive pricing pressures, availability of foundry capacity, our ability to match supply with demand, low order visibility, variations in manufacturing cycle times, fluctuations in manufacturing yields and manufacturing utilization, the timing of significant orders, changes in product and customer mix, market acceptance of new or enhanced versions of our products, changes in the channels through which our products are distributed, timing of new product announcements and introductions by us and our competitors, the timing of license and royalty revenues, fluctuations in product costs, increased research and development expenses, weak worldwide economic conditions and uncertainty, and exchange rate fluctuations. We have experienced seasonality in the past, and as the proportion of our products sold for use in consumer electronics applications increases, our revenues may become subject to more pronounced seasonal declines in the first quarter of each year. See "Factors That May Affect Future Results--Our Operating Results May Fluctuate Significantly Which May Adversely Affect Our Stock Price" and "--There is Seasonality in Our Business." Beginning in late 1995, we adopted a strategy of licensing our flash technology, including our patent portfolio, to third-party manufacturers of flash products. To date, we have entered into patent cross-license agreements with several companies, and intend to pursue opportunities to enter into additional licenses. Under our current license agreements, licensees pay us license fees, royalties, or a combination thereof. In some cases, the compensation to us may be partially in the form of guaranteed access to flash memory manufacturing capacity from the licensee. The timing and amount of royalty payments and the recognition of license fees can vary substantially from quarter to quarter depending on the terms of each agreement and, in some cases, the timing of sales of products by the other parties. As a result, license and royalty revenues have fluctuated significantly in the past and are likely to continue to fluctuate in the future. Given the relatively high gross margins associated with license and royalty revenues, gross margins and net income are likely to fluctuate more with changes in license and royalty revenues than with changes in product revenues. We market our products using a direct sales organization, distributors, manufacturers' representatives, private label partners, OEMs and retailers. We expect that sales through the retail channel will comprise an increasing share of our product revenues in the future, and that a substantial portion of our sales into the retail channel will be made to participants that will have the right to return unsold products. Our policy is to defer recognition of revenues from these sales to the retail and distribution channels until the products are sold to the end customers. Historically, a majority of our sales have been to a limited number of customers. We expect that sales of our products to a limited number of customers will continue to account for a substantial portion of our product revenues for the foreseeable future. We have also experienced significant changes in the composition of our customer base from year to year and expect this pattern to continue as market demand for our customers' products fluctuates. The loss of, or significant reduction in purchases by any of our major customers, could have a material adverse effect on our business, financial condition and results of operations. See "Factors That May Affect Future Results--Sales to a Small Number of Customers Represent a Significant Portion of Our Revenues". All of our products require silicon wafers, the majority of which are currently manufactured for us by UMC in Taiwan. Industry-wide demand for semiconductors increased significantly in 1999 and the first nine months of 2000, due to increased demand in the consumer electronics and cellular phone markets. This increased demand caused supply constraints for most of 2000. Semiconductor manufacturers, including UMC and Toshiba added new advanced wafer fab capacity during 2000. This additional capacity, along with slowing economic conditions experienced late in the fourth quarter of 2000 and into 2001, has resulted in excess supply and intense pricing pressure. If industry-wide demand for our products continues to be below the industry-wide available supply, our product prices could decrease further causing our revenues and profits to continue to decline significantly. Under our wafer supply agreements, there are limits on the number of wafers we can order and our ability to change that quantity, either up or down, is restricted. Accordingly, our ability to react to significant fluctuations in demand for our products is limited. If customer demand 11 exceeds our forecasts, we may be unable to obtain an adequate supply of wafers to fill customer orders, which could result in lost sales and lower revenues. If we are unable to obtain adequate quantities of flash memory wafers with acceptable prices and yields from our current and future wafer foundries, our business, financial condition and results of operations could be harmed. See "Factors That May Affect Future Results--Our Operating Results May Fluctuate Significantly." In the first quarter of 2001, we have taken an inventory charge of $45.3 million, reflecting lower market pricing and the write off of excess and obsolete inventories, and we may be forced to write down inventories again if the current deterioration in market demand for our products continues and our inventory levels continue to exceed customer orders. In addition, we may have to write down our inventories if continued pricing pressure results in a net realizable value that is lower than our cost, or if part of the inventory becomes obsolete. Due to the market demand for our products changing so rapidly, we ended the first quarter of 2001 with significant amounts of excess inventory. Although we are working to reduce this inventory in line with the current level of business, we are obligated to honor existing purchase orders that we have placed with our suppliers. Furthermore, to assure favorable future business relations with our major suppliers, we may choose not to shut down their production of our products. In the case of FlashVision manufacturing at Dominion in Virginia, both Toshiba and SanDisk are obligated to purchase their share of the production output, which may make it more difficult for us to reduce our inventory. Excess inventory not only ties up our cash, but also can result in substantial losses if such inventory, or large portions thereof, has to be revalued due to lower market pricing or product obsolescence. These inventory adjustments decrease gross margins and have resulted in, and could in the future result in, fluctuations in gross margins and net earnings in the quarter in which they occur. The inventory charge of $45.3 million in the first quarter of 2001 represented 51% of product revenues, resulting in a decrease of gross margins from positive 17% to negative 35%. Export sales are an important part of our business. Our international sales are impacted by changes in economic conditions in our international markets. Economic conditions in our international markets, including Asia and the European Union, may adversely affect our revenues to the extent that demand for our products in these regions declines. Given the recent adverse economic conditions in Asia and the European Union and the weakness of the Euro, Yen and other currencies relative to the United States Dollar, our products may be relatively more expensive in these regions, which could result in a decrease of our sales in these regions. While most of our sales are denominated in U.S. Dollars, we invoice certain Japanese customers in Japanese Yen and are subject to exchange rate fluctuations on these transactions, which could affect our business, financial condition and results of operations. See "Factors That May Affect Future Results--Our international operations make us vulnerable to changing conditions and currency fluctuations." For the foreseeable future, we expect to realize a significant portion of our revenues from recently introduced and new products. Typically, new products initially have lower gross margins than more mature products because the manufacturing yields are lower at the start of manufacturing each successive product generation. In addition, manufacturing yields are generally lower at the start of manufacturing any product at a new foundry. To remain competitive, we are focusing on a number of programs to lower manufacturing costs, including development of future generations of flash memory. There can be no assurance that we will successfully develop such products or processes or that development of such processes will lower manufacturing costs. If the current industry-wide and worldwide economic slowdown continues for the rest of fiscal 2001, we may be unable to efficiently utilize the NAND flash wafer production from FlashVision, which would force us to amortize the fixed costs of the fabrication facility over a reduced wafer output, making these wafers significantly more expensive. The output of Nand flash wafers from Flashvision is expected to increase substantially in the second half of 2001, which will result in a corresponding increase of our Nand inventory if the market conditions for the sale of our products do not improve materially in the second half. See "Factors That May Affect Future Results--We Must Achieve Acceptable Manufacturing Yields." Results of Operations Product Revenues. Our product revenues were $88.1 million in the first quarter of 2001, down $9.2 million or 9% from the first quarter of 2000. During the first quarter of 2001, total flash memory product units sold increased 12 approximately 18% over the first quarter of 2000. The largest increase came from sales of CompactFlash products. CompactFlash products represented 53% of product revenues and MultiMediaCards 15% of product revenues for the first quarter of 2001, compared to 50% and 15%, respectively, in the first quarter of 2000. The average selling price per megabyte of memory shipped declined 27% in the first quarter of 2001 when compared to the first quarter of 2000 due primarily to competitive pricing pressures driven by excess supply in the market. Average unit selling prices for memory products decreased by 9% due to the decline per megabyte, partially offset by an increase in the average megabytes per unit. Product revenues were down $66.6 million or 43% from the fourth quarter of 2000, and total units sold declined 23%, as we experienced significantly weakened market conditions and weak overall economic conditions. The average selling price per megabyte of memory declined by 13% for the quarter, primarily due to competitive pricing pressures driven by the excess supply in the market. Compared to the fourth quarter of 2000, average unit selling prices for memory products decreased 15% from quarter to quarter. Total revenues for the first quarter of 2001 were down $76.3 million or 43% compared to $177.7 million in the fourth quarter of 2000. Due to the rapid deterioration of market conditions and lack of visibility, which began late in the fourth quarter of 2000 and continued into in the first quarter of 2001, we have had difficulty predicting customer demand. Customer demand for the first quarter was significantly below our previous forecasts. Anticipated demand for 2001 is significantly below our previous forecasts. We expect second quarter 2001 product revenues to be approximately unchanged from our first quarter 2001 product revenues, and for average selling prices to continue to decline significantly due to competition. Sales to the consumer market represented approximately 72% of product revenues in the first quarter of 2001, with sales to the telecommunications/industrial market accounting for the remaining 28%. This compares to 70% for the consumer market and 30% for the telecommunications/industrial market in the first quarter of 2000. Sales to the retail channel represented 38% of product revenues in the first quarter of 2001, compared to 26% in the first quarter of 2000. Our mix of products sold varies from quarter to quarter and will continue to vary in the future, affecting our overall average selling prices and gross margins. Export sales represented 57% of our product revenues in the first quarter of 2001, compared to 50% in the first quarter of 2000 and 50% in the fourth quarter of 2000. We expect international sales to continue to represent a significant portion of our product revenues. In the first quarter of 2001, our top ten customers represented approximately 64% of our product revenues compared to 52% in the first quarter of 2000 and 51% in the fourth quarter of 2000. In the first quarter of 2001, sales to one customer exceeded 10% of product sales, and there were two customers that each represented more than 10% of product sales in the first quarter of 2000. We expect that sales to a limited number of customers will continue to represent a substantial portion of our product revenues for the foreseeable future. License and Royalty Revenues. We currently earn patent license fees and royalties under several cross-license agreements. License and royalty revenues from patent cross-license agreements were $13.2 million in the first quarter of 2001, up from $12.1 million in the first quarter of 2000 due primarily to recognition of royalty revenues related to the Lexar settlement in the fourth quarter of 2000. Revenues from licenses and royalties increased to 13% of total revenues in the first quarter of 2001 from 11% in the first quarter of 2000. Our revenues from patent license and royalties fluctuate quarterly based on the timing of revenue recognition under our various agreements. License and royalty revenue for the first quarter of 2001 was down $9.7 million or 42% from the fourth quarter of 2000 primarily due to lower royalty revenues resulting from the overall weak market conditions for our entire market segment which resulted in lower royalty bearing sales by our licensees. We expect license and royalty revenues to be approximately $10.0 million in the second quarter of 2001. Gross Profits. In the first quarter of 2001, gross profits were negative $17.5 million, or negative 17% of total revenues compared to positive $41.6 million, or 38% of total revenues in first quarter of 2000. Product gross margin decreased to negative 35% of product revenues in the first quarter of 2001 from positive 30% in the first quarter of 2000 and positive 34% in the fourth quarter of 2000. The decrease included a $45.3 million inventory charge reflecting substantially lower market pricing, reduced demand for our products, and the write off of excess and obsolete inventory components. Excluding this inventory charge, our product gross margin was 17%. Our product 13 gross margins were also adversely affected by the significant decreases in average selling prices per unit and megabyte in the first quarter of 2001, which we expect to continue at least through the second quarter. Research and Development. Research and development expenses consist principally of salaries and payroll-related expenses for design and development engineers, prototype supplies and contract services. Research and development expenses were $16.4 million in the first quarter of 2001, up $7.6 million or 86% from $8.8 million in the first quarter of 2000. This increase was primarily due to increased salary and related expenses associated with additional personnel, increased project expenses to support the development of new generations of flash data storage products including the 512 megabit and 1 gigabit flash memory co-development with Toshiba, and increased depreciation and amortization expenses. Research and development expenses represented 16% of total revenues in the first quarter of 2001 compared to 8% in the first quarter of 2000. We expect our research and development expenses to continue to increase in future quarters to support the development and introduction of new generations of flash data storage products, including the joint venture with Toshiba and the development of advanced controller chips. Sales and Marketing. Sales and marketing expenses include salaries, sales commissions, benefits and travel expenses for our sales, marketing, customer service and applications engineering personnel. These expenses also include other selling and marketing expenses, such as independent manufacturer's representative commissions, advertising and tradeshow expenses. Sales and marketing expenses were $10.2 million in the first quarter of 2001, down $0.3 million or 3% from $10.5 million in the first quarter of 2000. This decrease was primarily due to decreased variable compensation and selling expenses related to reduced revenue levels, offset by increased salary and related expenses associated with additional personnel. Sales and marketing expenses represented approximately 10% of total revenues in the first quarters of 2001 and 2000. We expect sales and marketing expenses to continue to increase, as we continue to develop the retail channel and brand awareness for our products and as we increase our marketing activities for our Secure Digital Card products. General and Administrative. General and administrative expenses include the cost of our finance, information systems, human resources, stockholder relations, legal and administrative functions. General and administrative expenses were $4.3 million in the first quarter of 2001, down approximately 10% from $4.7 million in the first quarter of 2000. This decrease was primarily due to lower legal fees, offset by increased salary and related expenses associated with additional personnel. General and administrative expenses represented 4% of total revenues in the first quarters of 2001 and 2000. General and administrative expenses could increase substantially in the future if we continue to pursue litigation to defend our patent portfolio. In addition, we expect general and administrative expenses to continue to increase as our general and administrative functions grow to support our overall growth and our investments in infrastructure. Given the current market conditions, we have instituted strict expense control measures. These measures in the first quarter of 2001 included a reduction in our work force and cuts in discretionary spending. However, we are continuing to invest in research and development of advanced technologies and future products. Equity in Income of Joint Ventures. In the first quarter of 2001, equity in income of joint ventures of $634,000 included our share of interest income, net of expenses, from our FlashVision joint venture and expenses from our DigitalPortal joint venture. Interest Income. Interest income was $4.1 million in the first quarter of 2001 compared to $5.6 million in the first quarter of 2000. The decrease is a result of our lower cash and investment balances, as a result of investments in Tower and FlashVision, as well as cash used in operations. We expect interest income to decrease in the second quarter of 2001 as we continue to invest in the Tower foundry investment and DigitalPortal Inc and make internal capital acquisitions. Loss on Investment in Foundry. As discussed in footnote 9 of the financial statements included in this report, the market value of our investment in UMC has declined significantly. On January 3, 2000, the date we exchanged our USIC shares for UMC shares, our investment was worth $395.4 million. At that time, we recorded a pretax gain of $344.2 million on our original investment of $51.2 million. Due to the current weakness in the semiconductor industry, the value of our UMC shares declined to $215.8 million on March 31, 2001. The downturn in the semiconductor industry, and the economy in general, appears to be more severe than previously anticipated, and there is a great deal of uncertainty regarding when the semiconductor industry will recover from this down cycle. 14 Because of the continued downturn in the economy, we believe that the decline in the market value of our investment in UMC as of March 31, 2001, was other than temporary as defined by accounting principles generally accepted in the United States. In the first quarter of 2001, we recorded a loss in other income and expense on this other than temporary decline in value of $179.6 million, or $114.0 million after taxes. If the value of our UMC shares declines further, we may be required to record an additional loss. In addition, in future periods, we may recognize a gain or loss if we sell our UMC shares due to fluctuations in the market value of UMC's stock. Also included on this line is an loss on our investment in SmartDisk for $382,000, as its decline in value was also determined to be other than temporary. Other Income (Expenses), Net. Other expense, net was $1.8 million in the first quarter of 2001 compared to other income, net, of $434,000 in the first quarter of 2000. The expense in the first quarter was primarily due to foreign exchange losses on our Japanese Yen denominated assets. Provision for Income Taxes. In the first quarter of 2001, our blended effective tax rate benefit was 36.5%, compared to an effective tax rate expense of 36% in the first quarter of 2000. The larger benefit percentage was a result of the higher rate on the UMC investment loss. Liquidity and Capital Resources As of March 31, 2001, we had working capital of $488.1 million, which included $77.5 million in cash and cash equivalents and $229.0 million in short- term investments, excluding our investment in UMC. Operating activities used $24.3 million of cash in the first quarter of 2001 primarily due to the net loss and cash used by decreases in taxes payable and deferred revenues, which were partially offset by cash provided by a decline in accounts receivable of $33.6 million and inventory of $12.9 million. Net cash used in investing activities in the first quarter of 2001 of $8.7 million included our additional investment in the FlashVision foundry joint venture of $15.0 million, our investment in Tower of $16.1 million, net of prepaid wafer credits of $14.9 million, and capital equipment purchases of $9.1 million, which were partially offset by net proceeds of short term investments of $31.5 million. In the first quarter of 2000, cash used by investing activities of $44.9 million was primarily due the net purchases of short term investments. In the first quarters of both 2001 and 2000, cash provided by financing activities was primarily due to the sale of common stock through our stock option and employee stock purchase plans. On January 3, 2000, the USIC foundry was merged into UMC. We had invested $51.2 million in USIC. In exchange for its USIC shares, we received 111 million UMC shares. These shares were valued at approximately $396 million at the time of the merger, resulting in a pretax gain of $344.2 million ($203.9 million after-tax) in the first quarter of 2000. Trading restrictions expired on one- half of the shares on July 3, 2000, and the remaining shares become available for sale over a two-year period beginning in January 2002. Due to the current weakness in the semiconductor industry, the value of our UMC shares declined to $215.8 million on March 31, 2001. The downturn in the semiconductor industry, and the economy in general, appears to be more severe than previously anticipated, and there is a great deal of uncertainty regarding when the semiconductor industry will recover from this down cycle. Because of the continued downturn in the economy, we believed that the decline in the market value of our investment in UMC as of March 31, 2001, was other than temporary as defined by accounting principles generally accepted in the United States. In the first quarter of 2001, we recorded a loss in other income and expense on this other than temporary decline in value of $179.6 million, or $114.0 million after taxes. This loss is included in other income and expense. If the value of our UMC shares declines further, we may be required to record an additional loss. In addition, in future periods, we may recognize a gain or loss if we sell our UMC shares due to fluctuations in the market value of UMC's stock. In January 2001, we invested the final $15 million of $150 million in cash in FlashVision LLC, our joint venture with Toshiba for the development and manufacture of 512 megabit and 1 gigabit flash memory chips and Secure Digital Card controllers. On January 26, 2001, we guaranteed $20 million in equipment lease lines to equip Toshiba's Dominion Semiconductor manufacturing clean room with advanced wafer processing equipment, and a total of $215 million will be guaranteed by us. We account for this investment under the equity method, and recorded equity in income of joint ventures of $894,000 in the first quarter of 2001, which included interest income, net of operating expenses. 15 On July 4, 2000, we entered into a share purchase agreement to make a $75 million investment in Tower Semiconductor, or Tower, in Israel, representing approximately 10% ownership of Tower. On January 26, 2001, Tower satisfied the closing conditions of the share purchase agreement, and we transferred the first $20.0 million of this investment from an escrow account to purchase 866,551 shares ordinary shares and obtain $8.8 million in pre-paid wafer credits. On March 1, 2001, we paid Tower $11.0 million upon its completion of milestone one, to purchase 366,690 ordinary shares and obtain $6.1 million prepaid wafer credits. Additional contributions will take the form of mandatory warrant exercises for ordinary shares at an exercise price of $30.00 per share if other milestones are met. The warrants will expire five years from the date of grant, and in the event the key milestones are not achieved, the exercise of these warrants will not be mandatory. We expect first wafer production to commence at the new fabrication facility in late 2002. On August 9, 2000, we entered into a joint venture, DigitalPortal Inc., or DPI, with Photo-Me International, or PMI, for the manufacture, installation, marketing and maintenance of self-service, digital photo printing labs, or kiosks, bearing the SanDisk brand name in locations in the U.S. and Canada. Under the agreement, we and PMI each own 50% of DPI and will each make an initial investment of $4.0 million and secure lease financing for the purchase of the kiosks. The total value of the lease financing will depend on the number of kiosks deployed by the joint venture. We estimate that, as part of this joint venture, we will guarantee equipment lease arrangements of approximately $40.0 million over the first two years of the agreement. PMI will manufacture the kiosks for the joint venture and will install and maintain the kiosks under contract with the joint venture. We expect the first kiosks to be deployed in pilot programs in select retail stores in the United States starting in the third quarter of 2001. We account for this investment under the equity method, and recorded a loss of $260,000 as equity in loss of joint venture in the first quarter of 2001. We may make additional investments, which could be substantial, in assembly and test manufacturing equipment or foundry capacity to support our business in the future. We believe our existing cash and cash equivalents and short-term investments along with the planned capital equipment lease arrangements currently in negotiation related to our FlashVision, L.L.C. and Digital Portal, Inc. joint ventures will be sufficient to meet our currently anticipated working capital, capital equipment expenditure and joint venture and Tower foundry investment requirements, for at least the next twelve months. Impact of Currency Exchange Rates A portion of our revenues are denominated in Japanese yen. We enter into foreign exchange forward contracts to hedge against changes in foreign currency exchange rates. Future exchange rate fluctuations could have a material adverse effect on our business, financial condition and results of operations. Factors That May Affect Future Results Our operating results may fluctuate significantly, which may adversely affect our stock price. Our quarterly and annual operating results have fluctuated significantly in the past and we expect that they will continue to fluctuate in the future. This fluctuation is a result of a variety of factors, including the following: . unpredictable demand for our products; . decline in the average selling prices of our products due to competitive pricing pressures; . seasonality in sales of our products; . excess capacity of flash memory from our competitors and our own new flash wafer capacity; . difficulty of forecasting and management of inventory levels; in particular, building a large inventory of unsold product due to non- cancelable contractual obligations to purchase materials such as flash wafers, controllers, printed circuit boards and discrete components; 16 . expenses related to obsolescence or devaluation of unsold inventory, or reserves necessary to protect us against future write-offs of such unsold inventory; . adverse changes in product and customer mix; . slower than anticipated market acceptance of new or enhanced versions of our products; . competing flash memory card standards which displace the standards used in our products; . changes in our distribution channels; . timing of license and royalty revenue; . fluctuations in product costs, particularly due to fluctuations in manufacturing yields and utilization; . availability of sufficient silicon wafer foundry capacity to meet customer demand; . shortages of components such as capacitors and printed circuit boards required for the manufacturing of our products; . significant yield losses which could affect our ability to fulfill customer orders and could increase our costs; . manufacturing flaws affecting the reliability, functionality or performance of our products which could increase our product costs, reduce demand for our products or require product recalls; . increased research and development expenses; . exchange rate fluctuations, particularly the U.S. dollar to Japanese yen exchange rate; . changes in general economic conditions, particularly in Japan and the European Union; . natural disasters affecting the countries in which we conduct our business, particularly Taiwan, Japan and the United States; Difficulty of estimating silicon wafer needs When we order silicon wafers from our foundries, we have to estimate the number of silicon wafers needed to fill product orders several months into the future. If we overestimate this number, we will build excess inventories, which could harm our gross margins and operating results. Bookings visibility declined significantly late in the fourth quarter of 2000, and remains low in 2001 due to the current economic uncertainty in our markets. On the other hand, if we underestimate the number of silicon wafers needed to fill product orders, we may be unable to obtain an adequate supply of wafers, which could harm our product revenues. Because our largest volume products, CompactFlash and MultiMediaCard, are sold into emerging consumer markets, it has been difficult to accurately forecast future sales. A substantial majority of our quarterly sales have historically been from orders received and fulfilled in the same quarter, which makes accurate forecasting very difficult. In addition, our product order backlog may fluctuate substantially from quarter to quarter. Anticipated growth in expense levels We significantly increased our expense levels in 2000 to support our growth. We may need to hire additional personnel or increase our operating expenses in 2001 to support our sales and marketing efforts and research and development activities, including our joint venture with Toshiba providing for the development of 512 megabit and 1 gigabit flash memory chips. We have significant fixed costs and we cannot readily reduce these expenses over the short term. If our revenues do not increase proportionately to our operating expenses, or if revenues decrease or do not meet expectations for a particular period, such as we are forecasting for the second quarter of 2001, our business, financial condition and results of operations will be harmed. Variability of average selling prices and gross margins Our product mix varies quarterly, which affects our overall average selling prices and gross margins. Our CompactFlash and MultiMediaCard products, which currently represent the majority of our product revenues, have 17 lower average selling prices and gross margins than our higher capacity FlashDisk and FlashDrive products. We believe that sales of CompactFlash and MultiMediaCard products will continue to represent a significant percentage of our product revenues as consumer applications, such as digital cameras and digital music players, become more popular. In fiscal 2000, average selling prices per megabyte decreased 22% compared to fiscal 1999, reflecting the Flash memory supply shortages that prevailed during the first nine months of the year, which helped to keep selling prices in 2000 more stable than in 1999. Due to recent increases in flash memory foundry capacity and the economic slow-down in the first quarter of 2001, we expect that the decline in our average selling prices in 2001 will be more severe than in 2000. We experienced a 13% decline in our average selling price per megabyte of memory shipped when comparing the first quarter of 2001 to the fourth quarter of 2000. If we cannot reduce our product manufacturing costs in 2001 to offset these reduced prices, our gross margins and net profitability will suffer. Variability of license fees and royalties Our intellectual property strategy consists of cross-licensing our patents to other manufacturers of flash products. Under these arrangements, we earn license fees and royalties on individually negotiated terms. The timing of revenue recognition from these payments is dependent on the terms of each contract and on the timing of product shipments by the third parties. Our income from patent licenses and royalties can fluctuate significantly from quarter to quarter. A substantial portion of this income comes from royalties based on the actual sales by our licensees. Given the current market outlook for 2001, sales of licensed flash products by our licensees may be substantially lower than the corresponding sales in recent quarters, which may cause a substantial drop in our royalty revenues. Because these revenues have higher gross margins than product revenues, gross margins and net income fluctuate significantly with changes in license and royalty revenues. Continuing declines in our average sales prices may result in declines in our gross margins. In 2000, the average price per megabyte shipped declined 22% compared to 1999, and we experienced a 13% decline when comparing the first quarter of 2001 to the fourth quarter of 2000. Flash data storage markets are intensely competitive and accordingly, price reductions for our products are necessary to meet consumer price points. Due to recent increases in flash memory foundry capacity and the worldwide economic slow-down in the first quarter of 2001, we expect that further price declines for our products in the next several quarters could be significant. If we cannot reduce our product manufacturing costs in 2001 to offset these reduced prices, our gross margins and net profitability will suffer. Our selling prices may be affected by excess capacity in the market for flash memory products. In the first nine months of 2000, industry-wide demand for flash memory products exceeded the available supply, driven by an explosion in the growth of cellular phones and the accelerating shift in consumer electronics from analog to digital devices. Flash memory suppliers, including SanDisk, responded to this strong demand by significantly increasing investments in new advanced flash memory production capacity. This has led to a significant increase in worldwide flash memory supply at a time when customer demand has decreased significantly, causing excess supply in the markets for our products and significant declines in average selling prices. If this situation continues throughout 2001, we expect that price declines for our products could be significant on an annualized basis. If we cannot reduce our product manufacturing costs in 2001 to offset these reduced prices, our gross margins and net profitability will suffer. Our business depends upon consumer products. In 2000, and the first quarter of 2001, we continued to receive more product revenue and ship more units of products for consumer electronics applications, principally digital cameras, compared to other applications. The consumer market is intensely competitive and is more price sensitive than our other target markets. In addition, we must spend more on marketing and promotion in consumer markets to establish brand name recognition and drive demand. A significant portion of our sales to the consumer electronics market is made through distributors and to retailers. Sales through these channels typically include rights to return unsold inventory. As a result, we do not recognize revenue until after the product has been sold through to the end user. If our distributors and retailers are 18 not successful in this market, there could be substantial product returns, which would harm our business, financial condition and results of operations. There is seasonality in our business. Sales of our products, in particular the sale of CompactFlash and MultiMediaCard products, in the consumer electronics market may be subject to seasonality. As a result, product sales may be impacted by seasonal purchasing patterns with higher sales generally occurring in the second half of each year. In addition, in the past we have experienced a decrease in orders in the first quarter from our Japanese OEM customers primarily because most customers in Japan operate on a fiscal year ending in March and prefer to delay purchases until the beginning of their next fiscal year. Although we did not experience seasonality in 2000, we cannot assure you that we will not experience seasonality in 2001 or future years. In transitioning to new processes and products, we face production and market acceptance risks. General Successive generations of our products have incorporated semiconductor devices with greater memory capacity per chip. Two important factors have enabled us to decrease the cost per megabyte of our flash data storage products: the development of higher capacity semiconductor devices and the implementation of smaller geometry manufacturing processes. A number of challenges exist in achieving a lower cost per megabyte, including: . lower yields often experienced in the early production of new semiconductor devices; . manufacturing flaws with new processes including manufacturing processes at our subcontractors which may be extremely complex; . problems with design and manufacturing of products that will incorporate these devices; and . production delays. Because our products are complex, we periodically experience significant delays in the development and volume production ramp up of our products. Similar delays could occur in the future and could harm our business, financial condition and results of operations. D2 flash technology We have developed new products based on D2 flash technology, a flash architecture designed to store two bits in each flash memory cell. High density flash memory, such as D2 flash, is a complex technology that requires strict manufacturing controls and effective test screens. Problems encountered in the shift to volume production for new flash products could impact both reliability and yields, and result in increased manufacturing costs and reduced product availability. We may not be able to manufacture future generations of our D2 products with yields sufficient to result in lower costs per megabyte. If we are unable to bring future generations of high density flash memory into full production as quickly as planned or if we experience unplanned yield or reliability problems, our revenues and gross margins will decline. Secure Digital Card products SanDisk, along with Matsushita and Toshiba, jointly developed and will promote the Secure Digital Card. The Secure Digital Card is an enhanced version of our MultiMediaCard that incorporates advanced security and copyright protection features required by the emerging markets for the electronic distribution of music, video and other copyrighted works. We began shipping our Secure Digital Card products in the first quarter of 2001, and expect to begin high-volume production in the first half of 2001. The Secure Digital Card incorporates a number of new features, including SDMI compliant security and copy protection, a mechanical write protect switch and a high data transfer rate. We have never before built products incorporating these features. Any problems or delays in establishing production capabilities or ramping up production volumes of our Secure Digital Card products could result in lost sales or increased manufacturing costs in 2001 and beyond. In addition, we cannot be sure that manufacturers of consumer electronic products will develop 19 new products that use the Secure Digital Card or that content providers such as music studios will agree to distribute their copyrighted content for storage on Secure Digital Cards. For example, in 2000 the major U.S. based content providers have had significant success in U.S. courts in their litigation with Napster.Com and MP3.Com, and this may have slowed down the widespread distribution of digital music on the internet. Although the Secure Digital Card is designed specifically to address the copy protection rights of the content providers, there can be no assurance that these content providers will find these measures sufficient or will agree to support them. Furthermore, there is no assurance that consumers will widely adopt Secure Digital Cards, as they only operate with copyrighted content. Conversely, broad acceptance of our Secure Digital Card by consumers may reduce demand for our MultiMediaCard and CompactFlash card products. See "--The success of our business depends on emerging markets and new products." We are transitioning our technology to NAND based products The transition to NAND based products is very complex, and requires good execution from our manufacturing, technology, quality, marketing, and customer support staffs. If the current soft market conditions continue through the second half of this year, or if we are unable for any reason to achieve customer acceptance of our card products built with these NAND flash chips, we will experience a significant increase in our inventory, as we are contractually obligated to purchase half of FlashVision's NAND wafer production output. This may result in write offs and have a material adverse effect on our business, results of operations and financial condition. Coincidentally, with our ramping up of NAND flash wafer production through the FlashVision joint venture, we began to reduce our purchases of NOR flash wafers from UMC, and are limiting our flash wafers production from three wafer fabs to one fab. At the same time, we began to increase our purchase of controller wafers from UMC. Despite the significantly reduced level of business at UMC, our business relationship with UMC remains good. However, if market conditions improve significantly, there can be no assurances that we will be able to contract for the same amount of capacity we have used in the past. We depend on third party foundries for silicon wafers. All of our products require silicon wafers. We rely on UMC in Taiwan and Toshiba in Yokkaichi, Japan to supply the majority of our silicon wafers. We depend on UMC to allocate a portion of its capacity to meet our needs, produce acceptable quality wafers with acceptable manufacturing yields and deliver our wafers on a timely basis at a competitive price. If UMC is unable to satisfy these requirements, our business, financial condition and operating results may suffer. Any disruption in supply from UMC due to natural disaster, power failure or other causes could significantly harm our business, financial condition and results of operations. Under the terms of our wafer supply agreements with UMC, we are obligated to provide a rolling forecast of anticipated purchase orders for the next six calendar months. Generally, the estimates for the first three months of each forecast are binding commitments. The estimates for the remaining months may only be changed by a certain percentage from the previous month's forecast. This limits our ability to react to fluctuations in demand for our products. For example, if customer demand falls below our forecast and we are unable to reschedule or cancel our wafer orders, we may end up with excess wafer inventories, which could result in higher operating expenses and reduced gross margins. Conversely, if customer demand exceeds our forecasts, we may be unable to obtain an adequate supply of wafers to fill customer orders, which could result in dissatisfied customers, lost sales and lower revenues. In addition, in February 2000, we entered into a capacity and reservation deposit agreement with UMC. To reserve additional foundry capacity under this agreement, we paid UMC a reservation deposit. This deposit will be refunded to us on a quarterly basis, over the agreement term, if we purchase the full wafer capacity reserved for us. We may forfeit part of our deposit if we are unable to utilize our reserved capacity within four quarters of the end of the agreement term. If we are unable to obtain scheduled quantities of wafers with acceptable price and yields from any foundry, our business, financial condition and results of operations could be harmed. Our investment in new flash memory wafer production may result in increased expenses and fluctuations in operating results. On June 30, 2000, we closed a transaction with Toshiba providing for the joint development and manufacture of 512 megabit and 1 gigabit flash memory chips and Secure Digital Card controllers. As a part of this transaction, 20 we and Toshiba formed and contributed initial funding to FlashVision LLC, a joint venture to equip and operate a silicon wafer manufacturing line at Dominion Semiconductor in Virginia. In January 2001, we invested the final $15 million of $150 million in cash. On January 26, 2001, we guaranteed $20 million in equipment lease lines to equip Toshiba's Dominion Semiconductor manufacturing clean room with advanced wafer processing equipment, and a total of $215 million will be guaranteed. We will use the new production capacity at Dominion to manufacture primarily NAND flash memory wafers with minimum lithographic feature size of 0.16 micron initially, moving to 0.13 micron in the future. Such minimum feature sizes are considered today to be among the most advanced for mass production of silicon wafers and have never been used for the high volume manufacture of flash memory chips. Therefore, it is difficult to predict how long it will take to equip and commence production at the new facility and achieve adequate yields, reliable operation, and economically attractive product costs based on our new designs. We have not operated our own wafer fabrication facility in the past and therefore we rely on Toshiba to address these challenges. With our investments in the Dominion facility, we are now exposed to the adverse financial impact of any delays or manufacturing problems associated with the wafer production line. Any problems or delays in commencing production at the new Dominion facility could adversely impact our operating results in 2001 and beyond. We expect to incur substantial start up expenses related to the hiring and training of manufacturing personnel, facilitizing the clean room and installing equipment. During the ramp-up period, currently expected to begin in the middle of 2001, equipment depreciation begins and line operating expenses increase substantially. While the wafer output is still relatively low, the cost of wafers from the Dominion facility is expected to be significantly higher than the cost of wafers from our other suppliers. This may negatively impact our overall product gross margins until flash wafer output from Dominion reaches an optimum level, which may never occur. Under our agreement with Toshiba, we are committed to purchase 50% of the output from the Dominion facility. We will incur startup costs and pay our share of ongoing operating activities even if we do not utilize our full share of the Dominion output. Should customer demand for NAND flash products be less than our available supply, we may suffer from reduced revenues and increased expenses, and increased inventory of unsold NAND flash wafers, which could adversely affect our operating results. We cannot assure you that we or Toshiba will be able to secure sufficient funding to support this manufacturing line. Furthermore, in order for us to sell NAND based CompactFlash, MultiMediaCards and Secure Digital Cards, we will have to develop new controllers, printed circuit boards and test algorithms because the architecture of NAND flash is significantly different from our current NOR flash designs. Any technical difficulties or delays in the development of these elements could prevent us from taking advantage of the available NAND output and could adversely affect our results of operations. On July 4, 2000, we entered into a share purchase agreement to make a $75 million investment in Tower Semiconductor, or Tower, in Israel, representing approximately 10% ownership of Tower. On January 26, 2001, Tower satisfied the closing conditions of the share purchase agreement, and we transferred the first $20 million of this investment from an escrow account to purchase 866,551 shares ordinary shares and obtain $8.8 million in pre-paid wafer credits. On March 1, 2001, we paid Tower $11 million upon its completion of milestone one, to purchase 366,690 ordinary shares and obtain $6.1 million prepaid wafer credits. Additional contributions will take the form of mandatory warrant exercises for ordinary shares at an exercise price of $30.00 per share if other milestones are met. The warrants will expire five years from the date of grant, and in the event the key milestones are not achieved, the exercise of these warrants will not be mandatory. We expect first wafer production to commence at the new fabrication facility in late 2002. The success of our business depends on emerging markets and new products. In order for demand for our products to grow, the markets for new products that use CompactFlash, the MultiMediaCard, and Secure Digital Card such as portable digital music players and smart phones, must develop and grow. If sales of these products do not grow, our revenues and profit margins could level off or decline. Because we sell our products for use in many new applications, it is difficult to forecast demand. During the third quarter of 2000, the U.S. Courts ruled against Napster.Com and MP3.Com in two cases involving unlicensed distribution of copyrighted digital music over the Internet. This action is being carefully studied by the original equipment manufacturers, or OEMs, who have been developing MP3 players using Flash memory cards such as our MultiMediaCards for storage of music. If these OEMs reduce their production of digital music players in response to these recent court decisions or other factors, demand for our products will decrease. In addition, we believe that 21 these OEMs may redesign their platforms to work with our Secure Digital Card, which we began shipping in the first quarter of 2001. Accordingly, we may experience a drop in demand from our MultiMediaCard customers before the new anticipated demand for our Secure Digital Card materializes. Secure Digital Card products As part of our June 2000 collaboration with Toshiba and Matsushita Electric Industrial Co. Ltd., we have jointly developed the Secure Digital Card, an enhanced version of our MultiMediaCard, which incorporates advanced security and copyright protection features required by the emerging markets for the electronic distribution of music, video and other copyrighted works. We began shipping our Secure Digital Card products in 32 and 64 megabyte capacities in the first quarter of 2001. The Secure Digital Card is slightly thicker and uses a different interface than our MultiMediaCard. Because of these differences, the Secure Digital Card will not work in current products that include a MultiMediaCard slot. In order for the market for our Secure Digital Card to develop, manufacturers of digital audio/video and portable computing products must include a Secure Digital Card compatible slot in their products and acquire a license to the security algorithms. If OEMs do not incorporate Secure Digital Card slots in their products or do not buy our Secure Digital Cards, our business, financial condition and results of operations may be harmed. In addition, consumers may postpone or altogether forego buying products that utilize our MultiMediaCard in anticipation of new products such as MP3 players and digital camcorders that will incorporate the Secure Digital Card. If this occurs, sales of our MultiMediaCard products may be harmed. The main competition for the Secure Digital Card is expected to come from the Sony Memory Stick. Sony has substantially greater financial and other resources than we do and extensive marketing and sales channels and brand recognition. We cannot assure you that our Secure Digital Card will be successful in the face of such competition. In addition, the market for portable digital music players is very new and it is uncertain how quickly consumer demand for these players will grow. If this market does not grow as quickly as anticipated or our customers are not successful in selling their portable digital music players to consumers, our revenues could be adversely affected. In addition, it is often the case with new consumer markets that after an initial period of new market formation and initial acceptance by early adopters, the market enters a period of slow growth as standards emerge and infrastructure develops. In the event that this occurs in the portable digital music player market or other emerging markets, sales of our products would be harmed. The success of our new product strategy will depend upon, among other things, the following: . our ability to successfully develop new products with higher memory capacities and enhanced features at a lower cost per megabyte; . the development of new applications or markets for our flash data storage products; . the adoption by the major content providers of the copy protection features offered by our Secure Digital Card products; . the extent to which prospective customers design our products into their products and successfully introduce their products; and . the extent to which our products or technologies become obsolete or noncompetitive due to products or technologies developed by others. 512 megabit and 1 gigabit flash memory card products On June 30, 2000, we closed a transaction with Toshiba providing for the joint development and manufacture of 512 megabit and 1 gigabit flash memory chips and Secure Digital Card controllers. As part of this venture, we and Toshiba plan to employ Toshiba's 0.16 micron and future 0.13 micron NAND flash integrated circuit manufacturing technology and SanDisk's multilevel cell flash and controller system technology. During the third quarter of 2000, we announced with Toshiba the completion of the joint development of the 512 Megabit NAND flash chip employing Toshiba's .16 micron manufacturing process technology. We expect cards employing the 512 megabit technology to be shipped in significant quantities in the second half of 2001, and cards employing the 1 gigabit technology to be shipped in 2002. The development of 512 megabit and 1 gigabit flash memory chips and Secure Digital Card controllers is expected to be complex and incorporates SanDisk and Toshiba technology that is still under development. We cannot assure you that we and Toshiba will successfully develop and bring into full 22 production with acceptable yields and reliability these new products or the underlying technology, or that any development or production ramp will be completed in a timely or cost-effective manner. If we are not successful in any of the above, our business, financial condition and results of operations could suffer. We may be unable to maintain market share. During periods of excess supply in the market for our flash memory products, such as we are experiencing in the first half of 2001, we may lose market share to competitors who aggressively lower their prices. Conversely, under conditions of tight flash memory supply, we may be unable to increase our production volumes at a sufficiently rapid rate so as to maintain our market share. Ultimately, our growth rate depends on our ability to obtain sufficient flash memory wafers and other components to meet demand. If we are unable to do so in a timely manner, we may lose market share to our competitors. Our international operations make us vulnerable to changing conditions and currency fluctuations. Political risks Currently, the majority of our flash memory wafers are produced by UMC in Taiwan. We also use a third-party subcontractor in Taiwan for the assembly and testing of our MultiMediaCard products. We may therefore be affected by the political, economic and military conditions in Taiwan. Taiwan is currently engaged in various political disputes with China and in the past both countries have conducted military exercises in or near the other's territorial waters and airspace. The Taiwanese and Chinese governments may escalate these disputes, resulting in an economic embargo, a disruption in shipping routes or even military hostilities. This could harm our business by interrupting or delaying the production or shipment of flash memory wafers or MultiMediaCard products by our Taiwanese foundries and subcontractor. See "-- We depend on our suppliers and third party subcontractors." We use a third-party subcontractor in China for the assembly and testing of our CompactFlash products. As a result, our business could be harmed by the effect of political, economic, legal and other uncertainties in China. Under its current leadership, the Chinese government has been pursuing economic reform policies, including the encouragement of foreign trade and investment and greater economic decentralization. The Chinese government may not continue to pursue these policies and, even if it does continue, these policies may not be successful. The Chinese government may also significantly alter these policies from time to time. In addition, China does not currently have a comprehensive and highly developed legal system, particularly with respect to the protection of intellectual property rights. As a result, enforcement of existing and future laws and contracts is uncertain, and the implementation and interpretation of such laws may be inconsistent. Such inconsistency could lead to piracy and degradation of our intellectual property protection. Although we do not believe the current political unrest in Israel represents a major security problem for Tower since Migdal Haemek, Israel is in a secure geographic location, the unrest may expand and even if it remains at current levels, could cause scheduling delays. We cannot assure you that the Tower facility will be completed or will begin production as scheduled, or that the processes needed to fabricate our wafers will be qualified at the new facility. Moreover, we cannot assure you that this new facility will be able to achieve acceptable yields or deliver sufficient quantities of wafers on a timely basis at a competitive price. In addition, while the political unrest has not yet posed a direct security risk to our engineering design center in Israel, it may cause unforeseen delays in the development of our products. Economic risks We price our products primarily in U.S. dollars. Given the recent economic conditions in Asia and the European Union and the weakness of the Euro, Yen and other currencies relative to the United States dollar, our products may be relatively more expensive in these regions, which could result in a decrease in our sales. While most of our sales are denominated in U.S. Dollars, we invoice certain Japanese customers in Japanese Yen and are subject to exchange rate fluctuations on these transactions which could harm our business, financial condition and results of operations. General risks 23 Our international business activities could also be limited or disrupted by any of the following factors: . the need to comply with foreign government regulation; . general geopolitical risks such as political and economic instability, potential hostilities and changes in diplomatic and trade relationships; . natural disasters affecting the countries in which we conduct our business, such as the earthquake experienced in Taiwan in 1999; . imposition of regulatory requirements, tariffs, import and export restrictions and other barriers and restrictions, particularly in China; . longer payment cycles and greater difficulty in accounts receivable collection, particularly as we increase our sales through the retail distribution channel, and general business conditions deteriorate; . Adverse tax rules and regulations; . weak protection of our intellectual property rights; and . delays in product shipments due to local customs restrictions. We depend on our suppliers and third party subcontractors. We rely on our vendors, some of which are sole source suppliers, for several of our critical components. We do not have long-term supply agreements with some of these vendors. Our business, financial condition and operating results could be significantly harmed by delays or reductions in shipments if we are unable to develop alternative sources or obtain sufficient quantities of these components. For example, we rely on UMC for the majority of our flash memory wafers. NEC has traditionally supplied 100% of certain designs of our microcontrollers. During the second quarter, we expect to commence production of other controller designs at UMC. We also rely on third-party subcontractors for a substantial portion of wafer testing, packaged memory final testing, card assembly and card testing, including Silicon Precision Industries Co., Ltd. in Taiwan, Celestica, Inc. in China, and Amkor, in the Philippines. These three subcontractors will also be assembling and testing a majority of our mature, high-volume products. We began transferring portions of our testing and assembly operations to these subcontractors in the second half of 1999 and are still continuing this transition. We will continue operations at our Sunnyvale production facility for new products and special customer requirements. However, we do not have sufficient duplicative production testing equipment at Sunnyvale and at our subcontractors. Any problems in this complex transition may result in a disruption of production and a shortage of product to meet customer demand. We have no long-term contracts with these subcontractors and cannot directly control product delivery schedules. Any significant problems that occur at our subcontractors, or their failure to perform at the level we expect could lead to product shortages or quality assurance problems, which could increase the manufacturing costs of our products and have adverse effects on our operating results. Furthermore, we are moving to turnkey manufacturing with some of our subcontract suppliers, which may reduce our visibility and control of their inventories of purchased parts necessary to build our products. Our markets are highly competitive. Flash memory manufacturers and memory card assemblers We compete in an industry characterized by intense competition, rapid technological changes, evolving industry standards, declining average selling prices and rapid product obsolescence. Our competitors include many large domestic and international companies that have greater access to advanced wafer foundry capacity, substantially greater financial, technical, marketing and other resources, broader product lines and longer standing relationships with customers. 24 Our primary competitors include companies that develop and manufacture storage flash chips, such as Hitachi, Samsung, Micron Technology and Toshiba. In addition, we compete with companies that manufacture other forms of flash memory and companies that purchase flash memory components and assemble memory cards. Companies that manufacture socket flash, linear flash and components include Advanced Micro Devices, Atmel, Intel, Macronix, Mitsubishi, Fujitsu, Sharp Electronics and ST Microelectronics. Companies that combine controllers and flash memory chips developed by others into flash storage cards include Lexar Media, M-Systems, Pretec, Simple Technology, Sony Corporation, Kingston Technology, Panasonic, Silicon Storage Technology, TDK Corporation, Matsushita Battery, Delkin Devices, Inc., Feiya Technology Corporation, Dane-Elec Manufacturing, Silicon Tek, Infineon Technologies and Viking Components. In addition, many companies have been certified by the CompactFlash Association to manufacture and sell their own brand of CompactFlash. We believe additional manufacturers will enter the CompactFlash market in the future. We have announced an agreement with Matsushita and Toshiba to jointly develop and promote a next generation flash memory card called the Secure Digital Card. Under this agreement, Secure Digital Card royalty-bearing licenses will be granted to other flash memory card manufacturers, which will increase the competition for our Secure Digital Card, CompactFlash and MultiMediaCard products. In addition, Matsushita and Toshiba have commenced selling Secure Digital Cards that will compete directly with our products. While other flash card manufacturers will be required to pay the SD Association license fees and royalties which will be shared between Matsushita, Toshiba and SanDisk, there will be no royalties or license fees payable among the three companies for their respective sales of the Secure Digital Card. Thus, we will forfeit potential royalty income from Secure Digital Card sales by Matsushita and Toshiba. In addition, we and Toshiba will each separately market and sell any 512 megabit and 1 gigabit flash memory chips and Secure Digital Card controllers developed and manufactured under our relationship. Accordingly, we will compete directly with Toshiba for sales of these advanced chips and controllers. We have entered into patent cross-license agreements with several of our leading competitors including Hitachi, Lexar, Samsung, Toshiba, Intel, SST, Sharp, SmartDisk and TDK. Under these agreements, each party may manufacture and sell products that incorporate technology covered by the other party's patents related to flash memory devices. As we continue to license our patents to certain of our competitors, competition will increase and may harm our business, financial condition and results of operations. Currently, we are engaged in licensing discussions with several of our competitors. There can be no assurance that we will be successful in concluding licensing agreements under terms which are favorable to us. Alternative storage media Competing products have been introduced that promote industry standards that are different from our CompactFlash and MultiMediaCard products including Toshiba's SmartMedia, Sony Corporation's Memory Stick, Sony's standard floppy disk used for digital storage in its Mavica digital cameras, Panasonic's Mega Storage cards, Iomega's Clik drive, a miniaturized, mechanical, removable disk drive, M-Systems' Diskonchip for embedded storage applications and the Secure MultiMediaCard from Hitachi and Infineon. Each competing standard is mechanically and electronically incompatible with CompactFlash and MultiMediaCard. If a manufacturer of digital cameras or other consumer electronic devices designs in one of these alternative competing standards, CompactFlash or MultiMediaCard will be eliminated from use in that product. IBM's microdrive, a rotating disk drive in a Type II CompactFlash format competes directly with our Type II CompactFlash memory cards for use in high-end professional digital cameras. M-Systems' Diskonchip 2000 Millennium product competes against our Flash ChipSet products in embedded storage applications such as set top boxes and networking appliances. According to independent industry analysts, Sony's Mavica digital camera captured a considerable portion of the U.S. market for digital cameras from 1998 to 2000. The Mavica uses a standard floppy disk to store digital images and therefore uses no CompactFlash, or any other flash cards. Our sales prospects for CompactFlash cards have been adversely impacted by the success of the Mavica. Recently, Sony has shifted its focus to the use of its flash Memory Stick in its latest digital camera models. 25 Our MultiMediaCard products also have faced significant competition from Toshiba's SmartMedia flash cards and we expect to face similarly significant competition from Sony's Memory Stick. Sony has licensed its proprietary Memory Stick to other companies. If it is adopted and achieves widespread use in future products, sales of our MultiMediaCard and CompactFlash products may decline. Recently, Hitachi, Infineon, Sanyo and Fujitsu have proposed their Secure MultiMediaCard which provides the copy protection function that is included in our Secure Digital Card. Should this initiative gain industry wide acceptance, it may reduce the widespread adoption of the Secure Digital Card. In the first quarter of 2000, Sanyo announced that it is developing a miniature magneto-optical storage device for use in future digital cameras, music players and camcorders. There can be no assurance that this device will not be adopted by some of our OEM customers. Alternative flash technologies We also face competition from products based on multilevel cell flash technology from Intel and Hitachi. These products compete with our D2 multilevel cell flash technology. Multilevel cell flash is a technological innovation that allows each flash memory cell to store two bits of information instead of the traditional single bit stored by the industry standard flash technology. Furthermore, we expect to face competition from existing competitors and from other companies that may enter our existing or future markets that have similar or alternative data storage solutions which may be less costly or provide additional features. For example, Infineon has formed a joint venture with Saifun, an Israeli startup company, to develop a proprietary flash memory technology which will be targeted at low cost data storage applications. Price is an important competitive factor in the market for consumer products. Increased price competition could lower gross margins if our average selling prices decrease faster than our costs and could also result in lost sales. Sales to a small number of customers represent a significant portion of our revenues. Approximately one-half of our revenues came from a small number of customers in fiscal 2000 and 1999. For example, sales to our top 10 customers accounted for approximately 64% of our product revenues in the first quarter of 2001, and 52% in the first quarter of 2000. In the first quarter of 2001, sales to one customer exceeded 10% of product sales, and there were two customers that each represented more than 10% of product sales in the first quarter of 2000. If we were to lose one of our major customers or experience any material reduction in orders from any of these customers, our revenues and operating results would suffer. Our sales are generally made by standard purchase orders rather than long-term contracts. In addition, the composition of our major customer base changes from year to year as the market demand for our customers' products changes. Our multiple sales channels may compete for a limited number of customer sales. Web based sales of our products today represent a small but growing portion of our overall sales. Sales on the Internet tend to undercut traditional distribution channels and may dramatically change the way our consumer products are purchased in future years. We cannot assure you that we will successfully develop the Internet sales channel or successfully manage the inherent conflict between the Internet and our traditional sales channels. We must achieve acceptable wafer manufacturing yields. The fabrication of our products requires wafers to be produced in a highly controlled and ultra clean environment. Semiconductor companies that supply our wafers sometimes have experienced problems achieving acceptable wafer manufacturing yields. Semiconductor manufacturing yields are a function of both our design technology and the foundry's manufacturing process technology. Low yields may result from design errors or manufacturing failures. Yield problems may not be determined or improved until an actual product is made and can be tested. As a result, yield problems may not be identified until the wafers are well into the production process. The risks associated with yields are even greater because we rely exclusively on independent offshore foundries for our wafers which increases the effort and time required to identify, communicate and resolve manufacturing yield 26 problems. If the foundries cannot achieve planned yields, we will experience higher costs and reduced product availability, which could harm our business, financial condition and results of operations. In addition, we cannot assure you that the Dominion fabrication facility we are co-developing with Toshiba, will produce satisfactory quantities of wafers with acceptable prices, reliability and yields. Any failure in this regard could materially harm our business, financial condition and results of operations. In addition, the construction and operation of this line will cause us to incur significant expense and may result in the diversion of resources from other important areas of our business. In addition, we have no experience in operating a wafer manufacturing line and we intend to rely on the existing manufacturing organization at the Dominion facility. This organization will be trained in NAND flash manufacturing by Toshiba, but we cannot assure you that they will be successful in manufacturing these advanced NAND flash products on a cost- effective basis or at all. Risks associated with patents, proprietary rights and related litigation. General We rely on a combination of patents, trademarks, copyright and trade secret laws, confidentiality procedures and licensing arrangements to protect our intellectual property rights. In the past, we have been involved in significant disputes regarding our intellectual property rights and claims that we may be infringing third parties' intellectual property rights. We expect that we may be involved in similar disputes in the future. We cannot assure you that: . any of our existing patents will not be invalidated; . patents will be issued for any of our pending applications; . any claims allowed from existing or pending patents will have sufficient scope or strength; . our patents will be issued in the primary countries where our products are sold in order to protect our rights and potential commercial advantage; or . any of our products may infringe on the patents of other companies. In addition, our competitors may be able to design their products around our patents. We intend to vigorously enforce our patents but we cannot be sure that our efforts will be successful. If we were to have an adverse result in any litigation, we could be required to pay substantial damages, cease the manufacture, use and sale of infringing products, expend significant resources to develop non-infringing technology, discontinue the use of certain processes or obtain licenses to the infringing technology. Any litigation is likely to result in significant expense to us, as well as divert the efforts of our technical and management personnel. For example, our recent Litigation with Lexar lasted for two and one-half years and resulted in cumulative litigation expenses of approximately $6.0 million. Cross-licenses and indemnification obligations If we decide to incorporate third party technology into our products or if we are found to infringe on others' intellectual property, we could be required to license intellectual property from a third party. We may also need to license some of our intellectual property to others in order to enable us to obtain cross-licenses to third party patents. Currently, we have patent cross-license agreements with several companies, including Hitachi, Intel, Lexar, Samsung, Sharp, SST, SmartDisk, TDK and Toshiba and we are in discussions with other companies regarding potential cross-license agreements. We cannot be certain that licenses will be offered when we need them, or that the terms offered will be acceptable. If we do obtain licenses from third parties, we may be required to pay license fees or royalty payments. In addition, if we are unable to obtain a license that is necessary to the manufacture of our products, we could be required to suspend the manufacture of products or stop our wafer suppliers from using processes that may infringe the rights of third parties. We cannot assure you that we would be successful in redesigning our products or that the necessary licenses will be available under reasonable terms. 27 We have historically agreed to indemnify various suppliers and customers for alleged patent infringement. The scope of such indemnity varies, but may, in some instances, include indemnification for damages and expenses, including attorney's fees. We may periodically engage in litigation as a result of these indemnification obligations. We are not currently engaged in any such indemnification proceedings. Our insurance policies exclude coverage for third party claims for patent infringement. Any future obligation to indemnify our customers or suppliers could harm our business, financial condition or results of operations. Litigation risks associated with our intellectual property From time to time, it may be necessary to initiate litigation against third parties to preserve our intellectual property rights. These parties could in turn bring suit against us. On March 21, 2000, Mitsubishi Denki Co. Ltd. (Mitsubishi Electric) filed a complaint in Tokyo District Court against SanDisk K.K., our wholly owned subsidiary in Japan. The complaint alleges that SanDisk K.K., based in Yokohama, Japan, infringes on three Mitsubishi Japanese patents. The Mitsubishi patents in question are #JP2099342, #JP2129071 and #JP2138047, which are related primarily to the mechanical construction of memory cards. In the complaint, Mitsubishi asked the court for a preliminary injunction halting the sale of SanDisk CompactFlash and flash ATA memory cards in Japan. Mitsubishi has since dropped patents #JP2129071 and #JP2138047 from the suit. We and SanDisk K.K. are vigorously defending against Mitsubishi's remaining claims. Our rapid growth may strain our operations. We have experienced rapid growth, which has placed a significant strain on our personnel and other resources. To accommodate future growth, we must continue to hire, train, motivate and manage our employees. We have experienced difficulty hiring the necessary engineering, sales and marketing personnel to support our growth. In addition, we must make a significant investment in our existing internal information management systems to support increased manufacturing, as well as accounting and other management related functions. Our systems, procedures and controls may not be adequate to support rapid growth, which could in turn harm our business, financial condition and results of operations. California energy crisis In recent months, California has been experiencing a shortage of energy supply. This shortage is expected to continue throughout 2001 and possibly into future years. Although the majority of our product assembly and testing is done outside of California, we may experience some hardship due to rolling blackouts and the need for reduced power consumption, as well as increased power costs. Our success depends on key personnel, including our executive officers, the loss of whom could disrupt our business. Our success greatly depends on the continued contributions of our senior management and other key research and development, sales, marketing and operations personnel, including Dr. Eli Harari, our founder, President and Chief Executive Officer. Our success will also depend on our ability to recruit additional highly skilled personnel. We cannot assure you that we will be successful in hiring or retaining such key personnel, or that any of our key personnel will remain employed with us. Anti-takeover provisions in our charter documents, stockholder rights plan and in Delaware law could prevent or delay a change in control and, as a result, negatively impact our stockholders. We have taken a number of actions that could have the effect of discouraging a takeover attempt. For example, we have adopted a stockholder rights plan that would cause substantial dilution to a stockholder, and substantially increase the cost paid by a stockholder, who attempts to acquire us on terms not approved by our board of directors. This could prevent us from being acquired. In addition, our certificate of incorporation grants the board of directors the authority to fix the rights, preferences and privileges of and issue up to 4,000,000 shares of preferred stock without stockholder action. Although we have no present intention to issue shares of preferred stock, such an issuance could have the effect of making it more difficult and less attractive for a third party to acquire a majority of our outstanding voting stock. Preferred stock may also have other rights, including economic rights senior to our 28 common stock that could have a material adverse effect on the market value of our common stock. In addition, we are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law. This section provides that a corporation shall not engage in any business combination with any interested stockholder during the three-year period following the time that such stockholder becomes an interested stockholder. This provision could have the effect of delaying or preventing a change of control of SanDisk. Our stock price has been, and may continue to be, volatile. The market price of our stock has fluctuated significantly in the past and is likely to continue to fluctuate in the future. For example, in the 12 months ending March 31, 2001 our stock price fluctuated significantly from a low of $18.63 to a high of $126.50. We believe that such fluctuations will continue as a result of future announcements concerning us, our competitors or principal customers regarding technological innovations, new product introductions, governmental regulations, litigation or changes in earnings estimates by analysts. In addition, in recent years the stock market has experienced significant price and volume fluctuations and the market prices of the securities of high technology companies have been especially volatile, often for reasons outside the control of the particular companies. These fluctuations as well as general economic, political and market conditions may have an adverse affect on the market price of our common stock. Item 3. Quantitative and Qualitative Disclosures About Market Risk Please refer to the Company's Form 10-K for the year ended December 31, 2000. 29 PART II. OTHER INFORMATION Item 1. Legal Proceedings The information required by this item is set forth in Note 6 of the Notes to the Condensed Consolidated Financial Statements on pages 7 to 8 and under "Factors That May Affect Future Results - Risks Associated with Patents, Proprietary Rights and Related Litigation" on pages 26 to 27 of this report, and is incorporated herein by reference. Item 2. Changes in Securities None Item 3. Defaults upon Senior Securities None Item 4. Submission of Matters to a Vote of Security Holders None Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K A. Exhibits Exhibit Number Exhibit Title ------ ------------- 3.1 Certificate of Incorporation of the Registrant, as amended to date.(2),(13) 3.2 Form of Amended and Restated Certificate of Incorporation of the Registrant.(2) 3.3 Bylaws of the Registrant, as amended.(2) 3.4 Form of Amended and Restated Bylaws of the Registrant.(2) 3.5 Certificate of Designation for the Series A Junior Participating Preferred Stock, as filed with the Delaware Secretary of State on April 24, 1997.(4) 4.1 Reference is made to Exhibits 3.1, 3.2, 3.3 and 3.4.(2) 4.3 Amended and Restated Registration Rights Agreement, among the Registrant and the investors and founders named therein, dated March 3, 1995.(2) 4.5 Series F Preferred Stock Purchase Agreement between Seagate Technology, Inc. and the Registrant dated January 15, 1993.(2) 4.8 Rights Agreement, dated as of April 18, 1997, between the Company and Harris Trust and Savings Bank.(4) 4.9 First Amendment to Rights Agreement dated October 22, 1999, between Harris Trust and the Registrant.(11) 9.1 Amended and Restated Voting Agreement, among the Registrant and the investors named therein, dated March 3, 1995.(2) 10.10 License Agreement between the Registrant and Dr. Eli Harari, dated September 6, 1988.(2) 10.13 1989 Stock Benefit Plan.(2) 10.15 Employee Stock Purchase Plan.(2) 10.16 1995 Non-Employee Directors Stock Option Plan.(2) 10.18 Lease Agreement between the Registrant and G.F. Properties, dated March 1, 1996.(3) 10.21 Amendment to Lease Agreement between the Registrant and G.F. Properties, dated April 3, 1997.(5) 10.23 Foundry Venture Agreement between the Registrant and United Microelectronics Corporation, dated June 27, 1997.(1),(6) 10.24 Written Assurances Re: Foundry Venture Agreement between the Registrant and United 30 Exhibit Number Exhibit Title ------ ------------- Microelectronics Corporation, dated September 13, 1995.(1), (6) 10.25 Side Letter between Registrant and United Microelectronics Corporation, dated May 28, 1997.(1), (6) 10.27 Clarification letter with regards to Foundry Venture Agreement between the Registrant and United Microelectronics Corporation dated October 24, 1997.(7) 10.28 Lease Agreement between the Registrant and G.F. Properties, dated June 10, 1998.(8) 10.29 Trade Finance Agreement between the Registrant and Union Bank of California, dated July 15, 1998.(9) 10.30 1995 Stock Option Plan Amended and Restated as of December 17, 1998.(12) 10.31 1995 Non-Employee Directors Stock Option Plan Amended and Restated as of December 17, 1998.(12) 10.32 1995 Employee Stock Purchase Plan Amended and Restated as of December 17, 1998. (12) 10.33 Master Agreement, dated as of May 9, 2000, by and among the Registrant, Toshiba Corporation and Semiconductor North America, Inc.(13),(+) 10.34 Operating Agreement dated as of May 9, 2000, by and between the Registrant and Semiconductor North America, Inc.(13) 10.35 Common R&D and Participation Agreement, dated as of May 9, 2000, by and between the Registrant and Toshiba Corporation.(13),(+) 10.36 Product Development Agreement, dated as of May 9, 2000, by and between the Registrant and Toshiba Corporation.(13),(+) 10.37 Share Purchase Agreement, dated as of July 4, 2000, by and between the Registrant and Tower Semiconductor Ltd.(14) 10.38 Escrow Agreement, dated as of August 14, 2000, by and between the Registrant, Tower Semiconductor Ltd. and Union bank of California, N.A.(14) 10.39 Additional Purchase Obligation Agreement, dated as of July 4, 2000, by and between the Registrant and Tower Semiconductor Ltd.(14) 10.40 Shareholders Agreement, dated as of July 4, 2000, by and between the Registrant and the Israel Corporation.(14) 10.41 Definitive Agreement to Form Vending Business, dated August 7, 2000, by and between the Registrant and Photo-Me International, Plc.(14),(+) 10.42 Non-Solicitation Agreement, dated August 7, 2000, by and between the Registrant, DigitalPortal Inc. and Photo-Me International, Plc.(14),(+) 10.43 Exclusive Product Purchase Agreement, dated as of August 7, 2000, by and between Photo-Me, International Plc., and DigitalPortal Inc. (14),(+) 10.44 Stockholders' Agreement, dated as of August 7, 2000, by and among the Registrant, DigitalPortal Inc. and Photo-Me, International, Plc.(14),(+) 10.45 Bylaws of DigitalPortal Inc.(14),(+) 10.46 Registration Rights Agreement, dated as of January 18, 2001, by and between Registrant, The Israel Corporation, Alliance Semiconductor Ltd., Macronix International Co., Ltd. and Quick Logic Corporation (15) 10.47 Consolidated Shareholders Agreement, dated as of January 18, 2001, by and among Registrant, The Israel Corporation, Alliance Semiconductor Ltd. And Macronix International Co., Ltd. (15) 10.48 Appendix 1 to FlashVision L.L.C. 2000 lease financing agreement between FlashVision L.L.C. Corporation to ABN AMRO Bank N.V. (16), (++) 10.49 Master Lease agreement between FlashVision L.L.C. Corporation to ABN AMRO Bank N.V. (16), (++) 10.50 Guarantee, dated as of December 27, 2000 from SanDisk Corporation to ABN AMRO Bank N.V., related to FlashVision L.L.C. 2000 lease financing. (16), (++) 21.1 Subsidiaries of the Registrant. (10) ______________ * Filed herewith. 31 + Confidential treatment has been granted for certain portions thereof. ++ Confidential treatment has been requested for certain portions thereof. 1. Confidential treatment granted as to certain portions of these exhibits. 2. Previously filed as an Exhibit to the Registrant's Registration Statement on Form S-1 (No. 33-96298). 3. Previously filed as an Exhibit to the Registrant's 1995 Annual Report on Form 10-K. 4. Previously filed as an Exhibit to the Registrant's Current Report on Form 8-K/A dated April 18, 1997. 5. Previously filed as an Exhibit to the Registrant's Form 10-Q for the quarter ended June 30, 1997. 6. Previously filed as an Exhibit to the Registrant's Current Report on form 8-K dated October 16, 1997. 7. Previously filed as an Exhibit to the Registrant's Form 10-Q for the quarter ended September 30, 1997. 8. Previously filed as an Exhibit to the Registrant's Form 10-Q for the quarter ended June 30, 1998. 9. Previously filed as an Exhibit to the Registrant's Form 10-Q for the quarter ended September 30, 1998. 10. Previously filed as an Exhibit to the Registrant's Annual Report on Form 10-K. 11. Previously filed as an Exhibit to the Registrant's Current Report on Form 8-K dated January 1, 1999. 12. Previously filed as an Exhibit to the Registrant's Form 10-Q for the quarter ended March 31, 1999. 13. Previously filed as an Exhibit to the Registrant's Form 10-Q for the quarter ended June 30, 2000. 14. Previously filed as an Exhibit to the Registrant's Form 10-Q for the quarter ended September 30, 2000. 15. Previously filed as an Exhibit to the Registrant's Schedule 13(d) dated January 26, 2001. 16. Previously filed as an Exhibit to the Registrant's 2000 Annual Report on Form 10-K. B. Reports on Form 8-K None 32 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. SANDISK CORPORATION (Registrant) Dated: May 8, 2001 By: /s/ Frank Calderoni ---------------------------------------- Frank A. Calderoni Senior Vice President, Finance and Administration and Chief Financial Officer (On behalf of the Registrant and as Principal Financial Officer.) 33 -----END PRIVACY-ENHANCED MESSAGE-----