Prepared by R.R. Donnelley Financial -- Amendment No. 3 to Form 10-K

10-K/A 1 d10ka.htm AMENDMENT NO. 3 TO FORM 10-K Prepared by R.R. Donnelley Financial -- Amendment No. 3 to Form 10-K

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K/A

Amendment No. 3

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

For the fiscal year ended December 31, 2001 or *

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

Commission File No. 0-26734

SANDISK CORPORATION

(Exact name of Registrant as specified in its charter)

Delaware		77-0191793

(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

140 Caspian Court, Sunnyvale, California		94089
(Address of principal executive office)		(Zip Code)

Registrant’s telephone number, including area code: (408) 542-0500

Securities registered pursuant to Section 12(b) of the Act:

Title of each class		Name of each exchange on which registered
None		None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.001 par value;

Rights to Purchase Series A, Junior Participating Preferred Stock

(Title of Class)

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K ¨.

The aggregate market value of the voting stock held by non-affiliates of the Registrant, based upon the closing sale price of the Common Stock on March 1, 2002 as reported on the Nasdaq National Market System, was approximately $902,017,880. Shares of Common Stock held by each officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

As of March 1, 2002, Registrant had 68,637,117 shares of Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s Proxy Statement for the 2002 Annual Meeting of Stockholders held on May 22, 2002 are incorporated by reference into Part III of this Form 10-K/A.

For purposes of this Form 10-K/A the Registrant has indicated its fiscal year as ending on December 31st. The Registrant operates on a fifty-two/fifty-three week fiscal year cycle ending on the Sunday closest to December 31st.

SANDISK CORPORATION

TABLE OF CONTENTS

		Page No.

	PART I

Item 1.	Business	3

Item 2.	Properties	18

Item 3.	Legal Proceedings	18

Item 4.	Submission of Matters to a Vote of Security Holders	20

	Executive Officers of the Registrant	20

	PART II

Item 5.	Market for the Registrant’s Common Equity and Related Stockholder Matters	22

Item 6.	Selected Financial Data	23

Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	25

Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	58

Item 8.	Financial Statements and Supplementary Data	60

Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	92

	PART III

Item 10.	Directors and Executive Officers of the Registrant	93

Item 11.	Executive Compensation	93

Item 12.	Security Ownership of Certain Beneficial Owners and Management	93

Item 13.	Certain Relationships and Related Transactions	93

	PART IV

Item 14.	Exhibits, Financial Statements, Schedules, and Reports on Form 8-K	94

	Signatures	98

PART I

Item 1. Business

Statements in this report which are not historical facts are forward-looking statements within the meaning of the federal securities laws. These statements may contain words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates,” or other wording indicating future results. Forward-looking statements are subject to risks and uncertainties. Actual results may differ materially from the results discussed in forward-looking statements. Factors that could cause actual results to differ materially include, but are not limited to, those discussed under “Factors That May Affect Future Results” under Item 7 below, and elsewhere in this report. We undertake no obligation to revise or update any forward-looking statements to reflect any event or circumstance that may arise after the date of this report.

Overview

We design, manufacture and market flash memory storage products that are used in a wide variety of electronic systems. We have designed our flash memory storage solutions to address the storage requirements of emerging applications in the consumer electronics and industrial/communications markets. Our products are used in a number of rapidly growing consumer electronics applications, such as digital cameras, personal digital assistants, or PDAs, portable digital music players, digital video recorders and smart phones, as well as in industrial and communications applications, such as communications routers and switches and wireless communications base stations. In fiscal 2001, we shipped approximately 11 million flash memory cards and flash chip sets. Our products include removable CompactFlash cards, SmartMedia cards, FlashDisk cards, MultiMediaCards, Secure Digital cards, Memory Stick, and Ultra CompactFlash cards and embedded Flash ChipSets, NAND Flash Components and FlashDrives with storage capacities ranging from 8 megabytes to 2 gigabytes. During 2001, we completed a technology transition from NOR flash manufactured for us by UMC in Taiwan to NAND flash manufactured for us under our FlashVision joint venture with Toshiba. In fiscal 2001, our customers included Arrow Electronics, Inc., Avnet Electronics, Bell Microproducts, Inc., Best Buy Company, Inc., Canon, Inc., Circuit City Stores, Inc., Costco Wholesale Corporation, Eastman Kodak Company, Ericsson, Hewlett-Packard Company, Ingram Micro, Inc., Matsushita Electric Industrial Co., Ltd., Mitsubishi Plastic Co. Ltd., Nikon Corporation, Office Depot, Inc., Siemens AG, Staples, Inc., Thomson Multimedia, Inc., and Wynit, Inc., among others. In addition, we currently license our technologies to several companies including Hitachi Ltd., Intel Corporation, Lexar Media, Incorporated, Matsushita Electronics Corporation, Samsung Electronics Company Ltd., Sharp Electronics Corporation, SmartDisk Corporation, Silicon Storage Technologies, Incorporated, Sony Corporation, TDK Corporation and Toshiba Corporation.

In September 2001, we signed an agreement with Sony Corporation, or Sony, involving their Memory Stick card format. Under the agreement, Sony will supply us a portion of their Memory Stick output for resale under the SanDisk brand name. Sony has also agreed to purchase a portion of their NAND flash memory requirements from us provided that we meet market competitive pricing for these components. In addition, we and Sony agreed to co-develop and co-own the specifications for the next generation Memory Stick.

In 2000, we entered into a joint venture agreement with Toshiba Corporation, or Toshiba, under which we formed FlashVision, L.L.C., or FlashVision, to produce advanced flash memory, utilizing fabrication space at Dominion Semiconductor, L.L.C., or Dominion, in Manassas, Virginia. Production commenced in the second half of 2001 and Toshiba and SanDisk each receive 50% of Dominion’s flash memory output. In December 2001, we and Toshiba signed a binding memorandum of understanding, or MOU, under which we and Toshiba agreed to restructure our FlashVision joint venture by consolidating our FlashVision advanced NAND wafer fabrication manufacturing operations with Toshiba’s memory fabrication facility at Yokkaichi, Japan. In April 2002, we and Toshiba finalized certain agreements related to the restructuring. The Yokkaichi fabrication facility, or Yokkaichi, is Toshiba’s most advanced memory fabrication facility and has approximately twice the wafer fabrication capacity of Dominion. Through this consolidation, we expect Yokkaichi to provide more cost-

competitive NAND flash wafers than is possible at Dominion. Under the terms of the agreements, Toshiba will transfer the FlashVision owned and leased NAND production tool-set from Dominion to Yokkaichi and has agreed to bear substantially all the costs associated with the equipment transfers. Toshiba will continue to supply our NAND flash requirements out of its existing production at Yokkaichi during the transfer. We terminated all

manufacturing operations at Virginia in the first quarter of 2002 and will transfer substantially all the FlashVision equipment to Yokkaichi in 2002. Once the consolidation is completed, we expect that Yokkaichi’s total NAND wafer output will match the combined prior NAND capacity of Yokkaichi and Dominion. The FlashVision operation at Yokkaichi will continue essentially the same 50-50 joint venture and on essentially the same terms as it has had at Dominion in Virginia. In March 2002, FlashVision exercised its right of early termination under the lease facility and in April 2002 repaid all amounts outstanding thereunder. Accordingly, we are no longer subject to the financial covenants or collateralization requirements of the ABN AMRO bank lease. FlashVision completed interim financing in the form of a bridge loan from Toshiba in April 2002.

Recent Developments

In May 2002, FlashVision secured a new equipment lease arrangement with Mizuho Corporate Bank, Ltd., or Mizuho, and certain other financial institutions. In certain circumstances we will indemnify Toshiba for any liabilities Toshiba incurs as a result of Toshiba’s guarantee of the FlashVision equipment lease arrangement with Mizuho, up to a maximum contingent indemnification obligation by us of $150.0 million.

On February 22, 2002, we announced that Michael Gray, Vice President, Finance, would assume responsibility for our financial and accounting functions until we hire a successor to Frank A. Calderoni, Senior Vice President, Finance and Administration and Chief Financial Officer, who resigned in February 2002.

On December 24, 2001, we completed a private placement of $125 million of 4½% Convertible Subordinated Notes due 2006, or Notes, and on January 10, 2002, we sold an additional $25.0 million of the Notes pursuant to the exercise by the initial purchasers of their option.

References in this annual report on Form 10-K/A to “SanDisk,” “we,” “our,” and “us” collectively refer to SanDisk Corporation, a Delaware corporation, its subsidiaries and SunDisk Corporation, its predecessor. Our principal executive offices are located at 140 Caspian Court, Sunnyvale, California 94089 and our telephone number is (408) 542-0500.

Industry Background

In recent years, digital computing and processing have expanded beyond the boundaries of desktop computer systems to include a broader array of consumer electronic, industrial and communications products. These new devices include digital cameras, PDAs, highly portable computers, portable music players, digital video recorders, wireless base stations, network computers, communication routers and switches, cellular telephones, mobile communication systems, handheld data collection terminals, medical monitors and other electronic systems. These emerging applications have storage requirements that are not well addressed by traditional storage solutions. These requirements include small form factor size, high reliability, low power consumption and the capability to withstand high levels of shock and vibration and extreme temperature fluctuations. Because storage products based on flash semiconductor technology can meet these requirements, these devices and systems represent market opportunities for flash storage systems.

The SanDisk Solution

Our flash memory storage solution, known as system flash or data storage flash, addresses the needs of many emerging applications in the consumer electronics and industrial/communications markets. Since our inception, we have been actively involved in all aspects of flash memory process development, chip design, controller development and system-level integration, as well as the creation and promotion of new flash card industry standards, to ensure the creation of fully-integrated, broadly interoperable products that are compatible

with both existing and new system platforms. We believe our core technical competencies are in high-density flash memory process and design, controller design, system-level integration, compact packaging and low-cost system testing. To achieve compatibility among various electronic platforms, regardless of the host processor or operating system used, we have developed new capabilities in flash memory chip design and created intelligent controllers. We have also developed an architecture that can leverage advances in flash memory process technology to ensure a scaleable, high-yield, cost-effective and highly reliable manufacturing process. Our CompactFlash, MultiMediaCard, Secure Digital card and FlashDisk products are portable, have an on-board controller and use file formats that are forward- and backward-compatible. All of our flash data storage products can store almost any type of digital information, including voice, e-mail, music, video clips and digital images.

SanDisk’s products offer the following features:

Small form factor. Our CompactFlash products weigh about one-half ounce and are approximately the size of a matchbook. Our MultiMediaCard and Secure Digital Card products are approximately the size of a quarter coin and weigh less than two grams. Our FlashDisk cards are small and lightweight with a length of 85.6 mm, width of 54.0 mm, thickness of 5.0 mm or 10.5 mm and weight of less than 2.0 ounces.

Non-volatility. Our products store information in non-volatile memory cells that do not require power to retain information.

High degree of ruggedness. Our devices have an operating shock rating of 2,000 Gs for CompactFlash and 1,000 Gs for all other products (equivalent to being able to withstand ten foot and eight foot drops onto concrete, respectively). Our products are also designed to tolerate extensive fluctuations in temperatures and humidity.

Low power consumption. During read and write operations, our products use less power than the rotating disk drives found in many portable computers. At all other times during system operation, our products require virtually no power. Depending upon the end product making use of our flash data storage, this translates into longer battery life.

High reliability. Our products utilize sophisticated error detection and correction algorithms and dynamic defect management techniques to provide high data reliability and endurance.

High performance. We believe that the read and write data rates of our products meet or exceed the read and write data rates required today by the majority of consumer and industrial/communications applications.

The flash process and flash memory chip designs developed by us in cooperation with our partners make our products scaleable over several generations of semiconductor fabrication processes. This feature has allowed us to significantly reduce our cost per megabyte of capacity with each new generation of our products. By maintaining the same basic design parameters, each generation of our flash memory products maintains full compatibility with prior generations. This chip architecture has allowed us to significantly reduce cell size and thereby chip size. This has allowed us to increase storage capacity and lower the cost of our flash memory products.

We have developed core competencies in low-cost micropackaging technology as well as low-cost batch testing, both of which are important elements in building high-capacity, high-reliability flash cards at a competitive cost and in high volumes.

Applications and Markets for Flash Data Storage

We target the consumer electronics and the industrial/communications markets for our flash data storage products.

Our products are used in a number of rapidly growing consumer electronics applications, such as digital cameras, PDAs, portable music players, digital video recorders and smart phones, as well as in industrial and

communications applications, such as communications routers and switches and wireless communications base stations.

Consumer Electronics. The increasing trend towards the use of digital technology in consumer electronics devices has created requirements for new data storage products. For example, a number of major camera and imaging companies have introduced digital cameras that we believe will enable professionals and consumers to eliminate the need for standard 35mm photographic film by replacing it with re-usable compact digital data storage devices. In addition, flash data storage products, such as our removable CompactFlash, SmartMedia, FlashDisk, MultiMediaCard, Secure Digital, Memory Stick, and Ultra CompactFlash products and embedded Flash ChipSet, NAND Flash Components and FlashDrive products are used in PDAs, highly portable computers, digital audio players, network computers, cellular telephones, next-generation smart telephones and other devices.

Industrial/Communications Market. The communications market has applications that require new types of data storage. For example, communications switches and cellular base stations require data storage in environments that are subject to shock and vibration and a wide range of temperature and humidity conditions. As the storage capacity of our cards grows, we are increasingly able to displace disk drives in routers and switches manufactured by telecommunications companies such as Cisco, Nortel and Lucent.

In the fiscal years ended December 30, 2001, 2000, and 1999, product sales to our top 10 customers accounted for approximately 49%, 48%, and 57% of our product revenues, respectively. In 2001 and 2000, no single customer accounted for greater than 10% of our total revenues. In 1999, revenues from one customer exceeded 10% of total revenues. We expect that sales of our products to a limited number of customers will continue to account for a substantial portion of our revenues for the foreseeable future. We have also experienced significant changes in the composition of our major customer base from year to year and expect this pattern to continue as certain customers increase or decrease their purchases of our products as a result of fluctuations in market demand for their products. Sales to our customers are generally made pursuant to standard purchase orders rather than long-term contracts. The loss of, or significant reduction in, purchases by any of our major customers, could harm our business, financial condition and results of operations.

SanDisk’s Products

Our storage products are high capacity, solid-state, non-volatile flash memory devices that comply with industry standards, including the PC Card ATA and/or IDE, MultiMediaCard, Secure Digital and Memory Stick standards. We offer a broad line of flash data storage products in terms of capacities, form factors, operating voltage and temperature ranges. Our current product families include removable CompactFlash cards, SmartMedia cards, FlashDisk cards, MultiMediaCards, Secure Digital Cards, Memory Stick, and Ultra CompactFlash cards, and embedded Flash ChipSets, NAND Flash Components, FlashDrives and TriFlash. Our products are compatible with the majority of today’s computing and communications systems that are based on industry standards. Our principal products, as of December 31, 2001, are listed in the following table:

Product Family	Form Factor	Uncompressed Capacity
CompactFlash (Removable)	36.4 mm x 42.8 mm x 3.3 mm	8 megabytes to 1 gigabyte
Ultra CompactFlash (Removable)	36.4 mm x 42.8 mm x 3.3 mm	128 to 512 megabytes
SmartMedia (Removable)	Flash Card (45 mm x 37.0 mm x 0.76 mm)	8 to 128 megabytes
Secure Digital (Removable)	32.0 mm x 24.0 mm x 2.1 mm	8 to 256 megabytes
Memory Stick (Removable)	50.0 mm x 21.45 mm x 2.8 mm	16 to 128 megabytes
MultiMediaCard (Removable)	32.0 mm x 24.0 mm x 1.4 mm	8 to 64 megabytes
FlashDisk (Removable)	PC Card Type II (54.0 mm x 85.6 mm x 5.0 mm)	16 megabytes to 2 gigabytes
Flash ChipSet (Embedded)	ATA controller and flash memory chip	128 megabit to 1 gigabit
NAND Flash Components	TSOP (thin small outline package)	64 megabit to 1 gigabit
FlashDrive (Embedded)	2.5 & 3.5 inches	32 megabytes to 2 gigabytes

CompactFlash. Our CompactFlash products provide full PC Card ATA functionality but are only one-fourth the size of a standard PC Card. CompactFlash’s compact size, ruggedness, low-power requirements and its ability to operate at either 3.3V or 5V make it well-suited for a range of current and next-generation, small form factor consumer applications such as digital cameras, PDAs, personal communicators and audio recorders. CompactFlash products provide interoperability with systems based upon the PC Card ATA standard by using a low-cost passive Type II adapter. CompactFlash cards are available in capacities ranging from 8 megabytes to 1 gigabyte in Type I form factor.

Ultra CompactFlash. Ultra CompactFlash is a line of high-speed CompactFlash cards specifically designed for use in the rapidly growing market for high-performance digital cameras. Ultra CompactFlash cards are targeted at advanced photographers who require high-speed cards to quickly shoot many high-resolution images. Ultra CompactFlash cards have more than twice the sustained write speed of our standard CompactFlash Products. Capacities range from 128 megabytes to 512 megabytes. We introduced our Ultra CompactFlash cards in the fourth

quarter of 2001. We cannot assure you that our Ultra CompactFlash cards will receive substantial market acceptance. Any failure by our customers to accept our Ultra CompactFlash products could harm our business, financial condition and results of operations.

SmartMedia Cards. Our SmartMedia card is a removable flash memory card that can be used in several different types of digital devices including digital cameras, digital music players and digital voice recorders. Our SanDisk brand SmartMedia Cards are available in capacities ranging from 8 to 128 megabytes.

Secure Digital Card. The Secure Digital Card measures 32.0 mm by 24.0 mm by 2.1 mm. The Secure Digital Card is an enhanced version of our MultiMediaCard that incorporates advanced security and copyright protection features for the emerging markets for the electronic distribution of music, video and other copyrighted works. Our Secure Digital Card is available in storage capacities of 8 to 256 megabytes. We began shipping the Secure Digital Card in the first quarter of 2001.

The Secure Digital Card incorporates a number of new features, including Secure Digital Music Initiative, or SDMI, compliant security and copy protection, a mechanical write protect switch and a high data transfer rate. The Secure Digital Card is slightly thicker (2.1mm) than our MultiMediaCard and uses a nine-pin interface instead of the seven-pin interface of the MultiMediaCard. Because of these differences, the Secure Digital Card will not work in current products that include a MultiMediaCard slot. However, our MultiMediaCard products are forward compatible and will work in Secure Digital Card slots. Broad acceptance of our Secure Digital Card by consumers may reduce demand for our MultiMediaCard and other flash memory card products. The Secure Digital Card relies on the copy protection features that have been developed for the DVD standard and therefore may be more likely to be endorsed by the leading content providers. We cannot assure you that our Secure Digital Card will receive substantial market acceptance. Any failure by our customers to accept our Secure Digital Card products could harm our business, financial condition and results of operations.

Memory Stick. The SanDisk Memory Stick, introduced in the fourth quarter of 2001, is a popular, small-size flash memory card targeted at a wide variety of electronic products. It is sold in capacities ranging between 16 and 128MB and is used primarily in consumer electronics products sold under the Sony brand name. During 2001, we entered into an agreement with Sony under which they will supply us Memory Stick products under the SanDisk brand. Sony has also agreed to purchase a portion of their NAND flash chip requirements from us provided that we meet market competitive pricing for these components. Sony and SanDisk also agreed to co-develop and co-own the specifications for the next generation Memory Stick. We do not expect to generate revenues from the second generation Memory Stick before 2003.

MultiMediaCard. Our MultiMediaCard measures 32.0 mm by 24.0 mm by 1.4 mm, about the size of a quarter coin, and weighs less than two grams. MultiMediaCard is targeted at the emerging markets for mobile smart phones, consumer multimedia devices, digital audio recorders, digital video recorders, portable music

players and other products that need removable data storage in a small form factor. Our MultiMediaCard is available in storage capacities of 8, 16, 32 and 64 megabytes.

FlashDisk. Our FlashDisk products are used in data storage, data backup and data transport applications. Our FlashDisk products are available in the PC Card Type II form factor with capacities ranging from 16 megabytes to 2 gigabytes.

Flash ChipSet. Our Flash ChipSet products provide a very small footprint, solid-state ATA mass storage system. Our Flash ChipSet products consist of a single chip ATA controller and a flash memory chip, and are available in capacities of 128 megabit to 1 gigabit. We provide full PC Card, ATA and IDE disk drive compatibility in a chip set format.

NAND Flash Components. NAND is a widely-used type of flash memory for high capacity data storage applications. NAND flash memory has much lower power dissipation, lower cost per bit and higher capacity than the standard NOR flash commonly used for code store applications. NAND flash has gained wide acceptance in embedded storage consumer electronics applications. Our NAND Flash Components are sold as TSOP (thin small outline package) chips. Available capacities range from 64 megabit to 1 gigabit.

FlashDrive. Our FlashDrives come in 2.5 and 3.5 inch form factors and are targeted at applications that require embedded data storage devices. FlashDrives offer rugged, portable, low-power data storage and are plug and play replacements for rotating IDE drives making them ideal for mobile computers, communication devices and other systems that require embedded storage. Capacities of our FlashDrive products range from 32 megabytes to 2 gigabytes.

TriFlash. Our TriFlash is a high capacity, small size embedded flash memory device. TriFlash is ideal for storing audio, video, data and images on small portable systems. These products are targeted at Internet music players and cell phones. TriFlash will give product manufacturers the option of either using TriFlash and/or removable flash memory cards in their consumer electronics products. TriFlash is available in 16, 32 and 64 megabyte capacities. We expect to begin shipping our TriFlash products in second quarter of 2002. We cannot assure you that our TriFlash products will receive substantial market acceptance. Any failure by our customers to accept our TriFlash products could harm our business, financial condition and results of operations.

Other SanDisk products. We also sell ImageMate external memory card readers and PC Card adapters under the SanDisk brand name. Our ImageMate external memory card readers offer a fast, convenient way to transfer data between our memory card products and a personal computer through a USB connection. The ImageMates are available in CompactFlash, MultiMediaCard, Secure Digital and SmartMedia Card versions. Our PC Card adapters allow the user to transfer data between our memory card products and a laptop through the laptop’s PC Card (PCMCIA) slot. The PC Card adapters are available in CompactFlash, MultiMediaCard, Secure Digital and SmartMedia Card versions.

In January 2002, we introduced our Cruzer product. The Cruzer is a portable, pocket-size storage device that uses our MultiMediaCards or Secure Digital cards for the easy storage and transport of personal computer data files, image files, video and audio files. The Cruzer plugs into the industry-standard USB port that is built into desktop PCs, notebook computers and other devices. We expect to begin shipping our Cruzer product in the second quarter of 2002, in 32, 64, 128 and 256 megabyte capacities. We cannot assure you that our Cruzer products will receive substantial market acceptance. Any failure by our customers to accept our Cruzer products could harm our business, financial condition and results of operations.

Our Personal Tag, or P-Tag, is a wearable, matchbook size, memory card that can be used to store critical data such as medical records and other personal information. The target markets for these cards include military agencies, government departments, insurance and health care companies worldwide for healthcare and security applications. The product evaluation process of these types of customers is lengthy. We also believe that the

current generation P-Tag may not provide sufficient security for stored data, and that to make it a more attractive product we will have to improve its on-board security for data protection. We do not expect to generate meaningful revenue from the P-Tag until 2003 or 2004 at the earliest. We cannot assure you that our P-Tag products will receive substantial market acceptance. Any failure by our customers to accept our P-Tag products could harm our business, financial condition and results of operations.

Technology

Since our inception, we have focused our research, development and standardization efforts on developing highly reliable, high-performance and cost-effective flash memory storage products to address a variety of emerging markets needs. We have been actively involved in all aspects of this development, including flash memory process development, chip design, controller development and system-level integration to ensure the creation of fully-integrated, broadly interoperable products that are compatible with both existing and newly developed system platforms. In 2000, we entered into a long term strategic partnership with Toshiba to jointly develop and manufacture advanced NAND flash memory components to be used in all our products. We believe our core technical competencies are in high-density flash memory process and design, controller design, system-level integration, compact packaging and low-cost system testing. We have also initiated, defined and developed new standards such as CompactFlash, MultiMediaCard & Secure Digital card to meet new market needs and to promote wide acceptance of the standards through interoperability and ease of use.

To achieve compatibility with various electronic platforms regardless of the host processors or operating systems used, we developed new capabilities in flash memory chip design and created intelligent controllers. We also developed an architecture that can leverage advances in process technology to ensure a scaleable, high-yielding, cost-effective and highly reliable manufacturing process. We believe that these technical competencies and our system design approach have enabled us to introduce flash data storage products that are better suited for our target markets than linear flash cards based on socket flash chips. We design our products to be compatible with industry-standard IDE, ATA, MultiMediaCard, Secure Digital and Memory Stick interfaces used in all standard operating (OS) systems such as Windows and Apple compatible personal computers, and operating systems used in cell phones, PDAs, and other consumer and industrial products.

Our patented intelligent controller with its advanced defect management system permits our products to achieve a high level of reliability and longevity. Latent bit failure can occur several years into the life of a flash card product and can be difficult to detect with traditional flash technology. Our system allows the automatic substitution of entire sectors or major blocks of the memory chip in case of any latent flash memory failures. Additionally, our controller generates an error correcting code that is stored simultaneously with the data and is used to detect and dynamically correct any errors when the data is read. This design permits our products to maintain error-free operation for hundreds of thousands of erase and write cycles and reduces manufacturing costs by allowing us to incorporate partial die with less than 100% of the physical bits on each chip into the products without loss of functionality.

Strategic Manufacturing Relationships

An important element of our strategy has been to establish strategic relationships with leading technology companies that can provide us with access to leading edge semiconductor manufacturing capacity and participate in the development of some of our products. This enables us to concentrate our resources on the product design and development areas where we believe we have competitive advantages. We have developed strategic relationships with United Microelectronics, Inc., or UMC, in Taiwan, and Toshiba with whom we have a joint venture, FlashVision, which manufactures our NAND flash memory. We may establish relationships with other foundries in the future.

All of our products require silicon wafers that are currently supplied by Toshiba’s wafer facility at Yokkaichi, Japan, under our joint venture agreement, as well as UMC in Taiwan. All of our memory wafers

are currently manufactured using NAND process technology primarily in 0.16 micron feature sizes. UMC and other ASIC suppliers currently manufacture our controller wafers. In the past, we have experienced periods of supply constraints or excesses, each of which can have a significant impact on our gross margins and supplier relationships. Any delays in wafer availability or uncompetitive wafer pricing could limit our revenue growth and harm our business, financial condition and results of operations.

In December 2001, we signed a binding memorandum of understanding, or MOU, with Toshiba under which we and Toshiba agreed to restructure our FlashVision business by consolidating our FlashVision advanced NAND wafer fabrication manufacturing operations with Toshiba’s memory fabrication facility at Yokkaichi, Japan. In April 2002, we and Toshiba finalized certain agreements related to the restructuring. The Yokkaichi fabrication facility is Toshiba’s most advanced memory fabrication facility and has approximately twice the wafer fabrication capacity of Dominion. Through this consolidation, we expect Yokkaichi to provide more cost-competitive NAND flash wafers than is possible at Dominion. Under the terms of the agreements, Toshiba will transfer the FlashVision owned and leased NAND production tool-set from Dominion to Yokkaichi and has agreed to bear substantially all the costs associated with the equipment transfers, which are expected to be completed in 2002. Once the consolidation is completed, Yokkaichi’s total NAND wafer output will match the combined prior NAND capacity of Yokkaichi and Dominion. The FlashVision operation at Yokkaichi will continue essentially the same 50-50 joint venture and on essentially the same terms as it has had at Dominion in Virginia. In March 2002, FlashVision notified ABN AMRO that it was exercising its right of early termination under the lease facility and repaid all amounts outstanding thereunder in April 2002. Accordingly, we are no longer subject to the financial covenants or collateralization requirements of the ABN AMRO bank lease. FlashVision completed interim financing in the form of a bridge loan from Toshiba in April 2002 and we anticipate that FlashVision will finalize a new equipment lease arrangement by the end of the second quarter of 2002. The transfer and qualification of the advanced fabrication equipment from Dominion Virginia to Yokkaichi Japan is a highly complex operation. It is quite possible that we may encounter difficulties and delays. Although the additional costs associated with such potential delays will generally be borne by Toshiba, our results of operations may suffer if this equipment transfer is not completed on time and production does not commence at Yokkaichi as planned, thereby reducing the total NAND production capacity available to us.

Under the terms of our wafer supply agreements with UMC, we are obligated to provide a rolling forecast of anticipated purchase orders for the next six calendar months. Except in limited circumstances and subject to acceptance by UMC, the estimates for a portion of the forecast, generally three months, constitute a binding commitment and the estimates for the remaining months may not increase or decrease by more than a certain percentage from the previous month’s forecast. We have similar forecast requirements and binding commitments under our supply agreement with Toshiba for wafers from their current Yokkaichi foundry and we are obligated to purchase 50% of the NAND flash wafer output from the FlashVision Yokkaichi facility or bear the costs of unused capacity if we choose not to purchase our share of the available wafers. These requirements limit our ability to react to any significant fluctuations in demand for our products. When the demand for our products experiences an unexpected, sudden and sharp decline, and we are unable to reschedule or cancel our wafer orders, we end up with excess wafer inventories, which result in higher costs and reduced gross margins. Furthermore, if a significant drop in demand is also accompanied by a rapid decline in market prices for our products, we may have to reduce the value of our inventory to market, resulting in lower gross margins. Conversely, if customer demand exceeds our forecasts, we may be unable to obtain an adequate supply of wafers to fill customer orders, which could result in lost sales and the loss of customers to competitors who are able to meet the customer requirements. We are dependent upon our foundry partners to deliver wafers and to maintain acceptable yields and quality.

credits of $21.4 million. In September 2001, we agreed to convert 75% of our wafer credits to equity at a price of $12.75 per share and received an additional 1,284,007 ordinary shares.

Due to the continued weakness in the semiconductor industry, the value of our Tower investment and remaining wafer credits had declined to $16.6 million at December 31, 2001. It was determined that this decline was other than temporary, as defined by generally accepted accounting principles and a loss of $20.6 million was recorded in the second half of 2001. In addition, we recognized a loss of $5.5 million on our exchange of 75% of our Tower wafer credits for ordinary shares. These losses, totaling $26.1 million, or $15.8 million net of tax benefit, were recorded as loss on foundry investment in 2001. If the fair value of the Tower investment declines further, it may be necessary to record additional losses.

Under our original agreement, additional contributions by us will take the form of mandatory warrant exercises for ordinary shares at an exercise price of $30.00 per share if other milestones are met by Tower. The warrants will expire five years from the date of grant, and in the event the key milestones are not achieved, the exercise of these warrants will not be mandatory. However, in March 2002, we modified our share purchase agreement with Tower by agreeing to advance the payments for the third and fourth milestones to April 5, 2002 and October 1, 2002, respectively. The payment for the third milestone of $11.0 million was paid on April 5, 2002 and the payment for the fourth milestone of $11.0 million will be paid on October 1, 2002. We will make this payment whether or not Tower actually achieves its previously agreed upon milestone obligations. In exchange for this, and as part of the modification to the share purchase agreement, Tower has agreed that of the aggregate payment of $22.0 million represented by the third and fourth milestone payments, (i) 60% of this amount, or $13.2 million, will be applied to the issuance of additional ordinary Tower shares based on the average closing price of Tower shares on the NASDAQ in the thirty consecutive trading days preceding each payment date, referred to as the ATP, (provided, however, that pursuant to the purchase agreement as modified, the ATP shall not exceed $12.50 per share) and (ii) 40% of this amount, or $8.8 million, will be credited to our pre-paid wafer account, to be applied against orders placed with Tower’s new fabrication facility, when completed; provided, however, that until July 1, 2005, these amounts added to the pre-paid wafer account may only be applied towards a maximum of 7.5% of wafer purchases. As a result of our investment of $11.0 million for the third milestone, we received 1,071,497 additional Tower ordinary shares and $4.4 million in prepaid wafer credits. On a quarterly basis, we will assess the value of the prepaid wafer credits considering the timing and quantity of our planned wafer purchases from Tower, the contractual limitations on the amount of wafer credits that can be applied to purchases on an annual basis, the status of foundry construction and general economic conditions. If we determine that the value of these wafer credits is not recoverable, we will record a write-down. Currently, we expect Tower to supply us a portion of the ASIC controller chips used in our flash cards. We currently expect first wafer production to commence at the new fabrication facility in the first half of 2003.

Tower’s completion of the wafer foundry facility is dependent on its ability to obtain additional financing for the foundry construction from equity and other sources and the release of grants and approvals for changes in grant programs from the Israel government’s Investment Center. If Tower is unable to obtain additional financing, complete foundry construction in a timely manner or successfully complete the development and transfer of advanced CMOS process technologies and ramp-up of production, the value of our investment in Tower will decline significantly or possibly become worthless and we may be unable to obtain the wafers needed to manufacture our products, which would harm our results of operations. In addition, the value of our investment in Tower may be adversely affected by a further deterioration of conditions in the market for foundry manufacturing services and the market for semiconductor products generally.

We believe additional foundry capacity will be necessary to meet future demand for our products. Our ability to increase our revenues and net income in future periods is dependent on establishing additional wafer supply relationships and on receiving an uninterrupted supply of wafers from our manufacturing partners.

Our reliance on third-party wafer manufacturers involves several material risks, including shortages of manufacturing capacity, reduced control over delivery schedules, quality assurance, production yields and costs. This reliance could significantly harm our business, financial condition and results of operations. In addition, as a result of our dependence on foreign wafer manufacturers, we are subject to the risks of conducting business internationally, including political risks and exchange rate fluctuations.

Assembly and Testing

We test our wafers at Toshiba in Yokkaichi, Japan, and at the UMC facility and United Test Center, Inc. in Taiwan. Substantially all of the tested wafers are then shipped to our third party memory assembly subcontractors: Silicon Precision Industries Co., Ltd. in Taiwan and Mitsui & Co., Ltd. in Japan.

A substantial portion of our packaged memory final test, card assembly and card test is performed at Silicon Precision Industries and United Test Center, Inc. in Taiwan, and Celestica, Inc. in China. We completed the transfer of our testing and assembly operations to these subcontractors in the second half of 2001. In fiscal 2002, these subcontractors will assemble and test the vast majority of our products. We expect our reliance on subcontractors will continue to reduce the cost of our operations and give us access to increased production capacity. Any significant problems that occur at our subcontractors, or their failure to perform at the level we expect, could result in a disruption of production and a shortage of products to meet customer demand.

Our customers have demanding requirements for quality and reliability. To maximize quality and reliability, we monitor electrical and inspection data from our wafer foundries and assembly and test subcontractors. We monitor wafer foundry production for consistent overall quality, reliability, yield and defect levels. Most of our major component suppliers and subcontractors are ISO 9001 or 9002 certified.

Research and Development

We believe that our future success will depend on the continued development and introduction of new generations of flash memory chips, controllers and products designed specifically for the flash data storage market. In fiscal 2001, the majority of our production output shifted from the 256 megabit, 0.24 micron D2 technology to the 512 megabyte, 0.16 micron NAND flash memory supplied by FlashVision LLC, our joint venture with Toshiba. In December 2001, SanDisk received the first production output of the next generation of 1 gigabit, 0.16 micron NAND MLC (Multi Level Cell, which is the same as our D2) flash memory. We expect we will begin production of 1 gigabit NAND flash memory that employs 0.13 micron process feature size through our joint venture with Toshiba

late in the second half of 2002. We do not expect the 0.13 micron NAND flash memory wafers to contribute substantially to revenues until 2003.

Our research and development expenses were $58.9 million, $46.1 million, and $26.9 million for the fiscal years ended December 31, 2001, 2000, and 1999, respectively. As of December 31, 2001, we had 160 full-time equivalent employees engaged in research and development activities, including 20 in our Israel design center. In fiscal 2002 and beyond, we expect to significantly increase our spending on process and design research and development to support the development and introduction of new generations of flash data storage products, including our 1gigabit and 2 gigabit NAND MLC flash memory co-development and manufacturing joint venture with Toshiba.

Sales and Distribution

We market our products using a direct sales organization, distributors and manufacturers’ representatives. We also sell products to various customers on a private label basis and under the SanDisk brand in the retail channel. Our sales efforts are organized as follows:

Direct Sales Force. Our direct sales offices are located in Maitland, Florida; Herndon, Virginia; Nashua, New Hampshire; Sunnyvale and Irvine, California; Hannover, Munich and Rantingen, Germany; Kista, Sweden; Hong Kong, China; and Yokohama and Osaka, Japan. These offices support our major OEM customers and our distribution and manufacturers’ representative partners. Our retail sales offices are located in Trabuco Canyon, California; Avon, Ohio; Bedford, Texas; Hetfordshire, England; Haarlem, the Netherlands; and Osaka, Japan.

Distributors. In the United States, our products are sold through Arrow Electronics Inc., Avnet Inc. and Bell MicroProducts Inc. to OEM customers for a wide variety of industrial applications. In addition, we have distributors in various regions of the world including Europe, Japan, Australia, New Zealand, Taiwan, Korea, Singapore and Hong Kong.

Independent Manufacturers’ Representatives. In the United States, Canada and Europe, our direct sales force is supported in its sales efforts by more than 40 independent firms. These domestic and international firms receive a commission for providing support to our direct sales force and distributors in the industrial distribution, OEM and retail channels. The manufacturers’ representative companies sell our products as well as products from other manufacturers.

OEMs. We provide private label products to OEMs in the United States, Europe and the Pacific Rim.

Retail. We ship SanDisk brand name products directly to consumer electronics stores, office superstores, photo retailers, mass merchants, catalog and mail order companies, Internet and e-commerce retailers and selected retail distributors. Our retail distributors include Ingram Micro, Inc., Tech Data Corporation, Laguna Corporation and Wynit, Inc. in the United States, in addition to international distributors. Our products are available in more than 38,000 retail stores worldwide. Fourteen independent manufacturers’ representative firms are supporting our sales efforts in the retail channel. In addition, we sell our products on the Internet through third parties such as Amazon.com.

Customer Service and Technical Support

We provide customers with comprehensive product service and support. We provide technical support through our applications engineering group located in the United States, Japan and Hong Kong. We work closely with our customers to monitor the performance of our product designs, to provide application design support and assistance, and to gain insight into our customers’ needs to help in the design of future products.

Our support package includes technical documentation and application design assistance. In some cases, we offer additional support which includes training, system-level design, implementation and integration support and failure analysis. We believe that tailoring the technical support level to our customers’ needs is essential for the success of product introductions and to achieve a high level of satisfaction among our customers. We generally provide a one-year warranty on our products.

Patents and Licenses

We rely on a combination of patents, trademarks, copyright and trade secret laws, confidentiality procedures and licensing arrangements to protect our intellectual property rights. We vigorously protect and defend our intellectual property rights. In the past, we have been involved in significant disputes regarding our intellectual property rights and we believe we may be involved in similar disputes in the future.

In 1988, we developed the concept of emulation of a hard disk drive with flash solid-state memory. The first related patents were filed in 1988 by Dr. Eli Harari and exclusively licensed to us. We currently own or have exclusive rights to 174 United States and 37 foreign issued patents, and 109 patent applications pending in the United States, as well as 56 pending in foreign patent offices. We intend to seek additional international and United States patents on our technology. We believe some of our patents are fundamental to the implementation of flash data storage systems, as well as the implementation of MLC flash, independent of the flash technology used. However, we cannot assure you that any patents held by us will not be invalidated, that patents will be issued for any of our pending applications, or that any claims allowed from existing or pending patents will be of sufficient scope or strength or be issued in the primary countries where our products can be sold to provide meaningful protection or any commercial advantage to us. Additionally, our competitors may be able to design their products around our patents.

The semiconductor industry is characterized by vigorous protection and pursuit of intellectual property rights or positions, which has resulted in significant and often protracted and expensive litigation. To preserve our intellectual property rights, we believe it may be necessary to initiate litigation against one or more third parties, including but not limited to those we have already notified of possible patent infringement. In addition, one or more of these parties may bring suit against us.

For example, on or about August 3, 2001, the Lemelson Medical, Education & Research Foundation, or Lemelson Foundation, filed a complaint for patent infringement against us and four other defendants. The suit, captioned Lemelson Medical, Education, & Research Foundation, Limited Partnership vs. Broadcom Corporation, et al., Civil Case No. CIV01 1440PHX HRH, was filed in the United States District Court, District of Arizona. On November 13, 2001, the Lemelson Foundation filed an Amended Complaint, which made the same substantive allegations against us but named more than twenty-five additional defendants. The Amended Complaint alleges that we, and the other defendants, have infringed certain patents held by the Lemelson Foundation pertaining to bar code scanning technology. By its complaint, the Lemelson Foundation requests that we be enjoined from our allegedly infringing activities and seeks unspecified damages. On February 4, 2002, we filed an answer to the amended complaint, wherein we alleged that we do not infringe the asserted patents, and further contend that the patents are not valid or enforceable.

On October 15, 2001, we filed a complaint for patent infringement in the United States District Court for the Northern District of California against Micron Technology, Inc., or Micron. In the suit, captioned SanDisk Corp. v. Micron Technology, Inc., Civil No. CV 01-3855 CW, the complaint seeks damages and an injunction against Micron for making, selling, importing or using flash memory cards that infringe our U.S. Patent No. 6,149,316. On February 15, 2002, Micron answered the complaint, denied liability, and counterclaimed seeking a declaration that the patent in suit is not infringed, is invalid, and is unenforceable. On April 19, 2002, Micron filed a motion seeking to amend its counterclaim to assert allegations that we have infringed or are infringing five patents: U.S. Patent No. 4,468,308; U.S. Patent No. 5,286,344; U.S. Patent No. 5,320,981; U.S. Patent No. 6,015,760; and U.S. Patent No. 6,287,978 B1. We intend to oppose Micron’s motion.

On October 31, 2001, we filed a complaint for patent infringement in the United States District Court for the Northern District of California against Memorex Products, Inc., Pretec Electronics Corporation, Ritek Corporation and Power Quotient International Co., Ltd. In the suit, captioned SanDisk Corp. v. Memorex Products, Inc., et. al., Civil No. CV 01-4063 VRW, we seek damages and injunctions against these companies from making, selling, importing or using flash memory cards that infringe our U.S. patent No. 5,602,987, or the ‘987 Patent. Defendants Memorex, Pretec and Ritek have filed answers denying the allegations. We have filed a motion for a preliminary injunction in the suit to enjoin Memorex, Pretec and Ritek from making, selling, importing or using flash memory cards that infringe our ‘987 Patent prior to the trial on the merits. On May 17, 2002, the Court denied our motion. Discovery has commenced. The Court has set a trial date for the later half of 2003.

On November 30, 2001, we filed a complaint for patent infringement in the United States District Court for the Northern District of California against Power Quotient Internationa-USA Inc, or PQI-USA. In the suit, captioned SanDisk Corp. v. Power Quotient International-USA Inc., Civil No. C 01-21111, we seek damages and an injunction against PQI-USA from making, selling, importing or using flash memory cards that infringe our U.S. patent No. 5,602,987. The PQI-USA complaint and litigation are related to the October 31, 2001 litigation referred to above. The products at issue in the PQI-USA case are identical to those charged with infringement in the October 31, 2001 litigation. On December 21, 2001, PQI-USA filed an answer to the complaint denying the allegations, which included a counter claim for a declaratory judgment of non-infringement and invalidity of our ‘987 Patent. We have motioned for a preliminary injunction in the suit to enjoin PQI-USA from making, selling, importing or using flash memory cards that infringe our ‘987 Patent prior to the trial on the merits. On April 8, 2002, the Court heard argument on the preliminary injunction motion and a decision on the motion is pending. Discovery has commenced. The Court has set a trial date for the later half of 2003.

On or about March 5, 2002, Samsung Electronics Co., Ltd., or Samsung, filed a patent infringement lawsuit against us in the United States District Court for the Eastern District of Texas, Civil Action No. 9:02CV58. The lawsuit alleges that we infringe four Samsung United States patents, Nos. 5,473,563; 5,514,889; 5,546,341 and 5,642,309, and seeks a preliminary and permanent injunction against unnamed products of ours, as well as damages, attorneys’ fees and cost of the lawsuit. On March 28, 2002, we filed an answer and counterclaims denying infringement and asserting the Samsung patents are invalid and/or unenforceable. The counterclaims asserted that Samsung breached a 1997 agreement between SanDisk and Samsung. On April 3, 2002, Samsung filed its first amended complaint. The amended complaint restricted Samsung’s original infringement allegations with respect to the four patents listed above to SanDisk products that include NAND flash memory. A substantial percentage of SanDisk products include NAND flash memory devices. On April 26, 2002, we filed an answer to Samsung’s first amended complaint and amended counterclaims. This answer and amended counterclaims again denied infringement and asserted that the Samsung patents are invalid and/or unenforceable. In SanDisk’s amended counterclaims, we seek relief for both breach of the 1997 agreement and a declaration of our rights under the 1997 agreement. A trial has been schedule for October 2002 on this matter. On April 26, 2002, we filed a complaint against Samsung in the United States District Court for the Northern District of California, Civil No. C02-2069 MJJ, for declaratory judgment of non-infringement, invalidity, a declaration of rights under the 1997 agreement with Samsung and breach of contract.

From time to time, we have been contacted by various other parties who have alleged that certain of our products infringe on patents that these parties claim to hold. To date, no legal actions have been filed in connection with any such infringement, other than as discussed above.

In the event of an adverse result in any such litigation, we could be required to pay substantial damages, cease the manufacture, use and sale of infringing products, expend significant resources to develop non-infringing technology, discontinue the use of certain processes or obtain licenses to the infringing technology. Any litigation, whether as a plaintiff or as a defendant, would likely result in significant expense to us and divert the efforts of our technical and management personnel, whether or not such litigation is ultimately determined in our favor. In addition, the results of any litigation are inherently uncertain.

If we decide to incorporate third party technology into our products or our products are found to infringe on others’ patents or intellectual property rights, we may be required to license such patents or intellectual property rights. We may also need to license some or all of our patent portfolio to be able to obtain cross-licenses to the patents of others. We currently have patent cross-license agreements with several companies including Hitachi, Intel, Samsung, Sharp, SST, SmartDisk, TDK, Sony, Matsushita and Toshiba. From time to time, we have also entered into discussions with other companies regarding potential cross-license agreements for our patents. We cannot assure you that licenses will be offered or that the terms of any offered licenses will be acceptable to us. If we obtain licenses from third parties, we may be required to pay license fees or make royalty payments, which could reduce our gross margins. If we are unable to obtain a license from a third party for technology, we could incur substantial liabilities or be required to expend substantial resources redesigning our products to eliminate

the infringement. In addition, we might be required to suspend the manufacture of products or the use by our foundries of processes requiring the technology. We cannot assure you that we would be successful in redesigning our products or that we could obtain licenses under reasonable terms. Furthermore, any development or license negotiations could require substantial expenditures of time and other resources by us.

As is common in the industry, we agree to indemnify certain of our suppliers and customers for alleged patent infringement. The scope of such indemnity varies, but may in some instances include indemnification for damages and expenses, including attorneys’ fees. We may from time to time be engaged in litigation as a result of these indemnification obligations.

In our efforts to maintain the confidentiality and ownership of our trade secrets and other confidential information, we require all regular and temporary employees, consultants, foundry partners, certain customers, suppliers and partners to execute confidentiality and invention assignment agreements upon commencement of a relationship with us and extending for a period of time beyond termination of the relationship. We cannot assure you that these agreements will provide meaningful protection for our trade secrets or other confidential information in the event of unauthorized use or disclosure of such information.

Backlog

We manufacture and market primarily standard products. Sales are generally made pursuant to standard purchase orders. We include in our backlog only those customer orders for which we have accepted purchase orders and assigned shipment dates within the upcoming twelve months. Since orders constituting our current backlog are subject to changes in delivery schedules or cancellations, backlog is not necessarily an indication of future revenue. As of December 31, 2001, our backlog was $19.5 million, compared to $63.3 million at December 31, 2000. The decline in backlog in 2001 was primarily due to a reduction in orders from our OEM customers and a significant reduction in order lead times due to industry-wide overcapacity. Because of the deterioration in market conditions throughout most of 2001, our quarterly turns business, the business we book and ship in the same quarter, reached approximately 80% of product shipments in the third and fourth quarters of 2001. In 2001, sales to our OEM customers declined to 34% of our product revenues from 57% in 2000. Retail sales, which are typically booked and shipped in the same quarter, increased to 54% of our product revenues from 28% in 2000. We expect sales to the retail channel to continue to represent a significant portion of our revenue in 2002.

Competition

We compete in an industry characterized by intense competition, rapid technological changes, evolving industry standards, declining average selling prices and rapid product obsolescence. Our competitors include many large domestic and international companies that have greater access to advanced wafer foundry capacity, substantially greater financial, technical, marketing and other resources, broader product lines and longer standing relationships with customers.

Our primary competitors include companies that develop and manufacture storage flash chips, such as Hitachi, Samsung, Micron Technology and Toshiba. In addition, we compete with companies that manufacture other forms of flash memory and companies that purchase flash memory components and assemble memory cards. Companies that manufacture socket flash, linear flash and components include Advanced Micro Devices, Atmel, Fujitsu, Intel, Macronix, Mitsubishi, Sharp Electronics and ST Microelectronics. Companies that combine controllers and flash memory chips developed by others into flash storage cards include Dane-Elec Manufacturing, Delkin Devices, Inc., Feiya Technology Corporation, Fuji, Hagiwara, I/O Data, Ingentix, Kingston Technology, Lexar Media, M-Systems, Matsushita Battery, Matsushita Panasonic, Memorex, PNY, Pretec, Silicon Storage Technology, Silicon Tek, Simple Technology, Sony Corporation, TDK Corporation, Toshiba, and Viking Components.

In addition, many companies have been certified by the CompactFlash Association to manufacture and sell their own brand of CompactFlash. We believe additional manufacturers will enter the CompactFlash market in the future.

We have entered into an agreement with Matsushita and Toshiba, forming the Secure Digital Association, or SD Association, to jointly develop and promote a next generation flash memory card called the Secure Digital card. Under this agreement, royalty-bearing Secure Digital card licenses will be available to other flash memory card manufacturers, which will increase the competition for our Secure Digital card and other products. In addition, Matsushita and Toshiba have commenced selling Secure Digital cards that will compete directly with our products. While other flash card manufacturers will be required to pay the SD Association license fees and royalties, which will be shared among Matsushita, Toshiba and us, there will be no royalties or license fees payable among the three companies for their respective sales of the Secure Digital card. Thus, we will forfeit potential royalty income from Secure Digital card sales by Matsushita and Toshiba.

In addition, we and Toshiba will each separately market and sell any 512 megabit and 1 gigabit flash memory chips developed and manufactured by our joint venture, FlashVision. Accordingly, we will compete directly with Toshiba for sales of these advanced chips.

We have entered into patent cross-license agreements with several of our leading competitors including Hitachi, Intel, Matsushita, SST, Samsung, Sharp, Smartdisk, Sony, TDK and Toshiba. Under these agreements, each party may manufacture and sell products that incorporate technology covered by the other party’s patent or patents related to flash memory devices. As we continue to license our patents to certain of our competitors, competition will increase and may harm our business, financial condition and results of operations. Currently, we are engaged in licensing discussions with several of our competitors. There can be no assurance that we will be successful in concluding licensing agreements under terms which are favorable to us, or at all.

Competing products have been introduced that promote industry standards that are different from our products including Sony’s standard floppy disk used for digital storage in its Mavica digital cameras; Panasonic’s Mega Storage cards; Iomega’s Clik drive, a miniaturized, mechanical, removable disk drive; M-Systems’ DiskOnKey, a USB-based memory device; and the Secure MultiMediaCard from Hitachi and Infineon. Each competing standard may not be mechanically and electronically compatible with our products. If a manufacturer of digital cameras or other consumer electronic devices designs in one of these alternative competing standards, our products will be eliminated from use in that product. In addition, other companies, such as Sanyo, DataPlay and Matrix Semiconductor have announced products or technologies that may potentially compete with our products.

IBM’s Microdrive, a rotating disk drive in a Type II CompactFlash format competes directly with our larger capacity memory cards. M-Systems’ DiskOnChip 2000 Millennium product competes against our NAND Flash Component products in embedded storage applications such as set top boxes and networking appliances.

Sony has licensed its proprietary Memory Stick to us and other companies and Sony has agreed to supply us a portion of their Memory Stick output for resale under our brand name. If consumer electronics products using the Memory Stick achieve widespread use, sales of our MultiMediaCard, Secure Digital card, SmartMedia card and CompactFlash products may decline. Our MultiMediaCard products also have faced significant competition from Toshiba’s SmartMedia flash cards.

We also face competition from products based on multilevel cell flash technology from Intel and Hitachi. These products currently compete with our NAND multilevel cell products. Multilevel cell flash is a technological innovation that allows each flash memory cell to store two bits of information instead of the traditional single bit stored by conventional flash technology.

costly or provide additional features. For example, Infineon has formed a joint venture with Saifun, an Israeli startup company, called Ingentix, to develop a proprietary flash memory technology which will be targeted at low cost data storage applications. Price is an important competitive factor in the market for consumer products. Increased price competition could lower gross margins if our average selling prices decrease faster than our costs and could also result in lost sales.

We believe that our ability to compete successfully depends on a number of factors, including:

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price, quality, and on-time delivery to our customers;

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product performance and availability;

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success in developing new applications for system flash technology;

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adequate foundry capacity;

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efficiency of production;

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timing of new product announcements or introductions by us, our customers and our competitors;

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the ability of our competitors to incorporate their flash data storage systems into their customers’ products;

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the number and nature of our competitors in a given market;

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successful protection of intellectual property rights; and

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general market and economic conditions.

We believe that we compete reasonably favorably with other companies with respect to these factors. We cannot assure you that we will be able to compete successfully against current and future competitors or that competitive pressures faced by us will not materially adversely affect our business, financial condition or results of operations.

Employees

As of December 31, 2001, we had 565 full-time employees and 15 temporary employees, including 160 in research and development, 115 in sales and marketing, 111 in general and administration and 194 in operations. Our success is dependent on our retention of key technical, sales and marketing employees and members of senior management. Additionally, our success is contingent on our ability to attract and recruit skilled employees in a very competitive market. None of our employees are represented by a collective bargaining agreement and we have never experienced any work stoppage. We believe that our employee relations are good.

Item 2. Properties

Our principal facilities are located in Sunnyvale, California. We lease two adjacent buildings, a 104,000 square foot building that is dedicated to research and development and operations activities and a 63,000 square foot building which houses our administrative, sales and marketing functions. We occupy this space under lease agreements that expire in July 2006. Under these agreements, we have the option to renew the leases on both buildings for one additional five-year term ending on June 30, 2011. We believe that our facilities will be adequate to meet our near term needs and that additional space will be available as required. We also lease sales offices in the United States of America, Japan, Germany, the Netherlands, Hong Kong and Sweden, an operations support office in Taichung, Taiwan and a design center in Tefen, Israel.

Item 3. Legal Proceedings

Lemelson Medical, Education, & Research Foundation, Limited Partnership vs. Broadcom Corporation, et al., Civil Case No. CIV01 1440PHX HRH, was filed in the United States District Court, District of Arizona. On November 13, 2001, the Lemelson Foundation filed an Amended Complaint, which made the same substantive allegations against us but named more than twenty-five additional defendants. The Amended Complaint alleges that we, and the other defendants, have infringed certain patents held by the Lemelson Foundation pertaining to bar code scanning technology. By its complaint, the Lemelson Foundation requests that we be enjoined from our allegedly infringing activities and seeks unspecified damages. On February 4, 2002, we filed an answer to the amended complaint, wherein we alleged that we do not infringe the asserted patents, and further contend that the patents are not valid or enforceable.

On October 31, 2001, we filed a complaint for patent infringement in the United States District Court for the Northern District of California against Memorex Products, Inc., Pretec Electronics Corporation, Ritek Corporation and Power Quotient International Co., Ltd. In the suit, captioned SanDisk Corp. v. Memorex Products, Inc., et. al., Civil No. CV 01-4063 VRW, we seek damages and injunctions against these companies from making, selling, importing or using flash memory cards that infringe our U.S. patent No. 5,602,987, or the ‘987 Patent. Defendants Memorex, Pretec and Ritek have filed answers denying the allegations. We filed a motion for a preliminary injunction in the suit to enjoin Memorex, Pretec and Ritek from making, selling, importing or using flash memory cards that infringe our ‘987 Patent prior to the trial on the merits. On May 17, 2002, the Court denied our motion. Discovery has commenced. The Court has set a trial date for the later half of 2003.

On November 30, 2001, we filed a complaint for patent infringement in the United States District Court for the Northern District of California against Power Quotient International-USA Inc, or PQI-USA. In the suit, captioned SanDisk Corp. v. Power Quotient International-USA Inc., Civil No. C 01-21111, we seek damages and an injunction against PQI-USA from making, selling, importing or using flash memory cards that infringe our U.S. patent No. 5,602,987. The PQI-USA complaint and litigation are related to the October 31, 2001 litigation referred to above. The products at issue in the PQI-USA case are identical to those charged with infringement in the October 31, 2001 litigation. On December 21, 2001, PQI-USA filed an answer to the complaint denying the allegations, which included a counter claim for a declaratory judgment of non-infringement and invalidity of our ‘987 Patent. We have motioned for a preliminary injunction in the suit to enjoin PQI-USA from making, selling, importing or using flash memory cards that infringe our ‘987 Patent prior to the trial on the merits. On April 8, 2002, the Court heard argument on the preliminary injunction motion and a decision on the motion is pending. Discovery has commenced. The Court has set a trial date for the later half of 2003.

denying infringement and asserting the Samsung patents are invalid and/or unenforceable. The counterclaims asserted that Samsung breached a 1997 agreement between SanDisk and Samsung. On April 3, 2002, Samsung filed its first amended complaint. The amended complaint restricted Samsung’s original infringement allegations with respect to the four patents listed above to SanDisk products that include NAND flash memory. A substantial percentage of SanDisk products include NAND flash memory devices. On April 26, 2002, we filed an answer to Samsung’s first amended complaint and amended counterclaims. This answer and amended counterclaims again denied infringement and asserted that the Samsung patents are invalid and/or unenforceable. In SanDisk’s amended counterclaims, we seek relief for both breach of the 1997 agreement and a declaration of our rights under the 1997 agreement. A trial has been schedule for October 2002 on this matter. On April 26, 2002, we filed a complaint against Samsung in the United States District Court for the Northern District of California, Civil No. C02-2069 MJJ, for declaratory judgment of non-infringement, invalidity, a declaration of rights under the 1997 agreement with Samsung and breach of contract.

Litigation is subject to inherent risks and uncertainties that may cause actual results to differ materially from our expectations. Factors that could cause litigation results to differ include, but are not limited to, the discovery of previously unknown facts, changes in the law or in the interpretation of laws, and uncertainties associated with the judicial decision-making process.

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report.

EXECUTIVE OFFICERS OF THE REGISTRANT

Our executive officers, who are elected by and serve at the discretion of the Board of Directors, are as follows (all ages are as of March 1, 2002):

Name	Age	Position

Dr. Eli Harari	56	President, Chief Executive Officer and Director

Sanjay Mehrotra	43	Executive Vice President and Chief Operating Officer

Nelson Chan	40	Senior Vice President and General Manager, Retail Business Unit

Jocelyn Scarborough	57	Vice President, Human Resources

Dr. Eli Harari, the founder of SanDisk, has served as President and Chief Executive Officer and as a director of SanDisk since June 1988. Dr. Harari founded Wafer Scale Integration, a privately held semiconductor company, in 1983 and was its President and Chief Executive Officer from 1983 to 1986, and Chairman and Chief Technical Officer from 1986 to 1988. From 1973 to 1983, Dr. Harari held various management positions with Honeywell Inc., Intel Corporation and Hughes Aircraft Microelectronics. Dr. Harari holds a Ph.D. in Solid State Sciences from Princeton University and has more than 70 patents issued in the field of non-volatile memories and storage systems. Dr. Harari is a board member of Tower Semiconductor, a public company in which SanDisk holds a minority investment and Digital Portal, Inc. a joint venture firm created by SanDisk and Photo-Me International.

Mr. Sanjay Mehrotra co-founded SanDisk in 1988 and has served as SanDisk’s vice president of engineering, vice president of product development, director of memory design, and product engineering. He is currently Executive Vice President and Chief Operating Officer. He has more than 21 years of experience in the non-volatile semiconductor memory industry including engineering and engineering management positions at Intel Corporation, Seeq Technology, Integrated Device Technology and Atmel Corporation. Mr. Mehrotra earned

a B.S. and M.S. degrees in electrical engineering and computer sciences from the University of California, Berkeley. He also holds several patents and has published articles in the area of non-volatile memory design and flash memory systems. Mr. Mehrotra is a board member of Divio, a privately held semiconductor start-up company, in which SanDisk has a 10% ownership interest.

Mr. Nelson Chan brings more than 17 years of high-technology marketing and engineering experience and has served as SanDisk’s Vice President of Marketing and Senior Vice President, Sales and Marketing. He is currently Senior Vice President and General Manager, Retail Business Unit. Prior to joining SanDisk in 1992, Mr. Chan held marketing and engineering positions at Chips and Technologies, Signetics, and Delco Electronics. Mr. Chan was one of the principal organizers of the CompactFlash Association (CFA) and the MultiMediaCard Association (MMCA). He is an officer and board member of the CFA and a board member of the MMCA. Mr. Chan is also a board member of Digital Portal Inc., a joint venture firm created by SanDisk and Photo-Me International. He holds a B.S. in Electrical and Computer Engineering from the University of California at Santa Barbara and an M.B.A. from Santa Clara University.

Ms. Jocelyn Scarborough joined SanDisk as Vice President of Human Resources in March 1999. She was previously Principal of Scarborough and Associates from 1997 to 1999 and Vice President of Human Resources for the California State Automobile Association from 1994 to 1997. From 1973 to 1993, Ms. Scarborough held various professional and management positions in Human Resources and Marketing at Digital Equipment Corporation, including Marketing Manager, Director of Human Resources and Director of Management & Organization Development. Ms. Scarborough holds a B.S. in Psychology from Gordon College.

PART II

Item 5. Market for the Registrant’s Common Equity and Related Stockholder Matters

Market Price of Common Stock

Our Common Stock is traded on the Nasdaq National Market under the symbol “SNDK”. Our initial public offering of stock occurred on November 8, 1995 at a post-split price to the public of $5.00 per share. On January 26, 2000, our board of directors approved a 2-for-1 stock split, in the form of a 100% stock dividend, payable to stockholders of record as of February 8, 2000. The dividend was paid and the split was effected on February 22, 2000. Shares, share price, per share amounts, common stock at par value and capital in excess of par value have been restated to reflect the stock split for all periods presented. The following table lists the high and low sales prices for each quarter during the last two fiscal years.

	High		Low
Fiscal year 2000
First quarter	$	169.625	$	37.469
Second quarter	$	126.500	$	41.250
Third quarter	$	94.500	$	51.125
Fourth quarter	$	74.750	$	27.500

Fiscal year 2001
First quarter	$	48.688	$	18.625
Second quarter	$	30.000	$	17.250
Third quarter	$	27.940	$	8.610
Fourth quarter	$	18.290	$	9.050

As of March 1, 2002, we had approximately 361 stockholders of record. We have never declared or paid any cash dividends on our Common Stock and do not expect to pay cash dividends on our Common Stock in the foreseeable future. We currently intend to retain our earnings, if any, for use in our business.

On December 24, 2001, we sold to two qualified institutional buyers, Morgan Stanley & Co. Incorporated and ABN AMRO Rothschild LLC, $125.0 million principal amount of 4 ½% Convertible Subordinated Notes due 2006, or Notes, and on January 10, 2002, we sold an additional $25.0 million of the Notes pursuant to the exercise by the initial purchasers of their option. These initial purchasers received a commission from the sale of the Notes of an aggregate of $3.8 million. The Notes were resold by the initial purchasers to “qualified institutional buyers” pursuant to Rule 144A of the Securities Act of 1933, as amended and were not, when issued, of the same class as securities listed on a national securities exchange or quoted on Nasdaq. The Notes are convertible at the option of the holders into our common stock at a conversion rate which is equivalent to a conversion price of approximately $18.43 per share, which is equal to a conversion rate of approximately 54.2535 shares of common stock per $1,000 principal amount of Notes. The Notes are redeemable by us at any time on or after November 17, 2004 at specified prices. While the Notes are outstanding, we will have debt service obligations on the Notes of approximately $6.8 million per year in interest payments. We expect to use the net proceeds of the offering for general corporate purposes, including the development of new technologies and fabrication facilities, general working capital and capital expenditures. We may also use a portion of the net proceeds to fund acquisitions of products, technologies or complementary businesses. However, we currently have no commitments or agreements for any specific acquisitions.

Item 6: Sandisk Corporation Selected Financial Data

	Year Ended December 31,
	2001(1)			2000(2)		1999		1998		1997
	(In thousands, except per share data)
Revenues
Product	$	316,867		$	526,359	$	205,770	$	103,190	$	105,675
License and royalty		49,434			75,453		41,220		32,571		19,578

Total revenues		366,301			601,812		246,990		135,761		125,253
Cost of product revenues		392,293			357,017		152,143		80,311		72,280

Gross profits (losses)		(25,992	)		244,795		94,847		55,450		52,973
Operating income (loss)		(152,990	)		124,666		30,085		12,810		19,680
Net income (loss)	$	(297,944	)	$	298,672	$	26,550	$	11,836	$	19,839
Net income (loss) per share
Basic	$	(4.37	)	$	4.47	$	0.48	$	0.23	$	0.43
Diluted	$	(4.37	)	$	4.11	$	0.43	$	0.21	$	0.40
Shares used in per share calculations
Basic		68,148			66,861		55,834		52,596		45,760
Diluted		68,148			72,651		61,433		55,344		49,940

	At December 31,
	2001			2000		1999		1998		1997
Working capital	$	415,096		$	525,950	$	482,793	$	38,471	$	134,298
Total assets		932,348			1,107,907		657,724		255,741		245,467
Long-term obligations		129,908			73,492		—		—		—
Total stockholders’ equity		675,379			863,058		572,127		207,838		191,374

(1)

Includes other-than-temporary impairment charges of $302.3 million, or $188.1 million net of tax and restructuring charges of $8.5 million or $6.7 million net of tax.

(2)

Includes gain on investment in UMC of $344.2 million, or $203.9 million net of tax.

See the Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations.

SANDISK CORPORATION

SUPPLEMENTARY QUARTERLY DATA

(Unaudited. In thousands, except per share data)

	Quarterly/2001
	1st			2nd			3rd			4th
Revenues
Product	$	88,083		$	88,115		$	57,305		$	83,364
License and royalty		13,244			19,033			8,582			8,575

Total revenues		101,327			107,148			65,887			91,939
Gross profits (losses)		(17,453	)		396			(23,539	)		14,604
Operating income (loss)		(48,303	)		(28,650	)		(61,373	)		(14,664	)
Net income (loss)*		(143,102	)		(9,994	)		(170,476	)		25,628
Net income (loss) per share
Basic+	$	(2.11	)	$	(0.15	)	$	(2.50	)	$	0.37
Diluted+	$	(2.11	)	$	(0.15	)	$	(2.50	)	$	0.36

	Quarterly/2000
	1st			2nd			3rd			4th
Revenues
Product	$	97,249		$	122,572		$	151,817		$	154,721
License and royalty		12,120			21,377			19,022			22,934

Total revenues		109,369			143,949			170,839			177,655
Gross profits		41,611			59,435			68,965			74,784
Operating income		17,551			30,852			35,535			40,728
Net income**		219,271			24,269			25,602			29,530
Net income per share
Basic+	$	3.32		$	0.36		$	0.38		$	0.44
Diluted+	$	3.00		$	0.33		$	0.35		$	0.41

In the first and third quarters of 2001, we recognized losses of $179.9 million and $116.4 million, respectively, on the other-than-temporary decline in the market value of our foundry investments in UMC and Tower Semiconductor.

On January 3, 2000, the USIC foundry was merged into the UMC parent company. We had invested $51.2 million in USIC. In exchange for our USIC shares, we received 111 million UMC shares. These shares were valued at approximately $396 million at the time of the merger, resulting in a pretax gain of $344.2 million in the first quarter of 2000.

⁺

Quarterly earnings per share figures may not total to yearly earnings per share, due to rounding and the fluctuations in the number of options included or omitted from diluted calculations based on the stock price or option strike prices.

See the Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Item 7: Management’s Discussion and Analysis of Financial Condition and Results of Operations

Statements in this report which are not historical facts are forward-looking statements within the meaning of the federal securities laws. These statements may contain words such as “expects,” “anticipates,” “intends,” “plans,” “believes”, “estimates,” or other wording indicating future results or expectations. Forward-looking statements are subject to risks and uncertainties. Our actual results may differ materially from the results discussed in forward-looking statements. Factors that could cause our actual results to differ materially include, but are not limited to, those discussed under “Factors That May Affect Future Results” below, and elsewhere in this report. The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto. We undertake no obligation to revise or update any forward-looking statements to reflect any event or circumstance that may arise after the date of this report.

Overview

SanDisk was founded in 1988 to develop and market flash data storage systems. We sell our products to the consumer electronics and industrial/communications markets. In fiscal 2001, approximately 78% of our product sales were attributable to the consumer electronics market, particularly sales of CompactFlash and SmartMedia card products for use in digital camera applications. Our CompactFlash products have lower average selling prices and gross margins than our higher capacity FlashDisk and FlashDrive products. In addition, a substantial portion of our products are sold into the retail channel, which usually has shorter customer order lead-times than our other channels. A majority of our sales to the retail channel are turns business, with orders received and fulfilled in the same quarter, thereby decreasing our ability to accurately forecast future production needs. We believe sales to the consumer market will continue to represent a substantial majority of our sales, and may increase as a percentage of sales in future years, as the popularity of consumer applications, including digital cameras, increases.

Our operating results are affected by a number of factors including the volume of product sales, competitive pricing pressures, availability of foundry capacity, variations in manufacturing cycle times, fluctuations in manufacturing yields and manufacturing utilization, the timing of significant orders, our ability to match supply with demand, changes in product and customer mix, market acceptance of new or enhanced versions of our products, changes in the channels through which our products are distributed, timing of new product announcements and introductions by us and our competitors, the timing of license and royalty revenues, fluctuations in product costs, increased research and development expenses, and exchange rate fluctuations. We have experienced seasonality in the past. As the proportion of our products sold for use in consumer electronics applications increases, our revenues may become increasingly subject to seasonal increases in the fourth quarter of each year and declines in the first quarter of the following year. See “Factors That May Affect Future Results—Our Operating Results May Fluctuate Significantly Which May Adversely Affect Our Stock Price” and “—There is Seasonality in Our Business.”

Beginning in late 1995, we adopted a strategy of licensing our flash technology, including our patent portfolio, to third party manufacturers of flash products. To date, we have entered into patent cross-license agreements with several companies, and intend to pursue opportunities to enter into additional licenses. Under our current license agreements, licensees pay license fees, royalties, or a combination thereof. In some cases, the compensation to us may be partially in the form of guaranteed access to flash memory manufacturing capacity from the licensee company. The timing and amount of royalty payments and the recognition of license fees can vary substantially from quarter to quarter depending on the terms of each agreement and, in some cases, the timing of sales of products by the other parties. As a result, license and royalty revenues have fluctuated significantly in the past and are likely to continue to fluctuate in the future. Given the relatively high gross margins associated with license and royalty revenues, gross margins and net income are likely to fluctuate more with changes in license and royalty revenues than with changes in product revenues.

We market our products using a direct sales organization, distributors, manufacturers’ representatives, private label partners, OEMs and retailers. In 2001, retail sales accounted for 54% of total product revenues,

compared to 28% in 2000. We expect that sales through the retail channel will comprise an increasing share of our product revenues in the future, and that a substantial portion of our sales into the retail channel will be made to participants that will have the right to return unsold products. Our policy is to defer recognition of revenues from these sales until the products are sold to the end customers.

Historically, a majority of our sales have been to a limited number of customers. Sales to our top 10 customers accounted for approximately 49%, 48%, and 57%, respectively, of our product revenues for 2001, 2000, and 1999. In 2001 and 2000, no single customer accounted for greater than 10% of our total revenues. In 1999, revenues from one customer exceeded 10% of our total revenues. We expect that sales of our products to a limited number of customers will continue to account for a substantial portion of our product revenues for the foreseeable future. We have also experienced significant changes in the composition of our customer base from year to year and expect this pattern to continue as market demand for our customers’ products fluctuates. The loss of, or a significant reduction in purchases by any of our major customers, could harm our business, financial condition and results of operations. See “Factors That May Affect Future Results—Sales to a Small Number of Customers Represent a Significant Portion of Our Revenues”.

All of our products require silicon wafers, the majority of which are currently manufactured for us by Toshiba’s wafer facility at Yokkaichi, Japan, under our joint venture agreement, as well as UMC in Taiwan. Industry-wide demand for semiconductors decreased significantly in 2001, due to decreased demand in the cellular phone markets and the broad, general economic downturn leading to a US recession. Semiconductor manufacturers, including some of our suppliers and competitors, added new advanced wafer fab capacity prior to the downturn. This additional capacity, along with slowing economic conditions, resulted in excess supply and led to intense pricing pressure. From the fourth quarter of 2000 to the fourth quarter of 2001, the average sales price per megabyte we sold decreased by 68%, far in excess of our ability to reduce our cost per megabyte. Consequently we saw a dramatic reduction in our product gross margins, which resulted in substantial operating losses in 2001. If industry-wide demand for our products continues to be below the industry-wide available supply, our product prices could decrease further causing our operating losses to continue in 2002.

Under our wafer supply agreements, there are limits on the number of wafers we can order and our ability to change that quantity, either up or down, is restricted. Accordingly, our ability to react to significant fluctuations in demand for our products is limited. If customer demand falls below our forecast and we are unable to reschedule or cancel our orders for wafers or other long lead-time items such as controller chips or printed circuit boards, we may end up with excess inventories, which could result in higher operating expenses and reduced gross margins. If customer demand exceeds our forecasts, we may be unable to obtain an adequate supply of wafers to fill customer orders, which could result in lost sales and lower revenues. If we are unable to obtain adequate quantities of flash memory wafers with acceptable prices and yields from our current and future wafer foundries, our business, financial condition and results of operations could be harmed.

We have from time to time taken write-downs for excess or obsolete inventories and lower of cost or market price adjustments. In 2001, such write-downs and lower of cost or market adjustments were approximately $85.0 million. We may be forced to take additional write-downs for excess or obsolete inventory in future quarters if the current deterioration in market demand for our products continues and our inventory levels continue to exceed customer orders. In addition, we may record additional lower of cost or market price adjustments to our inventories if continued pricing pressure results in a net realizable value that is lower than our cost. Although we continuously try to reduce our inventory in line with the current level of business, we are obligated to honor existing purchase orders, which we have placed with our suppliers. In the case of FlashVision manufacturing, both we and Toshiba are obligated to purchase their share of the production output, which makes it more difficult for us to reduce our inventory.

Excess inventory not only ties up our cash, but also can result in substantial losses if such inventory, or large portions thereof, has to be revalued due to lower market pricing or product obsolescence. These inventory adjustments decrease gross margins and in 2001 resulted in, and could in the future result in, fluctuations in gross

margins and net earnings in the quarter in which they occur. See “Factors That May Affect Future Results—Our Operating Results May Fluctuate Significantly.”

Export sales are an important part of our business, representing 55%, 57% and 53% of our total revenues in 2001, 2000, and 1999, respectively. Our sales may be impacted by changes in economic conditions in our international markets. Economic conditions in our international markets, including Japan, Asia and the European Union, may adversely affect our revenues to the extent that demand for our products in these regions declines. While most of our sales are denominated in U.S. Dollars, we invoice certain Japanese customers in Japanese Yen and are subject to exchange rate fluctuations on these transactions which could affect our business, financial condition and results of operations. See “Factors That May Affect Future Results—Our international operations make us vulnerable to changing conditions and currency fluctuations.”

For the foreseeable future, we expect to realize a significant portion of our revenues from recently introduced and new products. Typically, new products initially have lower gross margins than more mature products because the manufacturing yields are lower at the start of manufacturing each successive product generation. In addition, manufacturing yields are generally lower at the start of manufacturing any product at a new foundry. In 2001, we experienced start-up costs of approximately $22.0 million associated with ramping up NAND wafer production at FlashVision. During the start-up phase, the fabrication equipment and operating expenses are applied to a relatively small output of production wafers, making this output very expensive.

To remain competitive, we are focusing on a number of programs to lower manufacturing costs, including development of future generations of NAND flash memory. There can be no assurance that we will successfully develop such products or processes or that development of such processes will lower manufacturing costs. If the current industry-wide and worldwide economic slowdown continues throughout fiscal 2002, we may be unable to efficiently utilize the NAND flash wafer production from FlashVision, which would force us to amortize the fixed costs of the fabrication facility over a reduced wafer output, making these wafers significantly more expensive. See “Factors That May Affect Future Results—We must achieve acceptable manufacturing yields.”

Critical Accounting Policies & Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent liabilities. On an on-going basis, we evaluate our estimates, including those related to customer programs and incentives, product returns, bad debts, inventories, investments, income taxes, warranty obligations, restructuring, and contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Revenue recognition. We recognize net revenues when the earnings process is complete, as evidenced by an agreement with the customer, transfer of title and acceptance if applicable, fixed pricing and collectibility is reasonably assured. Because of frequent sales price reductions and rapid technology obsolescence in the industry, sales made to distributors and retailers under agreements allowing price protection and/or right of return are deferred until the retailers or distributors sell the merchandise. Accordingly, we defer the net gross margin, resulting from the deferral of both revenue and related product costs, from sales to our distributors and retailers.

Customer Incentives, Returns and Allowances. We record estimated reductions to revenue for customer programs and incentive offerings including promotions and other volume-based incentives, when these programs are granted to our customers. These incentives generally apply only to our retail customers, which represented 75% of our product revenues in fourth quarter of 2001. If market conditions were to decline, we may take actions to increase customer incentive offerings to our retail customers, possibly resulting in an incremental reduction of

revenue at the time the incentive is offered. In addition, we record a provision for estimated sales returns and allowances on product sales in the same period as the related revenues are recorded. Our reserve for returns was not material at December 31, 2001 and 2000.

Allowance for Doubtful Accounts—Methodology. We evaluate the collectibility of our accounts receivable based on a combination of factors. In circumstances where we are aware of a specific customer’s inability to meet its financial obligations to us (e.g., bankruptcy filings, substantial down-grading of credit ratings), we record a specific reserve for bad debts against amounts due to reduce the net recognized receivable to the amount we reasonably believe will be collected. For all other customers, we recognize reserves for bad debts based on the length of time the receivables are past due based on our historical experience. If circumstances change (i.e., higher than expected defaults or an unexpected material adverse change in a major customer’s ability to meet its financial obligations to us), our estimates of the recoverability of amounts due us could be reduced by a material amount.

Warranty Costs. We provide for the estimated cost of product warranties at the time revenue is recognized. While we engage in product quality programs and processes, our warranty obligation is affected by product failure rates and repair or replacement costs incurred in correcting a product failure. Should actual product failure rates, repair or replacement costs differ from our estimates, increases to our warranty liability would be required.

Valuation of Financial Instruments. Our short-term investments include investments in marketable equity and debt securities. We also have equity investments in semiconductor wafer manufacturing companies, UMC of $194.9 million and Tower of $16.6 million, as of December 31, 2001. In determining if and when a decline in market value below amortized cost of these investments is other-than-temporary, we evaluate the market conditions, offering prices, trends of earnings, price multiples, and other key measures for our investments in marketable equity securities and debt instruments. When such a decline in value is deemed to be other-than-temporary, we recognize an impairment loss in the current period operating results to the extent of the decline. Due to the slowdown in the semiconductor industry and economic recession in 2001, the market value of our UMC and Tower investments declined significantly. These declines were deemed to be other-than-temporary and losses totaling $302.3 were recognized. If the slowdown in the semiconductor industry continues in 2002, we may recognize additional losses on these investments.

Inventories—Slow Moving and Obsolescence. We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about future demand and market conditions, including assumptions about changes in average selling prices. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

Use of Estimates. The preparation of financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from our estimates.

Deferred Tax Assets. As of December 31, 2001, we had a net deferred tax asset of approximately $36 million that has been fully offset by a valuation allowance. Due to our current losses, we have not used projections of future taxable income in determining the amount of the valuation allowance required.

Results of Operations

We operate in one business segment, flash memory products. Our products are sold throughout the world. In the United States and foreign countries our products are sold through direct, OEM, reseller, and distributor channels. Our chief decision-maker, the President and Chief Executive Officer, evaluate our performance based on total our results. Revenue is evaluated based on geographic region and product category. Separate financial information is not available by product category in regards to asset allocation, expense allocation, or profitability.

Product Revenues. In 2001, our product revenues were $316.9 million, a decrease of 40% from $526.4 million in 2000. The decrease was primarily due to the downturn in the worldwide economy, industry-wide excess supply of flash memory, and reduced demand from OEM customers who were liquidating existing inventories throughout most of 2001. All of these factors reduced the demand for our products and resulted in intense pricing pressures causing the average selling price of our products to decline significantly. In 2001, the largest decline in revenues came from MultiMediaCards, due to the slowdown in the market for digital music players and CompactFlash, due to the decline in average selling price. In 2001, our flash memory product unit sales declined 19% and our average selling price per megabyte of flash memory shipped declined 50% compared to 2000. However, the decline in average selling price per megabyte was even more severe, at 68%, when comparing the fourth quarter of 2001 to the same period in 2000.

In 2000, our product revenues increased 156% to $526.4 million from $205.8 million in 1999. The increase consisted of an increase of 173% in unit sales, which was partially offset by a 7% decline in average selling prices per unit. In 2000, the largest increase in unit volume came from sales of CompactFlash products that represented 47% of product revenues and MultiMediaCard products that represented 21% of product revenues. The continuing move towards higher capacity cards in 2000 partially offset a decline in the average selling price per megabyte of capacity shipped. In 2000, the average megabyte capacity per unit shipped increased 17% while the average selling price per megabyte of flash memory shipped declined 22% compared to the prior year.

Our backlog as of December 31, 2001 was $19.5 million compared to $63.3 million in 2000 and $157.2 million in 1999. The decrease in 2001 was primarily due to a reduction in orders from our OEM customers and a significant reduction in order lead times due to industry-wide overcapacity. Because of the deterioration in market conditions throughout most of 2001, our quarterly turns business, the business we book and ship in the same quarter, reached approximately 80% of our product shipments in the third and fourth quarters of 2001. In 2001, OEM sales decreased to 34% of product revenues in 2001, compared to 57% in 2000. Retail sales, which are typically booked and shipped in the same quarter, increased to 54% of our product revenues, compared to 28% in 2000. In the fourth quarter of 2001, sales through our retail channels accounted for approximately 75% of product revenues.We expect sales to the retail channel to continue to be a significant portion of our revenue in 2002. See “Factors That May Affect Future Results—Our Operating Results May Fluctuate Significantly” and “—There is Seasonality in Our Business.”Since orders constituting our current backlog are subject to changes in delivery schedules or cancellations, backlog is not necessarily an indication of future revenue.

License and Royalty Revenues. We currently earn patent license fees and royalties under several cross-license agreements, including agreements with Hitachi, Intel, Sharp, Samsung, SmartDisk, Sony, SST, TDK and Toshiba. License and royalty revenues from patent cross-license agreements were $49.4 million in 2001, compared to $75.5 million in 2000 and $41.2 million in 1999. The decrease in license and royalty revenues in 2001 was primarily due to lower patent royalties from lower royalty bearing sales by some of our licensees resulting in decreased patent license revenues recognized. The increase in license and royalty revenues in 2000 was primarily due to patent royalties from increased sales by certain of our licensees, and $4.7 million of revenue recognized in conjunction with the settlement of the Lexar litigation. Revenues from licenses and royalties were 13% of total revenues in 2001 and 2000, and 17% in 1999.

Our income from patent licenses and royalties can fluctuate significantly from quarter to quarter. A substantial portion of this income comes from royalties based on the actual sales by our licensees. Given the current market outlook for 2002, sales of licensed flash products by our licensees may be lower than the corresponding sales in recent quarters, which may cause a drop in our royalty revenues.

Gross Profits (Losses). In fiscal 2001, gross profits declined to negative $26.0 million, or negative 7% of total revenues from $244.8 million, or 41% of total revenues in 2000 and $94.8 million, or 38% of total revenues in 1999. Product gross margins decreased to negative 24% in 2001, from positive 32% in 2000 and positive 26% in 1999. The decline in gross margins in 2001 was primarily due to lower sales volume, severely reduced average

selling prices, inventory write downs of approximately $85.0 million and start-up costs associated with our FlashVision foundry joint venture of approximately $22.0 million. The increases in gross margins in 2000 were primarily due to the lower cost per megabyte of our 256 megabit flash memory products, which represented the majority of our product sales in 2000.

Due to weak economic conditions, excess supply in the markets for our products and lower demand from customers as they continued to reduce their inventories, we experienced intense pricing pressures in 2001. We expect our average selling prices per megabyte to decline significantly in 2002 and possibly beyond, until market supply and demand for our products returns to equilibrium. Although we are taking significant steps to lower our product costs, given the current market conditions, we cannot guarantee that our product cost will decline as quickly as our average selling prices. If our average selling prices decline faster than our costs, our gross margin will be negatively impacted in 2002.

Research and Development. Research and development expenses consist principally of salaries and payroll-related expenses for design and development engineers, prototype supplies and contract services. Research and development expenses increased to $58.9 million in 2001 from $46.1 million in 2000 and $26.9 million in 1999. As a percentage of revenues, research and development expenses were 16% in 2001, 8% in 2000 and 11% in 1999. In 2001, the change was primarily due to an increase of $13.3 million in project related expenses.The additional project expenses in 2001 were to support the development of new generations of NAND flash data storage products. In 2000 the increase in research and development expenses was primarily due to an increase in salaries and payroll-related expenses associated with additional personnel of $9.4 million and an increase in project-related expenses of $3.9 million. We expect our research and development expenses to continue to increase in future quarters to support the development and introduction of new generations of flash data storage products, including our joint venture with Toshiba, our co-development agreement with Sony and our development of advanced controller chips.

Sales and Marketing. Sales and marketing expenses include salaries, sales commissions, benefits and travel expenses for our sales, marketing, customer service and applications engineering personnel. These expenses also include other selling and marketing expenses such as independent manufacturer’s representative commissions, advertising and tradeshow expenses. Sales and marketing expenses decreased to $42.6 million in 2001 from $49.3 million in 2000 and $25.3 million in 1999. The decrease in 2001 was primarily due to a decrease of $5.6 million commission expenses due to lower product revenues, a decrease in marketing expenses of $1.1 million and a reduction of $0.7 million in travel expenses. The increase in 2000 was primarily due to an increase of $6.0 million in salaries and payroll-related expense, an increase of $5.7 commission expenses due to higher product revenues and an increase of $8.0 million in marketing expenses. Sales and marketing expenses represented 12% of total revenues in 2001 compared to 8% in 2000 and 10% in 1999. We expect sales and marketing expenses to increase as sales of our products grow and as we continue to develop the retail channel and brand awareness for our products.

General and Administrative. General and administrative expenses include the cost of our finance, information systems, human resources, shareholder relations, legal and administrative functions. General and administrative expenses were $17.0 million in 2001 compared to $24.8 million in 2000 and $12.6 million in 1999. The decrease in 2001 was primarily due to a decrease of $3.2 million in legal fees, a reduction of $3.2 million in the allowance for doubtful accounts related to lower accounts receivable balances and a decrease of $0.7 million in salaries and related expenses associated with reduced headcount. The increase in 2000 was primarily due to an increase of $4.5 million in salaries and related expenses associated with additional personnel, an increase of $6.5 million in legal fees and an increase of $3.0 million in the allowance for doubtful accounts associated with higher trade accounts receivable balances from increased revenues. General and administrative expenses represented 5% of total revenues in 2001 compared to 4% in 2000 and 5% in 1999. General and administrative expenses could increase in the future if we pursue litigation to defend our patent portfolio and grow our infrastructure to support our growth. See “Factors That May Affect Future Results—Risks Associated with Patents, Proprietary Rights and Related Litigation.”

Restructuring Charges. In the third quarter of 2001, we adopted a plan to transfer all of our card assembly and test manufacturing operations from our Sunnyvale location to offshore subcontractors. As a result we recorded a restructuring charge of $8.5 million. The charge included $1.1 million of severance and employee related costs for a reduction in workforce of approximately 193 personnel, equipment write-off charges of $6.4 million and lease commitments of $1.0 million on a vacated warehouse facility. See Note 10 of Notes to Condensed Consolidated Financial Statements.

As a part of our plan to transfer all card assembly and test manufacturing operations to offshore subcontractors, we abandoned excess equipment and recorded a charge of $6.4 million in the third quarter of fiscal 2001.

We are attempting to sublease one warehouse building in San Jose, California. Given the current real estate market conditions in the San Jose area, we do not expect to be able to sublease this building before the end of 2003 and as a result, we recorded a charge of $1.0 million in the third quarter of 2001.

Of the $8.5 million restructuring charge, cash payments of $0.8 million were paid in 2001. After writing off certain non-cash charges, accruals of $1.7 million remain as of December 31, 2001, primarily related to severance and benefits to be paid out during fiscal 2002 and excess facility charges, which will be paid over the respective lease terms. We believe that the savings resulting from the restructuring activity will contribute to a reduction in manufacturing and operating expense levels of approximately $11.8 million in fiscal 2002.

Equity in Income of Joint Venture. In 2001, equity in income of joint ventures of $2.1 million included our share of net income from our FlashVision joint venture and losses from our DPI joint venture.

Interest Income/Expense. Interest income was $12.3 million in 2001 compared to $22.8 million in 2000 and $8.3 million in 1999. The decrease in 2001 was primarily due to a reduction in cash and investment balances resulting from cash used by operations and strategic investments in Tower Semiconductor and FlashVision. In addition, overall market interest rates were lower in 2001 due to reductions in the Federal funds rate. We expect interest income to decline and interest expense to increase in 2002 relative to 2001 due to interest expense payable on the convertible notes issued in late 2001 and early 2002 and the continuing impact of the reduction in the Federal funds rate in the fourth quarter of 2001.

Loss on investment in foundries. The market value of our investments in UMC and Tower Semiconductor have declined significantly due to the downturn in the economy and excess supply in the semiconductor industry. We determined that the decline in value of these investments was other than temporary and losses were recorded in 2001. In our determination of the substantial and other than temporary decline in the value of our investments in UMC and Tower, we considered the substantial and sustained decline in the companies’ share price, the financial condition and results of operations of each company and the down turn in the semiconductor industry and economy in general. The value of our investment in UMC had declined to $194.9 million at December 31, 2001. We recorded a loss of $275.8 million on our UMC investment in 2001, or $166.9 million net of taxes, in accordance with Statement of Financial Accounting Standards Number 115. If the fair value of our UMC investment declines further, it may be necessary to record additional losses. In addition, in future periods, if our UMC shares are sold, there may be a gain or loss, due to fluctuations in the market value of UMC’s stock.

The value of our Tower investment and wafer credits had declined to $16.6 million at December 31, 2001. A loss of $20.6 million, which included the write-off of wafer credits received, was recognized in 2001. In addition, we recorded a loss of $5.5 million on our exchange of 75% of our Tower wafer credits for 1,284,007 ordinary shares at $12.75 per share. These losses totaling $26.1 million, or $15.8 million net of tax benefit, were recorded in loss on foundry investment in 2001. If the fair value of our Tower investment declines further, it may be necessary to record additional losses. We periodically assess the value of prepaid wafer credits for recoverability and write down the value as necessary.

Other Income (Loss), Net. Other Income (Loss), net was a loss of $1.0 million in 2001 compared to income of $572,000 in 2000 and income of $1.3 million in 1999. The loss in 2001 was primarily due to foreign currency transaction losses on our Yen denominated assets. Other income in 2000 and 1999 came primarily from foreign currency transaction gains.

Provision for (Benefit from) Income Taxes. Our 2001 effective tax benefit rate was approximately 33%, while our 2000 and 1999 effective tax rates were approximately 39% and 33%, respectively. Our 2001 tax benefit was generated primarily from our ability to benefit from the 2001 net operating loss using carryback capacity along with the unrealized gain on our investment in UMC shares. The 2001 tax benefit is limited to the amount of tax refund that we will receive from our loss carryback and the amount available to offset unrealized tax gains related to the UMC investment. As of December 31, 2001, we had recorded the maximum carryback benefit available and therefore future losses may not give rise to a current tax benefit.

Our assessment of the amount of valuation allowance required will be influenced by the amount of unrealized tax gains on investments. Any increase in the mark to market value of the investments may result in the recognition of some portion of the valuation allowance. This may cause the interim tax rate to fluctuate significantly.

Liquidity and Capital Resources

At December 31, 2001, we had working capital of $415.1 million, which included $189.4 million in unrestricted cash and unrestricted cash equivalents and $105.5 million in unrestricted short-term investments, excluding our investment in UMC. Under the terms of the FlashVision lease agreement, we as guarantor are required to pledge cash and equity securities up to the full value of the outstanding lease commitments guaranteed by us. As of December 31, 2001, we had guaranteed $129.5 million of FlashVision’s lease commitments and pledged $64.7 million of cash and cash equivalents and $64.7 million of our UMC equity securities. This pledged cash and cash equivalents and marketable equity securities are included in “Restricted cash and cash equivalents” and “Restricted investment in UMC” on our balance sheet.

Operating activities used $72.1 million of cash in 2001 primarily due to our net loss, an increase in deferred tax assets of $134.5 million, a decrease in accounts payable of $39.2 million, and a decrease in deferred income on shipments to distributors and retailers and deferred revenue of $34.9 million. These were partially offset by cash provided by a decline in accounts receivable of $51.2 million a reduction in inventories of $40.6 million and an increase in other current liabilities, related party of $31.3 million. Cash provided by operations was $84.9 million 2000 and $17.0 million in 1999.

Net cash provided by investing activities was $25.1 million in 2001. Proceeds from net sales of investments of $155.5 million were partially offset by $15.0 million invested in FlashVision, our foundry joint venture with Toshiba, $42.5 million invested in Tower, $2.0 million invested in DPI, our joint venture with Photo-Me International and $26.2 million of capital equipment purchases. Net cash used in investing activities was $137.9 million in 2000 and $214.4 million in 1999.

Net cash provided by financing activities was $130.2 million in 2001, which included the $121.5 million net proceeds from the issuance of long-term convertible subordinated notes in the fourth quarter of 2001, and $8.6 million from the sale of common stock through our stock option and employee stock purchase plans. In 2000, financing activities provided $13.2 million and $328.2 million in 1999.

On December 24, 2001, we completed a private placement of $125.0 million of 4½% Convertible Subordinated Notes due 2006, or Notes, and on January 10, 2002, the initial purchasers completed the exercise of their option to purchase an additional $25.0 million of Notes, for which we received net proceeds of approximately $145.9 million. Based on the aggregate principal amount at maturity of $150.0 million, the Notes provide for semi-annual interest payments of $3.4 million each on May 15 and November 15. The Notes are

convertible into shares of our common stock at any time prior to the close of business on the maturity date, unless previously redeemed or repurchased, at a conversion rate of 54.2535 shares per $1,000 principal amount of the Notes, subject to adjustment in certain events. At anytime on or after November 17, 2004, we may redeem the notes in whole or in part at a specified percentage of the principal amount plus accrued interest. The debt issuance costs are being amortized over the term of the Notes using the interest method. We intend to fulfill our debt service obligations from cash generated by our operations, if any, and from our existing cash and investments. If necessary, among other alternatives, we may add lease lines of credit to finance capital expenditures and obtain other long-term debt and lines of credit. We may incur substantial additional indebtedness in the future. There can be no assurance that we will be able to meet our debt service obligations, including our obligations under the Notes.

In January 2000, the USIC foundry was merged into the UMC parent company. In exchange for our USIC shares, we received 111 million UMC shares. These shares were valued at approximately $396 million at the time of the merger, resulting in a pretax gain of $344.2 million ($203.9 million after-tax) in the first quarter of 2000. All of the UMC shares we received as a result of the merger were subject to trading restrictions imposed by UMC and the Taiwan Stock Exchange. As of December 31, 2001, the trading restrictions had expired on 66.7 million shares. The remaining 44.4 million shares will become available for sale over a two-year period beginning in January 2002. We also received 20.0 million and 22.2 million shares as stock dividends from UMC in 2001 and 2000. Due to the decline in UMC stock price from the weakness in the semiconductor industry, the value of the Company’s investment in UMC had declined to $194.9 at December 31, 2001. In 2001, it was determined that the decline in the market value of the investment was other than temporary, as defined by generally accepted accounting principles and a loss of $275.8 million, or $166.9 million net of taxes was recorded in accordance with Statement of Financial Accounting Standards Number 115. The loss was included in loss on investment in foundry. If the fair value of the UMC investment declines further, it may be necessary to record additional losses. In addition, in future periods, there may be a gain or loss due to fluctuations in the market value of UMC stock or if UMC shares are sold.

On June 30, 2000, we closed a transaction with Toshiba providing for the joint development and manufacture of 512 megabit and 1 gigabit flash memory chips and Secure Digital Card controllers. As part of this transaction, SanDisk and Toshiba formed FlashVision, a joint venture to equip and operate a silicon wafer manufacturing line at Dominion Semiconductor in Virginia. In January 2001, we invested the final $15.0 million of our $150.0 million cash commitment in FlashVision. We are obligated to guarantee one-half of all FlashVision lease amounts up to a maximum guarantee of $175.0 million. As of December 31, 2001, we had guarantee obligations in the amount of $129.5 million, with ABN AMRO Bank, N.V. as agent for a syndicate of financial institutions, on the equipment lease lines to equip FlashVision’s manufacturing clean room with advanced wafer processing equipment. Although FlashVision recently terminated the ABN AMRO lease facility, as further discussed below, under the terms of the FlashVision lease agreements, we as guarantor were subject to certain financial covenants. We obtained a compliance waiver for the third quarter of 2001 and negotiated an amendment to the lease agreement which included a modification of the covenant requirements and required us to pledge cash and equity securities up to the full value of the outstanding guaranteed lease commitments. As of December 31, 2001, we had pledged cash of $64.7 million and UMC equity securities of $64.7 million. While these assets were pledged, they were not available to us to be used to fund operations.

expected to be completed in 2002. Once the consolidation is completed, Yokkaichi’s total NAND wafer output will match the combined prior NAND capacity of Yokkaichi and Dominion. The FlashVision operation at Yokkaichi will continue essentially the same 50-50 joint venture and on essentially the same terms as it has had at Dominion in Virginia. Under our joint venture agreement, we are contractually obligated, and expect to continue to be obligated after the restructuring of our FlashVision joint venture, to purchase half of FlashVision’s NAND wafer production output. In March 2002, FlashVision notified ABN AMRO that it was exercising its right of early termination under the lease facility and repaid all amounts outstanding thereunder in April 2002. Accordingly, we are no longer subject to the financial covenants or collateralization requirements of the ABN AMRO bank lease. FlashVision completed interim financing in the form of a bridge loan from Toshiba in April 2002 and we anticipate that FlashVision will finalize a new equipment lease arrangement by the end of the second quarter of 2002. The transfer and qualification of the advanced fabrication equipment from Dominion, Virginia to Yokkaichi, Japan is a highly complex operation. It is quite possible that we may encounter difficulties and delays. Although the additional costs associated with these potential delays will generally be borne by Toshiba, our results of operations may suffer if this equipment transfer is not completed on time and production does not commence at Yokkaichi as planned, thereby reducing the total NAND production capacity available to us.

On July 4, 2000, we entered into a share purchase agreement to make a $75.0 million investment in Tower, in Israel, representing approximately 10% ownership of Tower. The investment is subject to the completion of certain milestones. During 2001, Tower satisfied the closing conditions of the share purchase agreement and completed the first two milestones. Under the terms of the agreement, we invested $42.5 million to purchase 1,599,931 ordinary shares and obtain wafer credits of $21.4 million. In September 2001, we agreed to convert 75% of our wafer credits to equity at a price of $12.75 per share and received an additional 1,284,007 ordinary shares. Due to the continued weakness in the semiconductor industry, the value of our Tower investment and remaining wafer credits had declined to $16.6 million at December 31, 2001. It was determined that this decline was other than temporary, as defined by generally accepted accounting principles and a loss of $20.6 million was recorded in the second half of 2001. In addition we recognized a loss of $5.5 million on the exchange of 75% of our Tower wafer credits for 1,284,007 ordinary shares at $12.75 per share. These losses totaling $26.1 million, or $15.8 million net of tax benefit were recorded in loss on foundry investment in 2001.

write-down. Currently, we expect Tower to supply us a portion of the ASIC controller chips used in our flash cards. We currently expect first wafer production to commence at the new fabrication facility in the first half of 2003.

On August 9, 2000, we entered into a joint venture, DPI, with PMI for the manufacture, installation, marketing, and maintenance of self-service, digital photo printing labs, or kiosks, bearing the SanDisk brand name in locations in the U.S. and Canada. Under the agreement, we invested $2.0 million. In April 2002, we and PMI agreed that SanDisk would scale down its kiosk activities while PMI will assume responsibility to finance and direct the future growth of DPI. Under the new agreement, we will convert approximately $400,000 in receivables due from DPI to equity in DPI and will no longer be required to make additional equity investments in DPI or guarantee DPI’s equipment leases. DPI has experienced delays in its U.S. market rollout of the kiosks, due primarily to modifications to improve the kiosk’s operation as a standalone, reliable, user-friendly photo printing device. These delays have provided opportunities for several competitors to enter the digital photo printing market with alternative products, which may offer more attractive features or lower costs than the DPI kiosks. We cannot assure you that these kiosks, if and when they are introduced, will function reliably as intended, or that they will receive favorable acceptance from consumers. If DPI is unsuccessful, our investment may become worthless, requiring us to record a loss equal to the total amount invested. We account for this investment under the equity method, and recorded a loss of $1.4 million as our share of the equity in loss of joint venture in 2001.

On November 2, 2000, we made a strategic investment of $7.2 million in Divio, Inc., or Divio. Divio is a privately-held manufacturer of digital imaging compression technology and products for future digital camcorders that will be capable of using our flash memory cards to store home video movies, replacing the magnetic tape currently used in these systems. Under the agreement, we own approximately 10% of Divio and are entitled to one board seat. A number of companies are developing compression chip products that may be superior to, or may be offered at a lower cost than the Divio chips. These competing products may render Divio’s products uncompetitive and thereby significantly reduce the value of our investment in Divio.

The following summarizes our contractual obligations and off balance sheet arrangements at December 31, 2001, and the effect such obligations are expected to have on our liquidity and cash flow in future periods (in thousands).

	Total			Less Than 1 Year		1-3 Years		4-5 Years		After 5 Years
CONTRACTUAL OBLIGATIONS:
Convertible subordinated notes payable (See Note 4)	$	125,000	(1)	$	—	$	—	$	125,000	$	—
Operating leases		10,754			2,623		4,838		3,293		—
Purchase commitments for flash memory wafers		32,500			32,500		—		—		—

Total contractual cash obligations	$	168,254		$	35,123	$	4,838	$	128,293	$	—

(1)

On January 10, 2002, we sold an additional $25.0 million of the Notes pursuant to the exercise by the initial purchasers of their option.

	As of December 31, 2001
OFF BALANCE SHEET ARRANGEMENTS:
Guarantee of FlashVision foundry equipment lease	$	129,500

Depending on the demand for our products, we may decide to make additional investments, which could be substantial, in assembly and test manufacturing equipment or foundry capacity to support our business in the future. We may also invest in or acquire other companies’ product lines or assets. Our operating expenses may increase as a result of the need to hire additional personnel to support our sales and marketing efforts and research and development activities, including our collaboration with Toshiba for the joint development of 512 megabit and 1 gigabit flash memory chips and Sony for the joint development of the next generation Memory Stick. We plan to fund our short-term operations from our current cash and short-term investment balances and cash generated from operations. We believe our existing cash and cash equivalents and short-term investments will be sufficient to meet our currently anticipated working capital and capital expenditure requirements for the next twelve months. However, if our average product selling prices continue to decline significantly, as they did in 2001, or demand for our products declines and we are required to purchase more wafers than we need due to our FlashVison joint venture commitments, we may not be able to generate enough cash from our operations and will have to rely solely on our current cash and short-term investment balances to fund our operating activities.

Impact of Currency Exchange Rates

A portion of our revenues is denominated in Japanese Yen. We enter into foreign exchange forward contracts to hedge against changes in foreign currency exchange rates. At December 31, 2001, one forward contract with a notional amount of $9.8 million was outstanding. No forward contacts were outstanding at December 31, 2000. Future exchange rate fluctuations could have a material adverse effect on our business, financial condition and results of operations.

Impact of Recently Issued Accounting Standards

In June 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations” and No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 141 supersedes Accounting Principles Board (“APB”) Opinion 16 “Business Combinations” and SFAS No. 38 “Accounting for Pre-acquisition Contingencies,” and eliminates the pooling-of-interests method of accounting for business combinations except for qualifying business combinations that were initiated prior to July 1, 2001. SFAS No. 141 also includes new criteria to recognize intangible assets separately

from goodwill. The requirements of SFAS 141 are effective for any business combination accounted for by the purchase method that is completed after June 30, 2001 (i.e., the acquisition date is July 1, 2001 or after). We did not engage in any merger or acquisition activity during the year and therefore, application of SFAS 141 is not expected to have a material impact on results of operation and financial position in 2002.

SFAS No. 142, supersedes APB Opinion No. 17, “Intangible Assets,” and states that goodwill and intangible assets with indefinite lives are no longer amortized but are reviewed for impairment annually, or more frequently if impairment indicators arise. Separable intangible assets that are not deemed to have an indefinite life will continue to be amortized over their useful lives. The discontinuing of amortization provisions under SFAS No. 142 of goodwill and indefinite lived intangible assets apply to assets acquired after June 30, 2001. In addition, the impairment provisions of SFAS 142 apply to assets acquired prior to July 1, 2001 upon adoption of SFAS 142. Application of the non-amortization provisions and changes in estimated useful lives of intangibles of FAS 142 for goodwill is not expected to have a material impact on results of operation and financial position in 2002.

In October 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144”), which supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be disposed of.” The primary objective of SFAS No. 144 is to develop one accounting model based on the framework established in SFAS No. 121 for long-lived assets to be disposed of by sale, and to address significant implementation issues. The provisions of this statement are effective for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years, with early application encouraged. We are evaluating the impact of SFAS No. 144 on our financial position and results of operations.

In November 2001, the Emerging Issues Task Force (“EITF”) issued EITF Issue No. 01-09 (“EITF 01-09”), “Accounting for Consideration Given by a Vendor to a Customer/Reseller,” which addresses the accounting for consideration given by a vendor to a customer including both a reseller of the vendor’s products and an entity that purchases the vendor’s products from a reseller. EITF 01-09 also codifies and reconciles related guidance issued by the EITF including EITF No. 00-25 “Vendor Income Statement Characterization of Consideration Paid to a Reseller of the Vendor’s Products” (“EITF 00-25”). EITF 01-09 outlines the presumption that consideration given by a vendor to a customer, a reseller or a customer of a reseller is to be treated as a deduction from revenue. Treatment of such payments as an expense would only be appropriate if two conditions are met: (a) the vendor receives an identifiable benefit in return for the consideration paid that is sufficiently separable from the sale such that the vendor could have entered into an exchange transaction with a party other than the purchaser or its products in order to receive that benefit; and (b) the vendor can reasonably estimate the fair value of that benefit. We will adopt EITF 01-09 effective January 1, 2002. The adoption of EITF 01-09 is not expected to have a material impact on our results of operations and financial position in 2002.

Factors That May Affect Future Results

Risks Related to Our Business

Our operating results may fluctuate significantly, which may adversely affect our operating results and our stock price.

Our quarterly and annual operating results have fluctuated significantly in the past and we expect that they will continue to fluctuate in the future. This fluctuation is a result of a variety of factors, including the following:

•

unpredictable or declining demand for our products;

•

decline in the average selling prices of our products due to competitive pricing pressures;

•

Seasonality in sales of our products;

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natural disasters affecting the countries in which we conduct our business, particularly Japan, where our sole source of NAND flash memory wafer capacity is located and, to a lesser extent, Taiwan, China and the United States;

•

excess capacity of flash memory from our competitors and our own flash wafer capacity, which may continue the acceleration in the decline in our average selling prices;

•

difficulty of forecasting and management of inventory levels, particularly, building a large inventory of unsold product due to non-cancelable contractual obligations to purchase materials such as flash wafers, controllers, printed circuit boards and discrete components;

•

expenses related to obsolescence or devaluation of unsold inventory;

•

adverse changes in product and customer mix;

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slower than anticipated market acceptance of new or enhanced versions of our products;

•

competing flash memory card standards, which displace the standards used in our products;

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changes in our distribution channels;

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fluctuations in our license and royalty revenue;

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fluctuations in product costs, particularly due to fluctuations in manufacturing yields and utilization;

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Availability of sufficient silicon wafer foundry capacity to meet customer demand;

•

shortages of components such as capacitors and printed circuit boards required for the manufacturing of our products;

•

significant yield losses, which could affect our ability to fulfill customer orders and could increase our costs;

•

manufacturing flaws affecting the reliability, functionality or performance of our products, which could increase our product costs, reduce demand for our products or require product recalls;

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increased research and development expenses;

•

exchange rate fluctuations, particularly the U.S. Dollar to Japanese Yen exchange rate;

•

changes in general economic conditions, particularly in Japan and the European Union; and

•

reduced sales to our retail customers if consumer confidence declines or economic conditions worsen.

Difficulty of estimating future silicon wafer needs may cause us to overestimate our needs and build excess inventories, or underestimate our needs and have a shortage of silicon wafers, either of which will harm our financial results.

When we order silicon wafers from our foundries, we have to estimate the number of silicon wafers needed to fill product orders several months into the future. If we overestimate this number, we will build excess inventories, which could harm our gross margins and operating results. On the other hand, if we underestimate the number of silicon wafers needed to fill product orders, we may be unable to obtain an adequate supply of wafers, which could harm our product revenues. Because the majority of our CompactFlash, SmartMedia card, MultiMediaCard and Secure Digital card are sold into emerging consumer markets, it has been difficult to accurately forecast future sales. In addition, bookings visibility remains low due to the current economic uncertainty in our markets. A substantial majority of our quarterly sales are currently, and have historically been, from orders received and fulfilled in the same quarter, which makes accurate forecasting very difficult. Our product order backlog may fluctuate substantially from quarter to quarter.

Variability of expense levels and significant fixed costs will harm our business if our revenues do not exceed our operating expenses.

Despite the significant actions we took in 2001 to align expense levels with decreased revenues, we may need to hire additional personnel in certain business areas or otherwise increase our operating expenses in the

future to support our sales and marketing efforts and research and development activities. We have significant fixed costs and we cannot readily reduce these expenses over the short term. If our revenues do not increase proportionately to our operating expenses, or if revenues decrease or do not meet expectations for a particular period, our business, financial condition and results of operations will be harmed.

License fees and royalties from our patent cross license agreements are variable and fluctuate from period to period making it difficult to predict our royalty revenues.

Our intellectual property strategy consists of cross-licensing our patents to other manufacturers of flash products. Under these arrangements, we earn license fees and royalties on individually negotiated terms. The timing of revenue recognition from these payments is dependent on the terms of each contract and on the timing of product shipments by the third parties. Our income from patent licenses and royalties can fluctuate significantly from quarter to quarter. A substantial portion of this income comes from royalties based on the actual sales by our licensees. Given the current market outlook for the second quarter of 2002 and beyond, sales of licensed flash products by our licensees may be substantially lower than the corresponding sales in recent quarters, which may cause a substantial drop in our royalty revenues. Because these revenues have higher gross margins than our product revenues, our overall gross margins and net income (loss) fluctuate significantly with changes in license and royalty revenues. We cannot assure you that our existing licensees will renew their licenses upon expiration, or that we will be successful in signing new licensees in the future.

Terrorist attacks and threats, and government responses thereto, may negatively impact all aspects of our operations, revenues, costs and stock price.

The recent terrorist attacks in the United States, the U.S. retaliation for these attacks and the related decline in consumer confidence and continued economic weakness have had a substantial adverse impact on our retail sales. If consumer confidence does not recover, our revenues and results of operations may be adversely impacted in the second quarter of 2002 and beyond.

In addition, any similar future events may disrupt our operations or those of our customers and suppliers and may affect the availability of materials needed to manufacture our products or the means to transport those materials to manufacturing facilities and finished products to customers. In addition, these events have had and may continue to have an adverse impact on the U.S. and world economy in general and consumer confidence and spending in particular, which could harm our sales. Any of these events could increase volatility in the U.S. and world financial markets which could harm our stock price and may limit the capital resources available to us and our customers or suppliers. This could have a significant impact on our operating results, revenues and costs and may result in increased volatility in the market price of our common stock.

Because of our international operations, we must comply with numerous international laws and regulations and we are vulnerable to political instability and currency fluctuations.

Political risks. Currently, the majority of our flash memory and controller wafers are produced by Toshiba in Japan and UMC in Taiwan. After the restructuring of our FlashVision business, all of our flash memory and controller wafers are now produced overseas by Toshiba and UMC. We also use third-party subcontractors in Taiwan and China for the assembly and testing of some of our card and component products. We may therefore be affected by the political, economic and military conditions in Taiwan. Taiwan is currently engaged in various political disputes with China and in the past both countries have conducted military exercises in or near the other’s territorial waters and airspace. The Taiwanese and Chinese governments may escalate these disputes, resulting in an economic embargo, a disruption in shipping routes or even military hostilities. This could harm our business by interrupting or delaying the production or shipment of flash memory wafers or card products by our Taiwanese foundry and subcontractors. See “—We depend on our suppliers and third party subcontractors.”

We use a third-party subcontractor in China for the assembly and testing of our CompactFlash products. As a result, our business could be harmed by the effect of political, economic, legal and other uncertainties in China.

Under its current leadership, the Chinese government has been pursuing economic reform policies, including the encouragement of foreign trade and investment and greater economic decentralization. The Chinese government may not continue to pursue these policies and, even if it does continue, these policies may not be successful. The Chinese government may also significantly alter these policies from time to time. In addition, China does not currently have a comprehensive and highly developed legal system, particularly with respect to the protection of intellectual property rights. As a result, enforcement of existing and future laws and contracts is uncertain, and the implementation and interpretation of such laws may be inconsistent. Such inconsistency could lead to piracy and degradation of our intellectual property protection.

Although we do not believe the current political unrest and escalation of violence in Israel represent a major security problem for Tower since Migdal Haemek, Israel is in a relatively secure geographic location, the unrest may expand and even if it remains at current levels, could cause scheduling delays, as well as economic uncertainty, which could cause potential foundry customers to go elsewhere for their foundry business. Moreover, if U.S. military actions in Afghanistan, or elsewhere, result in retaliation against Israel, Tower’s fabrication facility and our engineering design center in Israel may be adversely impacted. We cannot assure you that the Tower facility will be completed or will begin production as scheduled, or that the processes needed to fabricate our wafers will be qualified at the new facility. Moreover, we cannot assure you that this new facility will be able to achieve acceptable yields or deliver sufficient quantities of wafers on a timely basis at a competitive price. Furthermore, if the depressed business conditions for semiconductor wafers persists throughout 2002 and beyond, Tower may be unable to operate their new fabrication facility at an optimum capacity utilization, which would cause them to operate at a loss. In addition, while the political unrest has not yet posed a direct security risk to our engineering design center in Israel, it may cause unforeseen delays in the development of our products and may in the future pose such a direct security risk.

Economic risks. We price our products primarily in U.S. Dollars. Given the recent economic conditions in Asia and the European Union and the weakness of the Euro, Yen and other currencies relative to the U.S. Dollar, our products may be relatively more expensive in these regions, which could result in a decrease in our sales. While most of our sales are denominated in U.S. Dollars, we invoice certain Japanese customers in Japanese Yen and are subject to exchange rate fluctuations on these transactions, which could harm our business, financial condition and results of operations.

General risks. Our international business activities could also be limited or disrupted by any of the following factors:

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the need to comply with foreign government regulation;

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general geopolitical risks such as political and economic instability, potential hostilities and changes in diplomatic and trade relationships;

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natural disasters affecting the countries in which we conduct our business, particularly Japan, such as the earthquakes experienced in Taiwan in 1999 and in Japan and China in previous years;

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imposition of regulatory requirements, tariffs, import and export restrictions and other barriers and restrictions;

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longer payment cycles and greater difficulty in accounts receivable collection, particularly as we increase our sales through the retail distribution channel, and general business conditions deteriorate;

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adverse tax rules and regulations;

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weak protection of our intellectual property rights; and

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delays in product shipments due to local customs restrictions.

Risks Related to the Development of New Products

In transitioning to new processes and products, we face production and market acceptance risks which have caused, and may in the future cause, significant product delays that could harm our business.

Successive generations of our products have incorporated semiconductor devices with greater memory capacity per chip. Two important factors have enabled us to decrease the cost per megabyte of our flash data storage products: the development of higher capacity semiconductor devices and the implementation of smaller geometry manufacturing processes. A number of challenges exist in achieving a lower cost per megabyte, including:

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lower yields often experienced in the early production of new semiconductor devices;

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manufacturing flaws with new processes including manufacturing processes at our subcontractors which may be extremely complex;

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problems with design and manufacturing of products that will incorporate these devices, which may result in delays or product recalls; and

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production delays.

Because our products are complex, we periodically experience significant delays in the development and volume production ramp up of our products. Similar delays could occur in the future and could harm our business, financial condition and results of operations.

New products based on NAND MLC flash technology may encounter production delays and problems impacting production reliability and yields, which may cause our revenues and gross margins to decline.

We have developed new products based on NAND MLC (Multi Level Cell) flash technology, a flash architecture designed to store two bits in each flash memory cell. High density flash memory, such as NAND MLC flash, is a complex technology that requires strict manufacturing controls and effective test screens. Problems encountered in the shift to volume production for new flash products could impact both reliability and yields, and result in increased manufacturing costs and reduced product availability. NAND MLC technology is highly complex and has not previously been successfully commercialized. We may not be able to manufacture future generations of NAND MLC products with yields sufficient to result in lower costs per megabyte. If we are unable to bring future generations of high density flash memory into full production as quickly as planned or if we experience unplanned yield or reliability problems, our revenues and gross margins will decline.

The Secure Digital card standard has been slow to develop as a major new standard and may not be widely adopted by consumers.

We, along with Matsushita and Toshiba, jointly developed and jointly promote the Secure Digital card. The Secure Digital card incorporates advanced security and copyright protection features required by the emerging markets for the electronic distribution of music, video and other copyrighted works. Although the Secure Digital card is designed specifically to address the copy protection rights of the content providers, there can be no assurance that these content providers will find these measures sufficient or will agree to support them. Furthermore, despite numerous design wins, the Secure Digital card standard has been slow to develop as a major new standard and we cannot assure you that consumers will widely adopt the Secure Digital card. Conversely, broad acceptance of our Secure Digital card by consumers will likely reduce demand for our MultiMediaCard and CompactFlash card products. During 2001, we experienced a substantial decline in sales of MultiMediaCards which was not matched by a corresponding increase in sales of Secure Digital cards. See “—The success of our business depends on emerging markets and new products.”

Memory Stick products sold by us may not generate substantial revenues for us or contribute to our gross margins.

In September 2001, we signed an agreement with Sony involving their Memory Stick card format. Under the agreement, Sony will supply us a portion of their Memory Stick output for us to resell under our brand name. Sony has also agreed to purchase a portion of their NAND memory chip requirements from us provided that we meet market competitive pricing for these components. In addition, we and Sony agreed to co-develop and co-own the specifications for the next generation Memory Stick. Each of us will have all rights to manufacture and sell this new generation Memory Stick. In the fourth quarter of 2001, we commenced retail sales of Memory Stick cards supplied to us under an OEM supply and purchase agreement with Sony. We cannot assure you that the gross margins on the sale of Memory Stick products will be comparable to the gross margins from the sale of our other products or this new business will generate substantial revenues or gross margin contributions for us. Consumers may prefer to purchase the Sony brand Memory Stick over our SanDisk brand Memory Stick. Furthermore, the second generation Memory Stick is still in the early stages of development and is not expected to generate significant sales before 2003. We cannot assure you that the second generation Memory Stick will achieve commercial success in the marketplace when it is introduced.

We are transitioning our technology to NAND-based products which requires us to significantly increase our inventory of NAND flash chips and if these products do not achieve customer acceptance, may result in inventory write offs that adversely affect our business.

The transition to NAND-based products is very complex, and requires good execution from our manufacturing, technology, quality, marketing, and sales and customer support staffs. If the current soft market conditions continue throughout 2002 and beyond, or if we are unable for any reason to achieve customer acceptance of our card products built with these NAND flash chips, we will experience a significant increase in our inventory, as we are contractually obligated, and will continue to be obligated after the restructuring of our FlashVision business, to purchase half of FlashVision’s NAND wafer production output. This may result in inventory write offs and have a material adverse effect on our business, results of operations and financial condition. See “—Our investment in new flash memory wafer production may result in increased expenses and fluctuations in operating results.”

In the third quarter of 2001, we began to purchase controller wafers from UMC and are continuing development of advanced flash memory technology utilizing the 0.15 micron technology design rules at UMC.

The success of our business depends on emerging markets and new products.

In order for demand for our products to grow, the markets for new products that use CompactFlash, the MultiMediaCard, and Secure Digital card such as digital cameras, portable digital music players and cellular phones must develop and grow. If sales of these products do not grow, our revenues and profit margins could be adversely impacted.

In 2001, we experienced a substantial drop in demand from our MultiMediaCard customers, which we believe is attributable to the switch by these customers to the Secure Digital card, as well as the generally soft market conditions.

The success of our new product strategy will depend upon, among other things, the following:

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our ability to successfully develop new products with higher memory capacities and enhanced features at a lower cost per megabyte;

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the development of new applications or markets for our flash data storage products;

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the adoption by the major content providers of the copy protection features offered by our Secure Digital card products;

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the extent to which prospective customers design our products into their products and successfully introduce their products; and

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the extent to which our products or technologies become obsolete or noncompetitive due to products or technologies developed by others.

512 megabit and 1 gigabit flash memory card products. On June 30, 2000, we closed a transaction with Toshiba providing for the joint development of 512 megabit and 1 gigabit flash memory chips and the manufacture of Secure Digital card controllers. As part of this venture, we and Toshiba plan to employ Toshiba’s 0.16 micron and future 0.13 micron NAND flash integrated circuit manufacturing technology and SanDisk’s multilevel cell flash and controller system technology. During the third quarter of 2000, we announced with Toshiba the completion of the joint development of the 512 megabit NAND flash chip employing Toshiba’s 0.16 micron manufacturing process technology. We began employing the 512 megabit technology in the second half of 2001, and expect to commence shipments of cards employing the 1 gigabit technology in the first half of 2002. The development of the next generation .13 micron, 1 gigabit and 2 gigabit NAND flash memory chips is highly complex. We cannot assure you that we and Toshiba will successfully develop and bring into full production with acceptable yields and reliability these new products or the underlying technology, or that any development or production ramp will be completed in a timely or cost-effective manner. If we are not successful in any of the above, or if our cost structure is not competitive, our business, financial condition and results of operations could suffer.

We may be unable to maintain market share which would reduce our potential revenues and benefit our competitors.

During periods of excess supply in the market for our flash memory products, such as we experienced in 2001 and continue to experience in 2002, we may lose market share to competitors who aggressively lower their prices. Conversely, under conditions of tight flash memory supply, we may be unable to increase our production volumes at a sufficiently rapid rate so as to maintain our market share. Ultimately, our growth rate depends on our ability to obtain sufficient flash memory wafers and other components to meet demand. If we are unable to do so in a timely manner, we may lose market share to our competitors. Currently, we are experiencing severe price competition for our products which is adversely impacting our product gross margins and overall profitability.

Rapid growth may strain our operations.

Despite actions we took in 2001 to align expense levels with decreased revenues, we must continue to hire, train, motivate and manage our employees to accommodate future growth. In the past, we have experienced difficulty hiring the necessary engineering, sales and marketing personnel to support our growth. In addition, we must make a significant investment in our existing internal information management systems to support increased manufacturing, as well as accounting and other management related functions. Our systems, procedures and controls may not be adequate to support rapid growth, which could in turn harm our business, financial condition and results of operations.

Our success depends on key personnel, including our executive officers, the loss of whom could disrupt our business.

Our success greatly depends on the continued contributions of our senior management and other key research and development, sales, marketing and operations personnel, including Dr. Eli Harari, our founder, President and Chief Executive Officer. Our success will also depend on our ability to recruit additional highly skilled personnel. We cannot assure you that we will be successful in hiring or retaining such key personnel, or that any of our key personnel will remain employed with us.

Risks Related to Our FlashVision Joint Venture

Our FlashVision joint venture with Toshiba makes us vulnerable to certain risks, including potential inventory write-offs, disruptions or shortages of supply, limited ability to react to fluctuations in product demand, direct competition with Toshiba, and guarantee obligations, any of which could substantially harm our business and financial condition.

On June 30, 2000, we closed a transaction with Toshiba providing for the joint development and manufacture of 512 megabit and 1 gigabit flash memory chips and Secure Digital card controllers. As a part of this transaction, we and Toshiba formed and contributed initial funding to FlashVision, a joint venture to equip and operate a silicon wafer manufacturing line at Dominion Semiconductor in Virginia. We and Toshiba will each separately market and sell any 512 megabit and 1 gigabit flash memory chips developed and manufactured by our joint venture. Accordingly, we will compete directly with Toshiba for sales of these advanced chips.

We and Toshiba have restructured our FlashVision business and transferred certain assets to Toshiba’s Yokkaichi fabrication facility in Japan, which may cause production delays and reduce NAND wafer supply available to us, which could adversely impact our operating results.

In April 2002, we and Toshiba finalized certain of the agreements related to the restructuring of our FlashVision business and the transfer of its operations to Toshiba’s Yokkaichi fabrication facility in Japan. Under the terms of the agreements, Toshiba will transfer the FlashVision owned and leased NAND production tool-set from Dominion to Yokkaichi and has agreed to bear substantially all of the costs associated with the equipment transfers, which are expected to be completed in 2002. The transfer and qualification of the advanced fabrication equipment from Dominion, Virginia to Yokkaichi, Japan is a highly complex operation. It is quite possible that we may encounter difficulties and delays. Although the additional costs associated with potential delays will be borne substantially by Toshiba, our results of operations may suffer if this equipment transfer is not completed on time and production does not commence at Yokkaichi as planned, thereby reducing the total NAND production capacity available to us.

In addition, we incurred substantial start up expenses related to the hiring and training of manufacturing personnel, facilitizing the clean room and installing equipment at the Dominion fabrication facility. Although as a part of our agreement with Toshiba to restructure our FlashVision business we will recapture substantially all of the Dominion start-up expenses incurred by us, we will incur similar start-up expenses in connection with the new Yokkaichi fabrication facility. In addition, we may not achieve the expected cost benefits of this transition until the second half of 2002, if at all. We will incur start-up costs and pay our share of ongoing operating activities even if we do not utilize our full share of the new Yokkaichi output.

We face challenges and possible delays relating to the expected shift in a portion of our production at Yokkaichi to 0.13 micron NAND, which could adversely affect our operating results.

We were using the new production capacity at Dominion to manufacture NAND flash memory wafers with minimum lithographic feature size of 0.16 micron. Late in 2002, we expect to start shifting a portion of our production output at Yokkaichi to 0.13 micron NAND. Such minimum feature sizes are considered today to be among the most advanced for mass production of silicon wafers. Therefore, it is difficult to predict how long it will take to achieve adequate yields, reliable operation, and economically attractive product costs based on our new designs. Introduction of new feature sizes and technologies are subject to the same risks and uncertainties after the restructuring of our FlashVision business. We currently rely and will continue to rely on Toshiba to address these challenges. With our investments in the Dominion facility and in Toshiba’s Yokkaichi facility after the restructuring of our FlashVision business, we are now and will continue to be exposed to the adverse financial impact of any delays or manufacturing problems associated with wafer production lines. Any problems or delays in volume production at the Yokkaichi fabrication facility could adversely impact our operating results in 2002 and beyond.

All of our NAND flash memory wafers are supplied by Toshiba’s Yokkaichi facilities and any disruption in this supply will reduce our revenues, earnings and gross margins.

Until the transition of the Dominion tool-set is completed, we will rely solely on Toshiba’s current Yokkaichi fabrication facility to supply all of our NAND wafers. If we experience increased demand during the transition period, we may not be able to procure a sufficient number of wafers from Toshiba’s current Yokkaichi fabrication facility to meet this demand, which would harm our business and operating results. Even if FlashVision establishes the new Yokkaichi fabrication facility, the Yokkaichi fabrication facilities may not produce satisfactory quantities of wafers with acceptable prices, reliability and yields. Any failure in this regard would be particularly harmful to our business, financial condition and results of operations, as we will not have an alternate source of supply. In addition, any disruption in supply from the Yokkaichi fabrication facility due to natural disaster, power failure, labor unrest or other causes could significantly harm our business, financial condition and results of operations. Moreover, we have no experience in operating a wafer manufacturing line and we intend to rely on the existing manufacturing organizations at the Yokkaichi fabrication facilities. The new Yokkaichi fabrication facility will be tasked to “copy exactly” the same manufacturing flow employed by Toshiba in its existing Yokkaichi fabrication facility, but they may not be successful in manufacturing these advanced NAND flash products on a cost-effective basis or at all. If Toshiba and FlashVision are uncompetitive, are unable to satisfy our wafer supply requirements, our business, financial condition and results of operations would be harmed.

Our obligations under our wafer supply agreements with Toshiba and FlashVision, or failure to obtain customer acceptance, may result in excess inventories and lead to inventory write offs, and any technical difficulties or manufacturing problems may result in shortages in supply, either of which would adversely affect our business.

Under the terms of our wafer supply agreements with Toshiba, we are obligated to purchase half of FlashVision’s NAND wafer production output and we will also purchase NAND wafers from Toshiba’s current Yokkaichi fabrication facility on a foundry relationship basis. If the current soft market conditions continue throughout 2002 and beyond, or if we are unable for any reason to achieve customer acceptance of our card products built with these NAND flash chips, we will experience a significant increase in our inventory, which may result in inventory write offs and harm our business, results of operations and financial condition. Apart from our commitment to purchase FlashVision wafer output from Yokkaichi after the restructuring, under our foundry relationship with Toshiba, we order NAND wafers under purchase orders at market prices that cannot be cancelled. If we place purchase orders with Toshiba and our business condition deteriorates, we may end up with excess inventories of NAND wafers, which could harm our business and financial condition. Should customer demand for NAND flash products be less than our available supply, we may suffer from reduced revenues and increased expenses, and increased inventory of unsold NAND flash wafers, which could adversely affect our operating results.

On the other hand, under the terms of our foundry relationship with Toshiba and wafer supply agreements with FlashVision, we are obligated to provide a rolling forecast of anticipated purchase orders for the next six calendar months, which are difficult to estimate. Generally, the estimates for the first three months of each forecast are binding commitments. The estimates for the remaining months may only be changed by a certain percentage from the previous month’s forecast. This limits our ability to react to fluctuations in demand for our products. At the beginning of the second quarter of 2002, the demand for foundry wafers began to grow and the leading foundries started to allocate their capacity as well as extend delivery lead-times and raise prices. If this trend continues, we may encounter shortages in our supply of wafers and we may also incur higher manufacturing cost for some of our products, which would make us unable to meet our customer demand and adversely impact our product gross margins.

In addition, in order for us to sell NAND based CompactFlash, MultiMediaCards and Secure Digital cards, we have been developing new controllers, printed circuit boards and test algorithms because the architecture of

NAND flash is significantly different from our prior NOR flash designs. Any technical difficulties or delays in the development of these elements could prevent us from taking advantage of the available NAND output and could adversely affect our results of operations. See “—Our investment in new flash memory wafer production may result in increased expenses and fluctuations in operating results.”

We have contingent indemnification obligations for any liabilities Toshiba incurs as a result of Toshiba’s guarantee of the FlashVision equipment lease arrangement.

Under June 2000 our joint venture agreement with Toshiba, we agreed to guarantee one-half of all FlashVision lease amounts up to a maximum guarantee of $175.0 million. As of March 31, 2002, we had guarantee obligations in the amount of $148.8 million in favor of ABN AMRO Bank N.V., or ABN AMRO, as agent for a syndicate of financial institutions, on the equipment lease lines to equip FlashVision. This guarantee constituted senior indebtedness under the Notes. In March 2002, FlashVision exercised its right of early termination under the lease facility and repaid all amounts outstanding thereunder in April 2002. FlashVision completed interim financing in the form of a bridge loan from Toshiba in April 2002 and secured a new equipment lease arrangement in May 2002 with Mizuho and certain other financial institutions. In certain circumstances we will indemnify Toshiba for any liabilities Toshiba incurs as a result of Toshiba’s guarantee of the FlashVision equipment lease arrangement with Mizuho, up to a maximum contingent indemnification obligation by us of $150.0 million. This contingent indemnification obligation might constitute senior indebtedness under the Notes.

Risks Related to Our Investment in Tower Semiconductor Ltd.

Our $75.0 million investment in Tower Semiconductor Ltd. is subject to certain inherent risks, including those associated with certain Israeli regulatory requirements, political unrest and financing difficulties, which could harm our business and financial condition.

On July 4, 2000, we entered into a share purchase agreement to make a $75.0 million investment in Tower Semiconductor, or Tower, in Israel, representing approximately 10% ownership of Tower. The investment is subject to the completion of certain milestones relative to the construction of a new wafer fabrication facility by Tower. During 2001, Tower satisfied the closing conditions of the share purchase agreement and completed the first two milestones. Under the terms of the agreement, we invested $42.5 million to purchase 1,599,931 ordinary shares and obtain wafer credits of $21.4 million. In September 2001, we agreed to convert 75% of our wafer credits to equity at a price of $12.75 per share and received an additional 1,284,007 ordinary shares. Due to the continued weakness in the semiconductor industry, the value of our Tower investment and remaining wafer credits had declined to $16.6 million on December 31, 2001. It was determined that this decline was other than temporary, as defined by generally accepted accounting principles and a loss of $20.6 million was recorded in the second half of 2001. In addition, we recognized a loss of $5.5 million on our exchange of 75% of our Tower wafer credits for ordinary shares. These losses totaling $26.1 million, or $15.8 million net of tax benefit, were recorded in loss on investment in foundry in 2001.

In March 2002, we modified our share purchase agreement with Tower by agreeing to advance the payments for the third and fourth milestones. The payment for the third milestone of $11.0 million was paid on April 5, 2002 and the payment for the fourth milestone of $11.0 million will be paid on October 1, 2002. We will make this payment whether or not Tower actually achieves its previously agreed upon milestone obligations. In exchange for this, and as part of the modification to the share purchase agreement, Tower has agreed that of the aggregate payment of $22.0 million represented by the third and fourth milestone payments, (i) 60% of this amount, or $13.2 million, will be applied to the issuance of additional ordinary Tower shares based on the average closing price of Tower shares on the NASDAQ in the thirty consecutive trading days preceding each payment date, referred to as the ATP, (provided, however, that pursuant to the purchase agreement as modified, the ATP shall not exceed $12.50 per share) and (ii) 40% of this amount, or $8.8 million, will be credited to our pre-paid wafer account, to be applied against orders placed with Tower’s new fabrication facility, when completed; provided, however, that until July 1, 2005, these amounts added to the pre-paid wafer account may

only be applied towards a maximum of 7.5% of wafer purchases. As a result of our investment of $11.0 million for the third milestone, we received 1,071,497 additional Tower ordinary shares and $4.4 million in prepaid wafer credits. On a quarterly basis, we will assess the value of the prepaid wafer credits considering the timing and quantity of our planned wafer purchases from Tower, the contractual limitations on the amount of wafer credits that can be applied to purchases on an annual basis, the status of foundry construction and general economic conditions. If we determine that the value of these wafer credits is not recoverable, we will record a write-down.

The final contribution by us, if any, will take the form of a mandatory warrant exercise for 366,690 ordinary shares at an exercise price of $30.00 per share if the final milestone is met by Tower. The final milestone warrant will expire in July 2005, and in the event the milestone is not achieved, the exercise of the warrant will not be mandatory. If Tower’s stock price is trading below $30.00 per share on the day, if ever, that the final contribution is made, we will receive wafer credits in an amount equal to the number of shares purchased on the final contribution date multiplied by the difference between $30.00 and the ATP (provided, however, that the ATP shall not be less than $12.50). If we make timely milestone payments, Tower is contractually obligated to fill our wafer orders with up to 15% of available wafers from the new fabrication facility. We currently expect Tower to supply us a portion of the ASIC controller chips used in our flash cards. Tower’s new foundry facility is currently on schedule to begin production in the first half of 2003.

Completion of Tower’s wafer foundry facility is dependent on several factors and may never occur, which may harm our business and results of operations.

Tower’s completion of the wafer foundry facility is dependent on its ability to obtain additional financing for the foundry construction from equity and other sources and the release of grants and approvals for changes in grant programs from the Israel government’s Investment Center. If Tower is unable to obtain additional financing, complete foundry construction in a timely manner or is unable to successfully complete the development and transfer of advanced CMOS process technologies and ramp-up of production, the value of our investment in Tower will decline significantly or possibly become worthless and we may be unable to obtain the wafers needed to manufacture our products, which would harm our results of operations. In addition, the value of our investment in Tower may be adversely affected by a further deterioration of conditions in the market for foundry manufacturing services and the market for semiconductor products generally. If the fair value of the Tower investment declines further, we may record additional losses.

We cannot assure you that the Tower facility will be completed or will begin production as scheduled, or that the processes needed to fabricate our wafers will be qualified at the new facility. Moreover, we cannot assure you that this new facility will be able to achieve acceptable yields or deliver sufficient quantities of wafers on a timely basis at a competitive price. Furthermore, if the depressed business conditions for semiconductor wafers persists throughout 2002 and beyond, Tower may be unable to operate their new fabrication facility at an optimum capacity utilization, which would cause them to operate at a loss.

The current political unrest and violence in Israel may hinder the completion of and delay competitive production from Tower’s fabrication facility, which would harm our business.

Risks Related to Our UMC and DPI Joint Ventures

Fluctuations in the market value of our UMC foundry investment affect our financial results and in fiscal 2001 we recorded a loss on investment in foundry of $275.8 million on our UMC investment.

In 1997, we invested $51.2 million in United Silicon, Inc., or USIC, a semiconductor manufacturing subsidiary of United Microelectronics Corporation, or UMC, which was merged into the UMC parent company on January 3, 2000. In exchange for our USIC shares, we received 111 million UMC shares. Our equity investment in UMC was valued at $214.2 million at March 31, 2002 and included an unrealized gain of $19.3 million, or $8.3 million net of taxes, in the first quarter of 2002, which was included in other comprehensive income. In fiscal year 2001, we recorded a loss on investment in foundry of $275.8 million, or $166.9 million net of taxes, on our UMC investment. If the fair value of our UMC investment declines in future periods, we may record additional losses for those periods. In addition, in future periods, we may recognize a gain or loss upon the sale of our UMC shares, which will impact our financial results.

Our Digital Portal, Inc., or DPI, joint venture has an unproven product and an untested market and may not be successful.

On August 9, 2000, we entered into a joint venture, DPI, with Photo-Me International Plc., or PMI, for the manufacture, installation, marketing and maintenance of self-service, digital photo printing labs, or kiosks, bearing the SanDisk brand name in locations in the U.S. and Canada. In April 2002, we and PMI agreed that we would scale down our kiosk activities while PMI will assume responsibility to finance and direct the future growth of DPI Under the new agreement, we will convert approximately $400,000 in receivables from DPI to equity in DPI and will no longer be required to make additional investments in DPI or guarantee DPI’s equipment leases. If DPI is unsuccessful, our investment may become worthless, requiring us to record a loss equal to the total amount invested.

Risks Related to Vendors and Subcontractors

We depend on our suppliers and third-party subcontractors for several of our critical components and our business could be harmed if we are unable to obtain a sufficient supply of these components on a timely basis.

We rely on our vendors, some of which are sole source suppliers, for several of our critical components. We do not have long-term supply agreements with some of these vendors. Our business, financial condition and operating results could be significantly harmed by delays or reductions in shipments if we are unable to develop alternative sources or obtain sufficient quantities of these components. For example, after the restructuring of our FlashVision business, we now rely on Toshiba’s Yokkaichi fabrication facility for all of our flash memory wafers. Any disruption in the supply of wafers from the Yokkaichi fabrication facility would severely adversely impact our business. Until the transition of the Dominion tool-set is completed, we will rely solely on the current Yokkaichi fabrication facility for our NAND wafers. If we experience increased demand during this transition period, we may not be able to procure a sufficient number of wafers from Toshiba to meet this demand, which would harm our business and operating results.

We also rely on third-party subcontractors for a substantial portion of wafer testing, packaged memory final testing, card assembly and card testing, including Silicon Precision Industries Co., Ltd. in Taiwan and Celestica, Inc. in China. These subcontractors will also be assembling and testing a majority of our mature, high-volume products. In the fourth quarter of 2001, we completed the transfer of all of our card assembly and test manufacturing operations from our Sunnyvale location to these offshore subcontractors. We have no long-term contracts with these subcontractors and cannot directly control product delivery schedules. Any significant problems that occur at our subcontractors, or their failure to perform at the level we expect could lead to product shortages or quality assurance problems, which could increase the manufacturing costs of our products and have adverse effects on our operating results. Furthermore, we are moving to turnkey manufacturing with some of our subcontract suppliers, which may reduce our visibility and control of their inventories of purchased parts necessary to build our products.

We depend on third party foundries for silicon wafers and any shortage or disruption in our supply from these sources will reduce our revenues, earnings and gross margins.

All of our flash memory card products require silicon wafers, the majority of which are currently supplied by Toshiba’s wafer facility at Yokkaichi, Japan, as well as UMC in Taiwan. After the restructuring of our FlashVision business, all of our NAND flash memory wafers are now supplied by Toshiba’s Yokkaichi wafer facilities. If Toshiba, FlashVision and UMC are uncompetitive or are unable to satisfy these requirements, our business, financial condition and operating results may suffer. Any disruption in supply from these sources due to natural disaster, power failure, labor unrest or other causes could significantly harm our business, financial condition and results of operations.

Our obligation to provide a rolling forecast of anticipated purchase orders for the next six calendar months under the terms of our wafer supply agreements with Toshiba, FlashVision and UMC, limits our ability to react to fluctuations in demand for our products which may lead to excess wafer inventories and could result in higher operating expenses and reduced gross margins.

Under the terms of our wafer supply agreements with Toshiba, FlashVision and UMC, we are obligated to provide a rolling forecast of anticipated purchase orders for the next six calendar months. Generally, the estimates for the first three months of each forecast are binding commitments. The estimates for the remaining months may only be changed by a certain percentage from the previous month’s forecast. This limits our ability to react to fluctuations in demand for our products. For example, if customer demand falls below our forecast and we are unable to reschedule or cancel our wafer orders, we may end up with excess wafer inventories, which could result in higher operating expenses and reduced gross margins. Conversely, if customer demand exceeds our forecasts, we may be unable to obtain an adequate supply of wafers to fill customer orders, which could result in dissatisfied customers, lost sales and lower revenues. If we are unable to obtain scheduled quantities of wafers with acceptable price and yields from any foundry, our business, financial condition and results of operations could be harmed. At the beginning of the second quarter of 2002, the demand for foundry wafers began to grow and the leading foundries started to allocate their capacity as well as extend delivery lead-times and raise prices. If this trend continues, we may encounter shortages in our supply of wafers and we may also incur higher manufacturing cost for some of our products, which would make us unable to meet our customer demand and adversely impact our product gross margins.

Risks Related to Competition

We must achieve acceptable wafer manufacturing yields or our costs will increase and production will decrease, which could negatively impact our business.

The fabrication of our products requires wafers to be produced in a highly controlled and ultra clean environment. Semiconductor companies that supply our wafers sometimes have experienced problems achieving acceptable wafer manufacturing yields. Semiconductor manufacturing yields are a function of both our design technology and the foundry’s manufacturing process technology. Low yields may result from design errors or manufacturing failures. Yield problems may not be determined or improved until an actual product is made and can be tested. As a result, yield problems may not be identified until the wafers are well into the production process. The risks associated with yields are even greater because we rely exclusively on independent offshore foundries for our wafers which increases the effort and time required to identify, communicate and resolve manufacturing yield problems. If the foundries cannot achieve planned yields, we will experience higher costs and reduced product availability, which could harm our business, financial condition and results of operations.

In addition, we cannot assure you that the Yokkaichi fabrication facilities will produce satisfactory quantities of wafers with acceptable prices, reliability and yields. Any failure in this regard could materially harm our business, financial condition and results of operations. During the transition from the Dominion fabrication facility to the new Yokkaichi fabrication facility, when we will be solely reliant on the current Yokkaichi fabrication facility for our NAND wafers, any such failure will be particularly harmful to us as we will not have

an alternate source of supply. In addition, we have no experience in operating a wafer manufacturing line and we intend to rely on the existing manufacturing organizations at the Yokkaichi fabrication facilities. The new Yokkaichi fabrication facility will be tasked to “copy exactly” the same manufacturing flow employed by Toshiba in its existing Yokkaichi fabrication facility but we cannot assure you that they will be successful in manufacturing these advanced NAND flash products on a cost-effective basis or at all.

We face competition from flash memory manufacturers and memory card assemblers and if we cannot compete effectively, our business will be harmed.

We have entered into agreements with, and face direct competition from, Toshiba and other competitors.

We have entered into patent cross-license agreements with several of our leading competitors including Hitachi, Intel, Matsushita, SST, Samsung, Sharp, Sony, Toshiba and TDK. Under these agreements, each party may manufacture and sell products that incorporate technology covered by the other party’s patent or patents related to flash memory devices. As we continue to license our patents to certain of our competitors, competition

will increase and may harm our business, financial condition and results of operations. Currently, we are engaged in licensing discussions with several of our competitors. There can be no assurance that we will be successful in concluding licensing agreements under terms which are favorable to us, or at all.

Our products compete against new products that promote different industry standards from ours, and if these new industry standards gain market acceptance, our business will be harmed.

Competing products have been introduced that promote industry standards that are different from our products including Sony’s standard floppy disk used for digital storage in its Mavica digital cameras, Panasonic’s Mega Storage cards, Iomega’s Clik drive, a miniaturized, mechanical, removable disk drive, M-Systems’ DiskOnKey, a USB-based memory device, and the Secure MultiMediaCard from Hitachi and Infineon. Each competing standard may not be mechanically and electronically compatible with our products. If a manufacturer of digital cameras or other consumer electronic devices designs in one of these alternative competing standards, our products will be eliminated from use in that product. In addition, other companies, such as Sanyo, DataPlay and Matrix Semiconductor have announced products or technologies that may potentially compete with our products.

IBM’s Microdrive, a rotating disk drive in a Type II CompactFlash format competes directly with our larger capacity memory cards. M-Systems’ DiskOnChip 2000 Millennium product competes against our NAND Flash Components in embedded storage applications such as set top boxes and networking appliances.

We face competition from products based on alternative flash technologies and if we cannot compete effectively, our business will be harmed.

We also face competition from products based on multilevel cell flash technology from Intel and Hitachi. These products currently compete with our NAND MLC products. Multilevel cell flash is a technological innovation that allows each flash memory cell to store two bits of information instead of the traditional single bit stored by conventional flash technology.

Furthermore, we expect to face competition both from existing competitors and from other companies that may enter our existing or future markets that have similar or alternative data storage solutions, which may be less costly or provide additional features. For example, Infineon has formed a joint venture with Saifun, an Israeli startup company, to develop a proprietary flash memory technology which will be targeted at low cost data storage applications. Price is an important competitive factor in the market for consumer products. Increased price competition could lower gross margins if our average selling prices decrease faster than our costs and could also result in lost sales.

Risks Related to Sales of Our Products

Sales to a small number of customers represent a significant portion of our revenues and if we were to lose one of our major customers or experience any material reduction in orders from any of these customers, our revenues and operating results would suffer.

Approximately one-half of our revenues come from a small number of customers. For example, sales to our top 10 customers accounted for approximately 49%, 48%, and 57%, respectively, of our product revenues for 2001, 2000, and 1999. In 2001 and 2000, no single customer accounted for greater than 10% of our total revenues. In 1999, revenues from one customer exceeded 10% of our total revenues. If we were to lose one of

our major customers or experience any material reduction in orders from any of these customers, our revenues and operating results would suffer. Our sales are generally made by standard purchase orders rather than long-term contracts. In addition, the composition of our major customer base changes from year to year as the market demand for our customers’ products changes.

We may not be successful selling our products on the Internet and these sales may undercut our traditional sales channels.

Web-based sales of our products today represent a small but growing portion of our overall sales. Sales on the Internet tend to undercut traditional distribution channels and may dramatically change the way our consumer products are purchased in future years. We cannot assure you that we will successfully develop the Internet sales channel or successfully manage the inherent conflict between the Internet and our traditional sales channels.

Variability of average selling prices and gross margins resulting from changes in our product mix and price reductions for certain of our products may cause our gross margins and net profitability to suffer.

Our product mix varies quarterly, which affects our overall average selling prices and gross margins. Our CompactFlash, SmartMedia card, MultiMediaCard and Secure Digital card products, which currently represent the majority of our product revenues, have lower average selling prices and gross margins than our higher capacity FlashDisk and FlashDrive products. We believe that sales of CompactFlash, SmartMedia card, MultiMediaCard and Secure Digital card products will continue to represent a significant percentage of our product revenues as consumer applications, such as digital cameras and digital music players, become more popular. Flash data storage markets are intensely competitive, and price reductions for our products are necessary to meet consumer price points. Due to continued oversupply in flash memory foundry capacity throughout 2001 and the economic slow-down in 2001, the decline in our average selling price per megabyte of 50% was much more severe than the 22% decrease we experienced in 2000 and price declines for our products could continue to be significant in the next several quarters. If we cannot reduce our product manufacturing costs in future periods to offset further price reductions, our gross margins and net profitability will suffer.

Our selling prices may decline due to excess capacity in the market for flash memory products and if we cannot reduce our manufacturing costs to offset these price declines, our gross margins and net profitability will be harmed.

Throughout 2001, worldwide flash memory supply exceeded customer demand, causing excess supply in the markets for our products and significant declines in average selling prices. If this situation continues throughout 2002, price declines for our products could continue to be significant. If we cannot reduce our product manufacturing costs to offset these reduced prices, our gross margins and net profitability will be adversely impacted.

Our business depends significantly upon sales of products in the highly competitive consumer market, a significant portion of which are made to retailers and through distributors, and if our distributors and retailers are not successful in this market, we could experience substantial product returns, which would negatively impact our business, financial condition and results of operations.

In 2001 and the first quarter of 2002, we continued to receive more product revenue and ship more units of products for consumer electronics applications, including digital cameras and PDAs, compared to other applications. The consumer market is intensely competitive and is more price sensitive than our other target markets. In addition, we must spend more on marketing and promotion in consumer markets to establish brand name recognition and drive demand.

A significant portion of our sales to the consumer electronics market are made to retailers and through distributors. Sales through these channels typically include rights to return unsold inventory. As a result, we do

not recognize revenue until after the product has been sold through to the end user. If our distributors and retailers are not successful in this market, there could be substantial product returns, which would harm our business, financial condition and results of operations.

There is seasonality in our business which may impact our product sales, particularly in the fourth and first quarters of the fiscal year.

Sales of our products in the consumer electronics market may be subject to seasonality. As a result, product sales may be impacted by seasonal purchasing patterns with higher sales generally occurring in the fourth quarter of each year followed by declines in the first quarter of the following year. In addition, in the past we have experienced a decrease in orders in the first quarter from our Japanese OEM customers primarily because most customers in Japan operate on a fiscal year ending in March and prefer to delay purchases until the beginning of their next fiscal year.

Risks Related to Our Intellectual Property

We may be unable to protect our intellectual property rights which would harm our business, financial condition and results of operations.

We rely on a combination of patents, trademarks, copyright and trade secret laws, confidentiality procedures and licensing arrangements to protect our intellectual property rights. In the past, we have been involved in significant disputes regarding our intellectual property rights and claims that we may be infringing third parties’ intellectual property rights. We expect that we may be involved in similar disputes in the future. We cannot assure you that:

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any of our existing patents will not be invalidated;

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patents will be issued for any of our pending applications;

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any claims allowed from existing or pending patents will have sufficient scope or strength;

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our patents will be issued in the primary countries where our products are sold in order to protect our rights and potential commercial advantage; or

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any of our products do not infringe on the patents of other companies.

In addition, our competitors may be able to design their products around our patents.

We intend to vigorously enforce our patents but we cannot be sure that our efforts will be successful. If we were to have an adverse result in any litigation, we could be required to pay substantial damages, cease the manufacture, use and sale of infringing products, expend significant resources to develop non-infringing technology, discontinue the use of certain processes or obtain licenses to the infringing technology. Any litigation is likely to result in significant expense to us, as well as divert the efforts of our technical and management personnel.

We may be unable to license intellectual property to or from third parties as needed, or renew existing licenses, and have agreed to indemnify various suppliers and customers for alleged patent infringement, which could expose us to liability for damages, increase our costs or limit or prohibit us from selling certain products.

If we decide to incorporate third party technology into our products or if we are found to infringe on others’ intellectual property, we could be required to license intellectual property from a third party. We may also need to license some of our intellectual property to others in order to enable us to obtain cross-licenses to third party patents. Currently, we have patent cross-license agreements with several companies, including Hitachi, Intel, Matsushita, SST, Samsung, Sharp, Smartdisk, Sony, TDK and Toshiba and we are in discussions with other companies regarding potential cross-license agreements. We cannot be certain that licenses will be offered when

we need them, or that the terms offered will be acceptable. If we do obtain licenses from third parties, we may be required to pay license fees or royalty payments. In addition, if we are unable to obtain a license that is necessary to the manufacture of our products, we could be required to suspend the manufacture of products or stop our wafer suppliers from using processes that may infringe the rights of third parties. We cannot assure you that we would be successful in redesigning our products or that the necessary licenses will be available under reasonable terms, or that our existing licensees will renew their licenses upon expiration, or that we will be successful in signing new licensees in the future.

We have historically agreed to indemnify various suppliers and customers for alleged patent infringement. The scope of such indemnity varies, but may, in some instances, include indemnification for damages and expenses, including attorney’s fees. We may periodically engage in litigation as a result of these indemnification obligations. We are not currently engaged in any such indemnification proceedings. Our insurance policies exclude coverage for third party claims for patent infringement. Any future obligation to indemnify our customers or suppliers could harm our business, financial condition or results of operations.

We may be involved in litigation regarding our intellectual property rights or those of third parties, which would be costly and would divert the efforts of our technical and management personnel.

On or about August 3, 2001, the Lemelson Medical, Education & Research Foundation, or Lemelson Foundation, filed a complaint for patent infringement against us and four other defendants. The suit, captioned Lemelson Medical, Education, & Research Foundation, Limited Partnership vs. Broadcom Corporation, et al., Civil Case No. CIV01 1440PHX HRH, was filed in the United States District Court, District of Arizona. On November 13, 2001, the Lemelson Foundation filed an Amended Complaint, which made the same substantive allegations against us but named more than twenty-five additional defendants. The Amended Complaint alleges that we, and the other defendants, have infringed certain patents held by the Lemelson Foundation pertaining to bar code scanning technology. By its complaint, the Lemelson Foundation requests that we be enjoined from our allegedly infringing activities and seeks unspecified damages. On February 4, 2002, we filed an answer to the amended complaint, wherein we alleged that we do not infringe the asserted patents, and further contend that the patents are not valid or enforceable.

On October 15, 2001, we filed a complaint for patent infringement in the United States District Court for the Northern District of California against Micron Technology, Inc., or Micron. In the suit, captioned SanDisk Corp. v. Micron Technology, Inc., Civil No. CV 01-3855 CW, the complaint seeks damages and an injunction against Micron for making, selling, importing or using flash memory cards that infringe our U.S. Patent No. 6,149,316. On February 15, 2002, Micron answered the complaint, denied liability, and counterclaimed seeking a declaration that the patent in suit is not infringed, is invalid, and is unenforceable. On May 31, 2002, based on allegations of infringement leveled by Micron against us, we filed a complaint for declaratory judgment, seeking a declaration that we have not infringed and are not infringing five patents (or, in the alternative, that the patents are invalid). The patents in question are U.S. Patent No. 4,468,308; U.S. Patent No. 5,286,344; U.S. Patent No. 5,320,981; U.S. Patent No. 6,015,760; and U.S. Patent No. 6,287,978 B1. The suit is captioned SanDisk Corp. v. Micron Technology, Inc., Civil No. CV 02-2627 VRW. On June 4, Micron answered and counterclaimed alleging that we do infringe the five listed patents.

Products, Inc., et. al., Civil No. CV 01-4063 VRW, we seek damages and injunctions against these companies from making, selling, importing or using flash memory cards that infringe our U.S. patent No. 5,602,987 or the ‘987 Patent. Defendants Memorex, Pretec and Ritek have filed answers denying the allegations. We filed a motion for a preliminary injunction in the suit to enjoin Memorex, Pretec and Ritek from making, selling, importing or using flash memory cards that infringe our ‘987 Patent prior to the trial on the merits. On May 17, 2002, the Court denied our motion. Discovery has commenced. The Court has set a trial date for the later half of 2003.

On November 30, 2001, we filed a complaint for patent infringement in the United States District Court for the Northern District of California against Power Quotient International-USA Inc, or PQI-USA. In the suit, captioned SanDisk Corp. v. Power Quotient International-USA Inc., Civil No. C 01-21111, we seek damages and an injunction against PQI-USA from making, selling, importing or using flash memory cards that infringe our U.S. patent No. 5,602,987. The PQI-USA complaint and litigation are related to the October 31, 2001 litigation referred to above. The products at issue in the PQI-USA case are identical to those charged with infringement in the October 31, 2001 litigation. On December 21, 2001, PQI-USA filed an answer to the complaint denying the allegations, which included a counter claim for a declaratory judgment of non-infringement and invalidity of our ‘987 Patent. We have motioned for a preliminary injunction in the suit to enjoin PQI-USA from making, selling, importing or using flash memory cards that infringe our ‘987 Patent prior to the trial on the merits. On April 8, 2002, the Court heard argument on the preliminary injunction motion and a decision on the motion is pending. Discovery has commenced. The Court has set a trial date for the later half of 2003.

On or about March 5, 2002, Samsung Electronics Co., Ltd., or Samsung, filed a patent infringement lawsuit against us in the United States District Court for the Eastern District of Texas. The lawsuit alleges that we infringe four Samsung United States patents, Nos. 5,473,563; 5,514,889; 5,546,341 and 5,642,309, and seeks a preliminary and permanent injunction against unnamed products of ours, as well as damages, attorneys’ fees and cost of the lawsuit. On March 28, 2002, we filed an answer and counterclaims denying infringement and asserting the Samsung patents are invalid and/or unenforceable. The counterclaims asserted that Samsung breached a 1997 agreement between SanDisk and Samsung. On April 3, 2002, Samsung filed its first amended complaint. The amended complaint restricted Samsung’s original infringement allegations with respect to the four patents listed above to SanDisk products that include NAND flash memory. A substantial percentage of SanDisk products include NAND flash memory devices. On April 26, 2002, we filed an answer to Samsung’s first amended complaint and amended counterclaims. This answer and amended counterclaims again denied infringement and asserted that the Samsung patents are invalid and/or unenforceable. In SanDisk’s amended counterclaims, we seek relief for both breach of the 1997 agreement and a declaration of our rights under the 1997 agreement. A trial has been schedule for October 2002 on this matter. On April 26, 2002, we filed a complaint against Samsung in the United States District Court for the Northern District of California, Civil No. C02-2069 MJJ, for declaratory judgment of non-infringement, invalidity, a declaration of rights under the 1997 agreement with Samsung and breach of contract.

Risks Related to Our Charter Documents, Stockholder Rights Plan and Our Stock Price

Anti-takeover provisions in our charter documents, stockholder rights plan and in Delaware law could prevent or delay a change in control and, as a result, negatively impact our stockholders.

We have taken a number of actions that could have the effect of discouraging a takeover attempt. For example, we have adopted a stockholder rights plan that would cause substantial dilution to a stockholder, and substantially increase the cost paid by a stockholder, who attempts to acquire us on terms not approved by our board of directors. This could prevent us from being acquired. In addition, our certificate of incorporation grants the board of directors the authority to fix the rights, preferences and privileges of and issue up to 4,000,000 shares of preferred stock without stockholder action. Although we have no present intention to issue shares of preferred stock, such an issuance could have the effect of making it more difficult and less attractive for a third party to acquire a majority of our outstanding voting stock. Preferred stock may also have other rights, including economic rights senior to our common stock that could have a material adverse effect on the market

value of our common stock. In addition, we are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law. This section provides that except in certain limited circumstances a corporation shall not engage in any business combination with any interested stockholder during the three-year period following the time that such stockholder becomes an interested stockholder. This provision could have the effect of delaying or preventing a change of control of SanDisk.

Our stock price has been, and may continue to be, volatile, which could result in investors losing all or part of their investments.

The market price of our stock has fluctuated significantly in the past and is likely to continue to fluctuate in the future. For example, in the 12 months ending December 31, 2001, our stock price fluctuated significantly from a low of $8.61 to a high of $48.69. We believe that such fluctuations will continue as a result of future announcements concerning us, our competitors or principal customers regarding technological innovations, new product introductions, governmental regulations, litigation or changes in earnings estimates by analysts. In addition, in recent years the stock market has experienced significant price and volume fluctuations and the market prices of the securities of high technology and semiconductor companies have been especially volatile, often for reasons outside the control of the particular companies. These fluctuations as well as general economic, political and market conditions may have an adverse affect on the market price of our common stock.

Risks Related to Our Indebtedness

We have substantially increased our indebtedness, which may restrict our cash flow, make it difficult for us to obtain future financing, divert our resources from other uses, limit our ability to react to changes in the industry, and place us at a competitive disadvantage.

On December 24, 2001, we completed a private placement of $125.0 million of 4 ½% Convertible Subordinated Notes due 2006, or Notes, and on January 10, 2002, we sold an additional $25.0 million of the Notes pursuant to the exercise by the initial purchasers of their option. As a result, we incurred $150.0 million aggregate principal amount of additional indebtedness, substantially increasing our ratio of debt to total capitalization. While the Notes are outstanding, we will have debt service obligations on the Notes of approximately $6.8 million per year in interest payments. If we are unable to generate sufficient cash to meet these obligations and must instead use our existing cash or investments, we may have to reduce, curtail or terminate other activities of our business.

We intend to fulfill our debt service obligations from cash generated by our operations, if any, and from our existing cash and investments. If necessary, among other alternatives, we may add lease lines of credit to finance capital expenditures and obtain other long-term debt and lines of credit. We may incur substantial additional indebtedness in the future. The level of our indebtedness, among other things, could:

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require the dedication of a substantial portion of any cash flow from our operations to service our indebtedness, thereby reducing the amount of cash flow available for other purposes, including working capital, capital expenditures and general corporate purposes;

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make it difficult for us to obtain any necessary future financing for working capital, capital expenditures, debt service requirements or other purposes;

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cause us to use a significant portion of our cash and cash equivalents or possibly liquidate other assets to repay the total principal amount due under the Notes and our other indebtedness if we were to default under the Notes or our other indebtedness;

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limit our flexibility in planning for, or reacting to changes in, our business and the industries in which we complete;

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place us at a possible competitive disadvantage with respect to less leveraged competitors and competitors that have better access to capital resources; and

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make us more vulnerable in the event of a further downturn in our business.

There can be no assurance that we will be able to meet our debt service obligations, including our obligations under the Notes.

In 2000, we entered into a joint venture agreement with Toshiba, under which we formed FlashVision. We agreed to guarantee one-half of all FlashVision lease amounts up to a maximum guarantee of $175.0 million. As of March 31, 2002, we had guarantee obligations in the amount of $148.8 million in favor of ABN AMRO on the equipment lease lines to equip FlashVision. This guarantee constituted senior indebtedness under the Notes. In March 2002, FlashVision exercised its right of early termination under the lease facility and repaid all amounts outstanding thereunder in April 2002. FlashVision completed interim financing in the form of a bridge loan from Toshiba in April 2002 and secured a new equipment lease arrangement in May 2002 with Mizuho and certain other financial institutions. In certain circumstances we will indemnify Toshiba for any liabilities Toshiba incurs as a result of Toshiba’s guarantee of the FlashVision equipment lease arrangement with Mizuho, up to a maximum contingent indemnification obligation by us of $150.0 million.

This contingent indemnification obligation might constitute senior indebtedness under the Notes and we may use a portion of the proceeds from the Notes to repay the obligation. This would result in the diversion of resources from other important areas of our business and could significantly harm our business, financial condition and results of operations.

We may not be able to satisfy a fundamental change offer under the indenture governing the Notes.

The indenture governing the Notes contains provisions that apply to a fundamental change. A fundamental change as defined in the indenture would occur if we were to be acquired for consideration other than cash or securities traded on a major U.S. securities market. If someone triggers a fundamental change, we may be required to offer to purchase the Notes with cash. This would result in the diversion of resources from other important areas of our business and could significantly harm our business, financial condition and results of operations.

If we have to make a fundamental change offer, we cannot be sure that we will have enough funds to pay for all the Notes that the holders could tender. Our failure to redeem tendered notes upon a fundamental change would constitute a default under the indenture and might constitute a default under the terms of our other indebtedness, which would significantly harm our business and financial condition.

We may not be able to pay our debt and other obligations which would cause us to be in default under the terms of our indebtedness which would result in harm to our business and financial condition.

If our cash flow is inadequate to meet our obligations, we could face substantial liquidity problems. If we are unable to generate sufficient cash flow or otherwise obtain funds necessary to make required payments on the Notes or our other indebtedness, we would be in default under the terms thereof, which would permit the holders of the Notes to accelerate the maturity of the Notes and also could cause defaults under our other indebtedness. Any such default would harm our business, prospects, financial condition and operating results. In addition, we cannot assure you that we would be able to repay amounts due in respect of the Notes if payment of the Notes were to be accelerated following the occurrence of any other event of default as defined in the indenture governing the Notes. Moreover, we cannot assure that we will have sufficient funds or will be able to arrange for financing to pay the principal amount due on the Notes at maturity.

We may need additional financing, which could be difficult to obtain, which may result in preventing us from developing or enhancing our products, taking advantage of future opportunities, growing our business or responding to competitive pressures or unanticipated industry changes, any of which could harm our business.

We currently expect that our existing cash and investment balances, cash generated from operations and the proceeds from the sale of the Notes will be sufficient to meet our cash requirements to fund operations and expected capital expenditures for at least the next twelve months. However, in the event we need to raise additional funds during that time period or in future periods, we cannot be certain that we will be able to obtain additional financing on favorable terms, if at all. From time to time, we may decide to raise additional funds through public or private debt or equity financings to fund our activities. If we issue additional equity securities, our stockholders will experience additional dilution and the new equity securities may have rights, preferences or privileges senior to those of existing holders of common stock or debt securities. In addition, if we raise funds through debt financing, we will have to pay interest and may be subject to restrictive covenants, which could harm our business. If we cannot raise funds on acceptable terms, if and when needed, we may not be able to develop or enhance our products, take advantage of future opportunities, grow our business or respond to competitive pressures or unanticipated industry changes, any of which could have a negative impact on our business.

The Notes and other indebtedness have rights senior to those of our current stockholders such that in the event of our bankruptcy, liquidation or reorganization or upon acceleration of the Notes due to an event of default under the indenture and in certain other events, our assets will be available for distribution to our current stockholders only after all senior indebtedness.

In the event of our bankruptcy, liquidation or reorganization or upon acceleration of the Notes due to an event of default under the indenture and in certain other events, our assets will be available for distribution to our current stockholders only after all senior indebtedness, including the obligations under the Notes, have been paid in full. As a result, there may not be sufficient assets remaining to make any distributions to our stockholders.

Item 7A. Qualitative and Quantitative Disclosures About Market Risk

We are exposed to financial market risks, including changes in interest rates, foreign currency exchange rates and marketable equity security prices. To mitigate some of these risks, we utilize currency forward contracts. We do not use derivative financial instruments for speculative or trading purposes, and no significant derivative financial instruments were outstanding at December 31, 2001.

Interest Rate Risk. Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. The primary objective of our investment activities is to preserve principal while maximizing yields without significantly increasing risk. This is accomplished by investing in widely diversified short-term investments, consisting primarily of investment grade securities, substantially all of which either mature within the next twelve months or have characteristics of short-term investments. A hypothetical 50 basis point increase in interest rates would result in an approximate $429,000 decline (less than 0.5%) in the fair value of our available-for-sale debt securities.

Foreign Currency Risk. A substantial majority of our revenue, expense and capital purchasing activity are transacted in U.S. dollars. However, we do enter into transactions in other currencies, primarily the Japanese Yen. To protect against reductions in value and the volatility of future cash flows caused by changes in foreign exchange rates, we have established a hedging program. Currency forward contracts are utilized in this hedging program. Our hedging program reduces, but does not always entirely eliminate the impact of foreign currency exchange rate movements. An adverse change of 10% in exchange rates would result in a decline in income before taxes in 2001 of approximately $256,000.

Market Risk. We also hold available-for-sale equity securities in our short-term investment portfolio and equity investments in semiconductor wafer manufacturing companies. A reduction in prices of 10% of these marketable equity securities would result in a decrease in the fair value of our investments in marketable equity securities of approximately $17.0 million. As of December 31, 2001, we had net unrealized gains on short-term equity securities totaling $96.8 million which were included in other comprehensive income. These unrealized gains include an unrealized gain of $95.8 million on the appreciation in value of our investment in UMC. The market value of our investment in UMC has fluctuated significantly in the past and may decline in the future due to downturns in the semiconductor industry, declines in demand for UMC’s products or unfavorable economic conditions. If we sell UMC shares in future periods, we may recognize a gain or loss due to fluctuations in the market value of our UMC stock.

All of the potential changes noted above are based on sensitivity analysis performed on our financial position at December 31, 2001. Actual results may differ materially.

Item 8. Financial Statements and Supplementary Data

SANDISK CORPORATION

CONSOLIDATED FINANCIAL STATEMENTS

Contents

		Page
Report of Ernst & Young LLP, Independent Auditors		61
Consolidated Balance Sheets		62
Consolidated Statements of Operations		63
Consolidated Statements of Stockholders’ Equity		64
Consolidated Statements of Cash Flows		65
Notes to Consolidated Financial Statements		66

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors and Stockholders

SanDisk Corporation

We have audited the accompanying consolidated balance sheets of SanDisk Corporation as of December 31, 2001 and 2000, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2001. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. 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 consolidated financial position of SanDisk Corporation at December 31, 2001 and 2000 and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2001, in conformity with accounting principles generally accepted in the United States.

/s/ ERNST & YOUNG LLP

San Jose, California

January 21, 2002, except for Note 3,

as to which the date is May 17, 2002

and Note 8, as to which the date is

April 5, 2002.

SANDISK CORPORATION

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share amounts)

	December 31,
	2001		2000
ASSETS
Current assets:
Cash and cash equivalents	$	189,499	$	106,277
Short-term investments		105,501		260,462
Investment in foundries		105,364		112,854
Accounts receivable, net of allowance for doubtful accounts of $4,919 in 2001 and $5,010 in 2000		45,223		96,405
Inventories		55,968		96,600
Tax refund receivable		28,473		—
Prepaid expenses and other current assets		12,129		17,709

Total current assets		542,157		690,307
Restricted cash and cash equivalents		64,734		—
Property and equipment, net		33,730		41,095
Investment in foundries		41,380		197,688
Restricted investment in UMC		64,734		—
Investment in FlashVision		153,168		134,730
Deferred tax asset		18,842		—
Deposits and other non-current assets		13,603		37,087

Total assets	$	932,348	$	1,100,907

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	19,938	$	59,179
Accounts payable to related parties		24,008		7,933
Accrued payroll and related expenses		5,279		16,215
Income taxes payable		7,361		16,427
Deferred tax liability		18,842		—
Research & development liability, related party		15,256		—
Other accrued liabilities		20,571		13,863
Deferred income on shipments to distributors and retailers and deferred revenue		15,806		50,740

Total current liabilities		127,061		164,357
Convertible subordinated notes payable		125,000		—
Long-term liabilities, related parties		4,908		3,492
Deferred taxes and other liabilities		—		70,000

Total liabilities		256,969		237,849

Commitments and contingencies

Stockholders’ equity:
Preferred stock, $0.001 par value; Authorized shares: 4,000,000; Issued: none		—		—
Common stock, $0.001 par value; Authorized shares: 400,000,000; Issued and outstanding: 68,464,000 in 2001 and 67,464,000 in 2000		68		67
Capital in excess of par value		580,363		566,934
Retained earnings		48,525		346,469
Accumulated other comprehensive income (loss)		46,423		(50,412	)

Total stockholders’ equity		675,379		863,058

Total liabilities and stockholders’ equity	$	932,348	$	1,100,907

See accompanying notes.

SANDISK CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

	Years Ended December 31,
	2001		2000		1999
Revenues
Product	$	316,867	$	526,359	$	205,770
License and royalty