10-Q 1 ovt10q3q02c.txt OMNIVISION TECHNOLOGY 3Q02 FORM 10-Q =============================================================================== SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q --------- [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the quarterly period ended January 31, 2002 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the transition period from to ------------ ------------ Commission file number: 0-29939 --------- OMNIVISION TECHNOLOGIES, INC. (Exact name of registrant as specified in its charter) Delaware 77-0401990 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification Number) 930 Thompson Place, Sunnyvale, CA 94085 (Address of Principal Executive Offices) (Zip Code) Registrant's telephone number, including area code: (408) 733-3030 --------- 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 and Exchange Act of 1934 during the preceding 12 months (or for 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 [ ] At March 12, 2002, 22,243,313 shares of common stock of the Registrant were outstanding. ===============================================================================
OMNIVISION TECHNOLOGIES, INC. INDEX Page No. --- PART I. FINANCIAL INFORMATION Item 1. Financial Statements: Condensed Consolidated Balance Sheets - January 31, 2002 and April 30, 2001................................................ 3 Condensed Consolidated Statements of Operations - Three and Nine Months Ended January 31, 2002 and 2001................... 4 Condensed Consolidated Statements of Cash Flows - Nine Months Ended January 31, 2002 and 2001............................... 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 6. Exhibits and Reports on Form 8-K.................................. 30 Signatures................................................................ 31
2 PART I - FINANCIAL INFORMATION ITEM 1: FINANCIAL STATEMENTS OMNIVISION TECHNOLOGIES, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands) (unaudited)
January 31, April 30, 2002 2001 ---- ---- ASSETS Current assets: Cash and cash equivalents........................ $ 52,568 $ 51,053 Short-term investments........................... 3,000 3,000 Accounts receivable, net......................... 8,939 5,269 Inventories...................................... 4,776 11,445 Refundable and deferred income taxes............. 3,324 3,288 Prepaid expenses and other assets................ 514 219 ---------- ---------- Total current assets........................... 73,121 74,274 Property, plant and equipment, net................. 5,064 4,080 Other non-current assets........................... 291 293 ---------- ---------- Total assets................................... $ 78,476 $ 78,647 ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable................................. $ 4,541 $ 4,284 Accrued expenses and other liabilities........... 3,313 2,255 Deferred revenue................................. 1,032 832 ---------- ---------- Total current liabilities...................... 8,886 7,371 ---------- ---------- Commitments and Contingencies (Note 8) Stockholders' equity: Common stock, $0.001 par value; 100,000 shares authorized; 22,239 and 22,000 shares issued and outstanding................................ 22 22 Additional paid-in capital....................... 95,245 94,531 Deferred compensation related to stock options... (577) (1,058) Accumulated deficit.............................. (25,100) (22,219) ---------- ---------- Total stockholders' equity..................... 69,590 71,276 ---------- ---------- Total liabilities and stockholders' equity..... $ 78,476 $ 78,647 ========== ==========
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements. 3 OMNIVISION TECHNOLOGIES, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts) (unaudited)
Three Months Ended Nine Months Ended ----------------------- ----------------------- January 31, January 31, January 31, January 31, 2002 2001 2002 2001 ---- ---- ---- ---- Revenues........................ $ 9,973 $ 8,110 $ 33,399 $ 44,314 Cost of revenues*............... 5,732 23,774 19,456 49,018 -------- -------- -------- -------- Gross profit (loss)............. 4,241 (15,664) 13,943 (4,704) -------- -------- -------- -------- Operating expenses: Research and development*..... 1,851 1,376 5,337 4,020 Selling, general and administrative*............. 2,205 1,649 8,828 4,073 Stock compensation charge*.... 107 293 432 802 Litigation settlement......... -- -- 3,500 -- -------- -------- -------- -------- Total operating expenses.... 4,163 3,318 18,097 8,895 -------- -------- -------- -------- Income (loss) from operations... 78 (18,982) (4,154) (13,599) Interest income (expense), net.. 252 888 1,273 2,015 -------- -------- -------- -------- Income (loss) before income taxes......................... 330 (18,094) (2,881) (11,584) Income tax benefit.............. -- (2,474) -- -- -------- -------- -------- -------- Net income (loss)............... $ 330 $(15,620) $ (2,881) $(11,584) ======== ======== ======== ======== Net income (loss) per share: Basic......................... $ 0.02 $ (0.73) $ (0.13) $ (0.74) ======== ======== ======== ======== Diluted....................... $ 0.01 $ (0.73) $ (0.13) $ (0.74) ======== ======== ======== ======== Shares used in computing net income (loss) per share: Basic......................... 21,936 21,414 21,801 15,634 ======== ======== ======== ======== Diluted....................... 24,605 21,414 21,801 15,634 ======== ======== ======== ======== (*) Stock-based compensation charges included in: Cost of revenues............ $ 4 $ (33) $ 21 $ 43 ======== ======== ======== ======== Operating expenses: Research and development.. $ 54 $ 182 $ 181 $ 503 Selling, general and administrative.......... 53 111 251 299 -------- -------- -------- -------- $ 107 $ 293 $ 432 $ 802 ======== ======== ======== ========
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements. 4 OMNIVISION TECHNOLOGIES, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited)
Nine Months Ended ----------------------- January 31, January 31, 2002 2001 ---- ---- Cash flows from operating activities: Net loss............................................... $ (2,881) $ (11,584) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization........................ 574 440 Allowance for doubtful accounts and sales returns...... (49) 391 Amortization of deferred compensation.................. 453 845 Changes in assets and liabilities: Accounts receivable.................................. (3,621) 2,352 Inventories.......................................... 6,669 (3,315) Refundable and deferred income taxes................. (36) -- Prepaid expenses and other assets.................... (293) (3,467) Accounts payable..................................... 257 (3,819) Accrued expenses and other liabilities............... 158 90 Deferred revenue..................................... 200 135 -------- -------- Net cash provided by (used in) operating activities 1,431 (17,932) -------- -------- Cash flows from investing activities: Purchase of short-term investments..................... -- (3,021) Purchases of property, plant and equipment............. (1,558) (555) -------- -------- Net cash used in investing activities.............. (1,558) (3,576) -------- -------- Cash flows from financing activities: Deposit received....................................... 900 -- Proceeds from issuance of common stock, net............ 746 67,997 Payment for repurchase of common stock, net............ (4) (20) -------- -------- Net cash provided by financing activities.......... 1,642 67,977 -------- -------- Net increase in cash and cash equivalents................ 1,515 46,469 Cash and cash equivalents at beginning of period......... 51,053 5,888 -------- -------- Cash and cash equivalents at end of period............... $ 52,568 $ 52,357 ======== ======== Supplemental cash flow information: Interest paid.......................................... $ -- $ 36 ======== ======== Taxes paid............................................. $ 36 $ 3,483 ======== ======== Supplemental non-cash investing and financial information: Conversion of redeemable convertible preferred stock to common stock......................................... $ -- $ 21,082 ======== ========
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements. 5 OMNIVISION TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS For the Nine Months Ended January 31, 2002 and 2001 (unaudited) Note 1 - Basis of Presentation ------------------------------ The accompanying unaudited condensed consolidated financial statements as of January 31, 2002 and April 30, 2001 and for the three and nine months ended January 31, 2002 and 2001 have been prepared by OmniVision Technologies, Inc. and subsidiaries (the "Company" or "OmniVision") in accordance with the rules and regulations of the Securities and Exchange Commission. The amounts as of April 30, 2001 have been derived from our annual audited financial statements. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted in accordance with such rules and regulations. In the opinion of management, the accompanying unaudited financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial position of the Company and its results of operations and cash flows. These financial statements should be read in conjunction with the annual audited financial statements and notes as of and for the year ended April 30, 2001, included in the Company's Annual Report on Form 10-K. The results of operations for the three and nine months ended January 31, 2002 are not necessarily indicative of the results that may be expected for the year ending April 30, 2002 or any other future interim period, and the Company makes no representations related thereto. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Note 2 - Revenue Recognition ---------------------------- The Company recognizes revenue upon the shipment of its products to the customer provided that the Company has received a signed purchase order, the price is fixed, title has transferred, collection of resulting receivables is considered probable, product returns are reasonably estimable, there are no customer acceptance requirements and there are no remaining significant obligations. For certain shipments to distributors under agreements allowing for return or credits, revenue is deferred until the distributor resells the product. The Company provides for future returns based on historical experiences at the time revenue is recognized. Note 3 - Short-term Investments ------------------------------- The Company's short-term investments, which are classified as available- for-sale, are invested in high-grade corporate securities and government bonds maturing approximately twelve months or less from the date of purchase. These investments are reported at fair value. Unrealized gains or losses are recorded in stockholders' equity and included in other comprehensive income (losses). Unrealized gains or losses were not significant during any period covered. 6 OMNIVISION TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued) For the Nine Months Ended January 31, 2002 and 2001 (unaudited) Note 4 - Balance Sheet Accounts (In Thousands) ----------------------------------------------
January 31, April 30, 2002 2001 ---- ---- Cash and cash equivalents: Cash............................................... $ 6,519 $ 1,918 Money market funds................................. 5,382 3,563 Commercial paper................................... 40,667 45,572 --------- --------- $ 52,568 $ 51,053 ========= ========= Short-term investments: Corporate notes.................................... $ 3,000 $ 3,000 --------- --------- $ 3,000 $ 3,000 ========= ========= Inventories: Work in progress................................... $ 1,816 $ 3,752 Finished goods..................................... 2,960 7,693 --------- --------- $ 4,776 $ 11,445 ========= =========
Note 5 - Net Income (Loss) Per Share ------------------------------------ The following table sets forth the computation of basic and diluted income (loss) per share attributable to common stockholders for the period indicated (in thousands, except per share data):
Three Months Ended Nine Months Ended ----------------------- ----------------------- January 31, January 31, January 31, January 31, 2002 2001 2002 2001 ---- ---- ---- ---- Numerator: Net income (loss)............. $ 330 $(15,620) $ (2,881) $(11,584) ======== ======== ======== ======== Denominator: Weighted average shares....... 22,188 21,954 22,118 16,345 Weighted average unvested common stock subject to repurchase.................. (252) (540) (317) (711) -------- -------- -------- -------- Denominator for basic net income (loss) per share..... 21,936 21,414 21,801 15,634 Effect of dilutive securities: Common stock options........ 2,417 -- -- -- Unvested common stock subject to repurchase..... 252 -- -- -- Convertible preferred stock. -- -- -- -- -------- -------- -------- -------- Denominator for dilutive net income (loss) per share....... 24,605 21,414 21,801 15,634 ======== ======== ======== ======== Basic net income (loss) per share......................... $ 0.02 $ (0.73) $ (0.13) $ (0.74) ======== ======== ======== ======== Diluted net income (loss) per share......................... $ 0.01 $ (0.73) $ (0.13) $ (0.74) ======== ======== ======== ========
Note 6 - Equity --------------- In July 2000, the Company completed its initial public offering of 5,000,000 shares of common stock at $13.00 per share. Net proceeds aggregated approximately $59.2 million after paying the underwriters' fee and related expenses. At the closing of the offering, all issued and outstanding shares of the Company's preferred stock were converted into an aggregate of 12,305,001 shares of common stock. In August 2000, the underwriters of the Company's initial public offering exercised their over-allotment option to purchase an additional 750,000 shares of common stock at $13.00 per share. Net proceeds aggregated approximately $8.5 million after paying the underwriters' fee and related expenses. 7 OMNIVISION TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued) For the Nine Months Ended January 31, 2002 and 2001 (unaudited) Note 7 - Segment and Geographic Information ------------------------------------------- The Company identifies its operating segments based on business activities, management responsibility and geographic location. For all periods presented, the Company operated in a single business segment. The Company sells its products primarily in the United States and to the Asia Pacific region. Revenues by geographic locations based on the country or region of the customer were as follows (in thousands):
Three Months Ended Nine Months Ended ----------------------- ----------------------- January 31, January 31, January 31, January 31, 2002 2001 2002 2001 ---- ---- ---- ---- United States............ $ 342 $ 2,430 $ 10,605 $ 6,368 Taiwan................... 3,877 645 8,284 12,831 Hong Kong................ 2,908 753 7,232 3,825 Japan.................... 732 2,043 2,720 4,688 Korea.................... 1,054 593 2,111 4,520 Singapore................ 266 355 598 7,755 China.................... 199 644 293 1,910 All other................ 595 647 1,556 2,417 -------- -------- -------- -------- $ 9,973 $ 8,110 $ 33,399 $ 44,314 ======== ======== ======== ========
Note 8 - Commitments and Contingencies -------------------------------------- In December 2000, the Company formed a subsidiary to conduct design and testing operations in Shanghai, the People's Republic of China. The registered capital of this company is $12.0 million, of which $3.8 million was funded by the Company in the fiscal year ended April 30, 2001, as required. The Company funded an additional $1.0 million during the nine months ended January 31, 2002. The Company is further obligated to fund the remaining $7.2 million of registered capital by December 2003. As of January 31, 2002, $3.2 million of the $4.8 million funded to date was paid for land use rights and to building contractors in partial payment for the construction of the facility, $1.2 million was deposited in a bank account in China and $0.4 million was expended for general purposes. The formation and operation of the company in China requires a large initial capital investment. Also there may be significant administrative, legal and governmental barriers in China, which may prevent the Company's ability to begin operation of the subsidiary and prevent the Company from using the funds outside of China. From time to time, the Company has been subject to legal proceedings and claims with respect to such matters as patents, product liabilities and other actions arising out of the normal course of business. On November 29, 2001, a complaint captioned McKee v. OmniVision Technologies, Inc., et. al., Civil Action No. 01 CV 10775, was filed in the United States District Court for the Southern District of New York against the Company, some of its directors and officers, and various underwriters for its initial public offering. Plaintiffs generally allege that the named defendants violated federal securities laws because the prospectus related to the Company's offering failed to disclose, and contained false and misleading statements regarding, certain commissions purported to have been received by the underwriters, and other purported underwriter practices in connection with their allocation of shares in the Company's offering. Substantially similar actions have been filed concerning the initial public offerings for more than 300 different issuers, and the cases have been coordinated as In re Initial Public Offering Securities Litigation, 21 MC 92. The complaint against the Company seeks unspecified damages on behalf of a purported class of purchasers of its common stock between July 14, 2000 and December 6, 2000. 8 OMNIVISION TECHNOLOGIES, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - (Continued) For the Nine Months Ended January 31, 2002 and 2001 (unaudited) In March 2000, the Company received a letter from Koninklijke Philips N.V. in which Philips claimed to have patent rights in a serial bus system for data transmission, known as the I2C bus system. Although the Company does not believe any of its products infringe any Philips patent, the Company had discussed possible royalty or licensing arrangements as a means of business resolution. In the meantime, the Company has completed implementation of a new serial bus system for its products. The Company has entered into an agreement with Photobit Corporation ("Photobit") and the California Institute of Technology ("CalTech"), effective September 18, 2001, to settle all litigation that the Company had with Photobit and CalTech, including an action in the U.S. District Court, Northern District of California, Case No. C 00 3791 PJH, and an investigation before the U.S. International Trade Commission ("ITC"), Inv. No. 337-TA-451. Both actions involved patents alleged to pertain to its CMOS image sensor products, such as those used in digital cameras, PC cameras and other optical applications. The action pending in California was dismissed on September 24, 2001, and final termination of the ITC investigation occurred on November 9, 2001. The confidential settlement includes non-exclusive cross-licenses for seven years under the Company's and Photobit's respective patent portfolios, including patents and applications licensed by CalTech to Photobit. The Company has also made a one-time payment to Photobit of $3.5 million dollars. The settlement agreement referred to in the above paragraph relates only to claims made by Photobit and CalTech. It is possible that other companies might pursue litigation with respect to any claims such companies purport to have against the Company. The results of any litigation are inherently uncertain. In the event of an adverse result in any litigation with respect to intellectual property rights relevant to the Company's products that could arise in the future, the Company could be required to obtain licenses to the infringing technology, pay substantial damages under applicable law, including treble damages if the Company is held to have willfully infringed, cease the manufacture, use and sale of infringing products or to expend significant resources to develop non-infringing technology. Litigation frequently involves substantial expenditures and can require significant management attention, even if the Company ultimately prevails. 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934 which involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward- looking statements as a result of certain factors that include, but are not limited to, the risks discussed in "Factors Affecting Future Results". These forward-looking statements include, but are not limited to: the statements relating to the development of new products in new and existing markets, the expansion of the range of picture resolutions offered in our products, the development of new products which require only three volts for portable applications, the improvement of image quality, the integration of additional functions and the continued improvement to the interface chip in the third paragraph under "Overview;" the statements relating to the generation of revenues from five-volt and three-volt products in the remainder of fiscal year 2002 in the fourth paragraph under "Overview;" the statements relating to technology leadership and increase in research and development expenses in the seventh paragraph under "Overview;" the statements regarding the administrative, legal and governmental barriers in China in the last paragraph under "Overview," the statements regarding factors which may continue to affect gross margins in the future under "Gross Profit;" the statements regarding the potential fluctuations and expected increases of research and development costs under "Research and Development;" the statements regarding decreases in selling, general and administrative expenses under "Selling, General and Administrative;" the statements regarding the size of and amortization of compensation charges under "Stock Compensation Charge;" the statements regarding cash resources available to meet capital requirements, the factors affecting capital requirements and the raising and availability of additional funds and investment in the sixth paragraph under "Liquidity and Capital Resources;" and the statements regarding evaluation of acquisitions in the seventh paragraph under "Liquidity and Capital Resources," the statements under "Part II Other Information - Item 1. Legal Proceedings," and the statements under "Part II Other Information - Item 2. Changes in Securities and Use of Proceeds," among others. These forward-looking statements are based on current expectations and entail various risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Such risks and uncertainties are set forth below under "Factors Affecting Future Results." Overview -------- We design, develop and market high performance, high quality, highly integrated and cost efficient semiconductor image sensor devices. Our image sensors are used in a variety of electronic cameras and camera related products for both still picture and live video applications. Our image sensors are used in cameras and camera related products such as personal computer cameras, digital still cameras, closed circuit TV's, mobile phone cameras and personal digital assistant cameras, security and surveillance cameras, and cameras for automobiles and toys. Our image sensors are designed to use the complementary metal oxide semiconductor, or CMOS, fabrication process. Our single chip image sensors can allow our customers to build cameras that are smaller, require fewer chips, consume less power and cost less to build than cameras using traditional charged couple device, or CCD, technology, or multiple chip CMOS image sensors. Unlike competitive image sensors, which require multiple chips to achieve the same functions, we are able to integrate nearly all camera functions into a single chip. This leads us to believe that we supply one of the most highly integrated single chip CMOS image sensor solutions. We sell our products worldwide through a direct sales force and indirectly through distributors and manufacturers' representatives. Our image sensors are sold to camera manufacturers who market camera products under their own brand. We also sell to large manufacturing companies that produce camera products for others to market under different brand names. Image sensors are characterized by several important attributes such as picture resolution, color, lens size, voltage requirements and type of video output. We intend to continue developing new products aimed at new and existing markets. We plan to expand the range of picture resolutions we offer, provide additional products that require only three volts for portable applications and further improve image quality and integrate additional functions into our image sensor. In addition, we developed and market an interface chip that connects a camera to the universal serial bus on personal computers, and we plan to continue to make improvements to that product as well. 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) Our first image sensor was a low resolution, black and white sensor introduced in 1996. We introduced an improved version of this sensor in early 1997. In addition, we introduced color and digital image sensors in 1997 and have introduced higher resolution and higher quality image sensors in each subsequent year. For the year ended April 30, 2001, or Fiscal Year 2001, and the three and nine months ended January 31, 2002, the majority of our revenues were generated from sales of our five-volt color image sensors. Given the growth of the Internet and multimedia applications which allow for digital images to be captured, stored and transported, we expect that a significant portion of our revenues in the remainder of the year ended April 30, 2002, or Fiscal Year 2002, will be generated from our five volt color image sensors, which are used primarily in affordable and easy to use personal computer and security cameras, and increasingly from 3.2 volt color image sensors which are used in both personal computer cameras and cellular phone accessories. We outsource all of our semiconductor manufacturing and assembly. This approach allows us to focus our resources on the design, development and marketing of our products and significantly reduces our capital requirements. We outsource our wafer manufacturing to Taiwan Semiconductor Manufacturing Company, or TSMC, and Powerchip Semiconductor Company, or PSC. A majority of our unit sales of image sensors for the three and nine months ended January 31, 2002 are color image sensors. These require a color filter to be applied to the wafer before packaging. We outsource the application of this color filter to Toppan Printing Co., or Toppan, and TSMC. We outsource the packaging of our image sensors to Kyocera Corporation, or Kyocera, and Alphatec Semiconductor Packaging Co., or Alphatec. Outside testing services do not offer suitable tests for the key parameter of product performance and image quality. Therefore, we design and produce our own automatic testing equipment specifically for image sensor testing, and we do substantially all of our testing in house. Our control over the testing process helps us maintain consistent product quality and identify areas to improve product quality and reduce costs. Sales of our image sensors are subject to seasonality. Some of the products using our image sensors such as personal computer video cameras and digital still cameras are consumer electronics goods. Typically, these goods are subject to seasonality with generally increased consumer sales in November and December due to the holidays. As a result, product sales are impacted by seasonal purchasing patterns with higher sales generally occurring in the second half of the calendar year. In addition, we typically experience a decrease in orders in the quarter ended January 31 from our Chinese and Taiwanese customers primarily due to the Chinese New Year. We intend to maintain our technology leadership by continuing to develop our core technology through our in house research and development efforts. As a result, we expect that our future research and development expenses will increase in absolute dollars and may increase as a percentage of revenues as we design and develop our next generation of image sensor products. In December 2000, we formed a subsidiary to conduct design and testing operations in Shanghai, the People's Republic of China. The registered capital of this company is $12.0 million, of which $3.8 million was funded by us in the fiscal year ended April 30, 2001, as required by Chinese law. We funded an additional $1.0 million during the nine months ended January 31, 2002. We are further obligated to fund the remaining $7.2 million of registered capital by December 2003. As of January 31, 2002, $3.2 million of the $4.8 million funded to date was paid for land use rights and to building contractors in partial payment for the construction of the facility, $1.2 million was deposited in a bank account in China and $0.4 million was expended for general purposes. The formation and operation of the company in China requires a large initial capital investment. Also there may be significant administrative, legal and governmental barriers in China, which may prevent our ability to begin operation of the subsidiary and prevent us from using the funds outside of China. 11 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) Results of Operations --------------------- The following table sets forth the results of our operations as a percentage of revenues. Our historical operating results are not necessarily indicative of the results for any future period.
Three Months Ended Nine Months Ended ----------------------- ----------------------- January 31, January 31, January 31, January 31, 2002 2001 2002 2001 ---- ---- ---- ---- Revenues......................... 100.0% 100.0% 100.0% 100.0% Cost of revenues................. 57.5 293.2 58.2 110.6 ------ ------ ------ ------ Gross profit (loss)............ 42.5 (193.2) 41.8 (10.6) ------ ------ ------ ------ Operating expenses: Research and development....... 18.6 17.0 16.0 9.1 Selling, general and administrative............... 22.1 20.3 26.4 9.2 Stock compensation charge...... 1.0 3.6 1.3 1.8 Litigation settlement.......... -- -- 10.5 -- ------ ------ ------ ------ Total operating expenses..... 41.7 40.9 54.2 20.1 ------ ------ ------ ------ Income (loss) from operations.... 0.8 (234.1) (12.4) (30.7) Interest income (expense), net... 2.5 11.0 3.8 4.6 ------ ------ ------ ------ Income (loss) before income taxes 3.3 (223.1) (8.6) (26.1) Income tax benefit............... -- (30.5) -- -- ------ ------ ------ ------ Net income (loss)................ 3.3% (192.6)% (8.6)% (26.1)% ====== ====== ====== ======
Three and Nine Months Ended January 31, 2002 as Compared to Three and Nine Months Ended January 31, 2001 Revenues -------- We derive revenues from the sale of our standard image sensor array products and other companion circuits for use in a variety of applications. Revenues for the three months ended January 31, 2002 increased 23% to approximately $10.0 million from $8.1 million for the three months ended January 31, 2001. Revenues for the nine months ended January 31, 2002 decreased 25% to approximately $33.4 million from $44.3 million for the nine months ended January 31, 2001. The increase in revenues during the three months ended January 31, 2002 was primarily due to increased demand by our contract manufacturing customers located in Asia which are engaged in the manufacturing of digital still cameras. Revenues also benefited during the three months ended January 31, 2002 from the continued slow recovery in personal computer, or PC, camera manufacturing market which accounted for 33% of revenues as compared to 32% of revenues in the similar prior year period, partially offset by a decline in cell phone camera revenues from the year ago levels. The decrease in revenues during the nine months ended January 31, 2002 was due to a decrease in the number of PC camera unit sales, primarily caused by reduced demand and excess customer inventory build-up that occurred during the October through November 2000 time frame resulting from the general economic slowdown, partially offset by improved security camera revenues. Domestic and international revenues for the three months ended January 31, 2002 were $0.3 million and $9.7 million, respectively, as compared to $2.4 million and $5.7 million, respectively, for the three months ended January 31, 2001, representing a shift from the year ago quarter in our revenue by geographic region from domestic to Asia-Pacific manufacturers. Domestic and international revenues for the nine months ended January 31, 2002 were $10.6 million and $22.8 million, respectively, as compared to approximately $6.4 million and $37.9 million, respectively, for the nine months ended January 31, 2001. For the three months ended January 31, 2002, no single original equipment manufacturing customer accounted for 10% or more of revenues. Our two largest distributors during the three months ended January 31, 2002 were World Peace Industrial Co. Ltd., or World Peace, headquartered in Taiwan, which accounted for 22.7% of revenues, and SEC Development Co. Ltd., or SEC, headquartered in Hong Kong, which accounted for 11.6% of revenues. For the nine months ended January 31, 2002, one of our security camera manufacturer customers, X10 Wireless Technology, Inc., or X10, represented 27.8% of revenues, and World Peace accounted for approximately 15.6% of revenues. For the three months ended January 31, 2001, X10 represented approximately 21.5% of revenues and one of 12 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) our cellular telephone manufacturer customers, Teksel Co., Ltd., or Teksel, who distributes our products to Kyocera, accounted for approximately 20.9% of revenues. For the nine months ended January 31, 2001, one of our distributors, World Peace, represented approximately 17.6% of revenues and one of our camera manufacturer customers, Creative Technologies Ltd., or Creative, accounted for approximately 17.4% of revenues. Gross Profit (Loss) ------------------ Gross margins for the three months ended January 31, 2002 and 2001 were 42.5% and (193.2)% of revenues, respectively. Gross margins for the nine months ended January 31, 2002 and 2001 were 41.8% and (10.6)% of revenues, respectively. The increase in gross margin for the three months ended January 31, 2002 was primarily due to favorable product mix and improved yields on certain products. Gross margins during the three months ended January 31, 2002 also included an approximately $1.3 million one-time benefit from the sale of inventory that was previously written off in the three months ended January 31, 2001. During the quarter ended January 31, 2001, we recognized an $18.1 million charge for excess inventory. Excluding the benefit of previously written-off inventory and the inventory write-down, the gross margin was 35.1% of revenues for the quarter ended January 31, 2002 as compared to 29.9% of revenues in the corresponding quarter of the previous fiscal year. Excluding the benefit of previously written-off inventory, the adjusted gross margin was 34.7% of revenues for the nine months ended January 31, 2002 as compared to 31.5% of revenues in the corresponding period of the previous fiscal year. The increase in gross margins on an adjusted basis for the three and nine months ended January 31, 2002 was due to favorable changes in product mix and yield improvements. These factors may continue to influence gross margin in the future. Research and Development ------------------------ Research and development expenses for the three months ended January 31, 2002 and 2001 were approximately $1.9 million and $1.4 million, respectively. Research and development expenses for the nine months ended January 31, 2002 and 2001 were approximately $5.3 million and $4.0 million, respectively. As a percentage of revenues, research and development expenses for the three months ended January 31, 2002 and 2001 represented 18.6% and 17.0%, respectively. As a percentage of revenues, research and development expenses for the nine months ended January 31, 2002 and 2001 represented 16.0% and 9.1%, respectively. Research and development expenses increased as a percentage of revenues during the three months ended January 31, 2002 due to the increased research and development expenses to improve our current product line and support new product introductions. Research and development expenses increased as a percentage of revenues during the nine months ended January 31, 2002 due to the increase in research and development expenses on an absolute dollar basis and the decline in revenues for the nine months ended January 31, 2002, as compared to the nine months ended January 31, 2001. Our research and development expenses increased for the three and nine months ended January 31, 2002 by approximately $0.5 million and $1.3 million, respectively, from the three and nine months ended January 31, 2001 due to an increase in salaries, payroll related expenses associated with additional personnel and contracted costs associated with new product development. Research and development expenses consist primarily of compensation and personnel related expenses and costs for purchased materials, designs and tooling, depreciation of computers and workstations, and amortization of computer aided design software, all of which may fluctuate significantly from period to period as a result of our product development cycles. We expect that our future research and development expenses will increase in absolute dollars and may increase as a percentage of revenues as we design and develop our next generation of image sensor products. Selling, General and Administrative ----------------------------------- Selling, general and administrative expenses for the three months ended January 31, 2002 and 2001 were approximately $2.2 million and $1.6 million, respectively. Selling, general and administrative expenses for the nine months ended January 31, 2002 and January 31, 2001 were approximately $8.8 million and $4.1 million, respectively. The increase in selling, general and administrative expenses of approximately $0.6 million for the three months ended 13 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) January 31, 2002 from the same period in the prior year was principally due to salaries and payroll related expenses associated with additional personnel, and commissions paid to distributors and manufacturers' representatives. The increase in selling, general and administrative expenses of approximately $4.8 million for the nine months ended January 31, 2002 was principally due to an increase in salaries and payroll related expenses associated with additional personnel, and increased litigation expense associated with patent litigation, partially offset by a decrease in commissions paid to distributors and manufacturers' representatives. As a percentage of revenues, selling, general and administrative expenses for the three months ended January 31, 2002 and 2001 represented 22.1% and 20.3%, respectively. As a percentage of revenues, selling, general and administrative expenses for the nine months ended January 31, 2002 and January 31, 2001 represented 26.4% and 9.2%, respectively. Selling, general and administrative expenses increased as a percentage of revenues for the nine months ended January 31, 2002 from the nine months ended January 31, 2001 as a result primarily of the increase in legal expenses associated with patent litigation combined with the decline in revenues. As a result of our recent settlement of certain intellectual property claims, we expect that our future selling, general and administrative expenses may decrease in absolute dollars and are likely to decrease as a percentage of revenues. Stock Compensation Charge ------------------------- We incurred stock compensation charges of approximately $0.1 million and $0.3 million for the three months ended January 31, 2002 and 2001, respectively. We incurred stock compensation charges of approximately 0.5 million and $0.8 million for the nine months ended January 31, 2002 and 2001, respectively. Deferred compensation represents the difference between the deemed fair market value of our common stock on the date of grant and the exercise price of stock options to purchase our common stock on the date of grant, and it is amortized on an accelerated basis as the stock options vest. We expect deferred compensation charges of approximately $0.6 million as of January 31, 2002 to be amortized on an accelerated basis over the vesting period of the stock options of generally five years. Stock Option Exchange Program ----------------------------- On November 1, 2001, we announced a voluntary stock option exchange program for our employees. Under the program, our employees were given the opportunity to elect to cancel outstanding stock options held by them in exchange for an equal number of new options to be granted at a future date, scheduled to be June 5, 2002. These elections were required to be made by December 3, 2001 and included all options granted during the prior six months. The exercise price of the new options will be equal to the closing price of our common stock on June 4, 2002. The exchange program is not available to our executives, directors or any of our employees who live or work outside the United States. On December 4, 2001, 49,400 options were returned and cancelled. We did not record any associated compensation expenses. Litigation Settlement --------------------- We did not incur any litigation settlement expenses for the three months ended January 31, 2002 and 2001. Litigation settlement expenses for the nine months ended January 31, 2002 and 2001 were $3.5 million and zero, respectively. The increase in litigation settlement expenses of $3.5 million for the nine months ended January 31, 2001 from the same period in the prior year was due to a one-time payment of $3.5 million to Photobit Corporation, or Photobit, to settle all pending litigation that we had with Photobit and California Institute of Technology, or CalTech. As a percentage of revenues, litigation settlement expenses for the three months ended January 31, 2002 and 2001 each represented zero, respectively. As a percentage of revenues, litigation settlement expenses for the nine months ended January 31, 2002 and 2001 represented 10.5% and zero, respectively. 14 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) Interest Income (Expense), Net ------------------------------ Interest income and interest expense, net for the three months ended January 31, 2002 and 2001 were income of approximately $0.3 million and $0.9 million, respectively. Interest income and interest expense, net for the nine months ended January 31, 2002 and 2001 were income of approximately $1.3 million and $2.0 million respectively. Interest income and interest expense, net, decreased for the three and nine months ended January 31, 2002 primarily due to a decline in interest rates and a decline in the amount of funds invested from the net proceeds from our initial public offering. These funds are invested in interest-bearing accounts consisting primarily of high-grade corporate securities and government bonds maturing approximately twelve months or less from the date of purchase. Provision for Income Taxes -------------------------- We recorded approximately $0.3 million in income before income taxes and an $18.1 million loss before income taxes for the three months ended January 31, 2002 and 2001, respectively. We recorded a loss before income taxes of approximately $2.9 million and $11.6 million for the nine months ended January 31, 2002 and 2001, respectively. We had no provision for income taxes for the three and nine months ended January 31, 2002, respectively. During the three months ended January 31, 2001, we recorded an income tax benefit amounting to approximately $2.5 million due to the net taxable loss during this quarter which reversed the previous year-to-date income tax provisions and resulted in no provision for income taxes for the nine months ended January 31, 2001. Recent Accounting Pronouncements -------------------------------- In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 141 ("SFAS No. 141"), "Business Combinations." SFAS 141 requires the purchase method of accounting for business combinations initiated after June 30, 2001 and eliminates the pooling-of-interests method. We believe that the adoption of SFAS 141 will not have a significant impact on our consolidated financial statements. In June 2001, the FASB issued SFAS 142, "Goodwill and Other Intangible Assets", which is effective for fiscal years beginning after December 15, 2001. SFAS 142 requires, among other things, the discontinuance of goodwill amortization. In addition, the standard includes provisions upon adoption for the reclassification of certain existing recognized intangibles as goodwill, reassessment of the useful lives of existing recognized intangibles, reclassification of certain intangibles out of previously reported goodwill and the testing for impairment of existing goodwill and other intangibles. We are currently assessing but have not yet determined the impact of SFAS 142 on our financial position and results of operations. In August 2001, the FASB issued SFAS 143, "Accounting for Obligations Associated with the Retirement of Long-Lived Assets." The objectives of SFAS 143 are to establish accounting standards for the recognition and measurement of an asset retirement obligation and its associated asset retirement cost. SFAS 143 will be effective for financial statements issued for fiscal years beginning after June 15, 2002. We believe that the adoption of SFAS 143 will not have any material impact on our consolidated financial statements. In October 2001, the FASB issued SFAS 144, "Accounting for the Impairment or Disposal of Long-Lived Assets," which is effective for fiscal years beginning after December 15, 2001. SFAS 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This statement supersedes SFAS 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of." It establishes a single accounting method, based on the framework established in SFAS 121, for long-lived assets to be disposed of by sale. We are currently assessing, but have not yet determined the impact of SFAS 144 on our financial position and results of operations. 15 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) Liquidity and Capital Resources ------------------------------- Since inception, we have financed our growth through sales of common stock and private sales of equity securities, totaling approximately $90.1 million. Principal sources of liquidity at January 31, 2002 consisted of cash, cash equivalents and short-term investments of $55.6 million. Our working capital decreased by approximately $2.7 million to $64.2 million as of January 31, 2002 from $66.9 million as of April 30, 2001. The decrease was attributable to a $6.7 million decrease in inventories and $1.1 million increase in accrued expenses and other liabilities, which were partially offset by a $3.7 million increase in accounts receivable, net, and a $1.5 million increase in cash and cash equivalents. For the nine months ended January 31, 2002, net cash provided by operating activities increased to approximately $1.4 million as compared to our use of cash for operating activities of $17.9 million for the similar period in the prior year, primarily due to a $6.7 million decrease in inventories which was partially offset by a net loss of approximately $2.9 million for the nine months ended January 31, 2002 and $3.6 million increase in accounts receivable. For the nine-month period ended January 31, 2001, we used approximately $17.9 million in cash for operating activities, primarily due to a $3.8 million reduction in accounts payable, a $3.5 million increase in prepaid expenses and other assets, and a $3.3 million increase in inventory in anticipation of future sales, partially offset by a $2.4 million decrease in accounts receivable, combined with a net loss of $11.6 million. For the nine months ended January 31, 2002, our use of cash for investing activities decreased to approximately $1.6 million from a use of $3.6 million for the similar period in the prior year, primarily due to a $3.0 million reduction in purchases of short-term investments, partially offset by a $1.0 million increase in purchases of property, plant and equipment. Net cash used for investing activities for the nine-month period ended January 31, 2001, resulted primarily from purchases of short-term investments. For the nine months ended January 31, 2002, net cash provided from financing activities decreased to approximately $1.6 million from $68.0 million for the similar period in the prior year. The decrease was primarily due to a reduction in proceeds from the issuance and sale of common stock which totaled $0.7 million during the nine months ended January 31, 2002 from employee purchases through the employee stock purchase plan as compared to $68.0 million aggregate net proceeds from our initial public offering, including the proceeds from the exercise of the over-allotment option, after deducting underwriting discounts and commissions of approximately $5.2 million and directly paying expenses of the offering of approximately $1.9 million. Approximately $43.7 million of these proceeds were invested in cash equivalents and short-term investments. Based on our current working capital position and the cash flows that we expect to generate through the end of fiscal 2002, we believe these cash resources will be sufficient to meet our capital and investment requirements, including anticipated capital expenditures in the amount of approximately $2.0 million and anticipated investment expenditures of approximately $6.0 million associated with the new company that we have formed in The People's Republic of China and other potential investments, for at least the next 12 months. After this period, capital requirements will depend on many factors, including the levels at which we maintain inventory and accounts receivable, costs of securing access to adequate manufacturing capacity and increases in our operating expenses. To the extent that existing cash resources are insufficient to fund our future activities, we may need to raise additional funds through public or private equity or debt financing. Additional funds may not be available, or if available, we may not be able to obtain them on terms favorable to us or to our stockholders. In the event that we do raise additional cash through financings, current investors could be further diluted. From time to time, we may evaluate acquisitions of companies, products or technologies that complement our business. Although we have no current plans in this regard, any transactions, if consummated, may consume a portion of our working capital or require the issuance of securities that may result in further dilution to existing stockholders. 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) FACTORS AFFECTING FUTURE RESULTS We have a history of losses, we were only profitable on an annual basis in -------------------------------------------------------------------------- Fiscal Year 2000 and we may not ever return to profitability on an annual ------------------------------------------------------------------------- basis. ----- We incurred a net loss of approximately $11.6 million in Fiscal Year 2001 and approximately $4.0 million in Fiscal Year 1999. For the year ended April 30, 2000, the only year in which we have been profitable, our net income was approximately $3.4 million. In the nine months ended January 31, 2002, our net loss was $2.9 million. In the future, as we develop new products, we expect research and development expenses to increase. In addition, if we are not able to accurately forecast the number of wafers we need, our operating expenses will increase. If these expenses increase and our revenues do not increase for any reason including the recent slowdown of the United States economy, we may not subsequently sustain profitability. The recent economic slowdown and other economic conditions have reduced and may ------------------------------------------------------------------------------- continue to reduce our revenues and to harm our business. --------------------------------------------------------- Since the third quarter of Fiscal Year 2001, our customers and distributors, primarily our PC video camera customers and distributors, have been impacted by significantly lower demand for camera related products, which forced them to unexpectedly reschedule or cancel orders for our products in recent quarters. As a result, our revenues and earnings were adversely affected. In February 2002, we announced projected revenues and earnings for the fourth quarter of Fiscal Year 2002. If demand for camera related products, in particular PC video cameras, does not recover in the fourth quarter of Fiscal Year 2002, or if we are unable to manage our operating expenses, we will not be able to meet these projections. In addition, the terrorist attacks of September 11, 2001, the subsequent military response by the United States and future events occurring in response to or in connection with the attacks have negatively impacted the economy in general. If our customers decide to delay their product orders or reduce their demand of our products as a result of any of these occurrences, our results of operations, revenues and financial condition would be adversely affected. We may not adequately forecast the number of wafers we need, and therefore we ----------------------------------------------------------------------------- may not be able to react to fluctuations in demand for our products, which -------------------------------------------------------------------------- could result in higher operating expenses and lower revenues. ------------------------------------------------------------- We must forecast the number of wafers we need from each of our foundries. However, if customer demand falls below our forecast and we are unable to reschedule or cancel our wafer orders, we may retain 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 lower revenues and could harm our relationship with key customers. For example, as a consequence of a product order forecast which proved to be greater than market demand for our products, we recognized an $18.7 million inventory adjustment in Fiscal Year 2001. Fluctuations in our quarterly operating results make it difficult to predict ---------------------------------------------------------------------------- our future performance and may result in volatility in the market price of our ------------------------------------------------------------------------------ common stock. ------------- Our quarterly operating results have varied significantly from quarter to quarter in the past and are likely to vary significantly in the future based on a number of factors related to how we manage our business. These factors, many of which are more fully discussed in other risk factors, include: o our ability to manage our product transitions; o our ability to accurately forecast the number of wafers we need; 17 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) o the mix of the products we sell and the distribution channels through which they are sold; and o the availability of production capacities at the semiconductor foundries that manufacture our products or components of our products. In the past, our introduction of new products and our product mix have affected our quarterly operating results. We also anticipate that the rate of orders from our customers may vary significantly from quarter to quarter. Our expenses and inventory levels are based on our expectations of future revenues and our expenses are relatively fixed in the short term. Consequently, if revenues in any quarter do not occur when expected, expenses and inventory levels could be disproportionately high and our operating results for that quarter and, potentially future quarters, may be harmed. Certain other factors have in the past caused and are likely in the future to cause fluctuations in our quarterly operating results. These factors are industry risks over which we have little or no control. These factors include: o the growth of the market for products and applications using CMOS image sensors; o the timing and amount of orders from our camera manufacturers and distributor customers; o the deferral of customer orders in anticipation of new products, designs or enhancements by us or our competitors; and o the announcement and introduction of products and technologies by our competitors. Any one or more of these factors is difficult to forecast and could result in fluctuations in our quarterly operating results. Fluctuations in our quarterly operating results could adversely affect the price of our common stock in a manner unrelated to our long term operating performance. Due to the potential volatility of our stock price, you should not rely on the results of any one quarter as an indication of our future performance. It is likely that at some point our quarterly operating results will fall below the expectations of security analysts and investors. In this event, the price of our common stock would likely decrease. We do not have long-term commitments from our customers, and we allocate ------------------------------------------------------------------------ resources based on our estimates of customer demand, which could lead to excess ------------------------------------------------------------------------------- inventory and lost revenue opportunities. ----------------------------------------- Our sales are generally made on the basis of purchase orders rather than long-term purchase commitments. In addition, our customers may cancel or defer purchase orders. We manufacture our products according to our estimates of customer demand. This process requires us to make multiple demand forecast assumptions, each of which may introduce error into our estimates. If we overestimate customer demand, we may allocate resources to manufacturing products which we may not be able to sell or we may have to sell our products to other customers for lower prices. As a result, we would have excess inventory, which would have an adverse impact on our results of operations. For example, one customer, Creative, unexpectedly cancelled its purchase orders for one of our products in the second quarter of Fiscal Year 2001 which resulted in our shipping substantially fewer quantities to them in the third and fourth quarters of Fiscal Year 2001 and contributed to a higher than expected inventory position. Conversely, if we underestimate customer demand or if sufficient manufacturing capacity is unavailable, we may forego revenue opportunities, lose market share and damage our customer relationships. We depend on the acceptance of CMOS technology for mass market image sensor --------------------------------------------------------------------------- applications, and any delay in the widespread acceptance of this technology --------------------------------------------------------------------------- could adversely affect our ability to increase our revenues and improve our --------------------------------------------------------------------------- earnings. --------- Our business strategy depends on the rapid and widespread adoption of the CMOS fabrication process for image sensors and the acceptance of our single chip technology. The image sensor market has been dominated by CCD 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) technology for over 25 years. Although CMOS technology has been available for over 20 years, CMOS technology has only recently been used in image sensors. Along with the other risk factors described in this section, the following factors may delay the widespread adoption of the CMOS fabrication process and our single chip technology, the occurrence of any of which could adversely affect our ability to increase our revenues and earnings: o the failure of the emergence of a universal platform for imaging solutions for computers and the Internet; o improvements or cost reductions to CCD image sensors, which could slow the adoption of CMOS image sensors in markets already dominated by CCD image sensors, such as the security and surveillance market. o the failure of development of user friendly and affordable products; and o the limited availability of bandwidth to run CMOS image sensor applications; o the uncertainty of emerging markets for products incorporating CMOS technology; If we do not achieve acceptable wafer manufacturing yields, our costs could --------------------------------------------------------------------------- increase, and our products may not be deliverable which could lead to higher ---------------------------------------------------------------------------- operating expenses and lower revenues and damage to our customer relationships. ------------------------------------------------------------------------------- The fabrication of our products requires wafers to be produced in a highly controlled and 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 particular foundry's manufacturing process technology. Low yields may result from design errors or manufacturing failures in new or existing products. Yield problems may not be determined or improved until an actual image sensor is made and can be tested. As a result, yield problems may not be identified until the wafers are well into the production process. We only test our products after they are assembled, as their optical nature makes earlier testing difficult and expensive. The risks associated with yields are even greater because we rely on third party offshore foundries for our wafers which increases the effort and time required to identify, communicate and resolve manufacturing yield problems. If the foundries cannot achieve the planned yields, this will result in higher costs and reduced product availability. We depend on third party vendors for color filter processing and assembly, -------------------------------------------------------------------------- which reduces our control over delivery schedules, product quality and cost. ---------------------------------------------------------------------------- After our wafers are produced, they are color filter processed and assembled by six independent vendors: TSMC and Toppan for the color filtering process and Kyocera and Alphatec for additional processing and assembly. We do not have long-term agreements with any of these vendors and typically obtain services from them on a purchase order basis. Our reliance on these vendors involves risks such as reduced control over delivery schedules, quality assurance and costs. These risks could result in product shortages or could increase our costs of manufacturing, assembling or testing our products. If these vendors are unable or unwilling to continue to provide color filter processing and assembly services and deliver products of acceptable quality, at acceptable costs and in a timely manner, our business would be seriously harmed. We would also have to identify and qualify substitute vendors, which could be time consuming and difficult and result in unforeseen operations problems. 19 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) We depend on a limited number of third party wafer foundries to manufacture a ----------------------------------------------------------------------------- substantial majority of our products, which reduces our ability to control the ------------------------------------------------------------------------------ manufacturing process. ---------------------- We do not own or operate a semiconductor fabrication facility. We rely on TSMC and PSC to produce a substantial majority of our wafers and final products. Our reliance on these third party foundries involves a number of significant risks, including: o reduced control over delivery schedules, quality assurance, manufacturing yields and production costs; o lack of guaranteed production capacity or product supply; and o unavailability of, or delayed access to, next generation or key process technologies. We do not have long term supply agreements with any of our foundries and instead secure manufacturing availability on a purchase order basis. These foundries have no obligation to supply products to us for any specific period, in any specific quantity or at any specific price, except as set forth in a particular purchase order. Our requirements represent a small portion of the total production capacities of these foundries and TSMC or PSC may reallocate capacity to other customers, even during periods of high demand for our products. If any of our foundries were to become unable or unwilling to continue manufacturing our wafers in the required volumes, at acceptable quality, yields and costs and in a timely manner, our business would be seriously harmed. As a result, we would have to identify and qualify substitute foundries, which would be time consuming and difficult and could result in unforeseen manufacturing and operations problems. In addition, if competition for foundry capacity increases, our product costs may increase, and we may be required to pay or invest significant amounts to secure access to manufacturing services. We are also exposed to additional risks if we decide to transfer our production of semiconductors from one foundry to another. We may qualify additional foundries in the future which is a time consuming and difficult process that could result in unforeseen product or operation problems. If we do not qualify additional foundries, we may be exposed to increased risk of capacity shortages due to our complete dependence on our foundries. Our lengthy manufacturing, packaging and assembly cycle, in addition to our --------------------------------------------------------------------------- customers' design cycle, may result in uncertainty and delays in generating --------------------------------------------------------------------------- revenues. --------- A lengthy manufacturing, packaging and assembly process, typically lasting four months or more, is required to manufacture our image sensors. It can take additional time before a customer commences volume shipments of products that incorporate our image sensors. Even when a manufacturer decides to design our image sensors into its products, the manufacturer may never ship final products incorporating our image sensors. Given this lengthy cycle, we experience a delay between the time we incur expenditures for research and development, and sales and marketing efforts and the time we generate revenues, if any, from these expenditures. As a result, our revenues and profits could be seriously harmed if a significant customer reduces or delays orders or chooses not to release products incorporating our products. If the demand for our products in current markets and emerging markets fails to ------------------------------------------------------------------------------- increase as we anticipate, our growth prospects would be diminished. -------------------------------------------------------------------- Our success depends in large part on the continued growth of various markets that use our products and the emergence of new markets for our products. The current markets that use our products include digital still cameras, personal computer video cameras, personal digital assistant cameras, mobile phone cameras, cameras for security and surveillance systems, closed circuit television systems, and cameras for toys and games and automotive applications. Emerging markets for our products include cameras for personal identification systems, medical imaging devices, machine control systems, and videophones. If these markets do not continue to grow and develop, the need for cameras which are lower in cost, smaller, lighter in weight, consume less power and are more reliable might not fully develop. In such case, it would be unlikely that our products would achieve commercial success. 20 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) Failure to obtain design wins could cause our revenues to level off or decline. ------------------------------------------------------------------------------- Our future success will depend on camera manufacturers designing our image sensors into their systems. To achieve design wins, which are decisions by those manufacturers to design our products into their systems, we must define and deliver cost effective, innovative and integrated semiconductor solutions. Once a manufacturer has designed a supplier's products into its systems, the manufacturer may be reluctant to change its source of components due to the significant costs associated with qualifying a new supplier. Accordingly, the failure to achieve design wins with key camera manufacturers could decrease our market share or revenues. Continuing declines in our average sales prices since the first quarter of -------------------------------------------------------------------------- Fiscal Year 1999 may result in declines in our gross margins. ------------------------------------------------------------- Because the image sensor market is characterized by intense competition, and price reductions for our products are necessary to meet consumer price- points, we expect to experience market driven pricing pressures. This will likely result in a decline in average sales prices for our products. We believe that we can offset declining average sales prices by achieving manufacturing cost efficiencies, developing new products that incorporate more advanced technology and including more advanced features that can be sold at stable average gross margins. However, if we are unable to achieve such cost reductions and technological advances, or are unable to timely introduce new products, we will lose revenues and gross margins will decline. Seasonality in our business will cause our results of operations to fluctuate ----------------------------------------------------------------------------- from period to period and could cause our stock price to fluctuate or decline. ------------------------------------------------------------------------------ Sales of our image sensors are subject to seasonality. Some of the products using our image sensors such as personal computer video cameras and digital still cameras are consumer electronics goods. Typically, these goods are subject to seasonality with generally increased consumer sales in November and December due to the holidays. As a result, product sales are impacted by seasonal purchasing patterns with higher sales generally occurring in the second half of the calendar year. In addition, we typically experience a decrease in orders in the quarter ended January 31 from our Chinese and Taiwanese customers primarily due to the Chinese New Year. As a result, we believe product sales are impacted by seasonal purchasing patterns with higher sales generally occurring in the second half of each calendar year. We depend on a few key customers and distributors, and the loss of any of them ------------------------------------------------------------------------------ could significantly reduce our revenues. ---------------------------------------- Historically, a relatively small number of customers and distributors has accounted for a significant portion of our product revenues. For the three months ended January 31, 2002, no single customer accounted for 10% or more of revenues. Our two largest distributors during the three months ended January 31, 2002 were World Peace Industrial Co. Ltd., or World Peace, headquartered in Taiwan, which accounted for 22.7% of revenues, and SEC Development Co. Ltd., or SEC, headquartered in Hong Kong, which accounted for 11.6% of revenues. For the nine months ended January 31, 2002, one of our security camera manufacturer customers, X10 Wireless Technology, Inc., or X10, represented 27.8% of revenues, and World Peace accounted for approximately 15.6% of revenues. For the three months ended January 31, 2001, X10 represented approximately 21.5% of revenues and one of our cellular telephone manufacturer customers, Teksel Co., Ltd., Teksel, who distributes our products to Kyocera, accounted for approximately 20.9% of revenues. For the nine months ended January 31, 2001, one of our distributors, World Peace, represented approximately 17.6% of revenues and one of our camera manufacturer customers, Creative, accounted for approximately 17.4% of revenues. 21 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) A significant reduction, delay or cancellation of orders from our key customers or distributors, or a decision by them to select or distribute products manufactured by a competitor could seriously harm our business. For example, in 1999, we had to replace one of our largest distributors with Wintek Electronics Co., Ltd. because that distributor decided to distribute a competitor's products. We expect our operating results to continue to depend on sales to or design decisions of a relatively small number of distributors and camera manufacturers. We face foreign business, political and economic risks because a majority of ---------------------------------------------------------------------------- our products, and our customers' products are manufactured and sold outside of ------------------------------------------------------------------------------ the United States. ------------------ A substantial portion of our business, in particular, the manufacturing, processing and assembly of our products, is conducted outside of the United States, and as a result, we are subject to foreign business, political and economic risks. All of our products are manufactured outside of the United States. Many of our customers are camera manufacturers or are the manufacturers or suppliers for camera manufacturers and are located in Japan, Korea, Singapore and Taiwan. In addition, sales outside of the United States accounted for approximately 96.6% and 68.3% of our revenues for three and nine months ended January 31, 2002 and 70.0% and 85.6% of our revenues for three and nine months ended January 31, 2001. We anticipate that sales outside of the United States will continue to account for a substantial portion of our revenue in future periods. Accordingly, we are subject to foreign risks, including: o difficulties in managing distributors; o difficulties in staffing and managing foreign operations; o difficulties in managing foundries and third party manufacturers; o political and economic instability which may have an adverse impact on foreign exchange rates in Asia; o inadequacy of local infrastructure, in particular with respect to our future expansion in China; o longer payment cycles; o the adverse effects of tariffs, duties, price controls or other restrictions that impair trade; and o difficulties in accounts receivable collections. In addition, camera manufacturers who design our solutions into their products sell them outside of the United States. This exposes us indirectly to foreign risks. Because sales of our products have been denominated to date exclusively in United States dollars, increases in the value of the United States dollar will increase the price of our products so that they become relatively more expensive to customers in the local currency of a particular country, leading to a reduction in revenues and profitability in that country. A portion of our international revenues may be denominated in foreign currencies in the future, which will subject us to risks associated with fluctuations in those foreign currencies. Our dependence on selling through distributors increases the complexity of our ------------------------------------------------------------------------------ business which may increase our operating costs and may reduce our ability to ----------------------------------------------------------------------------- forecast revenues. ------------------ Our revenues depend on design wins with new camera manufacturers which, in turn, rely on third party manufacturers or distributors to provide inventory management and purchasing functions. Selling through distributors reduces our ability to forecast sales and increases the complexity of our business, requiring us to: o manage a more complex supply chain; 22 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) o manage the level of inventory at each distributor; o provide for credits, return rights and price protection; o estimate the impact of credits, return rights, price protection and unsold inventory at distributors; and o monitor the financial condition and credit worthiness of our distributors. Any failure to manage these challenges could reduce our revenues and damage our relationships with our distributors. We face intense competition in our markets from more established CCD image -------------------------------------------------------------------------- sensor manufacturers and CMOS image sensor manufacturers and if we are unable ----------------------------------------------------------------------------- to compete successfully, we will not achieve our financial objectives. ---------------------------------------------------------------------- The image sensor market is intensely competitive. These markets are characterized by rapid technological change, evolving standards, short product life cycles and decreasing prices. Our current products face competition from a number of sources including companies which sell charged couple device image sensors as well as other companies which sell multiple chip CMOS image sensors. We expect competition in our markets to increase. Many of our competitors have longer operating histories and greater presence in key markets, greater name recognition, access to large customer bases and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other resources than we do. As a result, they may be able to adapt more quickly to new or emerging technologies and customer requirements or devote greater resources to the promotion and sale of their product than we may. Our competition includes CCD image sensor manufacturers, including Fuji Corporation, or Fuji, Matsushita Electric Industrial, or Matsushita, Nippon Electric Corporation or NEC, Sharp Corporation, or Sharp, Sony Corporation, or Sony, and Toshiba Corporation, or Toshiba, as well as CMOS image sensor manufacturers such as Agilent Technologies, Inc., ST Microelectronics, Conexant Systems, Inc., Hyundai Electronics Industries Co. Ltd., Mitsubishi Electronic, Motorola, Inc., and Toshiba Corporation. In addition, there are a large number of smaller startup companies including Photobit Corporation and Zoran Corporation, which may or do compete with us. In particular, Hyundai and Agilent Technologies have introduced multiple chip CMOS image sensors. We cannot assure you that we can compete successfully against current or potential competitors, or that competition will not seriously harm our business by reducing sales of our products, reducing our profits and reducing our market share. Our success depends on the development and introduction of new products, which ------------------------------------------------------------------------------ we may not be able to do in a timely manner because the process of developing ----------------------------------------------------------------------------- products using CMOS image sensors is complex and costly. -------------------------------------------------------- The development of new products is highly complex, and we have experienced delays in completing the development and introduction of new products on several occasions in the past, some of which exceeded six months. As our products integrate new and more advanced functions, they become more complex and increasingly difficult to design and debug. Successful product development and introduction depend on a number of factors, including: o accurate prediction of market requirements and evolving standards, including pixel resolution, output interface standards, power requirements, optical lens size, input standards and operating systems for personal computers and other platforms; o development of advanced technologies and capabilities; o definition of new products which satisfy customer requirements; 23 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) o timely completion and introduction of new product designs; o use of leading edge foundry processes and achievement of high manufacturing yields; and o market acceptance of the new products. Accomplishing all of this is extremely challenging, time consuming and expensive. We cannot assure you that any new products or product enhancements will be developed in time to capture market opportunities or achieve a significant or sustainable level of acceptance in new and existing markets. The high level of complexity and integration of functions of our products ------------------------------------------------------------------------- increases the risk of latent defects which could damage customer relationships ------------------------------------------------------------------------------ and increase our costs. ----------------------- Because we integrate many functions on a single chip, our products are complex. The greater integration of functions and complexity of operations of our products, the greater the risk that latent defects or subtle faults could be discovered by customers or end users after volumes of product have been shipped. Although we test our products, they may contain defects and errors. In the past we have encountered defects and errors in our products. Delivery of products with defects or reliability, quality or compatibility problems may damage our reputation and our ability to retain existing customers and attract new customers. In addition, product defects and errors could result in additional development costs, diversion of technical resources, delayed product shipments, increased product returns, product warranty costs for recall and replacement and product liability claims against us which may not be fully covered by insurance. We maintain a backlog of customer orders which is subject to cancellation or ---------------------------------------------------------------------------- delay in delivery schedules, and any cancellation or delay may result in lower ------------------------------------------------------------------------------ than anticipated revenues. -------------------------- We manufacture and market primarily standard products. Our sales are generally made pursuant to standard purchase orders. We include in our backlog only those customer orders for which we have accepted purchase orders and assigned shipment dates within the upcoming 12 months. Although our backlog is typically filled within two to four quarters, orders constituting our current backlog are subject to cancellation or changes in delivery schedules, and backlog may not necessarily be an indication of future revenue. In addition, the current backlog will not necessarily lead to revenues in any future period. Any cancellation or delay in orders which constitute our current or future backlog may result in lower than expected revenues. Our bookings visibility continues to be limited with a substantial majority of our quarterly product revenues coming from orders that are received and fulfilled in the same quarter. We must attract and retain qualified personnel to be successful, and -------------------------------------------------------------------- competition for qualified personnel is intense in our market. ------------------------------------------------------------- Our success depends to a significant extent upon the continued contributions of our key management, technical and sales personnel, many of who would be difficult to replace. The loss of one or more of these employees could seriously harm our business. We do not have key person life insurance on any of our key personnel. We have no agreements which obligate our employees to continue working for us. Our success also depends on our ability to identify, attract and retain qualified technical (particularly analog or mixed signal design engineers), sales, marketing, finance and management personnel. Competition for qualified personnel is particularly intense in our industry and in Silicon Valley, California. This is due to a number of factors, including the high concentration of established and emerging growth technology companies. This competition makes it difficult to retain our key personnel and to recruit new qualified personnel. We have experienced, and may continue to experience, difficulty in hiring and retaining candidates with appropriate qualifications. If we do not succeed in hiring and retaining candidates with appropriate qualifications, our revenues and product development efforts could be harmed. 24 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) We may be unable to adequately protect our intellectual property and therefore ------------------------------------------------------------------------------ we may lose some of our competitive advantage. ---------------------------------------------- We rely on a combination of patent, copyright, trademark and trade secret laws, as well as nondisclosure agreements and other methods to protect our proprietary technologies. We have been issued patents and have a number of pending United States and foreign patent applications. However, we cannot assure you that any patent will issue as a result of any applications or, if issued, that any claims allowed will be sufficiently broad to protect our technology. In addition, it is possible that existing or future patents may be challenged, invalidated or circumvented. It may be possible for a third party to copy or otherwise obtain and use our products, or technology without authorization, develop corresponding technology independently or design around our patents. Effective copyright, trademark and trade secret protection may be unavailable or limited in foreign countries. These disputes may result in costly and time consuming litigation or the license of additional elements of our intellectual property for free. We could become subject to litigation regarding intellectual property, which ---------------------------------------------------------------------------- could divert management attention, be costly to defend and prevent us from -------------------------------------------------------------------------- using or selling the challenged technology. ------------------------------------------- From time to time, we have been subject to legal proceedings and claims with respect to such matters as patents, product liabilities and other actions arising out of the normal course of business. In March 2000, we received a letter from Koninklijke Philips N.V. in which Philips claimed to have patent rights in a serial bus system for data transmission, known as the I2C bus system. Although we do not believe any of our products infringe any Philips patent, we are currently discussing possible royalty or licensing arrangements as a means of business resolution. In the meantime, we have completed implementation of a new serial bus system for our products. We entered into an agreement with Photobit Corporation ("Photobit") and the California Institute of Technology ("CalTech"), effective September 18, 2001, to settle all litigation that we had with Photobit and CalTech, including an action in the U.S. District Court, Northern District of California, Case No. C 00 3791 PJH, and an investigation before the U.S. International Trade Commission ("ITC"), Inv. No. 337-TA-451. Both actions involved patents alleged to pertain to our CMOS image sensor products, such as those used in digital cameras, PC cameras and other optical applications. The action pending in California was dismissed on September 24, 2001, and final termination of the ITC investigation occurred on November 9, 2001. The confidential settlement includes non-exclusive cross-licenses for seven years under our and Photobit's respective patent portfolios, including patents and applications licensed by CalTech to Photobit. We have also made a one-time payment to Photobit of $3.5 million dollars. The settlement agreement referred to in the above paragraph relates only to claims made by Photobit and CalTech. It is possible that other companies might pursue litigation with respect to any claims such companies purport to have against us. The results of any litigation are inherently uncertain. In the event of an adverse result in any litigation with respect to intellectual property rights relevant to our products that could arise in the future, we could be required to obtain licenses to the infringing technology, pay substantial damages under applicable law, including treble damages if we are held to have willfully infringed, cease the manufacture, use and sale of infringing products or to expend significant resources to develop non- infringing technology. Litigation frequently involves substantial expenditures and can require significant management attention, even if we ultimately prevail. Failure to effectively manage our growth could adversely affect our ability to ------------------------------------------------------------------------------ increase our revenues and improve our earnings. ----------------------------------------------- Our growth has placed, and will continue to place, a significant strain on our management and other resources. To manage our growth effectively, we must, among other things: o implement and improve operational and financial systems; 25 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) o train and manage our employee base; and o attract and retain qualified personnel with relevant experience. We must also manage multiple relationships with customers, business partners and other third parties, such as our foundries and process and assembly vendors. Moreover, our growth may significantly overburden our management and financial systems and other resources. We also cannot assure you that we have made adequate allowances for the costs and risks associated with our expansion. In addition, our systems, procedures or controls may not be adequate to support our operations, and we may not be able to expand quickly enough to capitalize on potential market opportunities. Our future operating results will also depend on expanding sales and marketing, research and development and administrative support. Our investment in a Chinese entity to conduct design and testing operations may ------------------------------------------------------------------------------- not reduce our design and testing costs nor improve our gross margins and as a ------------------------------------------------------------------------------ result our earnings would be adversely affected. ------------------------------------------------ In December 2000, we formed a subsidiary to conduct design and testing operations in Shanghai, the People's Republic of China. The registered capital of this Chinese subsidiary is $12.0 million, of which $3.8 million was funded by us in Fiscal Year 2001, as required by Chinese law. We funded an additional $1.0 million during the nine months ended January 31, 2002. We are further obligated to fund the remaining $7.2 million of registered capital by December 2003. As of January 31, 2002, $3.2 million of the $4.8 million was paid for land use rights and to building contractors in partial payment for the construction of the facility, $1.2 million was deposited in a bank account in China and $0.4 million was expended for general purposes. The formation and operation of this Chinese subsidiary requires a large initial capital investment, and there may be significant administrative, legal and governmental barriers in China, which may prevent or harm us from beginning operation of this Chinese subsidiary as well as using the funds outside of China. We cannot be sure that our investment in our Chinese subsidiary will eventually result in the reduction of our design and testing costs. The formation and operation of our Chinese subsidiary requires a large initial capital investment and will also require significant future capital investment as we continue to maintain and upgrade our facility. In addition, the design and testing of our products is a highly complex, sensitive and precise process which is subject to a wide variety of factors, any number of which could result in an increase of our costs. If our design and testing costs fail to decrease as a result of our investment in our China subsidiary our earnings may be adversely affected. The incorporation, formation and development of our Chinese subsidiary has resulted and will continue to result in the diversion of capital away from other business issues, as the operation of our design and testing facility will require that we constantly upgrade our technology to remain competitive. The incorporation, formation and development of our Chinese subsidiary has also resulted in the diversion of management's attention away from other business issues. If our ongoing investment in the Chinese subsidiary does not result in offsetting gains in the form of design and testing improvements accompanied by reduced design and testing costs, whether because of the risks and difficulties entailed by foreign operations or for other reasons, our business and financial condition will be adversely affected. Provisions in our charter documents and Delaware law, as well as our -------------------------------------------------------------------- Stockholders Rights Plan, could prevent or delay a change in control of us and ------------------------------------------------------------------------------ may reduce the market price of our common stock. ------------------------------------------------ Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. These provisions include: o adjusting the price, rights, preferences, privileges and restrictions of preferred stock without stockholder approval; 26 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) o providing for a classified board of directors with staggered, three year terms; o requiring supermajority voting to amend some provisions in our certificate of incorporation and bylaws; o limiting the persons who may call special meetings of stockholders; and o prohibiting stockholder actions by written consent. Provisions of Delaware law also may discourage, delay or prevent another company from acquiring or merging with us. Our Board of Directors adopted a Preferred Stock Rights Agreement in August 2001 (the "Rights Agreement"). Pursuant to the Rights Agreement, our Board of Directors declared a dividend of one right (a "Right") to purchase one one-thousandth share of our Series A Participating Preferred Stock ("Series A Preferred") for each outstanding share of our common stock. The dividend was paid on September 28, 2001 to stockholders of record as of the close of business on that date. Each Right entitles the registered holder to purchase from us one one-thousandth of a share of Series A Preferred at an exercise price of $40.00, subject to adjustment. The exercise of the Rights could have the effect of delaying, deferring or preventing a change of control of us, including, without limitation, discouraging a proxy contest or making more difficult the acquisition of a substantial block of our common stock. The Rights Agreement could also limit the price that investors might be willing to pay in the future for our common stock. Our stock has been and will likely continue to be subject to substantial price ------------------------------------------------------------------------------ and volume fluctuations due to a number of factors, many of which will be ------------------------------------------------------------------------- beyond our control, that may prevent our stockholders from reselling our common ------------------------------------------------------------------------------- stock at a profit. ------------------ The securities markets have experienced significant price and volume fluctuations in the past and the market prices of the securities of semiconductor companies have been especially volatile. This market volatility, as well as general economic, market or political conditions, could reduce the market price of our common stock in spite of our operating performance. The market price of our common stock may fluctuate significantly in response to a number of factors, including: o actual or anticipated fluctuations in our operating results; o changes in expectations as to our future financial performance; o changes in financial estimates of securities analysts; o release of lock-up or the transfer restrictions on our outstanding shares of common stock or sales of additional shares of common stock; o changes in market valuations of other technology companies; and o announcements by us or our competitors of significant technical innovations, design wins, contracts, standards or acquisitions. Due to these factors, the price of our stock may decline and investors may be unable to resell their shares of our stock for a profit. In addition, the stock market experiences extreme volatility that often is unrelated to the performance of particular companies. These market fluctuations may cause our stock price to decline regardless of our performance. 27 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (Continued) We rely on a continuous power supply to conduct our operations and any ---------------------------------------------------------------------- interruption of our power supply could disrupt our operations and increase our ------------------------------------------------------------------------------ expenses. --------- In the event of an acute power shortage in California, that is, when power reserves for the State of California fall below one and one-half percent, the State of California has in the past implemented, and may in the future implement, rolling blackouts throughout the state. We currently do not have backup generators or alternate sources of power in the event of a blackout, and our current insurance does not provide coverage for any damages we or our customers or distributors may suffer as a result of any interruption in our power supply. If blackouts interrupt our ability to continue operations at our facilities, then our reputation could be damaged, our ability to retain existing customers could be harmed and we could fail to obtain new customers. These interruptions could also result in lost revenue, any of which could substantially harm our business and results of operations. Furthermore, the deregulation of the energy industry instituted in 1996 by the California state government has caused power prices to increase. Under deregulation, utilities were encouraged to sell their plants, which traditionally had produced most of California's power, to independent energy companies that were expected to compete aggressively on price. Instead, due in part to a shortage of supply, wholesale prices skyrocketed. If wholesale energy prices increase in the future, our operating expenses will likely increase, as our U.S. facilities are located in California. Class action litigation due to stock price volatility could lead to substantial ------------------------------------------------------------------------------- costs and divert our management's attention and resources. ---------------------------------------------------------- In the past, securities class action litigation often has been brought against a company following periods of volatility in the market price of its securities. Companies in the semiconductor industry and other technology industries are particularly vulnerable to this kind of litigation due to the high volatility of their stock prices. Accordingly, we may in the future be the target of securities litigation. Securities litigation could result in substantial costs and could divert our management's attention and resources. 28 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are an international company, selling our products globally and, in particular in China, Japan, Korea, Singapore and Taiwan. Although we transact our business in U.S. dollars, future fluctuations in the value of the U.S. dollar may affect the competitiveness of our products, gross profits realized, and results of operations. Further, we incur expenses in Japan, Korea, Taiwan, Thailand, China and other countries that are denominated in currencies other than the U.S. dollar. We cannot estimate the effect that an immediate 10% change in foreign currency exchange rates would have on our future operating results or cash flows as a direct result of changes in exchange rates. However, we do not believe that we currently have any significant direct foreign currency exchange rate risk, and we have not hedged exposures denominated in foreign currencies or any other derivative financial instruments. Our cash equivalents and short-term investments are exposed to financial market risk due to fluctuation in interest rates, which may affect our interest income and, in the future, the fair market value of our investments. We manage our exposure to financial market risk by performing ongoing evaluations of our investment portfolio. We presently invest in short term bank market rate accounts, certificates of deposit issued by banks, high-grade corporate securities and government bonds maturing approximately 12 months or less from the date of purchase. Due to the short maturities of our investments, the carrying value should approximate the fair market value. In addition, we do not use our investments for trading or other speculative purposes. Due to the short duration of our investment portfolio, we do not expect that an immediate 10% change in interest rates would have a material effect on the fair market value or our portfolio. Therefore, we would not expect our operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest rates. 29 PART II-OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS From time to time, we have been subject to legal proceedings and claims with respect to such matters as patents, product liabilities and other actions arising out of the normal course of business. On November 29, 2001, a complaint captioned McKee v. OmniVision Technologies, Inc., et. al., Civil Action No. 01 CV 10775, was filed in the United States District Court for the Southern District of New York against our company, some of our directors and officers, and various underwriters for our initial public offering. Plaintiffs generally allege that the named defendants violated federal securities laws because the prospectus related to our offering failed to disclose, and contained false and misleading statements regarding, certain commissions purported to have been received by the underwriters, and other purported underwriter practices in connection with their allocation of shares in our offering. Substantially similar actions have been filed concerning the initial public offerings for more than 300 different issuers, and the cases have been coordinated as In re Initial Public Offering Securities Litigation, 21 MC 92. The complaint against us seeks unspecified damages on behalf of a purported class of purchasers of our common stock between July 14, 2000 and December 6, 2000. We believe that we have meritorious defenses to this lawsuit and will defend this lawsuit vigorously. It is possible that other companies might pursue litigation with respect to any claims such companies purport to have against us. The results of any litigation are inherently uncertain. In the event of an adverse result in any litigation with respect to intellectual property rights relevant to our products that could arise in the future, we could be required to obtain licenses to the infringing technology, pay substantial damages under applicable law, including treble damages if we are held to have willfully infringed, cease the manufacture, use and sale of infringing products or to expend significant resources to develop non-infringing technology. Litigation frequently involves substantial expenditures and can require significant management attention, even if we ultimately prevail. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits
Exhibit Number Description ------ --------------------------------------------------------------- 10.19 Non-exclusive Distributor Agreement between the Registrant and SEC Development Co., Ltd., dated February 23, 2001.
(b) Reports on Form 8-K The Company did not file any reports on Form 8-K during the three months ended January 31, 2002. 30 SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. OMNIVISION TECHNOLOGIES, INC. ----------------------------- (Registrant) Dated: March 15, 2002 By: /s/ SHAW HONG ---------------------------------- Shaw Hong Chief Executive Officer, President and Director (Principal Executive Officer) Dated: March 15, 2002 By: /s/ H. GENE MCCOWN ---------------------------------- H. Gene McCown Vice President of Finance and Chief Financial Officer (Principal Financial and Accounting Officer) 31