ITEM 1. BUSINESS
SMART Modular Technologies, Inc., a California corporation ("SMART" or the "Company"), is a leading independent manufacturer of specialty and standard memory modules and Flash memory cards and also manufactures high performance embedded computer modules, as well as communication card solutions in PC card and other form factors. SMART offers more than 500 products to leading original equipment manufacturers ("OEMs") in the computer, networking and telecommunications industries. The Company's principal customers include Cisco Systems, Inc. ("Cisco"), Compaq Computer Corporation ("Compaq"), Data General Corporation ("Data General"), Electronics For Imaging, Inc. ("EFI"), Fujitsu Microelectronics ("Fujitsu"), Hewlett-Packard Company ("Hewlett-Packard"), Hyundai Electronics America ("Hyundai"), IBM Corporation ("IBM"), Lucent Technologies ("Lucent"), Motorola, Inc. ("Motorola"), NCR Corp. ("NCR") and Solectron Corp. ("Solectron").
SMART has developed extensive design, manufacturing, testing and logistics expertise that the Company believes enables it to respond to its customers' rapidly changing product and service requirements; provide its customers with timely access to new higher speed or higher performance modules or subsystems; reduce its customers' time-to-market and capital requirements; and decrease its customers' production and inventory costs.
INDUSTRY BACKGROUND
The demand for semiconductor memory devices and other subsystems in digital electronic systems has grown dramatically over the last several years as a result of the increasing importance of both of these components in determining system performance. The demand for greater overall system performance, as well as the increasing number and variety of electronic devices, has required that electronics manufacturers increase the number and functionality of memory devices and the performance of other subsystems.
The factors contributing to the increasing demand for memory devices and communications and embedded computer subsystems include the expanding unit sales of PCs in the business and consumer market segments; the increasing use of PCs to perform memory-intensive graphics and multimedia functions; the volume of memory required to support faster microprocessors; the proliferation of increasingly complex operating system and applications software; the increased use of local area network and wide area network routing and switching equipment that incorporates complex memory and embedded computer subsystems; the growth in on-line communications, such as e-mail and the Internet; and, in general, the increasing performance requirements of workstations, servers and networking and telecommunications equipment.
Memory integrated circuits ("ICs") and subsystems encompass several types of devices designed to perform specific functions within computer and other electronic systems. The three most significant categories of memory ICs are DRAM, SRAM and non-volatile memory, including Flash. DRAM provides large capacity "main" memory; SRAM provides specialized high speed memory; and Flash and other non-volatile memory provide low power memory that retains data after a system is turned off. Within each of these broad categories of memory products, semiconductor manufacturers are offering an increasing variety of memory devices that are designed for different application and performance requirements. For example, the variety of DRAM memory ICs has increased in recent years with the introduction and adoption of technologies such as Rambus DRAM, DDR, SDRAM, SGRAM, VRAM, FPM and EDO. This increase in the variety of memory ICs has placed greater demands on OEMs to maintain a current knowledge base and expertise. In addition, other specialized subsystems, such as modems, networking devices and embedded computer solutions, enable critical data transfer and data processing functions.
MARKETS
Memory Module Market. Memory modules are compact circuit board assemblies consisting of DRAM, SRAM, Flash or other semiconductor memory devices and related circuitry. Electronic systems increasingly employ memory modules as building blocks in system design as a result of the many advantages memory
modules offer OEMs and end users. The use of memory modules enables OEMs to easily configure a system with a variety of different levels of memory, thus increasing their flexibility to address multiple price points or applications with a single base system design. In addition, the use of memory modules enables OEMs to offer a relatively easy path for upgradeability of a PC or workstation, a feature of system design that is increasingly required by end users. To achieve this flexibility and upgradeability, both PC and communications OEMs frequently design their systems to use memory modules as a "daughter card," reducing the need to include memory devices on the motherboard. This design structure frees up space on the motherboard and enables the OEM to use a single motherboard as a common central element for a variety of different systems, resulting in significant cost savings. The use of memory modules further reduces costs by reducing OEMs' work-in-process inventories by allowing them to add expensive and increasingly diverse memory devices to products during the final stages of the manufacturing process.
The market for memory modules includes both standard and specialty modules. The high volume standard memory module market includes modules that can be sourced from many module suppliers, and are designed to be incorporated into a wide variety of equipment. These modules employ designs meeting widely used industry specifications and are available with a variety of options to address the needs of multiple OEMs. Standard memory modules are typically used in desktop PCs and printers and are sold both to OEMs and through computer resellers directly to end users.
Specialty memory modules include both custom and application specific modules. The varying requirements of different electronic systems and the increased number of memory device options have resulted in a market for specialized memory modules that are designed to enhance the performance of a particular system or a set of applications. These modules are based on either Rambus DRAM, DDR, SDRAM, FPM, EDO, SRAM or Flash technologies and may include additional control circuitry. Specialty memory modules are typically sourced from a limited number of suppliers. Application specific and custom memory modules are generally used in mobile computers, workstations and telecommunications devices, such as routers and switches, and are primarily sold to OEMs.
Communication Card Market. Communication card products come in PC card, desktop (ISA and PCI) and proprietary form factors. PC cards are small form factor cards conforming to the Personal Computer Memory Card International Association ("PCMCIA") standards and are used as peripheral devices in products such as notebook and subnotebook computers, personal digital assistants ("PDAs"), cellular phones, pagers and digital cameras. The Company believes that growth in the mobile computing market will expand the market for mobile computing peripherals and communications (wireline and wireless data/fax modems). Increasingly important aspects of PC card modem functionality are the abilities to be easily configurable for use internationally and to provide high speed connections over wireline and wireless networks such as ISDN, switched cellular, digital cellular (GSM and CDMA) and personal communications services (PCS).
Embedded Computer Subsystem Market. Unlike PCs or workstations that serve as general purpose computers, embedded computer subsystems are integrated into larger systems and perform a single function or a closely related group of functions such as input/output ("I/O") and data processing with high degrees of repeatability, accuracy and reliability. Embedded computer subsystems are incorporated into an ever-increasing array of products used in a variety of markets, including telecommunications, networking, imaging, simulation, command and control, industrial control and desktop publishing. Examples of embedded computer subsystem applications include ATM and Gigabit ethernet switches, network security systems, Digital Satellite Systems, set-top boxes, video games, laser printers, scanners, network routers and switches, robots, computer guided missiles, paint mixing systems, medical imaging analyzers, automated toll collection systems and Global Positioning System receivers. With current market conditions requiring shorter design cycles and the options for implementation becoming more varied and complex, OEMs are increasingly outsourcing their requirements for embedded computer subsystems to specialists that complement the value added by the OEM.
Opportunity for Manufacturers of Memory Modules and Subsystems. As the variety of memory devices and subsystems available to address specific applications has expanded, the design and manufacture of memory modules, communication cards and embedded computer subsystems have increasingly become areas
in which electronics OEMs employ outsourcing strategies. OEM outsourcing practices for memory products range from contract manufacturing, in which the OEM may turn to an outside supplier to procure third-party components and design, manufacture and distribute a specific product for the OEM on a turnkey basis, to consignment, in which the OEM employs the outside supplier to design and manufacture a product using memory or other components supplied by the OEM. OEMs may also purchase memory modules or subsystems which have been designed by a supplier for a specific application.
The use of outsourcing strategies has many benefits for OEMs. By outsourcing design, manufacturing, testing and logistics functions, OEMs are able to focus their resources on activities and technologies in which they add the greatest value, such as system design, sales, marketing and distribution. In addition, OEMs can reduce their time to market by utilizing the manufacturing and logistics expertise of specialized manufacturers. In particular, the increasing trend under which large PC OEMs are implementing build-to-order and direct sales distribution strategies may create opportunities for independent suppliers of memory modules, as these strategies place increased reliance on the manufacturing, logistics and inventory management functions of these suppliers. Moreover, as memory modules, communication cards, embedded computer subsystems and other subsystems become more complex and differentiated, the design, manufacturing and test processes become increasingly automated and more complex, requiring a greater level of investment in capital equipment and skilled engineers and specialists. Outsourcing enables OEMs to gain access to advanced manufacturing facilities, thereby reducing the OEMs' overall capital equipment requirements. Also, the proliferation of a wide variety of DRAM, SRAM and Flash memory devices combined with frequent product design changes, short product life cycles and component price fluctuations, have created increasing difficulties for OEMs in planning, procuring and managing their inventories efficiently. By using a manufacturing specialist's volume procurement capabilities and expertise in inventory management, OEMs can reduce production and inventory costs.
THE SMART SOLUTION
SMART is a leading independent manufacturer of specialty and standard memory modules and Flash memory cards and also manufactures high performance embedded computer modules, as well as communication card solutions in PC card and other form factors. SMART offers more than 500 products to leading OEMs in the computer, networking and telecommunications industries. SMART has developed extensive design, manufacturing, testing and logistics expertise that the Company believes enables it to respond to its customers' rapidly changing product and service requirements; provide its customers with timely access to new higher speed or higher performance modules or subsystems; reduce its customers' time-to-market and capital requirements; and decrease its customers' production and inventory costs.
PRODUCTS
The Company designs and markets products consisting of memory modules, communication cards and embedded computer modules. The Company's memory modules include Rambus DRAM, DDR, SDRAM, FPM, EDO, SRAM and Flash memory-based products. The Company offers custom and application specific memory modules, as well as standard memory modules that comply with industry standards established by the Joint Electronic Development Engineering Council ("JEDEC"). The Company's communication card products come in PC card, ISA, PCI and proprietary form factors. They include wireless data modems with international PTT approval and 56 kbps technology. The Company's embedded computer module products include a range of standard and perfect fit embedded computers for use in a variety of specialized computing applications.
Memory Modules
DRAM Modules. The Company offers a comprehensive line of DRAM memory modules, including a wide range of single in-line memory modules ("SIMMs"), dual in-line memory modules ("DIMMs") and small outline dual in-line memory modules ("SO DIMMs"). The Company's DRAM modules are available in various configurations of up to 200 pins and densities of up to 256 MBytes. Many of these products are offered in both 5.0 volt and 3.3 volt versions, with FPM, EDO, SDRAM and SGRAM architectures.
Among the latest emerging DRAM technology memory products are high density PC100 modules, Rambus RIMMs and SO-RIMMs, DDR, and PC133 based modules. Each of these technologies require an increasing level of design, manufacturing and test expertise. SMART has positioned itself at the leading edge of these technologies by continuing to strengthen its core engineering, design, and manufacturing strengths. SMART has also established important technology partnerships with chip makers Intel Corporation and Rambus, Inc. to provide engineering and design support.
The following table summarizes certain of the Company's DRAM module product offerings:
SRAM Modules. The Company offers a comprehensive line of SRAM memory modules, including L2 cache modules and other high speed and low power SRAM modules. The Company's L2 cache modules are available in speeds from 50 to 83 MHz, in asynchronous and synchronous versions, with burst, pipelined burst and serial access operating modes and in densities from 256 KBytes to 8 MBytes.
The following table summarizes certain of the Company's high speed SRAM L2 cache module product offerings:
The following table summarizes certain of the Company's other high speed and low power SRAM module product offerings:
Flash Modules. The Company offers a comprehensive line of Flash modules, including 72 Pin DRAM-like SIMMs, 80 Pin synchronous SIMMs, 80 Pin asynchronous SIMMs and 168 Pin synchronous and asynchronous DIMMs. The Company's Flash modules are available in densities of up to 64 MBytes. The Company also offers additional options such as an on-board active reset control, system reset control and DC to DC power conversion which allows the use of 12.0 volt components in a 5.0 volt system.
The following table summarizes certain of the Company's Flash module product offerings:
Sales of memory modules accounted for a substantial majority of the Company's net sales during fiscal 1998, fiscal 1997 and fiscal 1996.
PC Card Products
The Company sells PC card products that provide both memory, I/O and communication functions. The Company offers a comprehensive line of memory PC card products, including 68 Pin PC cards with densities ranging from 2 MBytes to 64 MBytes and 68 Pin ATA Flash memory PC cards with densities ranging from 2 MBytes to 256 MBytes. These cards provide additional memory for notebook and subnotebook computers and PDAs. The Company's memory PC cards are PCMCIA Type I compatible.
The following table summarizes certain of the Company's PC card memory product offerings:
The Company also offers a comprehensive line of modem and communication card products. These products include a full line of PC card data/fax modems for notebook and PDA devices, as well as internal (ISA and PCI) modems for desktop computers. The Company has integrated the V.90 standard into its products for the highest level of compatibility. To address the needs of users demanding international mobility,
the Company's world-approved modems allow users to have one modem that can be used worldwide. The Company has added digital GSM technology to its world-approved modems providing users with secure, digital, wireless communications. In addition, the Company has added ISDN technology in both United States and European interfaces.
The following chart summarizes certain of the Company's communication card product offerings:
Embedded Computer Modules
The Company believes that its SMARTengine family of products helps accelerate time to market, reduce system cost, lower power requirements and provide a clear upgrade path for OEMs. The Company offers a line of standard and perfect-fit embedded computers with complete software support that offer varying price/ performance and industry standard bus interfaces. The Company's product line is processor independent and operates in systems using 32 and 64 bit CPUs from several vendors. This compatibility enhances flexibility to match price, performance and power requirements to the customer's application. The Company has also used industry standard buses, including ISA, EISA, PCI and Compact PCI, as well as custom buses, where required. All products are supported by on-board software for development and real-time operating systems support.
The following table summarizes certain of the Company's SMARTengine embedded computer module product offerings:
CUSTOMERS, SALES AND MARKETING
The Company's principal customers include major computing, networking and telecommunication OEMs and semiconductor manufacturers. For fiscal 1998, fiscal 1997 and fiscal 1996, the Company's ten largest customers accounted for 87%, 86% and 71% of net sales, respectively. For fiscal 1998, the Company's largest customer was Compaq, which accounted for 62% of net sales. In fiscal 1997, the Company's three
largest customers were Compaq, Cisco and Hewlett-Packard, which accounted for 53%, 12% and 11% of net sales, respectively. In fiscal 1996, the Company's three largest customers were Cisco, Hewlett-Packard and IBM, which accounted for 19%, 15% and 12% of net sales, respectively. During these periods, no other customers accounted for more than 10% of net sales.
The Company primarily sells its products directly to major OEM customers and uses a network of independent sales representatives located throughout North America and Europe for sales to other OEM customers. The Company's direct sales and marketing efforts are conducted in an integrated process involving direct salespeople, customer service representatives and senior executives. An important aspect of the Company's sales and marketing efforts is that the Company's experienced applications engineers work closely with OEM customers in designing the Company's products into the OEMs' systems. The Company's sales offices are located in California, Colorado, Texas, Massachusetts, New York, Florida, North Carolina, the United Kingdom, Malaysia, France and Germany.
To address the needs of its OEM customers, the Company has developed and maintains relationships with leading vendors of memory devices located in the United States, Japan and South Korea. These include limited and sole source suppliers of certain products, such as NEC Corporation, IBM, Intel Corporation ("Intel"), Oki Semiconductor, Inc., Rockwell and Samsung Electronics Company Ltd. ("Samsung"). The Company frequently works jointly with these vendors in bidding for customers' design-in opportunities. The Company's OEM marketing activities include advertising in technical journals and direct mail solicitation.
Sales are generally made pursuant to standard purchase orders. The Company includes in its backlog only those customer orders for which it has accepted purchase orders and it expects to ship within the next twelve (12) months. Since orders constituting the Company's current backlog are subject to changes in delivery schedules and are subject to cancellation with only limited or no penalties, backlog is not necessarily an accurate indication of future net sales. There can be no assurance that current backlog will necessarily lead to net sales in any future period. The Company's total backlog was approximately $29.7 million and $35.2 million as of October 31, 1998 and 1997, respectively.
DESIGN, MANUFACTURING AND TEST
The Company has a staff of engineers for applications development, component selection, schematic design, layout, firmware and software driver development. The layouts for memory modules, communication cards and embedded computer modules are specialized due to their high component and trace densities, particularly for high-speed memory modules. To further enhance its design capability, the Company established in fiscal 1995 a design center in Bangalore, India.
The Company believes that the efficiency of its manufacturing operations has benefited from its extensive experience and its library of proven designs which stress high manufacturability and quality. Through its extensive library of memory module designs and its experience in designing and manufacturing memory modules, the Company is able to work closely with its customers and suppliers to design competitive solutions to system memory problems and shorten the time it takes its customers to get their products to market.
The Company's manufacturing processes rely on a high level of automation and involve the use of a substantial base of fine pitch surface mount equipment which is specialized for the production of memory modules, embedded computer modules, communication card products and PC cards. The Company's surface mount manufacturing lines have been optimized to support the placement and configuration of a high number of ICs on each board, in contrast to surface mount equipment used in less specialized electronics manufacturing which typically involves a fewer number of ICs and a greater number of passive components on each printed circuit board. The Company also has developed automated methods for PC card case assembly and test. As a result of its design efficiencies, high level of automation and general manufacturing expertise, the Company believes that it achieves relatively high manufacturing yields. In addition, due to the high level of automation in the Company's manufacturing approach, the Company maintains a relatively low percentage of direct labor costs. The Company believes that it has achieved and maintains a rapid manufacturing cycle and is able to offer its customers quick turnaround of both small and large projects. The Company is frequently able to provide turnaround on major customer orders within days or weeks.
An important aspect of the Company's manufacturing operations is its focus on product testing. The Company tests 100% of its memory modules, communication card products and embedded computer modules for full functionality, in contrast with many other suppliers which the Company believes may test only at the system level. The Company believes that it has established substantial technical expertise in the testing of memory modules, communication card products and embedded computer modules. The Company further believes that test capability will grow in importance as the speed and complexity of memory devices and modules utilizing those devices increase. The Company has a group of experienced test engineers that develop proprietary testing routines and parameters which, combined with the Company's continued investment in advanced test equipment, enable it to diagnose problems in system design or memory components, to characterize the performance of new products and to provide high quality products in volume.
The Company currently manufactures and tests the majority of its products in a 62,250 square foot facility in Fremont, California. In addition, the Company utilizes an 83,000 square foot manufacturing and test facility in Aguada, Puerto Rico, a 50,000 square foot manufacturing and test facility in East Kilbride, Scotland and a 33,000 square foot manufacturing and test facility in Penang, Malaysia. The Company operates multiple production lines at these facilities. The Company subcontracts a limited amount of production requirements to third party manufacturers.
RESEARCH AND DEVELOPMENT
The Company believes that the timely development of new memory modules, communication card products and embedded computer modules is essential to maintaining the Company's competitive position. In the memory market, the Company's research and development activities are focused primarily on new high speed memory modules, the continual improvement in test routines and software and the ongoing improvement in manufacturing processes and technologies. In particular, the Company is focusing its research and development resources on the development of Rambus DRAM, DDR, SDRAM, Flash and SRAM products. The Company plans to continue to devote substantial research and development efforts to the design of new memory module products which address the requirements of OEMs and corporate end users.
In the communication card market, the Company's research and development efforts are focused primarily on the design and introduction of new communication card products which provide improved functionality and the latest technology in various form factors. The Company's research and development efforts in the embedded computer market are focused on the design of standard and custom embedded computer modules.
The Company's research and development expenses totaled $8.9 million, $8.5 million and $5.9 million in fiscal 1998, fiscal 1997 and fiscal 1996, respectively.
COMPETITION
The memory module, communication card and embedded computer subsystem industries are intensely competitive. Each of these markets includes a large number of competitive companies, several of which have achieved a substantial market share. Certain of the Company's competitors in each of these markets have substantially greater financial, marketing, technical, distribution and other resources, greater name recognition, lower cost structures and larger customer bases than the Company. In the memory module market, the Company competes against semiconductor manufacturers that maintain captive memory module production capabilities, including Samsung. The Company also competes with independent memory module manufacturers, including Celestica Inc., MCMS, Inc., PNY Electronics, Inc. and Simple Technology Incorporated. In the computer systems reseller market for memory modules, the Company primarily competes with companies such as Kingston Technology, Inc., Viking Technology, Inc. and Vision Tek, Inc. In the communication card market, the Company competes with GVC, TDK and U.S. Robotics, Inc. (a subsidiary of 3Com Corporation), among others. In the embedded computer subsystem market, the Company competes with Force Computers Inc. (a subsidiary of Solectron Corporation), Motorola and Radisys Corporation, among others. The Company faces competition from current and prospective customers that evaluate the Company's capabilities against the merits of manufacturing products internally. In addition, certain of the Company's
competitors, such as Samsung, are significant suppliers to the Company. These suppliers have the ability to manufacture competitive products at lower costs than the Company as a result of their higher levels of integration and therefore have the ability to sell competitive products at lower prices than the Company's products. The Company also faces competition from new and emerging companies that have recently entered or may in the future enter the markets in which the Company participates.
The Company expects its competitors to continue to improve the performance of their current products, to reduce their current product sales prices and to introduce new products that may offer greater performance and improved pricing, any of which could cause a decline in sales or loss of market acceptance of the Company's products. There can be no assurance that enhancements to or future generations of competitive products will not be developed that offer better prices or technical performance features than the Company's products. To remain competitive, the Company must continue to provide technologically advanced products and manufacturing services, maintain quality levels, offer flexible delivery schedules, deliver finished products on a reliable basis, reduce manufacturing and testing costs and compete favorably on the basis of price. In addition, increased competitive pressure has led in the past and may continue to lead to intensified price competition, resulting in lower prices and gross margin, which could materially adversely affect the Company's business, financial condition and results of operations. There can be no assurance that the Company will be able to compete successfully in the future.
INTELLECTUAL PROPERTY
The Company has one issued patent. The Company expects to file new patent applications where appropriate to protect its proprietary technologies; however, the Company believes that its continued success depends primarily on factors such as the technological skills and innovation of its personnel rather than on patent protection. In the semiconductor, computer, telecommunications and networking industries, it is typical for companies to receive notices from time to time alleging infringement of patents, copyrights or other intellectual property rights of others. The Company is currently being sued by a party who alleges that certain of the Company's communication card products have infringed and continue to infringe upon the party's intellectual property rights. Moreover, the Company has been and may from time to time continue to be notified of claims that it may be infringing patents, copyrights or other intellectual property rights owned by other third parties. There can be no assurance that these or other companies will not in the future pursue claims against the Company with respect to the alleged infringement of patents, copyrights or other intellectual property rights. In addition, litigation may be necessary to protect the Company's intellectual property rights and trade secrets, to determine the validity of and scope of the proprietary rights of others or to defend against third party claims of invalidity. The current litigation or any other litigation could result in substantial costs and diversion of resources and could have a material adverse effect on the Company's business, financial condition and results of operations.
There can be no assurance that additional infringement, invalidity, right to use or ownership claims by third parties or claims for indemnification resulting from infringement claims will not be asserted in the future. The Company has entered into license agreements in the past regarding certain alleged infringement claims asserted by third parties. In response to the current litigation or if any other claims or actions are asserted against the Company, the Company may again seek to obtain a license under a third party's intellectual property rights. There can be no assurance, however, that a license will be available under reasonable terms or at all. The failure to obtain a license under a patent or intellectual property right from a third party for technology used by the Company could cause the Company to incur substantial liabilities and to suspend the manufacture of the products utilizing the intellectual property. In addition, should the Company decide to litigate the current claim or such other claims, such litigation could be extremely expensive and time consuming and could materially and adversely affect the Company's business, financial condition and results of operations, regardless of the outcome of the litigation.
The Company attempts to protect its intellectual property rights through a variety of measures including non-disclosure agreements, trademarks, trade secrets and to a lesser extent, patents. There can be no assurance, however, that such measures will provide adequate protection for the Company's trade secrets or other proprietary information, that disputes with respect to the ownership of its intellectual property rights will
not arise, that the Company's trade secrets or proprietary technology will not otherwise become known or be independently developed by competitors or that the Company can otherwise meaningfully protect its intellectual property rights.
EMPLOYEES
As of October 31, 1998, the Company had 831 regular, full time employees of which 588 were in manufacturing (including test, quality assurance and materials work), 80 were in design and product development, 68 were in marketing and sales and 95 were in finance and administration. The Company's future results depend in significant part upon its ability to attract, train and retain qualified management, manufacturing and quality assurance, engineering, marketing, sales and support personnel. The Company's employees are not represented by any collective bargaining agreements and the Company has never experienced a work stoppage. The Company believes that its employee relations are good.
FACTORS THAT MAY AFFECT FUTURE RESULTS
The Company's business, financial condition and results of operations can be impacted by a number of factors. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Factors that May Affect Future Results." For the impact of recently issued Financial Accounting Standards on the Company's financial position and results of operations, see Note 2 to the Consolidated Financial Statements.
ITEM 2.
ITEM 2. PROPERTIES
The Company's corporate headquarters are located in a 22,500 square foot facility in Fremont, California. The lease on this facility expires in December 2004. The Company leases a 62,250 square foot manufacturing facility in Fremont, California. The lease on this facility expires in January 2003. The Company leases an additional 25,000 square foot facility in Fremont, California. The lease on this facility expires in January 2003. The Company leases an 83,000 square foot manufacturing facility in Aguada, Puerto Rico and a 50,000 square foot manufacturing facility in East Kilbride, Scotland. The leases on these facilities expire in October 2007 and September 2006, respectively. The Company also leases a 33,000 square foot manufacturing facility in Penang, Malaysia. The lease on this facility expires in May 2000. In addition, the Company leases various small facilities for its sales offices.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company and certain of its officers and directors have been named as defendants in six securities class action lawsuits filed in the United States District Court for the Northern District of California, Boren v. SMART Modular Technologies, Inc., et al., No. C 98 20692 JW (PVT) (filed July 1, 1998), Woszczak v. SMART Modular Technologies, Inc., et al., No. C 98 2617 JL (filed July 2, 1998), Bisson v. SMART Modular Technologies, Inc., et al., No. C 98 20714 JF (filed July 8, 1998), D'Amato v. SMART Modular Technologies, Inc., et al., No. C 98 2804 PJH (filed July 16, 1998), Cha v. SMART Modular Technologies, Inc., et al., No. C 98 2833 BZ (filed July 17, 1998) and Chang v. SMART Modular Technologies, Inc., et al., No. C 98 3151 SI (filed August 13, 1998) (collectively, the "Federal Actions"). The plaintiffs in the Federal Actions allege that defendants made material misrepresentations and omissions during the period from July 1, 1997 through May 21, 1998 in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The Federal Actions were consolidated on October 9, 1998, and a consolidated complaint was filed on November 30, 1998 (the "Federal Complaint").
On October 22, 1998, a putative securities class action lawsuit, captioned Reagan v. SMART Modular Technologies, Inc., et al., Case No. H204162-5 (the "State Complaint"), was filed against the Company and certain of its officers and directors in the Superior Court of the State of California, County of Alameda. The State Complaint alleges violations of Sections 25400 and 25500 of the California Corporations Code and seeks unspecified damages on behalf of a purported class of purchasers of SMART common stock during the period
from July 1, 1997 through May 21, 1998. The factual allegations of the State Complaint are nearly identical to the factual allegations contained within the Federal Complaint.
The Company believes that all claims related to the state and federal securities actions are without merit and intends to defend itself vigorously against these actions. Currently, the Company is unable to estimate the financial impact of the state and federal securities actions.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS
Not Applicable.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
The Company's Common Stock is traded on the Nasdaq National Market under the symbol "SMOD." The following table sets forth, for the periods indicated, the high and low closing sale prices for the Common Stock as reported by the Nasdaq National Market. In December 1997, the Company consummated a stock split effected as a stock dividend whereby each issued and outstanding share of the Common Stock was converted into two shares of Common Stock. Accordingly, all share and per share amounts presented herein have been retroactively adjusted to reflect the stock split.
On January 4, 1999, the reported last sale price for the Common Stock on the Nasdaq National Market was $26 per share. At January 4, 1999, the Company had approximately 158 holders of record of the Common Stock and approximately 11,300 beneficial holders of the Common Stock. The Company has never paid cash dividends on the Common Stock. The Company presently intends to retain any earnings for use in its business and does not anticipate paying any cash dividends in the foreseeable future. Certain financial covenants set forth in the Company's bank line of credit agreement prohibit the Company from paying dividends.
On November 17, 1995, the Company commenced its initial public offering of 6,000,000 shares of Common Stock with an aggregate offering price of $36,000,000 (the "Offering"). The Company's Registration Statement on Form S-1 (File No. 33-97748) for the Offering became effective on November 16, 1995. The Offering terminated upon the sale of all securities registered at the offering price. Donaldson, Lufkin & Jenrette Securities Corporation, Cowen & Company and Oppenheimer & Co., Inc. served as the managing underwriters for the Offering.
In connection with the issuance and distribution of the securities registered, direct or indirect payments to others were made as follows: (i) underwriting discounts and commissions of $2,520,000, and (ii) estimated other expenses of $1,028,536. Total estimated expenses for the Offering were $3,548,536. The Company received net offering proceeds of $32,451,464, of which as of October 31, 1998 an estimated $24,950,000 has been used for the purchase and installation of machinery and equipment and an estimated $7,500,000 toward the repayment of indebtedness. These uses of net offering proceeds were made in the form of direct or indirect payments to others.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data presented below under the captions "Consolidated Statement of Income Data" and "Consolidated Balance Sheet Data" are derived from the consolidated financial statements of the Company and subsidiaries, which financial statements have been audited by Arthur Andersen LLP, independent public accountants, to the extent indicated in their reports. On July 28, 1995, a wholly-owned subsidiary of the Company merged with Apex Data, Inc., a Delaware corporation ("Apex"), which resulted in Apex becoming a wholly-owned subsidiary of the Company. The merger was accounted for as a pooling of interests. On July 31, 1996, a wholly-owned subsidiary of the Company merged with RISQ Modular Systems, Inc., a California corporation ("RISQ"), which resulted in RISQ becoming a wholly-owned subsidiary of the Company. The merger was accounted for as a pooling of interests.
The selected consolidated financial data set forth below is qualified in its entirety by, and should be read in conjunction with, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements.
SELECTED CONSOLIDATED FINANCIAL DATA
- --------------- (1) The cumulative effect of the change in accounting principle did not materially impact diluted or basic net income per share.
(2) See Note 2 to the Consolidated Financial Statements for an explanation of the method used to determine the number of shares used in computing diluted and basic net income per share.
ITEM 7.
ITEM 7.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
In addition to other areas of this Management's Discussion and Analysis of Financial Condition and Results of Operations, the fourth and sixth paragraphs of the Overview Section, the first paragraph of the Gross Profit Section, the first paragraph of the Research and Development Section, the first paragraph of the Sales, General and Administrative Section and the first, third and fifth paragraphs of the Liquidity and Capital Resources Section contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Actual results could differ materially from those projected in the forward-looking statements as a result of the factors set forth in "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Factors that May Affect Future Results." In particular, note the factors entitled "Significant Customer Concentration," "Product Concentration; Dependence on Memory Market," "Dependence on Semiconductor, Computer, Telecommunications and Networking Industries," "Intense Competition," "Fluctuations in Operating Results," "Dependence on Sole or Limited Sources of Supply," "Rapid Technological Change" and "International Sales." The discussion of those factors is incorporated herein by this reference as if said discussion was fully set forth at this point.
OVERVIEW
The Company commenced operations in 1989 and initially focused on the design and manufacture of standard memory modules for OEMs and semiconductor manufacturers. Standard memory modules implement industry standard specifications, primarily utilize DRAM and are designed to be incorporated into a wide variety of electronic equipment. In 1991, the Company expanded its design, manufacturing and marketing efforts to offer specialty memory modules and PC card memory products. The Company expanded its PC card communication product line through the acquisition of Apex in July 1995. The Company further expanded its product line to include embedded computer modules through the acquisition of RISQ in July 1996.
The Company's net sales and gross profit have increased over the last three fiscal years. Over the last three fiscal years, SMART's gross margin has ranged from 16.1% to 18.0%. One of the primary factors affecting gross margin has been the proportion of the Company's memory products manufactured on either a turnkey or consignment basis. Products manufactured on a turnkey basis are designed and manufactured by the Company with purchased memory devices. Products manufactured on a consignment basis are generally designed and manufactured by the Company with memory devices which are owned and supplied by the customer. While products manufactured on a turnkey basis typically have lower gross margin than products manufactured on a consignment basis, products manufactured on a turnkey basis generally contribute greater net sales and higher gross profit per unit than products manufactured on a consignment basis. Currently, a substantial majority of the Company's net sales is derived from sales of products manufactured on a turnkey basis.
The other primary factor affecting the Company's gross margin has been the mix between sales of specialty memory modules, standard memory modules, communication card products and embedded computer modules. Prior to the last two fiscal years, a significant majority of the Company's net sales were derived from the sales of its specialty memory modules, which typically have slightly higher gross margin than the Company's standard memory modules. In fiscal 1998 and fiscal 1997, sales of standard memory modules accounted for approximately one half of the Company's net sales. The Company's embedded computer modules currently generate the Company's highest gross margin, followed by the Company's PC card communication products. Both of these product lines currently contribute a relatively small portion of the Company's net sales.
The Company expects that its net sales and gross margin will continue to vary significantly based on these and other factors, including the mix of products sold and the manufacturing services provided, the channels through which the Company's products are sold, changes in product selling prices and component costs, the level of manufacturing efficiencies achieved and pricing by competitors. The selling prices of the Company's products have declined in the past and the Company expects that prices could continue to decline in the
future. In particular, during fiscal 1998, the selling prices of the Company's products declined due to significant declines in DRAM semiconductor prices and declines in SRAM and Flash semiconductor prices. Because a substantial portion of the Company's net sales are attributable to the resale of semiconductor memory devices, a continued decline in the prices of these components would have a material adverse effect on the Company's net sales and could have a material adverse effect on the Company's business, financial condition and results of operations. Accordingly, the Company's ability to maintain or increase net sales will be highly dependent upon its ability to increase unit sales volumes of existing products and to introduce and sell new products in quantities sufficient to compensate for the anticipated declines in selling prices. Declining product selling prices may also materially and adversely affect the Company's gross margin unless the Company is able to reduce its cost per unit to offset declines in product selling prices. There can be no assurance that the Company will be able to increase unit sales volumes, introduce and sell new products or reduce its cost per unit. In addition, the Company's business has in the past been subject to seasonality, although the Company believes such seasonality has been masked by its growth. The Company expects that its business will experience more significant seasonality to the extent it continues to sell a material portion of its products in Europe and to the extent its exposure to the personal computer market remains significant.
The Company primarily sells its products to OEMs and semiconductor manufacturers in the computer, networking and telecommunications industries. A relatively small number of customers have accounted for a significant percentage of the Company's net sales. For fiscal 1998, fiscal 1997 and fiscal 1996, the Company's ten largest customers accounted for 87%, 86% and 71% of net sales, respectively. For fiscal 1998, the Company's largest customer was Compaq, which accounted for 62% of net sales. For fiscal 1997, the Company's three largest customers were Compaq, Cisco and Hewlett-Packard, which accounted for 53%, 12% and 11% of net sales, respectively. In fiscal 1996, the Company's three largest customers were Cisco, Hewlett-Packard and IBM, which accounted for 19%, 15% and 12% of net sales, respectively. During these periods, no other customers accounted for more than 10% of net sales.
The Company expects that sales to relatively few customers will continue to account for a significant percentage of its net sales in the foreseeable future. However, there can be no assurance that any of these customers or any of the Company's other customers will continue to utilize the Company's products at current levels, if at all. The Company has experienced significant changes in the composition of its major customer base and expects that this variability will continue in the future. For example, sales to Compaq, which represented less than 10% of net sales in fiscal 1996, represented 62% and 53% of the Company's net sales in fiscal 1998 and fiscal 1997, respectively. The loss of any major customer or any reduction in orders by any such customer would have a material adverse effect on the Company's business, financial condition and results of operations.
RESULTS OF OPERATIONS
The following table sets forth certain consolidated statement of income data of the Company expressed as a percentage of net sales:
Net Sales
Fiscal Year 1998 vs. 1997. Net sales consist of sales of specialty and standard memory products, PC cards, embedded computer modules and communication card products, less returns and discounts. Net sales increased 2.9% to $714.7 million in fiscal 1998 from $694.7 million in fiscal 1997. The increase in net sales was primarily due to an increase in sales of standard memory products, communication card products and embedded computer modules as compared to the same period of fiscal 1997. This increase was partially offset by a substantial decline in the cost of certain memory devices used in the production of the Company's products and a decrease in sales of specialty memory products.
Fiscal Year 1997 vs. 1996. Net sales increased 72.9% to $694.7 million in fiscal 1997 from $401.8 million in fiscal 1996, reflecting an overall increase in demand for the Company's products from new customers and certain existing customers. In addition, increases in sales of products manufactured on a turnkey basis as compared to products manufactured on a consignment basis further contributed to the increase in net sales as compared to the same period of fiscal 1996.
Gross Profit
Fiscal Year 1998 vs. 1997. Cost of sales includes the costs of semiconductor devices and other components and materials purchased by the Company for its products, as well as the direct labor and overhead costs associated with manufacturing. Gross profit increased 6.4% to $119.4 million in fiscal 1998 from $112.2 million in fiscal 1997. Gross margin increased to 16.7% in fiscal 1998 from 16.1% in fiscal 1997. The increase in gross margin was principally due to a decrease in the cost of certain memory chips used in the production of the Company's products as compared to the same period of fiscal 1997. Further contributing to the increase in gross margin was an increase in the proportion of the Company's net sales derived from its higher margin embedded computer modules and PC card communication products as compared to the same period of fiscal 1997. The increase in gross margin was partially offset by a decrease in the proportion of the Company's net sales derived from its specialty memory products. The Company expects gross margin to continue to be affected in future periods by, among other things, changes in the cost of memory devices used in the production of the Company's products, changes in the sales mix of the Company's products and changes in the proportion of products manufactured on a turnkey basis versus those manufactured on a consignment basis.
Fiscal Year 1997 vs. 1996. Gross profit increased 55.5% to $112.2 million in fiscal 1997 from $72.1 million in fiscal 1996. Gross margin decreased to 16.1% in fiscal 1997 from 18.0% in fiscal 1996. The decrease in gross margin was due in large part to an increase in the proportion of products manufactured on a turnkey basis versus those products manufactured on a consignment basis as compared to fiscal 1996. Further contributing to the decline in gross margin in fiscal 1997 was an increase in the proportion of the Company's net sales derived from its lower margin standard memory products as compared to fiscal 1996.
Research and Development
Fiscal Year 1998 vs. 1997. Research and development expenses consist primarily of the costs associated with the design and testing of new products. These costs relate primarily to compensation of personnel involved with development efforts, materials and outside design and testing services. Research and development expenses increased 5.3% to $8.9 million in fiscal 1998 from $8.5 million in fiscal 1997. As a percentage of net sales, research and development expenses were 1.3% and 1.2% in fiscal 1998 and fiscal 1997, respectively. The increase in research and development expenses was primarily due to an increase in the number of employees involved with development efforts as compared to the same period of fiscal 1997. The Company expects that its research and development expenses will increase in absolute dollars in future periods to the extent the Company expands its research and development efforts.
Fiscal Year 1997 vs. 1996. Research and development expenses increased 43.2% to $8.5 million in fiscal 1997 from $5.9 million in fiscal 1996. As a percentage of net sales, research and development expenses were 1.2% and 1.5% in fiscal 1997 and fiscal 1996, respectively. The increase in research and development expenses was primarily due to an overall increase in non-compensation based research and development expenses as compared to the same period of fiscal 1996. Research and development expenses were further increased by an increase in employees involved with development efforts as compared to the same period of fiscal 1996.
Sales, General and Administrative
Fiscal Year 1998 vs. 1997. Sales, general and administrative expenses consist primarily of personnel costs (including salaries, performance-based bonuses, commissions and employee benefits), facilities and equipment costs, costs related to advertising and marketing and other support costs including utilities, insurance and professional fees. Sales, general and administrative expenses increased 12.4% to $41.8 million in fiscal 1998 from $37.2 million in fiscal 1997. Sales, general and administrative expenses totaled 5.8% and 5.3% of net sales in fiscal 1998 and fiscal 1997, respectively. The increase in sales, general and administrative expenses as a percentage of net sales was due in part to growth in the Company's staffing and infrastructure, particularly in its international operations. The Company expects that its sales, general and administrative expenses will increase in absolute dollars in future periods to the extent the Company expands its staffing, information systems and other systems and personnel in connection with the expansion of the Company's infrastructure.
Fiscal Year 1997 vs. 1996. Sales, general and administrative expenses increased 30.1% to $37.2 million in fiscal 1997 from $28.5 million in fiscal 1996. Sales, general and administrative expenses totaled 5.3% and 7.1% of net sales in fiscal 1997 and fiscal 1996, respectively. The decrease in sales, general and administrative expenses as a percentage of net sales was principally due to the growth in net sales generated by certain OEM customers, which sales generally require lower incremental levels of selling and marketing expenses.
Other Income (Expense), Net
Other income (expense), net consists primarily of interest income, less interest expense. Interest expense is attributable to the Company's utilization of its line of credit and interest paid on certain lease obligations. Interest income from the proceeds of the Company's secondary public offering of common stock completed during September 1997 has resulted in significant increases in other income during fiscal 1998 as compared to fiscal 1997 and fiscal 1996.
Provision for Income Taxes
Provisions for income taxes were $24.2 million, $23.4 million and $14.8 million in fiscal 1998, fiscal 1997 and fiscal 1996, respectively. The Company's effective tax rates for these periods were 32.0%, 34.0% and 37.0%, respectively. The decrease in the Company's consolidated effective tax rate for fiscal 1998 was principally due to anticipated increases in the amount of income contributed to the Company from its Puerto Rican and international operations as compared to fiscal 1997. At October 31, 1998, the Company had a net operating loss carryforward of approximately $1.8 million for federal income tax purposes arising from the acquisition of Apex. Utilization of this net operating loss carryforward is subject to certain annual limitations. See Note 9 to the Consolidated Financial Statements.
Liquidity and Capital Resources
Since inception, SMART has used funds generated primarily from operations, certain borrowings, capital leases and equity financings to support its operations, acquire capital equipment and finance inventory and accounts receivable. The Company generated cash from operations totaling $63.8 million, $15.9 million and $27.0 million in fiscal 1998, fiscal 1997 and fiscal 1996, respectively. The increase in cash provided by operations in fiscal 1998 as compared to fiscal 1997 was primarily due to increases in net income and depreciation and amortization, and decreases in accounts receivable and certain prepaid expenses related to the Company's international operations, and partially offset by decreases in accounts payable and other accrued expenses. At October 31, 1998, the Company had $175.3 million of cash, cash equivalents and short-term investments, and $231.3 million of working capital. The Company primarily funds its liquidity requirements from existing cash balances and amounts borrowed under its existing line of credit. The Company expects to fund any future liquidity requirements from a combination of available cash balances and certain short-term borrowings under its existing line of credit. The Company currently anticipates that its working capital requirements will continue to increase in future periods to the extent that the Company's operations continue to expand.
The Company has a revolving line of credit agreement (the "Credit Line") with a term expiring in May 1999. Borrowings under the Credit Line are limited to $20.0 million. Borrowings under the Credit Line bear interest at either the bank's prime rate or a spread over LIBOR, at the Company's option. The Company is required to maintain specified levels of tangible net worth and comply with certain other covenants. As of October 31, 1998, the Company was in compliance with all covenants related to the Credit Line. The Credit Line is unsecured and no borrowings were outstanding under the Credit Line as of October 31, 1998.
Capital expenditures totaled $33.3 million, $17.1 million and $9.0 million in fiscal 1998, fiscal 1997 and fiscal 1996, respectively. These expenditures were primarily for manufacturing and test equipment and the expansion of the Company's manufacturing facilities. SMART anticipates spending an additional $35.0 million to $40.0 million during fiscal 1999 for the continued growth and expansion of the Company's manufacturing facilities and related equipment.
SMART has entered into certain capital lease arrangements. The outstanding principal on these obligations was approximately $176,000 and $1.2 million at October 31, 1998 and October 31, 1997, respectively. See Note 4 to the Consolidated Financial Statements.
On May 25, 1998, the Company's Board of Directors authorized the repurchase from time to time of up to 4,000,000 shares of the Company's Common Stock through open market purchases. During fiscal 1998, the Company repurchased 620,000 shares of its Common Stock in the open market at an average purchase price of $14.80 per share and a total cost of approximately $9.2 million.
Year 2000 Readiness Disclosure; Information Technology Transition
Many currently installed computer systems and software products are coded to accept only two digit entries in the date code field. Beginning with 21st century dates, these date code fields will need to accept four digit entries to distinguish 21st century dates from 20th century dates. As a result, computer systems and software used by many companies may need to be upgraded, to comply with such "Year 2000" requirements.
Significant uncertainty exists concerning the potential effects associated with such compliance. The Company believes its existing management information system is not Year 2000 compliant. The Company has licensed a new management information system that is Year 2000 compliant and intends to replace its existing management information system with the new system as early as the second quarter of fiscal 1999. The implementation of the new system will impact almost all phases of the Company's operations (e.g., planning, manufacturing, finance and accounting). Implementation of the new system and transition from the existing system to the new system will require substantial financial resources, time and personnel. There can be no assurance that the new system will be implemented in time to avoid any Year 2000 compliance problems, or that the Company will not experience problems, delays or unanticipated additional costs in implementing the new management information system or in the use of its existing system that could have a material adverse effect on the Company's business, financial condition and results of operations, particularly in the period in which the new system is brought online. The new system will be centrally operated from one location for all of the Company's facilities worldwide. Each of the Company's facilities will remotely access the new system via a wide area network. There can be no assurance that the Company will not experience interruption of use of the new system due to telecommunications problems or otherwise that could have a material adverse effect on the Company's business, financial condition and results of operations.
During the second quarter of fiscal 1998, the Company began a Year 2000 assessment of its management information system, other information technology systems, non-information technology systems, products and key suppliers. Items identified and under review include manufacturing and test equipment, telecommunications systems and equipment and computer systems and equipment. In addition, the Company is assessing the Year 2000 compliance of its products. The Company intends to have its Year 2000 assessment, testing, remediation efforts and development of necessary contingency plans complete by the year 2000, the total cost of which has not yet been determined. To date, however, costs incurred to address Year 2000 compliance issues have not been material. Costs related to Year 2000 compliance issues continue to be funded through operating cash flows. There can be no assurance that the Company will be able to complete its Year 2000 assessment, testing, remediation efforts and development of necessary contingency plans by the year 2000. Any failure to complete the Year 2000 assessment, testing, remediation efforts and development of necessary contingency plans prior to the year 2000 could have a material adverse effect on the Company's business, financial condition and results of operations.
During the third quarter of fiscal 1998, the Company initiated formal communications with its key suppliers of raw materials and services. Although a number of respondents indicated that their products are or will be Year 2000 compliant prior to the year 2000 and that they expect their operations and services will continue uninterrupted, there can be no assurance that the Company's key suppliers have, or will have information technology systems, non-information technology systems and products that are Year 2000 compliant. Similarly, there can be no assurance that the Company's customers have or will have information technology systems, non-information technology systems and products that are Year 2000 compliant. Any Year 2000 compliance problem facing the Company, its customers or suppliers could have a material adverse effect on the Company's business, financial condition and results of operations.
FACTORS THAT MAY AFFECT FUTURE RESULTS
The Company's business, financial condition and results of operations could be impacted by a number of factors including without limitation the following factors.
Significant Customer Concentration
A relatively small number of customers have accounted for a significant percentage of the Company's net sales. For fiscal 1998, fiscal 1997 and fiscal 1996, the Company's ten largest customers accounted for 87%, 86% and 71% of net sales, respectively. For fiscal 1998, the Company's largest customer was Compaq, which accounted for 62% of net sales. In fiscal 1997, the Company's three largest customers were Compaq, Cisco and Hewlett-Packard, which accounted for 53%, 12% and 11% of net sales, respectively. In fiscal 1996, the Company's three largest customers were Cisco, Hewlett-Packard and IBM, which accounted for 19%, 15% and 12% of net sales, respectively. During these periods, no other customers accounted for more than 10% of
net sales. The Company expects that sales to relatively few customers will continue to account for a significant percentage of its net sales in the foreseeable future. However, there can be no assurance that any of these customers or any of the Company's other customers will continue to utilize the Company's products at current levels, if at all. The Company has experienced significant changes in the composition of its major customer base and expects that this variability will continue in the future. For example, sales to Compaq, which represented less than 10% of net sales in fiscal 1996, represented 62% and 53% of the Company's net sales in fiscal 1998 and fiscal 1997, respectively. The loss of any major customer or any reduction in orders by any such customer would have a material adverse effect on the Company's business, financial condition and results of operations.
The Company has no firm long-term volume commitments from any of its major customers and generally enters into individual purchase orders with its customers, in certain cases under master agreements governing the terms and conditions of the relationship. The Company has experienced cancellations of orders and fluctuations in order levels from period to period and expects it will continue to experience such cancellations and fluctuations in the future. Customer purchase orders may be canceled and order volume levels can be changed, canceled or delayed with limited or no penalties. The replacement of canceled, delayed or reduced purchase orders with new business cannot be assured. Moreover, the Company's business, financial condition and results of operations will depend in significant part on its ability to obtain orders from new customers, as well as on the financial condition and success of its customers. Therefore, any adverse factors affecting any of the Company's customers or their customers could have a material adverse effect on the Company's business, financial condition and results of operations.
Product Concentration; Dependence on Memory Market
A substantial majority of the Company's net sales is derived from memory products. The market for memory products is characterized by frequent transitions in which products rapidly incorporate new features and performance standards. A failure to develop products with required feature sets or performance standards or a delay as short as a few months in bringing a new product to market could significantly reduce the Company's net sales for a substantial period, which would have a material adverse effect on the Company's business, financial condition and results of operations.
The market for semiconductor memory devices has been cyclical. The industry has experienced significant economic downturns at various times, characterized by diminished product demand, accelerated erosion of average selling prices and production overcapacity. During fiscal 1998, there were significant declines in DRAM semiconductor prices and declines in SRAM and Flash semiconductor prices. Because a substantial portion of the Company's net sales are attributable to the resale of semiconductor memory devices, a continued decline in the prices of these components would have a material adverse effect on the Company's net sales and could have a material adverse effect on the Company's business, financial condition and results of operations.
Dependence on Semiconductor, Computer, Telecommunications and Networking Industries
The Company may experience substantial period-to-period fluctuations in future operating results due to factors affecting the semiconductor, computer, telecommunications and networking industries. From time to time, each of these industries has experienced downturns, often in connection with, or in anticipation of, declines in general economic conditions. A decline or significant shortfall in growth in any one of these industries could have a material adverse impact on the demand for the Company's products and therefore a material adverse effect on the Company's business, financial condition and results of operations. Moreover, changes in end user demand for the products sold by any individual OEM customer can have a rapid and exaggerated effect on demand for the Company's products from that customer in any given period, particularly in the event that the OEM customer has accumulated excess inventories of products purchased from the Company. There can be no assurance that the Company's net sales and results of operations will not be materially and adversely affected in the future due to changes in demand from individual customers or cyclical changes in the semiconductor, computer, telecommunications, networking or other industries utilizing the Company's products.
Intense Competition
The memory module, communication card and embedded computer subsystem industries are intensely competitive. Each of these markets includes a large number of competitive companies, several of which have achieved a substantial market share. Certain of the Company's competitors in each of these markets have substantially greater financial, marketing, technical, distribution and other resources, greater name recognition, lower cost structures and larger customer bases than the Company. In the memory module market, the Company competes against semiconductor manufacturers that maintain captive memory module production capabilities, including Samsung. The Company also competes with independent memory module manufacturers, including Celestica Inc., MCMS, Inc., PNY Electronics, Inc. and Simple Technology Incorporated. In the computer systems reseller market for memory modules, the Company primarily competes with companies such as Kingston Technology, Inc., Viking Technology, Inc. and Vision Tek, Inc. In the communication card market, the Company competes with GVC, TDK and U.S. Robotics, Inc. (a subsidiary of 3Com Corporation), among others. In the embedded computer subsystem market, the Company competes with Force Computers Inc. (a subsidiary of Solectron Corporation), Motorola and Radisys Corporation, among others. The Company faces competition from current and prospective customers that evaluate the Company's capabilities against the merits of manufacturing products internally. In addition, certain of the Company's competitors, such as Samsung, are significant suppliers to the Company. These suppliers have the ability to manufacture competitive products at lower costs than the Company as a result of their higher levels of integration and therefore have the ability to sell competitive products at lower prices than the Company's products. The Company also faces competition from new and emerging companies that have recently entered or may in the future enter the markets in which the Company participates.
The Company expects its competitors to continue to improve the performance of their current products, to reduce their current product sales prices and to introduce new products that may offer greater performance and improved pricing, any of which could cause a decline in sales or loss of market acceptance of the Company's products. There can be no assurance that enhancements to or future generations of competitive products will not be developed that offer better prices or technical performance features than the Company's products. To remain competitive, the Company must continue to provide technologically advanced products and manufacturing services, maintain quality levels, offer flexible delivery schedules, deliver finished products on a reliable basis, reduce manufacturing and testing costs and compete favorably on the basis of price. In addition, increased competitive pressure has led in the past and may continue to lead to intensified price competition, resulting in lower prices and gross margin, which could materially adversely affect the Company's business, financial condition and results of operations. There can be no assurance that the Company will be able to compete successfully in the future.
Fluctuations in Operating Results
The Company's results of operations and gross margin have fluctuated significantly from period to period in the past and may in the future continue to fluctuate significantly from period to period. The primary factors that have affected and may in the future affect the Company's results of operations include the partial or complete loss of a principal customer or the reduction in orders from a customer due to, among other things, excess product inventory accumulation by such customer, adverse changes in the mix of products sold by the Company, and the inability to procure required components. Other factors that have affected and may in the future affect the Company's results of operations include fluctuating market demand for and declines in the selling prices of the Company's products, decreases or increases in the costs of the components of the Company's products, market acceptance of new products and enhanced versions of the Company's products, the Company's competitors selling products that compete with the Company's products at lower prices or on better terms than the Company's products, delays in the introduction of new products and enhancements to existing products, manufacturing inefficiencies associated with the start up of new product introductions, and the Company's semiconductor customers manufacturing memory modules, internally or with other third parties, outside of the United States due to concerns about United States antidumping investigations and laws.
The Company's operating results may also be affected by the timing of new product announcements and releases by the Company or its competitors, the timing of significant orders, the ability to produce products in volume, delays, cancellations or reschedulings of orders due to customer financial difficulties or other events, inventory obsolescence, including the reduction in value of the Company's inventories due to price declines, unexpected product returns, the timing of expenditures in anticipation of increased sales, cyclicality in the Company's targeted markets, and expenses associated with acquisitions. In particular, declines in DRAM, SRAM and Flash semiconductor prices could affect the valuation of the Company's inventory which could result in adverse changes in the Company's business, financial condition and results of operations. The concentration of the Company's assets in its Fremont, California facility could make the Company's exposure to business disruptions greater than if the Company's assets were more geographically dispersed.
The Company's net sales and gross margin have varied and will continue to vary significantly based on a variety of factors, including the mix of products sold and the manufacturing services provided, the channels through which the Company's products are sold, changes in product selling prices and component costs, the level of manufacturing efficiencies achieved and pricing by competitors. The selling prices of the Company's products have declined in the past and the Company expects that prices could continue to decline in the future. In particular, during fiscal 1998, the selling prices of the Company's products declined due to significant declines in DRAM semiconductor prices and declines in SRAM and Flash semiconductor prices. Because a substantial portion of the Company's net sales are attributable to the resale of semiconductor memory devices, a continued decline in the prices of these components would have a material adverse effect on the Company's net sales and could have a material adverse effect on the Company's business, financial condition and results of operations. Accordingly, the Company's ability to maintain or increase net sales will be highly dependent upon its ability to increase unit sales volumes of existing products and to introduce and sell new products in quantities sufficient to compensate for the anticipated declines in selling prices. Declining product selling prices may also materially and adversely affect the Company's gross margin unless the Company is able to reduce its cost per unit to offset declines in product selling prices. There can be no assurance that the Company will be able to increase unit sales volumes, introduce and sell new products or reduce its cost per unit. In addition, the Company's business has in the past been subject to seasonality, although the Company believes such seasonality has been masked by its growth. The Company expects that its business will experience more significant seasonality to the extent it continues to sell a material portion of its products in Europe and to the extent its exposure to the personal computer market remains significant.
Sales of the Company's individual products and product lines toward the end of a product's life cycle are typically characterized by steep declines in sales, pricing and gross margin, the precise timing of which may be difficult to predict. The Company has experienced and could continue to experience unexpected reductions in sales of products as customers anticipate new product purchases. In addition, to the extent that the Company manufactures products in anticipation of future demand that does not materialize, or in the event a customer cancels outstanding orders during a period of either declining product selling prices or decreasing demand, the Company could experience an unanticipated decrease in sales of products. These factors could give rise to charges for obsolete or excess inventory, returns of products by distributors, or substantial price protection charges or discounts. In the past, the Company has had to write-down and write-off excess or obsolete inventory. To the extent that the Company is unsuccessful in managing product transitions, its business, financial condition and results of operations could be materially and adversely affected.
The need for continued significant expenditures for capital equipment purchases, research and development and ongoing customer service and support, among other factors, will make it difficult for the Company to reduce its operating expenses in any particular period if the Company's expectations for net sales for that period are not met. The Company has significantly increased its expense levels to support its recent growth, and there can be no assurance that the Company will maintain its current level of net sales or rate of growth for any period in the future. Accordingly, there can be no assurance that the Company will be able to continue to be profitable. The Company believes that period-to-period comparisons of the Company's financial results are not necessarily meaningful and should not be relied upon as indications of future performance. Due to the foregoing factors, it is likely that in some future period the Company's operating results will be below
the expectations of public market analysts or investors. In such event, the market price of the Company's securities would be materially and adversely affected.
Dependence on Sole or Limited Sources of Supply
The Company is dependent on certain suppliers, including limited and sole source suppliers, to provide key components used in the Company's products. In particular, the Company is dependent in significant part upon certain limited or sole source suppliers for critical components in the Company's memory module, communication card and embedded computer products. The Company also depends on sole source third party manufacturers to produce certain of the Company's embedded computer products. The electronics industry has experienced in the past, and may experience in the future, shortages in semiconductor devices, including DRAM, SRAM and Flash memory. The Company has experienced and may continue to experience delays in component deliveries and quality problems with respect to certain component deliveries which have caused and could in the future cause delays in product shipments and have required and could in the future require the redesign of certain products. The Company generally has no written agreements with its suppliers. There can be no assurance that the Company will receive adequate component supplies on a timely basis in the future. The inability to continue to obtain sufficient supplies of components as required, or to develop alternative sources if required, could cause delays, disruptions or reductions in product shipments or require product redesigns which could damage relationships with current or prospective customers, could increase costs and/or prices and could have a material adverse effect on the Company's business, financial condition and results of operations.
Management of Growth; Expansion of Operations
The Company has significantly expanded its operations over the last several years. This growth has resulted in a significant increase in responsibility for existing management which has placed, and may continue to place, a significant strain on the Company's limited personnel and management, manufacturing and other resources. The Company's ability to manage the recent and any possible future growth will require an expansion of its manufacturing capacity, accounting and other internal management systems and the implementation of a variety of procedures and controls. There can be no assurance that significant problems in these areas will not occur. Any failure to expand these systems and implement such procedures and controls in an efficient manner and at a pace consistent with the Company's business could have a material adverse effect on the Company's business, financial condition and results of operations.
The Company has licensed a new management information system that is Year 2000 compliant and intends to replace its existing management information system with the new system as early as the second quarter of fiscal 1999. The implementation of the new system will impact almost all phases of the Company's operations (e.g., planning, manufacturing, finance and accounting). Implementation of the new system and transition from the existing system to the new system will require substantial financial resources, time and personnel. There can be no assurance that the Company will not experience problems, delays or unanticipated additional costs in implementing the new management information system or in the use of its existing system that could have a material adverse effect on the Company's business, financial condition and results of operations, particularly in the period in which the new system is brought online. The new system will be centrally operated from one location for all of the Company's facilities worldwide. Each of the Company's facilities will remotely access the new system via a wide area network. There can be no assurance that the Company will not experience interruption of use of the new system due to telecommunications problems or otherwise that could have a material adverse effect on the Company's business, financial condition and results of operations.
In connection with the Company's growth over the last several years, the Company's operating expenses have increased significantly, and the Company anticipates that operating expenses will continue to increase in absolute dollars in the future. In particular, in order to continue to provide quality products and customer service and to meet any anticipated demand of its customers, the Company will be required to continue to increase staffing and other expenses, including expenditures on capital equipment, sales and marketing. Should the Company increase its expenditures in anticipation of a future level of sales that does not materialize, the
Company's business, financial condition and results of operations would be materially and adversely affected. Certain customers have required and may continue to require rapid increases in production and accelerated delivery schedules which have placed and may continue to place a significant burden on the Company's resources. In order to achieve anticipated sales levels and profitability, the Company will continue to be required to manage its assets and operations efficiently. In addition, should the Company continue to expand geographically, it may experience certain inefficiencies from the management of geographically dispersed facilities.
In fiscal 1998, the Company opened a new manufacturing facility in Penang, Malaysia, which has resulted and will continue to result in higher operating expenses. There can be no assurance that enough future sales will exist to support the operating expenses of the new facility or that the production lines of the new facility will be efficient or that they will result in an increase in output. Any delay or difficulties arising from the start-up of the new facility could materially and adversely affect the Company's business, financial condition and results of operations.
Year 2000 Readiness Disclosure; Information Technology Transition
Many currently installed computer systems and software products are coded to accept only two digit entries in the date code field. Beginning with 21st century dates, these date code fields will need to accept four digit entries to distinguish 21st century dates from 20th century dates. As a result, computer systems and software used by many companies may need to be upgraded to comply with such Year 2000 requirements. Significant uncertainty exists concerning the potential effects associated with such compliance. The Company believes its existing management information system is not Year 2000 compliant. The Company has licensed a new management information system that is Year 2000 compliant and intends to replace its existing management information system with the new system as early as the second quarter of fiscal 1999. The implementation of the new system will impact almost all phases of the Company's operations (e.g., planning, manufacturing, finance and accounting). Implementation of the new system and transition from the existing system to the new system will require substantial financial resources, time and personnel. There can be no assurance that the new system will be implemented in time to avoid any Year 2000 compliance problems, or that the Company will not experience problems, delays or unanticipated additional costs in implementing the new management information system or in the use of its existing system that could have a material adverse effect on the Company's business, financial condition and results of operations, particularly in the period in which the new system is brought online. The new system will be centrally operated from one location for all of the Company's facilities worldwide. Each of the Company's facilities will remotely access the new system via a wide area network. There can be no assurance that the Company will not experience interruption of use of the new system due to telecommunications problems or otherwise that could have a material adverse effect on the Company's business, financial condition and results of operations.
During the second quarter of fiscal 1998, the Company began a Year 2000 assessment of its management information system, other information technology systems, non-information technology systems, products and key suppliers. Items identified and under review include manufacturing and test equipment, telecommunications systems and equipment and computer systems and equipment. In addition, the Company is assessing the Year 2000 compliance of its products. The Company intends to have its Year 2000 assessment, testing, remediation efforts and development of necessary contingency plans complete by the year 2000, the total cost of which has not yet been determined. To date, however, costs incurred to address Year 2000 compliance issues have not been material. Costs related to Year 2000 compliance issues continue to be funded through operating cash flows. There can be no assurance that the Company will be able to complete its Year 2000 assessment, testing, remediation efforts and development of necessary contingency plans by the year 2000. Any failure to complete the Year 2000 assessment, testing, remediation efforts and development of necessary contingency plans prior to the year 2000 could have a material adverse effect on the Company's business, financial condition and results of operations.
During the third quarter of fiscal 1998, the Company initiated formal communications with its key suppliers of raw materials and services. Although a number of respondents indicated that their products are or will be Year 2000 compliant prior to the year 2000 and that they expect their operations and services will
continue uninterrupted, there can be no assurance that the Company's key suppliers have, or will have information technology systems, non-information technology systems and products that are Year 2000 compliant. Similarly, there can be no assurance that the Company's customers have or will have information technology systems, non-information technology systems and products that are Year 2000 compliant. Any Year 2000 compliance problem facing the Company, its customers or suppliers could have a material adverse effect on the Company's business, financial condition and results of operations.
Rapid Technological Change
The semiconductor, computer, telecommunications and networking industries are subject to rapid technological change, short product life cycles, frequent new product introductions and enhancements, changes in end user requirements and evolving industry standards. The Company's ability to be competitive in these markets will depend in significant part upon its ability to invest significant amounts of resources for research and development efforts, to successfully develop, introduce and sell new products and enhancements on a timely and cost-effective basis and to respond to changing customer requirements that meet evolving industry standards. For example, the semiconductor memory market is expected to transition from SDRAM to Direct RDRAM. The Company is currently focusing its research and development resources on the development of Rambus DRAM, DDR, SDRAM, Flash and SRAM products, 56 kbps asynchronous modem products and various embedded computer products. The success of the Company in developing new and enhanced products will depend upon a variety of factors, including integration of various elements of complex technology, timely and efficient completion of product design, timely and efficient implementation of manufacturing and assembly processes, availability of production capacity, achievement of acceptable manufacturing yields and product performance, quality and reliability. The Company has experienced, and may in the future experience, delays from time to time in the development and introduction of new products. Moreover, there can be no assurance that the Company will be successful in selecting, developing, manufacturing and marketing new products or enhancements. There can be no assurance that defects or errors will not be found in the Company's products after commencement of commercial shipments, which could result in the delay in market acceptance of such products. The inability of the Company to introduce new products or enhancements that contribute to net sales could have a material adverse effect on the Company's business, financial condition and results of operations.
Dependence on Key Personnel
The Company's future operating results depend in significant part upon the continued contributions of its key technical and senior management personnel, many of whom would be difficult to replace. None of such persons, including the executive officers, has an employment agreement with the Company. The Company's future operating results also depend in significant part upon its ability to attract, train and retain qualified management, manufacturing and quality assurance, engineering, marketing, sales and support personnel. The Company is actively recruiting such personnel. However, competition for such personnel is intense, and there can be no assurance that the Company will be successful in attracting, training or retaining such personnel now or in the future. There may be only a limited number of persons with the requisite skills to serve in these positions and it may be increasingly difficult for the Company to hire such persons over time. The loss of any key employee, the failure of any key employee to perform in his or her current position, the Company's inability to attract, train and retain skilled employees as needed or the inability of the officers and key employees of the Company to expand, train and manage the Company's employee base could materially and adversely affect the Company's business, financial condition and results of operations.
International Sales
International sales accounted for 30%, 18% and 8% of net sales in fiscal 1998, fiscal 1997 and fiscal 1996, respectively. The Company anticipates that international sales will continue to be material in future periods. As a result, a material portion of the Company's sales may be subject to certain risks, including changes in regulatory requirements, tariffs and other barriers, timing and availability of export licenses, political and economic instability, difficulties in accounts receivable collections, natural disasters, difficulties in staffing and
managing foreign subsidiary and branch operations, difficulties in managing distributors, difficulties in obtaining governmental approvals for telecommunications and other products, foreign currency exchange fluctuations, the burden of complying with a wide variety of complex foreign laws and treaties, potentially adverse tax consequences and uncertainties relative to regional, political and economic circumstances. In particular, recent instability in certain Asian economies and financial markets could have an adverse effect on the Company's business, financial condition and results of operations in future quarters. In fiscal 1998, the Company's net sales to customers in Asia accounted for less than one percent of all net sales. In addition to net sales to customers in Asia, the Company maintains strategic supply relationships with companies located in Asia. Moreover and as a result of currency changes and other factors, certain of the Company's competitors may have the ability to manufacture competitive products in Asia at lower costs than the Company. There can be no assurance that current economic instability in Asia will not have a material adverse effect on the Company's net sales, its ability to compete or its ability to receive raw materials for its products.
The Company is also subject to the risks associated with the imposition of legislation and regulations relating to the import or export of high technology products. The Company cannot predict whether quotas, duties, taxes or other charges or restrictions upon the importation or exportation of the Company's products will be implemented by the United States or other countries. Because sales of the Company's products have been denominated to date primarily in United States dollars, increases in the value of the United States dollar could increase the price of the Company's products so that they become relatively more expensive to customers in the local currency of a particular country, leading to a reduction in sales and profitability in that country. Future international activity may result in increased foreign currency denominated sales. Gains and losses on the conversion to United States dollars of accounts receivable, accounts payable and other monetary assets and liabilities arising from international operations may contribute to fluctuations in the Company's results of operations. Some of the Company's customer's purchase orders and agreements are governed by foreign laws, which may differ significantly from United States laws. Therefore, the Company may be limited in its ability to enforce its rights under such agreements and to collect damages, if awarded. There can be no assurance that any of these factors will not have a material adverse effect on the Company's business, financial condition and results of operations.
Uncertainty Regarding Protection of Proprietary Rights
In the semiconductor, computer, telecommunications and networking industries, it is typical for companies to receive notices from time to time alleging infringement of patents, copyrights or other intellectual property rights of others. The Company is currently being sued by a party who alleges that certain of the Company's communication card products have infringed and continue to infringe upon the party's intellectual property rights. Moreover, the Company has been and may from time to time continue to be notified of claims that it may be infringing patents, copyrights or other intellectual property rights owned by other third parties. There can be no assurance that these or other companies will not in the future pursue claims against the Company with respect to the alleged infringement of patents, copyrights or other intellectual property rights. In addition, litigation may be necessary to protect the Company's intellectual property rights and trade secrets, to determine the validity of and scope of the proprietary rights of others or to defend against third party claims of invalidity. The current litigation or any other litigation could result in substantial costs and diversion of resources and could have a material adverse effect on the Company's business, financial condition and results of operations.
There can be no assurance that additional infringement, invalidity, right to use or ownership claims by third parties or claims for indemnification resulting from infringement claims will not be asserted in the future. The Company has entered into license agreements in the past regarding certain alleged infringement claims asserted by third parties. In response to the current litigation or if any other claims or actions are asserted against the Company, the Company may again seek to obtain a license under a third party's intellectual property rights. There can be no assurance, however, that a license will be available under reasonable terms or at all. The failure to obtain a license under a patent or intellectual property right from a third party for technology used by the Company could cause the Company to incur substantial liabilities and to suspend the manufacture of the products utilizing the intellectual property. In addition, should the Company decide to
litigate the current claim or such other claims, such litigation could be extremely expensive and time consuming and could materially and adversely affect the Company's business, financial condition and results of operations, regardless of the outcome of the litigation.
The Company attempts to protect its intellectual property rights through a variety of measures including non-disclosure agreements, trademarks, trade secrets and to a lesser extent, patents. There can be no assurance, however, that such measures will provide adequate protection for the Company's trade secrets or other proprietary information, that disputes with respect to the ownership of its intellectual property rights will not arise, that the Company's trade secrets or proprietary technology will not otherwise become known or be independently developed by competitors or that the Company can otherwise meaningfully protect its intellectual property rights.
Risks Associated with Acquisitions
As part of its business strategy, the Company expects to acquire or make significant investments in businesses that offer complementary products and technologies. Any such future acquisitions or investments would expose the Company to the risks commonly encountered in acquisitions of businesses. Such risks include, among others, difficulty of assimilating the operations, information systems and personnel of the acquired businesses, the potential disruption of the Company's ongoing business, the inability of management to maximize the financial and strategic position of the Company through the successful incorporation of acquired employees and customers, the maintenance of uniform standards, controls, procedures and policies and the impairment of relationships with employees and customers as a result of any integration of new management personnel. There can be no assurance that any potential acquisition will be consummated or, if consummated, that it will not have a material adverse effect on the Company's business, financial condition and results of operations.
Volatility of Stock Prices
There has been a history of significant volatility in the market prices of the common stock of technology companies, including the Common Stock of the Company, and it is likely that the market price of the Company's Common Stock will continue to be subject to significant fluctuations. Factors such as the timing and market acceptance of new product introductions by the Company, demand for products of the Company's customers, the introduction of new products by the Company's competitors, variations in quarterly operating results, changes in securities analysts' recommendations regarding the Company's Common Stock, developments in the technology industry and general economic conditions may have a significant impact on the market price of the Company's Common Stock. In addition, the equity markets in recent years have experienced significant price and volume fluctuations that have affected the market prices of technology companies and that have often been unrelated to the operating performance of such companies.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Risk
The Company's exposure to market risk for changes in interest rates relate primarily to the Company's investment portfolio. Currently, the Company does not use derivative financial instruments in its investment portfolio. The Company invests in high-credit quality issuers and, by policy, limits the amount of principal exposure to any one issuer. As stated in the Company's policy, the Company seeks to ensure the safety and preservation of its invested principal funds by limiting default and market risk.
The Company seeks to mitigate default risk by investing in high-credit quality securities and by positioning its investment portfolio to respond to a significant reduction in a credit rating of any investment issuer, guarantor or depository. The Company seeks to mitigate market risk by limiting the principal and investment term of funds held with any one issuer and by investing funds in marketable securities with active secondary or resale markets.
The table below presents principal amounts and related weighted average interest rates by year of maturity for the Company's investment portfolio as of October 31, 1998 (in thousands):
Foreign Currency Exchange Risk
The Company transacts business in various foreign countries. The Company's primary foreign currency cash flows are in certain European countries. Currently, the Company does not employ a foreign currency hedge program with respect to transactions and expenditures originating in these or any other foreign countries. The Company believes that its foreign currency exchange risk is immaterial. See Note 2 to the Consolidated Financial Statements.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Company's financial statements and the report of the independent auditors appear on pages through of this report.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not Applicable.
PART III
Certain information required by Part III is omitted from this Annual Report on Form 10-K because the Registrant will file a definitive proxy statement for its Annual Meeting of Shareholders currently scheduled for March 16, 1999 (the "Proxy Statement") with the Securities and Exchange Commission within one hundred twenty (120) days after the end of its fiscal year pursuant to Regulation 14A, and certain information included in the Proxy Statement is incorporated herein by reference.
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item is incorporated by reference to the information in the Registrant's Proxy Statement under the headings "Election of Directors" and "Other Information -- Executive Officers."
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference to the information in the Registrant's Proxy Statement under the headings "Other Information -- Executive Compensation," "Other Information -- Option Grants in Last Fiscal Year," and "Other Information -- Aggregate Option Exercises in Last Fiscal Year and Fiscal Year End Option Values."
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference to the information in the Registrant's Proxy Statement under the headings "Information Concerning Solicitation and Voting -- Record Date and Shares Outstanding" and "Other Information -- Security Ownership of Certain Beneficial Owners and Management."
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference to the information in the Registrant's Proxy Statement under the headings "Other Information -- Compensation Committee Interlocks and Insider Participation" and "Other Information -- Certain Transactions."
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) The following documents are filed as part of this report:
1. FINANCIAL STATEMENTS. The following Consolidated Financial Statements of SMART Modular Technologies, Inc. are filed as part of this report:
2. FINANCIAL STATEMENT SCHEDULES. The following financial statement schedules of SMART Modular Technologies, Inc. for the years ended October 31, 1998, 1997 and 1996 are filed as part of this report and should be read in conjunction with the Consolidated Financial Statements of SMART Modular Technologies, Inc.:
Schedules not listed above have been omitted because they are not applicable or are not required or the information required to be set forth therein is included in the Consolidated Financial Statements or Notes thereto.
3. EXHIBITS. The following exhibits are filed as part of this report:
- --------------- (1) Incorporated by reference to exhibit filed with the Registrant's Registration Statement on Form S-1 (No. 33-97748) filed October 4, 1995, Amendment No. 1 thereto filed October 24, 1995, Amendment No. 2 thereto filed November 6, 1995, Amendment No. 3 thereto filed November 14, 1995 and Amendment No. 4 thereto filed November 16, 1995, which Registration Statement became effective November 16, 1995.
(2) Incorporated by reference to exhibit filed with the Registrant's Report on Form 10-Q filed March 16, 1996.
(3) Incorporated by reference to exhibit filed with the Registrant's Report on Form 10-Q filed June 14, 1996.
(4) Incorporated by reference to exhibit filed with the Registrant's Report on Form 10-Q filed June 16, 1997.
(5) Incorporated by reference to exhibit filed with the Registrant's Report on Form 10-Q filed August 28, 1997.
(6) Incorporated by reference to exhibit filed with the Registrant's Report on Form 10-K filed January 29, 1998.
(7) Incorporated by reference to exhibit filed with the Registrant's Report on Form 10-Q filed June 15, 1998.
(8) Incorporated by reference to exhibit filed with the Registrant's Report on Form 10-Q filed September 11, 1998.
* Pursuant to Rule 406(b) under the Securities Act of 1933, confidential treatment has been granted to certain portions of this exhibit, which portions have been deleted and filed separately with the Securities and Exchange Commission.
** Pursuant to Rule 24b-2 under the Securities Exchange Act of 1934, confidential treatment has been granted to certain portions of this exhibit, which portions have been deleted and filed separately with the Securities and Exchange Commission.
(b) REPORTS ON FORM 8-K.
No reports on Form 8-K were filed during the last quarter of fiscal 1998.
(c) EXHIBITS.
See Item 14(a)(3) above.
(d) FINANCIAL STATEMENT SCHEDULES.
See Item 14(a)(2) above.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
SMART MODULAR TECHNOLOGIES, INC.
By: /s/ AJAY SHAH
------------------------------------ Ajay Shah President, Chief Executive Officer and Chairman of the Board of Directors
Dated: January 27, 1999
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Ajay Shah and David B. Mullin and each of them singly, as true and lawful attorneys-in-fact and agents with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities to sign any or all amendments to this report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission granting unto said attorneys-in-fact and agents the full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the foregoing, as full to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or his substitute, may lawfully do or cause to be done by virtue hereof. Witness our hands on the date set forth below.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of SMART Modular Technologies, Inc.:
We have audited the accompanying consolidated balance sheets of SMART Modular Technologies, Inc. (a California corporation) and subsidiaries as of October 31, 1998 and 1997, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended October 31, 1998. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of SMART Modular Technologies, Inc. and subsidiaries as of October 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended October 31, 1998 in conformity with generally accepted accounting principles.
/s/ ARTHUR ANDERSEN LLP
-------------------------------------- ARTHUR ANDERSEN LLP
San Jose, California November 18, 1998
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS OCTOBER 31, (IN THOUSANDS, EXCEPT SHARE DATA)
ASSETS
The accompanying notes are an integral part of these consolidated financial statements.
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME FOR THE YEARS ENDED OCTOBER 31, (IN THOUSANDS, EXCEPT PER SHARE DATA)
The accompanying notes are an integral part of these consolidated financial statements.
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (IN THOUSANDS, EXCEPT SHARE DATA)
The accompanying notes are an integral part of these consolidated financial statements.
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED OCTOBER 31, (IN THOUSANDS)
The accompanying notes are an integral part of these consolidated financial statements.
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND OPERATIONS OF THE COMPANY
SMART Modular Technologies, Inc. (the "Company") was incorporated in California in August 1988. The Company designs, manufactures and markets memory modules, Flash memory cards, high performance embedded computer modules and communication card products primarily to the computer, networking and telecommunications industries. The Company is headquartered in Fremont, California and has manufacturing operations in Fremont, Scotland, Puerto Rico and Malaysia.
On September 11, 1997, the Company completed a secondary public offering of 2,821,000 shares of common stock (including underwriters' over-allotment) at $32 3/8 per share (as adjusted for the Company's stock split in December 1997-- See Note 2). Total proceeds to the Company (net of underwriting discounts and commissions) were approximately $86.4 million.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Estimates
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.
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and its subsidiaries after elimination of all intercompany accounts and transactions.
Stock Split
In December 1997, the Company consummated a stock split effected as a stock dividend whereby each issued and outstanding share of the Company's common stock was converted into two shares of common stock. All share and per share amounts in the accompanying consolidated financial statements have been retroactively adjusted to reflect the stock split.
Cash Equivalents
The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents.
Investments in Debt and Equity Securities
The Company accounts for its investments in debt and equity securities pursuant to the provisions of Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities." In accordance with SFAS No. 115, debt securities are classified as held-to-maturity and recorded at amortized cost when the Company has the positive intent and ability to hold the securities to maturity. Marketable debt securities not classified as held-to-maturity are classified as available- for-sale. Available-for-sale securities are carried at fair value, with unrealized holding gains and losses reported as a separate component of shareholders' equity, if significant.
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
All of the Company's investments are classified as available-for-sale securities as summarized below (in thousands):
Property and Equipment
Property and equipment are stated at cost. Depreciation is provided using the straight-line method over the estimated useful life of five years. Assets acquired under capital leases are recorded at the present value of the related lease obligations and depreciated on a straight-line basis over five years. Betterments, renewals and extraordinary repairs that extend the life of the asset are capitalized; other repairs and maintenance are expensed. The cost and accumulated depreciation applicable to assets retired are removed from the accounts and any resulting gain or loss on disposition is recognized in income.
Property, plant and equipment consists of the following as of October 31, (in thousands):
Included in property and equipment are assets acquired under capital lease obligations with an original cost of approximately $4,461,000 and $4,732,000 as of October 31, 1998 and 1997, respectively. Accumulated amortization on the leased assets was approximately $3,076,000 and $2,178,000 as of October 31, 1998 and 1997, respectively.
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Foreign Currency Translation
The functional currency of the Company's subsidiaries is the United States dollar. Accordingly, all translation gains and losses resulting from transactions denominated in currencies other than United States dollars are included in net income. To date the resulting gains and losses have not been material.
Revenue Recognition
Revenue is recognized upon shipment to the customer. The Company provides for estimated future returns for inventory rebalancing, stock rotation, established price protection arrangements and the estimated costs of warranty at the time of sale.
Net Income Per Share
The Financial Accounting Standards Board issued SFAS No. 128, "Earnings per Share," in March 1997 and is effective for years ending after December 15, 1997. The Company retroactively adopted SFAS No. 128 in fiscal 1998. This statement requires companies to compute net income per share under two different methods, basic and diluted, and present per share data for all periods in which a statement of operations is presented. Basic net income per share is computed by dividing net income by the weighted average number of shares of common stock outstanding during the period. Diluted net income per share is computed using the weighted average number of shares of common stock and common stock equivalents outstanding during the period. Common stock equivalents consist of preferred stock (using the "if converted" method), stock options and warrants (using the treasury stock method). Preferred stock, stock options and warrants are excluded from the computation of diluted net income per share if their effect is anti-dilutive.
The following table reconciles the amounts used in the computation of basic and diluted net income per share as of October 31, (in thousands, except per share data):
Risks and Uncertainties
Financial instruments which potentially subject the Company to a concentration of credit risk principally consist of accounts receivable. As of October 31, 1998, approximately 90% of accounts receivable were concentrated with seven customers. As of October 31, 1997, approximately 83% of accounts receivable were concentrated with four customers. The Company generally does not require collateral on accounts receivable as the majority of the Company's customers are large, well established companies.
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The Company is dependent on certain suppliers, including limited and sole source suppliers, to provide key components used in the Company's products. Although there are a limited number of manufacturers of such key components, management believes that other suppliers could provide similar components on comparable terms. A change in suppliers, however, could cause a delay in manufacturing and a possible loss of net sales, which would affect operating results adversely.
A substantial majority of the Company's net sales are derived from memory products. The market for memory products is characterized by frequent transitions in which products rapidly incorporate new features and performance standards. A failure to develop products with required feature sets or performance standards or a delay in bringing a new product to market could adversely affect the Company's operating results.
Inventories
Inventories are stated at the lower of cost (first-in, first-out) or market and include material, labor and manufacturing costs. Inventories consist of the following as of October 31, (in thousands):
Effect of Recent Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board issued SFAS No. 130, "Reporting Comprehensive Income," which establishes standards for reporting and display of comprehensive income and its individual components. The statement requires the disclosure of all changes in equity of an enterprise that result from transactions and other economic events of the period other than transactions with owners ("comprehensive income"). The Company is required to adopt the provisions of SFAS No. 130 in the first quarter of fiscal 1999. At that time, reclassification of financial statements for all periods presented will be required. The Company does not expect the adoption of SFAS No. 130 to have a material effect on the Company's consolidated financial statements.
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information," which establishes annual and interim reporting standards for an enterprise's business segments and related disclosures about its products, services, geographic areas of operations and major customers. The Company is required to adopt the provisions of SFAS No. 131 beginning with its annual report on Form 10-K for the fiscal year ended October 31, 1999 and for all subsequent interim periods. The Company does not expect the adoption of SFAS No. 131 to have a material effect on the Company's consolidated financial statements.
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivative Investments and Hedging Activities." The statement establishes accounting and reporting standards requiring that every derivative instrument be recorded in the balance sheet as either an asset or liability measured at its fair value. The statement also requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999. The Company does not expect the adoption of SFAS No. 133 to have a material effect on the Company's consolidated financial statements.
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. LINE OF CREDIT
In June 1997, the Company entered into an unsecured revolving bank line of credit agreement which expires in May 1999. Borrowings under this agreement are limited to $20.0 million and bear interest at either the bank's prime rate (8.0% at October 31, 1998) or a spread over LIBOR (5.2% at October 31, 1998), at the Company's option. The Company is required to maintain specified levels of tangible net worth and comply with certain other covenants. As of October 31, 1998 and 1997, no borrowings were outstanding under this agreement.
4. CAPITAL LEASE OBLIGATIONS
Minimum future lease payments under capital leases as of October 31, 1998 are summarized as follows (in thousands):
5. COMMITMENTS
The Company leases its current facilities and certain equipment under noncancelable operating leases that expire at various dates through fiscal 2007. Under the terms of the facilities leases, the Company is responsible for utilities, maintenance, insurance and property taxes. As of October 31, 1998, the future minimum lease payments are as follows (in thousands):
Rental expense was approximately $1,609,000, $1,417,000 and $1,025,000 for the years ended October 31, 1998, 1997 and 1996, respectively.
6. PROFIT SHARING AND 401(K) PLANS
The Company has a profit sharing plan (the "Plan") which generally covers all employees of the Company who are over 21 years of age and have worked for the Company for at least one year. Annual contributions to the Plan are discretionary, as determined by the Board of Directors. Contributions vest at a rate of 20% per year beginning with an individual's third year with the Company. There were no contributions to the Plan for the fiscal years ended October 31, 1998, 1997 or 1996.
Effective November 1, 1993, the Company established a 401(k) Plan. The 401(k) Plan covers all employees of the Company who are over 18 years of age and have worked for the Company for at least 90 days. Annual Company contributions are discretionary, as determined by the Board of Directors and are
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
based on the Company's annual performance. Contributions vest at a rate of 20% per year beginning with an individual's second year with the Company. Employer contributions to the 401(k) Plan for the years ended October 31, 1998, 1997 and 1996 were approximately $236,000, $86,000 and $50,000, respectively.
7. SHAREHOLDERS' EQUITY
Preferred Stock
The Board of Directors has the authority to issue up to 30,000,000 shares of preferred stock in one or more series, and to fix the number of shares of any series and to determine or alter the rights, preferences, privileges, restrictions and designation granted to or imposed upon any wholly unissued series of preferred stock, without any further vote or action by the shareholders. No preferred shares were issued during fiscal 1998 and no shares were outstanding as of October 31, 1998.
Stock Plans
The Company has four stock plans: the 1989 Incentive Stock Plan (the "1989 Stock Plan"), the 1995 Stock Plan (the "1995 Stock Plan"), the 1995 Director Option Plan (the "Director Plan") and the Employee Stock Purchase Plan (the "Purchase Plan"). The Company accounts for these plans under Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." Pursuant to the provisions of APB No. 25, no compensation cost has been recognized by the Company related to option grants issued under any of its stock plans. Under SFAS No. 123, "Accounting for Stock-Based Compensation," the Company is required to calculate compensation cost related to option grants issued to employees subsequent to October 31, 1995 and present the pro forma effect of this expense on net income and net income per share.
Had compensation cost been charged to the Company pursuant to the provisions of SFAS No. 123 for option grants issued under its stock plans, the Company's net income and net income per share would have been adjusted to the following pro forma amounts for the years ended October 31, (in thousands, except per share data):
Because the SFAS No. 123 method of accounting has not been applied to options granted prior to November 1, 1995, the resulting pro forma compensation cost may not be representative of that to be expected in future years.
1989 Incentive Stock Plan
Under the 1989 Stock Plan, the Board of Directors may grant incentive stock options to employees and nonstatutory stock options and stock purchase rights ("SPRs") to employees, directors and consultants. SPRs are rights, other than stock options, to purchase common stock pursuant to the 1989 Stock Plan. The exercise price for an incentive stock option cannot be less than the fair market value on the date of grant. The exercise price per share of nonstatutory stock options granted under the 1989 Stock Plan cannot be less than 85% of the
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
fair market value on the date of grant. As of October 31, 1998, a total of 13,540,000 shares of common stock have been authorized by the Company's Board of Directors and shareholders for grant under the 1989 Stock Plan.
Under the 1989 Stock Plan, in the event of the termination of a purchaser's continuous status as an employee or consultant, the Company has the right to repurchase, at the original purchase price, any unvested stock granted under a SPR.
The 1989 Stock Plan grants the Board of Directors the discretion to determine when the SPRs and options granted thereunder shall become exercisable. The majority of the options vest at the rate of 1/36th per month. In addition, under the 1989 Stock Plan, all unvested stock options are exercisable at any time in whole or in part provided that the optionee executes a purchase agreement that grants the Company repurchase rights similar to those described above. In October 1995, the Board of Directors suspended the issuance of further grants under the 1989 Stock Plan.
Stock option and purchase right activity under the 1989 Stock Plan is as follows:
The following table summarizes information about stock options outstanding under the 1989 Stock Plan as of October 31, 1998:
1995 Stock Plan
On October 3, 1995, the Company's Board of Directors adopted and its shareholders approved the 1995 Stock Plan to be effective as of the date of the Company's initial public offering (November 17, 1995). The 1995 Stock Plan provides for the granting to employees (including officers and employee directors) of incentive stock options and for the granting to employees (including officers and employee directors) and consultants of nonstatutory stock options and SPRs. Unless terminated sooner, the 1995 Stock Plan will terminate automatically in October 2005. A total of 12,000,000 shares of common stock are reserved for issuance under the 1995 Stock Plan.
The exercise price of all nonstatutory stock options and SPRs granted under the 1995 Stock Plan will be determined by the 1995 Stock Plan administrator. With respect to any participant who owns stock possessing more than 10% of the voting power of all classes of the Company's outstanding capital stock (a "10% Shareholder"), the exercise price of any incentive stock option granted must equal at least 110% of the fair market value on the date of grant. The exercise price of incentive stock options for all other employees will be no less than 100% of the fair market value per share on the date of grant. The maximum term of an option granted under the 1995 Stock Option Plan will not exceed ten years from the date of grant (five years in the case of an incentive stock option granted to a 10% Shareholder).
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Stock option activity under the 1995 Stock Plan is as follows:
The following table summarizes information about stock options outstanding under the 1995 Stock Plan as of October 31, 1998:
The per share weighted average fair value of options granted under the 1995 Stock Plan in fiscal 1998, fiscal 1997 and fiscal 1996 was $10.68, $9.67 and $5.27, respectively. The fair value of each option granted is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions used for grants in fiscal 1998, fiscal 1997 and fiscal 1996, respectively: average risk-free interest rates of 5.17%, 6.20% and 6.04%; expected dividend yield of 0.0% in all fiscal years; expected life of 3 years in fiscal 1998 and 5 years in both fiscal 1997 and 1996; and expected volatility of 80%, 78.0% and 83.5%.
1995 Director Option Plan
Non-employee directors are entitled to participate in the Director Plan. The Director Plan has a term of ten years, unless terminated sooner by the Board of Directors. A total of 200,000 shares of common stock are reserved for issuance under the Director Plan.
The Director Plan provides that each non-employee director who first becomes a non-employee director on or after the date of the Company's initial public offering (November 17, 1995) will be automatically granted an option to purchase 24,000 shares of common stock (the "First Option") on the date on which the person first becomes a non-employee director, unless immediately prior to becoming a non-employee director,
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
such person was a director of the Company. Beginning November 1, 1996, each non-employee director will be automatically granted an option to purchase 7,200 shares (a "Subsequent Option") on November 1 of each year provided he or she is then a non-employee director and, provided further, that on such date he or she has served on the Board of Directors for at least the preceding six months. Each First Option and each Subsequent Option shall have a term of ten years and the shares subject to the option shall vest as to 1/36th of the shares at the end of each month after the date of grant, provided that the optionee continues to serve as a director on such dates. The exercise prices of the First Option and each Subsequent Option shall be 100% of the fair market value per share of the common stock on the date of grant of the option.
Stock option activity under the 1995 Director Plan is as follows:
The following table summarizes information about stock options outstanding under the Director Plan as of October 31, 1998:
The weighted average fair value of options granted under the Director Plan in fiscal 1998 and fiscal 1997 was $17.89 and $7.12 per share, respectively. There were no grants in fiscal 1996. The fair value of each option granted is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions used for grants in fiscal 1998 and fiscal 1997, respectively: average risk-free interest rates of 5.84% and 6.13%; expected dividend yield of 0.0% in both fiscal years; expected lives of 5 years in both fiscal years; and expected volatility of 80.0% and 78.0%.
Employee Stock Purchase Plan
On October 3, 1995, the Company's Board of Directors adopted and its shareholders approved the Purchase Plan to be effective as of the date of the Company's initial public offering (November 17, 1995). A total of 1,000,000 shares of common stock are reserved for issuance under the Purchase Plan. The Purchase Plan permits eligible employees of the Company to purchase common stock through payroll deductions of up
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
to 15% of their compensation (excluding payments for overtime, shift premium, incentive compensation, incentive payments, bonuses and other compensation), up to a maximum of $21,250 for all purchase periods ending within any calendar year.
The price of common stock purchased under the Purchase Plan will be 85% of the lower of the fair market value of the common stock on the first or last day of each six-month purchase period. Employees may end their participation in the Purchase Plan at any time during an offering period, upon which time, any payroll deductions not used to purchase Company stock will be refunded. Participation ends automatically upon termination of employment with the Company.
Employees are eligible to participate if they are customarily employed by the Company or any designated subsidiary for at least 20 hours per week and for more than five months in any calendar year. The Purchase Plan will terminate in October 2005. For the year ended October 31, 1998, a total of 78,283 shares of the Company's common stock were issued under the Purchase Plan at an approximate average of $10.93 per share. For the year ended October 31, 1997, a total of 67,592 shares of the Company's common stock were issued under the Purchase Plan at an approximate average of $8.50 per share. For the year ended October 31, 1996, a total of 47,040 shares of the Company's common stock were issued under the Purchase Plan at $5.10 per share. The per share weighted average fair value of shares sold in fiscal 1998, fiscal 1997 and fiscal 1996 was $5.86, $3.41 and $2.12, respectively. At October 31, 1998, 807,085 shares remained available for sale under the Purchase Plan.
8. STOCK REPURCHASE
On May 25, 1998, the Company's Board of Directors authorized the repurchase from time to time of up to 4,000,000 shares of the Company's Common Stock through open market purchases. During the fiscal year ended October 31, 1998, the Company repurchased 620,000 shares of its Common Stock in the open market at an average purchase price of $14.80 per share and a total cost of approximately $9.2 million.
9. INCOME TAXES
Effective November 1, 1993, the Company adopted the provisions of SFAS No. 109 "Accounting for Income Taxes." SFAS No. 109 provides for an asset and liability approach to accounting for income taxes under which deferred income taxes are provided based upon enacted tax laws and rates applicable to the periods in which taxes become payable.
Pre-tax income from continuing operations for the years ended October 31 was taxed in the following jurisdictions (in thousands):
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The provision for income taxes consisted of the following components as of October 31, (in thousands):
The provision for income taxes differs from the amount computed by applying the statutory Federal income tax rates as follows as of October 31, (in thousands):
The major components of deferred tax assets and liabilities are as follows as of October 31, (in thousands):
Net operating loss and tax credit carryforwards, all of which resulted from the acquisition of Apex Data, Inc., a Delaware corporation ("Apex"), expire at various dates through 2010. In accordance with certain provisions of the Internal Revenue Code, a change in ownership of greater than 50% within a three year period results in an annual limitation of the Company's ability to utilize its net operating loss
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
carryforwards from tax periods prior to the ownership change. Accordingly, utilization of net operating loss carryforwards of approximately $1,770,000 for Federal income tax purposes is subject to this annual limitation. Realization is dependent on generating sufficient taxable income prior to the expiration of the loss carryforwards. Although realization is not assured, management believes it is more likely than not that all the deferred tax asset will be realized. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced.
10. RELATED PARTY TRANSACTIONS
Research and Development Funding
In July 1994, the Company paid $30,000 for a warrant to purchase 2,000,000 shares of Series A Preferred Stock of a company in which certain shareholders of the Company and members of its Board of Directors had concurrently purchased a combined 42.8% interest in the affiliate's common stock. The Company has the right to exercise the warrant until January 29, 2000 at $0.05 per warrant share. The Company also entered into a license and supply agreement with the affiliate, whereby the affiliate agreed to supply the Company with 100% of the Company's requirements for certain of the affiliate's product, and the Company agreed to purchase 100% of such requirements from the affiliate. In addition, the affiliate granted to the Company certain license and trademark rights, with respect to the use and modification of the affiliate's product. In exchange, the Company agreed to provide research and development funding to the affiliate in an aggregate amount of $750,000. Prior to fiscal 1996, all agreed upon funding had been paid in full to the affiliate. Pursuant to the affiliate's Series C Preferred Stock financing in June 1998, the Company agreed to amend the termination provisions of the agreement. In general, the license portion of the agreement has no expiration date and all other provisions of the agreement shall continue in effect for a period of 15 years; provided, however, the agreement, including the license portion of the agreement, can be terminated earlier upon certain events including the affiliate's initial public offering.
In January 1996, the Company and the affiliate entered into an agreement whereby the Company paid an additional $80,000 for a warrant to purchase 2,000,000 shares of Series B Preferred Stock of the affiliate. The Company has the right to exercise the warrant for a period of up to 48 months after the date of issuance at $0.15 per warrant share. The Company and the affiliate also entered into a license and supply agreement similar to that described above but covering different intellectual property. In exchange, the Company provided research and development funding to the affiliate totaling $500,000. Pursuant to the affiliate's Series C Preferred Stock financing in June 1998, the Company agreed to amend the termination provisions of the agreement. In general, the license portion of the agreement has no expiration date and all other provisions of the agreement shall continue in effect for a period of 15 years; provided, however, the agreement, including the license portion of the agreement, can be terminated earlier upon certain events including the affiliate's initial public offering. Concurrently with the Company's purchase of the warrant, certain shareholders of the Company and members of its Board of Directors purchased additional common stock of the affiliate, which increased their interest to 50.0% of the affiliate.
In April 1996, certain shareholders of the Company and members of its Board of Directors purchased additional common stock of the affiliate from other shareholders of the affiliate. As of October 31, 1998, certain shareholders of the Company and members of its Board of Directors have a 40.2% interest in the affiliate.
During fiscal 1998, the Company paid approximately $200,000 to the affiliate for its products. As of October 31, 1997, the affiliate owed the Company approximately $7,600 on a note bearing interest at 10% per annum and payable in full by April 1998. As of October 31, 1998, no amount was owed to the Company from the affiliate.
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Note Receivable from Shareholder
On November 15, 1993, a former officer of the Company borrowed $146,250 from the Company. The debt arose from the issuance and sale of shares of the common stock of Apex to the officer prior to the acquisition of Apex. The loan, which is unsecured, bears interest at a rate of 6.5% per annum, and is payable in annual interest-only installments through November 15, 1998, when the principal balance is due in full. As of October 31, 1998, the officer owed the Company approximately $71,500 under this loan.
Stock Option Grant
On August 31, 1995, pursuant to the 1989 Stock Plan, the Company granted a nonstatutory stock option exercisable for 60,000 shares of common stock to one of the Company's directors. The stock option exercise price is $3.50 per share and vests at the rate of 1/36th of the shares on the first day of each calendar month.
11. EXPORT SALES, SIGNIFICANT CUSTOMERS AND GEOGRAPHIC DATA
The Company operates in a single industry segment. The Company markets its products in the United States (which includes Puerto Rico) and in foreign countries through its sales personnel, independent sales representatives and distributors. The Company's geographic sales as a percent of net sales were as follows for the years ended October 31,:
A relatively small number of customers have accounted for a significant percentage of the Company's net sales. Sales to major customers as a percentage of net sales were as follows for the years ended October 31,:
- --------------- * Less than 10%
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The Company's operations by geographic area for each of the three years in the period ended October 31, 1998 were as follows (in thousands):
Intercompany sales and transfers are accounted for based on established intercompany sales prices. The Company's Malaysian subsidiary was not material to the Company's fiscal 1998 consolidated results of operations.
12. LITIGATION
The Company and certain of its officers and directors have been named as defendants in six securities class action lawsuits filed in the United States District Court for the Northern District of California, Boren v. SMART Modular Technologies, Inc., et al., No. C 98 20692 JW (PVT) (filed July 1, 1998), Woszczak v. SMART Modular Technologies, Inc., et al., No. C 98 2617 JL (filed July 2, 1998), Bisson v. SMART Modular Technologies, Inc., et al., No. C 98 20714 JF (filed July 8, 1998), D'Amato v. SMART Modular Technologies, Inc., et al., No. C 98 2804 PJH (filed July 16, 1998), Cha v. SMART Modular Technologies, Inc., et al., No. C 98 2833 BZ (filed July 17, 1998) and Chang v. SMART Modular Technologies, Inc., et al., No. C 98 3151 SI (filed August 13, 1998) (collectively, the "Federal Actions"). The plaintiffs in the Federal Actions allege that defendants made material misrepresentations and omissions during the period from July 1, 1997 through May 21, 1998 in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The Federal Actions were consolidated on October 9, 1998, and a consolidated complaint was filed on November 30, 1998 (the "Federal Complaint").
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
On October 22, 1998, a putative securities class action lawsuit, captioned Reagan v. SMART Modular Technologies, Inc., et al., Case No. H204162-5 (the "State Complaint"), was filed against the Company and certain of its officers and directors in the Superior Court of the State of California, County of Alameda. The State Complaint alleges violations of Sections 25400 and 25500 of the California Corporations Code and seeks unspecified damages on behalf of a purported class of purchasers of SMART common stock during the period from July 1, 1997 through May 21, 1998. The factual allegations of the State Complaint are nearly identical to the factual allegations contained within the Federal Complaint.
The Company believes that all claims related to the state and federal securities actions are without merit and intends to defend itself vigorously against these actions. Currently, the Company is unable to estimate the financial impact of the state and federal securities actions.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SCHEDULE
We have audited, in accordance with generally accepted auditing standards, the consolidated financial statements of SMART Modular Technologies, Inc. and subsidiaries included in this Form 10-K and have issued our report thereon dated November 18, 1998. Our audits were made for the purpose of forming an opinion on the basic consolidated financial statements taken as a whole. The schedule listed under Item 14 is the responsibility of the Company's management and is presented for purposes of complying with the Securities and Exchange Commission's rules and is not part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic consolidated financial statements and, in our opinion, fairly states in all material respects the financial data required to be set forth therein in relation to the basic consolidated financial statements taken as a whole.
/s/ ARTHUR ANDERSEN LLP
-------------------------------------- Arthur Andersen LLP
San Jose, California November 18, 1998
SCHEDULE II
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS)
SMART MODULAR TECHNOLOGIES, INC. AND SUBSIDIARIES
SUPPLEMENTARY CONSOLIDATED FINANCIAL DATA
QUARTERLY FINANCIAL DATA (UNAUDITED)
SMART MODULAR TECHNOLOGIES, INC.
ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED OCTOBER 31, 1998
INDEX TO EXHIBITS
E-1
E-2
- --------------- (1) Incorporated by reference to exhibit filed with the Registrant's Registration Statement on Form S-1 (No. 33-97748) filed October 4, 1995, Amendment No. 1 thereto filed October 24, 1995, Amendment No. 2 thereto filed November 6, 1995, Amendment No. 3 thereto filed November 14, 1995 and Amendment No. 4 thereto filed November 16, 1995, which Registration Statement became effective November 16, 1995.
(2) Incorporated by reference to exhibit filed with the Registrant's Report on Form 10-Q filed March 16, 1996.
(3) Incorporated by reference to exhibit filed with the Registrant's Report on Form 10-Q filed June 14, 1996.
(4) Incorporated by reference to exhibit filed with the Registrant's Report on Form 10-Q filed June 16, 1997.
(5) Incorporated by reference to exhibit filed with the Registrant's Report on Form 10-Q filed August 28, 1997.
(6) Incorporated by reference to exhibit filed with the Registrant's Report on Form 10-K filed January 29, 1998.
(7) Incorporated by reference to exhibit filed with the Registrant's Report on Form 10-Q filed June 15, 1998.
(8) Incorporated by reference to exhibit filed with the Registrant's Report on Form 10-Q filed September 11, 1998.
* Pursuant to Rule 406(b) under the Securities Act of 1933, confidential treatment has been granted to certain portions of this exhibit, which portions have been deleted and filed separately with the Securities and Exchange Commission.
** Pursuant to Rule 24b-2 under the Securities Exchange Act of 1934, confidential treatment has been granted to certain portions of this exhibit, which portions have been deleted and filed separately with the Securities and Exchange Commission.
E-3