UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-K

 

 

 

Commission file number: 0-26734

 

SANDISK CORPORATION

(Exact name of registrant as specified in its charter)

 

 

(408) 542-0500

(Registrant’s telephone number, including area code)

 

[None]

(Former name, former address and former fiscal year, if changed since last report)

 

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

 

 

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

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.  Yes o     No  þ

 

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

 

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.  o

 

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

Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o

 

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

 

As of July 3, 2005, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $3,559,616,995 based on the closing sale price as reported on the National Association of Securities Dealers Automated Quotation System National Market System.

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

DOCUMENTS INCORPORATED BY REFERENCE

 

 

 

SANDISK CORPORATION

 

Table of Contents

 

 

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,” “seeks,” “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 these forward-looking statements. Factors that could cause our actual results to differ materially include, but are not limited to, those discussed in “Risk Factors” in Item 1A of this report, and elsewhere in this report. Our business, financial condition or results of operations could be materially adversely affected by any of these factors. We undertake no obligation to revise or update any forward-looking statements to reflect any event or circumstance that arises after the date of this report. References in this report to “SanDisk^®,” “we,” “our,” and “us” collectively refer to SanDisk Corporation, a Delaware corporation, and its subsidiaries. All references to years or annual periods are references to our fiscal years, which consisted of 52 weeks in 2005, 53 weeks in 2004 and 52 weeks in 2003.

 

Overview

 

Who We Are.  We are the worldwide leader in flash storage card products. We design, develop and market flash storage devices used for a wide variety of consumer electronics products such as digital cameras, mobile phones, Universal Serial Bus, or USB, drives, gaming devices, MP3 players and other digital consumer devices. Flash storage allows data to be stored in a compact format that retains the data for an extended period of time after the power has been turned off.

 

Our Strategy.  Our strategy is to identify and develop current and emerging mass consumer markets for flash storage products and through our vertical integration supply strategy sell in high volumes all major flash storage card formats for our target markets, enabling us to be a one-stop-shop for our retail and original equipment manufacturer, or OEM, customers.

 

Our revenues are driven by the sale of products and licensing of our intellectual property. We believe the market for flash storage is price elastic. From 2004 to 2005, we increased the number of megabytes sold by 166% in large measure due to a decrease of 52% in our average selling price per megabyte over the same period. Our management team believes that more applications for flash storage will be created through the continued increase in the number of megabytes a consumer can purchase at a given price point. The dynamics of these price declines driving increased volume resulted in an increase in our product revenues from $1.6 billion in 2004 to $2.1 billion in 2005. In addition, our license revenue increased from $174.2 million in 2004 to $239.5 million in 2005 as a result of continued adoption of flash technologies by our licensees.

 

We create new markets for flash memory. Together with Matsushita Electric Industries, Ltd., or Matsushita, which owns the Panasonic brand, and a subsidiary of Toshiba Corporation, or Toshiba, we launched the Secure Digital card, or SD^tm card, which is currently the most popular form factor of flash storage cards. We followed that effort by working with mobile network operators and handset manufacturers to develop the miniSD^tm card and microSD^tm card, an even smaller form factor memory card. Our market-driving efforts now include investment in the U3^tm platform, with which software developers can transform USB drives from a simple mass storage device to a platform for on-the-go computing. We are also in the early stages of developing the market for pre-loaded content, such as music, and other digital content for end-users in specific fields such as education. We are working with device manufacturers, infrastructure and copyright owners and software developers in developing these emerging markets, which we believe will contribute to the future of flash storage products.

 

We are founders or co-founders of most major form factors of flash storage cards in the market today. We co-own the Memory Stick PRO^tm format with Sony Corporation, or Sony, we have worked with Canon, Inc., or Canon, to co-found CompactFlash^®, and worked with Matsushita and a subsidiary of Toshiba to co-found the SD card. We co-developed miniSD with NTT DoCoMo, Inc., Toshiba and Matsushita, and we pioneered TransFlash^tm in collaboration with Motorola, Inc., or Motorola. We plan to continue to work with leading companies in mobile

communications and digital consumer devices to find additional ways for flash storage card products to enable proliferation of those technologies and markets.

 

We develop and own leading-edge technology and patents for flash memory and data storage cards. Our research and development spending was approximately $195 million in 2005. Our team has a deep understanding of flash memory. We own or control many patents, know-how and other intellectual property covering the design, manufacture and operation of flash memory and flash memory cards. One of the key technologies that we have patented and successfully commercialized to date is multi-level cell technology, or MLC, which allows a flash memory cell to be programmed to store two or more bits of data in approximately the same area of silicon that is typically required to store one bit of data. This technology is an important factor in our ability to reduce the cost of our flash memory. We have an extensive patent portfolio that has been licensed by three of the four largest semiconductor companies based on revenues. Our license and royalty revenues over the last three years cumulatively were over $511 million.

 

We are investing with Toshiba in joint ventures, that are high volume, state-of-the-art flash manufacturing facilities in Japan. Our commitment takes the form of capital investments and loans to the ventures, credit enhancements of the ventures’ leases of semiconductor manufacturing equipment, commitments, on a take-or-pay basis, to purchase 50% of the output of the ventures at manufacturing cost plus a mark-up and sharing in the cost of SanDisk-Toshiba joint research and development activities related to flash memory. We supplement our sourcing of flash memory from the Toshiba ventures with purchases of memory on favorable terms from Renesas Technology Corporation, or Renesas, Samsung Electronics Corporation, or Samsung, and Toshiba. Additionally, we design in-house and fabricate at third-party foundries the controllers which interface between the flash memory and digital consumer devices. Our team manages a network of contract manufacturers that assemble and test our flash memory and cards according to our specifications.

 

We sell our product globally to retail and OEM customers. We intend to continue to expand our retail customer base to additional new geographic regions as well as to new outlets such as supermarkets and drug stores. We also seek to strengthen our current retailer relationships and establish exclusive arrangements where practical. In North America, we sell our products principally through retailers, such as Best Buy Company, Inc., or Best Buy, Circuit City Stores, Inc., Wal-Mart Stores, Inc. and Costco Wholesale Corporation. In North America and the rest of the world, we manage a network of distributors who sell to other retailers and dealers. We also are expanding a separate network of distributors and retail locations specifically focused on the mobile phone market. There are now more than 150,000 worldwide retail storefronts where consumers may purchase SanDisk products. We also sell directly and through distributors, to key OEM accounts, including mobile phone manufacturers and digital camera manufacturers who include our products with their products when sold to end users.

 

Additional Information.  We were incorporated in Delaware in June 1988 under the name SunDisk Corporation and changed our name to SanDisk Corporation in August 1995. We file reports and other information with the Securities and Exchange Commission, or SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and proxy or information statements. Those reports and statements as well as all amendments to those documents filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act (1) may be read and copied at the SEC’s public reference room at 450 Fifth Street, N.W., Washington, DC 20549, (2) are available at the SEC’s internet site (http://www.sec.gov), which contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC and (3) are available free of charge through our website as soon as reasonably practicable after electronic filing with, or furnishing to, the SEC. Information regarding the operation of the SEC’s public reference room may be obtained by calling the SEC at 1-800-SEC-0330. Our website address is www.sandisk.com. Information on our website is not incorporated by reference nor otherwise included in this report. Our principal executive offices are located at 140 Caspian Court, Sunnyvale, California 94089 and our telephone number is (408) 542-0500. “SanDisk” is a registered trademark of SanDisk Corporation. All other trade names used in this report are trademarks of their respective holders.

Description of Our Business

 

Industry Background.  The digital computing industry includes traditional computers and consumer electronic, communications and industrial products. We focus our products on digital consumer devices like digital cameras, mobile phones, gaming devices, personal computers and portable digital audio players. The storage requirements of these applications include small form factor size, portable and removable storage, high reliability and storage capacity, low power consumption and the capability to withstand high levels of shock vibration and temperature fluctuations.

 

The flash memory market is primarily comprised of NOR and NAND technologies. NOR is traditionally used for code storage and characterized by fast read speeds with generally higher costs per megabyte and lower storage capacities than NAND. NAND flash memory is traditionally used for embedded and removable data storage and is characterized by fast write speeds, high capacity and lower manufacturing cost than NOR flash memory. We are focused on NAND-based products.

 

Our Primary Markets.  We currently focus primarily on five consumer electronics markets: imaging, mobile phones, USB flash drives, gaming devices and digital audio players.

 

 

Our Sales Channels.  Our products are delivered to end-users through approximately 150,000 worldwide retail storefronts and as data storage cards bundled with host products by our OEM customers. We market our products under the SanDisk brand in the retail channel using a direct sales organization, distributors and manufacturers’ representatives. We also sell directly and through distributors, SanDisk branded and private label products to OEM customers. Our sales efforts are organized as follows:

 

 

We also sell product to smaller retailers through distributors. Our retail distributors include AVS Technologies, Inc., D&H Distributing Co., Inc., Duttenhofer GMBH & Co., Hama Corporation, Inc., Holst

Import BV, Ingram Micro, Inc., Kaga Electronics Co., Ltd., Princeton Technology Corporation, Tech Data Corporation and Wynit, Inc., in addition to approximately 50 other distributors.

 

We have a separate distribution network focused on the cellular phone market. Our distributors provide us access to mobile network operator branded storefronts as well as other retailers with significant mobile communications offerings. We intend to continue to emphasize offering our products throughout the mobile communication retail community as an important driver of our planned growth in that market.

 

We support our retail sales channels with both direct sales representatives and independent manufacturers’ representatives. We have multiple domestic retail sales offices and have organized our sales efforts in the rest of the world around three regional territories: Europe, Middle East and Africa, or EMEA, Japan and non-Japan Asia/Pacific, which we refer to as Asia Pacific. Information regarding our sales by geography is included in Note 4 to our consolidated financial statements included in Item 8 of this report.

 

 

Due to industry practice that allows customers to change or cancel orders with limited advance notice prior to shipment, we do not believe that backlog as of any particular date is indicative of future sales. As of the end of fiscal 2005 and fiscal 2004, our backlog was $105.7 and $78.6 million, respectively. The following table describes the distribution of our net product revenues (in millions):

 

 

The significance of our North American retail channel to our business has resulted in our revenues being seasonally higher in our fourth quarter due to the holiday buying season. Our first and third quarters have sometimes been seasonally lower than their preceding quarters.

 

Our Customers.  In 2005, 2004 and 2003, revenues from our top 10 customers and licensees accounted for approximately 50%, 55% and 48% of our revenues, respectively. In 2005, Best Buy accounted for 11% of our total revenues; all other customers were less than 10% of our revenues. In 2004 and 2003, no single customer or licensee accounted for greater than 10% of our total revenues. The composition of our major customer base from year-to-year has changed over time, and we expect this pattern to continue as our markets and strategies evolve. Sales to our customers are generally made pursuant to purchase orders rather than long-term contracts.

 

Our Products.  Our products can be categorized by form factor and performance. Form factor generally correlates with our targeted end-market.

 

We make many form factors of removable data storage cards as well as USB flash drives and flash digital audio players. The principal form factors of our products are:

 

 

 

Technology.  Since our inception, we have focused our research, development and standardization efforts on developing highly reliable, high-performance, small form factor and cost-effective flash memory storage products to address a variety of emerging markets. 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. We believe our core technical competencies are in:

 

 

We have also initiated, defined and developed standards 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 designed for scaleable, high-yielding, cost-effective and highly reliable manufacturing processes. We design our products to be compatible with industry-standard interfaces used in standard operating systems for personal computers, mobile phones, gaming devices, music players and other consumer and industrial products.

 

Our patented intelligent controller technology with its advanced defect management system permits our flash storage card products to achieve a high level of reliability and longevity. Each one of our flash cards contains many millions of flash memory cells. For example, our 4 gigabyte cards may contain as many as 35 billion storage cells. A failure in any one of these cells or in a group or block of cells can result in loss of data such as picture files, and this can occur several years into the life of a flash storage card. The controller chip inside our cards is designed to detect such defects and recover data under most standard conditions.

 

Our research and development expenses were $194.8 million, $125.0 million and $84.2 million in 2005, 2004 and 2003, respectively.

 

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. See Item 1A, “Risk Factors.”

 

In 1988, we developed the concept of emulation of a hard disk drive with flash solid-state memory. The first related patents were filed by our president and chief executive officer Dr. Eli Harari and exclusively licensed to us. As of the end of 2005, we owned or had rights to 349 United States patents, 212 foreign patents, 450 patent applications pending in the United States, and have foreign counterparts pending on many of the applications in multiple jurisdictions. We intend to seek additional international and United States patents on our technology.

 

On January 13, 2006, we completed the acquisition of Matrix Semiconductor, Inc., or Matrix. Matrix is a pioneer in the design and development of three dimensional semiconductor memory technology. Patents transferred to us upon completion of the acquisition included 124 United States patents, approximately 14 foreign patents, and approximately 141 patent applications pending in the United States, and have foreign counterparts pending on many of the applications in multiple jurisdictions.

 

We have various patent licenses with several companies including, among others, Intel Corporation, or Intel, Lexar Media, Inc., or Lexar, Matsushita, Renesas, Samsung, Sharp Electronics KK, or Sharp, Sony and Toshiba. From time to time, we have also entered into discussions with other companies regarding potential license agreements for our patents.

 

Trade secrets and other confidential information are also important to our business. We protect our trade secrets through confidentiality and invention assignment agreements.

 

Supply Chain.  Our supply chain is an important competitive advantage.

 

 

Ventures with Toshiba

 

FlashVision.  In May 2000, we invested in the FlashVision venture, which operated in Manassas, Virginia until May 2002. In April 2002, we and Toshiba agreed to consolidate the NAND wafer fabrication manufacturing operations in Fabs 1 and 2 of Toshiba’s Yokkaichi operations in Japan, through a venture named FlashVision, Ltd., or FlashVision.

 

 

At the end of fiscal 2005, our loans to FlashVision were 7.3 billion Japanese yen, or approximately $62 million based upon the exchange rate at January 1, 2006, and we are not committed to fund additional amounts in fiscal 2006. FlashVision’s stated life will terminate in December 2016, but may be terminated by Toshiba or by us by notice given from May 16, 2008 to May 15, 2009. There are other termination events described in the master agreement and the operating agreement, which are exhibits to this report. Those agreements should be read carefully in their entirety for a comprehensive understanding of our rights and obligations.

 

 

Flash Partners.  In September 2004, the Flash Partners, Ltd., or Flash Partners, venture was formed. The key elements of the venture are:

 

 

 

 

Flash Partners is expected to generate cash over time as a result of being paid as part of its manufacturing cost for its non-cash depreciation expense. This cash is currently expected to be used to fund expansion of Flash Partners’ flash memory manufacturing capacity and ultimately to repay loans from us and Toshiba.

 

 

We refer to our wafer purchases from the Toshiba ventures and foundry arrangement with Toshiba as captive capacity as compared with our market-priced purchases of flash memory from Samsung and Renesas, which we refer to as non-captive capacity.

 

Competition

 

Our industry is very competitive. We face competition from numerous flash memory card manufacturers, as well as from semiconductor manufacturers of NAND flash memory. We also face competition from hard disk drives and from new technologies. See Item 1A, “Risk Factors.”

 

Our Key Competitive Advantages.  We believe our key competitive advantages in NAND flash products include:

 

 

Semiconductor Competitors.  Our primary semiconductor competitors currently include our historical competitors Renesas, Samsung and Toshiba. New competitors include Hynix Semiconductor, Inc., or Hynix, IM Flash Technologies, LLC, or IM Flash (a new company formed by Micron Technology, Inc., or Micron, and Intel), Infineon Technologies, A.G., or Infineon, Micron, and STMicroelectronics N.V., or STMicro, who began shipping NAND or NAND-competitive memory in 2004. If any of these competitors increase their memory output, it will likely result in a decline in the prevailing prices for packaged NAND semiconductor components. Additionally, manufacturers of NOR flash memory, such as Intel and Spansion LLC, or Spansion, are attempting to use their flash memory for traditional NAND applications, both embedded and in data storage cards.

 

Card and USB Flash Drive Competitors.  We compete with manufacturers and resellers of flash memory cards and USB flash drives. These companies purchase (or have captive supply of) flash memory components and assemble memory cards. These companies include, among others, Buffalo Technology, Dane-Elec Manufacturing, or Dane-Elec, Delkin Devices, Inc., or Delkin, Fuji, Hagiwara Sys-Com Co., Ltd., or Hagiwara, Hama Corporation, Inc., or Hama, I/O Data Device, Inc., or I/O Data, Infineon, Kingmax, Inc., or KingMax, Kingston Technology Company, Inc., or Kingston, Eastman Kodak Company, or Kodak, Lexar, M-Systems, Matsushita, Memorex Products, Inc., or Memorex, Micron, PNY Technologies, Inc., or PNY, PQI Corporation, or PQI Corp., Pretec Electronics Corporation (USA), or Pretec Electronics, Renesas, Samsung, Sharp, SimpleTech, Inc., Sony, Toshiba and Viking Components, Inc., or Viking Components.

 

Digital Audio Players.  Our digital audio players face competition from products offered by other companies, including Apple Computer, Inc., or Apple, Creative Technologies, Ltd., or Creative, iriver America, Inc., or iriver, and Samsung.

Other.  There are other technologies that compete with our product offerings. There are many companies that are attempting to develop memory cells that use different designs and materials than the semiconductors in the marketplace today. When these technologies can be manufactured in high volume, they could have a significant cost advantage over NAND memory technologies. One example is NROM technology which was invented and patented by Saifun Semiconductors Ltd. We also face competition from hard disk drives. Small hard disk drives have a lower cost per megabyte today than does NAND flash; however the minimum density is higher making the hard disk drive expensive in applications that may not require as much memory as the hard disk provides. The hard disk drives in the market today also have significant power requirements and are not as rugged as flash memory. The competitive disadvantages of these other technologies may be reduced or eliminated over time.

 

Employees

 

As of January 1, 2006, we had 1,083 full-time employees, including 450 in research and development, 167 in sales and marketing, 208 in general and administration and 258 in operations. None of our employees is represented by a collective bargaining agreement and we have never experienced any work stoppage. We believe that our employee relations are satisfactory.

 

Executive Officers

 

Our executive officers, who are elected by and serve at the discretion of our Board of Directors, are as follows (all ages are as of March 1, 2006):

 

 

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.

 

Sanjay Mehrotra co-founded SanDisk in 1988 and is Executive Vice President and Chief Operating Officer. He has also served as our Vice President of Engineering, Vice President of Product Development, Director of Memory Design, and Product Engineering. Mr. Mehrotra has more than 25 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 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.

 

Nelson Chan brings more than 20 years of high-technology marketing and engineering experience and has served as our Vice President of Marketing, Senior Vice President, Worldwide Sales and Marketing and Senior Vice President and General Manager, Retail Business Unit. Mr. Chan is currently our Executive Vice President and General Manager of our Consumer and Handheld Business. Prior to joining us in 1992, Mr. Chan held marketing

and engineering positions at Chips and Technologies, Inc., 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. Mr. Chan holds a B.S. degree in Electrical and Computer Engineering from the University of California, Santa Barbara and an M.B.A. degree from Santa Clara University.

 

Judy Bruner has been our Chief Financial Officer and Executive Vice President Administration since June 2004. She served as a member of our board of directors from July 2002 to July 2004. Ms. Bruner has over 25 years of financial management experience, including serving as Senior Vice President and Chief Financial Officer of palmOne, Inc., a provider of handheld computing and communications solutions, from September 1999 until June 2004. Prior to palmOne, Ms. Bruner held financial management positions with 3Com Corporation, Ridge Computers and Hewlett-Packard Company. Ms. Bruner also serves on the board of directors of Ciphergen Biosystems, Inc. Ms. Bruner holds a B.A. degree in Economics from the University of California, Los Angeles and an M.B.A. degree from Santa Clara University.

 

Randhir Thakur has been our Executive Vice President, Technology and Worldwide Operations since October 2005. Prior to joining us, Dr. Thakur was group Vice President and General Manager of the Front End Products Group at Applied Materials. He joined Applied Materials as Chief Technical Officer of the Transistor and Capacitor Products Business Group. Previously, Dr. Thakur was the Chief Technology Officer and General Manager at Steag Electronic Systems. He also worked at AG Associates as Vice President of Research and Development and he held various technical and management positions at Micron Technology. Dr. Thakur holds more than 250 patents and has published more than 200 technical publications. Dr. Thakur received his B.S. degree (honors) in Electronics and Telecommunications Engineering from the Regional Engineering College, Kurukshetra, India, and a M.S. degrees in Electrical Engineering from the University of Saskatchewan, Canada. Dr. Thakur received his Ph.D. in Electrical Engineering from the University of Oklahoma.

 

Yoram Cedar is our Executive Vice President, Handset Business and Corporate Engineering. Prior to October 2005, Mr. Cedar served as our Senior Vice President of Engineering and Emerging Market Business Development. Mr. Cedar began his career at SanDisk in 1998 when he joined as Vice President of Systems Engineering. He has extensive experience working in product definition, marketing and development of systems and embedded flash-based semiconductors. Prior to SanDisk, he was the Vice President of New Business Development at Waferscale Integration and has more than 27 years of experience in design and engineering management of electronic systems. Mr. Cedar earned B.S. and M.S. degrees in Electrical Engineering and Computer Architecture from Technion, Israel Institute of Technology, Haifa, Israel.

 

Our operating results may fluctuate significantly, which may adversely affect our operations 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 could result from a variety of factors, including, among others, the following:

 

 

 

Sales to a small number of customers represent a significant portion of our revenues and, if we were to lose one of our major licensees or customers or experience any material reduction in orders from any of our customers, our revenues and operating results would suffer.  Sales to our top 10 customers and licensees accounted for more than 50%, 55% and 48% of our total revenues during the fiscal years of 2005, 2004 and 2003, respectively. If we were to lose one of our major licensees or customers or experience any material reduction in orders from any of our customers or in sales of licensed products by our licensees, our revenues and operating results would suffer. Additionally, our license and royalty revenues may decline significantly in the future as our existing license agreements expire. Our sales are generally made by standard purchase orders rather than long-term contracts. Accordingly, our customers may generally terminate or reduce their purchases from us at any time without notice or penalty. In addition, the composition of our major customer base changes from year-to-year as we enter new markets.

 

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.  A significant portion of our sales are made through retailers, either directly or through distributors. Sales through these channels typically include rights to return unsold inventory and protection against price declines. As a result, we do not recognize revenue until after the product has been sold through to the end user, in the case of sales to retailers, or to our distributors’ customers, in the case of sales to distributors. If our distributors and retailers are not successful in this market, we could experience substantial product returns or price protection claims, which would harm our business, financial condition and results of operations. Availability of sell-through data varies throughout the retail channel, which makes it difficult for us to determine actual retail product revenues until after the end of each of our fiscal quarters. Our arrangements with our customers also provide them price protection against declines in our recommended selling prices, which has the effect of reducing our deferred revenue and eventually revenue. Except in limited circumstances, we do not have exclusive relationships with our retailers or distributors and therefore must rely on them to effectively sell our products over those of our competitors.

 

Our average selling prices, net of promotions, may decline due to excess supply, competitive pricing pressures and strategic price reductions initiated by us or our competitors.  The market for NAND flash products is competitive and characterized by rapid price declines. Price declines may be influenced by, among other factors, strategic price decreases by us or our competitors such as that implemented by us in the first quarter of 2006, supply

in excess of demand from existing or new competitors, technology transitions, including adoption of multi-level cell, or MLC, by other competitors, new technologies or other strategic actions by competitors to gain market share. If our technology transitions and cost reductions fail to keep pace with the rate of price decline or our price decreases fail to generate sufficient additional demand, our gross margin and operating results will be negatively impacted.

 

Our revenue depends in part on the success of products sold by our OEM customers.  A portion of our sales are to a number of OEMs, who bundle our flash memory products with their products, such as cameras or handsets. Our sales to these customers are dependent upon the OEM choosing our products over those of our competitors and on the OEM’s ability to create, introduce, market and sell these products successfully in its respective markets. Should our OEM customers be unsuccessful in selling their current or future products that include our product, or should they decide to discontinue bundling our products, our results of operation and financial condition could be harmed.

 

The continued growth of our business depends on the development of new markets and products for NAND flash memory.  Over the last several years, we have derived the majority of our revenue from the digital camera market. This market continues to experience slower growth rates for our products and continues to represent a declining percentage of our total revenue and therefore, our growth will be increasingly dependent on the development of new markets and new products for NAND flash memory. Furthermore, in 2005, our revenue from the digital camera market grew by only 4% over the prior year, and it is possible that our revenue from this market could decline in future years. Newer markets for flash memory include USB drives, handsets, gaming and digital audio players. There can be no assurance that new markets and products will develop and grow fast enough, or that new markets will adopt NAND flash technologies or our products, to enable us to continue our growth.

 

We continually seek to develop new applications, products, technologies and standards, which may not be widely adopted by consumers or, if adopted, may reduce demand by consumers for our older products.  We continually seek to develop new applications, products and standards and enhance existing products and standards with higher memory capacities and other enhanced features. New applications, such as the adoption of flash memory cards in mobile handsets, can take several years to develop. Early successes in working with handset manufacturers to add card slots to their mobile phones does not guarantee that consumers will adopt memory cards used for storing songs, images and other content. Our new products may not gain market acceptance and we may not be successful in penetrating the new markets that we target, such as handsets, digital audio players or pre-recorded flash memory cards. As we introduce new standards or technologies, such as TrustedFlash, it can take time for these new standards or technologies to be adopted, for consumers to accept and transition to these new standards or technologies and for significant sales to be generated from them, if this happens at all. Moreover, broad acceptance of new standards, technologies or products by consumers may reduce demand for our older products. For example, the digital still camera market is shifting away from use of CompactFlash memory cards to other form factors, such as SD cards. If this decreased demand is not offset by increased demand for our other form factors or our new products, our results of operations could be harmed. Any new applications, products, technologies or standards we develop may not be commercially successful.

 

We face competition from numerous manufacturers and marketers of products using flash memory, as well as from manufacturers of new and alternative technologies, and if we cannot compete effectively, our results of operations and financial condition will suffer.  Our competitors include many large domestic and international companies that have greater access to advanced wafer manufacturing capacity and substantially greater financial, technical, marketing and other resources than we do, which allows them to produce flash memory chips in high volumes at low costs and to sell these flash memory chips themselves or to our flash card competitors at a low cost. Some of our competitors may sell their flash memory chips at or below their true manufacturing costs to gain market share and to cover their fixed costs. Such practices have been common in the DRAM industry during periods of excess supply, and have resulted in substantial losses in the DRAM industry. In addition, many semiconductor companies have begun to bring up substantial new capacity of flash memory, including MLC flash memory. For example, Samsung began shipping its first MLC chips in the third quarter of 2005 and further ramped its MLC output in the fourth quarter of 2005. In addition, Hynix is aggressively ramping NAND output and IM Flash is expected to produce significant NAND output in the future. If the combined total new flash memory capacity exceeds the corresponding growth in demand, prices may decline dramatically, adversely impacting our results of

operations and financial condition. In addition, current and future competitors produce or could produce alternative flash memory technologies that compete against our NAND flash memory technology.

 

Our primary semiconductor competitors continue to include our historical competitors Renesas, Samsung and Toshiba. New competitors include Hynix, Infineon, Micron and STMicro, which began shipping NAND or NAND-competitive memory in 2004. If any of these competitors increase their memory output, as Hynix recently has, it will likely result in a decline in the prevailing prices for packaged NAND semiconductor components.

 

We compete with flash memory card manufacturers and resellers. These companies purchase, or have a captive supply of, flash memory components and assemble memory cards. These companies include, among others, Dane-Elec, Delkin, Fuji, Hagiwara, Hama, I/O Data, Infineon, Jessops PLC, KingMax, Kingston, Lexar, M-Systems, Matsushita Battery Industrial Co., Ltd., Matsushita, Micron, Memorex, Panasonic, PNY, PQI Corp., Pretec Electronics, Renesas, Samsung, Sharp, Sony, Toshiba and Viking Components.

 

Some of our competitors have substantially greater resources than we do, have well recognized brand names or have the ability to operate their business on lower margins than we do. The success of our competitors may adversely affect our future sales revenues and may result in the loss of our key customers. For example, Samsung, with significant manufacturing capacity, brand recognition and access to broad distribution channels, provides competing flash cards, such as the MMC micro^tm that competes directly with our microSD mobile card. Lexar markets a line of flash cards bearing the Kodak brand name, which competes with our flash memory cards. Our handset card products also face competition from embedded solutions from competitors including Intel, M-Systems and Samsung. Our digital audio players face competition from similar products offered by other companies, including Apple, Creative, iriver and Samsung. Our USB flash drives face competition from Lexar, Memorex, M-Systems and PNY, among others. If our products cannot compete effectively, our market share and profitability will be adversely impacted.

 

Furthermore, many companies are pursuing new or alternative technologies, such as nanotechnologies or microdrives, which may compete with flash memory. These new or alternative technologies may provide smaller size, higher capacity, reduced costs, lower power consumption or other advantages. If we cannot compete effectively, our results of operations and financial condition will suffer.

 

We have patent cross-license agreements with several of our leading competitors. Under these agreements, we have enabled competitors to manufacture and sell products that incorporate technology covered by our patents. If we continue to license our patents to our competitors, competition may increase and may harm our business, financial condition and results of operations.

 

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

 

 

We may not be able to successfully compete in the marketplace.

 

The semiconductor industry is subject to significant downturns that have harmed our business, financial condition and results of operations in the past and may do so in the future.  The semiconductor industry is highly

cyclical and is characterized by constant and rapid technological change, rapid product obsolescence and price declines, evolving standards, short product life cycles and wide fluctuations in product supply and demand. The industry has experienced significant downturns, often in connection with, or in anticipation of, maturing product cycles of both semiconductor companies’ and their customers’ products and declines in general economic conditions. These downturns have been characterized by diminished product demand, production overcapacity, high inventory levels and accelerated declines in selling prices. We have experienced these conditions in our business in the past and may experience such downturns in the future.

 

Our business and the markets we address are subject to significant fluctuations in supply and demand and our commitments to our ventures with Toshiba may result in losses.  Through our ramp in Flash Partners, we expect our 2006 captive memory supply to increase by a higher percentage than our flash memory supply increased in either of the last two years. Our obligation to purchase 50% of the output from FlashVision and Flash Partners could harm our business and results of operations if our committed supply exceeds demand for our products. The adverse effects could include, among other things, significant decreases in our product prices, significant excess, obsolete or lower of cost or market inventory write-downs and the impairment of our investments in the ventures with Toshiba. Any future excess supply could have a material adverse effect on our business, financial condition and results of operations.

 

We depend on third-party foundries for silicon supply 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 supply for the memory and controller components. The substantial majority of our flash memory is currently supplied by our ventures with Toshiba and by Toshiba pursuant to our foundry agreement, and to a lesser extent by Renesas and Samsung. Any disruption in supply of flash memory from our captive or non-captive sources would harm our operating results. For example, we intend to increase production at Fab 3 and we also procure wafers from non-captive sources. If Fab 3 production ramp does not increase as anticipated or our non-captive sources fail to supply wafers in the amounts and at the times we expect, we may not have sufficient supply to meet demand and our operating results will be harmed. Currently, our controller wafers are only manufactured by Tower and UMC, and some of these controllers are sole-sourced at either UMC or Tower. Any disruption in the manufacturing operations of Tower or UMC would result in delivery delays, would adversely affect our ability to make timely shipments of our products and would harm our operating results until we could qualify an alternate source of supply for our controller wafers, which could take three or more quarters to complete. In times of significant growth in global demand for flash memory, demand from our customers may outstrip the supply of flash memory and controllers available to us from our current sources. If our silicon vendors are unable to satisfy our requirements on competitive terms or at all due to lack of capacity, technological difficulties, natural disaster, financial difficulty, power failure, labor unrest, their refusal to do business with us, their relationships with our competitors or other causes, we may lose potential sales and our business, financial condition and operating results may suffer. In addition, these risks are magnified at Toshiba’s Yokkaichi operations, where the ventures are operated and Toshiba’s foundry capacity is located. For example, earthquakes, as well as unrelated power outages, have resulted in production line stoppage and loss of wafers in Yokkaichi and similar stoppages and losses may occur in the future. Also, the Tower fabrication facility, from which we source controller wafers, is facing financial challenges and is located in Israel, an area of political turmoil. Any disruption or delay in supply from our silicon sources could significantly harm our business, financial condition and results of operations.

 

Our actual manufacturing yields may be lower than our expectations resulting in increased costs and product shortages.  The fabrication of our products requires wafers to be produced in a highly controlled and ultra clean environment. Semiconductor manufacturing yields and product reliability are a function of both design technology and manufacturing process technology and production delays may be caused by equipment malfunctions, fabrication facility accidents or human errors. Yield problems may not be identified 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. We have from time to time experienced yields which have adversely affected our business and results of operations. We have experienced adverse yields on more than one occasion when we have transitioned to new generations of products. If actual yields are low, we will experience higher costs and reduced product supply, which could harm our business, financial condition and results of operations. For example, if the production ramp and/or yield of the 70-nanometer, 300-millimeter Flash Partners wafers does not increase as expected, we may not

have enough supply to meet demand and our cost competitiveness, business, financial condition and results of operations will be harmed.

 

We depend on our third-party subcontractors and our business could be harmed if our subcontractors do not perform as planned.  We rely on third-party subcontractors for our wafer testing, IC assembly, packaged testing, product assembly, product testing and order fulfillment. From time to time, our subcontractors have experienced difficulty in meeting our requirements. If we are unable to increase the capacity of our current sub-contractors or qualify and engage additional sub-contractors, we may not be able to meet demand for our products. We do not have long-term contracts with our existing subcontractors nor do we expect to have long-term contracts with any new subcontract suppliers. We do not have exclusive relationships with any of our subcontractors and therefore cannot guarantee that they will devote sufficient resources to manufacturing our products. We cannot, and will not, be able to directly control product delivery schedules. Furthermore, we manufacture on a turnkey basis with some of our subcontract suppliers. In these arrangements we do not have visibility and control of their inventories of purchased parts necessary to build our products or of the progress of our products through their assembly line. 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, either of which would have adverse effects on our operating results.

 

In transitioning to new processes, products and silicon sources, we face production and market acceptance risks that have caused, and may in the future cause significant product delays that could harm our business.  Successive generations of our products have incorporated semiconductors with greater memory capacity per chip. The transition to new generations of products, such as the 70-nanometer 8 gigabit MLC chip which we began shipping in the third quarter of 2005, is highly complex and requires new controllers, new test procedures and modifications of numerous aspects of manufacturing, as well as extensive qualification of the new products by both us and our OEM customers. In addition, procurement of MLC wafers from non-captive sources requires us to develop new controller technology and may result in inadequate quality or performance in our products that integrate these MLC components. Any material delay in a development or qualification schedule could delay deliveries and adversely impact our operating results. We periodically have experienced 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.

 

Our products may contain errors or defects, which could result in the rejection of our products, product recalls, damage to our reputation, lost revenues, diverted development resources and increased service costs and warranty claims and litigation.  Our products are complex, must meet stringent user requirements, may contain errors or defects and the majority of our products are warrantied for one to five years. Errors or defects in our products may be caused by, among other things, errors or defects in the memory or controller components, including components we procure from non-captive sources such as the MLC products we procure from a third-party supplier. These factors could result in the rejection of our products, damage to our reputation, lost revenues, diverted development resources, increased customer service and support costs and warranty claims and litigation. We record an allowance for warranty and similar costs in connection with sales of our product, but actual warranty and similar costs may be significantly higher than our recorded estimate and result in an adverse effect on our results of operations and financial condition.

 

Our new products have from time to time been introduced with design and production errors at a rate higher than the error rate in our established products. We must estimate warranty and similar costs for new products without historical information and actual costs may significantly exceed our recorded estimates. Underestimation of our warranty and similar costs would have an adverse effect on our results of operations and financial condition.

 

We and Toshiba plan to continue to expand the wafer fabrication capacity of the Flash Partners business venture and as we do so, we will make substantial capital investments and incur substantial start-up and tool relocation costs, which could adversely impact our operating results.  We and Toshiba are making, and plan to continue to make, substantial investments in new capital assets to expand the wafer fabrication capacity of our Flash Partners business venture in Japan. We and Toshiba recently announced our intention to accelerate expansion at Fab 3 to bring wafer capacity to 70,000 wafers per month by March 2007 and in addition, we and Toshiba are considering a potential new advanced NAND Fab beyond Fab 3. Each time that we and Toshiba add substantial new wafer fabrication capacity, we will experience significant initial design and development and start-up costs as a

result of the delay between the time of the investment and the time qualified products are manufactured and sold in volume quantities. For several quarters, we will incur initial design and development costs and start-up costs and pay our share of ongoing operating activities even if we do not achieve the planned output volume or utilize our full share of the expanded output, and these costs will impact our gross margins, results of operations and financial condition.

 

There is no assurance that Flash Partners’ 300-millimeter NAND flash memory facility will perform as expected.  We believe that our future success will continue to depend on the development and introduction of new generations of flash memory wafers, such as the 300-millimeter wafers produced by Flash Partners. These wafers are substantially larger in surface area and therefore more susceptible to new technological and manufacturing issues, such as mechanical and thermal stresses, than 200-millimeter wafers that we use in production at Yokkaichi Fabs 1 and 2. We have limited experience in operating a wafer manufacturing line and we rely on Toshiba’s capability to operate and manage the Yokkaichi facilities. Toshiba does not have prior experience in manufacturing 300-millimeter advanced NAND designs, nor in operating a new equipment set that has to be optimized to process 300-millimeter NAND wafers with competitive yields. Flash Partners’ facility may not perform as expected or ramp to volume production on time, and the cost to equip the facility may be significantly more than planned. Samsung, the world’s largest NAND flash memory manufacturer, already has experience manufacturing 300-millimeter wafers with 90- and 70-nanometer feature sizes. Also, Samsung is licensed under our patents to use MLC technology, which further enhances its manufacturing capabilities, and began shipping NAND/MLC products in the third quarter of 2005. Samsung may be able to produce product at a lower cost than we can and increase their market share, thus adversely affecting our operating results and financial condition.

 

We have a contingent indemnification obligation for certain liabilities Toshiba incurs as a result of Toshiba’s guarantee of the FlashVision equipment lease arrangement and have environmental and intellectual property indemnification as well as guarantee obligations with respect to Flash Partners.  Toshiba has guaranteed FlashVision’s lease arrangement with third-party lessors. The total minimum remaining lease payments as of January  1, 2006 were 17.7 billion Japanese yen, or approximately $150 million based upon the exchange rate at January 1, 2006. If Toshiba makes payments under its guarantee, we have agreed to indemnify Toshiba for 49.9% of its costs.

 

In December 2004, Flash Partners entered into an equipment lease facility of 50.0 billion Japanese yen, or approximately $424 million based upon the exchange rate at January 1, 2006, which, as of January 1, 2006, had been drawn down in its entirety. As of January 1, 2006, our cumulative guarantee under this equipment lease, net of cumulative lease payments was approximately 24.0 billion Japanese yen, or approximately $203 million based on the exchange rate at January 1, 2006. In December 2005, Flash Partners secured an additional equipment lease facility of 35.0 billion Japanese yen, or approximately $296 million based upon the exchange rate at January 1, 2006. Flash Partners had not drawn under this equipment lease facility at the end of fiscal 2005; however, the entire amount was drawn down in January 2006. We and Toshiba each guaranteed, on a several basis, 50% of Flash Partners’ obligation under this master lease.

 

We and Toshiba have also agreed to mutually contribute to, and indemnify each other and Flash Partners for, environmental remediation costs or liability resulting from Flash Partners’ manufacturing operations in certain circumstances. In addition, we and Toshiba entered into a Patent Indemnification Agreement under which in many cases we will share in the expenses associated with the defense and cost of settlement associated with such claims. This agreement provides limited protection for us against third-party claims that NAND flash memory products manufactured and sold by Flash Partners infringe third-party patents.

 

None of the foregoing obligations are reflected as liabilities on our consolidated balance sheets. If we have to perform our obligations under these agreements, our business will be harmed and our financial condition and results of operations will be adversely affected.

 

Seasonality in our business may result in our inability to accurately forecast our product purchase requirements.  Sales of our products in the consumer electronics market are subject to seasonality. For example, sales have typically increased significantly in the fourth quarter of each year, sometimes followed by declines in the first quarter of the following year. This seasonality increases the complexity of forecasting our business. If our forecasts are inaccurate, we can lose market share or procure excess inventory or inappropriately increase or decrease our

operating expenses, any of which could harm our business, financial condition and results of operations. This seasonality also may lead to higher volatility in our stock price, the need for significant working capital investments in receivables and inventory and our need to build up inventory levels in advance of our most active selling seasons.

 

From time to time, we overestimate our requirements and build excess inventories, and underestimate our requirements and have a shortage of supply, both of which harm our financial results.  The majority of our products are sold into consumer markets, which are difficult to accurately forecast. Also, a substantial majority of our quarterly sales are from orders received and fulfilled in that quarter. Additionally, we depend upon timely reporting from our retail and distributor customers as to their inventory levels and sales of our products in order to forecast demand for our products. Our international customers submit these reports on a monthly, not weekly, basis making it more difficult to accurately forecast demand. We have in the past significantly over-forecasted and under-forecasted actual demand for our products. The failure to accurately forecast demand for our products will result in lost sales or excess inventory both of which will have an adverse effect on our business, financial condition and results of operations. In addition, at times inventories may increase in anticipation of increased demand or as captive wafer capacity ramps. If demand does not materialize, we may be forced to write-down excess inventory which may harm our financial condition and results of operations.

 

Under conditions of tight flash memory supply, we may be unable to adequately increase our production volumes or secure sufficient supply in order to maintain our market share. If we are unable to maintain market share, our results of operations and financial condition could be harmed. Conversely, during periods of excess supply in the market for our flash memory products, we may lose market share to competitors who aggressively lower their prices.

 

Our ability to respond to changes in market conditions from our forecast is limited by our purchasing arrangements with our silicon sources. These arrangements generally provide that the first three months of our rolling nine-month projected supply requirements are fixed and we may make only limited percentage changes in the second three months of the period covered by our supply requirement projections.

 

We are sole sourced for a number of our critical components and the absence of a back-up supplier exposes our supply chain to unanticipated disruptions.  We rely on our vendors, some of which are a sole source of supply, for many of our critical components. We do not have long-term supply agreements with most 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.

 

We are exposed to foreign currency risks.  Our purchases of NAND flash memory from the Toshiba venture and our investments in those ventures are denominated in Japanese yen. Additionally, we expect over time to increase the percentage of our sales denominated in currencies other than the U.S. dollar. Management of these foreign exchange exposures and the foreign currency forward contracts used to mitigate these exposures is complicated and if we do not successfully manage our foreign exchange exposures, our business, results of operations and financial condition could be harmed.

 

Terrorist attacks, war, threats of war and government responses thereto may negatively impact our operations, revenues, costs and stock price.  Terrorist attacks, U.S. military responses to these attacks, war, threats of war and any corresponding decline in consumer confidence could have a negative impact on consumer retail demand, which is the largest channel for our products. Any of these 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. 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 or adversely affect consumer confidence. This could harm our business and results of operations.

 

Natural disasters or epidemics in the countries in which we or our suppliers or subcontractors operate could negatively impact our operations.  Our operations, including those of our suppliers and subcontractors, are concentrated in Sunnyvale, California, Yokkaichi, Japan, Hsinchu and Taichung, Taiwan and Dongguan, Shanghai and Shenzen, China. In the past, these areas have been affected by natural disasters such as earthquakes, tsunamis and typhoons, and some areas have been affected by epidemics, such as SARS. If a natural disaster or epidemic were

to occur in one or more or these areas, our disaster recovery processes may not provide adequate business continuity. In addition, we do not have insurance for most natural disasters, including earthquakes. This could harm our business and results of operations.

 

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 and expensive disputes regarding our intellectual property rights and those of others, including claims that we may be infringing third parties’ patents, trademarks and other intellectual property rights. We expect that we may be involved in similar disputes in the future.

 

We cannot assure you that:

 

 

In addition, our competitors may be able to design their products around our patents and other proprietary rights.

 

Several companies have recently entered or announced their intentions to enter the flash memory market, and we believe these companies may require a license from us. Enforcement of our rights may require litigation. If we bring a patent infringement action and are not successful, our competitors would be able to use similar technology to compete with us. Moreover, the defendant in such an action may successfully countersue us for infringement of their patent or assert a counterclaim that our patents are invalid or unenforceable. If we did not prevail as a defendant in patent infringement case, 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 specific processes or obtain licenses to the infringing technology.

 

We may be unable to license intellectual property to or from third parties as needed, or renew existing licenses, and we 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 products.  If we incorporate third-party technology into our products or if we are found to infringe 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 important cross-licenses to third-party patents. We cannot be certain that licenses will be offered when we need them, or that the terms offered will be acceptable, or that these licenses will help our business. 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 product suppliers from using processes that may infringe the rights of third parties. We may not be successful in redesigning our products, the necessary licenses may not be available under reasonable terms, our existing licensees may not renew their licenses upon expiration and we may not be successful in signing new licensees in the future.

 

We are currently and may in the future be involved in litigation, including litigation regarding our intellectual property rights or those of third parties, which may be costly, may divert the efforts of our key personnel and could result in adverse court rulings which could materially harm our business.  We are involved in a number of lawsuits, including among others, several cases involving our patents and the patents of third parties. We are the plaintiff in some of these actions and the defendant in other of these actions. Some of the actions could seek injunctions against the sale of our products and/or substantial monetary damages, which if granted or awarded, could have a material adverse effect on our business, financial condition and results of operations.

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. If we receive an adverse judgment in any litigation, we could be required to pay substantial damages and/or cease the manufacture, use and sale of products. Litigation, including intellectual property litigation, can be complex, can extend for a protracted period of time, and can be very expensive. Litigation initiated by us could also result in counter-claims against us, which could increase the costs associated with the litigation and result in our payment of damages or other judgments against us. In addition, litigation may divert the efforts and attention of some of our key personnel.

 

We have been, and expect to continue to be, subject to claims and legal proceedings regarding alleged infringement by us of the patents, trademarks and other intellectual property rights of third parties. From time to time we have sued, and may in the future sue, third parties in order to protect our intellectual property rights. Parties that we have sued and that we may sue for patent infringement may countersue us for infringing their patents. If we are held to infringe the intellectual property of others, we may need to spend significant resources to develop non-infringing technology or obtain licenses from third parties, but we may not be able to develop such technology or acquire such licenses on terms acceptable to us or at all. We may also be required to pay significant damages and/or discontinue the use of certain manufacturing or design processes. In addition, we or our suppliers could be enjoined from selling some or all of our respective products in one or more geographic locations. If we or our suppliers are enjoined from selling any of our respective products or if we are required to develop new technologies or pay significant monetary damages or are required to make substantial royalty payments, our business would be harmed.

 

Moreover, from time to time 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. Third-party claims for patent infringement are excluded from coverage under our insurance policies. A future obligation to indemnify our customers or suppliers may have a material adverse effect on our business, financial condition and results of operations. For additional information concerning legal proceedings, see Item 3, “Legal Proceedings.”

 

Because of our international business and operations, we must comply with numerous international laws and regulations, and we are vulnerable to political instability, currency fluctuations and other risks related to international operations.  Currently, all of our products are produced overseas in China, Israel, Japan, Taiwan and South Korea. We may, therefore, be affected by the political, economic and military conditions in these countries.

 

Specifically, China does not currently have a comprehensive and highly developed legal system, particularly with respect to the protection of intellectual property rights. This result, among other things, in the prevalence of counterfeit goods in China. The enforcement of existing and future laws and contracts remains 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. Our results of operations and financial condition could be harmed by the sale of counterfeit products.

 

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

 

 

 

Tower Semiconductor’s Financial Situation is Challenging.  Tower supplies a significant portion of our controller wafers from its Fab 2 facility and is currently a sole source of supply for some of our controllers. Tower’s Fab 2 is operational but has not been completed and a continued supply of controllers to us from Tower on a cost-effective basis may be dependent on this completion. Tower’s completion of the equipment installation, technology transfer and ramp-up of production at Fab 2 is dependent upon Tower (a) having, or being able to raise, sufficient funds to complete the Fab 2 project; (b) meeting the conditions to receive Israeli government grants and tax benefits approved for Fab 2; and (c) obtaining the approval of the Israeli Investment Center to extend the five-year investment period under its Fab 2 approved enterprise program. In addition, Tower recently entered into an amendment to the credit facility agreement with its banks. If Tower fails to raise funds in the amounts and at the times required under the amended credit facility agreement or otherwise fails to comply with the revised financial ratios and covenants to avoid being in default under its amended bank credit agreements, Tower may have to cease operations. If this occurs, we will be forced to source our controllers from another supplier and our business, financial condition and results of operations may be harmed. Specifically, our ability to supply a number of products would be disrupted until we were able to transition manufacturing and qualify a new foundry with respect to controllers that are currently sole sourced at Tower, which could take three or more quarters to complete.

 

We have recognized cumulative losses of approximately $53.6 million as a result of the other-than-temporary decline in the value of our investment in Tower ordinary shares, $10.1 million as a result of the impairment in value on our prepaid wafer credits and $1.3 million of losses on our warrant to purchase Tower ordinary shares as of January 1, 2006. Of the approximately 10.2 million Tower ordinary shares we own, we agreed not to sell approximately 7.2 million shares at January 1, 2006. This restriction is no longer in effect in fiscal 2006; however, we do remain subject to certain restrictions on the transfer of our Tower ordinary shares including certain rights of first refusal, and through January 2008, have agreed to maintain minimum shareholdings. It is possible that we will record further write-downs of our investment, which was carried on our consolidated balance sheet at $12.9 million as of January 1, 2006, which would harm our results of operations and financial condition.

 

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 may continue to fluctuate in the future. We believe that such fluctuations will continue as a result of many factors, including future announcements concerning us, our competitors or principal customers regarding financial results or expectations, technological innovations, new product introductions, governmental regulations, the commencement or results of 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.

 

We may make acquisitions that are dilutive to existing stockholders, result in unanticipated accounting charges or otherwise adversely affect our results of operations, and result in difficulties in assimilating and integrating the operations, personnel, technologies, products and information systems of acquired companies or businesses.  We continually evaluate and explore strategic opportunities as they arise, including business combinations, strategic partnerships, collaborations, capital investments and the purchase, licensing or sale of assets. If we issue equity

securities in connection with an acquisition, the issuance may be dilutive to our existing stockholders. Alternatively, acquisitions made entirely or partially for cash would reduce our cash reserves.

 

Acquisitions may require significant capital infusions, typically entail many risks and could result in difficulties in assimilating and integrating the operations, personnel, technologies, products and information systems of acquired companies. In order to realize the intended benefits of our recent acquisition of Matrix Semiconductor, Inc., we will have to successfully integrate and retain key Matrix personnel. We may experience delays in the timing and successful integration of acquired technologies and product development through volume production, unanticipated costs and expenditures, changing relationships with customers, suppliers and strategic partners, or contractual, intellectual property or employment issues. In addition, key personnel of an acquired company may decide not to work for us. The acquisition of another company or its products and technologies may also result in our entering into a geographic or business market in which we have little or no prior experience. These challenges could disrupt our ongoing business, distract our management and employees, harm our reputation and increase our expenses. These challenges are magnified as the size of the acquisition increases, and we cannot assure you that we will realize the intended benefits of any acquisition. Furthermore, acquisitions may require large one-time charges and can result in increased debt or contingent liabilities, adverse tax consequences, substantial depreciation or deferred compensation charges, the amortization of identifiable purchased intangible assets or impairment of goodwill, any of which could have a material adverse effect on our business, financial condition or results of operations.

 

Our success depends on key personnel, including our executive officers, the loss of who 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. We do not have employment agreements with any of our executive officers and they are free to terminate their employment with us at any time. Our success will also depend on our ability to recruit additional highly skilled personnel. We may not be successful in hiring or retaining key personnel and our key personnel may not remain employed with us.

 

To manage our growth, we may need to improve our systems, controls and procedures.  We have experienced and may continue to experience rapid growth, which has placed, and could continue to place a significant strain on our managerial, financial and operations resources and personnel. We expect that our number of employees, including management-level employees, will continue to increase for the foreseeable future. We must continue to improve our operational, accounting and financial systems and managerial controls and procedures, including fraud procedures, and we will need to continue to expand, as well as, train and manage our workforce. If we do not manage our growth effectively, our business could be harmed.

 

We expect to raise additional financing, which could be difficult to obtain, and which if not obtained in satisfactory amounts may prevent us from funding the ventures with Toshiba, increasing our wafer supply, 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 believe that we have sufficient cash resources to fund our operations as well as our investments in Flash Partners for at least the next twelve months; however, we expect to raise additional funds, including funds to meet our obligations with respect to Flash Partners, and 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, equity or lease financings. If we issue additional equity securities, our stockholders will experience dilution and the new equity securities may have rights, preferences or privileges senior to those of existing holders of common stock or debt securities. If we raise funds through debt or lease 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, fulfill our obligations to Flash Partners, 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.

 

Anti-takeover provisions in our charter documents, stockholder rights plan and in Delaware law could discourage 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 a

stockholders’ 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 discourage an acquisition of us. In addition, our certificate of incorporation grants our 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 (2,000,000 of which have already been reserved under our stockholder rights plan). Issuing preferred stock 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 a corporation may not engage in any business combination with any interested stockholder during the three-year period following the time that a stockholder became an interested stockholder. This provision could have the effect of delaying or discouraging a change of control of SanDisk.

 

Changes in securities laws and regulations have increased our costs; further, in the event we are unable to satisfy regulatory requirements relating to internal control, or if our internal control over financial reporting is not effective, our business could suffer.  The Sarbanes-Oxley Act of 2002 that became law in July 2002 required changes in our corporate governance, public disclosure and compliance practices. The number of rules and regulations applicable to us has increased and will continue to increase our legal and financial compliance costs, and has made some activities more difficult, such as stockholder approval of new option plans. In addition, we have incurred and expect to continue to incur significant costs in connection with compliance with Section 404 of that law regarding internal control over financial reporting. These laws and regulations and perceived increased risk of liability could make it more difficult for us to attract and retain qualified members of our board of directors, particularly to serve on our audit committee, and qualified executive officers. We cannot estimate the timing or magnitude of additional costs we may incur as a result.

 

In connection with our certification process under Section 404 of the Sarbanes-Oxley Act of 2002, we have identified and will from time to time identify a number of deficiencies in our internal control over financial reporting. We cannot assure you that individually or in the aggregate these deficiencies would not be deemed to be a material weakness. Furthermore, we may not be able to implement enhancements on a timely basis in order to prevent a failure of our internal controls or enable us to furnish future unqualified certifications. A material weakness or deficiency in internal control over financial reporting could materially impact our reported financial results and the market price of our stock could significantly decline. Additionally, adverse publicity related to the disclosure of a material weakness or deficiency in internal controls over financial reporting could have a negative impact on our reputation, business and stock price. Any internal control or procedure, no matter how well designed and operated, can provide only reasonable assurance of achieving desired control objectives.

 

Not applicable.

 

Our principal facilities are located in Sunnyvale, California. We lease three adjacent buildings comprising approximately 206,000 square feet. These facilities house our corporate offices, the majority of our engineering team, as well as a portion of our sales, marketing, operations and corporate services organizations. We occupy this space under lease agreements that expire in June 2006. In January 2006, we entered into an agreement to lease three adjacent buildings located in Milpitas, California, comprising approximately 349,000 square feet. Our corporate offices, the majority of our engineering team, as well as a portion of our sales, marketing, operations and corporate services organizations expect to move to these new facilities in June 2006.

 

We also lease sales and marketing offices in the United States, Japan, Germany, Hong Kong , Ireland, the Netherlands and Scotland, and operation support offices in Taichung, Taiwan, Shanghai and Shenzhen, China and design centers in Tefen and Petah Tikva, Israel, Edinburgh, Scotland and Bangalore, India.

 

From time to time, it has been and may continue to be necessary to initiate or defend litigation against third parties. These and other parties could bring suit against us.

 

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 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. The case as to us was stayed pending the outcome of litigation in the District Court of Nevada related to the same Lemelson bar code scanning patents asserted against us. In early 2004, the Nevada Court ruled that the Lemelson bar code patents (as well as other Lemelson patents) were invalid, not infringed and unenforceable. The Nevada Court’s findings were thereafter affirmed by the Federal Circuit. Based on the Federal Circuit’s affirmance, the Lemelson Foundation moved to dismiss with prejudice all claims against us, and that request for dismissal has been granted.

 

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 Case 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. The court granted summary judgment of non-infringement in favor of defendants Ritek, Pretec and Memorex and entered judgment on May 17, 2004. On June 2, 2004, we filed a notice of appeal of the summary judgment rulings to the United States Court of Appeals for the Federal Circuit. On July 8, 2005, the Federal Circuit held in favor of SanDisk, vacating the judgment of non-infringement and remanding the case back to district court.

 

On or about June 9, 2003, we received written notice from Infineon Technologies AG, or Infineon, that it believes we have infringed its U.S. Patent No. 5,726,601 (the ‘601 patent). On June 24, 2003, we filed a complaint against Infineon for a declaratory judgment of patent non-infringement and invalidity regarding the ‘601 patent in the United States District Court for the Northern District of California, captioned SanDisk Corporation v. Infineon Technologies AG, a German corporation, et al., Civil Case No. C 03 02931 BZ. On October 6, 2003, Infineon filed an answer and counterclaim: (a) denying that we are entitled to the declaration sought by the our complaint; (b) requesting that we be adjudged to have infringed, actively induced and/or contributed to the infringement of the ‘601 patent and an additional patent, U.S. Patent No. 4,841,222 (the ‘222 patent). On August 12, 2004, Infineon filed an amended counterclaim for patent infringement alleging that we infringe U.S. Patent Nos. 6,026,002 (the ‘002 patent); 5,041,894 (the ‘894 patent); and 6,226,219 (the ‘219 patent), and omitting the ‘601 and ‘222 patents. On August 18, 2004, we filed an amended complaint against Infineon for a declaratory judgment of patent non-infringement and invalidity regarding the ‘002, ‘894, and ‘219 patents. On February 9, 2006, we filed a second amended complaint to include claims for declaratory judgment that the ‘002, ‘894 and ‘219 patents are unenforceable.

 

On October 2, 2003, a purported shareholder class action lawsuit was filed on behalf of United States holders of ordinary shares of Tower as of the close of business on April 1, 2002 in the United States District Court for the Southern District of New York. The suit, captioned Philippe de Vries, Julia Frances Dunbar De Vries Trust, et al., v. Tower Semiconductor Ltd., et al., Civil Case No. 03 CV 4999, was filed against Tower and a number of its shareholders and directors, including us and Dr. Harari, who is a Tower board member, and asserts claims arising under Sections 14(a) and 20(a) of the Securities Exchange Act of 1934, as amended, and Rule 14a 9 promulgated there under. The lawsuit alleges that Tower and certain of its directors made false and misleading statements in a proxy solicitation to Tower shareholders regarding a proposed amendment to a contract between Tower and certain of its shareholders, including us. The plaintiffs are seeking unspecified damages and attorneys’ and experts’ fees and expenses. On August 19, 2004, the court granted our and the other defendants’ motion to dismiss the complaint

in its entirety with prejudice. On September 29, 2004, plaintiffs appealed the dismissal to the United States Court of Appeals for the Second Circuit.

 

On February 20, 2004, we and a number of other manufacturers of flash memory products were sued in the Superior Court of the State of California for the City and County of San Francisco in a purported consumer class action captioned Willem Vroegh et al. v. Dane Electric Corp. USA, et al., Civil Case No. GCG 04 428953, alleging false advertising, unfair business practices, breach of contract, fraud, deceit, misrepresentation and violation of the California Consumers Legal Remedy Act. The lawsuit purports to be on behalf of a class of purchasers of flash memory products and claims that the defendants overstated the size of the memory storage capabilities of such products. The lawsuit seeks restitution, injunction and damages in an unspecified amount. The parties have reached a settlement of the case, which is pending court approval.

 

On October 15, 2004, we filed a complaint for patent infringement and declaratory judgment of non-infringement and patent invalidity against STMicroelectronics N.V. and STMicroelectronics, Inc. in the United States District Court for the Northern District of California, captioned SanDisk Corporation v. STMicroelectronics, Inc., et al., Civil Case No. C 04 04379JF. The complaint alleges that STMicro’s products infringe one of our U.S. patents and seeks damages and an injunction. The complaint further seeks a declaratory judgment that we do not infringe several of STMicro’s U.S. patents. By order dated January 4, 2005, the court stayed our claim that STMicro infringes our patent pending an outcome in the ITC investigation initiated on November 15, 2004 (discussed below). On January 20, 2005, the court issued an order granting STMicro’s motion to dismiss the declaratory judgment causes of action. We have appealed this decision to the U.S. Court of Appeals for the Federal Circuit. The remainder of the case, including our infringement claim against STMicro, is stayed pending the outcome of the appeal.

 

On February 4, 2005, STMicro filed two complaints for patent infringement against us in the United States District Court for the Eastern District of Texas, captioned STMicroelectronics, Inc. v. SanDisk Corporation, Civil Case No. 4 05CV44, and STMicroelectronics, Inc. v. SanDisk Corporation, Civil Case No. 4 05CV45, respectively. The complaints seek damages and injunctions against unspecified SanDisk products. On April 22, 2005, we filed counterclaims on two patents against STMicroelectronics N.V. and STMicroelectronics, Inc. in the Civil Case 4-05CV45 proceeding. The counterclaims seek damages and injunctive relief against STMicroelectronics N.V. and STMicroelectronics, Inc. flash memory products.

 

On October 15, 2004, we filed a complaint under Section 337 of the Tariff Act of 1930 (as amended) titled, “In the matter of certain NAND flash memory circuits and products containing same” in the United States International Trade Commission, naming STMicroelectronics N.V. and STMicroelectronics, Inc. (“STMicro”) as respondents. In the complaint, we allege that STMicro’s NAND flash memory infringes U.S. Patent No. 5,172,338 (the ‘338 patent), and seek an order excluding their products from importation into the United States. In the complaint, we allege that STMicro’s NAND flash memory infringes the ‘338 patent and seeks an order excluding their products from importation into the United States. On November 15, 2004, the ITC instituted an investigation pursuant to 19 U.S.C. Section 1337 against STMicro in response to our complaint. A hearing was held from August 1-8, 2005. On October 19, 2005, the Administrative Law Judge issued an initial determination confirming the validity and enforceability of our United States Patent 5,172,338 (‘338 patent) by rejecting STMicro’s claims that the patent was invalidated by prior art. The initial determination, however, found that STMicro’s NAND flash memory chips did not infringe three claims of the ‘338 patent. On October 31, 2005, we filed a petition with the International Trade Commission to review and reverse the finding of non-infringement. Also, on October 31, 2005, STMicro filed a petition for review with the International Trade Commission to review and reverse the finding that the patent was valid and enforceable. On December  6, 2005, the ITC issued its decision. The ITC declined to review the finding of non-infringement, and, after reviewing the finding of validity, declined to take any position on the issue of validity. We are appealing the ITC’s decision to the U.S. Court of Appeals for the Federal Circuit.

 

On October 14, 2005, STMicroelectronics, Inc. filed a complaint against us and our CEO Eli Harari, in the Superior Court of the State of California for the County of Alameda, captioned STMicroelectronics, Inc. v. Harari, Case No. HG 05237216. The complaint alleges that STMicroelectronics, Inc., as the successor to Wafer Scale Integration, Inc.’s (“WSI”) legal rights, has an ownership interest in several SanDisk patents that issued from applications filed by Dr. Harari, a former WSI employee. The complaint seeks the assignment of certain inventions and patents conceived of by Harari as well as damages in an unspecified amount. On November 15, 2005, Harari

and we removed the case to the U.S. District Court for the Northern District of California, where it was assigned case number C05-04691. On November 23, 2005, Harari and we filed counterclaims, asserting our (i.e. SanDisk’s) ownership of the patents and applications raised in the complaint. On December 13, 2005, STMicroelectronics, Inc. filed a motion to remand the case back to the Superior Court of Alameda County. That motion remains pending.

 

On December 6, 2005, we filed a complaint for patent infringement in the United States District Court for the Northern District of California against STMicroelectronics, Inc. and STMicroelectronics, NV (“STMicro”) (Case No. C0505021 JF). In the suit, we seek damages and injunctions against STMicro from making, selling, importing or using flash memory chips or products that infringe our U.S. Patent No. 5,991,517. The case is presently stayed, pending the termination of the ITC investigation instituted February 8, 2006, discussed below.

 

On January 11, 2006, we filed a complaint for patent infringement in the United States District Court for the Northern District of California against STMicro (Case No.C06-00194 JF). In the suit, we seek damages and injunctions against STMicro from making, selling, importing or using flash memory chips or products that infringe our U.S. Patent No. 6,542,956. The case is presently stayed, pending the termination of the ITC investigation instituted February 8, 2006, discussed below.

 

On January 10, 2006, we filed a complaint under Section 337 of the Tariff Act of 1930 (as amended) titled, “In the matter of certain NAND flash memory circuits and products containing same” in the ITC, naming STMicro as respondents. In the complaint, we allege that: (i) STMicro’s NOR flash memory infringes the ‘338 patent; (ii) STMicro’s NAND flash memory infringes U.S. Patent No. 6,542,956; and (iii) STMicro’s NOR flash memory and NAND flash memory infringe U.S. Patent No. 5,991,517. The complaint seeks an order excluding STMicro’s NOR and NAND flash memory products from importation into the United States. The ITC instituted an investigation, based on our complaint, on February 8, 2006.

 

On or about July 15, 2005, Societa’ Italiana Per Lo Sviluppo Dell’electtronica, S.I.Sv.El., S.p.A., (“Sisvel”) filed suit against us and others in the district court of the Netherlands in The Hague in a case captioned Societa’ Italiana Per Lo Sviluppo Dell’electtronica, S.I.Sv.El., S.p.A. adverse to SanDisk International Sales, Moduslink B.V. and UPS SCS (Nederland) B.V., Case No. 999.131.1804. Sisvel alleges that certain of our MP3 products infringe three European patents of which Sisvel claims to be a licensee with the right to bring suit. Sisvel seeks an injunction and unspecified damages. Sisvel has previously publicly indicated that it will license these and other patents under reasonable and nondiscriminatory terms, and it has specifically offered us a license under the patents. We have submitted pleadings asking the court to strike Sisvel’s pleadings as legally insufficient and seeking other procedural relief. The court is still addressing these procedural matters and we will not be required to answer on the substance of Sisvel’s claim until April 2006 at the earliest.

 

In a related action, on February 21, 2006, we filed an action in the English High Court, Chancery Division, Patents Court, in London, against the owners of the patents Sisvel has asserted against us. The case is SanDisk Corporation v. Koninklijke Philips Electronics N.V. (a Dutch corporation), France Télécom (a French corporation), Télédiffusion de France S.A. (a French corporation), and Institut für Rundfunktechnik GmbH (a German corporation), Case No. HC06 C 00615. In this action, we seek a declaration that the patents asserted by Sisvel (as well as other patents owned by Philips and the other defendants) are invalid because they fail to properly claim anything new within the meaning of the European Patent Convention and because certain of them fail to comply with other requirements of the Convention. The defendants in that case are required to appear and announce their intention to defend on or about March 7, 2006. The defendants’ formal defense will be due in early April 2006.

 

In another related action, on March 9, 2006, we filed an action in the English High Court, Chancery Division, Patents Court, in London, against Sisvel and the owners of the patents Sisvel has asserted against us in the Netherlands. The case is SanDisk Corporation v. Koninklijke Philips Electronics N.V. (a Dutch corporation), France Télécom (a French corporation), Télédiffusion de France S.A. (a French corporation), Institut für Rundfunktechnik GmbH (a German corporation) and Societa’ Italiana Per Lo Sviluppo Dell’electtronica, S.I.Sv.El., S.p.A., Case No. HC06C00835. In this action, we seek a declaration of non-infringement of the patents asserted by Sisvel in connection with SanDisk’s MP3 products. We also seek a declaration that the patents are not “essential” to the technology of MP3 players, as Sisvel presently contends in the case filed in the Netherlands. The defendants are required to appear and announce their intention to defend at the end of March, 2006. The defendants’ formal defense will be due in early May 2006.

On or about January 12, 2006, we were served with a complaint in an action filed by SoftVault Systems, Inc. in the United States District Court for the Eastern District of Texas. The case is SoftVault Systems, Inc. v. Yahoo! Inc., Microsoft Corporation, Napster, Inc., Creative Labs, Inc., Dell USA LP, Gateway, Inc., iriver America, Inc., Samsung Electronics America, Inc., Toshiba America Consumer Products, L.L.C., Digital Networks North America, Inc., Palm, Inc., Audiovox Corporation, SanDisk Corporation, and Thomson Inc., Case No. 2:06-cv-00017-LED. SoftVault accuses us, and others, of infringing its patents through the use of Microsoft’s Windows Digital Rights Management technology. We are reviewing the matter and preparing our answer. We intend to vigorously defend against this action.

 

No matters were submitted to a vote of security holders during the fourth quarter of fiscal 2005.

 

Market For Our Common Stock and Related Stockholder Matters

 

Our common stock is traded on the NASDAQ National Market under the symbol “SNDK”. The information set forth below gives retroactive effect to a 2-for-1 stock split, in the form of a 100% stock dividend, effected on February 18, 2004. The following table summarizes the high and low bid quotations for our common stock as reported by the NASDAQ Stock Market.

 

 

As of March 1, 2006, we had approximately 605 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.

 

SANDISK CORPORATION SELECTED FINANCIAL DATA

 

 

 

 

 

SANDISK CORPORATION

 

SUPPLEMENTARY QUARTERLY DATA

 

 

 

 

 

Overview

 

 

General.  Our flash data storage devices are marketed and sold primarily in the consumer electronics market. We expect that as we reduce the price of our flash cards, consumers will demand an increasing number of megabytes of memory. In order to profitably capitalize on price elasticity in the market for flash data storage cards, we must reduce our cost per megabyte at a rate similar to the change in selling price per megabyte to the consumer.

 

Our operating results are affected by a number of factors including, among others, the unit volume of product sales, the flash memory density of the products sold, competitive pricing pressures, availability of foundry capacity from both captive and non-captive sources, the timing and volume of sell-through by our distributors and retail customers to their customers, variations in manufacturing cycle times, fluctuations in manufacturing yields and manufacturing capacity utilization, the timing of significant orders, our ability to accurately forecast demand and obtain sufficient supply, 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. See Item 1A, “Risk Factors.”

 

We operate in one business segment, flash memory products. Our chief decision-maker, our President and Chief Executive Officer, evaluates our performance based on company-wide, consolidated results. Revenue is evaluated based on geographic region and by product category.

 

Memory Sourcing.  NAND memory is the largest component of the cost of our products. The majority of our NAND memory is purchased from captive sources of supply and our ventures with Toshiba and our Toshiba foundry arrangement. We also purchase flash memory products from non-captive sources, to supplement our captive supply, allowing us to flexibly capture more market share. This non-captive supply enabled us to generate additional sales and profits even though the gross margin on our non-captive supply is significantly lower than the gross margin on our captive supply. However, our captive supply requires us to invest in capital assets, research and development and start-up and other production costs. We expect to continue sourcing both captive and non-captive flash memory.

Licensing and Royalties.  The timing and amount of royalty revenues and the recognition of license fees can vary substantially from quarter to quarter depending on the terms of our license agreements and the timing and volume of sales of products by our licensees. Gross margins and operating income fluctuate more with changes in license and royalty revenues than with changes in product revenues since license and royalty revenues have immaterial variable costs of sale.

 

Retail Sales.  Our arrangements with retailers often involve complex terms. These terms include providing the retailer with a right to return unsold product, market development funds, cooperative advertising funds, price protection, volume incentive rebates and other promotions. In some cases, we consign inventory to our customers. These consignment activities involve administrative costs to track and account for our inventory. We defer recognition of revenue on sales to retailers and distributors until they sell-through the product they have purchased from us to their customers. Our retail business is seasonal, with the fourth quarter being the strongest due to holiday sales in North America.

 

Memory Market Dynamics.  Semiconductor memory markets have generally been characterized by cycles of undersupply and oversupply. In an oversupply environment, price reductions occur and the value of our inventory may decrease resulting in a lower of cost or market price adjustment if pricing pressure results in a net realizable value that is lower than our cost. In 2001, for example, we recorded approximately $85.0 million of charges related to inventory revaluation. We may be forced to reduce the carrying value of our inventory if market demand for our products deteriorates and our inventory levels exceed customer orders.

 

Our business is characterized by constant focus on cost reduction. NAND flash memory cost reduction is achieved by transitioning to new generations of technology, by producing larger wafer sizes and by improving yields. Manufacturing yields are lower at the start of manufacturing each successive product generation. 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. In the next two to three years, we expect to make substantial new investments in additional fabrication capacity in the ventures with Toshiba.

 

Matrix Acquisition.  On January 13, 2006, we acquired Matrix Semiconductor, Inc. Matrix is a pioneer in the design and development of three-dimensional (3-D) integrated circuits. Matrix 3-D memory is used for one-time programmable storage applications where low cost is the paramount consideration, such as video games, music and archiving.

 

Critical Accounting Policies & Estimates

 

Our discussion and analysis of our financial condition and results of operations is 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, among others, those related to customer programs and incentives, product returns, bad debts, inventories and related reserves, investments, income taxes, warranty obligations, stock compensation, contingencies and litigation. We base our estimates on historical experience and on other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for our judgments about the carrying values of assets and liabilities when those values are not readily apparent from other sources. Estimates have historically approximated actual results. However, future results will differ from these estimates under different assumptions and conditions.

 

Revenue Recognition, Sales Returns and Allowances and Sales Incentive Programs.  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 reasonable assurance of realization. Sales made to distributors and retailers are generally under agreements allowing price protection and/or right of return and, therefore, the sales and related costs of these transactions are deferred until the retailers or distributors sell the merchandise to their end customer, or the rights of return expire. At January 1, 2006 and January 2, 2005, deferred income, from sales to distributors and retailers was $139.9 million and $82.0 million, respectively. Estimated sales returns are provided for as a reduction to product revenue and deferred revenue and were not material for any period presented in our consolidated financial statements.

We record estimated reductions to revenue or to deferred revenue for customer and distributor incentive programs and offerings, including price protection, promotions, co-op advertising, and other volume-based incentives and expected returns. Additionally, we have incentive programs that require us to estimate, based on historical experience, the number of customers who will actually redeem the incentive. All sales incentive programs are recorded as an offset to product revenues, deferred revenues or a charge to marketing expenses. In the past, actual returns and rebates have not been significantly different from our estimates. However, actual returns and rebates in any future period could differ from our estimates, which could impact the net revenue we report.

 

Inventories and Inventory Valuation.  Inventories are stated at the lower of cost (first-in, first-out) or market. Market value is based upon an estimated average selling price reduced by estimated costs of disposal. The determination of market value involves numerous judgments including estimating average selling prices based upon recent sales volumes, industry trends, existing customer orders, current contract prices, industry analysis of supply and demand and seasonal factors. Should actual market conditions differ from our estimates, our future results of operations could be materially affected. The valuation of inventory also requires us to estimate obsolete or excess inventory. The determination of obsolete or excess inventory requires us to estimate the future demand for our products within specific time horizons, generally six to twelve months. To the extent our demand forecast for specific products is less than our product on hand and our noncancelable orders, we could be required to record additional inventory reserves, which would have a negative impact on our gross margin.

 

Accounting for Investments.  We evaluate whether entities that we have invested in are variable interest entities within the definition of the Financial Accounting Standards Board Interpretation No. 46, Accounting for Variable Interest Entities. If those entities are variable interest entities, then we determine whether we are the primary beneficiary of that entity by reference to our contractual and business arrangements with respect to residual gains and residual losses on liquidation of that entity.

 

With respect to all equity investments, we review the degree of control that our investment and other arrangements give us over the entity we have invested in and our business to confirm that these conclusions are correct. Generally, after considering all factors, if we hold equity interests representing less than 20% of the outstanding voting interests of an entity we invested in, we use the cost method of accounting. If we hold at least 20% but less than a majority of the outstanding voting interests of an entity we invested in, we use the equity method of accounting.

 

We have the financial capability and the intent to hold our loans to the ventures with Toshiba until maturity and accordingly those loans are carried at cost and their value in our financial statements is not adjusted to market value.

 

Deferred Tax Assets.  We must make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes.

 

We must assess the likelihood that we will be able to recover our deferred tax assets. We consider historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance. If recovery is not likely, we must increase our provision for taxes by recording a valuation allowance against the deferred tax assets that we estimate will not ultimately be recoverable. We carried a valuation allowance on our deferred tax assets of $14.9 million and $12.3 million at January 1, 2006 and January 2, 2005, respectively, based on our view that it is more likely than not that we will not be able to take tax a benefit for unrealized capital losses on our investments in foundries.

Results of Operations

 

Product Revenues.

 

 

The increase in our 2005 product revenues was comprised of a 166% increase in the number of megabytes sold and partially offset by a 52% reduction in our average selling price per megabyte. The markets that we sell to have been price elastic. In 2005, as the price per megabyte came down, the average memory density of our products sold increased by 215%. Our unit sales also increased by 23% with the growth in our unit sales primarily attributable to growth in the markets for mobile cards for camera-phones and music-centric phones, USB flash drives and flash-based digital audio players. We expect to continue to reduce our price per megabyte, including price reductions already initiated in 2006, as technology advances allow us to further reduce our cost per megabyte. Partially offsetting the 2005 growth in revenues was the fact that fiscal 2005 consisted of 52 weeks as compared to 53 weeks in the prior year.

 

The increase in our 2004 product revenues was comprised of a 167% increase in the number of megabytes sold and partially offset by a 38% reduction in our average selling price per megabyte. Our 2004 unit sales increased by 53% compared to 2003, with the increase primarily attributable to growth in the markets for digital still cameras, USB flash drives and feature phones with card slots and the introduction, in the fourth quarter of fiscal 2004, of SanDisk flash-based digital audio players. In addition, our fiscal 2004 consisted of 53 weeks as compared to 52 weeks in the prior fiscal year.

 

Geographical Product Revenues.

 

 

In 2005, our revenue from Japan primarily reflects the reduction in the sales of flash memory cards to digital camera OEMs based in Japan to the transition of after market sales of flash memory cards primarily in North America and EMEA.

 

In 2004, the increase in North America and EMEA revenue reflects increased retail demand due to the growth in consumer based products requiring additional flash memory.

 

License and Royalty Revenues.

 

 

The increase in our 2005 and 2004 license and royalty revenue was primarily due to increased royalty bearing sales by our licensees in each of those fiscal years.

Gross Margins.

 

 

The largest driver of the 2005 increase in product gross margins was the reduction in our cost per megabyte due to the transition to 90-nanometer technology partially offset by decreases in our average selling price per megabyte. Fiscal 2005 gross margins were also benefited due to more production supply coming from captive sources which have lower costs.

 

The largest driver of the 2004 decline in product gross margins was an increased reliance on non-captive memory sources. We earn significantly lower gross margins on non-captive memory than on captive memory supply, and non-captive memory accounted for approximately 35% and 24% of our memory sourcing in 2004 and 2003, respectively. Our captive gross margin improved by approximately two percentage points as our cost reductions were greater than the decline in average selling price per megabyte. This partially offset the impact of our higher non-captive mix.

 

Research and Development.

 

 

Our 2005 research and development expense growth was primarily due to higher vendor engineering costs and costs associated with the initial design and development of manufacturing process technology related to Flash Partners’ 300-millimeter production line of $42.4 million, and payroll and payroll-related expenses of $15.6 million associated with headcount increases related to developing new products.

 

Our 2004 research and development expense growth was primarily due to increased payroll and payroll-related expenses associated with higher headcount in support of our broadening product portfolio, higher vendor engineering costs and costs associated with the initial design and development of manufacturing process technology related to Flash Partners’ 300-millimeter production line. We grew our research and development headcount to 340 at the end of 2004 from 272 at the end of 2003.

 

Sales and Marketing.

 

 

Our 2005 sales and marketing expense growth was primarily related to increased tradeshow, advertising and branding on a worldwide basis of $15.5 million, and payroll and payroll-related expenses of $7.3 million, all in support of our higher revenue base. In 2006, we plan to capitalize on the growing consumer awareness of the SanDisk brand by increasing our investments in building and promoting the SanDisk brand globally.

 

Our 2004 sales and marketing expenses were primarily related to increased tradeshow, advertising and branding, and payroll and payroll-related expenses, all in support of our higher revenue base. In 2004, advertising and branding activities included television advertising in the United States, increased North American and Asia

Pacific print media spending and advertising and merchandising for such product lines as USB drives, wireless mobile and Shoot & Store.

 

General and Administrative.

 

 

Our 2005 general and administrative expense growth was primarily related to increased legal expenses associated with litigation to defend our intellectual property of $17.3 million, increased payroll and payroll related expenses of $6.0 million and consulting expenses of $5.0 million to support our expanded business. Our 2005 general and administrative expenses also included significant consulting expenses associated with establishing new legal entities and modifying our corporate organization to reflect our global business.

 

Our 2004 general and administrative expenses increases were primarily relates to increased legal expenses related in part to higher litigation expenses to defend our intellectual property, increased staffing and consulting expenses to support our expanded business and compliance with the Sarbanes-Oxley Act, as well as provisions for doubtful accounts due to the growth in accounts receivable balances.

 

Non-Operating Income (Loss), net.

 

 

Non-operating income for 2005 was comprised of interest income of $42.8 million, an other- than-temporary reduction in the value of our investment in Tower of ($10.1) million and other items of $4.0 million.

 

Non-operating income for 2004 was comprised of interest income of $20.4 million, a settlement of $6.2 million from a third-party brokerage firm related to the unauthorized disposition of our investment in UMC, an other- than-temporary reduction in the value of our investment in Tower of ($11.8) million, interest expense on our 41/2% Convertible Subordinated Note of ($5.9) million and other items of ($4.3) million.

 

Provision for Income Taxes

 

 

Our 2005 and 2004 tax rates differ from the statutory rate primarily due to state tax expense, net of federal benefit. Our 2003 tax rate differs from the statutory rate due to state tax expense, a reversal of the tax benefit we recognized in 2001 and 2002 related to the unrealized gain on the disposition of our UMC shares and to the benefit provided by the reversal of $47 million in valuation allowance carried on the net deferred tax assets at the end of fiscal 2002 which could be taken principally because our net operating loss carryforwards have been fully realized. Our future tax rate may be impacted by state taxes, our ability to realize tax benefits from capital losses and the geographic mix of our earnings.

Liquidity and Capital Resources

 

Cash Flows.  Operating activities generated $480.9 million of cash during the year ended January 1, 2006. Significant contributors to the generation of cash from operations were net income of $386.4 million, non-cash adjustments to income for depreciation and amortization of $65.8 million, loss on investment in Tower Semiconductor of $10.1 million, foreign currency revaluation of FlashVision notes receivable of $7.7 million, amortization/accretion related to original premium/discount on short-term investments of $2.6 million, decreases in income tax receivable of $64.2 million, increases in accounts payable of $148.2 million, increases in related party liabilities of $24.7 million, accrued payroll and related expenses of $13.8 million, deferred income of $57.2 million and current and non-current other accrued liabilities of $6.9 million. These were partially offset by increases in the inventory balance of $135.2 million, accounts receivable of $134.2 million, other current and non-current assets of $31.1 million, wafer cost adjustments of $2.3 million and deferred taxes of $1.5 million.

 

Operating activities generated $227.6 million of cash during the year ended January 2, 2005. Significant contributors to the generation of cash from operations were net income of $266.6 million, non-cash adjustments to income for depreciation and amortization of $38.9 million, allowances for doubtful accounts of $4.6 million, amortization/accretion related to original premium/discount on short-term investments of $3.2 million and amortization of bond issuance costs of $2.6 million; decreases in deposits and other assets of $13.3 million, increases in accrued payroll and related expenses of $13.5 million and both current and non-current other accrued liabilities of $15.2 million. These were partially offset by increases in the inventory balance of $79.5 million, accounts receivable of $14.9 million and decreases in deferred income on shipments to distributors and retailers and deferred revenue of $15.4 million, and decreases in accounts payable, income taxes payable and other current liabilities to related parties of $6.2 million.

 

We used $299.5 million for investing activities during the year ended January 1, 2006. We increased our short-term investment balance by $81.0 million, loaned $34.2 million to FlashVision, invested $21.8 million in Flash Partners, loaned $20.0 million to Matrix Semiconductor, Inc., purchased $39.1 million of semiconductor wafer manufacturing equipment to be used at Toshiba’s Yokkaichi Operations, purchased $95.4 million of test equipment and $3.5 million of investment in foundries and acquired a technology license for $4.5 million.

 

For year ended January 2, 2005, we used $523.0 million for investing activities. We increased our short-term investment balance by $337.0 million, loaned $33.6 million to FlashVision, invested $23.1 million in Flash Partners, purchased $63.4 million of 200-millimeter semiconductor wafer manufacturing equipment to be used at Toshiba’s Yokkaichi Operations and purchased $62.4 million of test equipment and other capital items.

 

We generated $115.4 million and $24.6 million of cash from exercises of stock options and sales under our employee stock purchase plan during the years ended January 1, 2006 and January 2, 2005, respectively.

 

Liquid Assets.  At January 1, 2006, we had cash, cash equivalents and short-term investments of $1.7 billion. As of that date, the cost basis of our investment in 24.5 million UMC shares was $13.4 million and its market value was $13.9 million. As of January 1, 2006, we held 10.2 million Tower shares whose carrying value and market value was $12.9 million and $14.8 million, respectively. As of January 1, 2006, we have agreed not to sell 7.2 million of our 10.2 million Tower shares. This restriction is no longer in effect in fiscal 2006. However, we do remain subject to certain restrictions on the transfer of our Tower ordinary shares including certain rights of first refusal, and through January 2008, have agreed to maintain minimum shareholdings.

 

Short-Term Liquidity.  As of January 1, 2006, our working capital balance was $2.0 billion. We do not expect any liquidity constraints in the next twelve months. In 2006, we currently expect to loan or make investments in Flash Partners of approximately $500 million, and additionally to guarantee future operating leases of Flash Partners or procure other financing of approximately $500 million. We also expect to spend approximately $200 million on property and equipment, which includes assembly and test equipment as well as engineering equipment, and spending related to facilities and information systems.

 

Long-Term Requirements.  Depending on the demand for our products, we may decide to make additional investments, which could be substantial, in wafer fabrication foundry capacity and assembly and test manufacturing equipment to support our business in the future. We may also make equity investments in other companies or engage in merger or acquisition transactions. These additional investments may require us to raise additional financing,

which could be difficult to obtain, and which if not obtained in satisfactory amounts may prevent us from funding the ventures with Toshiba, increasing our wafer supply, 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.

 

Contingent Obligations.  We agreed to reimburse Toshiba for 49.9% of losses it sustains under its guarantee of FlashVision’s operating lease with Mizuho Leasing. As of January 1, 2006, the maximum exposure for both us and Toshiba under that guarantee was 17.7 billion Japanese yen, or approximately $150 million based upon the exchange rate at January 1, 2006, and our maximum exposure was 8.8 billion Japanese yen, or approximately $75 million based upon the exchange rate at January 1, 2006. See Item 1, “Business-Ventures With Toshiba-FlashVision.”

 

Toshiba Ventures.  We are a 49.9% percent owner in two ventures, FlashVision and Flash Partners. Toshiba owns 50.1% of each of these ventures. We account for our investments under the equity method and do not consolidate. FlashVision and Flash Partners are variable interest entities and we are not the primary beneficiary of either venture because we are entitled to less than a majority of any residual gains and are obligated with respect to less than a majority of residual losses with respect to both ventures. Both FlashVision and Flash Partners purchase wafers from Toshiba and then resell those wafers to Toshiba and us at cost plus a markup. The cost of the wafers we purchase from FlashVision and Flash Partners is recorded in inventory and ultimately cost of sales. Our share of the net income or loss of FlashVision and Flash Partners is included in our Consolidated Statement of Income as “Equity in income/(loss) of business ventures”. FlashVision and Flash Partners each own or lease separately semiconductor manufacturing equipment that is placed inside Toshiba’s Yokkaichi, Japan operations. The capital equipment owned by FlashVision and Flash Partners is funded through investments in or loans to the ventures from us and Toshiba. For semiconductor fixed assets that are leased by FlashVision or Flash Partners, we guarantee a portion of the outstanding lease payments under those leases through various methods. This obligation is denominated in Japanese yen and is noncancelable. We are contractually obligated to purchase half of FlashVision and Flash Partners NAND wafer supply. The cost of the wafer supply includes all amounts to reimburse FlashVision and Flash Partners for their costs to produce the NAND wafers. We cannot estimate the total amount of the wafer purchase commitment as of January 1, 2006 because our price is determined by reference to the future cost to produce the semiconductor wafers. In addition to the semiconductor assets owned by FlashVision and Flash Partners, we purchase and directly own semiconductor manufacturing equipment in Toshiba’s Yokkaichi operations for which we receive 100% of the output from this equipment. From time to time, we and Toshiba mutually approve increases in wafer supply capacity of FlashVision and Flash Partners that may contractually obligate us to increased capital funding. We and Toshiba each pay the cost of our own design teams and 50% of the wafer processing and similar costs associated with this direct design and development of flash memory. See Note 5 and Note 11 to our consolidated financial statements included in Item 8 of this report.

 

As part of the FlashVision and Flash Partners agreements, we agreed to share in Toshiba’s costs associated with NAND product development and its common semiconductor research and development activities. As of January 1, 2006, we had accrued liabilities related to those expenses of $4.2 million. Our common research and development obligation related to FlashVision and Flash Partners is variable but capped at increasing fixed quarterly amounts through 2008 and is not subject to any payment caps thereafter. See Note 5 to our consolidated financial statements included in Item 8 of this report. Our direct research and development contribution is determined based on a variable computation. The common R&D participation agreement and the product development agreement are exhibits to this report and should be read carefully in their entirety for a more complete understanding of these arrangements.

 

We have guaranteed on an unsecured and several basis 50% of Flash Partners’ lease obligation under a master lease agreement entered into in December 2004. Our total lease obligation guarantee, net of lease payments as of January 1, 2006, was 24.0 billion Japanese yen, or approximately $203 million based upon the exchange rate at January 1, 2006. In December 2005, Flash Partners secured an additional equipment lease facility of 35.0 billion Japanese yen, or approximately $297 million based upon the exchange rate at January 1, 2006, from a consortium of financial institutions. We agreed to guarantee on an unsecured and several basis 50% of the draw downs under this facility. As of January 1, 2006, no draw downs had been made, however the entire amount was drawn down in January 2006. Our maximum exposure under the guarantee is 17.5 billion Japanese yen, or approximately

$148 million based upon the exchange rate at January 1, 2006. See Item 1, “Business-Ventures With Toshiba-Flash Partners.”

 

The terms of the Flash Partners venture contractually obligate us and Toshiba to expand Flash Partners’ capacity. As of February 2006, we and Toshiba have committed to expand Flash Partners’ capacity to 70,000 wafer starts per month. We currently estimate the remaining total equipment funding obligation for the 70,000 wafer starts per month level to be approximately 365.0 billion Japanese yen, or approximately $3.1 billion based upon the exchange rate at January 1, 2006. Of this amount, we are obligated to fund 182.5 billion Japanese yen, or approximately $1.5 billion based upon the exchange rate at January 1, 2006, of which 42.5 billion Japanese yen, or approximately $361 million based upon the exchange rate at January 1, 2006, is being financed through Flash Partners’ operating lease facilities. Our remaining funding obligation at January 1, 2006 is approximately $1.0 billion. See Note 5 to our consolidated financial statements included in Item 8 of this report.

 

Contractual Obligations and Off Balance Sheet Arrangements

 

Our contractual obligations and off balance sheet arrangements at January  1, 2006, and the effect those contractual obligations are expected to have on our liquidity and cash flow over the next five years is presented in textual and tabular format in Note 5 to our consolidated financial statements included in Item 8 of this report.

 

Impact of Currency Exchange Rates

 

Future exchange rate fluctuations could have a material adverse effect on our business, financial condition and result of operations. In 2005, we used foreign currency forward contracts to mitigate transaction gains and losses generated by these monetary assets and liabilities denominated in other currencies than the U.S. dollar, currently only the Japanese yen. We did not use foreign currency forward contracts in 2004 and 2003. We do not enter into derivatives for speculative or trading purposes. Our derivative instruments are recorded at fair value with changes recorded in other income (expense). See Note 5 to our consolidated financial statements included in Item 8 of this report.

 

For a discussion of foreign operating risks and foreign currency risks, see Item 1A, “Risk Factors.”

 

Impact of Recently Issued Accounting Standards

 

The Financial Accounting Standards Board, or FASB, adopted a revised Statement of Financial Accounting Standards No. 123, or FAS 123R, Share Based Payments, with an effective date of June 15, 2005. In April 2005, the SEC amended the effective date of FAS 123R, and we will now be required to adopt this standard for our first fiscal year beginning after June 15, 2005. We adopted FAS 123R in January 2006 and currently do not expect to restate prior periods to conform to the new accounting standard as we will use the modified prospective method. FAS 123R requires us to recognize an expense based on the fair value of all share-based payments to employees, including grants of options to buy shares of our common stock. See Note 1 to our consolidated financial statements included in Item 8 of this report for information related to the pro forma effect on reported net income and net earnings per share of applying the fair value provisions of the FAS 123. Adoption of FAS 123R is expected to increase our operating expenses. In anticipation of expensing equity instruments, we have reduced overall stock option grants and reduced the percentage of incentive stock options to total stock options granted.

 

In May 2005, the FASB issued Financial Accounting Standards No. 154, or FAS 154, Accounting Changes and Error Corrections. FAS 154 replaced Accounting Pronouncement Board Opinion No. 20, or APB 20, Accounting Changes, and Financial Accounting Standards No. 3, or FAS 3, Reporting Accounting Changes in Interim Financial Statements. FAS 154 requires that a voluntary change in accounting principle be applied retrospectively with all

prior period financial statements presented based on the application of the new accounting principle. The statement will require the retrospective application of the impact of the direct effect of changes in accounting principles unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. FAS 154 carries forward without change the guidance contained in APB 20 for reporting the correction of an error in previously issued financial statements and changes in accounting estimates. FAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005 and require prospective application. We will adopt this standard on January 2, 2006 and currently do not anticipate that it will have a material effect on its financial statements or disclosures.

 

We are exposed to financial market risks, including changes in interest rates, foreign currency exchange rates and marketable equity security prices.

 

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. As of January  1, 2006, a hypothetical 50 basis point increase in interest rates would result in an approximate $2.6 million decline (less than 0.25%) 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 is transacted in U.S. dollars. However, we do enter into transactions in other currencies, primarily the Japanese yen. Movements in currency exchange rates, especially the Japanese yen, could cause variability in our revenues, expenses or other income (expense), net. We had forward exchange contracts in place with a notional amount of 3.95 billion Japanese yen, or approximately $34 million based upon the exchange rate at January 1, 2006 and zero as of January 2, 2005. The effect of an immediate 10% adverse change in exchange rates on forward exchange contracts would result in an approximate $3.0 million loss. However, as we utilize foreign currency instruments, for mitigating anticipated balance sheet exposures, a loss in fair value for those instruments is generally offset by increases in the value of the underlying exposure. See Item 1A, “Risk Factors.” and Note 5 to our consolidated financial statements included in Item 8 of this report.

 

Market Risk.  We also hold available-for-sale equity securities in semiconductor wafer manufacturing companies. As of January 1, 2006, 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 $2.7 million.

 

All of the potential changes noted above are based on sensitivity analysis performed on our financial position at January 1, 2006. Actual results may differ materially.

 

The information required by this item is set forth beginning at page F-1.

 

Not applicable.

 

Evaluation of Disclosure Controls and Procedures

 

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 as of the end of the period covered by this report (the “Evaluation Date”). Based upon the evaluation, our principal executive officer and principal financial officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective. Disclosure controls are controls and procedures designed to reasonably ensure that information required to be disclosed in our reports filed under the Exchange Act, such as this report, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls include controls and procedures designed to reasonably ensure that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure. Our quarterly evaluation of disclosure controls includes an evaluation of some components of our internal control over financial reporting, and internal control over financial reporting is also separately evaluated on an annual basis for purposes of providing the management report which is set forth below.

 

Report of Management on Internal Control Over Financial Reporting

 

Our management is responsible for establishing and maintaining a comprehensive system of internal control over financial reporting to provide reasonable assurance of the proper authorization of transactions, the safeguarding of assets and the reliability of the financial records. Our internal control system was designed to provide reasonable assurance to our management and board of directors regarding the preparation and fair presentation of published financial statements. The system of internal control over financial reporting provides for appropriate division of responsibility and is documented by written policies and procedures that are communicated to employees. The framework upon which management relied in evaluating the effectiveness of our internal control over financial reporting was set forth in Internal Controls — Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission.

 

Based on the results of our evaluation, our management concluded that our internal control over financial reporting was effective as of January 1, 2006.

 

Our independent registered public accounting firm, which has audited the financial statements included in Item 8 of this report, has issued an attestation report on management’s assessment of our internal control over financial reporting which is included at page F-3.

 

Independent Registered Public Accounting Firm’s Attestation Report

 

The report required by this item is set forth at page F-2.

 

Not applicable.

 

The information required by this item is set forth under “Business-Executive Officers” in this report and under “Election of Directors” and “Compliance with Section 16(a) of the Securities Exchange Act of 1934” in our Proxy Statement for our 2006 Annual Meeting of Stockholders, and is incorporated herein by reference.

 

We have adopted a code of ethics that applies to our principal executive officer and principal financial and accounting officer. This code of ethics, which consists of the “SanDisk Code of Ethics for Financial Executives”

section of our code of ethics that applies to employees generally, is posted on our website, www.sandisk.com. Our code of ethics may be found on our website as follows: