UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2006

OR

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

For the transition period from                   to                  .

Commission File Number 0-26944

SILICON STORAGE TECHNOLOGY, INC.
(Exact name of Registrant as Specified in its Charter)

California

 

 

 

77-0225590

(State or Other Jurisdiction of

 

 

 

(I.R.S. Employer

Incorporation or Organization)

 

 

 

Identification Number)

 

1171 Sonora Court, Sunnyvale, CA

 

 

 

94086

(Address of Principal Executive Offices)

 

 

 

(Zip Code)

 

(408) 735-9110
(Registrant’s Telephone Number, including Area Code)


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes o  No x

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated file” in Rule 12b-2 of the Exchange Act.  (check one):

Large Accelerated filer o

 

Accelerated filer x

 

Non-accelerated filer o

 

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

Number of shares outstanding of our Common Stock, no par value, as of the latest practicable date, October 31, 2006:  103,562,820.

 




SILICON STORAGE TECHNOLOGY, INC.

FORM 10-Q: QUARTER ENDED SEPTEMBER 30, 2006

TABLE OF CONTENTS

Part I - FINANCIAL INFORMATION

 

 

 

 

 

 

Item 1.

Condensed Consolidated Financial Statements (Unaudited):

 

 

 

 

Condensed Consolidated Statements of Operations

 

3

 

 

Condensed Consolidated Balance Sheets

 

4

 

 

Condensed Consolidated Statements of Cash Flows

 

5

 

 

Notes to Condensed Consolidated Financial Statements

 

6

 

 

 

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

21

 

 

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

 

31

 

 

 

 

 

 

Item 4.

Controls and Procedures

 

31

 

 

 

 

 

Part II - OTHER INFORMATION

 

 

 

 

 

 

Item 1.

Legal Proceedings

 

33

 

 

 

 

 

 

Item 1A.

Risk Factors

 

34

 

 

 

 

 

 

Item 5.

Other Information

 

44

 

 

 

 

 

 

Item 6.

Exhibits

 

44

 

 

 

 

 

 

Signatures

 

45

 

2




PART I - FINANCIAL INFORMATION

Item 1.    Condensed Consolidated Financial Statements (Unaudited)

SILICON STORAGE TECHNOLOGY, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(in thousands, except per share data)

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2005

 

2006

 

2005

 

2006

 

 

 

As Adjusted

 

 

 

As Adjusted

 

 

 

 

 

(Note 13)

 

 

 

(Note 13)

 

 

 

Net revenues:

 

 

 

 

 

 

 

 

 

Product revenues - unrelated parties

 

$

40,509

 

$

44,125

 

$

115,002

 

$

122,932

 

Product revenues - related parties

 

67,215

 

63,385

 

156,874

 

183,819

 

Technology licensing

 

10,319

 

8,443

 

25,650

 

26,084

 

Technology licensing - related parties

 

29

 

65

 

160

 

1,443

 

Total net revenues

 

118,072

 

116,018

 

297,686

 

334,278

 

 

 

 

 

 

 

 

 

 

 

Cost of revenues:

 

 

 

 

 

 

 

 

 

Cost of revenues - unrelated parties

 

34,407

 

32,481

 

100,116

 

89,555

 

Cost of revenues - related parties

 

64,520

 

53,250

 

154,570

 

153,149

 

Total cost of revenues

 

98,927

 

85,731

 

254,686

 

242,704

 

Gross profit

 

19,145

 

30,287

 

43,000

 

91,574

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Research and development

 

11,770

 

12,313

 

36,821

 

40,573

 

Sales and marketing

 

7,178

 

6,829

 

21,524

 

22,032

 

General and administrative

 

5,683

 

5,437

 

19,508

 

17,243

 

Other operating expenses

 

(16

)

 

2,895

 

 

Total operating expenses

 

24,615

 

24,579

 

80,748

 

79,848

 

Income (loss) from operations

 

(5,470

)

5,708

 

(37,748

)

11,726

 

Other income (expense), net

 

556

 

2,560

 

2,032

 

4,104

 

Interest expense

 

(98

)

(111

)

(156

)

(247

)

Gain on sale of equity investments

 

 

 

 

12,206

 

Impairment of equity investments

 

 

 

 

(3,523

)

Income (loss) before provision for (benefit from) income taxes, pro rata share of loss from equity investments and minority interest

 

(5,012

)

8,157

 

(35,872

)

24,266

 

Provision for (benefit from) income taxes

 

(403

)

2,800

 

2,037

 

6,115

 

Minority interest

 

 

 

(77

)

 

Income (loss) before pro rata share of loss from equity investments

 

(4,609

)

5,357

 

(37,832

)

18,151

 

Pro rata share of loss from equity investments

 

(427

)

(614

)

(1,267

)

(1,087

)

Net income (loss)

 

$

(5,036

)

$

4,743

 

$

(39,099

)

$

17,064

 

Net income (loss) per share - basic

 

$

(0.05

)

$

0.05

 

$

(0.39

)

$

0.17

 

Shares used in per share calculation - basic

 

102,677

 

103,495

 

100,899

 

103,271

 

Net income (loss) per share - diluted

 

$

(0.05

)

$

0.05

 

$

(0.39

)

$

0.16

 

Shares used in per share calculation - diluted

 

102,677

 

104,732

 

100,899

 

104,667

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

3




SILICON STORAGE TECHNOLOGY, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands)

 

 

December 31,

 

September 30,

 

 

 

2005

 

2006

 

 

 

 

 

 

 

 

 

 

 

 

 

ASSETS

 

 

 

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

77,382

 

$

85,056

 

Short-term available-for-sale investments

 

1,008

 

37,945

 

Trade accounts receivable-unrelated parties, net of allowance for doubtful accounts of $758 at December 31, 2005 and $879 at September 30, 2006

 

21,378

 

19,392

 

Trade accounts receivable-related parties

 

55,858

 

43,162

 

Inventories

 

108,343

 

86,109

 

Other current assets

 

13,109

 

12,711

 

Total current assets

 

277,078

 

284,375

 

 

 

 

 

 

 

Property and equipment, net

 

19,415

 

18,264

 

Long-term available-for-sale investments

 

39,057

 

23,998

 

Equity investments, GSMC

 

83,150

 

83,150

 

Equity investments, others

 

12,962

 

27,360

 

Goodwill

 

29,637

 

29,637

 

Intangible assets, net

 

11,816

 

10,833

 

Other assets

 

4,722

 

2,083

 

Total assets

 

$

477,837

 

$

479,700

 

 

 

 

 

 

 

LIABILITIES

 

 

 

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Notes payable, current portion

 

$

39

 

$

 

Borrowing under line of credit facility

 

3,000

 

3,032

 

Trade accounts payable-unrelated parties

 

48,660

 

22,638

 

Trade accounts payable-related parties

 

21,867

 

33,906

 

Accrued expenses and other liabilities

 

17,318

 

22,053

 

Deferred revenue

 

4,493

 

4,209

 

Total current liabilities

 

95,377

 

85,838

 

 

 

 

 

 

 

Other liabilities

 

2,627

 

2,159

 

Total liabilities

 

98,004

 

87,997

 

 

 

 

 

 

 

Commitments (Note 6) and Contingencies (Note 7)

 

 

 

 

 

 

 

 

 

 

 

SHAREHOLDERS’ EQUITY

 

 

 

 

 

 

 

 

 

 

 

Preferred stock, no par value:

 

 

 

 

 

Authorized: 7,000 shares Series A Junior Participating Preferred Stock, no par value Designated: 450 shares Issued and outstanding: none

 

 

 

Common stock, no par value:

 

 

 

 

 

Authorized: 250,000 shares Issued and outstanding: 102,827 shares at December 31, 2005 and 103,561 shares at September 30, 2006

 

377,027

 

385,687

 

Accumulated other comprehensive income

 

31,780

 

17,926

 

Accumulated deficit

 

(28,974

)

(11,910

)

Total shareholders’ equity

 

379,833

 

391,703

 

Total liabilities and shareholders’ equity

 

$

477,837

 

$

479,700

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

4




SILICON STORAGE TECHNOLOGY, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

 

 

Nine Months Ended

 

 

 

September 30,

 

 

 

2005

 

2006

 

 

 

As Adjusted

 

 

 

 

 

(Note 13)

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net income (loss)

 

$

(39,099

)

$

17,064

 

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:

 

 

 

 

 

Depreciation and amortization

 

7,154

 

7,511

 

Purchased in process research and development

 

1,661

 

 

Stock-based compensation expense

 

 

6,130

 

Provision (credits) for doubtful accounts receivable

 

245

 

59

 

Provision for sales returns

 

1,815

 

384

 

Provision for excess and obsolete inventories, write-down of inventories and adverse purchase commitments

 

32,067

 

11,889

 

Loss in equity interest

 

1,267

 

1,087

 

Impairment loss on equity investment

 

 

3,523

 

Gain on sale of equity investments

 

 

(12,206

)

(Gain) loss on disposal of equipment

 

82

 

(5

)

Minority interest

 

(77

)

 

Changes in operating assets and liabilities:

 

 

 

 

 

Trade accounts receivable-unrelated parties

 

2,254

 

1,535

 

Trade accounts receivable-related parties

 

(20,111

)

12,704

 

Inventories

 

(6,018

)

8,946

 

Other current and non-current assets

 

3,966

 

2,802

 

Trade accounts payable-unrelated parties

 

(14,839

)

(25,582

)

Trade accounts payable-related parties

 

(13,415

)

12,039

 

Accrued expenses and other liabilities

 

(8,906

)

5,926

 

Deferred revenue

 

1,438

 

(284

)

Net cash provided by (used in) operating activities

 

(50,516

)

53,522

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Acquisitions, net of cash

 

(7,818

)

 

Investments in equity securities

 

(333

)

(18,854

)

Purchase of property and equipment

 

(4,139

)

(3,628

)

Proceeds from sale of equipment

 

4

 

11

 

Purchase of intellectual property license

 

 

(494

)

Purchases of available-for-sale investments

 

(21,584

)

(49,875

)

Sales and maturities of available-for-sale and equity investments

 

88,010

 

26,428

 

Net cash provided by (used in) investing activities

 

54,140

 

(46,412

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Debt repayments

 

(325

)

(857

)

Repayments against line of credit

 

 

(3,000

)

Borrowing against line of credit

 

3,000

 

3,020

 

Issuance of shares of common stock

 

3,354

 

2,530

 

Capital lease payments

 

 

(1,129

)

Net cash provided by financing activities

 

6,029

 

564

 

Net increase in cash and cash equivalents

 

9,653

 

7,674

 

Cash and cash equivalents at beginning of period

 

35,365

 

77,382

 

Cash and cash equivalents at end of period

 

$

45,018

 

$

85,056

 

 

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

5




SILICON STORAGE TECHNOLOGY, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED):

1.              Basis of Presentation

In the opinion of management, the accompanying unaudited condensed interim consolidated financial statements contain all adjustments, all of which are normal and recurring in nature, necessary to fairly state our financial position, results of operations and cash flows.  The results of operations for the interim periods presented are not necessarily indicative of the results that may be expected for any future interim periods or for the full fiscal year.  These interim financial statements should be read in conjunction with the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2005.

The year-end balance sheet at December 31, 2005 was derived from audited financial statements, but does not include all disclosures required by U.S. generally accepted accounting principles.  Please refer to the audited financial statements in our Annual Report on Form 10-K for the year ended December 31, 2005.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the 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.

Stock Based Compensation

Effective January 1, 2006, we adopted the fair value recognition provisions of Financial Accounting Standards Board, or FASB, Statement of Financial Accounting Standards, or SFAS No. 123(R), “Share-Based Payments,” using the modified prospective application method. Under this transition method, compensation cost recognized in the three and nine months ended September 30, 2006, includes the applicable amounts of: (a) compensation cost of all stock-based payments granted prior to, but not yet vested as of January 1, 2006 (based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123 and previously presented in the pro forma footnote disclosures), and (b) compensation cost for all stock-based payments granted subsequent to January 1, 2006 (based on the grant-date fair value estimated in accordance with the new provisions of SFAS No. 123(R)). Results for prior periods have not been restated to reflect the adoption of SFAS No. 123(R).

Recent Accounting Pronouncements

In September 2005, the FASB ratified Emerging Issues Task Force Issue No. 04-13, “Accounting for Purchases and Sales of Inventory with the Same Counterparty”, or EITF 04-13. EITF 04-13 discusses whether inventory purchase and sales transactions with the same counterparty that are entered into in contemplation of one another should be combined and treated as a nonmonetary exchange and addresses (a) under what circumstances should two or more transactions with the same counterparty (counterparties) be viewed as a single nonmonetary transaction within the scope of APB Opinion No. 29, “Accounting for Nonmonetary Transactions”, or APB 29, and Financial Accounting Standard No. 153, “Exchanges of Nonmonetary Assets, an Amendment of APB 29”, or SFAS 153, and (b) if nonmonetary transactions within the scope of APB 29 and SFAS 153 involve inventory, are there any circumstances under which the transactions should be recognized at fair value. The pronouncement is effective for new inventory arrangements entered into, or modifications or renewals of existing inventory arrangements occurring in interim or annual reporting periods beginning after March 15, 2006. This pronouncement did not have a material effect on our consolidated financial statements.

In June 2006, the FASB issued FASB Interpretation No. 48, or FIN 48, “Accounting for Uncertainty in Income Taxes”.  FIN 48 provides interpretive guidance for recognition and measurement of tax positions taken or expected to be taken in a tax return.  This interpretation is effective for fiscal years beginning after December 15, 2006.  We have initiated a project to develop the documentation required to support uncertain tax positions as required by FIN 48.  The work required is not sufficiently complete to determine if the implementation of FIN 48 will have a material impact on our consolidated financial statements.

6




In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements.” This new standard defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. The new standard is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those years. The provisions of the new standard are to be applied prospectively for most financial instruments and retrospectively for others as of the beginning of the fiscal year in which the standard is initially applied. We will be required to adopt this new standard in the first quarter of 2008. We are currently evaluating the requirements of Statement No. 157 and have not yet determined the impact on our consolidated financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements.” SAB 108 addresses the views of the SEC staff regarding the process of quantifying financial statement misstatements. SEC registrants are expected to reflect the effects of initially applying the guidance in SAB 108 in their annual financial statements covering the first fiscal year ending after November 15, 2006. The cumulative effect of the initial application should be reported in the carrying amounts of assets and liabilities as of the beginning of that fiscal year and the offsetting adjustment should be made to the opening balance of retained earnings for that year. We will be required to adopt the interpretations in SAB 108 in the fourth quarter of 2006. We are currently evaluating the impact, if any, of applying this guidance.

In March 2006, the Emerging Issues Task Force reached a consensus on Issue No. 06-03 “How Taxes Collected from Customers and Remitted to Government Authorities Should Be Presented in the Income Statement (that is, Gross versus Net Presentation)” (“EITF No. 06-03”). We are required to adopt the provisions of EITF No. 06-03 beginning in fiscal year 2007. We do not expect the provisions of EITF No. 06-03 to have a material impact on the our consolidated financial position, results of operations or cash flows.

2.              Computation of Net Income (Loss) Per Share

We have computed and presented net income (loss) per share under two methods, basic and diluted.  Basic net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the period.  Diluted net income (loss) per share is computed by dividing net income (loss) by the sum of the weighted average number of common shares outstanding and potential common shares (when dilutive).  A reconciliation of the numerator and the denominator of basic and diluted net income (loss) per share is as follows (in thousands, except per share amounts):

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2005

 

2006

 

2005

 

2006

 

 

 

As Adjusted

 

 

 

As Adjusted

 

 

 

 

 

(Note 13)

 

 

 

(Note 13)

 

 

 

Numerator -basic

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(5,036

)

$

4,743

 

$

(39,099

)

$

17,064

 

 

 

 

 

 

 

 

 

 

 

Denominator - basic

 

 

 

 

 

 

 

 

 

Weighted average common stock outstanding

 

102,677

 

103,495

 

100,899

 

103,271

 

 

 

 

 

 

 

 

 

 

 

Basic net income (loss) per share

 

$

(0.05

)

$

0.05

 

$

(0.39

)

$

0.17

 

 

 

 

 

 

 

 

 

 

 

Denominator - diluted

 

 

 

 

 

 

 

 

 

Weighted average common stock outstanding

 

102,677

 

103,495

 

100,899

 

103,271

 

Dilutive potential of common stock equivalents

 

 

1,237

 

 

1,396

 

Options

 

102,677

 

104,732

 

100,899

 

104,667

 

 

 

 

 

 

 

 

 

 

 

Diluted net income (loss) per share

 

$

(0.05

)

$

0.05

 

$

(0.39

)

$

0.16

 

 

Stock options to purchase 11,102,000 and 13,559,000 shares with a weighted average price of $7.55 and $6.38 were outstanding for the three and nine months ended September 30, 2005, respectively.  These stock options were not included in the computation of diluted net loss per share for the three and nine months ended September 30, 2005 because we had a net loss for these periods. Stock options to purchase 8,820,180 and 8,553,643 shares with weighted

7




average per share prices of $8.70 and $8.99, respectively, were outstanding and not included in the computation of diluted net income per share for the three and nine months ended September 30, 2006, respectively, as they were anti-dilutive under the treasury stock method.

3.             Stock Compensation

Employee Stock Purchase Plan

Our 1995 Employee Stock Purchase Plan, or the Purchase Plan, as amended, has 6.0 million shares reserved for issuance.  Through July 31, 2005, the Purchase Plan provided for eligible employees to purchase shares of common stock at a price equal to 85% of the fair market value of our common stock on the date of the purchase, or, if lower, 85% of the fair market value of our common stock six months after the grant date, by withholding up to 10 percent of their annual base earnings.  Since July 31, 2005, the Purchase Plan provides for eligible employees to purchase shares of common stock at a price equal to 90% of the fair value of our common stock six months after the option date by withholding up to 10% of their annual base earnings.  At September 30, 2006, 641 thousand shares were available for purchase under the Purchase Plan.  Shares issued under the Purchase Plan for the nine months ended September 30, 2005 and 2006 were 769 thousand and 485 thousand, respectively.

Equity Incentive Plan

Our 1995 Equity Incentive Plan, or the Equity Incentive Plan, as amended, has 31.8 million shares of common stock reserved for issuance upon the exercise of stock options to our employees, directors, consultants and affiliates.  Under the Equity Incentive Plan, the Board of Directors has the authority to determine to whom options will be granted, the number of shares under option, the option term and the exercise price. The options generally are exercisable beginning one year from date of grant and generally thereafter over periods ranging from four to five years from the date of grant. The term of any options issued may not exceed ten years from the date of grant.

Directors’ Stock Option Plan

Each of our non-employee directors receives stock option grants under our 1995 Non-Employee Directors’ Stock Option Plan, or the Directors’ Plan. In April 2005, the Board of Directors amended the Directors’ Plan. Pursuant to the Directors’ Plan, upon each non-employee director’s initial election or appointment to the Board, such new non-employee director receives an initial stock option grant for 45,000 shares of common stock. Each initial stock option grant vests as to 25% of the shares subject to the grant on the anniversary of the grant date. Previously, each such initial stock option was fully vested and exercisable upon grant. In addition, each non-employee director will receive a fully vested annual stock option grant for 12,000 shares of common stock. Previously, each non-employee director received a fully vested annual stock option grant for 18,000 shares of common stock. The options expire ten years after the date of grant. As of September 30, 2006, the Directors’ Plan had 169 thousand shares available for issuance.

Compensation expense is recognized as follows: We amortize deferred stock-based compensation on the graded vesting method over the vesting periods of the stock options, generally four years. The graded vesting method provides for vesting of portions of the overall awards at interim dates and results in accelerated vesting as compared to the straight-line method.

The Employee Stock Purchase Plan, or the Purchase Plan, provides for eligible employees to purchase shares of common stock at a price equal to 90% of the fair value of our common stock on the last day of each six-month offering period.  The compensation is the difference between the fair value and purchase price on the date of purchase.

The amount of recognized compensation expense is adjusted based upon an estimated forfeiture rate which is derived from historical data.

The following table shows total stock-based compensation expense included in the Condensed Consolidated Statement of Operations (in thousands):

8




 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30, 2006

 

September 30, 2006

 

Cost of goods sold

 

$

159

 

$

469

 

Research and development

 

1,195

 

2,967

 

Sales and marketing

 

309

 

806

 

General and administrative

 

665

 

1,888

 

Effect on pre-tax income

 

2,328

 

6,130

 

Tax effect of stock-based compensation expense

 

 

 

Effect on net income

 

$

2,328

 

$

6,130

 

Effect on net income per share:

 

 

 

 

 

Basic

 

$

0.02

 

$

0.06

 

Diluted

 

$

0.02

 

$

0.06

 

 

There was no compensation cost capitalized for either of the above periods.

No similar expense was charged against income in the prior periods as we had elected to apply the provisions of APB No. 25, “Accounting for Stock Issued to Employees” to those periods as permitted by SFAS No. 123.

SFAS No. 123(R) also requires that the tax benefit from the exercise of options be reflected in the statement of cash flows as a cash inflow from financing activities. Prior to the adoption of SFAS No. 123(R), these tax benefits were reflected as a cash inflow from operations. Because we elected to adopt the “modified prospective application” transition method, the prior year statements of cash flows have not been restated. The tax benefit from the exercise of options was $0 thousand the three and nine months ended September 30, 2006.

Stock Option Plans

Pursuant to our 1995 Equity Incentive Plan and 1995 Non-Employee Director’s Stock Option Plan, stock options are granted with an exercise price equal to the market price of our common stock at the date of grant. Substantially all of the options granted to employees are exercisable pursuant to a four-year vesting schedule with a maximum contractual term of ten years. The fair value of these options is estimated using the Black-Scholes option pricing model which incorporates the assumptions noted in the table below. The risk-free interest rate for periods within the expected life of the option is based on the U.S. Treasury bond rate in effect at the time of grant. We do not pay dividends and do not expect to do so in the future. Expected volatilities are based on the historical performance of our common stock. The expected term of the options granted is 6.0 years calculated using the simplified method allowed under SAB 107.

The fair values of grants in the stated period were computed using the following assumptions for our stock option plans:

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30, 2006

 

September 30, 2006

 

Risk-free interest rate

 

5.2%

 

4.3%-5.2%

 

Dividend yield

 

0.0%

 

0.0%

 

Expected volatility

 

79.2%

 

77.0%-82.6%

 

Expected life

 

6.0 years

 

6.0 years

 

 

The following is a summary of all option activity for the three and nine months ended September 30, 2006 (options in thousands):

9




 

 

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

 

 

 

 

Average

 

Aggregate

 

 

 

Shares

 

Number of

 

Weighted

 

Remaining

 

Intrinsic Value

 

 

 

Available

 

Shares

 

Average 

 

Term (in

 

at September 30,

 

 

 

for Grant

 

Outstanding

 

Price

 

years)

 

2006

 

Outstanding at December 31, 2005

 

3,162

 

11,687

 

$

7.33

 

 

 

 

 

Granted

 

(116

)

116

 

$

4.72

 

 

 

 

 

Exercised

 

 

(82

)

$

2.57

 

 

 

 

 

Forfeited

 

195

 

(195

)

$

5.89

 

 

 

 

 

Expired

 

45

 

(45

)

$

14.00

 

 

 

 

 

Outstanding at March 31, 2006

 

3,286

 

11,481

 

$

7.30

 

6.13

 

$

6,782

 

 

 

 

 

 

 

 

 

 

 

 

 

Granted

 

(270

)

270

 

$

3.95

 

 

 

 

 

Exercised

 

 

(40

)

$

2.56

 

 

 

 

 

Forfeited

 

179

 

(179

)

$

5.95

 

 

 

 

 

Expired

 

170

 

(170

)

$

3.37

 

 

 

 

 

Outstanding at June 30, 2006

 

3,365

 

11,362

 

$

7.26

 

5.97

 

$

5,545

 

 

 

 

 

 

 

 

 

 

 

 

 

Granted

 

(785

)

785

 

$

3.80

 

 

 

 

 

Exercised

 

 

(127

)

$

2.33

 

 

 

 

 

Forfeited

 

177

 

(177

)

$

6.75

 

 

 

 

 

Expired

 

268

 

(268

)

$

13.04

 

 

 

 

 

Outstanding at September 30, 2006

 

3,025

 

11,575

 

$

6.95

 

5.99

 

$

5,407

 

 

 

 

 

 

 

 

 

 

 

 

 

Vested and Expected to Vest at September 30, 2006

 

 

 

11,336

 

$

6.99

 

5.90

 

$

5,373

 

 

 

 

 

 

 

 

 

 

 

 

 

Options Exercisable at September 30, 2006

 

 

 

7,402

 

$

7.76

 

4.49

 

$

4,876

 

 

A summary of our stock options outstanding at September 30, 2006 as follows (options in thousands):

 

Options Outstanding

 

Options Exercisable

 

 

 

 

 

Weighted-

 

Weighted-

 

 

 

Weighted-

 

 

 

 

 

Average

 

Average

 

 

 

Average

 

Range of

 

Number

 

Remaining

 

Exercise

 

Number

 

Exercise

 

Exercise Prices

 

Outstanding

 

Life

 

Price

 

Outstanding

 

Price

 

$

0.44

-

$

1.54

 

 

1,141

 

1.50

 

$

1.02

 

1,141

 

$

1.02

 

$

1.84

-

$

3.56

 

 

1,226

 

5.18

 

$

2.60

 

909

 

$

2.50

 

$

3.60

-

$

3.98

 

 

1,248

 

8.15

 

$

3.69

 

519

 

$

3.66

 

$

4.00

-

$

4.62

 

 

1,163

 

6.95

 

$

4.38

 

671

 

$

4.41

 

$

4.63

-

$

5.00

 

 

1,135

 

7.25

 

$

4.85

 

413

 

$

4.82

 

$

5.02

-

$

6.48

 

 

1,304

 

8.04

 

$

5.84

 

269

 

$

5.84

 

$

6.66

-

$

8.61

 

 

1,209

 

7.30

 

$

7.64

 

668

 

$

7.80

 

$

8.63

-

$

9.85

 

 

1,112

 

5.41

 

$

9.30

 

932

 

$

9.31

 

$

9.92

-

$

17.79

 

 

1,032

 

5.54

 

$

11.97

 

875

 

$

11.85

 

$

18.60

-

$

29.44

 

 

1,005

 

3.77

 

$

21.21

 

1,005

 

$

21.21

 

$

0.44

-

$

29.44

 

 

11,575

 

5.99

 

$

6.95

 

7,402

 

$

7.76

 

 

 

Three Months Ended

 

NIne Months Ended

 

 

 

September 30, 2006

 

September 30, 2006

 

 

 

 

 

 

 

Weighted average grant date fair value of options granted

 

$

2.78

 

$

2.82

 

Total fair value of shares vested

 

$

1,900,964

 

$

5,695,702

 

Total intrinsic value of options exercised

 

$

221,199

 

$

496,598

 

Total cash received from employees as a result of employee stock option excercises and employee stock plan purchases

 

$

1,156,812

 

$

2,529,908

 

 

10




We settle stock option exercises with newly issued common shares. We do not have any equity instruments outstanding other than the options described above as of September 30, 2006.

Total unrecognized compensation expense from stock options was $9.6 million excluding estimated forfeitures, which is expected to be recognized over a weighted-average period of 1.51 years as follows, in thousands:

 

Compensation

 

 

 

Expense excluding

 

 

 

Estimated Forfeitures

 

2006 (remaining three months)

 

$

1,749

 

2007

 

4,803

 

2008

 

2,198

 

2009

 

747

 

2010

 

118

 

Total

 

$

9,615

 

 

Pro Forma Information under SFAS 123 for the period prior to 2006

For the three and nine months ended September 30, 2005, we applied the intrinsic value based method of accounting for stock options prescribed by APB No. 25. Accordingly, no compensation expense was recognized for these stock options since all options granted have an exercise price equal to the market value of the underlying stock on the grant date. If compensation expense had been recognized based on the estimate of the fair value of each option granted in accordance with the provisions of SFAS No. 123 “Accounting for Stock-Based Compensation” as amended by SFAS No. 148 “Accounting for Stock-Based Compensation – Transition and Disclosure –An Amendment of FASB Statement No. 123”, our net loss would have been increased to the following pro forma amounts as follows, in thousands:

 

Three Months Ended
September 30, 2005

 

Nine Months Ended
September 30, 2005

 

Net loss as adjusted (Note 13)

 

$

(5,036

)

$

(39,099

)

 

 

 

 

 

 

Add: stock-based employee compensation expense in reported net income, net of related tax effects

 

 

 

Deduct: total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects

 

(2,044

)

(6,530

)

Pro forma net loss

 

$

(7,080

)

$

(45,629

)

 

 

 

 

 

 

Basic loss per share

 

 

 

 

 

As reported:

 

$

(0.05

)

$

(0.39

)

Pro forma:

 

$

(0.07

)

$

(0.45

)

Diluted net loss per share

 

 

 

 

 

As reported:

 

$

(0.05

)

$

(0.39

)

Pro forma:

 

$

(0.07

)

$

(0.45

)

 

The fair value of each option grant is estimated on the date of grant using the Black-Scholes multiple options pricing model. For the three months ended September 30, 2005, we assumed a risk-free interest rate of 3.8%, an option term of 4.7 years, volatility of 83% and an expected dividend yield of 0%. with the following weighted average assumptions. For the nine months ended September 30, 2005, we assumed risk-free interest rates between 3.7% and 4.2%, an option term of 4.7 years, volatility of 84% and an expected dividend yield of 0%.

 

Pro forma compensation expense recognized under SFAS No. 123 does not consider potential forfeitures.

4.             Investments

We consider cash and all highly liquid investments purchased with an original or remaining maturity of less than three months at the date of purchase to be cash equivalents.  Substantially all of our cash and cash equivalents are in the custody of three major financial institutions.

Short and long-term investments, which are comprised of federal, state and municipal government obligations, foreign and public corporate debt securities and marketable equity securities, are classified as available-for-sale and carried at fair value, based on quoted market prices, with the unrealized gains or losses, net of tax, reported in

11




shareholders’ equity as other comprehensive income.  The cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity, both of which are included in interest income. Realized gains and losses are recorded on the specific identification method. In the first quarter of 2006, we sold 4.0 million common shares of our investment in Powertech Technology, Incorporated, or PTI, for a pre-tax gain of approximately $12.2 million. We still owned approximately 5.5 million shares of PTI at September 30, 2006.

King Yuan Electronics Company Limited or KYE, Insyde Software Corporation or Insyde, PTI and Professional Computer Technology Limited or PCT, are Taiwanese companies that are listed on the Taiwan Stock Exchange.  Equity investments in these companies have been included in “Long-term available-for-sale investments.”  The investments that are not available for resale due to local securities regulations within one year at the balance sheet date are recorded at the investment cost.  The investments that are available for resale within one year at the balance sheet date are recorded at fair market value, with unrealized gains and losses, net of tax, reported in Shareholders’ Equity as Other Comprehensive Income.  If a decline in value is judged to be other than temporary, it is reported as an “Impairment of equity investments.”  Cash dividends and other distributions of earnings from the investees, if any, are included in other income when declared.

In June 2004, we acquired 9% interest in Advanced Chip Engineering Technology, or ACET, a privately held Taiwanese company for $4.0 million cash. ACET, a related entity of KYE, is a production subcontractor. Chen Tsai, our Senior Vice President of Worldwide Backend Operations, is also a member of ACET’s board of directors. During 2005, we recorded a $2.2 million impairment charge due to ACET’s anticipated secondary financing price per share which was lower than our carrying value. In September 2006, we completed an additional cash investment of $15.9 million in ACET’s common stock. At September 30, 2006, our investment represents 46.9% of the outstanding equity of ACET.

In the first quarter of 2006, we determined our investment in Nanotech Corporation, or Nanotech, a privately held Cayman Island company, had become impaired as Nanotech defaulted on loan payments to certain of its business partners and is now in the process of discontinuing operations. Consequently, our remaining investment of $3.3 million along with a loan of $225 thousand were written down to a net realizable value of zero.

The fair values of available-for-sale investments as of September 30, 2006 were as follows (in thousands):

 

 

Amortized

 

Unrealized

 

Unrealized

 

Fair

 

 

 

Cost

 

Gain

 

Loss

 

Value

 

Corporate bonds and notes

 

$

20,302

 

$

 

$

(4

)

$

20,298

 

Government bonds and notes

 

48,370

 

4

 

 

48,374

 

Foreign listed equity securities

 

6,095

 

17,903

 

 

23,998

 

Total bonds, notes and equity securities

 

$

74,767

 

$

17,907

 

$

(4

)

$

92,670

 

 

 

 

 

 

 

 

 

 

 

Less amounts classified as cash equivalents

 

 

 

 

 

 

 

(30,728

)

Total short and long-term available-for-sale investments

 

 

 

 

 

 

 

$

61,942

 

 

Contractual maturity dates of our available-for-sale investments for debt securities are in 2006 and 2007.  All of these securities are classified as current as they are expected to be realized in cash or sold or consumed during the normal operating cycle of our business.

The unrealized gains and losses as of September 30, 2006 are recorded in accumulated other comprehensive income, net of tax.

The fair values of available-for-sale investments as of December 31, 2005 were as follows (in thousands):

 

 

Amortized

 

Unrealized

 

Unrealized

 

Fair

 

 

 

Cost

 

Gain

 

Loss

 

Value

 

Corporate bonds and notes

 

$

67

 

$

 

$

 

$

67

 

Government bonds and notes

 

5,632

 

 

(1

)

5,631

 

Foreign listed equity securities

 

7,283

 

31,774

 

 

39,057

 

Total bonds, notes and equity securities

 

$

12,982

 

$

31,774

 

$

(1

)

$

44,755

 

 

 

 

 

 

 

 

 

 

 

Less amounts classified as cash equivalents

 

 

 

 

 

 

 

(4,690

)

Total short and long-term available-for-sale investments

 

 

 

 

 

 

 

$

40,065

 

 

The unrealized gains and losses as of December 31, 2005 are recorded in accumulated other comprehensive income, net of tax.

Market values were determined for each individual security in our investment portfolio.  With respect to our foreign listed equity securities, our policy is to review our equity holdings on a regular basis to

12




evaluate whether or not such securities have experienced an other than temporary decline in fair value.  Our policy includes, but is not limited to, reviewing each company’s cash position, earnings and revenue outlook, stock price performance over the past nine months, liquidity, management and ownership.  If we believe that an other-than-temporary decline in value exists, it is our policy to write down these investments to the market value and record the related write-down in our consolidated statement of operations.

Investments in privately held enterprises and certain restricted stocks are accounted for using either the cost or equity method of accounting, as appropriate.  As of September 30, 2006, the carrying value of these investments was $110.5 million, which includes an investment of $83.2 million in Grace Semiconductor Manufacturing Corporation, or GSMC, which represents a 10% interest and a $16.6 million investment in Advanced Chip Engineering Technology Inc. or ACET, which represents a 46.9% interest.  As of December 31, 2005, the carrying value of these investments was $96.1 million.

5.             Selected Balance Sheet Detail

Details of selected balance sheet accounts are as follows (in thousands):

Inventories comprise:

 

 

December 31,

 

September 30,

 

 

 

2005

 

2006

 

Raw materials

 

$

65,404

 

$

54,145

 

Work in process

 

6,491

 

9,138

 

Finished goods

 

29,450

 

16,977

 

Finished goods inventories held at logistics center

 

6,998

 

5,849

 

 

 

$

108,343

 

$

86,109

 

 

Inventories are stated at the lower of cost, determined on a first-in, first-out basis, or market value.  We typically plan our production and inventory levels based on internal forecasts of customer demand, which are highly unpredictable and can fluctuate substantially.  The value of our inventory is dependent on our estimate of future average selling prices, and, if our projected average selling prices are over estimated, we may be required to adjust our inventory value.  If we over estimate future market demand, we may end up with excess inventory levels that cannot be sold within a normal operating cycle and we may be required to record a provision for excess inventory.  Our inventories include high technology parts and components that are specialized in nature or subject to rapid technological obsolescence.  Some of our customers have requested that we ship them product that has a finished goods date of manufacture less than one year.  In the event that this becomes a common requirement, it may be necessary for us to provide for an additional allowance for our on-hand finished goods inventory with a date of manufacture of greater than one year, which could result in a material adjustment and could harm our financial results.  We review on-hand inventory including inventory held at the logistic center for potential excess, obsolescence and lower of cost or market exposure and record provisions accordingly.  Due to the large number of units in our inventory, even a small change in average selling prices could result in a significant adjustment and have a material impact on our financial position and results of operations.

Our allowance for excess and obsolete inventories includes an allowance for finished goods inventory with a date of manufacture of greater than two years and for certain products with a date of manufacture of greater than one year.  In addition, our allowance includes an allowance for die, work-in-process and finished goods that exceed our estimated forecast for the next twelve to twenty four months.  For the obsolete inventory analysis, we review inventory items in detail and consider date code, customer base requirements, known product defects, planned or recent product revisions, end of life plans and diminished market demand.  For excess inventory analysis, we review inventory items in detail and consider our customer base requirements and market demand.  While we have programs to minimize inventories on hand and we consider technological obsolescence when estimating allowances for potentially excess and obsolete inventories and those required to reduce recorded amounts to market values, it is reasonably possible that such estimates could change in the near term.  Such changes in estimates could have a material impact on our financial position and results of operations.

Accrued expenses and other liabilities comprise (in thousands):

13




 

 

 

December 31,

 

September 30,

 

 

 

2005

 

2006

 

Accrued compensation and related items

 

$

5,934

 

$

6,196

 

Accrued adverse purchase commitments

 

1,752

 

354

 

Accrued commission

 

2,762

 

2,355

 

Accrued income tax payable

 

1,319

 

6,219

 

Accrued warranty

 

803

 

434

 

Other accrued liabilities

 

4,748

 

6,495

 

 

 

$

17,318

 

$

22,053

 

 

Changes in the warranty reserves during the three months ended September 30, 2005 and 2006 were as follows (in thousands):

 

 

Nine Months Ended September 30,

 

 

 

2005

 

2006

 

Beginning balance

 

$

3,826

 

$

803

 

Provisions for warranty

 

1,972

 

2,113

 

Change in estimate of prior period accrual

 

(1,058

)

 

Consumption of reserves

 

(3,576

)

(2,482

)

Ending balance

 

$

1,164

 

$

434

 

 

Our products are generally subject to warranty and we provide for the estimated future costs of repair, replacement or customer accommodation upon shipment of the product in our condensed consolidated statements of operations.  Our warranty accrual is estimated based on historical claims compared to historical revenues. For new products, we use our historical percentage for the appropriate class of product. The higher warranty reserve as of September 30, 2005 compared to September 30, 2006 related mainly to the rescreening test work related to two specific customers.  The test work was completed during 2005 so there is no comparable reserve as of September 30, 2006.

6.             Commitments

Our technology license agreements generally include an indemnification clause that indemnifies the licensee against liability and damages (including legal defense costs) arising from any claims of patent, copyright, trademark or trade secret infringement by our proprietary technology. The terms of these guarantees approximate the terms of the technology license agreements, which typically range from five to ten years. Our current license agreements expire from 2006 through 2014.  The maximum possible amount of future payments we could be required to make, if such indemnifications were required on all of these agreements, is $41.7 million. We have not recorded any liabilities as of September 30, 2006 related to these indemnities as no such claims have been made or asserted.

During our normal course of business, we have made certain indemnities, commitments and guarantees under which we may be required to make payments in relation to certain transactions.  These include indemnities to various lessors in connection with facility leases for certain claims arising from such facility or lease and indemnities to our directors and officers to the maximum extent permitted under the laws of California.  In addition, we have contractual commitments to some customers, which could require us to incur costs to repair an epidemic defect with respect to our products outside the normal warranty period if such defect were to occur. The duration of these indemnities, commitments and guarantees varies.  The majority of these indemnities, commitments and guarantees do not provide for any limitation of the maximum potential future payments that we could be obligated to make.  We have not recorded any liability for these indemnities, commitments and guarantees in the accompanying condensed consolidated balance sheets. We do, however, accrue for losses for any known contingent liability, including those that may arise from indemnification provisions, when future payment is probable and the amount is reasonably estimatable.

14




7.             Contingencies

In January and February 2005, multiple putative shareholder class action complaints were filed against SST and certain directors and officers, in the United States District Court for the Northern District of California, following our announcement of anticipated financial results for the fourth quarter of 2004.  On March 24, 2005, the putative class actions were consolidated under the caption In re Silicon Storage Technology, Inc., Securities Litigation, Case No. C 05 00295 PJH (N.D. Cal.).  On May 3, 2005, the Honorable Phyllis J. Hamilton appointed the “Louisiana Funds Group,” consisting of the Louisiana School Employees’ Retirement System and the Louisiana District Attorneys’ Retirement System, to serve as lead plaintiff and the law firms of Pomeranz Haudek Block Grossman & Gross LLP and Berman DeValerio Pease Tabacco Burt & Pucillo to serve as lead counsel and liason counsel, respectively, for the class.  The lead plaintiff filed a Consolidated Amended Class Action Complaint on July 15, 2005.  The complaint seeks unspecified damages on alleged violations of federal securities laws during the period from April 21, 2004 to December 20, 2004.  We moved to dismiss the complaint on September 16, 2005.  Plaintiff served an opposition to the motion to dismiss on November 4, 2005.  Our reply in further support of the motion to dismiss was filed on December 19, 2005.  On January 18, 2006, the Court heard arguments on the motion to dismiss.  On March 10, 2006, the Court granted our motion to dismiss the consolidated amended complaint, with leave to file an amended complaint. Plaintiffs filed a second amended complaint on May 1, 2006. We responded with a motion to dismiss on June 19, 2006. We intend to take all appropriate action in response to these lawsuits.  The impact related to the outcome of these matters is undeterminable at this time.

In January and February 2005, following the filing of the putative class actions, multiple shareholder derivative complaints were filed in California Superior Court for the County of Santa Clara, purportedly on behalf of SST against certain of our directors and officers.  The factual allegations of these complaints are substantially identical to those contained in the putative shareholder class actions filed in federal court.  The derivative complaints assert claims for, among other things, breach of fiduciary duty and violations of the California Corporations Code.  These derivative actions have been consolidated under the caption In Re Silicon Storage Technology, Inc. Derivative Litigation, Lead Case No. 1:05CV034387 (Cal. Super. Ct., Santa Clara Co.).  On April 28, 2005, the derivative action was stayed by court order.  We intend to take all appropriate action in response to these lawsuits.  The impact related to the outcome of these matters is undeterminable at this time.

On July 13, 2006, a shareholder derivative complaint was filed in the United States District Court for the Northern District of California by Mike Brien under the caption Brien v. Yeh, et al., Case No. C06-04310 JF (N.D. Cal.). On July 18, 2006, a shareholder derivative complaint was filed in the United States District Court for the Northern District of California by Behrad Bazargani under the caption Bazargani v. Yeh, et al., Case No. C06-04388 HRL (N.D. Cal.). Both complaints were brought purportedly on behalf of SST against certain of our current and former officers and directors and allege among other things, that the named officers and directors: (a) breached their fiduciary duties as they colluded with each other to backdate stock options, (b) violated Rule 10b-5 of the Securities Exchange Act of 1934 through their alleged actions, and (c) were unjustly enriched by their receipt and retention of such stock options.  The Brien and Bazargani cases were consolidated into one case: In re Silicon Storage Technology, Inc. Derivative Litigation, Case No. C06-04310 JF and a consolidated amended shareholder derivative complaint was filed on October 30, 2006.  On October 31, 2006, a similar shareholder derivative complaint was filed in the Superior Court of the State of California for the County of Santa Clara by Alex Chuzhoy under the caption Chuzhoy v. Yeh, et al., Case No. 1-06-CV-074026.  This complaint was brought purportedly on behalf of SST against certain of our current and former officers and directors and alleges among other things, that the named officers and directors breached their fiduciary duties as they colluded with each other to backdate stock options and were allegedly unjustly enriched by their actions.  The Chuzhoy complaint also alleges that certain of our officers and directors violated section 25402 of the California Corporations Code by selling shares of our common stock while in possession of material non-public adverse information.  We intend to take all appropriate action in responding to all of the complaints.

From time to time, we are also involved in other legal actions arising in the ordinary course of business.  We have accrued certain costs associated with defending these matters.  There can be no assurance that the shareholder class action complaints, the shareholder derivative complaints or other third party assertions will be resolved without costly litigation, in a manner that is not adverse to our financial position, results of operations or cash flows or without requiring royalty payments in the future which may adversely impact gross margins. No estimate can be made of the possible loss or possible range of loss associated with the resolution of these contingencies.  As a result, no losses have been accrued in our financial statements as of September 30, 2006.

8.             Line of Credit

On August 11, 2006, we entered into a 1-year loan and security agreement with Cathay Bank, a U.S. bank, for a $40.0 million revolving line of credit all of which was available to us as of September 30, 2006. The line of credit will be used for working capital but there are no restrictions in the agreement as to how the funds may be used.  The interest rate for the line of credit is 1% below the prime rate reported from time to time by the Wall Street Journal, Western Edition (8.25% at September 30, 2006). The line of credit is collateralized by substantially all of the assets of SST other than intellectual property.  The agreement contains certain financial covenants, including the levels of qualifying accounts receivable and inventories, which could limit the availability of funds under the agreement. As of September 30, 2006, a standby letter of credit in the amount of $8.0 million has been issued against the line as collateral for the line of credit with Bank of America in China.

15




On September 15, 2006, SST China Limited entered into a 10-month facility agreement with Bank of America, N.A. Shanghai Branch, a U.S. bank, for RMB 60.8 million revolving line of credit. The line of credit will be used for working capital but there are no restrictions in the agreement as to how the funds may be used.  The interest rate for the line of credit is 90% of People’s Bank of China’s base rate (5.58% at September 30, 2006).  This facility line is secured by a standby letter of credit of $8 million issued by Cathay Bank for Silicon Storage Technology, Inc, and is guaranteed by Silicon Storage Technology, Inc. As of September 30, 2006, SST China Limited has drawn RMB $24 million, or approximately $3.0 million US dollars, at the interest rate of 5.02%.

9.             Goodwill and Intangible Assets:

Our acquisitions in prior years included the acquisition of $16.5 million of finite-lived intangible assets.  Certain of our acquisitions also included an aggregate of $29.6 million of goodwill. The goodwill is not being amortized but is tested for impairment annually, as well as when an event or circumstance occurs indicating a possible impairment in value.  Of our $1.7 million of intellectual property, $1.2 of was acquired prior to fiscal 2006 and included in property, plant and equipment.

As of September 30, 2006, our intangible assets consisted of the following (in thousands):

 

 

 

Accumulated

 

 

 

 

 

Cost

 

Amortization

 

Net

 

Existing technology

 

$

11,791

 

$

4,767

 

$

7,024

 

Intellectual property

 

1,694

 

 

1,694

 

Trade name

 

1,198

 

492

 

706

 

Customer relationships

 

1,857

 

902

 

955

 

Backlog

 

811

 

811

 

 

Non-Compete Agreements

 

810

 

356

 

454

 

 

 

$

18,161

 

$

7,328

 

$

10,833

 

 

As of December 31, 2005, our intangible assets consisted of the following (in thousands):

 

 

 

Accumulated

 

 

 

 

 

Cost

 

Amortization

 

Net

 

Existing technology

 

$

11,791

 

2,830

 

$

8,961

 

Trade name

 

1,198

 

313

 

885

 

Customer relationships

 

1,857

 

528

 

1,329

 

Backlog

 

811

 

806

 

5

 

Non-Compete Agreements

 

810

 

174

 

636

 

 

 

$

16,467

 

$

4,651

 

$

11,816

 

 

All intangible assets are being amortized on a straight-line method over their estimated useful lives.  Existing technologies have been assigned useful lives of between four and five years, with a weighted average life of approximately 4.6 years.  Non-compete agreements have been assigned useful lives between two and four years, with a weighted average of 3.6 years.  Intellectual property has been assigned an estimated life of five years and will begin amortization as it is put into service. Trade names and backlogs have been assigned useful lives of five years,  and one year, respectively.  Customer relationships have been assigned useful lives between three and five years with a weighted average of 4.0 years. Amortization expense for intangible assets for the nine months ended September 30, 2006 was $2.7 million.

Estimated future intangible asset amortization expense for the next five years is as follows (in thousands):

16




 

 

Fiscal Year

 

Amortization of
Intangible Assets

 

2006 remaining three months

 

$

891

 

2007

 

3,679

 

2008

 

3,395

 

2009

 

1,963

 

2010 and after

 

905

 

 

 

$

10,833

 

 

There was no change in the carrying amount of goodwill for the nine months ended September 30, 2006 from December 31, 2005.

10.          Segment Reporting

A key objective of ours is to diversify our product offerings from primarily flash to a multi-product line company and to be a leading worldwide supplier of low to medium density NOR flash memory devices, a leading supplier of other semiconductor products in the consumer electronics market and a leading licensor of embedded flash technology.  As a result, the operating results that the company’s chief operating decision maker reviews to make decisions about resource allocations and to assess performance have changed.  Effective January 1, 2006, we have re-evaluated our operating segments to bring them in line with our key objectives and focus.  The new segments include Memory Products, Non-Memory Products and Technology Licensing.

Our Memory Product segment, which is comprised of NOR flash memory products, includes the Multi-Purpose Flash, or MPF, family, the Multi-Purpose Flash Plus, or MPF+, family, the Concurrent SuperFlash, or CSF, family, the Firmware Hub, or FWH, family, the Serial Flash family, the ComboMemory family, the Many-Time Programmable, or MTP, family, and the Small Sector Flash, or SSF, family.

Our Non-Memory Products segment includes other semiconductor products including flash microcontrollers, smart card integrated circuits, or ICs, and modules, radio frequency, or RF, ICs and modules, NAND controllers and NAND-controller based modules.

Technology Licensing includes both license fees and royalties generated from the licensing of our SuperFlash technology to semiconductor manufacturers for use in embedded flash applications.

We do not allocate operating expenses, interest and other income/expense, interest expense, impairment of equity investments or provision for or benefit from income taxes to any of these segments for internal reporting purposes, as we do not believe that allocating these expenses are material in evaluating segment performance.

Prior period segment information has been reclassified to conform to the current period’s presentation.

The following table shows our revenues and gross profit (loss) for each segment (in thousands):

17




 

 

Three Months Ended

 

Three Months Ended

 

 

 

September 30, 2005

 

September 30, 2006

 

 

 

 

 

Gross

 

 

 

Gross

 

 

 

Revenues

 

Profit

 

Revenues

 

Profit

 

 

 

 

 

 

 

 

 

 

 

Memory

 

$

89,556

 

$

4,820

 

$

90,676

 

$

17,055

 

Non-Memory

 

18,168

 

3,977

 

16,834

 

4,724

 

Technology Licensing

 

10,348

 

10,348

 

8,508

 

8,508

 

 

 

$

118,072

 

$

19,145

 

$

116,018

 

$

30,287

 

 

 

Nine Months Ended

 

Nine Months Ended

 

 

 

September 30, 2005

 

September 30, 2006

 

 

 

 

 

Gross

 

 

 

Gross

 

 

 

Revenues

 

Profit

 

Revenues

 

Profit

 

 

 

 

 

 

 

 

 

 

 

Memory

 

$

232,490

 

$

8,893

 

$

253,684

 

$

49,027

 

Non-Memory

 

39,386

 

8,297

 

53,067

 

15,020

 

Technology Licensing

 

25,810

 

25,810

 

27,527

 

27,527

 

 

 

$

297,686

 

$

43,000

 

$

334,278

 

$

91,574

 

 

11.          Comprehensive Income (Loss)

The components of comprehensive income (loss), as adjusted (Note 13), net of tax, are as follows (in thousands):

 

 

For the Three Months Ended

 

For the Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2005

 

2006

 

2005

 

2006

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) as adjusted (Note13)

 

$

(5,036

)

$

4,743

 

$

(39,099

)

$

17,064

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

Change in unrealized gains on investments, net of tax

 

640

 

1,408

 

10,430

 

(13,871

)

Change in cumulative translation adjustment

 

6

 

1

 

(29

)

17

 

Total comprehensive income

 

$

(4,390

)

$

6,152

 

$

(28,698

)

$

3,210

 

 

The components of accumulated other comprehensive income are, as adjusted (Note 13), as follows (in thousands):

 

Balances as of

 

 

 

December 31, 2005

 

September, 30 2006

 

Componentsof accumulated other comprehensive income as adjusted (Note 13):

 

 

 

 

 

 

 

 

 

 

Net unrealized gains on investments, net of tax

 

$

31,774

 

$

17,903

 

Cumulative translation adjustment

 

6

 

23

 

 

 

$

31,780

 

$

17,926

 

 

12.          Related Party Transactions and Balances

The following table is a summary of our related party revenues and purchases for the three and nine months ended September 30, 2005 and 2006, and our related party accounts receivable and accounts payable and accruals as of December 31, 2005 and September 30, 2006 (in thousands):

18




 

 

 

Three Months Ended

 

Three Months Ended

 

 

 

September 30, 2005

 

September 30, 2006

 

 

 

Revenues

 

Purchases

 

Revenues

 

Purchases

 

 

 

 

 

 

 

 

 

 

 

Silicon Technology Co., Ltd.

 

$

879

 

$

 

$

413

 

$

 

Apacer Technology, Inc. & related entities

 

512

 

 

542

 

 

Silicon Professional Technology Ltd.

 

65,824

 

 

62,430

 

 

Grace Semiconductor Manufacturing Corp.

 

29

 

4,138

 

65

 

25,084

 

King Yuan Electronics Company, Limited

 

 

7,461

 

 

7,958

 

Powertech Technology, Incorporated

 

 

3,317

 

 

4,498

 

 

 

$

67,244

 

$

14,916

 

$

63,450

 

$

37,540

 

 

 

 

Nine Months Ended

 

Nine Months Ended

 

 

 

September 30, 2005

 

September 30, 2006

 

 

 

Revenues

 

Purchases

 

Revenues

 

Purchases

 

 

 

 

 

 

 

 

 

 

 

Silicon Technology Co., Ltd.

 

$

2,717

 

$

 

$

899

 

$

 

Apacer Technology, Inc. & related entities

 

1,354

 

 

2,222

 

 

Silicon Professional Technology Ltd.

 

152,803

 

 

180,698

 

 

Grace Semiconductor Manufacturing Corp.

 

160

 

38,910

 

1,443

 

49,226

 

King Yuan Electronics Company, Limited

 

 

24,283

 

 

22,991

 

Powertech Technology, Incorporated

 

 

10,144

 

 

11,402

 

 

 

$

157,034

 

$

73,337

 

$

185,262

 

$

83,619

 

 

 

 

December 31, 2005

 

September 30, 2006

 

 

 

Trade

 

Accounts

 

Trade

 

Accounts

 

 

 

Accounts

 

Payable and

 

Accounts

 

Payable and

 

 

 

Receivable

 

Accruals

 

Receivable

 

Accruals

 

 

 

 

 

 

 

 

 

 

 

Silicon Technology Co., Ltd.

 

$

370

 

$

 

$

176

 

$

 

Apacer Technology, Inc. & related entities

 

237

 

 

121

 

 

Professional Computer Technology Limited

 

 

123

 

 

89

 

Silicon Professional Technology Ltd.

 

53,785

 

846

 

42,865

 

668

 

Grace Semiconductor Manufacturing Corp.

 

1,466

 

4,949

 

 

18,592

 

King Yuan Electronics Company, Limited

 

 

10,004

 

 

10,206

 

Powertech Technology, Incorporated

 

 

5,945

 

 

4,351

 

 

 

$

55,858

 

$

21,867

 

$

43,162

 

$

33,906

 

 

Professional Computer Technology Limited or PCT, earns commissions for point-of-sales transactions to customers.  PCT’s commissions are paid at the same rate as all of our other stocking representatives in Asia.  In addition, we pay Silicon Professional Technology Ltd. or SPT, a wholly-owned subsidiary of PCT, a fee for providing logistics center functions.  This fee is based on a percentage of revenue for each product shipped through SPT to our end customers. The fee paid to SPT covers the costs of warehousing and insuring inventory and processing accounts receivable, the personnel costs required to maintain logistics and information technology functions and the costs to perform demand forecasting, billing and collection of accounts receivable.

13.          Change in Accounting Principle

In September 2006, we invested an additional $15.9 million in Advanced Chip Engineering Technology Inc. or ACET, a development stage, private company in Taiwan that specializes in advanced semiconductor packaging technology. This investment increased our ownership share of ACET’s outstanding capital stock from 9.4% to 46.9% and required us to change from the cost method of accounting to the equity method of accounting for this investment. Under the equity method of accounting, we are required to record our 46.9% interest in ACET’s reported net income or loss each reporting period as well as require that prior period financial results be restated to reflect the

19




equity method of accounting from the date of the initial investment. The third quarter of 2006 results includes a charge of $607 thousand, as a result our increased investment in ACET.

The following table lists the relevant captions from our statements of operations as originally presented and after the change in accounting principle.

 

(in thousands, except per share data)

 

 

 

3Q04

 

4Q04

 

1Q05

 

2Q05

 

3Q05

 

4Q05

 

1Q06

 

2Q06

 

As previously presented

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) from operations

 

$

14,752

 

$

(27,330

)

$

(13,414

)

$

(18,864

)

$

(5,470

)

$

10,998

 

$

4,548

 

$

1,470

 

Other income (expense), net

 

$

684

 

$

828

 

$

201

 

$

1,014

 

$

371

 

$

204

 

$

439

 

$

1,056

 

Equity Impairment

 

 

(509

)

 

 

 

(2,240

)

(3,523

)

 

Net income (loss)

 

14,522

 

(26,925

)

(13,897

)

(19,587

)

(4,793

)

8,440

 

11,290

 

1,455

 

Earnings per share

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.15

 

$

(0.28

)

$

(0.14

)

$

(0.19

)

$

(0.05

)

$

0.08

 

$

0.11

 

$

0.01

 

Diluted

 

$

0.15

 

$

(0.28

)

$

(0.14

)

$

(0.19

)

$

(0.05

)

$

0.08

 

$

0.11

 

$

0.01

 

 

 

 

 

 

 

 

 

 

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