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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-K



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



For the fiscal year ended December 31, 2004



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



For the Transition Period from              to



Commission File Number 000-50553



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LOGO

STAKTEK HOLDINGS, INC.

(Exact name of registrant as specified in its charter)



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 56-2354935                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



8900 Shoal Creek
Blvd, Austin, TX 78757

(Address of principal executive offices) (Zip Code)



Registrants telephone number, including area code:

(512) 454-9531



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



|                    |  |                                          
|------------------- |  | -----------------------------------------
|Title of Each Class |  | Name of Each Exchange on Which Registered
|Common Stock        |  | NASDAQ                                   



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

None.



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.  YESx  NO ̈



Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and
will not be contained, to the best of the 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.  YES x  NO ̈



Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).  YES ̈NO x



The aggregate market value of voting and non-voting common equity held by non-affiliates, computed by reference to the price at which the common equity
was last sold as of June 30, 2004, was approximately $60,300,000 (assuming, for this purpose, that directors, executive officers and Austin Ventures, LP are deemed affiliates).



The number of shares of the registrants common stock, $0.001 par value, outstanding as of March 1, 2005, was
50,583,560.



Documents Incorporated by Reference



Portions of the Proxy Statement for the registrants Annual Meeting of
Stockholders are incorporated by reference into Part III of this Form 10-K.

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|         |  |                                                                                                              |  |     
|-------- |  | ------------------------------------------------------------------------------------------------------------ |  | ----
|         |  | PART I                                                                                                       |  | Page
|         |  |                                                                                                             
|Item 1.  |  | Business                                                                                                     |  | 3   
|Item 2.  |  | Property                                                                                                     |  | 28  
|Item 3.  |  | Legal Proceedings                                                                                            |  | 28  
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                                          |  | 28  
|         |  |                                                                                                             
|         |  | PART II                                                                                                      |  |     
|         |  |                                                                                                             
|Item 5.  |  | Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |  | 29  
|Item 6.  |  | Selected Financial Data                                                                                      |  | 31  
|Item 7.  |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                        |  | 33  
|Item 7A. |  | Quantitative and Qualitative Disclosures About Market Risk                                                   |  | 45  
|Item 8.  |  | Financial Statements and Supplementary Data                                                                  |  | 46  
|Item 9.  |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                         |  | 78  
|Item 9A. |  | Controls and Procedures                                                                                      |  | 78  
|Item 9B. |  | Other Information                                                                                            |  | 78  
|         |  |                                                                                                             
|         |  | PART III                                                                                                     |  |     
|         |  |                                                                                                             
|Item 10. |  | Directors and Executive Officers of the Registrant                                                           |  | 79  
|Item 11. |  | Executive Compensation                                                                                       |  | 79  
|Item 12. |  | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters               |  | 79  
|Item 13. |  | Certain Relationships and Related Transactions                                                               |  | 79  
|Item 14. |  | Principal Accountant Fees and Services                                                                       |  | 79  
|         |  |                                                                                                             
|         |  | PART IV                                                                                                      |  |     
|         |  |                                                                                                             
|Item 15. |  | Exhibits and Financial Statement Schedules                                                                   |  | 80  



CAUTIONARY STATEMENT



EXCEPT FOR THE HISTORICAL FINANCIAL INFORMATION
CONTAINED HEREIN, THE MATTERS DISCUSSED IN THIS REPORT ON FORM 10-K (AS WELL AS DOCUMENTS INCORPORATED HEREIN BY REFERENCE) MAY BE CONSIDERED FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF SECTION 27A OF THE SECURITIES ACT OF 1933, AS
AMENDED, AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. THESE FORWARD-LOOKING STATEMENTS INCLUDE DECLARATIONS REGARDING THE INTENT, BELIEF OR CURRENT EXPECTATIONS OF STAKTEK HOLDINGS, INC. AND ITS MANAGEMENT, AND MAY BE
EVIDENCED BY WORDS SUCH AS WE EXPECT, ANTICIPATE, TARGET, PROJECT, BELIEVE, GOALS, ESTIMATE, POTENTIAL, PREDICT, MAY,
MIGHT, COULD, INTEND, VARIATIONS OF THESE TYPES OF WORDS AND SIMILAR EXPRESSIONS. YOU ARE CAUTIONED THAT ANY FORWARD-LOOKING STATEMENTS ARE NOT GUARANTIES OF FUTURE PERFORMANCE AND INVOLVE A NUMBER OF RISKS AND
UNCERTAINTIES. ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE INDICATED BY THESE FORWARD-LOOKING STATEMENTS. FACTORS THAT COULD CAUSE OR CONTRIBUTE TO THESE DIFFERENCES INCLUDE THOSE DISCUSSED UNDER FACTORS AFFECTING OUR FUTURE OPERATING
RESULTS AND ELSEWHERE IN THIS REPORT. STAKTEK HOLDINGS, INC. DISCLAIMS ANY INTENTION OR OBLIGATION TO UPDATE OR REVISE ANY FORWARD-LOOKING STATEMENTS, WHETHER AS A RESULT OF NEW INFORMATION, FUTURE EVENTS OR OTHERWISE.



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PART I



ITEM 1. BUSINESS



Staktek
Holdings, Inc. was originally formed by two investment funds affiliated with Austin Ventures in May 2003 for the purpose of acquiring Staktek Corporation, which was incorporated in Texas in June 1990. In August 2003, we acquired by merger Staktek
Corporation, which survives as our wholly owned subsidiary. We refer to our acquisition of Staktek Corporation throughout this annual report on Form 10-K as the Staktek acquisition. In addition, the terms Staktek,
we, us and our refer to Staktek Holdings, Inc. and all of its subsidiaries that are consolidated in conformity with accounting principles generally accepted in the United States and its predecessor company,
Staktek Corporation.



Overview



We provide manufacturing services to deliver memory stacking solutions and
also offer licenses of our technologies to our customers to enable them to manufacture stacked memory products. In addition, we offer a broad range of services to support our customers needs, including design of custom-stacked memory
assemblies, electrical modeling assistance and component inventory management.



Since our inception in 1990, we have been an innovator in the development of technologies to enable stacking of integrated circuits, with an initial focus on customized stacking solutions. In 1994, we released our
original Stakpak® technology, which stacked dynamic
random access memory, or DRAM, chips packaged in industry-standard thin small outline packages, or TSOPs. In 1998, we began shipping our third-generation Stakpak technology by offering our Performance Stakpak®, enabling dramatically lower Stakpak pricing through our implementation of automated
manufacturing processes. In 2001, we introduced our Value Stakpak® product as a low-cost stacked memory solution for devices and systems with lower thermal management requirements. Our fourth generation solution, the High Performance Stakpak®, was introduced in 2003 and offers next-generation memory and performance capabilities
in non-leaded stacked memory packages.



We apply our expertise
in packaged memory stacking to provide intellectual property and services that enable our customers to cost-effectively improve the performance and reliability of their systems. Semiconductor memory typically consists of silicon circuits packaged in
a plastic body with metal leads for electrical connectivity. By stacking industry-standard, current-generation, memory packages, our Stakpak solutions can deliver up to four times the memory capacity per memory module. Our flagship Performance
Stakpak solution utilizes a patented interconnect system to stack memory circuits contained in industry-standard TSOPs, which are the most commonly used leaded plastic packages for memory. Our Performance Stakpak units fit within the same standard
physical footprint on a circuit board as a monolithic memory chip packaged in a TSOP. In addition, we believe that our copper interconnect technology delivers superior thermal management as compared to alternative solutions. Our Value Stakpak
solution is our low-cost stacked memory solution for devices and systems with lower thermal management requirements. Our High Performance Stakpak solution for stacking non-leaded packages, such as fine pitch ball grid array, or fBGA, offers similar
benefits to those of our Performance Stakpak. Non-leaded packages use small metal balls instead of metal leads to enable better electrical connectivity within a smaller surface area, and fBGA is the most common non-leaded package for memory.



The vast majority of the stacked solutions provided by us to
date have been to semiconductor manufacturers, memory module manufacturers and contract manufacturers for inclusion in midrange and high-performance servers and storage systems products of large original equipment manufacturers, or OEMs, such as
Cisco Systems, Dell, Hewlett-Packard (or HP), IBM, Intel and Sun Microsystems. To a lesser extent, we sell our stacked solutions directly to OEMs. Some of our customers place blanket purchase orders up to three months in advance to cover shipments
for the relevant period. These purchase orders do not represent commitments to purchase given quantities of our products, but serve as non-binding forecasts for pricing, administrative and



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general scheduling purposes. In some instances, purchase orders from customers are received no more than a day in advance or in the same shipment as the
consigned DRAM chips that are supplied to us for stacking. We have no long-term purchase agreements with any of our customers.



Through our flexible OEM-centric business model, our customers can license our proprietary stacking technologies. To date, we have entered into license
agreements with Samsung Electronics Co., Ltd. and Infineon Technologies A.G. Under these license arrangements, Samsung and Infineon are licensed to manufacture and sell memory modules containing stacked DRAM chips incorporating our leaded-package
stacking technologies. In 2004, 2003 and 2002, 43%, 26% and 14% of our total revenue in such respective periods were derived from royalties recognized under our agreement with Samsung. Our license to Infineon is more limited in scope than our
license to Samsung. We recognized a small amount of revenue from this license agreement in 2004, and we do not anticipate that we will derive material revenue from this license in the future.



We price our stacked memory solutions based on a number of factors, and in
particular, on the estimated quarterly volumes reflected in our customers forecasts. While relative demand for stacked memory products may fluctuate with variations in the average selling price of DRAM chips, the average selling prices for our
manufacturing services and technologies are not directly impacted by short-term changes in the price of memory. Through our investments in greater automation within our manufacturing operations and the implementation of other efficiencies in our
internal processes, over time we have achieved significant reductions in our internal manufacturing costs of both our Performance Stakpak and Value Stakpak products on a per-unit basis. By passing these cost savings through to our customers in the
form of lower average selling prices for our services, we are able to provide greater opportunities for OEMs to cost-effectively increase the memory capacity of their products. By increasing our production volumes within a lower cost structure,
combined with increased license revenue, which generally entails lower cost of revenue, our gross margins have improved from 29% in 2000 to 49%, 51%, 49% and 42% in 2001, 2002, 2003 and 2004, respectively.



We have made significant investments to establish a high-volume manufacturing
facility in Reynosa, Mexico and a quick-turn manufacturing facility in Austin, Texas. We combine proprietary tooling and flexible, state-of-the-art process technologies and tool sets to provide highly automated and cost-effective manufacturing with
high production yields and reliability. Our quick manufacturing turnaround times support our customers need for supply chain flexibility and responsiveness.



We believe that our strong patent portfolio and intellectual property position, with over 80 issued patents and over 45
pending patent applications as of January 31, 2005, will allow us to continue to expand our business as demand for high-density memory increases and to capitalize on emerging market opportunities. We intend to exploit our stacked memory intellectual
property and capabilities to establish market leadership in new technologies such as the second-generation, double-data-rate, or DDR-II, or DRAM, technology. We also are developing technologies that will enable integration of heterogeneous
integrated circuits, such as processors, Flash memory (a type of nonvolatile memory) and DRAM, in a variety of applications. We plan to continue to build strategic relationships with key OEMs, memory suppliers and channel partners, and intend to
leverage our flexible business model to accelerate adoption of our solutions, both in the delivery of manufactured stacked memory products and in the licensing of our technologies.



On February 11, 2004, we completed our initial public offering in which we sold 10 million shares of our common stock at $13
per share, for an aggregate public offering price of $130 million. On March 5, 2004, we sold an additional 1.19 million shares in connection with the underwriters over-allotment option, for an aggregate public offering price of approximately
$15.5 million. Our sale of shares of common stock, including the underwriters exercise of their over-allotment option, resulted in aggregate net proceeds of approximately $133.4 million.



In June 2004, we acquired from DPAC Technologies Corp. (DPAC) its
stacking patents and patent applications as well as certain customer information, as DPAC exited the stacking business to focus on other areas. We paid DPAC $0.6 million in June and paid additional amounts totaling approximately $0.1



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million in the third quarter of 2004, including payments for related transaction costs. We are working with former DPAC customers to transition them to our
Value Stakpak or Performance Stakpak products.



Industry Background



Memory is the storage available from memory chips
that a computing device uses to hold data sets and the operating system and applications that are executable within that device. With more memory capacity and speed, computing devices are able to run a greater number of complex applications, handle
larger data sets, manage more processes and generally perform faster. In order to obtain greater memory capacity, memory manufacturers have created memory chips containing transistors embedded in increasingly high numbers. Complex systems that
handle the processing, storage and transmission of large amounts of information and that require large amounts of DRAM include:



|                                           |  |                                     
|------------------------------------------ |  | ------------------------------------
|      enterprise and network servers;     |  |       mobile computing equipment;  
|                                           | 
|      mainframes;                         |  |       network routers and switches;
|                                           | 
|      high-end workstations and desktops; |  |       communications systems; and  
|                                           | 
|      disk arrays and data recorders;     |  |       parallel and super computers.



Demand for Memory
is Growing.The introduction of computing devices with greater processing power and more advanced operating systems and applications is driving the demand for greater amounts of memory, and in particular higher DRAM capacity. Advanced
processors, such as those based on new 64-bit architectures that process twice as many bits of information as compared to the current 32-bit standard, require higher levels of memory capacity to support large operating systems and properly perform
increasingly complex applications, such as data warehousing and data mining, web-based services, technical computing, digital imaging and other enterprise applications. In addition, the growing need for more bandwidth in storage and networking
equipment, such as network servers and network transmission, is escalating the demand for greater amounts of memory with faster performance characteristics. Similarly, the proliferation of next-generation routers, which utilize advanced transmission
techniques to efficiently direct information across networks, is increasing the demand for both processing power and memory within these devices.



Key Market Dynamics Are Intensifying.OEMs traditionally have sought to satisfy the need for greater memory capacity and higher memory speeds by
using memory chips with higher densities of transistors and by increasing the number of connectors, or memory module sockets, in their systems to support a greater number of memory chips. However, these approaches are becoming more difficult to
implement because significant availability, pricing and performance issues slow the transition from one generation of monolithic technology to the next.



Lagging Availability / Price-to-Performance Characteristics. In order to ensure that system parts, such as memory chips, are available to meet
their production needs, OEMs typically require that parts be available from multiple suppliers in sufficient volume prior to specifying a part for use within a system. Memory chips, or monolithic DRAM, formed from a single crystal of silicon have
been introduced by semiconductor manufacturers with ever-increasing memory capacity, with each new generation reflecting a doubling in available memory capacity. When first introduced, next-generation monolithic DRAM chips generally are only
available in limited supply and command a significantly higher price on a per bit basis when compared to current-generation DRAM chips. Until next-generation memory technologies become readily available and cost effective, it is not feasible for
OEMs to specify these technologies for use other than in their higher-end, more costly systems, leaving their broader product markets underserved.



Accelerating Speeds. In order to improve system performance, OEMs are designing systems that contain multiple central processing units, or CPUs,
with increasingly fast processing speeds. Since each CPU requires its own memory, systems with multiple CPUs require correspondingly more memory capacity to avoid becoming a



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bottleneck to overall system performance. However, since the memory chips must function at accelerated speeds to keep pace with these faster CPUs, the number
of memory module sockets must be reduced to mitigate loss of signal integrity and signal path delay, thus limiting the number of memory modules that can be installed.



Shrinking Form Factors. OEMs seek to design systems with smaller form factors to meet end-user demand for advanced
processing capabilities in physically smaller products, such as mobile devices and thinner, modular circuit boards that are designed to fit within a rack unit in a data center, including blade-server systems featuring high-speed interconnection to
enable networking capabilities that require less desktop equipment. In addition, as OEMs design systems with greater numbers of large CPUs, more memory is required in less available space. The combination of these factors causes OEMs to seek ways to
obtain greater memory capacity in less physical space.



Thermal Management Challenges. When CPUs and memory chips process information, they generate heat, which can compromise system performance and reliability if not properly managed. The denser packing of transistors in CPUs and memory
chips and the increased speeds of these devices result in more heat generation. Moreover, shrinking form factors at the system level require that these heat-generating parts be placed in a smaller space with less room for fans and other cooling
devices. The combination of these factors magnifies the thermal management challenges faced by OEMs.



OEM Supply Chain Demands. OEMs typically subject new products and technologies to rigorous and extensive testing and review prior to specifying
them for use within their systems. This qualification process can be expensive and time consuming with no assurance for success. OEMs also require conformance with standards, such as those set by the JEDEC Solid State Technology Association and
other standard-setting organizations in order to ensure consistency in design across multiple sources of packaged memory supply. Therefore, memory manufacturers must design new memory chips within strict architectural constraints, limiting
flexibility in design and requiring substantial investments in process development and production facilities in advance of qualification.



The demand for high-capacity memory solutions is growing, driven by technology improvements and new applications in computing devices, but the rate of
growth in demand for greater memory is outstripping the pace at which memory manufacturers are able to cost-effectively produce next-generation monolithic memory chips and reduce the cost of current-generation memory chips. OEMs are seeking
solutions that allow them to more effectively manage the transition from current- to next-generation memory. Intensifying market dynamics, such as accelerating processing speeds, shrinking form factors, higher thermal management demands and OEM
supply chain requirements, are making it more difficult to meet market needs. To meet all of these demands, memory providers and OEMs must focus on ways to obtain more memory capacity and optimize the price-to-performance attributes of their systems
within the intensely competitive environment of todays semiconductor marketplace.



Our Solution



We apply our expertise in
packaged memory stacking to provide intellectual property and services that enable our customers to cost-effectively improve the performance and reliability of their systems. By stacking industry-standard, current-generation memory packages, our
Stakpak solutions can deliver up to four times the memory capacity per memory module as compared to current-generation monolithic chips.



The substantial majority of our units contains stacked DRAM packages, but our stacking technologies can be used with Flash memory and other packaged
memory types and can be adapted to other emerging technologies. Our customers can license our stacking technologies for their in-house manufacturing of stacked memory units, outsource their manufacturing needs to us, buy stacked memory units from a
licensee such as Samsung or Infineon, or optimize their needs through a combination of these approaches.



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Our stacking solutions provide the following benefits:



Improve Availability / Price-to-Performance Characteristics. Our
stacked memory solutions utilize readily available, lower cost, current-generation memory chips to provide next-generation memory capacity. By doing so, we help to smooth the market transition to higher-capacity memory while production capacity for
next-generation memory chips is being developed. Once next-generation chips become readily available at lower costs, they become candidates for stacking to deliver even greater memory capacity to OEMs.



Enable Higher Memory Speeds. By vertically stacking TSOPs or fBGAs
onto a single connection, we shorten the distance that electrical signals must travel by reducing the distance between memory circuits, thereby minimizing delays in transmission and enabling higher operating speeds with less power dissipated in the
memory channel than would be attainable if the same number of chips were interconnected without stacking.



Overcome Physical Constraints. By stacking multiple TSOPs or fBGAs onto a single connection on a circuit board, our technologies enable a reduction
in the number of memory module sockets and, consequently, the number of circuit boards required in a system. This approach allows OEMs to design smaller, lighter and less expensive systems.



Improve Thermal Performance. We believe that the interconnect systems
featured in our Stakpak technologies help deliver superior thermal performance so that systems utilizing our stacked memory solutions reliably function according to their design specifications. We base this belief on extensive experimental data,
which is supported by thermal modeling simulations and basic principles of physics.



Satisfy OEM Supply Chain Needs. Our Stakpak technologies utilize widely available industry-standard components, enabling our memory stacks to fit on the same circuit board as monolithic packaged memory chips.
We combine our use of standard products with highly automated manufacturing and testing to deliver our stacked devices with high production yields.



Our Growth Strategy



We intend to build upon our leadership position in leaded packaged memory stacking and to leverage our technologies and flexible business model to
continue to grow our business and expand our market opportunities. The principal elements of our growth strategy include:



Expand our DRAM Stacking Business. We believe that the strength of our intellectual property position, our superior technologies and our focused
expertise uniquely position us to benefit from both growth in the high-capacity DRAM market and in the inclusion of stacked memory within that market. As monolithic memory capacity increases from 512-megabits to one-gigabit and beyond, we plan to
apply our technologies to each new generation of memory to allow memory manufacturers to smoothly transition from one generation to the next and to allow OEMs to more quickly bring to market systems with enhanced performance capabilities. We intend
to continually identify ways to penetrate fast-growing markets for high-capacity memory, such as next-generation routers, disk arrays that enable the redundant storage of the data across multiple disks and network interface cards that connect
computers across networks. We also intend to develop stacked memory solutions that address our customers particular requirements. We intend to promote the use and viability of three-high and four-high stacked configurations to expand the use
of stacked memory in the server and other markets and further capitalize on our leadership position.



Extend Technological Leadership into New Markets. We believe that our large patent portfolio and intellectual property position establish us as a
leader in the development of intellectual property for stacking solutions. We have introduced key innovations, such as our thermal management designs, in the market for stacked, packaged memory. In addition, we believe that we have more issued
United States patents directed to packaged memory integrated circuit stacks than any other United States manufacturer of such products. We



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intend to leverage our expertise and strong intellectual property position into markets where our technologies may have a significant impact. We intend to
pursue new product opportunities and penetrate the next-generation, non-leaded stacked memory market with our new High Performance Stakpak solution. Our High Performance Stakpak solution incorporates our patented fBGA stacking technologies, and
enables new levels of package miniaturization for multi-chip modules without requiring specialized testing. We also are developing our proprietary System Stakpak® technologies that will enable the stacking of multiple heterogeneous integrated circuit subsystem components, such as
processor, Flash memory and DRAM, as a single packaged module. We believe that these technologies will have applications across a broad spectrum of complementary markets for products with high processing needs and form factor constraints. We intend
to allocate increased resources to research and development to pursue these and other market opportunities.



Leverage Strategic Relationships. To grow our business, we will continue to cultivate strong relationships with leading OEMs, memory suppliers and
channel partners. We intend to continue to collaborate with leading OEMs and memory manufacturers to design more effective high-capacity memory solutions than are currently available. We intend to continue working with channel partners and
third-party manufacturers to make our stacked memory solutions widely available to OEM customers. As we expand and diversify our solutions, we intend to establish new, complementary customer and partner relationships beyond our traditional server,
networking and storage markets.



Capitalize on Our Flexible
Business Model. We believe that by offering our customers the options of licensing our technologies, outsourcing their manufacturing requirements to us, buying from our licensees or combining these options to best satisfy their needs, we offer
advantages over companies with solely a licensing or a manufacturing business model. We intend to continue to provide high-volume manufacturing services to facilitate adoption of our technologies by our customers while aggressively pursuing new
opportunities to license our technologies.



Our Stakpak Technologies



Our Stakpak solutions are designed to make our
stacked memory solutions more easily accepted by OEMs by utilizing industry-standard parts to cost-effectively provide next-generation memory capacity with better size characteristics and superior thermal management design features. Although our
stacking designs are capable of supporting all major types of commercially available packaged memory, including DRAM, Flash memory and static random access memory, or SRAM, which is a form of rapid access memory that retains information so long as
power is supplied, we have focused our development of Stakpak technologies on the stacking of DRAM chips in leaded TSOP packages and in non-leaded fBGA packages.



Performance Stakpak. Our Performance Stakpak utilizes a patented copper interconnect technology that provides a
structure and an electrical and thermal path for standard packaged DRAM chips. The Performance Stakpak uses primarily TSOPs in two-high or four-high stacked configurations. The interconnect system acts as a heat sink and heat spreader to reduce heat
build-up by collecting the thermal energy and conducting it from the center of the stack to the sides, where it can be dissipated from the package. This design allows the Performance Stakpak to achieve superior heat dissipation and lower die
temperatures than an unstacked TSOP.



Value Stakpak.Our
lower priced Value Stakpak uses a simplified design and assembly process in which the interconnect consists of a singulated printed circuit board placed horizontally along the edges or leads of the TSOP. As a result, our Value Stakpak does not
dissipate heat as well as our Performance Stakpak, but can be offered to customers for lower prices than our Performance Stakpak. For this reason, our Value Stakpak is targeted at lower-priced systems utilizing high-density memory where thermal
management is not as critical, such as entry-level server platforms, communications systems, set-top boxes and consumer applications.



High Performance Stakpak. Our High Performance Stakpak consists of non-leaded DDR DRAM packages connected by a newly-designed, proprietary
interconnect system to maximize interconnection signal integrity. This design supports all JEDEC-compliant DDR-II DRAM packages. The High Performance Stakpak has the



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same non-leaded fBGA footprint as the original monolithic fBGA packages, reducing the need for OEMs to redesign circuit boards for their stacked non-leaded
memory products. In addition, our High Performance Stakpak features our patented controlled impedance interconnect system to support the signal integrity needs of the high-speed DDR-II interface.



Customers



The markets for systems utilizing high-capacity memory are served mainly by large OEMs, such as Cisco, Dell,
Hewlett-Packard, IBM, Intel and Sun. We work with these and other OEMs to understand their requirements, and provide them with stacked memory solutions that they then qualify and in some cases specify for use within their systems. While we sell
directly to some OEMs, we provide our stacking services indirectly to OEMs, via semiconductor, memory module and contract manufacturers, who in turn assemble our Stakpak products onto memory modules that they deliver to the OEMs. Our major
semiconductor, memory module and contract manufacturing customers include Infineon, Kingston, Micron and SMART Modular, a subsidiary of Solectron, and prior to 2005, also included Celestica.



In 2004, Micron, Celestica and SMART Modular accounted for 17%, 9% and 12%,
respectively, of our total revenue. SMART Modular is a supply-chain partner of Hewlett-Packard, so our products are ultimately sold through to this OEM. During 2004, Celestica was a supply-chain partner of IBM. We do not have long-term contracts
with any of our manufacturing services customers. Sales of our stacked memory products are made under short-term, cancelable purchase orders that are typically received and fulfilled in the same quarter. As a result, our ability to predict future
sales in any given period is limited and subject to change based on demand for a specific OEMs systems that incorporate our stacked memory products and an OEMs supply chain decisions.



Sales and Marketing



Our sales and marketing strategy has been primarily focused on targeting
large OEMs based on the assumption that ultimate control over the selection of stacking solutions, module assembly and memory components resides with the OEMs. We have a dedicated internal sales and marketing staff responsible for maintaining
continual dialogues and forging close relationships with leading OEMs. Samsung and Infineons sales of stacked memory products utilizing our licensed stacking technologies also help us to increase the rate at which OEMs specify our stacked
memory technologies within their systems.



OEMs value
improvements in memory capacity, speed, form factor, thermal management, price and reliability. Our marketing efforts emphasize the benefits of utilizing our stacked memory solutions in OEMs systems and our ability to deliver our solutions
through our high-yield manufacturing processes with short lead times. To maintain broad application for our stacked memory technologies, we design our Stakpak solutions using industry-standard memory chips and footprints. This allows us to maintain
a neutral position with respect to silicon providers and memory and contract manufacturers, thus enabling OEMs to specify the use of standardized memory chips that are available from multiple sources in high volumes while still utilizing our
stacking technologies.



We generate new business primarily by
expanding our relationships and working closely with OEMs to design products that satisfy their systems memory needs. OEMs determine the technical specifications and control the selection of vendors and contract manufacturers or memory
manufacturers that will assemble and deliver the memory components. The typical OEM design cycle is a lengthy endeavor ranging from six months to two years, and during this process, our stacked memory solutions are considered among other alternative
solutions and undergo arduous testing and qualification.



In
August 2000, we entered into a license agreement with Samsung pursuant to which Samsung manufactures and sells memory modules containing stacked DRAM chips incorporating our leaded high-density memory stacking technologies. The agreement requires
Samsung to pay us per-unit royalties based upon the



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##### Index to Financial Statements

number of stacked memory products Samsung sells or bundles. The agreement requires Samsung to report to us on a quarterly basis the sale of products that
incorporate our technologies. Samsung generally reports shipment information 30 to 45 days after the end of the quarter in which such activity takes place. The agreement does not allow us to examine Samsungs records to verify that the amounts
being paid to us as license fees are correct. The agreement contains a non-compete provision that provides that during the term of the agreement, Samsung will not directly or indirectly sell, or invest in any company that sells, stacked products
other than Stakteks solutions for use in general and scientific computers such as mainframes, servers, work stations and desktop computers. The agreement expires in July 2005. Currently, we are in the process of negotiating with Samsung to
renew this agreement. It is too early in the process to determine whether Samsung and we will reach agreement. For the years ended December 31, 2004, 2003 and 2002, license revenue from Samsung accounted for approximately 43%, 26% and 14%,
respectively, of our total revenue.



In January 2004, we
entered into a license agreement with Infineon. Our license to Infineon is more limited in scope than our license to Samsung. We recognized a small amount of revenue from this license agreement in the second through fourth quarters of 2004, and we
do not anticipate that we will derive material revenue from this license in the future.



We do not have extended agreements with supply-chain partners but instead make sales to them from time to time through purchase orders.



Suppliers



Customers that outsource manufacturing services to us generally supply to us the packaged DRAM that they request we stack on a consignment basis. Once we
receive the packaged DRAM, we stack it in our manufacturing facilities and then ship the fully assembled stacked memory products back to them. Under this consignment model, we are not required to carry an inventory of packaged DRAM for these
customers, reducing our inventory costs and minimizing inventory risk associated with pricing, volumes and potential obsolescence. While we benefit from these minimized risks, if our customers are unable to obtain sufficient DRAM due to limited
availability, they are unable to consign it to us for our stacking services.



In the fourth quarter of 2004, we entered into a minimum unit purchase agreement with one of our vendors. The minimum purchase terms stipulate the purchase of 2 million units within an 18-month period that began in
October 2004. Actual costs could vary based on the actual volume of product ordered at one time, as compared to the expected future volume per order, due to the fact that pricing per unit is dependent upon the number of units in a given order.
Actual costs could also vary based on variances in actual versus forecast product mix as the minimum purchase contract covers a single product that is available in slightly varying configurations, with accordingly varying prices per unit. We expect
that the minimum purchase volumes under the contract will be fulfilled in 2005.



In order to manufacture our Stakpak units, we require raw materials and components such as flex circuits, printed circuit boards, epoxy adhesive, solder, nitrogen, ink marking supplies and tape and reel supplies.
While we generally have multiple sources of supply of these materials, we typically procure them from limited sources to take advantage of volume pricing discounts.



Manufacturing



We believe that our ability to deliver memory stacking technologies in high-volume and with short turnaround times distinguishes us from other stacking
technology providers. Our sophisticated manufacturing processes combine proprietary assembly equipment with standard, back-end automation in state-of-the-art manufacturing facilities. Since we began manufacturing our Stakpak products, we have been
increasing the degree of automation, overall efficiency and production yields of our manufacturing processes.



Historically, we manufactured all of our stacked memory products in our facility in Austin, Texas. In November 2002, we purchased a 45,000 square foot
manufacturing facility in Reynosa, Mexico with approximately 27,500 square feet of manufacturing space, of which approximately 75% is currently being



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##### Index to Financial Statements

utilized. We began transitioning our high-volume manufacturing to the Mexico facility in the first quarter of 2003. For the years ended December 31, 2004 and
2003, over 80% and 50%, respectively, of our units produced were manufactured in Mexico.



We have a formal quality assurance organization in place with a strategic focus on applying process improvements to achieve overall factory quality targets. We have been ISO certified to the ISO9001:2000 standard
since 2001, as assessed by Bureau Veritas Quality International (N.A.) Inc.



Research and Development



The market
for memory is subject to rapid technological changes, product obsolescence, frequent new product introductions and enhancements, changes in end-user requirements and evolving industry standards. Our ability to continue to succeed in these markets
will depend in significant part upon our ability to successfully develop, introduce and sell new and enhanced products on a timely and cost-effective basis and to respond to changing customer requirements.



Since 2001, we have focused our research and development spending primarily
towards the design of our Value Stakpak and High Performance Stakpak technologies, as well as to improve our manufacturing and industrial processes and engineering. We also have been designing our System Stakpak technology, which will enable
packaging of heterogeneous chips and processors. Our research and development expenses were approximately $2.6 million, $2.4 million and $2.1 million in 2004, 2003 and 2002, respectively. We believe that to remain competitive and to maintain our
growth, we must increase our investments in research and development with a continued focus both on designing advanced stacking and packaging technologies and on improving our manufacturing process, quality and industrial engineering and automation.
Through close integration of the product development and process automation initiatives, we seek to bring together advanced product designs with process efficiencies to reduce our time to market for new technologies and increase our overall
production.



Intellectual Property



Our current business and our future success depend in large part on our
ability to protect our proprietary intellectual property and technologies. We do not consider our business materially dependent upon any one patent, although taken as a whole, our rights and the products made and sold under patents are the most
significant element of our business. In addition to patents, we also rely on trade secrets and trademark laws and contractual provisions to protect our intellectual property. We enter into confidentiality agreements with our employees, consultants,
service providers, business partners and customers and have processes and controls in place to protect and manage access to, and distribution of, our proprietary and trade secret information.



As of January 31, 2005, we had over 80 issued domestic patents. These patents
primarily relate to our stacking solutions and help us protect our market position. These patents expire from time to time over the next 18 years. As of January 31, 2005, we also had over 45 patent applications pending. We continue to actively
pursue filing patent applications to cover our intellectual property advancements, and we may be required to spend significant resources to monitor and protect our intellectual property rights.



Competition



The market to provide memory solutions is intensely competitive. Within that market, we believe that we compete primarily
with other providers of high-capacity technologies and services to OEMs and manufacturers of high-density memory chips. The primary factors upon which we compete are product quality and reliability,



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manufacturing capacity, cycle times, price and prompt and effective customer service. We believe that our Stakpak technologies compete favorably in each of
these factors with other competitive technologies, services and manufacturers. Providers of technologies that compete with our Performance Stakpak technology include Elpida Memory, Infineon and Samsung. Providers of technologies that compete with
our Value Stakpak technology include Kingston, Micron and SimpleTech.



We have many competitors who have developed competing technologies. For example, planar solutions allow additional memory devices to be directly attached on the printed circuit board without the need for stacking. We believe that some of
the major OEMs and DRAM suppliers currently are using planar solutions and we expect them to utilize a greater percentage of planar solutions in the near future in legacy DDR technologies as well as in next-generation DDR-II technologies with the
migration to smaller footprint packages in these next-generation technologies. As a result of the increased use of planar solutions, we expect these OEMs and DRAM suppliers to decrease the use of stacked solutions in their products. However, we
believe that these planar solutions will have a limited window of opportunity, since increasing die sizes and higher speed requirements are expected to limit their use over time.



In addition, memory packages have been developed that place two DRAM chips into a single package that allows both DRAM chips
to fit in the same area as a single Stakpak.Other competitors utilize competing technologies that stack standard DRAM chips. These traditional stacking competitors include SimpleTech and also included DPAC before we acquired its stacking
patents and patent applications in June 2004. We also could face competition from many new technologies, such as 3D memory cells, stacked wafers, stacked die and module innovations or module stacking. These and other new technologies could change
the demand for or performance requirements of memory products, and could provide the market with cost-effective memory solutions that outperform our Stakpak solutions.



Some of our significant customers, including Samsung, Micron and Infineon, also are competitors of ours, and may have the
ability to manufacture competitive products at lower costs. Our current or potential competitors may also offer bundled arrangements offering a more complete or cost-effective product despite the technical merits or advantages of our services or
technologies. We also face competition from current and prospective customers that continually evaluate our capabilities against the merits of manufacturing products internally. Competition may also arise due to the development of cooperative
relationships among our current and potential competitors or third parties to increase the ability of their products to address the needs of our prospective customers. In addition, we expect to face competition from existing competitors and new and
emerging companies that may enter our existing or future markets with similar or alternative products, which may be less costly or provide additional features. Accordingly, it is possible that new competitors or alliances among competitors may
emerge and rapidly acquire significant market share.



Samsung
and Infineon sell their products into the same markets as we do, and we receive a royalty based upon the number of units that they sell. Our license agreement with Samsung provides that, during the term of the agreement, Samsung will not directly or
indirectly sell, or invest in any company that sells, stacked products other than our solutions for use in general and scientific computers such as mainframes, servers, work stations and desk top computers. Following the expiration of this license
agreement in July 2005, Samsung may be able to compete using other technologies in the stacked products markets currently restricted by the non-compete provision of the agreement. By the terms of the agreement, Samsung and we will be able to use
each others non-patented technology, information, know-how and processes related to the licensed technologies. However, we believe that our patent rights and the products sold under our patents are the most significant elements of our
relationship with Samsung, and we do not believe that Samsung would be able to continue to produce its current stacked memory products without infringing our patent rights. Furthermore, Samsung has made significant investments in tooling,
manufacturing and testing facilities and expertise as well as in product acceptance activities related to products that utilize our intellectual property. We also believe that Samsung realizes substantial financial benefits from the sale of stacked
memory solutions and that its continued ability to provide



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##### Index to Financial Statements

these solutions to its customers is important to its relationships with its customers and OEMs. Currently, we are in the process of negotiating with Samsung
to renew our license agreement. It is too early in the process to determine whether Samsung and we will reach agreement.



Government Regulation



We are subject to various United States and Mexican federal, state and local laws and regulations that are administered by numerous agencies and that
relate to the protection of the environment, including those governing the discharge or disposal of pollutants and hazardous materials.



We are authorized to operate our manufacturing facility in Mexico as a Maquiladoraby the Ministry of Economy of Mexico. This Maquiladorastatus allows us to import items into Mexico duty free, provided that such items, after processing, are re-exported from Mexico within 18 months. Our Maquiladora status is subject to various restrictions and requirements, including
compliance with the terms of the Maquiladoraauthorization program; proper utilization of imported materials; hiring and training of Mexican personnel; compliance with tax, labor, exchange control and notice provisions and regulations; and
compliance with local and national constraints. Under our Maquiladora authorization program, our Reynosa, Mexico facility is not subject to any mandatory periodic audits or inspections or any periodic evaluations of our Maquiladora
status. However, various Mexican government agencies, particularly Mexicos Ministry of Economy and Mexicos Ministry of Treasury, which are primarily responsible for the oversight and regulation of Mexicos Maquiladora
programs, have a statutory right to conduct inspections and evaluations of our Reynosa, Mexico operations at their discretion to ensure our compliance with the Maquiladora authorization program.



Employees



As of March 1, 2005, we had 370 full-time employees, including 241 in operations and engineering; 38 in quality assurance;
67 in sales, general and administrative functions; 16 in research and development; and 8 in executive positions.



By region, 134 and 236 of our employees are located in the United States and in Mexico, respectively. As of March 1, 2005, 65% of our employees in Mexico
are represented by a labor organization that has entered into a labor contract with us. We are not party to any collective bargaining agreements with any of our employees in the United States. We have never had a work stoppage, and we believe our
relations with our employees are good.



FACTORS AFFECTING OUR FUTURE
OPERATING RESULTS



Our business faces significant risks.
The risk factors set forth below may not be the only ones that we face. Additional risks that we are not aware of yet or that currently are not material may adversely affect our business operations.



We may not be able to increase our revenue and our operating results
are likely to fluctuate, which may cause the trading price of our common stock to decline.



We may not be able to increase revenue or generate gross profits or net income. Our revenue and operating results are likely to fluctuate, causing our
stock price to fluctuate. If our revenue or operating results fall below the expectations of market analysts or investors, the market price of our common stock could decline substantially.



Factors that may contribute to fluctuations in our revenue and operating
results include the risk factors discussed elsewhere in this annual report on Form 10-K and the following additional factors:



| |  |  | the timing and volume of orders received from our customers;
| | - |  | ------------------------------------------------------------



| |  |  | market demand for, and changes in the average sales prices of, our services and technologies;
| | - |  | ---------------------------------------------------------------------------------------------



| |  |  | the rate of qualification and adoption of our services and technologies by OEMs including, but not limited to, the transition from DDR-I to DDR-II technology and from leaded to
non-leaded packages;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | a shortage of DRAM chips, which may negatively impact our ability to fulfill customer orders;
| | - |  | ---------------------------------------------------------------------------------------------



| |  |  | the impact of the transition from current-generation stacked products, which are based on 256-megabit monolithic DRAMs to next-generation stacked products, which are based on
512-megabit monolithic DRAMs, resulting in lower unit volumes of stacked memory products;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  |  | the impact of a current reduction in the prices of 512-megabit monolithic DRAM, making this memory a competitive cost alternative to stacked 256-megabit monolithic DRAMs;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the increasing adoption of small-package planar solutions instead of our stacking solutions by OEMs as well as DRAM suppliers;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



| |  |  | fluctuating demand for, and life cycles of, the products and systems that incorporate our stacked solutions;
| | - |  | ------------------------------------------------------------------------------------------------------------



| |  |  | changes in OEMs DRAM and dual in-line memory module buying processes;
| | - |  | ----------------------------------------------------------------------



| |  |  | changes in the level of our operating expenses;
| | - |  | -----------------------------------------------



| |  |  | our ability to manufacture and ship products within a particular reporting period;
| | - |  | ----------------------------------------------------------------------------------



| |  |  | deferrals or cancellations of customer orders in anticipation of the development and commercialization of new technologies or for other reasons;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to enter into new licensing arrangements, and the terms and conditions for payment to us of license fees under those arrangements;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in our services and technologies and revenue mix;
| | - |  | ---------------------------------------------------------



| |  |  | seasonal purchasing patterns for our products with lower revenue generally occurring in the first and second quarters;
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | the timing of the introduction by others of competing, replacement or substitute technologies or manufacturing services;
| | - |  | ------------------------------------------------------------------------------------------------------------------------



| |  |  | our ability, or the ability of our customers, to procure or manufacture DRAM and other required components or fluctuations in the cost of such components;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to enforce our intellectual property rights or to defend claims that we infringe the intellectual property rights of others, and the significant costs to us of related
litigation;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | cyclical fluctuations in semiconductor markets generally; and
| | - |  | -------------------------------------------------------------



| |  |  | general economic conditions that may affect end-user demand for products that use our technologies.
| | - |  | ---------------------------------------------------------------------------------------------------



Fluctuations in the demand for our stacking solutions occur as the price of next-generation monolithic memory chips declines
and as OEMs respond to demand for their products, which will contribute to volatility in our revenue and operating results and may adversely impact our stock price. The rate at which OEMs adopt stacked memory products using a particular generation
of high-density memory chips, if they adopt stacked memory products at all, may affect our revenue and operating results. In the past, it has taken several quarters for new, higher-density memory chips to achieve market acceptance. Once accepted by
the market, demand for stacked memory products using these chips can accelerate rapidly and then level off such that rapid growth in sales of these products is not indicative of continued future growth. Likewise, demand for legacy memory chips can
quickly decline when a new, higher-density memory chip is introduced and receives market acceptance. Sales of our products and product lines toward the end of a products market life may fluctuate significantly, and the precise timing of these
fluctuations is difficult, if not impossible, to predict.



In other cases, revenue may decline as customers anticipate making new product purchases. The need for continued significant expenditures for capital equipment purchases, research and development and ongoing customer service and support,
among other factors, makes it difficult for us to reduce our operating expenses in



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any particular period if our expectations for revenue for that period are not met. Due to the various factors mentioned above, the results of any prior
quarterly or annual periods should not be relied upon as an indication of our future operating performance.



Because we do not have long-term agreements with our customers and generally do not have a significant backlog of unfilled orders, our revenue and
operating results in any quarter are difficult to forecast and are substantially dependent upon customer orders received and fulfilled in that quarter.



We do not have long-term purchase agreements with customers. Our customers generally place purchase orders for deliveries no more than three months in
advance and sometimes no more than a day in advance. These purchase orders generally have no cancellation or rescheduling penalty provisions. Therefore, cancellations, reductions or delays of orders from any significant customer could have a
material adverse effect upon our business, financial condition and results of operations.



Our revenue is difficult to forecast because we do not have a sufficient backlog of unfilled orders to meet our quarterly revenue targets at the beginning of a quarter. Rather, a majority of our revenue and earnings
in any quarter depends upon customer orders for our products that we receive and fulfill in that quarter. Because our expense levels are based in part on our expectations as to future revenue and to a large extent are fixed in the short term, we
likely will be unable to adjust spending on a timely basis to compensate for any unexpected shortfall in revenue. Accordingly, any significant shortfall of revenue in relation to our expectations could hurt our operating results and depress our
stock price.



We depend on a limited number of customers
for a substantial portion of our revenue, and the loss of, or a significant reduction in orders from, any key customer could significantly reduce our revenue.



The loss of any of our key customers, or a significant reduction in sales to any one of them, would significantly reduce our
revenue and adversely affect our business. Our five largest customers accounted for 86% of our total revenue in 2004, 88% of our total revenue in 2003 and 93% of our total revenue in 2002. In particular, Samsung accounted for most of our license
revenue and 43% of our total revenue in 2004, and Micron Technology, Celestica Corporation and SMART Modular Technologies accounted for 17%, 9% and 12%, respectively, of our total revenue in 2004. SMART Modular is a supply-chain partner of
Hewlett-Packard, so units incorporating our stacking solutions are ultimately sold through to HP as the OEM. We sold to Celestica as a supply-chain partner of another OEM, but this OEM adopted a different business model by sourcing more of its
high-density needs directly through silicon providers rather than indirectly through Staktek. The principal effect of this change was to shift some service revenue to license revenue. In addition, this shift may result in the potential loss of some
business to alternative technologies. Most of the markets for our services and technologies are dominated by a small number of potential customers. Therefore, our operating results in the foreseeable future will continue to depend on our ability to
effect sales to these dominant customers, as well as the ability of these customers to sell products that incorporate stacked memory utilizing our stacking technologies. In the future, these customers may decide not to specify products that
incorporate our stacking technologies for use in their systems, purchase fewer stacked memory products than they did in the past or alter their purchasing patterns.



Some of our customers have sought or are seeking to design alternative solutions, either internally or through third
parties, to address their need for greater memory capacity. The success of these efforts could have an adverse effect on the prices we are able to charge our customers, and the volume of units that incorporate our stacking solutions, which would
negatively affect our revenue and operating results.



Consolidation in some of our customers industries may result in increased customer concentration and the potential loss of customers. From time to time, the composition of our major customer base has changed from quarter to quarter as
the market demand for our customers products has changed, and we expect this variability to continue in the future. We expect that sales of our products to a limited number of customers will continue to represent a majority of our revenue in
the foreseeable future. The loss of, or a significant reduction in purchases by, any of our major customers could harm our business, financial condition and results of operations.



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A natural disaster, epidemic, labor strike, war or political unrest where our customers facilities
are located could reduce our sales to such customers. For example, Samsung Electronics is based in South Korea and represented most of our license revenue and 43% of our total revenue in 2004. North Koreas decision to withdraw from the Nuclear
Non-Proliferation Treaty and related geopolitical developments have created unrest. This unrest could create economic uncertainty or instability, could escalate to war or otherwise adversely affect South Korea and Samsung, which could materially and
adversely affect our operating results.



If we fail to
protect our proprietary rights, our customers or our competitors might gain access to our technologies, which could adversely affect our ability to sell or license our stacked memory solutions or to compete successfully in our markets and harm our
operating results.



Our solutions rely on our
proprietary rights, and we believe that the strength of our intellectual property rights is, and will continue to be, critical to the success of our business. If any of our key patents or other intellectual property rights are invalidated or deemed
unenforceable, or if a court limits the scope of the claims in any of our key patents or other intellectual property rights, the likelihood that companies will continue to purchase or license our stacked memory solutions could be significantly
reduced. The resulting loss in revenue could significantly harm our business and our operating results.



We rely on a combination of patent, trademark and trade secret laws, and restrictions on disclosure to protect our intellectual property rights. We also
enter into confidentiality agreements with our employees, consultants and third parties, and control access to and distribution of our documentation and other proprietary information. It is possible that these efforts to protect our intellectual
property rights may not:



| |  |  | prevent challenges to, or the invalidation or circumvention of, our existing patents;
| | - |  | -------------------------------------------------------------------------------------



| |  |  | result in patents that lead to commercially viable products or provide competitive advantages for our products;
| | - |  | ---------------------------------------------------------------------------------------------------------------



| |  |  | prevent our competitors from independently developing similar products, duplicating our products or designing around the patents owned by us;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | prevent third-party patents from having an adverse effect on our ability to do business;
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | provide adequate protection for our intellectual property rights;
| | - |  | -----------------------------------------------------------------



| |  |  | prevent disputes with third parties regarding ownership of our intellectual property rights;
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | prevent disclosure of our trade secrets and know-how to third parties or into the public domain; or
| | - |  | ---------------------------------------------------------------------------------------------------



| |  |  | result in valid patents, including international patents, from any of our pending applications.
| | - |  | -----------------------------------------------------------------------------------------------



Others may attempt to copy or otherwise obtain and use our proprietary technologies without our consent. Because we expect
to increasingly license our technologies to new customers and because of the difficulty of monitoring our licensees, the risk that licensees and their customers or others may attempt to copy or otherwise obtain and use our proprietary technologies
without our consent may increase. Monitoring unauthorized use of our technologies is difficult, and we cannot be certain that the steps we have taken will prevent unauthorized use of our technologies, particularly in foreign countries where the laws
may not protect our proprietary rights to the same extent as the laws of the United States.



We derive a substantial portion of our revenue from our license agreement with Samsung, which expires in July 2005. We may not be able to extend this agreement on favorable terms or at all, or Samsung may renew
but not utilize as much of our stacking technology as it currently utilizes, which could materially harm our business, financial condition and results of operations.



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Through the first quarter of 2004, we derived all of our license revenue from our license agreement with
Samsung. We expect to continue to receive the substantial majority of our license revenue from this license agreement until its expiration. This agreement requires Samsung to pay us royalties based on the number of stacked memory products Samsung
sells or bundles within its own products. This license expires in July 2005. Currently, we are in the process of negotiating with Samsung to renew this agreement. It is too early in the process to determine whether Samsung and we will reach
agreement. If we are unable to extend this agreement on terms favorable to us or at all, if Samsung terminates this agreement, or if Samsung renews this agreement but does not continue to utilize as much of our stacking technology as it currently
utilizes, our business, financial condition and results of operations could be materially harmed.



Our license agreement with Samsung requires Samsung to report to us on a quarterly basis the sale of products that incorporate our technologies. Our
license agreement with Samsung does not allow us to examine Samsungs records to verify that the amounts being paid to us as license fees are correct. As a result, we rely primarily on the accuracy of the reports from Samsung without
independent verification and secondarily on information obtained from customers, suppliers and market analysts and our own production data. Our inability to review Samsungs books and records may result in our receiving less license revenue
than we are entitled to receive under the terms of our license agreement. If we determine that Samsung is not accurately reporting to us the number of units it sold, we may be required to commence litigation against Samsung which, even if
meritorious, could be costly and time consuming, could harm our relationship and could adversely affect our business.



Following the expiration of our license agreement with Samsung, both we and Samsung will be able to use each others technology, information,
know-how and processes related to the licensed technologies that are not protected by patents, and Samsung will be able to compete in markets currently restricted by a non-compete provision of the agreement. At such time, subject to our patent
rights, Samsung may use such technology and its substantial resources to compete in our target markets.



We are subject to risks relating to product concentration and lack of revenue diversification.



We derive nearly all of our revenue from sales or licenses of our Stakpak
solutions, and we expect these solutions to continue to account for substantially all of our total revenue in the near term. Continued market acceptance of these solutions is critical to our future success. As a result, our business, operating
results, financial condition and cash flows could be adversely affected by:



| |  |  | any decline in demand for our Stakpak solutions;
| | - |  | ------------------------------------------------



| |  |  | failure of our services and technologies to achieve continued market acceptance;
| | - |  | --------------------------------------------------------------------------------



| |  |  | the introduction of services and technologies that can serve as a substitute for, replacement of or represent an improvement over, our services and technologies such as planar
solutions for small packages that do not require stacking;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | technological innovations that we are unable to address with our services and technologies; and
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | any inability by us to release new products or enhanced versions of our existing services and technologies on a timely basis or the failure of our products to achieve market
acceptance.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



We are particularly dependent on
sales of our Performance Stakpak solutions for use in the high-end and midrange server market, which constituted 82% of our total services revenue in 2004, 98% of our total services revenue in 2003 and 100% of our total services revenue in 2002. If
the market for these servers deteriorates or the use of our stacked services and technologies in this market declines, our operating results would be materially and adversely affected.



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The average selling prices of our services and technologies could decrease rapidly which may
negatively impact our revenue and gross margins.



We
may experience substantial period-to-period fluctuations in our future revenue and operating results due to a decline in the average selling prices for our services and technologies. From time to time, we reduce the average unit price of our
services and technologies in anticipation of future competitive pricing pressures, declining DRAM chip prices, introductions of new services and technologies by us or our memory suppliers and other factors. The high-density memory market is
extremely cost sensitive due to potentially high order volumes combined with memory buyers expectations for aggressive price reductions over time. As a consequence, the average selling prices of monolithic DRAM chips historically have declined
as new product generations are commercialized. We expect that these factors will continue to create downward pressure on our average selling prices, which may, in turn, negatively impact our revenue and gross margins, particularly if we are unable
to offset reductions in average selling prices by increasing our unit volumes or reducing our manufacturing costs. To maintain our gross margins, we will need to develop and introduce new services and technologies on a timely basis and continually
reduce our costs. Our failure to do so could cause our revenue and gross margins to decline.



We are a relatively small company with limited resources compared to some of our current and potential competitors, and we may not be able to compete effectively and maintain or increase our market share.



Some of our current and potential competitors have
longer operating histories, significantly greater resources and name recognition, and a larger base of customers than we have. Some of these companies are better positioned to influence industry acceptance of a particular industry standard or
competing technology than we are. These companies may also be able to devote greater resources to the development, promotion and sale of products, and may be able to deliver competitive products or technologies at a lower price. They also may be
able to adopt more aggressive pricing policies than we can adopt. In addition, some of our current and potential competitors have established relationships with the decision makers at our current or potential customers. These competitors may be able
to leverage their existing relationships to discourage their customers from purchasing products from us or persuade them to replace our products with their products.



Some of our significant customers, including Samsung, Micron and Infineon, also are competitors of ours, and may have the
ability to manufacture competitive products at lower costs. Our current or potential competitors may also offer bundled arrangements offering a more complete or cost-effective product despite the technical merits or advantages of our services or
technologies. We also face competition from current and prospective customers that continually evaluate our capabilities against the merits of manufacturing products internally. Competition may also arise due to the development of cooperative
relationships among our current and potential competitors or third parties to increase the ability of their products to address the needs of our prospective customers. In addition, we expect to face competition from existing competitors and new and
emerging companies that may enter our existing or future markets with similar or alternative products, which may be less costly or provide additional features. Accordingly, it is possible that new competitors or alliances among competitors may
emerge and rapidly acquire significant market share.



We have
many competitors who have developed competing technologies. For example, planar solutions allow additional memory devices to be directly attached on the printed circuit board without the need for stacking. We believe that some of the major OEMs and
DRAM suppliers currently are using planar solutions and we expect them to utilize a greater percentage of planar solutions in the near future in legacy DDR technologies as well as in next-generation DDR-II technologies with the migration to smaller
footprint packages in these next-generation technologies. As a result of the increased use of planar solutions, we expect these OEMs and DRAM suppliers to decrease the use of stacked solutions in their products. However, we believe that these planar
solutions will have a limited window of opportunity, since increasing die sizes and higher speed requirements are expected to limit their use over time.



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In addition, memory packages have been developed that place two DRAM chips into a single package that
allows both DRAM chips to fit in the same area as a single Stakpak.Other competitors utilize competing technologies that stack standard DRAM chips. These traditional stacking competitors include SimpleTech and also included DPAC before we
acquired its stacking patents and patent applications in June 2004. We also could face competition from many new technologies, such as 3D memory cells, stacked wafers, stacked die and module innovations or module stacking. These and other new
technologies could change the demand for or performance requirements of memory products, and could provide the market with cost-effective memory solutions that outperform our Stakpak solutions.



We expect our competitors to continue to improve the performance of their
current products, reduce their prices and introduce new services and technologies that may offer greater performance and improved pricing, any of which could cause a decline in revenue or loss of market acceptance of our products. In addition, our
competitors may develop enhancements to, or future generations of, competitive products that may render our services or technologies obsolete or uncompetitive. These and other competitive pressures may prevent us from competing successfully against
current or future competitors, and may materially harm our business. Competition could decrease our prices, reduce our revenue, lower our gross profits or decrease our market share.



As our current services and technology offerings evolve, we continue to derive a significant portion of our revenue
from royalties, which is inherently risky.



Because we
expect a significant portion of our future revenue to be derived from license royalties, our future success depends on:



| |  |  | our ability to secure broad patent coverage for our new technologies and enter into license agreements with potential licensees; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the ability of our licensees to develop and commercialize successful products that incorporate our stacking technologies.
| | - |  | -------------------------------------------------------------------------------------------------------------------------



Although we have engaged in discussions with potential licensees for our
Stakpak technologies, we historically have not devoted significant resources to licensing our technologies and currently have only two license arrangements. We face risks inherent in a royalty-based business model, many of which are outside of our
control, such as the following:



| |  |  | the rate of adoption of our technologies by, and the incorporation of our technologies into products of, semiconductor manufacturers and OEMs;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the extent to which large equipment vendors and materials providers develop and supply tools and materials to enable manufacturing using our stacking technologies on a
cost-effective basis and in quantities sufficient to enable volume manufacturing;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the willingness of our licensees and others to make investments in the manufacturing process that supports our licensed technologies, and the amount and timing of those investments;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our licensees ability to design and assemble memory modules and other system parts that utilize our technologies in components qualified for use by OEMs;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | any failure by our licensees to abide by compliance and quality control guidelines with respect to our proprietary rights;
| | - |  | --------------------------------------------------------------------------------------------------------------------------



| |  |  | actions by our licensees that could severely harm our ability to use our proprietary rights;
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | the demand for products incorporating memory modules and other system parts that utilize our licensed technologies;
| | - |  | -------------------------------------------------------------------------------------------------------------------



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| |  |  | our ability to structure, negotiate and enforce agreements for the determination and payment of royalties; and
| | - |  | --------------------------------------------------------------------------------------------------------------



| |  |  | the cyclicality of supply and demand for products using our licensed technologies.
| | - |  | ----------------------------------------------------------------------------------



It is difficult to predict when we will enter into additional license agreements, if at all. The time it takes to establish
a new licensing arrangement can be lengthy. We may also incur delays or deferrals in the execution of license agreements as we develop new technologies. The timing of our receipt of royalty payments and the timing of how we recognize license revenue
under license agreements may fluctuate and significantly impact our quarterly or annual operating results.



We have limited sales and marketing resources. As our business evolves to become more of a royalty-based model, we may have to employ more rigorous sales
and marketing efforts, hire more sales and marketing personnel and engage in lengthy negotiations to reach agreement with potential licensees. As a result, our operating expenses may increase, and we may incur losses in periods that precede the
generation of royalties under licensing agreements. If the sales and marketing efforts that we direct at potential licensees of our technologies are unsuccessful, then we may not be able to license our technologies or earn related royalties.



Our reliance on our memory manufacturer customers for
the DRAM chips used in stacked products that incorporate our stacking technologies subjects us to the risk of a shortage of these chips, adversely impacting our ability to fulfill orders from other customers, risks of natural disasters and other
factors that could cause disruptions in the supply of DRAM chips.



Our ability to fulfill customer orders is dependent on a sufficient supply of DRAM chips to which we apply our manufacturing services. Historically, our customers have shipped on consignment their DRAM chips to be
stacked, which we stack and then return to them. We have no DRAM supply contracts under which we are currently operating. In acquiring DRAM chips, supply options are very limited because of the small number of memory manufacturers. Our dependence on
our customers provision of DRAM chips to us on a just-in-time consignment basis, rather than through guaranteed supply contracts, subjects our business to risks associated with unforeseen disruptions in the industry availability of DRAM chips.
During the second and third quarters of 2004, there was a shortage of DRAM chips available in the market. This shortage negatively impacted our ability to fulfill customer orders, which resulted in a decrease in shipments in these quarters. Any
future shortage could result in a similar decrease in shipments, which would adversely impact our operating results and financial condition.



In addition, natural disasters or other factors could cause delays or reductions in product shipments that could negatively affect our revenue and
operating results. Moreover, since the majority of DRAM chips are manufactured in the Pacific Rim region, we believe that the risk of exposure of DRAM suppliers to earthquakes, typhoons, political unrest, terrorist activity, severe acute respiratory
syndrome, or SARS, other infectious diseases or other similar events is of particular concern. Any unexpected interruption in the manufacture of other key electronic components used in association with stacked products that incorporate our stacking
technologies could disrupt production of devices that use our services and technologies, thereby adversely affecting either our ability to deliver products to our customers or the customers demand for our services and technologies.



If we are unable to manufacture our products efficiently or we
experience credit losses or other collections issues, our operating results could suffer.



We are continuously modifying our manufacturing processes in an effort to maintain satisfactory manufacturing yields and product performance, lower our
costs and reduce the time it takes to design products based on our technologies. In addition, we are ramping high-volume production of a new technology with our High Performance Stakpak, which requires a new manufacturing process. We are facing
increased risks with this new process and we are incurring significant start-up costs associated with implementing new manufacturing technologies, methods and processes and purchasing new equipment for this product, which could negatively impact our
gross margins. We expect to experience manufacturing delays and inefficiencies as we develop or



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##### Index to Financial Statements

refine new manufacturing technologies and stacking methods, implement them in volume production and qualify them with customers, which could cause our
operating results to decline. As we manufacture more complex products, such as our High Performance Stakpak as well as future products, the risk of encountering delays or difficulties increases.



In addition, if demand for our products increases significantly, we will need
to expand our operations to manufacture sufficient quantities of products without increasing our production times or our unit costs. As a result of such expansion, we could be required to purchase new equipment, upgrade existing equipment, develop
and implement new manufacturing processes and hire additional technical personnel. Further, new or expanded manufacturing facilities could be subject to qualification by our customers. We cannot be certain that we will be able to add required
manufacturing capacity or that we will be able to maintain control over product quality, delivery schedules, manufacturing yields and costs as we increase our output. Any difficulties in expanding our manufacturing operations could cause product
delivery delays and lost sales.



If demand for our products
decreases, we could have excess manufacturing capacity. The fixed costs associated with excess manufacturing capacity could cause our operating results to decline. If we are unable to achieve further manufacturing efficiencies and cost reductions,
particularly if we are experiencing pricing pressures in the marketplace, our operating results could suffer.



We have not historically recorded a bad debt allowance or established reserves for our accounts receivable because we have not had significant credit
losses or other collections issues during the periods for which financial information is presented. Although we do not believe that we will incur any material credit losses in the foreseeable future, if we were to do so, our financial condition and
results of operations could be harmed. Furthermore, should we face any collections issues in the future, it could become necessary to begin recording a bad debt allowance, which could negatively impact our results of operations.



If we are unable to develop new and enhanced solutions that achieve
market acceptance in a timely manner, our operating results and competitive position could be harmed.



Our future success will be based in large part on our ability to reduce our dependence on our current Performance Stakpak solution for the vast majority
of our revenue by increasing revenue associated with our other Stakpak solutions, such as our High Performance Stakpak, and by developing new stacking and packaging technologies and enhancements that can achieve market acceptance in a timely and
cost-effective manner. Successful development and introduction of new technologies on a timely basis require that we:



| |  |  | identify and adjust to changing requirements of customers within the memory and semiconductor markets generally;
| | - |  | ----------------------------------------------------------------------------------------------------------------



| |  |  | identify and adapt to emerging technological trends in our target markets;
| | - |  | --------------------------------------------------------------------------



| |  |  | maintain effective marketing strategies;
| | - |  | ----------------------------------------



| |  |  | timely design and introduce cost-effective, innovative and performance-enhancing features that differentiate our services and technologies from those of our competitors;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | timely qualify and certify our stacking technologies for use in our customers products; and
| | - |  | --------------------------------------------------------------------------------------------



| |  |  | successfully develop our relationships with existing and potential customers, OEMs and supplier and channel partners.
| | - |  | ---------------------------------------------------------------------------------------------------------------------



Our research and development efforts are focused primarily on furthering the
technologies related to our High Performance Stakpak solution, which we recently introduced, and our System Stakpak solution, which we are currently developing. If the development of these technologies is delayed or abandoned, or if these new



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##### Index to Financial Statements

technologies fail to achieve market acceptance, our growth prospects, operating results and competitive position could be adversely affected. Furthermore, if
markets for these new technologies develop later than we anticipate, or do not develop at all, demand for our solutions that are currently in development would suffer, resulting in lower sales of these products than we currently anticipate.



Products that incorporate our stacking technologies
generally have long sales and implementation periods, and our customers require that our stacking technologies undergo a lengthy and expensive qualification process without any assurance of revenue.



Products that incorporate our stacking technologies are complex and are
typically intended for use in applications that may be critical to the systems being developed by our customers. Prospective customers generally must make a significant commitment of resources to test and evaluate our stacking technologies and to
integrate memory modules and other system parts into larger systems. As a result, our sales process is often subject to delays associated with lengthy approval processes that typically accompany the design, testing and adoption of new,
technologically complex products. This may delay the time in which we recognize revenue and result in our investing significant resources well in advance of orders for our products.



Prior to incorporating memory products utilizing our stacking technologies, OEMs require our stacking process and
technologies to undergo an extensive qualification process, which involves testing of products utilizing our stacking technologies in the customers system as well as rigorous reliability testing. This qualification process may continue for six
months or longer. However, qualification by a customer does not ensure any sales to that customer. Even after successful qualification and sales to a customer of products incorporating our stacking technologies, changes in our technologies may
require a new qualification process, which may result in additional delays. After our products are qualified, it can take an additional six months or more before the customer commences production of components or devices that incorporate our
products. Despite these uncertainties, we devote substantial resources, including design, engineering, sales, marketing and management efforts, toward qualifying our products with customers in anticipation of sales. If we are unsuccessful or delayed
in qualifying any of our products with a customer, such failure or delay would preclude or delay sales of such products to the customer, which may impede our growth and cause our business to suffer.



If the supply of materials used to manufacture our products is
interrupted, or our manufacturing turnaround times are extended, our results of operations could be adversely affected.



In order to manufacture our Stakpak solutions, we require raw materials and components such as flex circuits, printed circuit boards, epoxy adhesive,
solder, nitrogen, ink marking supplies and tape and reel supplies. We typically procure these materials from limited sources to take advantage of volume pricing discounts. Shortages in these materials may occur from time to time. In addition to
shortages, we could experience quality problems with these materials, which could result in returning them to our supplier. These shortages and returns could extend the turnaround times of our manufacturing services. If our supply of materials is
interrupted for any reason, or our manufacturing turnaround times are extended, our results of operations could be adversely affected.



We shifted the substantial majority of our manufacturing operations from Austin, Texas to Reynosa, Mexico, and our failure to continue to manage
this shift in our operations and our growth could materially and adversely affect our business.



We shifted our high-volume manufacturing capacity from our Austin, Texas facility to a new manufacturing facility in Reynosa, Mexico. We began
manufacturing operations in our Mexico facility in the first quarter of 2003, and in the fiscal year ended December 31, 2004, we manufactured over 80% of our units in Mexico. In addition, we shifted all of the production of our Performance Stakpak
to this facility in the fourth quarter of 2004. This shift in our operations, combined with the growth in our business overall in recent periods, has placed, and any future growth of our operations will continue to place, a significant strain on our
management personnel,



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##### Index to Financial Statements

systems and resources. We may need to implement a variety of new and upgraded operational and financial systems, procedures and controls, including the
improvement of our accounting and other internal management systems. We also expect that we will need to continue to expand, train, manage and motivate our workforce. All of these endeavors will require substantial management time and attention, and
we anticipate that we will require additional management personnel and internal processes to manage these efforts. If we are unable to effectively manage our expanding operations, our business could be materially and adversely affected.



Our manufacturing facility in Reynosa, Mexico could expose us to new
and significant risks.



Our high-volume manufacturing
facility in Reynosa, Mexico provided over 80% of our unit production in the fiscal year ended December 31, 2004. In addition, we shifted all of the production of our Performance Stakpak to this facility in the fourth quarter of 2004. This facility
is exposed to certain risks as a result of its location, including:



| |  |  | changes in international trade laws, such as the North American Free Trade Agreement, or other governmental regulations or tariffs affecting our import and export activities;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in labor laws and regulations affecting our ability to hire and retain employees;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | fluctuations of foreign currency and exchange controls;
| | - |  | -------------------------------------------------------



| |  |  | security measures at the United States-Mexico border;
| | - |  | -----------------------------------------------------



| |  |  | potential political instability and changes in the Mexican government; and
| | - |  | --------------------------------------------------------------------------



| |  |  | general economic conditions in Mexico.
| | - |  | --------------------------------------



Any of these risks could interfere with the operation of this facility or restrict or delay our ability to move components, finished products or
manufacturing equipment across the United StatesMexico border and result in reduced production, increased costs, or both. In the event that this facilitys production is reduced or we encounter disruptions or delays in moving products
across the border, we could fail to ship products on schedule and could face a reduction in future orders from dissatisfied customers. If our costs to operate this facility increase, our gross margins would decrease. Reduced shipments and margins
would have an adverse effect on our financial results and could lead to a decline in our stock price.



We operate our manufacturing facility in Mexico as a Maquiladora and any loss of this status or change in the laws affecting Maquiladoras, or
disputes with the labor union in Mexico, could materially harm our financial results.



In the fiscal year ended December 31, 2004, we manufactured over 80% of our stacked memory products at our manufacturing facility in Reynosa, Mexico. This facility is authorized to operate as a Maquiladora by
the Ministry of Economy of Mexico. Mexico has enacted this legislation to promote the use of such manufacturing operations by foreign companies, and continuation of these operations depends upon, among other factors, compliance with applicable laws
and regulations of the United States and Mexico. Maquiladora status allows us to import items into Mexico duty-free, provided that such items, after processing, are re-exported from Mexico within 18 months. Maquiladora status is
subject to various restrictions and requirements, including:



| |  |  | compliance with the terms of the Maquiladora authorization program;
| | - |  | -------------------------------------------------------------------



| |  |  | proper utilization of imported materials;
| | - |  | -----------------------------------------



| |  |  | hiring and training of Mexican personnel;
| | - |  | -----------------------------------------



| |  |  | compliance with tax, labor, exchange control and notice provisions and regulations; and
| | - |  | ---------------------------------------------------------------------------------------



| |  |  | compliance with local and national constraints.
| | - |  | -----------------------------------------------



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##### Index to Financial Statements

Because assembly operations in Mexico continue to be less expensive than comparable operations in the
United States, in recent years many companies have established Maquiladora operations in the Reynosa area to take advantage of lower labor costs. Increasing demand for labor, particularly skilled labor and professionals, from new and existing
Maquiladora operations could in the future result in increased labor costs. The loss of our Maquiladora status, changes in the Maquiladora program, the inability to recruit, hire and retain qualified employees, a significant
increase in labor costs, unfavorable exchange rates or interruptions in the trade relations between the United States and Mexico could have a material adverse effect on our business, operating results and financial condition.



While we are not party to any collective bargaining agreements with any of
our employees in the United States, as of March 1, 2005, 65% of our employees in Mexico were represented by a labor organization that has entered into a labor contract with us. As a result, our Reynosa operations are subject to union activities,
including organized strikes or other work stoppages, and cost factors arising from our negotiations of employment terms with the representatives of this union. To date, we have not experienced any organized strikes or other work stoppages at our
facilities in Reynosa, Mexico.



Our
operations could be disrupted by power outages, political unrest, natural disasters or other disasters.



As our manufacturing facilities are located in Reynosa, Mexico and in Austin, Texas, earthquakes, fires, flooding or other natural disasters in these
locations, or an epidemic, political unrest, war, labor strikes or work stoppages, or interruptions in supply or utilities at either of these locations would likely result in the disruption of our manufacturing services, would cause significant
delays in shipments of our products and materially and adversely affect our operating results.



We intend to expand our research and development activities and other operations, and this expansion may strain our resources and increase our operating expenses.



We intend to increase our research and development activities and other
operations, both in the United States and in Mexico, as we grow our business and expand our technology offerings. We may do so through both internal growth and acquisitions. We expect that this expansion could strain our systems and operational and
financial controls. In addition, we are likely to incur higher operating costs as a publicly held company and as we seek to expand our business. To manage our growth effectively, we must continue to improve and expand our systems and controls. If we
fail to do so, our growth would be limited.



Products
that incorporate our stacking technologies must conform to industry standards in order to be widely accepted by OEMs for use in their products.



Our services and technologies are used to create products that comprise only a part of a larger system. Typically, the components of these systems comply
with industry standards in order to operate efficiently together. We depend on companies that provide other components of systems and devices to support prevailing industry standards. Many of these companies are significantly larger and more
influential in affecting industry standards than we are. Some industry standards may not be widely adopted or implemented consistently, and competing standards may emerge that may be preferred by our customers or end users. If larger companies do
not support the same industry standards that we do, or if competing standards emerge, market acceptance of our products could be adversely affected which would harm our business.



Industry standards are continually evolving, and our ability to compete in the future will depend on our ability to identify
and ensure compliance with these evolving industry standards. The emergence of new industry standards could render our products incompatible with products developed by other suppliers. As a result, we could be required to invest significant time and
effort and to incur significant expense to implement new services and technologies to ensure compliance with relevant standards. If our products or those of our customers are not in compliance with prevailing industry standards for a significant
period of time, we may not be able to sell our



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##### Index to Financial Statements

services and technologies and our operating results would suffer. In addition, if we do not correctly anticipate new technologies and standards, or if the
products that we develop based on these new technologies and standards fail to achieve market acceptance, our competitors may be better able to address market demand than we would and our business and results of operations would be adversely
affected.



We depend on a few key personnel to manage our
business effectively, and if we lose the services of any of those personnel or are unable to hire additional personnel, our business could be harmed.



We believe our future success will depend in large part upon our ability to attract and retain highly skilled managerial, engineering, sales and marketing
personnel. Our success to date has been highly dependent on James W. Cady, our President and Chief Executive Officer, and other members of our senior management team. We believe that our future success will be dependent on retaining the services of
these key personnel, developing their successors and modifying our internal processes to reduce our reliance on specific individuals, and on properly managing the transition of key roles should departures occur. The loss of any of our key employees
or the inability to attract or retain qualified personnel, including engineers and sales and marketing personnel, could delay the development and introduction of, and negatively impact our ability to sell, our services and technologies.



If our stacking services and technologies are used in defective
products or include defective parts, we may be subject to product liability or other claims.



If we manufacture stacked memory products that are defectively manufactured, used in defective or malfunctioning products or contain defective components,
we could be subject to product liability claims and product recalls, safety alerts or advisory notices. While we have product liability insurance coverage, we cannot assume that it will be adequate to satisfy claims made against us in the future or
that we will be able to obtain insurance in the future at satisfactory rates or in adequate amounts. Product liability claims or product recalls in the future, regardless of their ultimate outcome, could have a material adverse effect on our
business, financial condition, results of operations and reputation, and on our ability to attract and retain licensees and customers.



We may be involved in costly legal proceedings to enforce or protect our intellectual property rights or to defend against claims that we infringe
the intellectual property rights of others.



Litigation
is inherently uncertain, and an adverse outcome could subject us to significant liability for damages or invalidate our proprietary rights. Legal proceedings we initiate to protect our intellectual property rights could also result in counterclaims
or countersuits against us. Any litigation, regardless of its outcome, could be time consuming and expensive to resolve and could divert our managements time and attention. Any intellectual property litigation also could force us to take
specific actions, including:



| |  |  | cease selling products that are claimed to be infringing a third partys intellectual property;
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | obtain licenses to make, use, sell, offer for sale or import the relevant technologies from the intellectual propertys owner, which licenses may not be available on reasonable
terms, or at all;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | redesign those products that are claimed to be infringing a third partys intellectual property; or
| | - |  | ---------------------------------------------------------------------------------------------------



| |  |  | pursue legal remedies with third parties to enforce our indemnification rights, which may not adequately protect our interests.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------



We have found it necessary to litigate against others, including our
customers, to enforce our intellectual property and contractual and commercial rights including, in particular, our trade secrets, as well as to challenge the validity and scope of the proprietary rights of others and to defend against claims of
infringement or invalidity. In some cases, our legal disputes may involve a key customer.



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##### Index to Financial Statements

Our failure to comply with environmental laws and regulations could subject us to significant fines
and liabilities, and new laws and regulations or changes in regulatory interpretation or enforcement could make compliance more difficult and costly.



We are subject to various and frequently changing U.S. federal, state and local, and foreign governmental laws and regulations relating to the protection
of the environment, including those governing the discharge of pollutants into the air and water, the management and disposal of hazardous substances and wastes, the cleanup of contaminated sites and the maintenance of a safe workplace. We could
incur substantial costs, including clean-up costs, civil or criminal fines or sanctions and third-party claims for property damage or personal injury, as a result of violations of or liabilities under environmental laws and regulations or
non-compliance with the environmental permits required for our facilities. These laws, regulations and permits also could require the installation of costly pollution control equipment or operational changes to limit pollutant emissions or decrease
the likelihood of accidental releases of hazardous substances.



In addition, new laws and regulations, stricter enforcement of existing laws and regulations, the discovery of previously unknown contamination at our sites or the imposition of new clean-up requirements could require us to curtail our
operations, restrict our future expansion, subject us to liability and cause us to incur future costs that would have a negative effect on our operating results and cash flow.



Economic, political and other risks associated with international sales and operations could adversely affect our
revenue.



Since we sell our services and technologies
worldwide, our business is subject to risks associated with doing business internationally. Our revenue originating outside the United States, including license revenue from Samsung and Infineon and services revenue from our United States and Mexico
manufacturing facilities derived from foreign customers, as a percentage of our total revenue, was 59% in 2004, 49% in 2003 and 73% in 2002. International turmoil, exacerbated by the war in Iraq and the escalating tensions in North Korea, have
contributed to an uncertain political and economic climate, both in the United States and globally, which may affect our ability to generate revenue on a predictable basis. In addition, terrorist attacks and the threat of future terrorist attacks
both domestically and internationally have negatively impacted the worldwide economy. As we ship stacked memory units both in the United States and internationally, the threat of future terrorist attacks may adversely affect our business. These
conditions make it difficult for us and for our customers to accurately forecast and plan future business activities and could have a material adverse effect on our business, financial condition and results of operations.



A portion of our revenue is derived from customers based in Asia. The
economies of Asia have been highly volatile and recessionary in the past, resulting in significant fluctuations in local currencies and other instabilities. Many countries in Asia have recently been affected by the occurrence of SARS and other
infectious diseases. These instabilities continue and may occur again in the future. Our exposure to the business risks presented by the economies of Asia will increase to the extent that we continue to expand our customer base and activities in
that region. An outbreak of SARS or another infectious disease could result in reduced demand for products incorporating our stacking technologies, extend the qualification periods for our technologies or otherwise adversely affect our business.



If we acquire other businesses or technologies in the
future, these acquisitions could disrupt our business and harm our financial condition.



As part of our growth and product diversification strategy, we will evaluate opportunities to acquire other businesses, intellectual property or
technologies that would complement our current offerings, expand the breadth of our markets or enhance our technical capabilities. Acquisitions entail a number of risks that could materially and adversely affect our business and operating results,
including:



| |  |  | difficulties in integrating the operations, technologies or products of the acquired companies;
| | - |  | -----------------------------------------------------------------------------------------------



| |  |  | the risk of diverting managements time and attention from the normal daily operations of the business;
| | - |  | -------------------------------------------------------------------------------------------------------



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##### Index to Financial Statements

| |  |  | insufficient revenue to offset increased expenses associated with acquisitions;
| | - |  | -------------------------------------------------------------------------------



| |  |  | difficulties in retaining business relationships with suppliers and customers of the acquired companies;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | risks of entering markets in which we have no or limited direct prior experience and where competitors in such markets have stronger market positions;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the potential loss of key employees of the acquired company; and
| | - |  | ----------------------------------------------------------------



| |  |  | the potential need to amortize intangible assets.
| | - |  | -------------------------------------------------



Future acquisitions also could cause us to incur debt or contingent liabilities or cause us to issue equity securities that could negatively impact the
ownership percentages of our existing stockholders.



Our
reported financial results may be adversely affected by changes in accounting principles generally accepted in the United States.



We prepare our financial statements in conformity with accounting principles generally accepted in the United States. These accounting principles are
subject to interpretation by the Financial Accounting Standards Board, the American Institute of Certified Public Accountants, the Securities and Exchange Commission and various bodies formed to interpret and create appropriate accounting
principles. A change in these principles or interpretations could have a significant effect on our reported financial results, and could affect the reporting of transactions completed before the announcement of a change.



Recently enacted and proposed changes in securities laws and
regulations have increased our costs.



The
Sarbanes-Oxley Act of 2002 that became law in July 2002, as well as new rules and regulations subsequently implemented by the Securities and Exchange Commission, or SEC, have required changes to some of our corporate governance practices. The
Sarbanes-Oxley Act also requires the Securities and Exchange Commission to promulgate additional new rules on a variety of subjects. In addition to final rules and rule proposals already made by the SEC, the National Association of Securities
Dealers, or NASD, has adopted revisions to its requirements for companies, such as us, that propose to have securities listed on the Nasdaq Stock Market. These new rules and regulations have increased our legal and financial compliance costs, and
have made some activities more difficult, time consuming and costly. These new rules and regulations have made it more difficult and more expensive for us to obtain director and officer liability insurance. These new rules and regulations could also
make it more difficult for us to attract and retain qualified members for our board of directors, particularly to serve on our audit committee, as well as qualified executive officers.



Available Information



We maintain a web site at www.staktek.com, which makes available free of charge our filings with the SEC. Our quarterly reports on Form 10-Q,
annual report on Form 10-K, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934 are available through the Investor Relations page of our web
site as soon as reasonably practicable after we electronically file this material with, or furnish it to, the SEC. Our web site and the information contained therein or connected thereto are not intended to be incorporated into this annual report on
Form 10-K.



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##### Index to Financial Statements

ITEM 2. PROPERTY



Our principal
executive offices are located at 8900 Shoal Creek Boulevard, Suite 125, Austin, Texas 78757. The facility consists of approximately 46,000 square feet of office space under lease through 2010. It houses all executive, administrative and research
functions and staff. We also manufacture at this facility.



In
January 2003, we commenced manufacturing operations at our new facility in Reynosa, Mexico. This facility consists of approximately 45,000 square feet, which we own. In the year ended December 31, 2004, we manufactured over 80% of our products at
this facility.



We continue to evaluate our future real estate
needs based on the current industry environment and our business requirements.



ITEM 3. LEGAL PROCEEDINGS



On
October 22, 2004, a class action complaint for violations of U.S. federal securities laws was filed in the U.S. District Court in New Mexico against us and two of our executive officers (the Defendants). The plaintiff claims that the
Defendants failed to disclose to the public an anticipated shortage of computer memory chips and that they knew or recklessly disregarded that the anticipated shortage would have a materially adverse impact on our revenue and earnings. In addition,
the plaintiff claims that the Defendants failed to disclose to investors that the industrys transition to a new generation of higher-capacity memory chips was causing computer makers to stockpile supplies of older memory chips, increasing the
shortage. The suit covers individuals who purchased our stock between November 26, 2003 and May 19, 2004.



We do not believe there is any merit to the claims asserted by the plaintiff in this complaint and plan to vigorously defend ourselves. Due to the early
stage of this lawsuit, we cannot estimate the outcome of this matter or the resulting financial impact to us, if any.



From time to time, we may be subject to legal proceedings and claims in the ordinary course of business. As of December 31, 2004, we were not involved in
any other material legal proceedings.



ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS



None.



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##### Index to Financial Statements

PART II



|ITEM 5. | MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
|------- | ------------------------------------------------------------------------------------------------------------



Market Information



Our common stock has been quoted on the Nasdaq National Market since
February 6, 2004 under the symbol STAK. As of March 1, 2005, there were 32 holders of record of our common stock.



The following tables sets forth, for the periods indicated, the high and low sales prices per share of our common stock as reported on the Nasdaq National
Market.



|                                              |  |      |       |     |   |      
|--------------------------------------------- |  | ---- | ----- | --- | - | -----
|                                              |  | High |       | Low
|Fiscal Year 2004:                             |  |      |       |     |   |      
|Quarter Ended March 31 (beginning February 6) |  | $    | 15.61 |     | $ | 11.42
|Quarter Ended June 30                         |  | $    | 13.00 |     | $ | 4.97 
|Quarter Ended September 30                    |  | $    | 6.46  |     | $ | 3.79 
|Quarter Ended December 31                     |  | $    | 4.77  |     | $ | 3.35 



Initial Public Offering



The Securities and Exchange Commission declared our
first registration statement effective on February 6, 2004, which we filed on Form S-1 (Registration No. 333-110806) under the Securities Act of 1933 in connection with the initial public offering of our common stock. Under this registration
statement, we registered 11.5 million shares of our common stock, including 1.5 million shares subject to the underwriters over-allotment option.



On February 11, 2004, we completed our initial public offering in which we sold 10 million shares of our common stock at $13 per share, for an aggregate
public offering price of $130 million. On March 5, 2004, we sold an additional 1.19 million shares in connection with the underwriters over-allotment option, for an aggregate public offering price of approximately $15.5 million. Our sale of
shares of common stock, including the underwriters exercise of their over-allotment option, resulted in aggregate gross proceeds of approximately $145.5 million.



Use of Proceeds



Of the approximately $145.5 million aggregate gross proceeds from our initial public offering, we applied approximately $10.2 million to underwriting
discounts and commissions; $1.9 million to related costs; $78.8 million to pay in full our senior, short-term and subordinated debt (including accrued interest and fees); and $30.6 million to redeem our outstanding preferred stock. As a result, we
retained approximately $24.0 million of the offering proceeds.



We are using the remainder of the proceeds of the offering for working capital and other general corporate purposes, including capital expenditures and research and development. We may also use a portion of the net proceeds to us to fund
possible investments in, or acquisitions of, complementary businesses, products or technologies or to establish joint ventures. We have no current agreements or commitments with respect to any investment, acquisition or joint venture, and we
currently are not engaged in negotiations with respect to any investment, acquisition or joint venture. We have invested the remaining net proceeds to us from this offering in short-term, interest-bearing, investment grade securities.



Dividends



We have not declared or paid cash dividends on our common stock. We expect to retain all available funds and any future
earnings for use in the operation and development of our business.



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Our redeemable preferred stock (the Preferred Stock) issued in August 2003 accrued a
cumulative dividend at a rate of 8% per annum. In February 2004, we paid all accumulated dividends totaling $1.1 million to holders of our Preferred Stock, and all outstanding shares of our Preferred Stock were redeemed and canceled.



Issuer Purchases of Equity Securities



The following table provides information with respect to our purchases of
our common stock during the quarter ended December 31, 2004:



|                    |  |                                   |  |                              |      |                                                                            |         |                                                                                              |                      
|------------------- |  | --------------------------------- |  | ---------------------------- | ---- | -------------------------------------------------------------------------- | ------- | -------------------------------------------------------------------------------------------- | ---------------------
|Period              |  | Total Numberof SharesPurchased(1) |  | AveragePricePaid perShare(2) |      | Total Numberof SharesPurchased asPart of PubliclyAnnouncedPlans orPrograms |         | Maximum ApproximateDollar Value of Sharesthat May Yet BePurchased under thePlans or Programs
|October 1-31, 2004  |  |                                  |  | $                            |     |                                                                            |        |                                                                                              | Approx. $12.6 million
|November 1-30, 2004 |  | 236,000                           |  |                              | 3.96 |                                                                            | 236,000 |                                                                                              | Approx. $11.7 million
|December 1-31, 2004 |  | 237,000                           |  |                              | 4.36 |                                                                            | 237,000 |                                                                                              | Approx. $10.6 million
|                    |  |                                   |  |                              |      |                                                                            |         |                                                                                              |                      
|TOTAL               |  | 473,000                           |  | $                            | 4.16 |                                                                            | 473,000 |                                                                                              |                      
|                    |  |                                   |  |                              |      |                                                                            |         |                                                                                              |                      

---

|(1) | On July 28, 2004, we announced that the Board approved a stock repurchase program for up to $15 million to purchase shares of our common stock.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Excludes commissions paid.
|--- | --------------------------



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##### Index to Financial Statements

|ITEM 6. | SELECTED FINANCIAL DATA
|------- | -----------------------



The selected financial data should be read in conjunction with Item 7. Managements Discussion and Analysis of Financial Condition and Results
of Operations and our consolidated financial statements and the related notes appearing in Item 8 of this annual report on Form 10-K. The consolidated statement of operations for the fiscal year ended December 31, 2002, the period from January
1, 2003 to August 20, 2003, the period from inception to December 31, 2003 and the fiscal year ended December 31, 2004, and the consolidated balance sheet data as of December 31, 2003 and December 31, 2004 are derived from our audited consolidated
financial statements appearing elsewhere in this annual report on Form 10-K. The consolidated statement of operations for the fiscal years ended December 31, 2000 and December 31, 2001, and the consolidated balance sheet data as of December 31,
2000, December 31, 2001 and December 31, 2002, are derived from our audited consolidated financial statements that are not included in this annual report on Form 10-K. Our historical results are not necessarily indicative of the results to be
expected in any future period.



31



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##### Index to Financial Statements

|                                                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|---------------------------------------------------------------------------------------------------------------- |  | ------------------------------------- | ------- | - | --------------------------------------- | - | ------- | ------------------------------------------- |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------ | - |  | - | ------
|                                                                                                                 |  | Staktek Holdings, Inc.                |         |   | Predecessor Company                    
|                                                                                                                 |  | Year Ended December 31, 2004          |         |   | Period fromInception toDecember 31,2003 |   |         | Period fromJanuary 1, 2003to August 20,2003 |  | Year Ended December 31,
|                                                                                                                 |  |                                       |         |   | 2002                                    |   | 2001    |                                             |  | 2000                   
|                                                                                                                 |  | (in thousands, except per share data)
|Consolidated Statement of Operations:                                                                            |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Revenue:                                                                                                         |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Services                                                                                                         |  | $                                     | 41,047  |   |                                         | $ | 21,020  |                                             |  | $                       | 31,509 |      | $ | 40,288 |  | $ | 48,298 |   |  | $ | 39,056
|License                                                                                                          |  |                                       | 32,579  |   |                                         |   | 6,202   |                                             |  |                         | 12,624 |      |   | 6,728  |  |   | 927    |   |  |   |      
|                                                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Total revenue                                                                                                    |  |                                       | 73,626  |   |                                         |   | 27,222  |                                             |  |                         | 44,133 |      |   | 47,016 |  |   | 49,225 |   |  |   | 39,056
|Cost of revenue:                                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Services                                                                                                         |  |                                       | 26,104  |   |                                         |   | 9,763   |                                             |  |                         | 19,813 |      |   | 23,063 |  |   | 24,922 |   |  |   | 27,733
|Amortization of acquisition intangibles                                                                          |  |                                       | 15,785  |   |                                         |   | 4,584   |                                             |  |                         |       |      |   |       |  |   |       |   |  |   |      
|Amortization of deferred stock-based compensation and stock compensation expense                                 |  |                                       | 601     |   |                                         |   | 1,935   |                                             |  |                         | 20     |      |   |       |  |   | (11    | ) |  |   | 24    
|                                                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Total cost of revenue                                                                                            |  |                                       | 42,490  |   |                                         |   | 16,282  |                                             |  |                         | 19,833 |      |   | 23,063 |  |   | 24,911 |   |  |   | 27,757
|                                                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Gross profit                                                                                                     |  |                                       | 31,136  |   |                                         |   | 10,940  |                                             |  |                         | 24,300 |      |   | 23,953 |  |   | 24,314 |   |  |   | 11,299
|Operating expenses:                                                                                              |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Selling, general and administrative (1)                                                                          |  |                                       | 8,431   |   |                                         |   | 3,397   |                                             |  |                         | 3,085  |      |   | 3,836  |  |   | 5,232  |   |  |   | 6,154 
|Research and development (1)                                                                                     |  |                                       | 2,563   |   |                                         |   | 854     |                                             |  |                         | 1,560  |      |   | 2,084  |  |   | 1,260  |   |  |   | 1,030 
|Business restructuring and acquisition                                                                           |  |                                       |        |   |                                         |   | 2,452   |                                             |  |                         | 3,376  |      |   | 306    |  |   |       |   |  |   |      
|In-process research and development                                                                              |  |                                       |        |   |                                         |   | 700     |                                             |  |                         |       |      |   |       |  |   |       |   |  |   |      
|Amortization of acquisition intangibles                                                                          |  |                                       | 1,855   |   |                                         |   | 1,058   |                                             |  |                         |       |      |   |       |  |   |       |   |  |   |      
|Amortization of deferred stock-based compensation and stock compensation expense                                 |  |                                       | 4,376   |   |                                         |   | 3,734   |                                             |  |                         | 22     |      |   |       |  |   | 19     |   |  |   | 24    
|                                                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Total operating expenses                                                                                         |  |                                       | 17,225  |   |                                         |   | 12,195  |                                             |  |                         | 8,043  |      |   | 6,226  |  |   | 6,511  |   |  |   | 7,208 
|                                                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Income (loss) from operations                                                                                    |  |                                       | 13,911  |   |                                         |   | (1,255  | )                                           |  |                         | 16,257 |      |   | 17,727 |  |   | 17,803 |   |  |   | 4,091 
|Interest and other income (expense), net                                                                         |  |                                       | (837    | ) |                                         |   | (3,363  | )                                           |  |                         | 80     |      |   | 238    |  |   | 1,843  |   |  |   | 13    
|                                                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Income (loss) before income taxes                                                                                |  |                                       | 13,074  |   |                                         |   | (4,618  | )                                           |  |                         | 16,337 |      |   | 17,965 |  |   | 19,646 |   |  |   | 4,104 
|Provision for income taxes                                                                                       |  |                                       | 5,268   |   |                                         |   | 656     |                                             |  |                         | 6,861  |      |   | 6,439  |  |   | 6,186  |   |  |   | 1,487 
|                                                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Net income (loss)                                                                                                |  |                                       | 7,806   |   |                                         |   | (5,274  | )                                           |  |                         | 9,476  |      |   | 11,526 |  |   | 13,460 |   |  |   | 2,617 
|Preferred stock dividends                                                                                        |  |                                       | (266    | ) |                                         |   | (872    | )                                           |  |                         |       |      |   |       |  |   |       |   |  |   |      
|                                                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Income (loss) available to common stockholders                                                                   |  | $                                     | 7,540   |   |                                         | $ | (6,146  | )                                           |  | $                       | 9,476  |      | $ | 11,526 |  | $ | 13,460 |   |  | $ | 2,617 
|                                                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Earnings (loss) per share:                                                                                       |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Basic                                                                                                            |  | $                                     | 0.16    |   |                                         | $ | (0.17   | )                                           |  | $                       | 5.16   |      | $ | 6.33   |  | $ | 7.49   |   |  | $ | 1.48  
|                                                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Diluted                                                                                                          |  | $                                     | 0.15    |   |                                         | $ | (0.17   | )                                           |  | $                       | 4.86   |      | $ | 6.01   |  | $ | 7.07   |   |  | $ | 1.39  
|                                                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Shares used in computing earnings (loss) per share:                                                              |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Basic                                                                                                            |  |                                       | 47,234  |   |                                         |   | 36,647  |                                             |  |                         | 1,836  |      |   | 1,822  |  |   | 1,798  |   |  |   | 1,767 
|Diluted                                                                                                          |  |                                       | 50,996  |   |                                         |   | 36,647  |                                             |  |                         | 1,949  |      |   | 1,917  |  |   | 1,903  |   |  |   | 1,884 
|(1)    Excludes the amortization of deferred stock-based compensation and stock compensation expense as
follows: |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Selling, general and administrative                                                                              |  | $                                     | 4,313   |   |                                         | $ | 3,718   |                                             |  | $                       | 22     |      | $ |       |  | $ | 19     |   |  | $ | 24    
|Research and development                                                                                         |  |                                       | 63      |   |                                         |   | 16      |                                             |  |                         |       |      |   |       |  |   |       |   |  |   |      
|                                                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|                                                                                                                 |  | $                                     | 4,376   |   |                                         | $ | 3,734   |                                             |  | $                       | 22     |      | $ |       |  | $ | 19     |   |  | $ | 24    
|                                                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|                                                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|                                                                                                                 |  | Staktek Holdings, Inc.                |         |   | Predecessor Company                     |   |         |                                            
|                                                                                                                 |  | As of December 31,                    |         |   | As of December 31,                      |   |         |                                            
|                                                                                                                 |  | 2004                                  |         |   | 2003                                    |   |         | 2002                                        |  | 2001                    |        | 2000 |   |        | 
|                                                                                                                 |  | (in thousands)                        |         |   |                                        
|Consolidated Balance Sheet Data:                                                                                 |  |                                       |         |   |                                         |   |         |                                             |  |                         |        |      |   |        |  |   |        |   |  |   |       
|Cash and cash equivalents                                                                                        |  | $                                     | 39,984  |   |                                         | $ | 31,165  |                                             |  | $                       | 31,449 |      | $ | 24,906 |  | $ | 19,417 |   |  |   |       
|Working capital                                                                                                  |  |                                       | 82,011  |   |                                         |   | 25,404  |                                             |  |                         | 36,188 |      |   | 26,275 |  |   | 11,023 |   |  |   |       
|Total assets                                                                                                     |  |                                       | 155,471 |   |                                         |   | 137,542 |                                             |  |                         | 58,781 |      |   | 41,571 |  |   | 41,080 |   |  |   |       
|Capitalized lease obligations, less current maturities                                                           |  |                                       |        |   |                                         |   | 51      |                                             |  |                         | 167    |      |   | 280    |  |   | 721    |   |  |   |       
|Long term debt, less current portion                                                                             |  |                                       |        |   |                                         |   | 65,125  |                                             |  |                         |       |      |   |       |  |   | 667    |   |  |   |       
|Redeemable preferred stock                                                                                       |  |                                       |        |   |                                         |   | 30,372  |                                             |  |                         |       |      |   |       |  |   |       |   |  |   |       
|Total stockholders equity                                                                                       |  |                                       | 141,807 |   |                                         |   | 315     |                                             |  |                         | 44,419 |      |   | 32,783 |  |   | 19,219 |   |  |   |       



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##### Index to Financial Statements

|ITEM 7. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|------- | -------------------------------------------------------------------------------------



Cautionary Statement



The following discussion should be read along with the audited consolidated financial statements and notes appearing in Item 8 of this annual report on
Form 10-K. This Managements Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements regarding future events and our future results are based on current expectations, estimates, forecasts, and projections and
the beliefs and assumptions of our management including, without limitation, our expectations regarding fiscal year 2005 revenue; selling, general and administrative expenses and research and development expenses in the next few quarters; the impact
of current transitions in our industry and their impact on our business; expectations regarding the transition from 256-megabit memory to 512-megabit memory; expectations regarding the future of planar solutions and the impact to our business; our
future position in our market; the sufficiency of our cash for operations for the next year; and the extension or renegotiation of our license agreement with Samsung. Words such as we expect, anticipate, target,
project, believe, goals, estimate, potential, predict, may, might, could, intend, variations of these types of words and similar
expressions are intended to identify these forward-looking statements. Readers are cautioned that these forward-looking statements are predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict. Therefore,
actual results may differ materially and adversely from those expressed in any forward-looking statements.



Among the important factors that could cause actual results to differ materially from those indicated by our forward-looking statements are those
discussed in Factors Affecting Our Future Operating Results appearing in Item 1 of this annual report on Form 10-K, and elsewhere in this report. We undertake no obligation to revise or update publicly any forward-looking statement for
any reason. Readers should carefully review the risk factors described in Factors Affecting Our Future Operating Results, as well as in the documents filed by us with the Securities and Exchange Commission, specifically our final
prospectus dated February 5, 2004, as well as our quarterly reports on Form 10-Q and in our other SEC filings, as they may be amended from time to time.



Overview



We provide manufacturing services to deliver high-capacity memory stacking solutions and also offer licenses of our technologies to our customers to
enable them to manufacture stacked memory products. In addition, we offer a broad range of services to support our customers needs, including design of custom-stacked memory assemblies, electrical modeling assistance and component inventory
management.



Since our inception in 1990, we have been an
innovator in the development of technologies to enable stacking of integrated circuits, with an initial focus on customized stacking solutions. In 1994, we released our original Stakpak technology, which stacked DRAM chips packaged in
industry-standard TSOPs. In 1998, we began shipping our third-generation Stakpak technology by offering our Performance Stakpak, enabling dramatically lower Stakpak pricing through our implementation of automated manufacturing processes. In 2001, we
introduced our Value Stakpak product as a low-cost stacked high-density memory solution for devices and systems with lower thermal management requirements. Our fourth generation solution, the High Performance Stakpak, was introduced in 2003 and
offers next-generation memory and performance capabilities in a non-leaded stacked memory package.



The vast majority of the stacked solutions provided by us to date have been to semiconductor manufacturers, memory module manufacturers and contract
manufacturers for inclusion in midrange and high-performance servers and storage systems products of large OEMs, such as Cisco Systems, Dell, HP, IBM, Intel and Sun Microsystems. To a lesser extent, we sell our stacked solutions directly to OEMs.
Some of our customers place blanket purchase orders up to three months in advance to cover shipments for the relevant period. These purchase



33



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##### Table of Contents

##### Index to Financial Statements

orders do not represent commitments to purchase given quantities of our products, but serve as non-binding forecasts for pricing, administrative and general
scheduling purposes. In some instances, purchase orders from customers are received no more than a day in advance or in the same shipment as the consigned DRAM chips that are supplied to us for stacking. We have no long-term purchase agreements with
any of our customers.



Through our flexible OEM-centric
business model, our customers can license our proprietary stacking technologies. To date, we have entered into license agreements with Samsung and Infineon. Under these license arrangements, Samsung and Infineon are licensed to manufacture and sell
memory modules containing stacked DRAM chips incorporating our leaded-package stacking technologies. In 2004, 2003 and 2002, 43%, 26% and 14% of our total revenue in such respective periods were derived from royalties recognized under our agreement
with Samsung. Our license to Infineon is more limited in scope than our license to Samsung. We recognized a small amount of revenue from this license agreement in the second through fourth quarters of 2004, and we do not anticipate that we will
derive material revenue from this license in the future.



We
price our stacked memory solutions based on a number of factors, and in particular, on the estimated quarterly volumes reflected in our customers forecasts. While relative demand for stacked memory products may fluctuate with variations in the
average selling price of DRAM chips, the average selling prices for our manufacturing services and technologies are not directly impacted by short-term changes in the price of memory. Through our investments in greater automation within our
manufacturing operations and the implementation of other efficiencies in our internal processes, over time we have achieved significant reductions in our internal manufacturing costs of both our Performance Stakpak and Value Stakpak products on a
per-unit basis. By passing these cost savings through to our customers in the form of lower average selling prices for our services, we are able to provide greater opportunities for OEMs to cost-effectively increase the memory capacity of their
products. By increasing our production volumes within a lower cost structure, combined with increased license revenue, which generally entails lower cost of revenue, we have been able to improve our gross margins from 29% in 2000 to 49%, 51%, 49%
and 42% in 2001, 2002, 2003 and 2004, respectively.



Our
predecessor company, Staktek Corporation, was incorporated in Texas in June 1990. Two investment funds affiliated with Austin Ventures, LP acquired Staktek Corporation in August 2003 through a merger of a wholly owned subsidiary of our Company with
and into Staktek Corporation. As a result of this merger, Staktek Corporation became our wholly owned subsidiary. We did not have any operations prior to August 21, 2003, other than in connection with the Staktek acquisition.



On February 11, 2004, we completed our initial public offering in which we
sold 10 million shares of our common stock at $13 per share, for an aggregate public offering price of $130 million. On March 5, 2004, we sold an additional 1.19 million shares in connection with the underwriters over-allotment option, for an
aggregate public offering price of approximately $15.5 million. Our sale of shares of common stock, including the underwriters exercise of their over-allotment option, resulted in aggregate net proceeds of approximately $133.4 million. See
Note 3 of Notes to the Consolidated Financial Statements for additional information.



In June 2004, we acquired from DPAC its stacking patents and patent applications as well as certain customer information, as DPAC exited the stacking business to focus on other areas. We paid DPAC $0.6 million in June
and paid additional amounts totaling approximately $0.1 million in the third quarter of 2004, including payments for related transaction costs. We are working with former DPAC customers to transition them to our Value Stakpak or Performance Stakpak
products.



The following text describes certain line items of
our consolidated statements of operations.



Revenue. Revenue consists of services revenue recognized from our manufacture of Stakpaks and of license revenue recognized under our license agreements with Samsung and Infineon. In most instances, our customers provide
high-density memory packages to us for stacking on a consignment basis. In some instances, we purchase high-density memory packages from the vendor specified by the customer, typically in quantities at or below the amounts that either the customer
is obligated to purchase or we are able to return to the vendor. We exclude from services revenue the costs of memory packages purchased by us and then sold to our customers since we do not bear meaningful inventory risk.



34



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##### Table of Contents

##### Index to Financial Statements

Cost of Revenue. Cost of revenue includes depreciation of equipment, direct and indirect
labor costs, costs of flex circuits and other components and raw materials and facilities costs associated with our manufacturing operations. Cost of revenue also includes the amortization of intangible assets associated with the Staktek acquisition
and amortization of certain patents. Portions of our cost of revenue are fixed in any given period. We exclude from cost of revenue the costs of memory packages purchased by us and then sold to our customers since we do not bear meaningful inventory
risk.



Selling, General and Administrative.
Selling, general and administrative expenses consist of salaries and wages for executive, sales and marketing and administrative personnel, travel expenses and other marketing costs. Additional expenses include administrative and information
technology costs, legal costs, amortization of customer relationships and non-compete agreements and other supporting costs. These expenses also include allocations or direct charges for insurance, consultants and other professional fees, utilities
and office supplies.



Research and Development.
Research and development expenses include expenses related to product development and design, engineering, process development, equipment and tooling design, fabrication and implementation, test hardware and software design and implementation and
amortization of certain patents. Research and development expenses, however, do not necessarily reflect all of our engineering efforts. Our engineering group also provides various support functions in the manufacturing of products currently in
production. The costs of such support are included in cost of revenue. Therefore, significant fluctuations in research and development expenses may occur from period to period depending on the nature and extent of engineering activities over any
given time frame. In addition, we devote significant resources to design, develop and implement automated machinery for our products. General product and process development costs that are not associated with either a specific customer product or a
standard product to be offered for sale are considered to be research and development activities and are accounted for as research and development expenses.



Business Restructuring and Acquisition. Business restructuring and acquisition costs consist of expenses associated with the Staktek
acquisition and costs associated with the reduction of our workforce in Austin, Texas during 2003 as the result of the move of our high-volume manufacturing facility to Reynosa, Mexico.



Amortization of Acquisition Intangibles. Amortization of acquisition intangibles consists of amortization of
acquired identifiable intangible assets resulting from the Staktek acquisition in August 2003.



Amortization of Deferred Stock-Based Compensation and Stock Compensation Expense. We recorded deferred stock-based compensation for the difference between the exercise price of option grants and the fair
value of our common stock at the time of these grants. We are amortizing this amount over the vesting periods of the applicable options.



Other Income (Expense), Net. Other income (expense), net generally consists of net interest income and interest expense and other
non-recurring items, such as the gain or loss on the disposition of assets.



Provision for Income Taxes. We accrue a provision for federal, state and foreign income taxes at the applicable statutory rates adjusted for non-deductible expenses. Foreign
income tax includes withholding tax on certain royalty income received from foreign customers. For the year ended December 31, 2004, the Companys effective tax rate was 40.3%.



35



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##### Index to Financial Statements

Results of Operations



The following table presents our operating results for the periods indicated as a percentage of total revenue:



|                                                                                 |  |                            |   |  |                                         |    |  |                                             |   |  |                            |  
|-------------------------------------------------------------------------------- |  | -------------------------- | - |  | --------------------------------------- | -- |  | ------------------------------------------- | - |  | -------------------------- | -
|                                                                                 |  | Staktek Holdings, Inc.     |   |  | Predecessor Company                     |   
|                                                                                 |  | Year EndedDecember 31,2004 |   |  | Period fromInception toDecember 31,2003 |    |  | Period fromJanuary 1, 2003to August 20,2003 |   |  | Year EndedDecember 31,2002 |  
|Revenue:                                                                         |  |                            |   |  |                                         |    |  |                                             |   |  |                            |  
|Services                                                                         |  | 55.8                       | % |  | 77.2                                    | %  |  | 71.4                                        | % |  | 85.7                       | %
|License                                                                          |  | 44.2                       |   |  | 22.8                                    |    |  | 28.6                                        |   |  | 14.3                       |  
|                                                                                 |  |                            |   |  |                                         |    |  |                                             |   |  |                            |  
|Total revenue                                                                    |  | 100.0                      |   |  | 100.0                                   |    |  | 100.0                                       |   |  | 100.0                      |  
|Cost of revenue:                                                                 |  |                            |   |  |                                         |    |  |                                             |   |  |                            |  
|Services                                                                         |  | 35.5                       |   |  | 35.9                                    |    |  | 44.9                                        |   |  | 49.1                       |  
|Amortization of acquisition intangibles                                          |  | 21.4                       |   |  | 16.8                                    |    |  |                                            |   |  |                           |  
|Amortization of deferred stock-based compensation and stock compensation expense |  | 0.8                        |   |  | 7.1                                     |    |  |                                            |   |  |                           |  
|                                                                                 |  |                            |   |  |                                         |    |  |                                             |   |  |                            |  
|Total cost of revenue                                                            |  | 57.7                       |   |  | 59.8                                    |    |  | 44.9                                        |   |  | 49.1                       |  
|                                                                                 |  |                            |   |  |                                         |    |  |                                             |   |  |                            |  
|Gross profit                                                                     |  | 42.3                       |   |  | 40.2                                    |    |  | 55.1                                        |   |  | 50.9                       |  
|Operating expenses:                                                              |  |                            |   |  |                                         |    |  |                                             |   |  |                            |  
|Selling, general and administrative                                              |  | 11.5                       |   |  | 12.5                                    |    |  | 7.0                                         |   |  | 8.2                        |  
|Research and development                                                         |  | 3.5                        |   |  | 3.1                                     |    |  | 3.5                                         |   |  | 4.4                        |  
|Business restructuring and acquisition                                           |  |                           |   |  | 9.0                                     |    |  | 7.7                                         |   |  | 0.6                        |  
|In-process research and development                                              |  |                           |   |  | 2.6                                     |    |  |                                            |   |  |                           |  
|Amortization of acquisition intangibles                                          |  | 2.5                        |   |  | 3.9                                     |    |  |                                            |   |  |                           |  
|Amortization of deferred stock-based compensation and stock compensation expense |  | 5.9                        |   |  | 13.7                                    |    |  | 0.1                                         |   |  |                           |  
|                                                                                 |  |                            |   |  |                                         |    |  |                                             |   |  |                            |  
|Total operating expenses                                                         |  | 23.4                       |   |  | 44.8                                    |    |  | 18.3                                        |   |  | 13.2                       |  
|                                                                                 |  |                            |   |  |                                         |    |  |                                             |   |  |                            |  
|Income (loss) from operations                                                    |  | 18.9                       |   |  | (4.6                                    | )  |  | 36.8                                        |   |  | 37.7                       |  
|Interest and other income (expense), net                                         |  | (1.1                       | ) |  | (12.4                                   | )  |  | 0.2                                         |   |  | 0.5                        |  
|                                                                                 |  |                            |   |  |                                         |    |  |                                             |   |  |                            |  
|Income (loss) before income taxes                                                |  | 17.8                       |   |  | (17.0                                   | )  |  | 37.0                                        |   |  | 38.2                       |  
|Provision for income taxes                                                       |  | 7.2                        |   |  | 2.4                                     |    |  | 15.5                                        |   |  | 13.7                       |  
|                                                                                 |  |                            |   |  |                                         |    |  |                                             |   |  |                            |  
|Net income (loss)                                                                |  | 10.6                       | % |  | (19.4                                   | %) |  | 21.5                                        | % |  | 24.5                       | %
|                                                                                 |  |                            |   |  |                                         |    |  |                                             |   |  |                            |  



We were formed in May
2003 for purposes of acquiring Staktek Corporation. We had no operations prior to August 21, 2003 other than in connection with the Staktek acquisition. In our discussion of our results of operations in 2003, we discuss each line item in the
consolidated statement of operations on a combined basis for comparative purposes. These combined amounts represent the sum of the financial data for Staktek Corporation and us for the periods from January 1, 2003 through December 31, 2003. These
combined amounts are for informational purposes only.



Revenue



Total revenue for the year ended December 31, 2004
was $73.6 million, compared to revenue of $71.4 million and $47.0 million for the years ended December 31, 2003 and 2002, respectively. Unit volume of Stakpak products that we recognized as revenue in 2004 increased by 21.1 million units, or 50%, to
63.3 million units, from 42.2 million units in 2003. The positive impact from this increase in unit volume was the result of an increase in units produced under license, offset by a decline in units manufactured by us. Services revenue in 2004 was
$41.0 million, compared to $52.5 million and $40.3 million for 2003 and 2002, respectively. License revenue in 2004 was $32.6 million, compared to $18.8 million and $6.7 million for 2003 and 2002, respectively.



Services revenue in fiscal year 2004 decreased from fiscal year 2003
primarily due to lower units shipped and a shift in customer demand to our lower-priced Value Stakpak product. The decrease in demand for our Performance Stakpak product was due mainly to three factors. The first factor was that as a result of the
price



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##### Index to Financial Statements

parity between stacked 256-megabit DRAM densities and non-stacked, monolithic 512-megabit DRAM densities, our customers did not need to utilize stacked
256-megabit DRAM but instead could use a single monolithic 512-megabit DRAM for the same cost or less. The second factor regarding the decrease in demand was the overall DRAM supply shortage during the second and third quarters of 2004. Third, we
had been selling to Celestica as a supply-chain partner of IBM, but IBM adopted a different business model by sourcing more of its high-density needs directly through silicon providers rather than indirectly through Staktek. The principle effect of
this change was to shift some service revenue to license revenue. In addition, this shift may result in the potential loss of some business to alternative technologies. It is not possible to specifically quantify the impact of these factors on our
2004 results. License revenue increased $13.8 million during 2004, compared with the same period of the prior year due primarily to higher royalty revenue from Samsung, and to a lesser extent, due to the addition of Infineon as a licensee in 2004.



Total revenue in 2003 increased by $24.4 million, or 51.8%, to
$71.4 million from $47.0 million in 2002. Services revenue increased by $12.2 million, or 30.4%, to $52.5 million, or 73.6% of total revenue, in 2003 from $40.3 million, or 85.7% of total revenue, in 2002. In 2003, license revenue increased by $12.1
million, or 180%, to $18.8 million, or 26.4% of total revenue, from $6.7 million, or 14.3% of total revenue, in 2002. Revenue in 2003 benefited from increased customer demand for greater high-density memory capacity and faster processor speeds over
a broader range of OEM products as provided by our Stakpak products and stacked memory packages using our technologies that were sold by Samsung. Unit volume of Stakpak products recognized as revenue in 2003 increased by 24.5 million units, or 138%,
to 42.2 million units from 17.7 million units in 2002. The positive impact from this increase in unit volume was partially offset by a 36% decline in overall average selling prices. We calculate average selling prices by dividing total revenue by
total manufactured and licensed units. This decline in the overall average selling price resulted in part from the increased proportion of license revenue as a component of total revenue.



Because next-generation TSOPs deliver twice as many bits of memory as the current generation, the demand for stacked memory
packages, as measured in megabits, will be satisfied at lower levels of unit volumes. This transition is underway, and accordingly, we are experiencing an increase in the number of units based on 512-megabit memory TSOPs shipped in 2004, as compared
to similar units shipped in 2003. We anticipate that the transition cycle will run its course in the next several quarters, but may repeat with future generations of DRAM chips, such as when one-gigabit chips displace 512-megabit chips as the lowest
cost-per-bit memory chip.



In addition to this transition,
there are two other transitions that are impacting us. The first is the transition from DDR-I to DDR-II memory devices. The second transition involves the shift from leaded to non-leaded package technology. We expect a significant portion of both of
these transitions to occur in 2005. This combination of industry transitions enables planar solutions, which allow additional memory devices to be directly attached on the printed circuit board without the need for stacking, to increase as a
competitive threat. We believe that some of the major OEMs and DRAM suppliers currently are using planar solutions and we expect them to utilize a greater percentage of planar solutions in the near future in legacy DDR-I technologies as well as in
next-generation DDR-II technologies. However, we believe that these planar solutions will have a limited window of opportunity, since increasing die sizes and higher speed requirements are expected to limit their use over time.



It is not possible to specifically quantify the impact of these three ongoing
transitions on our future business. We do expect decreased revenues in the short term with the combination of the transition from 256-megabit DRAM to 512-megabit DRAM, the transition from leaded to non-leaded packaging technology, and the increased
use of competitive technologies, such as planar solutions, for what we believe will be a limited period of time. However, we believe that once these transitions are complete, we will be well positioned in our market.



Our license agreement with Samsung expires in July 2005. Currently, we are in
the process of negotiating with Samsung to renew this agreement. It is too early in the process to determine whether Samsung and we will reach agreement. Samsung has made significant investments in tooling, manufacturing, testing facilities and



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expertise as well as in product acceptance activities. We also believe that Samsung realizes substantial financial benefits from the sale of stacked memory
solutions incorporating our proprietary technologies, and that Samsungs continued ability to provide these solutions is important to its relationships with its customers and OEMs. We believe that if Samsung does not extend or renegotiate this
agreement, Samsung would not be able to continue to produce its current stacked memory products without infringing our patent rights. If we enter into a relationship with Samsung whereby we provide manufacturing services to them, we expect that our
gross profit per unit would improve while our gross margins, or gross profit as a percentage of revenue, would decline as the proportion of our license revenue to overall revenue declines. If we are unable to extend this agreement on terms favorable
to us or at all, if Samsung renews but does not utilize as much of our stacking technology as it currently uses, or if Samsung terminates this agreement, our license revenue from this agreement could be reduced or eliminated. If Samsungs
customers do not use our manufacturing services or buy the stacked high-density memory solutions from one of our other supply-chain partners, our revenue, operating results and cash flows could be reduced.



The following tables summarize sales to customers that represent 10% or more
of consolidated total revenue for the periods indicated:



|          |  |                            |   |  |                                         |   |  |                                             |   |  |                            |  
|--------- |  | -------------------------- | - |  | --------------------------------------- | - |  | ------------------------------------------- | - |  | -------------------------- | -
|          |  | Staktek Holdings, Inc.     |   |  | Predecessor Company                     |  
|          |  | Year EndedDecember 31,2004 |   |  | Period frominception toDecember 31,2003 |   |  | Period fromJanuary 1, 2003to August 20,2003 |   |  | Year EndedDecember 31,2002 |  
|Samsung   |  | 43                         | % |  | 23                                      | % |  | 29                                          | % |  | 14                         | %
|Micron    |  | 17                         | % |  | 24                                      | % |  | 29                                          | % |  | 14                         | %
|Celestica |  | *                          |   |  | 17                                      | % |  | 17                                          | % |  | 21                         | %
|Smart     |  | 12                         | % |  | 11                                      | % |  | 10                                          | % |  | *                          |  
|Infineon  |  | *                          |   |  | *                                       |   |  | *                                           |   |  | 39                         | %

---

|* | Amount does not exceed 10% for the indicated period.
|- | ----------------------------------------------------



Gross Profit



Gross profit for the year ended December 31, 2004 was $31.1 million, or 42.3% of revenue. This amount represents a decrease of $4.1 million, compared to
gross profit of $35.2 million, or 49.4% of revenue, for the year ended December 31, 2003. The decrease in gross profit dollars for 2004 was due to the $11.2 million increase in the cost of revenue component of amortization of acquisition intangibles
recorded in 2004 versus 2003, a shift in our mix of products to our lower-margin Value Stakpak product and an overall decline in in-house stacked units in 2004. These decreases were partially offset by reduced direct labor and benefits as a result
of the increased utilization of our high-volume manufacturing facility in Reynosa, Mexico in 2004 and by the substantial increase in license revenue as a percentage of total revenue. License revenue increased to 44.2% of total revenue in 2004 from
26.4% of total revenue in 2003. Gross profit as a percentage of revenue was reduced by 22.2 percentage points during 2004 due to the amortization of acquisition intangibles and the amortization of deferred stock-based compensation and stock
compensation expense allocated to cost of revenue, as compared with a 9.2 percentage point impact of these items on overall gross margin during 2003. Our manufacturing services gross margin percentage, defined as gross profit calculated from
services revenue and services cost of revenue, decreased by approximately 7.3 percentage points in 2004 as compared to 2003 due mainly to fixed costs being spread over fewer units and the shift in mix to our Value Stakpak product, partially offset
by the reduction in manufacturing costs resulting from the increased utilization of our high-volume manufacturing facility in Mexico in 2004.



Gross profit increased $11.3 million, or 47.1%, in 2003 to $35.2 million from $24.0 million in 2002. Gross profit as a percentage of revenue, also
referred to as gross margin, decreased to 49.4% in 2003 from 50.9% in 2002. The improvement in gross profit was largely attributable to the substantial increase in license revenue as a



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##### Index to Financial Statements

percentage of total revenue. License revenue increased to 26.4% of total revenue in 2003 from 14.3% of total revenue in 2002. Gross margin in our
manufacturing services increased by approximately 0.9 percentage points in 2003 as we realized economies of scale in our automated manufacturing operations through increased volumes of production. However, gross margin was reduced by 9.2 percentage
points in 2003 due to the amortization of acquisition intangibles and the amortization of deferred stock-based compensation and stock compensation expense allocated to cost of revenue.



Selling, General and Administrative Expenses



Selling, general and administrative expense for the year ended December 31, 2004 was $8.4 million, or 11.5% of revenue. This
amount reflected an increase of $1.9 million, or 29.2%, as compared to selling, general and administrative expense of $6.5 million, or 9.1% of revenue, for the year ended December 31, 2003. The increase in selling, general and administrative expense
during 2004 relative to 2003 was primarily due to an increase in directors and officers insurance costs of $1.3 million, increased staffing costs of $0.7 million and audit and tax services of $0.2 million, mainly as a result of being a
public company. We expect our expenses related to operating as a public company will increase in 2005 as a result of completing our internal and external audits to comply with Section 404 of the Sarbanes-Oxley Act by December 31, 2005. We expect
selling, general and administrative expense to range between 15 to 18% of revenue over the next several quarters.



Selling, general and administrative expenses increased by $2.6 million, or 69.0%, to $6.5 million in 2003, or 9.1% of revenue, from $3.8 million, or 8.2%
of revenue, in 2002. The majority of the increase was due to increased salaries and benefits of $0.9 million, $0.7 million in higher litigation expenses as well as the increase in profit sharing and related incentive expenses of $0.5 million in
2003.



Research and Development



Research and development expense for the year ended December 31, 2004 was
$2.6 million, or 3.5% of revenue, which reflected an increase of $0.2 million, or 6.2%, as compared with research and development expense of $2.4 million, or 3.4% of revenue for the year ended December 31, 2003. The increase in costs for the year
was primarily due to increased materials costs as we develop our processes for stacking new fBGA packages and by amortization of the patents acquired from DPAC in the second quarter of 2004, partially offset by lower process development expenses. We
intend to devote additional resources to research and development in future periods to address market opportunities for advanced technologies, such as DDR-II, DRAM chips in fBGA packages, non-DRAM homogeneous circuits, and heterogeneous circuits
(our System Stakpak). As a result, we expect research and development expenses to range between 5 to 7% of revenue in the next several quarters. Our increased spending on research and development will be used to design and develop the tooling,
testing capabilities and automation equipment to position us for qualification and manufacturing of products based on these new technologies.



Research and development expenses increased by $0.3 million, or 15.8%, to $2.4 million, or 3.4% of revenue, in 2003 from $2.1 million, or 4.4% of revenue,
in 2002.



In-process Research and Development



Of the total purchase price we paid in the acquisition of the predecessor
company, we allocated $0.7 million to in-process research and development (IPR&D), and expensed it. We based the value of IPR&D on an evaluation of all developmental projects using the guidance set forth in Financial Accounting
Standards Board, or FASB, Interpretation No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method. Projects that qualify as IPR&D represent those that have not yet reached
technological feasibility and for which no future alternative uses exist. Technological feasibility is defined as being equivalent to a beta-phase working prototype in which there is no remaining risk relating to the development.



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##### Index to Financial Statements

Business Restructuring and Acquisition



There were no business restructuring or acquisition-related costs in 2004.



During the year ended December 31, 2003, we recorded business restructuring
and acquisition expenses of $5.8 million, comprised of $5.3 million of expenses associated with the Staktek acquisition and severance costs of $0.5 million associated with the move of our high-volume manufacturing facility to Reynosa, Mexico. In the
fourth quarter of 2002, we incurred $0.3 million in business restructuring costs associated with the move of our high-volume manufacturing facility to Reynosa, Mexico.



Amortization of Acquisition Intangibles



During the year ended December 31, 2004, we amortized $17.6 million of intangible assets resulting from the Staktek
acquisition during the third quarter of 2003, with $15.8 million allocated to cost of revenue and $1.8 million to operating expenses. During the year ended December 31, 2003, we amortized $5.6 million of intangible assets from that acquisition, with
$4.6 million allocated to cost of revenue and $1.0 million to operating expenses.



Amortization of Deferred Stock-Based Compensation and Stock Compensation Expense



We recorded amortization expense associated with deferred stock-based compensation of $5.0 million for the year ended December 31, 2004 with $0.6 million
allocated to cost of revenue and $4.4 million to operating expenses. We recorded amortization expense associated with deferred stock-based compensation of $5.7 million for the year ended December 31, 2003 with $1.9 million allocated to cost of
revenue and $3.8 million to operating expenses. There was no expense associated with deferred stock-based compensation for the year ended December 31, 2002. We will continue to amortize the existing deferred compensation balance through 2007.



Interest and Other Income (Expense)



Interest and other expense, net, for the year ended December 31, 2004, was
$0.8 million, as compared to $3.3 million for the year ended December 31, 2003. The decrease in interest and other expense, net, for 2004 versus 2003 was mainly due to interest expenses associated with the senior and subordinated debt incurred to
finance the Staktek acquisition in 2003, which was repaid following the Companys initial public offering in February 2004.



We incurred interest and other expense, net, in 2003 of $3.3 million compared to interest and other income, net, in 2002 of $0.2 million. The increased
expense in 2003 was primarily attributable to interest expenses associated with the senior and subordinated debt incurred to finance the Staktek acquisition.



Provision for Income Taxes



We incurred income tax expense of $5.3 million and $7.5 million in the years ended December 31, 2004 and 2003, respectively. For the years ended December
31, 2004 and 2003, our effective tax rate was 40.3% and 64.1%, respectively. The effective tax rate differed from the federal statutory rate of 35% due primarily to the impact of certain stock compensation expenses that were not tax deductible, in
addition to other permanent items.



We incurred income tax
expense of $7.5 million and $6.4 million in the years ended December 31, 2003 and 2002, respectively. For the years ended December 31, 2003 and 2002, our effective tax rate was 64.1% and 35.8%, respectively. The higher effective tax rate in 2003 was
primarily due to the non-deductibility for income tax purposes of certain transaction costs associated with the Staktek acquisition and the amortization of acquisition intangibles.



40



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##### Index to Financial Statements

Quarterly Results of Operations



The following table presents unaudited results of operations of the predecessor company for each of the quarters in the
period ended June 30, 2003 and for the period from July 1, 2003 to August 20, 2003 as well as our results of operations for the period from inception to September 30, 2003, the quarter ended December 31, 2003, and each of the quarters in the year
ended December 31, 2004. You should read the following table in conjunction with the consolidated financial statements and related notes contained in Item 8 in this annual report on Form 10-K. We have prepared the unaudited information on the same
basis as our audited consolidated financial statements. This table includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair presentation of our financial position and operating results for the
quarters presented. Operating results for any quarter are not necessarily indicative of results for any future quarters or for a full year.



|                                                    |  |                                       |        |             |                          |              |  |                           |        |                   |   |        |  |   |              |   |              |   |        |   |  |   |        |  |   |        |  |   |       
|--------------------------------------------------- |  | ------------------------------------- | ------ | ----------- | ------------------------ | ------------ |  | ------------------------- | ------ | ----------------- | - | ------ |  | - | ------------ | - | ------------ | - | ------ | - |  | - | ------ |  | - | ------ |  | - | ------
|                                                    |  | Staktek Holdings, Inc.                |        |             | Predecessor Company     
|                                                    |  | Three Months Ended                    |        |             | Inception toSep. 30,2003 |              |  | Jul. 1,2003 toAug. 202003 |        | Three MonthsEnded
|                                                    |  | Dec. 31,2004                          |        | Sep 30,2004 |                          | Jun. 30,2004 |  | Mar. 31,2004              |        | Dec. 31,2003      |   |        |  |   | Jun. 30,2003 |   | Mar. 31,2003
|                                                    |  | (in thousands, except per share data)
|Revenue:                                            |  |                                       |        |             |                          |              |  |                           |        |                   |   |        |  |   |              |   |              |   |        |   |  |   |        |  |   |        |  |   |       
|Services                                            |  | $                                     | 9,762  |             | $                        | 8,249        |  | $                         | 10,422 |                   | $ | 12,614 |  | $ | 15,325       |   |              | $ | 5,695  |   |  | $ | 8,450  |  | $ | 12,032 |  | $ | 11,027
|License                                             |  |                                       | 7,909  |             |                          | 7,820        |  |                           | 7,663  |                   |   | 9,187  |  |   | 6,202        |   |              |   |       |   |  |   | 4,808  |  |   | 3,656  |  |   | 4,160 
|                                                    |  |                                       |        |             |                          |              |  |                           |        |                   |   |        |  |   |              |   |              |   |        |   |  |   |        |  |   |        |  |   |       
|Total revenue                                       |  |                                       | 17,671 |             |                          | 16,069       |  |                           | 18,085 |                   |   | 21,801 |  |   | 21,527       |   |              |   | 5,695  |   |  |   | 13,258 |  |   | 15,688 |  |   | 15,187
|Gross profit                                        |  |                                       | 7,085  |             |                          | 6,169        |  |                           | 7,480  |                   |   | 10,402 |  |   | 9,461        |   |              |   | 1,479  |   |  |   | 8,942  |  |   | 7,994  |  |   | 7,364 
|Net income (loss)                                   |  |                                       | 1,686  |             |                          | 1,220        |  |                           | 2,042  |                   |   | 2,858  |  |   | (3,054       | ) |              |   | (2,220 | ) |  |   | 2,202  |  |   | 3,810  |  |   | 3,464 
|Income (loss) available to common stockholders      |  | $                                     | 1,686  |             | $                        | 1,220        |  | $                         | 2,042  |                   | $ | 2,592  |  | $ | (3,657       | ) |              | $ | (2,489 | ) |  | $ | 2,202  |  | $ | 3,810  |  | $ | 3,464 
|Earnings (loss) per share:                          |  |                                       |        |             |                          |              |  |                           |        |                   |   |        |  |   |              |   |              |   |        |   |  |   |        |  |   |        |  |   |       
|Basic                                               |  | $                                     | 0.03   |             | $                        | 0.03         |  | $                         | 0.04   |                   | $ | 0.06   |  | $ | (0.10        | ) |              | $ | (0.07  | ) |  | $ | 1.20   |  | $ | 2.07   |  | $ | 1.89  
|Diluted                                             |  | $                                     | 0.03   |             | $                        | 0.02         |  | $                         | 0.04   |                   | $ | 0.05   |  | $ | (0.10        | ) |              | $ | (0.07  | ) |  | $ | 1.13   |  | $ | 1.94   |  | $ | 1.76  
|Shares used in computing earnings (loss) per share: |  |                                       |        |             |                          |              |  |                           |        |                   |   |        |  |   |              |   |              |   |        |   |  |   |        |  |   |        |  |   |       
|Basic                                               |  |                                       | 48,880 |             |                          | 48,214       |  |                           | 48,407 |                   |   | 43,431 |  |   | 36,804       |   |              |   | 36,550 |   |  |   | 1,837  |  |   | 1,837  |  |   | 1,834 
|Diluted                                             |  |                                       | 51,001 |             |                          | 51,685       |  |                           | 52,877 |                   |   | 50,005 |  |   | 36,804       |   |              |   | 36,550 |   |  |   | 1,946  |  |   | 1,966  |  |   | 1,967 



The following table
presents our historical results for the periods indicated as a percentage of revenue:



|                                               |  |                        |   |  |                          |   |  |                           |   |  |                   |   |  |              |    |  |       |    |              |       |   |              |       |   |  |       |  
|---------------------------------------------- |  | ---------------------- | - |  | ------------------------ | - |  | ------------------------- | - |  | ----------------- | - |  | ------------ | -- |  | ----- | -- | ------------ | ----- | - | ------------ | ----- | - |  | ----- | -
|                                               |  | Staktek Holdings, Inc. |   |  | Predecessor Company      |  
|                                               |  | Three Months Ended     |   |  | Inception toSep. 30,2003 |   |  | Jul. 1,2003 toAug. 202003 |   |  | Three MonthsEnded |  
|                                               |  | Dec. 31,2004           |   |  | Sep 30,2004              |   |  | Jun. 30,2004              |   |  | Mar. 31,2004      |   |  | Dec. 31,2003 |    |  |       |    | Jun. 30,2003 |       |   | Mar. 31,2003 |      
|Revenue:                                       |  |                        |   |  |                          |   |  |                           |   |  |                   |   |  |              |    |  |       |    |              |       |   |              |       |   |  |       |  
|Services                                       |  | 55.2                   | % |  | 51.3                     | % |  | 57.6                      | % |  | 57.9              | % |  | 71.2         | %  |  | 100.0 | %  |              | 63.7  | % |              | 76.7  | % |  | 72.6  | %
|License                                        |  | 44.8                   |   |  | 48.7                     |   |  | 42.4                      |   |  | 42.1              |   |  | 28.8         |    |  |      |    |              | 36.3  |   |              | 23.3  |   |  | 27.4  |  
|                                               |  |                        |   |  |                          |   |  |                           |   |  |                   |   |  |              |    |  |       |    |              |       |   |              |       |   |  |       |  
|Total revenue                                  |  | 100.0                  |   |  | 100.0                    |   |  | 100.0                     |   |  | 100.0             |   |  | 100.0        |    |  | 100.0 |    |              | 100.0 |   |              | 100.0 |   |  | 100.0 |  
|Gross profit                                   |  | 40.1                   |   |  | 38.4                     |   |  | 41.4                      |   |  | 47.7              |   |  | 43.9         |    |  | 26.0  |    |              | 67.4  |   |              | 51.0  |   |  | 48.5  |  
|Net income (loss)                              |  | 9.5                    |   |  | 7.6                      |   |  | 11.3                      |   |  | 13.1              |   |  | (14.2        | )  |  | (39.0 | )  |              | 16.6  |   |              | 24.3  |   |  | 22.8  |  
|Income (loss) available to common stockholders |  | 9.5                    | % |  | 7.6                      | % |  | 11.3                      | % |  | 11.9              | % |  | (17.0        | %) |  | (43.7 | %) |              | 16.6  | % |              | 24.3  | % |  | 22.8  | %



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##### Index to Financial Statements

Liquidity and Capital Resources



Our contractual future obligations at December 31, 2004 for the next five years are summarized as follows (in thousands):



|                     |  |                 |       |          |   |          |  |                  |     |  |   |    
|-------------------- |  | --------------- | ----- | -------- | - | -------- |  | ---------------- | --- |  | - | ---
|                     |  | Less than1 year |       | 1-3years |   | 3-5years |  | More than5 years
|Operating leases     |  | $               | 521   |          | $ | 684      |  | $                | 717 |  | $ | 331
|Capital leases       |  |                 | 53    |          |   |         |  |                  |    |  |   |   
|Purchase obligations |  |                 | 745   |          |   |         |  |                  |    |  |   |   
|                     |  |                 |       |          |   |          |  |                  |     |  |   |    
|Total                |  | $               | 1,319 |          | $ | 684      |  | $                | 717 |  | $ | 331
|                     |  |                 |       |          |   |          |  |                  |     |  |   |    



Operating lease
obligations above included rent commitments at December 31, 2004 for our corporate office and production facility located in Austin, Texas. Other operating lease commitments at December 31, 2004 included leases for five machines. The capital lease
commitment at December 31, 2004 was for a single production machine.



Purchase obligations included a purchase commitment at December 31, 2004 that was for the expected future costs to be incurred in the fulfillment of a minimum purchases contract with one of our vendors. Purchase obligations also included
assets being developed. These are assets that were being custom built for our production facilities. Amounts due in 2005 represent the balance due for these assets, pending their successful completion and testing.



We believe that our cash and cash equivalents, and future cash flows from
operations will be sufficient to fund these obligations.



As of
December 31, 2004, we had no material future sales commitments to any of our customers.



As of December 31, 2004, we had working capital of $82.0 million, including $77.4 million of cash, cash equivalents and investments, compared to working capital of $25.4 million, including $31.2 million of cash, cash
equivalents and investments as of December 31, 2003. The $56.6 million increase in working capital during 2004 was primarily due to the $46.3 million increase in cash, cash equivalents and investments, including $24.0 million in net proceeds from
our initial public offering available for general corporate purposes, and the $12.5 million reduction in notes payable and current maturities of long-term debt due to the repayment in 2004 of debt incurred to finance the Staktek acquisition.



Net cash provided by operating activities was $31.1 million
for the year ended December 31, 2004, and resulted primarily from net income adjusted by non-cash expenses and a decrease in accounts receivable, partially offset by a decrease in deferred tax liabilities, a reduction in accrued liabilities due to
payment of accrued interest on the debt from the Staktek acquisition and a decrease in trade accounts payable. Net cash provided by operating activities during 2003 was $13.5 million and resulted mainly from net income adjusted by non-cash expenses,
partially offset by an increase in accounts receivable and prepaid expenses and other assets. Net cash provided by operating activities decreased to $13.5 million in 2003 as compared to $14.0 million in 2002, a decrease of $0.5 million, or 3.0%.
This decrease in operating cash flows was primarily the result of changes in working capital, partially offset by an increase in net income adjusted by non-cash expenses.



Net cash used in investing activities was $43.4 million for the year ended December 31, 2004, compared to $92.5 million for
2003. Investing activities during 2004 consisted primarily of additions to property and equipment of $4.8 million, purchases of investment securities of $45.6 million and the purchase of patents, patent applications and certain customer information
of $0.7 million, partially offset by sales of investment securities of $8.1 million. Investing activities during 2003 consisted primarily of the $85.8 million paid for the acquisition of Staktek, net of the cash acquired, and additions to property
and equipment of $1.3 million. Cash used in investing activities was $6.0 million in 2002, and consisted primarily of additions to property and equipment.



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##### Index to Financial Statements

Net cash provided by financing activities during the year ended December 31, 2004 was $21.1 million,
primarily due to the $145.5 million in gross proceeds received from our initial public offering, including the underwriters exercise of their over-allotment option, net of underwriter fees of $10.2 million and associated expenses of $1.5
million paid during the year, debt payments totaling $77.6 million and the $30.6 million redemption of the redeemable preferred stock. In the first quarter of 2004, we repaid all debt issued in connection with the Staktek acquisition, we redeemed
all redeemable preferred stock previously issued, and we terminated the senior revolving credit notes. Additionally, we paid $4.3 million during 2004 to purchase our stock on the open market as part of our stock repurchase program (see Item 5.
Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities). Net cash provided by financing activities for 2003 was $107.9 million, primarily due to the $79.5 million and the $29.5 million in
proceeds received from the issuance of debt and preferred stock, respectively, in connection with the Staktek acquisition. Cash flow used in financing activities was $1.4 million in 2002.



We believe that our current assets, including cash and cash equivalents, investments and expected cash flow from operations,
will be sufficient to fund our operations, our anticipated additions to property and equipment and any share repurchases under our stock repurchase program for at least the next 12 months. However, it is possible that we may need or elect to raise
additional funds to fund our activities beyond the next year or to acquire other businesses, products or technologies. We could raise these funds by borrowing money or selling more stock to the public or to selected investors. In addition, while we
may not need additional funds, we may elect to sell additional equity securities or obtain credit facilities for other reasons. We cannot assure you that we will be able to obtain additional funds on commercially favorable terms, or at all. If we
raise additional funds by issuing more equity or convertible debt securities, the ownership percentages of existing stockholders would be reduced. In addition, the equity or debt securities that we issue may have rights, preferences or privileges
senior to those of the holders of our common stock.



Critical Accounting
Policies



Our accounting policies are more fully described
in Note 1 of the Consolidated Financial Statements. As disclosed in Note 1, the preparation of financial statements in conformity with generally accepted accounting principles requires that management make estimates and assumptions about future
events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe that the following discussion addresses our most critical accounting policies,
which are those that are most important to the portrayal of our financial condition and results of operations and require managements most difficult, subjective and complex judgments.



Revenue Recognition and Presentation. We evaluate our customer
arrangements for manufacturing services to determine whether revenue from these arrangements should be recorded on a gross basis or a net basis. When evaluating our customer arrangements, we determine whether the arrangement represents a consigned
inventory transaction or a purchase and resale of inventory. In making this determination, we consider the following: (i) we are only responsible for the functionality of our stacking process, (ii) we do not select the vendor to provide the memory
packages, and (iii) we do not set the price for the memory packages. We have determined that a net basis of revenue recognition is appropriate for our customer arrangements for manufacturing services where the customer has instructed us to purchase
specified memory packages from a specified vendor for purposes of stacking and shipping to the customer. Should the considerations described above change, we may determine that future customer arrangements should be recorded on a gross basis that
would result in increases in both revenue and the cost of revenue. We recognize revenue when there is persuasive evidence of an arrangement, delivery has occurred, the fee is fixed or determinable, and collectibility of the resulting receivable is
reasonably assured.



Revenue from our license agreements with
Samsung and Infineon is recognized per unit stacked in the period in which they report royalties to us. Neither licensee typically provides us with forward estimates or current-quarter information concerning its shipments. Because we are not able to
reasonably estimate the



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##### Index to Financial Statements

amount of royalties earned during the period in which the licensees actually ship products using our stacking technologies, we do not recognize royalty
revenue until the royalties are reported to us. The collection of these royalties is considered probable.



Impairment of Assets. We evaluate the recoverability of losses on long-lived assets, such as property and equipment and intangible assets when
events or changes in circumstances indicate that the undiscounted cash flows estimated to be generated by such assets are less than the carrying value of these assets, and accordingly, all or a portion of this carrying value may not be recoverable.
Impairment losses are then measured by comparing the fair value of the assets to the carrying amounts. Actual useful lives and cash flow could be different than those estimated by us.



Goodwill and our trademarks are evaluated annually for impairment and are not amortized. The goodwill impairment test
requires judgment regarding the determination of fair value of the reporting unit, which we determined to be our company as a whole, and the determination of fair value of our assets and liabilities. We periodically assess our goodwill for
indications of impairment on a reporting unit level. A reporting unit is defined as a component of an entity for which the operating results are regularly reviewed by management and discrete financial information is available. We have a single
reporting unit at an enterprise level and allocate goodwill to this reporting unit for goodwill impairment testing. The trademark impairment test requires judgment regarding the timing and amount of future cash flows.



Income Taxes. We determine deferred tax assets and liabilities based
on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the years in which the differences are expected to affect taxable income. Valuation allowances are established when
necessary to reduce deferred tax assets to the amounts expected to be realized.



Deferred Stock-Based Compensation. We account for our employee stock-based compensation using the intrinsic value method. The intrinsic value method specifies that compensation exists if the fair value of the
common stock exceeds the exercise price of the stock option at the date of grant. Prior to the successful completion of our initial public offering during the first quarter of 2004, a ready market did not exist for our common stock. As a result, we
estimated fair value for our common stock using traditional valuation methodologies, such as multiples of earnings or cash flows.



Recent Accounting Pronouncements



In December 2004, the FASB issued a revised Statement of Financial Accounting Standards (SFAS) No. 123(R), Share-Based Payment  an
Amendment of FASB Statements No. 123 and 95. SFAS No. 123(R) establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services or incurs liabilities in exchange for goods or
services that are based on the fair value of the entitys equity instruments, focusing primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. SFAS No. 123(R) requires public
entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions) and recognize the cost over the period during which an employee is
required to provide service in exchange for the award. Adoption requires either a modified prospective or a modified retrospective application. Management is evaluating both approaches to determine the most appropriate. We are required to adopt SFAS
No. 123(R) in the third quarter of 2005. We are evaluating SFAS No. 123(R) and believe it may have a material effect on our financial position and results of operations.



In November 2004, the FASB issued SFAS No. 151, Inventory Costs  An Amendment of ARB No. 43, Chapter 4,
which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). We are required to adopt SFAS No. 151 in 2006 and we do not expect our adoption to have a significant impact on our
results of operations or financial condition.



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##### Index to Financial Statements

Subsequent Events



On January 20, 2005, J. Ross Cockrell resigned from our Board of Directors and from the Compensation Committee.



On January 20, 2005, our Board of Directors appointed Edward E. Olkkola to
serve as a director of the Company, to hold office for a term expiring at the Annual Meeting of Stockholders held in 2005. Mr. Olkkola was not appointed to serve on any committee of the Board of Directors. Mr. Olkkola is a general partner of the
general partners of both Austin Ventures VII, L.P. and Austin Ventures VIII, L.P., or Austin Ventures, which collectively hold a majority of our outstanding common stock. Mr. Olkkola may be deemed to share voting and investment power with respect to
all shares held by Austin Ventures, but Mr. Olkkola disclaims beneficial ownership of those shares except to the extent of his pecuniary interest therein. In February 2004, we used approximately $68 million of the proceeds of our initial public
offering to repay indebtedness owed to Austin Ventures and to redeem preferred stock held by Austin Ventures. These securities were originally issued in connection with the acquisition of us by Austin Ventures in 2003.



ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



Foreign Currency Exchange Risk. Nearly all of our transactions are denominated in U.S. dollars. The functional currency of our subsidiaries in
Mexico is the U.S. dollar. As a result, we have very little exposure to currency exchange risks and foreign exchange losses have been minimal to date. We do not currently enter into forward exchange contracts to hedge exposure denominated in foreign
currencies or any other derivative financial instruments for trading or speculative purposes. In the future, if we believe that our currency exposure has increased, we may consider entering into hedging transactions to help mitigate that risk.



Interest Rate Risk. The primary objective of our
investment activities is to preserve principal while maximizing the related income without significantly increasing risk. Even so, some of the securities in which we invest may be subject to market risk. This means that a change in prevailing
interest rates may cause the principal amount of the investment to fluctuate. To minimize this risk in the future, we intend to maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial
paper, money market funds, government and non-government debt securities and certificates of deposit. The risk associated with fluctuating interest rates is limited to our investment portfolio and we do not believe that a 10% change in interest
rates will have a significant impact on our interest income. As of December 31, 2004, all of our cash was held in deposit or money market accounts, or invested in investment grade securities.



Our exposure to market risk is also related to the increase or decrease in
the amount of interest expense we must pay on our outstanding debt instruments, which were primarily certain borrowings under our bank credit facility. Advances under our senior debt facilities bore a variable interest rate based on either
Eurocurrency or prime-based rates according to a ratio that was based on our earnings before income taxes, depreciation and amortization. The risk of fluctuating interest expense was limited to this debt instrument. In the first quarter of 2004, we
repaid this debt and as a result, our market risk has been reduced.



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##### Index to Financial Statements

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



Set forth below are our audited consolidated financial statements for the year ended December 31, 2004, the period from inception to December 31, 2003, the period from January 1, 2003 to August 20, 2003, and the year
ended December 31, 2002.



INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



|                                                        |  |     
|------------------------------------------------------- |  | ----
|                                                        |  | Page
|Report of Independent Registered Public Accounting Firm |  | 47  
|Consolidated Balance Sheets                             |  | 48  
|Consolidated Statements of Operations                   |  | 49  
|Consolidated Statements of Stockholders Equity         |  | 50  
|Consolidated Statements of Cash Flows                   |  | 52  
|Notes to Consolidated Financial Statements              |  | 54  



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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



The Board of Directors and Stockholders of Staktek Holdings, Inc.



We have audited the accompanying consolidated balance sheet of Staktek Holdings, Inc. (the Company) as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders
equity, and cash flows for the year ended December 31, 2004 and for the period from May 9, 2003 (inception) to December 31, 2003; and the accompanying consolidated statements of operations, stockholders equity, and cash flows of
Staktek Corporation (Predecessor Company) for the year ended December 31, 2002 and for the period from January 1, 2003 to August 20, 2003. These financial statements are the responsibility of the Companys management. Our
responsibility is to express an opinion on these financial statements based on our audits.



We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for
the purpose of expressing an opinion on the effectiveness of the Companys internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts
and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis
for our opinion.



In our opinion, the financial statements
referred to above present fairly, in all material respects, the consolidated financial position of Staktek Holdings, Inc. at December 31, 2004 and 2003, and the consolidated results of its operations and its cash flows for the year ended
December 31, 2004 and for the period from May 9, 2003 (inception) to December 31, 2003; and the consolidated statements of operations, stockholders equity, and cash flows of Staktek Corporation (Predecessor Company) for the year
ended December 31, 2002 and for the period from January 1, 2003 to August 20, 2003, in conformity with U.S. generally accepted accounting principles.



/s/ ERNST & YOUNG LLP



Austin, Texas



January 24, 2005



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STAKTEK HOLDINGS, INC.



CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data)



|                                                                                                                                                               |  |                   |         |   |                   |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | - | ----------------- | - | ------- | -
|                                                                                                                                                               |  | December 31, 2004 |         |   | December 31, 2003 |  
|                                                                                                                                                               |  |                  
|ASSETS                                                                                                                                                         |  |                   |         |   |                   |   |         |  
|Current assets:                                                                                                                                                |  |                   |         |   |                   |   |         |  
|Cash and cash equivalents                                                                                                                                      |  | $                 | 39,984  |   |                   | $ | 31,165  |  
|Investments                                                                                                                                                    |  |                   | 37,434  |   |                   |   |        |  
|Accounts receivable                                                                                                                                            |  |                   | 4,493   |   |                   |   | 14,001  |  
|Inventory held for others                                                                                                                                      |  |                   | 3       |   |                   |   | 1,301   |  
|Inventories                                                                                                                                                    |  |                   | 833     |   |                   |   | 495     |  
|Other current assets                                                                                                                                           |  |                   | 3,228   |   |                   |   | 3,771   |  
|                                                                                                                                                               |  |                   |         |   |                   |   |         |  
|Total current assets                                                                                                                                           |  |                   | 85,975  |   |                   |   | 50,733  |  
|Property and equipment, net                                                                                                                                    |  |                   | 10,162  |   |                   |   | 10,095  |  
|Goodwill                                                                                                                                                       |  |                   | 28,466  |   |                   |   | 29,726  |  
|Other intangibles, net                                                                                                                                         |  |                   | 30,447  |   |                   |   | 46,988  |  
|Other assets                                                                                                                                                   |  |                   | 421     |   |                   |   |        |  
|                                                                                                                                                               |  |                   |         |   |                   |   |         |  
|Total assets                                                                                                                                                   |  | $                 | 155,471 |   |                   | $ | 137,542 |  
|                                                                                                                                                               |  |                   |         |   |                   |   |         |  
|                                                                                                                                                               |  |                  
|LIABILITIES, REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS EQUITY                                                                                               |  |                   |         |   |                   |   |         |  
|Current liabilities:                                                                                                                                           |  |                   |         |   |                   |   |         |  
|Accounts payable                                                                                                                                               |  | $                 | 714     |   |                   | $ | 6,493   |  
|Accrued liabilities                                                                                                                                            |  |                   | 2,568   |   |                   |   | 6,221   |  
|Deferred revenue                                                                                                                                               |  |                   | 629     |   |                   |   |        |  
|Current maturities of capitalized lease obligations                                                                                                            |  |                   | 53      |   |                   |   | 115     |  
|Notes payable and current maturities of long-term debt                                                                                                         |  |                   |        |   |                   |   | 12,500  |  
|                                                                                                                                                               |  |                   |         |   |                   |   |         |  
|Total current liabilities                                                                                                                                      |  |                   | 3,964   |   |                   |   | 25,329  |  
|Capitalized lease obligations, less current maturities                                                                                                         |  |                   |        |   |                   |   | 51      |  
|Other accrued liabilities                                                                                                                                      |  |                   | 190     |   |                   |   | 87      |  
|Deferred tax liabilities                                                                                                                                       |  |                   | 9,510   |   |                   |   | 16,263  |  
|Long-term debt, less current maturities                                                                                                                        |  |                   |        |   |                   |   | 30,625  |  
|Subordinated loan from related party                                                                                                                           |  |                   |        |   |                   |   | 34,500  |  
|                                                                                                                                                               |  |                   |         |   |                   |   |         |  
|                                                                                                                                                               |  |                  
|Redeemable preferred stock; $0.001 par value; 1,000,000 shares authorized; 250 shares designated; 171.01449 shares issued and outstanding at
December 31, 2003 |  |                   |        |   |                   |   | 30,372  |  
|                                                                                                                                                               |  |                   |         |   |                   |   |         |  
|                                                                                                                                                               |  |                  
|Stockholders equity:                                                                                                                                          |  |                   |         |   |                   |   |         |  
|Common stock; $0.001 par value; 200,000,000 shares authorized;                                                                                                 |  |                   |         |   |                   |   |         |  
|51,102,215 shares and 40,377,396 shares issued at December 31, 2004 and December 31, 2003, respectively                                                        |  |                   | 49      |   |                   |   | 37      |  
|Additional paid-in capital                                                                                                                                     |  |                   | 155,810 |   |                   |   | 25,325  |  
|Treasury stock, at cost; 473,000 shares at December 31, 2004                                                                                                   |  |                   | (1,982  | ) |                   |   |        |  
|Deferred stock-based compensation                                                                                                                              |  |                   | (13,462 | ) |                   |   | (18,901 | )
|Unrealized loss on investments                                                                                                                                 |  |                   | (2      | ) |                   |   |        |  
|Retained earnings (accumulated deficit)                                                                                                                        |  |                   | 1,394   |   |                   |   | (6,146  | )
|                                                                                                                                                               |  |                   |         |   |                   |   |         |  
|Total stockholders equity                                                                                                                                     |  |                   | 141,807 |   |                   |   | 315     |  
|                                                                                                                                                               |  |                   |         |   |                   |   |         |  
|Total liabilities, redeemable preferred stock and stockholders equity                                                                                         |  | $                 | 155,471 |   |                   | $ | 137,542 |  
|                                                                                                                                                               |  |                   |         |   |                   |   |         |  



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



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STAKTEK HOLDINGS, INC.



CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)



|                                                                                                                 |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|---------------------------------------------------------------------------------------------------------------- |  | --------------------------- | ------ | - | ---------------------------------------- | - | ------ | ------------------------------------------- |  | - | -------------------------- | - |  | - | ------ | -
|                                                                                                                 |  | Staktek Holdings, Inc.      |        |   | Predecessor Company                      |  
|                                                                                                                 |  | Year Ended December 31,2004 |        |   | Period from Inception toDecember 31,2003 |   |        | Period fromJanuary 1, 2003to August 20,2003 |  |   | Year EndedDecember 31,2002 |  
|Revenue:                                                                                                         |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Services                                                                                                         |  | $                           | 41,047 |   |                                          | $ | 21,020 |                                             |  | $ | 31,509                     |   |  | $ | 40,288 |  
|License                                                                                                          |  |                             | 32,579 |   |                                          |   | 6,202  |                                             |  |   | 12,624                     |   |  |   | 6,728  |  
|                                                                                                                 |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Total revenue                                                                                                    |  |                             | 73,626 |   |                                          |   | 27,222 |                                             |  |   | 44,133                     |   |  |   | 47,016 |  
|Cost of revenue:                                                                                                 |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Services                                                                                                         |  |                             | 26,104 |   |                                          |   | 9,763  |                                             |  |   | 19,813                     |   |  |   | 23,063 |  
|Amortization of acquisition intangibles                                                                          |  |                             | 15,785 |   |                                          |   | 4,584  |                                             |  |   |                           |   |  |   |       |  
|Amortization of deferred stock-based compensation and stock compensation expense                                 |  |                             | 601    |   |                                          |   | 1,935  |                                             |  |   | 20                         |   |  |   |       |  
|                                                                                                                 |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Total cost of revenue                                                                                            |  |                             | 42,490 |   |                                          |   | 16,282 |                                             |  |   | 19,833                     |   |  |   | 23,063 |  
|                                                                                                                 |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Gross profit                                                                                                     |  |                             | 31,136 |   |                                          |   | 10,940 |                                             |  |   | 24,300                     |   |  |   | 23,953 |  
|Operating expenses:                                                                                              |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Selling, general and administrative (1)                                                                          |  |                             | 8,431  |   |                                          |   | 3,397  |                                             |  |   | 3,085                      |   |  |   | 3,836  |  
|Research and development (1)                                                                                     |  |                             | 2,563  |   |                                          |   | 854    |                                             |  |   | 1,560                      |   |  |   | 2,084  |  
|Business restructuring and acquisition                                                                           |  |                             |       |   |                                          |   | 2,452  |                                             |  |   | 3,376                      |   |  |   | 306    |  
|In-process research and development                                                                              |  |                             |       |   |                                          |   | 700    |                                             |  |   |                           |   |  |   |       |  
|Amortization of acquisition intangibles                                                                          |  |                             | 1,855  |   |                                          |   | 1,058  |                                             |  |   |                           |   |  |   |       |  
|Amortization of deferred stock-based compensation and stock compensation expense                                 |  |                             | 4,376  |   |                                          |   | 3,734  |                                             |  |   | 22                         |   |  |   |       |  
|                                                                                                                 |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Total operating expenses                                                                                         |  |                             | 17,225 |   |                                          |   | 12,195 |                                             |  |   | 8,043                      |   |  |   | 6,226  |  
|                                                                                                                 |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Income (loss) from operations                                                                                    |  |                             | 13,911 |   |                                          |   | (1,255 | )                                           |  |   | 16,257                     |   |  |   | 17,727 |  
|Other income (expense):                                                                                          |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Interest income                                                                                                  |  |                             | 401    |   |                                          |   | 29     |                                             |  |   | 102                        |   |  |   | 276    |  
|Interest expense                                                                                                 |  |                             | (1,210 | ) |                                          |   | (3,107 | )                                           |  |   | (12                        | ) |  |   | (79    | )
|Other                                                                                                            |  |                             | (28    | ) |                                          |   | (285   | )                                           |  |   | (10                        | ) |  |   | 41     |  
|                                                                                                                 |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Income (loss) before income taxes                                                                                |  |                             | 13,074 |   |                                          |   | (4,618 | )                                           |  |   | 16,337                     |   |  |   | 17,965 |  
|Provision for income taxes                                                                                       |  |                             | 5,268  |   |                                          |   | 656    |                                             |  |   | 6,861                      |   |  |   | 6,439  |  
|                                                                                                                 |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Net income (loss)                                                                                                |  |                             | 7,806  |   |                                          |   | (5,274 | )                                           |  |   | 9,476                      |   |  |   | 11,526 |  
|Preferred stock dividends                                                                                        |  |                             | (266   | ) |                                          |   | (872   | )                                           |  |   |                           |   |  |   |       |  
|                                                                                                                 |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Income (loss) available to common stockholders                                                                   |  | $                           | 7,540  |   |                                          | $ | (6,146 | )                                           |  | $ | 9,476                      |   |  | $ | 11,526 |  
|                                                                                                                 |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Earnings (loss) per share:                                                                                       |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Basic                                                                                                            |  | $                           | 0.16   |   |                                          | $ | (0.17  | )                                           |  | $ | 5.16                       |   |  | $ | 6.33   |  
|                                                                                                                 |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Diluted                                                                                                          |  | $                           | 0.15   |   |                                          | $ | (0.17  | )                                           |  | $ | 4.86                       |   |  | $ | 6.01   |  
|                                                                                                                 |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Shares used in computing earnings per share:                                                                     |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|Basic                                                                                                            |  |                             | 47,234 |   |                                          |   | 36,647 |                                             |  |   | 1,836                      |   |  |   | 1,822  |  
|Diluted                                                                                                          |  |                             | 50,996 |   |                                          |   | 36,647 |                                             |  |   | 1,949                      |   |  |   | 1,917  |  
|                                                                                                                 |  |                             |       
|(1)    Excludes the amortization of deferred stock-based compensation and stock
compensation expense as follows: |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   | 
|Selling, general and administrative                                                                              |  | $                           | 4,313  |   |                                          | $ | 3,718  |                                             |  | $ | 22                         |   |  | $ |       |  
|Research and development                                                                                         |  |                             | 63     |   |                                          |   | 16     |                                             |  |   |                           |   |  |   |       |  
|                                                                                                                 |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  
|                                                                                                                 |  | $                           | 4,376  |   |                                          | $ | 3,734  |                                             |  | $ | 22                         |   |  | $ |       |  
|                                                                                                                 |  |                             |        |   |                                          |   |        |                                             |  |   |                            |   |  |   |        |  



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



49



---

##### Table of Contents

##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY

(in thousands, except share amounts)



|                                                                            |  |                     |  |                          |    |  |               |       |                                 |  |   |                           |  |                                   |      |                          |  |   |        |  |   |   |  |   |       
|--------------------------------------------------------------------------- |  | ------------------- |  | ------------------------ | -- |  | ------------- | ----- | ------------------------------- |  | - | ------------------------- |  | --------------------------------- | ---- | ------------------------ |  | - | ------ |  | - | - |  | - | ------
|                                                                            |  | Predecessor Company
|                                                                            |  |                     |  | AdditionalPaid-InCapital |    |  | TreasuryStock |       | DeferredStock-BasedCompensation |  |   | RetainedEarnings(Deficit) |  | AccumulatedOtherComprehensiveLoss |      | TotalStockholdersEquity
|                                                                            |  | Common Stock        |  |                          |    |  |               |      
|                                                                            |  | Shares              |  | Amount                   |    |  |               |       |                                 | 
|Balances at December 31, 2001                                               |  | 1,809,973           |  | $                        | 18 |  | $             | 4,414 |                                 |  | $ |                          |  | $                                 | (152 | )                        |  | $ | 28,503 |  | $ |  |  | $ | 32,783
|Exercise of stock options                                                   |  | 14,803              |  |                          |   |  |               | 110   |                                 |  |   |                          |  |                                   |     |                          |  |   |       |  |   |  |  |   | 110   
|Effect of variable stock option grants                                      |  |                    |  |                          |   |  |               | (150  | )                               |  |   |                          |  |                                   | 150  |                          |  |   |       |  |   |  |  |   |      
|Net income                                                                  |  |                    |  |                          |   |  |               |      |                                 |  |   |                          |  |                                   |     |                          |  |   | 11,526 |  |   |  |  |   | 11,526
|                                                                            |  |                     |  |                          |    |  |               |       |                                 |  |   |                           |  |                                   |      |                          |  |   |        |  |   |   |  |   |       
|Balances at December 31, 2002                                               |  | 1,824,776           |  |                          | 18 |  |               | 4,374 |                                 |  |   |                          |  |                                   | (2   | )                        |  |   | 40,029 |  |   |  |  |   | 44,419
|Exercise of stock options                                                   |  | 12,645              |  |                          |   |  |               | 128   |                                 |  |   |                          |  |                                   |     |                          |  |   |       |  |   |  |  |   | 128   
|Effect of variable stock option grants                                      |  |                    |  |                          |   |  |               | 41    |                                 |  |   |                          |  |                                   | 1    |                          |  |   |       |  |   |  |  |   | 42    
|Tax benefit from disqualifying disposition of incentive stock option shares |  |                    |  |                          |   |  |               | 2,078 |                                 |  |   |                          |  |                                   |     |                          |  |   |       |  |   |  |  |   | 2,078 
|Net income                                                                  |  |                    |  |                          |   |  |               |      |                                 |  |   |                          |  |                                   |     |                          |  |   | 9,476  |  |   |  |  |   | 9,476 
|                                                                            |  |                     |  |                          |    |  |               |       |                                 |  |   |                           |  |                                   |      |                          |  |   |        |  |   |   |  |   |       
|Balances at August 20, 2003                                                 |  | 1,837,421           |  | $                        | 18 |  | $             | 6,621 |                                 |  | $ |                          |  | $                                 | (1   | )                        |  | $ | 49,505 |  | $ |  |  | $ | 56,143
|                                                                            |  |                     |  |                          |    |  |               |       |                                 |  |   |                           |  |                                   |      |                          |  |   |        |  |   |   |  |   |       





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



50



---

##### Table of Contents

##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY(Continued)

(in thousands, except share amounts)



|                                                                                                            |  |                        |   |                           |        |    |                |   |         |                                  |  |   |                            |   |  |                                    |         |   |                           |   |        |   |  |   |    |   |  |   |         |  
|----------------------------------------------------------------------------------------------------------- |  | ---------------------- | - | ------------------------- | ------ | -- | -------------- | - | ------- | -------------------------------- |  | - | -------------------------- | - |  | ---------------------------------- | ------- | - | ------------------------- | - | ------ | - |  | - | -- | - |  | - | ------- | -
|                                                                                                            |  | Staktek Holdings, Inc. |  
|                                                                                                            |  | Common Stock           |   | AdditionalPaid-In Capital |        |    | Treasury Stock |   |         | DeferredStock-Based Compensation |  |   | RetainedEarnings (Deficit) |   |  | AccumulatedOtherComprehensive Loss |         |   | TotalStockholders Equity |  
|                                                                                                            |  | Shares                 |   |                           | Amount |    |                |   |         |                                  | 
|Issuance of common stock at May 9, 2003 (inception)                                                         |  | 36,549,999             |   |                           | $      | 37 |                | $ | 463     |                                  |  | $ |                           |   |  | $                                  |        |   |                           | $ |       |   |  | $ |   |   |  | $ | 500     |  
|Issuance of stock options                                                                                   |  |                       |   |                           |        |   |                |   | 24,345  |                                  |  |   |                           |   |  |                                    | (24,345 | ) |                           |   |       |   |  |   |   |   |  |   |        |  
|Exercise of stock options                                                                                   |  | 435,880                |   |                           |        |   |                |   | 292     |                                  |  |   |                           |   |  |                                    |        |   |                           |   |       |   |  |   |   |   |  |   | 292     |  
|Exercise of stock options (shares subject to repurchase)                                                    |  | 3,391,517              |   |                           |        |   |                |   |        |                                  |  |   |                           |   |  |                                    |        |   |                           |   |       |   |  |   |   |   |  |   |        |  
|Issuance of warrant to purchase common stock                                                                |  |                       |   |                           |        |   |                |   | 225     |                                  |  |   |                           |   |  |                                    |        |   |                           |   |       |   |  |   |   |   |  |   | 225     |  
|Amortization of deferred stock-based compensation                                                           |  |                       |   |                           |        |   |                |   |        |                                  |  |   |                           |   |  |                                    | 5,444   |   |                           |   |       |   |  |   |   |   |  |   | 5,444   |  
|Dividends on preferred stock                                                                                |  |                       |   |                           |        |   |                |   |        |                                  |  |   |                           |   |  |                                    |        |   |                           |   | (872   | ) |  |   |   |   |  |   | (872    | )
|Net loss                                                                                                    |  |                       |   |                           |        |   |                |   |        |                                  |  |   |                           |   |  |                                    |        |   |                           |   | (5,274 | ) |  |   |   |   |  |   | (5,274  | )
|                                                                                                            |  |                        |   |                           |        |    |                |   |         |                                  |  |   |                            |   |  |                                    |         |   |                           |   |        |   |  |   |    |   |  |   |         |  
|Balances at December 31, 2003                                                                               |  | 40,377,396             |   |                           |        | 37 |                |   | 25,325  |                                  |  |   |                           |   |  |                                    | (18,901 | ) |                           |   | (6,146 | ) |  |   |   |   |  |   | 315     |  
|Issuance of common shares                                                                                   |  | 11,190,000             |   |                           |        | 11 |                |   | 135,276 |                                  |  |   |                           |   |  |                                    |        |   |                           |   |       |   |  |   |   |   |  |   | 135,287 |  
|Costs of initial public offering                                                                            |  |                       |   |                           |        |   |                |   | (1,942  | )                                |  |   |                           |   |  |                                    |        |   |                           |   |       |   |  |   |   |   |  |   | (1,942  | )
|Dividends on preferred stock                                                                                |  |                       |   |                           |        |   |                |   |        |                                  |  |   |                           |   |  |                                    |        |   |                           |   | (266   | ) |  |   |   |   |  |   | (266    | )
|Write-off of deferred stock-based compensation due to the repurchase of unvested excercisable stock options |  |                       |   |                           |        |   |                |   | (463    | )                                |  |   |                           |   |  |                                    | 463     |   |                           |   |       |   |  |   |   |   |  |   |        |  
|Open market repurchase of common shares                                                                     |  |                       |   |                           |        |   |                |   |        |                                  |  |   | (4,408                     | ) |  |                                    |        |   |                           |   |       |   |  |   |   |   |  |   | (4,408  | )
|Exercise of stock options                                                                                   |  | 181,793                |   |                           |        |   |                |   | 2       |                                  |  |   |                           |   |  |                                    |        |   |                           |   |       |   |  |   |   |   |  |   | 2       |  
|Vesting of previously exercised unvested stock options                                                      |  |                       |   |                           |        | 1  |                |   | 38      |                                  |  |   |                           |   |  |                                    |        |   |                           |   |       |   |  |   |   |   |  |   | 39      |  
|Amortization of deferred stock-based compensation                                                           |  |                       |   |                           |        |   |                |   |        |                                  |  |   |                           |   |  |                                    | 4,976   |   |                           |   |       |   |  |   |   |   |  |   | 4,976   |  
|Retirement of treasury stock                                                                                |  | (646,974               | ) |                           |        |   |                |   | (2,426  | )                                |  |   | 2,426                      |   |  |                                    |        |   |                           |   |       |   |  |   |   |   |  |   |        |  
|Net income                                                                                                  |  |                       |   |                           |        |   |                |   |        |                                  |  |   |                           |   |  |                                    |        |   |                           |   | 7,806  |   |  |   |   |   |  |   | 7,806   |  
|Unrealized loss on investment securities                                                                    |  |                       |   |                           |        |   |                |   |        |                                  |  |   |                           |   |  |                                    |        |   |                           |   |       |   |  |   | (2 | ) |  |   | (2      | )
|                                                                                                            |  |                        |   |                           |        |    |                |   |         |                                  |  |   |                            |   |  |                                    |         |   |                           |   |        |   |  |   |    |   |  |   |         |  
|Total comprehensive income                                                                                  |  |                       |   |                           |        |   |                |   |        |                                  |  |   |                           |   |  |                                    |        |   |                           |   |       |   |  |   |   |   |  |   | 7,804   |  
|                                                                                                            |  |                        |   |                           |        |    |                |   |         |                                  |  |   |                            |   |  |                                    |         |   |                           |   |        |   |  |   |    |   |  |   |         |  
|Balances at December 31, 2004                                                                               |  | 51,102,215             |   |                           | $      | 49 |                | $ | 155,810 |                                  |  | $ | (1,982                     | ) |  | $                                  | (13,462 | ) |                           | $ | 1,394  |   |  | $ | (2 | ) |  | $ | 141,807 |  
|                                                                                                            |  |                        |   |                           |        |    |                |   |         |                                  |  |   |                            |   |  |                                    |         |   |                           |   |        |   |  |   |    |   |  |   |         |  



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



51



---

##### Table of Contents

##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                           |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |        |  
|------------------------------------------------------------------------------------------ |  | -------------------------- | ------ | - | --------------------------------------- | - | ------ | ------------------------------------------ |  | - | -------------------------- | - |  | - | ------ | -
|                                                                                           |  | Staktek Holdings, Inc.     |        |   | Predecessor Company                     |  
|                                                                                           |  | Year EndedDecember 31,2004 |        |   | Period fromInception toDecember 31,2003 |   |        | Period fromJanuary 1,2003 toAugust 20,2003 |  |   | Year EndedDecember 31,2002 |  
|Cash flows from operating activities:                                                      |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |        |  
|Net income (loss)                                                                          |  | $                          | 7,806  |   |                                         | $ | (5,274 | )                                          |  | $ | 9,476                      |   |  | $ | 11,526 |  
|Adjustments to reconcile net income (loss) to net cash provided by operating activities:   |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |        |  
|Depreciation                                                                               |  |                            | 4,620  |   |                                         |   | 1,439  |                                            |  |   | 2,287                      |   |  |   | 3,232  |  
|Amortization of intangibles and write-off of purchased in-process research and development |  |                            | 17,713 |   |                                         |   | 6,342  |                                            |  |   | 53                         |   |  |   | 158    |  
|Amortization of deferred stock-based compensation and stock compensation expense           |  |                            | 4,977  |   |                                         |   | 5,669  |                                            |  |   | 42                         |   |  |   |       |  
|Deferred income taxes                                                                      |  |                            | (6,779 | ) |                                         |   | (1,196 | )                                          |  |   | (583                       | ) |  |   | 1,509  |  
|Other                                                                                      |  |                            | 18     |   |                                         |   | 234    |                                            |  |   |                           |   |  |   | (40    | )
|Changes in operating assets and liabilities, net of acquisitions:                          |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |        |  
|Accounts receivable                                                                        |  |                            | 9,508  |   |                                         |   | 1,218  |                                            |  |   | (3,842                     | ) |  |   | (5,238 | )
|Inventory held for others                                                                  |  |                            | 1,298  |   |                                         |   | (1,133 | )                                          |  |   | 4,226                      |   |  |   | (3,233 | )
|Inventories                                                                                |  |                            | (338   | ) |                                         |   | 29     |                                            |  |   | 639                        |   |  |   | 148    |  
|Other current assets                                                                       |  |                            | (142   | ) |                                         |   | 1,471  |                                            |  |   | (4,270                     | ) |  |   | (1,220 | )
|Income tax receivable/payable                                                              |  |                            | 822    |   |                                         |   | (181   | )                                          |  |   | (884                       | ) |  |   | 1,776  |  
|Accounts payable                                                                           |  |                            | (5,494 | ) |                                         |   | 2,222  |                                            |  |   | (5,022                     | ) |  |   | 6,539  |  
|Accrued liabilities                                                                        |  |                            | (3,528 | ) |                                         |   | (437   | )                                          |  |   | 1,014                      |   |  |   | 873    |  
|Deferred revenue                                                                           |  |                            | 629    |   |                                         |   |       |                                            |  |   |                           |   |  |   | (2,073 | )
|                                                                                           |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |        |  
|Net cash provided by operating activities                                                  |  |                            | 31,110 |   |                                         |   | 10,403 |                                            |  |   | 3,136                      |   |  |   | 13,957 |  
|                                                                                           |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |        |  





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



52



---

##### Table of Contents

##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



CONSOLIDATED STATEMENTS OF CASH FLOWS(Continued)

(in thousands)



|                                                             |  |                            |         |   |                                         |   |         |                                            |  |   |                            |   |  |   |        |  
|------------------------------------------------------------ |  | -------------------------- | ------- | - | --------------------------------------- | - | ------- | ------------------------------------------ |  | - | -------------------------- | - |  | - | ------ | -
|                                                             |  | Staktek Holdings, Inc.     |         |   | Predecessor Company                     |  
|                                                             |  | Year EndedDecember 31,2004 |         |   | Period fromInception toDecember 31,2003 |   |         | Period fromJanuary 1,2003 toAugust 20,2003 |  |   | Year EndedDecember 31,2002 |  
|Cash flows from investing activities:                        |  |                            |         |   |                                         |   |         |                                            |  |   |                            |   |  |   |        |  
|Purchases of investments                                     |  |                            | (45,564 | ) |                                         |   |        |                                            |  |   |                           |   |  |   |       |  
|Sales of investments                                         |  |                            | 8,125   |   |                                         |   |        |                                            |  |   |                           |   |  |   |       |  
|Additions to property and equipment                          |  |                            | (4,802  | ) |                                         |   | (1,302  | )                                          |  |   | (5,269                     | ) |  |   | (6,094 | )
|Proceeds from sale of equipment                              |  |                            |        |   |                                         |   |        |                                            |  |   |                           |   |  |   | 150    |  
|Purchase of intangible assets                                |  |                            |        |   |                                         |   |        |                                            |  |   |                           |   |  |   |       |  
|Acquisition of Staktek Corporation, net of cash acquired     |  |                            |        |   |                                         |   | (85,788 | )                                          |  |   |                           |   |  |   |       |  
|Purchase of assets from DPAC                                 |  |                            | (734    | ) |                                         |   |        |                                            |  |   |                           |   |  |   |       |  
|Patent application costs                                     |  |                            | (437    | ) |                                         |   | (30     | )                                          |  |   | (113                       | ) |  |   | (38    | )
|                                                             |  |                            |         |   |                                         |   |         |                                            |  |   |                            |   |  |   |        |  
|Net cash used in investing activities                        |  |                            | (43,412 | ) |                                         |   | (87,120 | )                                          |  |   | (5,382                     | ) |  |   | (5,982 | )
|                                                             |  |                            |         |   |                                         |   |         |                                            |  |   |                            |   |  |   |        |  
|Cash flows from financing activities:                        |  |                            |         |   |                                         |   |         |                                            |  |   |                            |   |  |   |        |  
|Proceeds from senior term loans                              |  |                            |        |   |                                         |   | 30,000  |                                            |  |   |                           |   |  |   |       |  
|Proceeds from senior revolving credit notes                  |  |                            |        |   |                                         |   | 10,000  |                                            |  |   |                           |   |  |   |       |  
|Proceeds from short-term loan                                |  |                            |        |   |                                         |   | 5,000   |                                            |  |   |                           |   |  |   |       |  
|Proceeds from subordinated loan from related party           |  |                            |        |   |                                         |   | 34,500  |                                            |  |   |                           |   |  |   |       |  
|Proceeds from issuance of redeemable preferred stock         |  |                            |        |   |                                         |   | 29,500  |                                            |  |   |                           |   |  |   |       |  
|Net proceeds from the issuance of common stock               |  |                            | 133,781 |   |                                         |   | 792     |                                            |  |   | 128                        |   |  |   | 110    |  
|Repayment of notes payable and long-term debt                |  |                            | (43,125 | ) |                                         |   | (1,875  | )                                          |  |   |                           |   |  |   | (778   | )
|Repayment of subordinated loan from related party            |  |                            | (34,500 | ) |                                         |   |        |                                            |  |   |                           |   |  |   |       |  
|Redemption of redeemable preferred stock                     |  |                            | (30,638 | ) |                                         |   |        |                                            |  |   |                           |   |  |   |       |  
|Purchase of treasury stock                                   |  |                            | (4,284  | ) |                                         |   |        |                                            |  |   |                           |   |  |   |       |  
|Payments on capitalized lease obligations                    |  |                            | (113    | ) |                                         |   | (35     | )                                          |  |   | (81                        | ) |  |   | (764   | )
|                                                             |  |                            |         |   |                                         |   |         |                                            |  |   |                            |   |  |   |        |  
|Net cash provided by (used in) financing activities          |  |                            | 21,121  |   |                                         |   | 107,882 |                                            |  |   | 47                         |   |  |   | (1,432 | )
|                                                             |  |                            |         |   |                                         |   |         |                                            |  |   |                            |   |  |   |        |  
|Net increase (decrease) in cash and cash equivalents         |  |                            | 8,819   |   |                                         |   | 31,165  |                                            |  |   | (2,199                     | ) |  |   | 6,543  |  
|Cash and cash equivalents at beginning of period             |  |                            | 31,165  |   |                                         |   |        |                                            |  |   | 31,449                     |   |  |   | 24,906 |  
|                                                             |  |                            |         |   |                                         |   |         |                                            |  |   |                            |   |  |   |        |  
|Cash and cash equivalents at end of period                   |  | $                          | 39,984  |   |                                         | $ | 31,165  |                                            |  | $ | 29,250                     |   |  | $ | 31,449 |  
|                                                             |  |                            |         |   |                                         |   |         |                                            |  |   |                            |   |  |   |        |  
|Supplemental disclosure of cash flows information:           |  |                            |         |   |                                         |   |         |                                            |  |   |                            |   |  |   |        |  
|Cash paid during the period for interest                     |  | $                          | 3,739   |   |                                         | $ | 333     |                                            |  | $ | 11                         |   |  | $ | 68     |  
|                                                             |  |                            |         |   |                                         |   |         |                                            |  |   |                            |   |  |   |        |  
|Cash paid during the period for income taxes, net of refunds |  | $                          | 11,226  |   |                                         | $ | 1,007   |                                            |  | $ | 6,243                      |   |  | $ | 2,386  |  
|                                                             |  |                            |         |   |                                         |   |         |                                            |  |   |                            |   |  |   |        |  
|Noncash operating and investing activities:                  |  |                            |         |   |                                         |   |         |                                            |  |   |                            |   |  |   |        |  
|Adjustment to goodwill                                       |  | $                          | 1,260   |   |                                         | $ |        |                                            |  | $ |                           |   |  | $ |       |  
|                                                             |  |                            |         |   |                                         |   |         |                                            |  |   |                            |   |  |   |        |  
|Unrealized loss on investment securities                     |  | $                          | (2      | ) |                                         | $ |        |                                            |  | $ |                           |   |  | $ |       |  
|                                                             |  |                            |         |   |                                         |   |         |                                            |  |   |                            |   |  |   |        |  



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



53



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##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS



1. Description of Business



Staktek Holdings, Inc. (we and
our) was originally formed by two investment funds affiliated with Austin Ventures in May 2003 for the purpose of acquiring Staktek Corporation (the Predecessor Company), which was incorporated in Texas in June 1990. As a
result of this merger, Staktek Corporation became our wholly owned subsidiary. We did not have any operations prior to August 21, 2003, other than in connection with the Staktek acquisition. Effective August 20, 2003, we acquired all of the capital
stock of Research Applications, Inc. (RAI). RAIs activities at the date of acquisition consisted solely of the ownership of 212,997 shares of the Predecessor Company and approximately $0.3 million in cash.



We provide manufacturing services to deliver memory stacking solutions and
also offer licenses of our technologies to our customers to enable them to manufacture stacked memory products. In addition, we offer a broad range of services to support our customers needs, including design of custom-stacked memory
assemblies, electrical modeling assistance and component inventory management. We have production facilities in Austin, Texas and Reynosa, Mexico.



2. Basis of Presentation and Significant Accounting Policies



The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America.



Basis of Presentation and Principles of Consolidation



The accompanying consolidated statements of
operations and cash flows for the year ended December 31, 2002 and for the period from January 1, 2003 to August 20, 2003 represent the results of operations and cash flows of the Predecessor Company and its wholly owned subsidiaries. The
accompanying consolidated balance sheets as of December 31, 2003 and December 31, 2004, and the accompanying consolidated statements of operations and cash flows for the period from inception to December 31, 2003 and the year ended December 31,
2004, represent the financial position, results of operations and cash flows of the Company and its wholly owned subsidiaries.



Our consolidated financial statements and those of the Predecessor Company include the accounts of Staktek Holdings, Inc. and its wholly owned
subsidiaries and the accounts of the Predecessor Company and its wholly owned subsidiaries, respectively. All significant intercompany accounts and transactions have been eliminated in consolidation.



Use of Estimates



The preparation of financial statements in accordance with accounting principles generally accepted in the United States
requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, as well as disclosure of assets and liabilities. Actual results could differ from those estimates.



Reclassifications



Certain reclassifications have been made to prior years consolidated
financial statements to conform to current year presentation.



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##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Cash and Cash Equivalents



We consider all highly liquid investments with original maturities of three months or less when purchased to be cash
equivalents. At December 31, 2004, our cash equivalents included funds in money market accounts, municipal bonds and commercial paper. At December 31, 2003 our cash equivalents included funds in money market accounts.



Investments



Marketable short-term investments are classified as available-for-sale. Short-term investments consist primarily of U.S.
government debt securities, municipal government securities and commercial paper instruments. We now classify auction rate securities and securities with hard put features and maturities in excess of one year as short-term investments.



Investments with original maturities in excess of one year may be
classified as short term due to their highly liquid nature and to the fact we do not hold investments with the intent of long-term investment, but rather with the short-term objective of maximizing interest earnings on surplus cash intended for
operations.



All of these investments are carried at fair value
with unrealized gains and losses, if any, included as a component of accumulated other comprehensive income (loss). Fair value is determined as the market value of the security at the measurement date. Interests, dividends and realized gains and
losses are included in interest and other income. Realized gains and losses are recognized based on the specific identification method.



Inventory Held for Others



Inventory held for others consists of memory products purchased from a customer or a vendor specified by the customer that will be stacked by us and sold
to the customer at a price equal to the price paid by us plus a fee for the stacking process. We record revenue related to the sale of memory packages on a net basis. We record memory packages purchased as Inventory Held for Others rather than
Inventory because the costs of these packages are not recorded to Cost of Services Revenue. Inventory Held for Others increases when we purchase memory products to be stacked and decreases when these products have been stacked and shipped to our
customers.



Inventories



Inventories consist of materials purchased and labor and overhead incurred
for product that has not yet been shipped. Inventories are stated at the lower of cost or market (estimated realizable value) using the first-in, first-out (FIFO) method.



Property and Equipment



We carry property and equipment, including leasehold improvements, at cost less accumulated depreciation. Depreciation of property and equipment is
computed using the straight-line method over the useful lives of the assets, ranging from 3 to 20 years. We amortize leasehold improvements over the shorter of the related lease term or the estimated life of the improvements. We amortize equipment
under capital leases over the lease term, and this amortization is included in the depreciation of property and equipment.



Goodwill and Other Intangible Assets



Goodwill represents the excess purchase price over the fair value of net assets acquired in the acquisition of the Predecessor Company effective August
21, 2003 (see Note 4). We periodically assess our goodwill for indications of impairment on a reporting unit level. A reporting unit is defined as a component of an entity for



55



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##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



which the operating results are regularly reviewed by management and discrete financial information is available. We have a single reporting unit at an
enterprise level and allocate goodwill to this reporting unit for goodwill impairment testing.



We assess whether goodwill and indefinite-lived intangible assets (trademarks) are impaired on an annual basis. Upon determining the existence of goodwill and/or trademarks impairment, we measure that impairment based
on the amount by which the book value of goodwill and/or trademarks exceeds its implied fair value. The implied fair value of goodwill is determined by deducting the fair value of a reporting units identifiable assets and liabilities from the
fair value of the reporting unit as a whole, as if that reporting unit had just been acquired and the purchase price were being initially allocated. Additional impairment assessments may be performed on an interim basis if we encounter events or
changes in circumstances that would indicate that, more likely than not, the book value of goodwill and/or trademarks has been impaired. In connection with our annual assessment on October 1, 2004, we determined that no impairment of goodwill and/or
trademarks existed.



Amounts allocated to acquired technology,
a customer contract and customer relationships are being amortized over the respective assets estimated useful lives of five to six years using a method of amortization that reflects the pattern in which their economic benefits are consumed
based upon estimated contribution to discounted cash flows during the period. Amounts allocated to non-compete agreements are being amortized over their estimated useful lives of four years using the straight-line method. Amortization of acquired
technology and a customer contract is included in Amortization of acquisition intangibles in cost of revenue in the accompanying Consolidated Statements of Operations. Amortization of customer relationships and non-compete agreements is
included in Amortization of acquisition intangibles in operating expenses in the accompanying Consolidated Statements of Operations. We periodically review the estimated useful lives of our identifiable intangible assets, taking into
consideration any events or circumstances that might result in a diminished fair value or revised useful life.



We capitalize third-party costs associated with patent registration. Capitalized patent costs are amortized over the estimated useful life of 12 years. At
the time patent registration is deemed unsuccessful, the related costs are written off.



Impairment of Long-lived Assets



Long-lived assets consist primarily of property and equipment and intangible assets. We evaluate property and equipment and other intangible assets held and used by us for impairment whenever events or changes in circumstances indicate that
their carrying value may not be recoverable. When these factors and circumstances exist, we compare the projected undiscounted future cash flows associated with the future use and disposal of the related asset or group of assets to their respective
carrying amounts. Impairment, if any, is measured as the excess of the carrying amount over the fair value, based on market value when available, or discounted expected cash flows, of those assets and is recorded in the period in which the
determination is made.



Fair Value of Financial Instruments



The fair values of our cash and cash equivalents,
accounts receivable, accounts payable and accrued expenses approximate their carrying values due to their short maturities.



Concentration of Credit Risk



Financial instruments that potentially subject us to significant concentrations of credit risk consist principally of cash and cash equivalents,
investments and accounts receivable.



56



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##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



We maintain our cash and cash equivalents in accounts with six major financial institutions in the
United States and in countries where our subsidiaries operate, in the form of demand deposits and money market accounts. At December 31, 2004 and 2003, we had amounts on deposit with financial institutions that were in excess of the federally
insured limit of $100,000. We have not experienced any losses on deposits of cash and cash equivalents.



We believe that the concentration of credit risk in our accounts receivable is substantially mitigated by our evaluation process, relatively short
collection terms and the high level of credit worthiness of our customers. We perform ongoing credit evaluations of our customers financial condition, but generally require no collateral. We record an allowance for doubtful accounts specific
to the accounts receivable balances outstanding based upon the results of our evaluation of our customers financial condition. We have not recorded an allowance for doubtful accounts for any period presented in the accompanying financial
statements, since we have not realized any significant credit losses, nor do we expect any significant credit losses relating to our customers.



The following table sets forth sales to customers comprising 10% or more of our total revenue for the periods indicated:



|          |  |                            |   |  |                                         |   |  |                                            |   |  |                            |  
|--------- |  | -------------------------- | - |  | --------------------------------------- | - |  | ------------------------------------------ | - |  | -------------------------- | -
|          |  | Staktek Holdings, Inc.     |   |  | Predecessor Company                     |  
|          |  | Year EndedDecember 31,2004 |   |  | Period fromInception toDecember 31,2003 |   |  | Period fromJanuary 1,2003 toAugust 20,2003 |   |  | Year EndedDecember 31,2002 |  
|Samsung   |  | 43                         | % |  | 23                                      | % |  | 29                                         | % |  | 14                         | %
|Micron    |  | 17                         | % |  | 24                                      | % |  | 29                                         | % |  | 14                         | %
|Celestica |  | *                          |   |  | 17                                      | % |  | 17                                         | % |  | 21                         | %
|Smart     |  | 12                         | % |  | 11                                      | % |  | 10                                         | % |  | *                          |  
|Infineon  |  | *                          |   |  | *                                       |   |  | *                                          |   |  | 39                         | %

---

|* | Amount does not exceed 10% for the indicated period.
|- | ----------------------------------------------------



Approximately 86%, 81% and 79% of our accounts receivable was due from three customers at December 31, 2004, 2003 and 2002, respectively.



Foreign Currency



Our foreign subsidiaries use the U.S. dollar as their functional currency. Gains or losses from foreign currency
transactions are included in our results of operations. For all periods presented, these foreign currency gains or losses were immaterial.



Revenue Recognition



We account for our revenue under the provisions of Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements as amended
by SAB 104 Revenue Recognition (SAB 101). Under the provisions of SAB 101, we recognize revenue when there is persuasive evidence of an arrangement, delivery has occurred, the fee is fixed or determinable, and collectibility
of the resulting receivable is reasonably assured. Our revenue is generated from manufacturing services performed for customers using our packaged memory solutions and from license fees or royalties earned pursuant to a license agreement with a
customer.



Our manufacturing services consist of customer
arrangements whereby the manufacture of our customers stacked memory units has been outsourced to us. These customer arrangements can be categorized into two basic types. In the first arrangement, which comprises the majority of our customer
arrangements, our customer



57



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##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



consigns its memory packages to us and we stack them using our proprietary solutions. We then ship stacked memory units as directed by our customer. In this
arrangement, we do not purchase or take title to the memory packages and, accordingly, do not record these packages as inventory. We do not warrant the performance of the memory packages outside of the performance directly related to the stacking
process. In the second arrangement, our customer prequalifies vendors for memory packages and the vendor remains the primary obligor for the functionality of the memory packages. Our customer also negotiates the pricing for memory packages directly
with the vendors. Our customer then places a purchase order with us for stacking the memory packages and the purchase order specifies the predetermined vendor, type of memory package and price for the memory package that we stack. After we receive
the purchase order from our customer, we purchase the specified memory packages and stack them using our proprietary solutions. We generally do not purchase quantities of memory packages in excess of our customers committed orders so we do not
bear inventory risk, such as the risk of excess and obsolescence, because the memory packages must be purchased by our customer at the price paid by us or the memory packages can be returned to their source. Accordingly, we recognize revenue upon
shipment only for our stacking services as charged to our customer for the stacking process. We do not record as revenue the fee charged our customer for the cost of memory packages and, similarly, we do not record as cost of revenue the cost of the
memory packages.



We report revenue for memory packages
purchased and sold on a net basis in accordance with Emerging Issues Task Force Issue No. 99-19. In customer arrangements for manufacturing services (i) we are responsible for the stacking process but are not the primary obligor for the memory
packages that comprise substantially all of the functionality of the stacked unit, (ii) we do not earn profit on memory packages sold, since our customer arrangement specifies that these packages are to be sold at the same price paid by us, (iii) we
do not bear credit risk related to the memory packages, since our customer must purchase the packages at the price paid by us or the packages can be returned to their source, (iv) we do not have latitude in establishing the price for the memory
packages, and (v) we do not have discretion in the selection of the supplier of the memory packages, since the supplier is selected or specified by our customer.



In addition, we have license agreements with two customers that specify that certain per unit royalties are earned by us
upon each customers shipment of products utilizing our proprietary stacking technologies. Our customers generally report shipment information 30 to 45 days after the end of the quarter in which the activity takes place. We recognize royalty
revenue in the period in which these royalties are reported to us because collection is considered probable.



Cost of Revenue



Cost of revenue includes the cost of labor, materials and overhead required to perform the stacking process. These costs are included in inventories until the product is shipped and revenue is recognized. Cost of revenue also includes the
amortization of acquired technology, a customer contract and certain patents.



Shipping and Handling Cost



We include
shipping and handling costs as part of cost of revenue as incurred.



Research and Development



We expense
costs for research and development of our technologies as they are incurred.



Advertising Costs



We expense
advertising costs as incurred. Advertising costs were not material for any periods presented.



58



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##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Stock-Based Compensation



We account for our employee stock-based compensation using the intrinsic value method in accordance with Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and Related Interpretations. We make disclosures regarding employee stock-based compensation using the fair value method in accordance with Statement of Financial
Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation as amended by SFAS No. 148, Accounting for Stock-Based Compensation- Transition and Disclosure- an amendment of FASB Statement No. 123.
We have calculated the fair value of options granted in these periods using the Black-Scholes option-pricing model and have determined the pro forma impact on net income (loss).



The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no
vesting restrictions and are fully transferable. In addition, this option valuation model requires the input of highly subjective assumptions including the expected stock price volatility. Because our employee stock options have characteristics
significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in managements opinion, the Black-Scholes model does not necessarily provide a
reliable single measure of the fair value of its employee stock options. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options vesting period.



The following table illustrates the pro forma effect on income (loss)
available to common stockholders and earnings (loss) per share if we and the Predecessor Company had applied the fair value recognition provisions of SFAS 123 to stock-based compensation (in thousands, except per share data):



|                                                                                                                                 |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |        |  
|-------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------- | ------ | - | --------------------------------------- | - | ------ | ------------------------------------------ |  | - | -------------------------- | - |  | - | ------ | -
|                                                                                                                                 |  | Staktek Holdings, Inc.     |        |   | Predecessor Company                     |  
|                                                                                                                                 |  | Year EndedDecember 31,2004 |        |   | Period fromInception toDecember 31,2003 |   |        | Period fromJanuary 1,2003 toAugust 20,2003 |  |   | Year EndedDecember 31,2002 |  
|Income (loss) available to common stockholders, as reported                                                                      |  | $                          | 7,540  |   |                                         | $ | (6,146 | )                                          |  | $ | 9,476                      |   |  | $ | 11,526 |  
|Add: Stock-based compensation cost, net of related tax effects, included in the determination of net income (loss) as
reported   |  |                            | 3,947  |   |                                         |   | 5,311  |                                            |  |   | 42                         |   |  |   |       |  
|Deduct: Total stock-based compensation cost, net of related tax effects, determined under fair-value based method for
all awards |  |                            | (4,314 | ) |                                         |   | (5,349 | )                                          |  |   | (683                       | ) |  |   | (662   | )
|                                                                                                                                 |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |        |  
|Pro forma income (loss) available to common stockholders                                                                         |  | $                          | 7,173  |   |                                         | $ | (6,184 | )                                          |  | $ | 8,835                      |   |  | $ | 10,864 |  
|                                                                                                                                 |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |        |  
|Earnings (loss) per share:                                                                                                       |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |        |  
|Basicas reported                                                                                                                |  | $                          | 0.16   |   |                                         | $ | (0.17  | )                                          |  | $ | 5.16                       |   |  | $ | 6.33   |  
|                                                                                                                                 |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |        |  
|Basicpro forma                                                                                                                  |  | $                          | 0.15   |   |                                         | $ | (0.17  | )                                          |  | $ | 4.81                       |   |  | $ | 5.96   |  
|                                                                                                                                 |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |        |  
|Dilutedas reported                                                                                                              |  | $                          | 0.15   |   |                                         | $ | (0.17  | )                                          |  | $ | 4.86                       |   |  | $ | 6.01   |  
|                                                                                                                                 |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |        |  
|Dilutedpro forma                                                                                                                |  | $                          | 0.14   |   |                                         | $ | (0.17  | )                                          |  | $ | 4.53                       |   |  | $ | 5.67   |  
|                                                                                                                                 |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |        |  



59



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##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The fair value for these options was estimated at the date of grant using a Black-Scholes
option-pricing model with the following weighted average assumptions:



|                        |  |                            |   |  |                                         |   |  |                                            |   |  |                            |  
|----------------------- |  | -------------------------- | - |  | --------------------------------------- | - |  | ------------------------------------------ | - |  | -------------------------- | -
|                        |  | Staktek Holdings, Inc.     |   |  | Predecessor Company                     |  
|                        |  | Year EndedDecember 31,2004 |   |  | Period fromInception toDecember 31,2003 |   |  | Period fromJanuary 1,2003 toAugust 20,2003 |   |  | Year EndedDecember 31,2002 |  
|Expected life (years)   |  | 4                          |   |  | 0.5-4                                   |   |  | 5                                          |   |  | 5                          |  
|Risk-free interest rate |  | 3.0                        | % |  | 3.0                                     | % |  | 5.0                                        | % |  | 5.0                        | %
|Dividend yield          |  | 0.0                        | % |  | 0.0                                     | % |  | 0.0                                        | % |  | 0.0                        | %
|Expected volatility     |  | 66.2                       | % |  | 98.0                                    | % |  | 98.0                                       | % |  | 98.0                       | %



The estimated weighted
average fair value of options granted during the year ended December 31, 2004, for the period from inception to December 31, 2003, for the period from January 1, 2003 to August 20, 2003, and for the year ended December 31, 2002 was $5.73, $3.57,
$15.30 and $15.36, respectively.



Equity instruments issued to
non-employees are accounted for in accordance with SFAS 123 and Emerging Issues Task Force Issue No. 96-18, Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or
Services.



Income Taxes



We account for income taxes under the provisions of SFAS 109,
Accounting for Income Taxes. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the
years in which the differences are expected to affect taxable income. We establish valuation allowances when necessary to reduce deferred tax assets to the amounts we expect to realized.



Earnings (Loss) Per Share



Basic earnings (loss) per share is computed by dividing income (loss) available to common stockholders by the weighted-average number of vested common
shares outstanding for the period. Diluted earnings (loss) per share is computed under the treasury method giving effect to all potential dilutive common stock, including options, warrants and common stock subject to repurchase. For the period from
inception to December 31, 2003, options and common stock subject to repurchase were not included in the computation of diluted loss per share because the effect would be antidilutive.



Recent Accounting Pronouncements



In December 2004, the Financial Accounting Standards Board
(FASB) issued a revised SFAS No. 123(R), Share-Based Payment  an Amendment of FASB Statements No. 123 and 95. SFAS No. 123(R) establishes standards for the accounting for transactions in which an entity exchanges its
equity instruments for goods or services or incurs liabilities in exchange for goods or services that are based on the fair value of the entitys equity instruments, focusing primarily on accounting for transactions in which an entity obtains
employee services in share-based payment transactions. SFAS No. 123(R) requires public entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with
limited exceptions) and recognize the cost over the period during which an employee is required to provide service in exchange for the award. Adoption requires either a modified prospective or a modified



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STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



retrospective application. Management is evaluating both approaches to determine the most appropriate. We are required to adopt SFAS No. 123(R) in the third
quarter of 2005. We are evaluating SFAS No. 123(R) and believe it may have a material effect on our financial position and results of operations.



In November 2004, the FASB issued SFAS No. 151, Inventory Costs  An Amendment of ARB No. 43, Chapter 4, which clarifies the accounting
for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). We are required to adopt SFAS No. 151 in 2006 and we do not expect our adoption to have a significant impact on our results of operations or
financial condition.



3. Initial Public Offering



On February 11, 2004, we completed our initial public offering in which we
sold 10 million shares of our common stock at $13 per share, for an aggregate public offering price of $130 million. On March 5, 2004, we sold an additional 1.19 million shares in connection with the underwriters over-allotment option, for an
aggregate public offering price of approximately $15.5 million. Of the total proceeds, we applied approximately $10.2 million to underwriting discounts and commissions; $1.9 million to related costs; $78.8 million to pay in full our senior,
short-term and subordinated debt (including accrued interest and fees); and $30.6 million to redeem our outstanding preferred stock. We retained approximately $24.0 million.



4. Acquisition



In August 2003, we purchased 100% of the stock of the Predecessor Company and Research Applications, Inc. for cash of approximately $125.3 million,
including acquisition costs of approximately $0.1 million. Accordingly, the results of operations of the acquired businesses are included in our consolidated financial statements from the date of acquisition. We acquired the Predecessor Company in
order to invest in an existing semiconductor manufacturing services business that provided opportunity for future growth in enterprise value. The contributing factors to the purchase price paid by us consisted primarily of the Predecessor
Companys historical earnings and cash flow from operations and perceived market opportunity for future growth. The purchase price was allocated to the acquired assets and liabilities assumed, based upon managements estimate of their fair
market values as of the acquisition date, as follows (in thousands):



|                                           |  |   |         |  
|------------------------------------------ |  | - | ------- | -
|Net current assets (1)                     |  | $ | 50,174  |  
|Property and equipment                     |  |   | 10,457  |  
|Deferred tax asset                         |  |   | 508     |  
|Identifiable intangibles (2)               |  |   | 52,600  |  
|Goodwill (not deductible for tax purposes) |  |   | 29,726  |  
|Deferred tax liability                     |  |   | (18,778 | )
|Other non-current liabilities              |  |   | (87     | )
|In-process research and development        |  |   | 700     |  
|                                           |  |   |         |  
|Total consideration                        |  | $ | 125,300 |  
|                                           |  |   |         |  

---

|(1) | Net current assets are comprised of cash and cash equivalents, accounts receivable and other current assets, less current liabilities. Assumed current liabilities included accounts
payable, accrued compensation and expenses and accrued income taxes. The fair value of current liabilities generally approximated the recorded book values at the date of acquisition because of the monetary nature of most of the liabilities.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) | Other intangibles included a customer contract of $26.1 million, customer relationships of $4.5 million, acquired technology of $19.1 million, trademarks of $1.8 million and
non-compete agreements of $1.1 million.
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



We financed the acquisition with proceeds from (i) the issuance of redeemable preferred stock of
$29.5 million to Austin Ventures, (ii) the issuance of senior term and revolving credit notes of $40.0 million, (iii) the issuance of subordinated debt of $34.5 million to Austin Ventures, (iv) $5.0 million in short-term loan and (v) cash. We repaid
all acquisition debt and redeemed all preferred stock with proceeds from the initial public offering.



The deferred tax assets and liabilities, acquired and assumed, at the acquisition date reflected managements best estimate of the tax basis of
acquired assets and assumed liabilities that would ultimately be accepted by the tax authority. During 2004, management decreased goodwill by approximately $1.3 million primarily related to a revision of the estimate of tax benefits associated with
costs incurred in the acquisition that were deductible for tax purposes and treated as part of the purchase price allocation for financial reporting purposes.



Intangible Assets



Acquired identified intangible assets were valued based on managements assumptions and other considerations for estimating fair values. These
intangible assets, other than trademarks, are being amortized over their respective useful lives according to the estimated present value of the net earning potential of each asset category.



Customer contract and customer relationships. The value of a customer
contract and customer relationships was determined by discounting net cash flows attributable to a current customer contract and customer relationships adjusted to take into account expected attrition.



Acquired technologies.The value of this asset was determined by
discounting the expected future cash flows attributable to all existing technologies that had reached technological feasibility, after considering risks relating to: (i) the characteristics and applications of the technology, (ii) existing and
future markets and (iii) life cycles of the technologies. Estimates of future revenues and expenses used to determine the value of developed technology were consistent with the historical trends in the industry and expected outlooks.



Non-compete agreements.The value of the non-compete agreements was
determined by discounting net cash flows with and without consideration of the non-compete agreements in order to capture the potential negative effects of competition by the key employees in the absence of non-compete agreements.



Trademarks.The value of trademarks was determined using a form of
discounted cash flow analysis known as the relief from royalty approach, which is premised on an analysis of economic benefits provided to the owner of the trademark.



In-process Research and Development



Of the total purchase price, we allocated $0.7 million to in-process research and development (IPR&D), which we expensed upon
acquisition. We based the value of IPR&D on an evaluation of all developmental projects using the guidance set forth in FASB Interpretation No. 4, Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase
Method. Projects that qualify as IPR&D represent those that have not yet reached technological feasibility and for which no future alternative uses exist. Technological feasibility is defined as being equivalent to a beta-phase working
prototype in which there is no remaining risk relating to the development.



We determined the value of the IPR&D by (i) estimating future revenue and operating profits associated with existing development projects, (ii) projecting the future cash flows and costs to complete the underlying
technologies and resultant products and (iii) discounting these cash flows to their net present value.



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STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Estimates of future revenue and expenses used to determine the value of in-process research and
development were consistent with the historical trends in the industry and the expected outlooks. The entire amount of $0.7 million was charged to operations because related technologies had not reached technological feasibility and they had no
alternative use.



5. Investments



During 2004, we invested in securities with original maturities greater than
three months. These securities are classified as available-for-sale. The amortized cost, gross unrealized gains and losses and fair value of these securities as of December 31, 2004 were as follows (in thousands):



|                                    |  |               |        |                      |   |                       |  |   |                     |   |  |   |       
|----------------------------------- |  | ------------- | ------ | -------------------- | - | --------------------- |  | - | ------------------- | - |  | - | ------
|                                    |  | AmortizedCost |        | GrossUnrealizedGains |   | GrossUnrealizedLosses |  |   | EstimatedFair Value
|Auction rate securities             |  | $             | 24,050 |                      | $ |                      |  | $ |                    |   |  | $ | 24,050
|Other available for sale securities |  |               | 13,386 |                      |   |                      |  |   | (2                  | ) |  |   | 13,384
|                                    |  |               |        |                      |   |                       |  |   |                     |   |  |   |       
|                                    |  | $             | 37,436 |                      | $ |                      |  | $ | (2                  | ) |  | $ | 37,434
|                                    |  |               |        |                      |   |                       |  |   |                     |   |  |   |       



Gross unrealized
losses at December 31, 2004 are temporary and the result of fluctuations in the current market value of these securities in the marketplace.



Maturities of investment securities classified as available-for-sale at December 31, 2004 by contractual maturity are shown below. Expected maturities
will vary from contractual maturities because borrowers may have the right to recall or prepay obligations with or without call or prepayment penalties.



|                      |  |               |        |                     |   |       
|--------------------- |  | ------------- | ------ | ------------------- | - | ------
|                      |  | AmortizedCost |        | EstimatedFair Value
|Within 1 year         |  | $             | 4,016  |                     | $ | 4,014 
|Between 1 and 2 years |  |               | 2,000  |                     |   | 2,000 
|After 2 years         |  |               | 31,420 |                     |   | 31,420
|                      |  |               |        |                     |   |       
|                      |  | $             | 37,436 |                     | $ | 37,434
|                      |  |               |        |                     |   |       



We sold approximately
$8.1 million in investment securities held as available-for-sale in the fiscal year ended December 31, 2004.



6. Inventories



Inventories at December 31, consisted of the following (in thousands):



|                    |  |      |     |      |   |    
|------------------- |  | ---- | --- | ---- | - | ---
|                    |  | 2004 |     | 2003
|Purchased materials |  | $    | 750 |      | $ | 307
|Labor and overhead  |  |      | 83  |      |   | 188
|                    |  |      |     |      |   |    
|                    |  | $    | 833 |      | $ | 495
|                    |  |      |     |      |   |    



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STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



7. Property and Equipment



Property and equipment at December 31, consisted of the following (in thousands):



|                                      |  |                          |  |      |        |   |      |   |        |  
|------------------------------------- |  | ------------------------ |  | ---- | ------ | - | ---- | - | ------ | -
|Asset Class                           |  | Estimated Life(in years) |  | 2004 |        |   | 2003 |  
|Land                                  |  |                          |  | $    | 371    |   |      | $ | 371    |  
|Buildings                             |  | 20                       |  |      | 1,967  |   |      |   | 1,946  |  
|Equipment software and development    |  | 3                        |  |      | 777    |   |      |   | 563    |  
|Vehicles                              |  | 5                        |  |      | 74     |   |      |   | 57     |  
|Office furniture and equipment        |  | 5                        |  |      | 1,829  |   |      |   | 1,397  |  
|Lab equipment                         |  | 3                        |  |      | 9,104  |   |      |   | 6,567  |  
|Tooling and fixtures                  |  | 3                        |  |      | 918    |   |      |   | 505    |  
|Leasehold improvements and clean room |  | 3                        |  |      | 289    |   |      |   | 128    |  
|Assets under development              |  |                          |  |      | 808    |   |      |   |       |  
|                                      |  |                          |  |      |        |   |      |   |        |  
|                                      |  |                          |  |      | 16,137 |   |      |   | 11,534 |  
|Accumulated depreciation              |  |                          |  |      | (5,975 | ) |      |   | (1,439 | )
|                                      |  |                          |  |      |        |   |      |   |        |  
|Property and equipment, net           |  |                          |  | $    | 10,162 |   |      | $ | 10,095 |  
|                                      |  |                          |  |      |        |   |      |   |        |  



Amortization of the
assets under capital lease was included in depreciation and was approximately $113,000, $42,000, $75,000 and $699,000 for the fiscal year ended December 31, 2004, for the period from inception to December 31, 2003, for the period from January 1,
2003 to August 20, 2003 and for the year ended December 31, 2002, respectively. Interest expense related to assets under capital lease was included in interest expense and was approximately $9,000, $6,000, $11,000 and $68,000 for the fiscal year
ended December 31, 2004, for the period from Inception to December 31, 2003, for the period from January 1, 2003 to August 20, 2003 and for the year ended December 31, 2002, respectively.



In October 2004, we moved several manufacturing assets to our facility in Reynosa, Mexico and decided to sell certain
assets; these assets have been recorded as assets held for sale. The market value of these assets at the time we decided to sell them was approximately $59,000, which is equal to the book value and therefore no impairment was recorded.



8. Other Intangible Assets



In June 2004, we acquired from DPAC Technologies Corp. (DPAC)
its stacking patents and patent applications as well as certain customer information for $0.5 million and $0.2 million, respectively, which are being amortized over 12 and 2 years, respectively.



The gross carrying amounts and accumulated amortization of our other
intangibles assets and patents at December 31, consisted of the following (in thousands):



|                                |  |                      |        |                          |      |         |                      |  |                          |        |  |   |        |  
|------------------------------- |  | -------------------- | ------ | ------------------------ | ---- | ------- | -------------------- |  | ------------------------ | ------ |  | - | ------ | -
|                                |  | 2004                 |        |                          | 2003 |        
|                                |  | Gross CarryingAmount |        | Accumulated Amortization |      |         | Gross CarryingAmount |  | Accumulated Amortization |       
|Acquired technology and patents |  | $                    | 20,104 |                          | $    | (9,092  | )                    |  | $                        | 19,130 |  | $ | (2,381 | )
|Customer contract               |  |                      | 26,100 |                          |      | (11,300 | )                    |  |                          | 26,100 |  |   | (2,203 | )
|Other intangible assets         |  |                      | 7,598  |                          |      | (2,963  | )                    |  |                          | 7,400  |  |   | (1,058 | )
|                                |  |                      |        |                          |      |         |                      |  |                          |        |  |   |        |  
|                                |  | $                    | 53,802 |                          | $    | (23,355 | )                    |  | $                        | 52,630 |  | $ | (5,642 | )
|                                |  |                      |        |                          |      |         |                      |  |                          |        |  |   |        |  



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STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Amortization expense for all intangibles in the fiscal year ended December 31, 2004 and the period
from inception to December 31, 2003 was $17.7 million and $5.6 million, respectively. Amortization expense for all intangibles of the Predecessor Company for January 1, 2003 to August 20, 2003 and the year ended December 31, 2002 was $0.1 million
and $0.2 million, respectively.



The following table details
the estimated aggregate annual amortization expense (in thousands) for each of the five succeeding fiscal years for all of the intangibles we own that are subject to amortization:



|     |  |   |       
|---- |  | - | ------
|2005 |  | $ | 14,096
|2006 |  |   | 7,535 
|2007 |  |   | 4,667 
|2008 |  |   | 1,458 
|2009 |  |   | 139   



9. Accrued Liabilities



Accrued liabilities at December 31, were as follows (in
thousands):



|                           |  |      |       |      |   |      
|-------------------------- |  | ---- | ----- | ---- | - | -----
|                           |  | 2004 |       | 2003
|Accrued interest           |  | $    |      |      | $ | 2,743
|Accrued salaries and wages |  |      | 669   |      |   | 1,113
|Accrued vacation           |  |      | 404   |      |   | 402  
|Accrued profit-sharing     |  |      | 526   |      |   | 764  
|Accrued property tax       |  |      | 464   |      |   | 152  
|Other accrued liabilities  |  |      | 505   |      |   | 1,047
|                           |  |      |       |      |   |      
|                           |  | $    | 2,568 |      | $ | 6,221
|                           |  |      |       |      |   |      



10. Debt



During January 2004, we paid a quarterly principal installment
of approximately $1.9 million on our senior term loans. During February 2004, we used a portion of the net proceeds from our initial public offering of common stock to repay all our outstanding debt plus accrued interest and fees as follows (in
thousands):



|                              |  |   |       
|----------------------------- |  | - | ------
|Senior term loans             |  | $ | 26,250
|Senior revolving credit notes |  |   | 10,000
|Short-term loan               |  |   | 5,000 
|Subordinated loan             |  |   | 34,500
|Accrued interest and fees     |  |   | 3,032 
|                              |  |   |       
|                              |  | $ | 78,782
|                              |  |   |       



Senior Term Loans



On August 19, 2003 in connection with the acquisition
(see Note 4), we issued to each of Comerica Bank and Guaranty Bank (the Banks) Senior Term Loans (Term Loans) in the principal amount of $15.0 million pursuant to the Revolving Credit and Term Loan Agreement (the Credit
Agreement). The Term Loans were collateralized by all of our assets. The Term Loans bore interest at an annual rate equal to the Banks prime rate (or, if greater, the federal funds rate plus 75 basis points) plus an applicable margin, as
defined in the Credit



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STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Agreement, or, at our option, a rate equal to the Eurocurrency rate plus an applicable margin, as defined in the Credit Agreement. At December 31, 2003, this
rate was 5.4%. The Term Loans were payable in quarterly principal installments of approximately $1.9 million on the first day of each calendar quarter, commencing on October 1, 2003 until October 1, 2007, when all principal plus accrued interest was
due and payable in full. We could have repaid a Term Loan bearing interest at the prime-based rate at any time without premium or penalty; in all other cases, we were required to reimburse the Banks for any loss, cost or expense they incurred as a
result of our prepayment. Additionally, the Term Loans were subject to required principal reductions if we had excess cash flows, net cash proceeds from any asset sale, or net cash proceeds from the issuance of capital stock, as defined in the
Credit Agreement. As of December 31, 2003, $28.1 million was outstanding on the Term Loans.



Senior Revolving Credit Notes



On August 19, 2003 in connection with the acquisition, we issued a senior revolving credit note (Revolving Notes) to each Bank for $6.0 million pursuant to the Credit Agreement referenced above. The
Revolving Notes were collateralized by all of our assets. As of December 31, 2003, $10.0 million was outstanding under the Revolving Notes and an additional $2.0 million was available for issuance. The Revolving Notes bore interest at an annual rate
of the Banks prime rate (or, if greater, the federal funds rate plus 75 basis points) plus an applicable margin, as defined in the Credit Agreement, or, at our option, a rate equal to the Eurocurrency rate plus an applicable margin, as defined
in the Credit Agreement. At December 31, 2003, this rate was 4.9%. The accrued interest was due on October 1, 2003, and on the first day of each calendar quarter thereafter. The Revolving Notes plus all accrued and unpaid interest were due on
October 1, 2006 and on other dates and in other amounts as was required from time to time pursuant to the Credit Agreement. Subject to certain minimum prepayment and minimum balance requirements, we could have repaid any prime-based advances under
the Revolving Notes at any time without premium or penalty; in all other cases, we were required to reimburse the Banks for any loss, cost or expense the Banks incurred as a result of our prepayment.



Short-term Loan



On August 19, 2003, in connection with the acquisition, we issued Comerica Bank a short-term promissory note (the
Promissory Note) in the principal amount of $5.0 million. The Promissory Note bore interest at an annual rate of the greater of (i) Comerica Banks prime rate, or (ii) the weighted average rates on overnight federal funds plus 1%;
the interest rate at December 31, 2003 was 4.0%. The accrued interest was due monthly commencing on September 30, 2003. The Promissory Note plus all accrued and unpaid interest were due on February 20, 2004. Subject to certain minimum prepayment
requirements, we could have repaid the Promissory Note at any time without premium or penalty. As of December 31, 2003, $5.0 million was outstanding under the Promissory Note. The Promissory Notes were guaranteed by Austin Ventures.



Subordinated Loan



On August 19, 2003 in connection with the acquisition, we received from
Austin Ventures a subordinated term loan (Subordinated Loan) for an aggregate of $34.5 million of our borrowings pursuant to a subordinated loan agreement (the Subordinated Agreement). The Subordinated Loan was subordinated
to the Term Loans and Revolving Notes discussed above. The Subordinated Loan was collateralized by all of our assets and bore interest at an annual rate of 17%, compounded quarterly. Accrued but unpaid interest under the Subordinated Loan was
payable at an annual rate of 12% on the first day of each quarter commencing January 1, 2005. The Subordinated Loan principal and all unpaid interest were due in full on August 20, 2008. Austin Ventures is a related party. As of December 31, 2003,
$34.5 million was outstanding under the Subordinated Loan.



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STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Covenants



Our Credit Agreement and Subordinated Agreement contained certain financial covenants including minimum tangible net worth, minimum liquidity, minimum
EBITDA levels, maximum capital expenditures, minimum current ratio, maximum senior leverage ratio, maximum leverage ratio and minimum fixed charge coverage ratio. As of December 31, 2003 and through the portion of 2004 in which there was debt
outstanding, we were in compliance with all debt covenants as defined in the Credit Agreement and the Subordinated Agreement.



Line of Credit



In connection with a term note issued in 1999, the Predecessor Company obtained a $10.0 million revolving line of credit with variable rates. This credit
facility was secured by the Predecessor Companys accounts, documents, inventory, equipment, fixtures and all products and proceeds of the foregoing. The amount available under the line of credit was limited to 80% of the Predecessor
Companys qualifying accounts receivable plus 40% of its inventory, less approximately $2.0 million. The Predecessor Company did not borrow funds, nor have a balance outstanding, under the revolving line of credit during 2003. Effective July
31, 2003, the Predecessor Company terminated and cancelled the revolving line of credit.



11. Redeemable Preferred Stock



In August 2003, we issued 171.01449 shares of redeemable preferred stock to Austin Ventures for total proceeds of $29.5 million.



Cumulative dividends accrued for the benefit of the preferred stockholders at the rate of 8.0% per annum. No dividends could be paid or declared to
holders of common stock so long as any shares of Preferred Stock were outstanding. In the event of a liquidation, dissolution or winding up of the Company, the preferred stockholders were entitled to receive a distribution equal to $172,500 per
share of preferred stock plus any accumulated but unpaid dividends (plus any interest accrued on such shares in the event that we failed to comply with certain redemption provisions), before any distribution could have been made to the common
stockholders. The distribution rate per share was adjustable as defined in the Certificate of Designations of the Preferred Stock (the Certificate of Designations).



Up to 33% of the Preferred Stock was redeemable upon election by a majority of the preferred stockholders beginning August
19, 2007; up to 66% of the Preferred Stock was redeemable upon election by a majority of the preferred stockholders beginning August 19, 2008; and up to 100% of the Preferred Stock was redeemable upon election by a majority of the preferred
stockholders beginning August 19, 2009. We were required to redeem all of the outstanding shares of Preferred Stock upon the occurrence of an extraordinary transaction as defined in the Certificate of Designations, including liquidation of the
Company or an initial public offering. The redemption price was set as the original Preferred Stock price plus any accrued but unpaid dividends at the redemption date (plus any interest accrued on such shares in the event that we failed to comply
with certain redemption provisions).



The preferred
stockholders were not entitled to voting rights; however, certain events as defined in the Certificate of Designations required more than 50% consent from the preferred stockholders.



During February 2004, we used $30.6 million of the net proceeds from our initial public offering to redeem all of the
outstanding shares of our redeemable preferred stock (the Preferred Stock) and to pay all accrued but unpaid dividends.



12. Commitments and Contingencies



At December 31, 2004 and 2003, we had advance payments on assets under development of approximately $0.8 million and $1.2 million, respectively, related
to the purchase of certain capital equipment and services. Approximately $0.5 million will be due in 2005 related to assets under development as of December 31, 2004.



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STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



At March 1, 2005, approximately 65% of our employees in Mexico, or approximately 41% of our total
employees, were represented by a labor organization that has entered into a labor contract with us.



We have indemnification agreements with our directors and executive officers. The agreements do not set monetary limits on our indemnity obligations. We
have a director and officer insurance policy that enables us to recover a portion of any future amounts paid in respect of our indemnity obligations to our directors and officers.



For warranties we offer, we record a liability for the estimated future costs associated with warranty claims, which is
based upon historical experience and our estimate of the level of future costs. The changes in our warranty liability are as follows (in thousands):



|                                               |  |   |   
|---------------------------------------------- |  | - | --
|Accrued warranty costs at December 31, 2001    |  | $ | 30
|Settlements made during the year               |  |   |  
|Accruals for warranties issued during the year |  |   | 25
|                                               |  |   |   
|Accrued warranty costs at December 31, 2002    |  |   | 55
|Settlements made during the year               |  |   |  
|Accruals for warranties issued during the year |  |   |  
|                                               |  |   |   
|Accrued warranty costs at December 31, 2003    |  |   | 55
|Settlements made during the year               |  |   |  
|Accruals for warranties issued during the year |  |   | 31
|                                               |  |   |   
|Accrued warranty costs at December 31, 2004    |  | $ | 86
|                                               |  |   |   



At December 31, 2004
we had a minimum purchases contract with one of our vendors. The minimum purchase terms stipulate the purchase of 2 million units within an 18-month period that began in October 2004. Actual costs could vary from the estimated commitment of
approximately $0.3 million based on the actual volume of product ordered at one time, as compared to the expected future volume per order, due to the fact that pricing per unit is dependent upon the number of units in a given order. Actual costs
could also vary from the estimated amount above based on variances in actual versus forecast product mix as the minimum purchase contract covers a single product that is available in slightly varying configurations, with accordingly varying prices
per unit. No costs were incurred in 2004 associated with this contract. We expect that the minimum purchase volumes under the contract will be fulfilled in 2005.



On October 22, 2004, a class action complaint for violations of U.S. federal securities laws was filed in the U.S. District
Court in New Mexico against us and two of our executive officers (the Defendants). The plaintiff claims that the Defendants failed to disclose to the public an anticipated shortage of computer memory chips and that they knew or
recklessly disregarded that the anticipated shortage would have a materially adverse impact on our revenue and earnings. In addition, the plaintiff claims that the Defendants failed to disclose to investors that the industrys transition to a
new generation of higher-capacity memory chips was causing computer makers to stockpile supplies of older memory chips, increasing the shortage. The suit covers individuals who purchased our stock between November 26, 2003 and May 19, 2004.



We do not believe there is any merit to the claims asserted by
the plaintiff in this complaint and plan to vigorously defend ourselves. Due to the early stage of this lawsuit, we cannot estimate the outcome of this matter or the resulting financial impact to us, if any.



From time to time, we may be subject to legal proceedings and claims in the
ordinary course of business. As of December 31, 2004, we were not involved in any other material legal proceedings.



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STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



13. Leases



We lease our Austin facility and certain production equipment under non-cancelable operating lease agreements. Facilities rent expense for the fiscal year
ended December 31, 2004, for the period from inception to December 31, 2003, for the period from January 1, 2003 to August 20, 2003 and for the year ended December 31, 2002 was approximately $1.1 million, $0.2 million, $1.2 million and $2.0 million,
respectively. Other operating lease expense was approximately $0.6 million, $0.3 million, $0.8 million and $1.2 million for the fiscal year ended December 31, 2004, for the period from inception to December 31, 2003, for the period from January 1,
2003 to August 20, 2003 and for the year ended December 31, 2002, respectively.



Future minimum payments under capital leases and non-cancelable operating leases with initial terms of one year or more consist of the following at December 31, 2004 (in thousands):



|                                            |  |               |     |   |                 |   |      
|------------------------------------------- |  | ------------- | --- | - | --------------- | - | -----
|                                            |  | CapitalLeases |     |   | OperatingLeases
|2005                                        |  | $             | 58  |   |                 | $ | 521  
|2006                                        |  |               |    |   |                 |   | 319  
|2007                                        |  |               |    |   |                 |   | 365  
|2008                                        |  |               |    |   |                 |   | 356  
|2009                                        |  |               |    |   |                 |   | 361  
|Thereafter                                  |  |               |    |   |                 |   | 331  
|                                            |  |               |     |   |                 |   |      
|Total minimum lease payments                |  |               | 58  |   |                 | $ | 2,253
|                                            |  |               |     |   |                 |   |      
|Amounts representing interest               |  |               | (5  | ) |                 |   |      
|                                            |  |               |     |   |                 |   |      
|Present value of net minimum lease payments |  |               | 53  |   |                 |   |      
|Less current maturities                     |  |               | (53 | ) |                 |   |      
|                                            |  |               |     |   |                 |   |      
|                                            |  | $             |    |   |                 |   |      
|                                            |  |               |     |   |                 |   |      



14. Related-Party Transactions



Relationship with Austin Ventures



At December 31, 2004, Austin Ventures and its affiliates beneficially owned
approximately 72% of our outstanding common stock. Set forth below is a brief description of the existing relationships and agreements between Austin Ventures and us.



Board of Directors



Mr. Aragona, a general partner of Austin Ventures, is Chairman of our board of directors and serves as chairperson of our nominating and governance
committee. Mr. Jernigan, a principal of Austin Ventures, is one of our directors and serves as chairperson of our compensation committee. Mr. Olkkola, a general partner of Austin Ventures, is one of our directors.



Registration Rights



Austin Ventures has registration rights with respect to the shares of our
common stock that it holds.



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##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Repayment of Indebtedness



In February 2004, we used approximately $37.4 million of the proceeds of our initial public offering to repay all
outstanding principal and accrued interest on subordinated indebtedness owed to Austin Ventures, Ross Cockrell and Clark Jernigan, as follows (in thousands):



|                           |  |   |       
|-------------------------- |  | - | ------
|Austin Ventures VII, L.P.  |  | $ | 18,631
|Austin Ventures VIII, L.P. |  |   | 18,743
|J. Ross Cockrell           |  |   | 33    
|Clark W. Jernigan          |  |   | 33    



We incurred the
subordinated indebtedness in connection with the Staktek acquisition in 2003.



Redemption of Preferred Stock



In
February 2004, we used approximately $30.6 million of the proceeds of our initial public offering to redeem, in accordance with its terms, an aggregate of 171.01449 shares of redeemable preferred stock held by Austin Ventures, Ross Cockrell and
Clark Jernigan, as follows (in thousands):



|                           |  |   |       
|-------------------------- |  | - | ------
|Austin Ventures VII, L.P.  |  | $ | 15,244
|Austin Ventures VIII, L.P. |  |   | 15,336
|J. Ross Cockrell           |  |   | 29    
|Clark W. Jernigan          |  |   | 29    



We originally issued
these shares of redeemable preferred stock in connection with the Staktek acquisition in 2003.



Loan Guarantee



In February 2004, we used approximately $5.0 million of the proceeds of our initial public offering to repay all outstanding principal and accrued interest on short-term indebtedness owed to Comerica Bank, that was guaranteed by Austin
Ventures. We incurred the short-term indebtedness in connection with the Staktek acquisition in 2003. Austin Ventures guarantee terminated upon repayment in full of the loan.



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##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



15. Earnings Per Share



A reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings (loss) per share
follows (in thousands, except per share data):



|                                                                                         |  |                            |        |                                         |                     |        |                                            |  |                            |       |  |   |       
|---------------------------------------------------------------------------------------- |  | -------------------------- | ------ | --------------------------------------- | ------------------- | ------ | ------------------------------------------ |  | -------------------------- | ----- |  | - | ------
|                                                                                         |  | Staktek Holdings, Inc.     |        |                                         | Predecessor Company
|                                                                                         |  | Year EndedDecember 31,2004 |        | Period fromInception toDecember 31,2003 |                     |        | Period fromJanuary 1,2003 toAugust 20,2003 |  | Year EndedDecember 31,2002
|Numerator:                                                                               |  |                            |        |                                         |                     |        |                                            |  |                            |       |  |   |       
|Income (loss) available to common stockholders                                           |  | $                          | 7,540  |                                         | $                   | (6,146 | )                                          |  | $                          | 9,476 |  | $ | 11,526
|                                                                                         |  |                            |        |                                         |                     |        |                                            |  |                            |       |  |   |       
|Denominator:                                                                             |  |                            |        |                                         |                     |        |                                            |  |                            |       |  |   |       
|Weighted average common shares outstanding                                               |  |                            | 50,035 |                                         |                     | 37,511 |                                            |  |                            | 1,836 |  |   | 1,822 
|Less: Common shares subject to repurchase                                                |  |                            | 2,801  |                                         |                     | 864    |                                            |  |                            |      |  |   |      
|                                                                                         |  |                            |        |                                         |                     |        |                                            |  |                            |       |  |   |       
|Total weighted average common shares used in computing basic earnings (loss) per share   |  |                            | 47,234 |                                         |                     | 36,647 |                                            |  |                            | 1,836 |  |   | 1,822 
|Effect of dilutive securities:                                                           |  |                            |        |                                         |                     |        |                                            |  |                            |       |  |   |       
|Common shares subject to repurchase                                                      |  |                            | 2,801  |                                         |                     |       |                                            |  |                            |      |  |   |      
|Stock options                                                                            |  |                            | 955    |                                         |                     |       |                                            |  |                            | 113   |  |   | 95    
|Stock warrants                                                                           |  |                            | 6      |                                         |                     |       |                                            |  |                            |      |  |   |      
|                                                                                         |  |                            |        |                                         |                     |        |                                            |  |                            |       |  |   |       
|Dilutive potential common shares                                                         |  |                            | 3,762  |                                         |                     |       |                                            |  |                            | 113   |  |   | 95    
|                                                                                         |  |                            |        |                                         |                     |        |                                            |  |                            |       |  |   |       
|Total weighted average common shares used in computing diluted earnings (loss) per share |  |                            | 50,996 |                                         |                     | 36,647 |                                            |  |                            | 1,949 |  |   | 1,917 
|                                                                                         |  |                            |        |                                         |                     |        |                                            |  |                            |       |  |   |       
|Earnings (loss) per share:                                                               |  |                            |        |                                         |                     |        |                                            |  |                            |       |  |   |       
|Basic                                                                                    |  | $                          | 0.16   |                                         | $                   | (0.17  | )                                          |  | $                          | 5.16  |  | $ | 6.33  
|                                                                                         |  |                            |        |                                         |                     |        |                                            |  |                            |       |  |   |       
|Diluted                                                                                  |  | $                          | 0.15   |                                         | $                   | (0.17  | )                                          |  | $                          | 4.86  |  | $ | 6.01  
|                                                                                         |  |                            |        |                                         |                     |        |                                            |  |                            |       |  |   |       



For the year ended
December 31, 2004, the period from inception to December 31, 2003, the period from January 1, 2003 to August 20, 2003 and the fiscal year ended December 31, 2002, we did not include approximately 532,000, 0, 7,000 and 69,000 weighted average common
stock equivalents, respectively, in the diluted earnings per share calculation because their impact would have been antidilutive.



16. Stockholders Equity



Common Stock



We have authorized 200,000,000 shares of common stock, of which 9,030,000 shares have been reserved for the issuance of stock options. At December 31,
2004, 7,737,491 of these options had been granted, of which 37,517 were forfeited during the year, leaving 1,330,026 available for issuance. At December 31, 2003, 7,363,741 had been granted and 1,666,259 were available for issuance.



Of the 51,102,215 shares and 40,377,396 shares of common stock issued and
outstanding as of December 31, 2004 and 2003, respectively, 1,854,481 shares and 3,391,517 shares, respectively, were unvested and subject to rights of repurchase, at a price per share equal to the original exercise price, which repurchase rights
lapse according to a time-based vesting schedule.



During 2004,
our Board of Directors approved a stock repurchase program. Under this program, we can spend up to $15 million to purchase shares of our common stock through open market transactions or privately negotiated transactions. During 2004, we purchased
920,900 shares of our stock on the open market under this program at a total cost of $4.4 million.



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##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



In January 2004, our Board of Directors authorized a 2.15-for-1 forward stock split of our common
stock. All common stock and per share information has been adjusted to reflect the stock split as if this stock split had taken place at the inception of the Company.



Common Stock Options



In July 2003, we adopted the 2003 Stock Option Plan (the 2003 Plan). Under the 2003 Plan, incentive stock options and non-statutory stock
options may be granted to our employees, consultants or directors at an exercise price of no less than 100% of the fair value on the date of grant. Any incentive stock options granted to a 10% owner optionee (optionee who, at the time of grant, owns
stock possessing more than 10% of the total combined voting power) must be granted an exercise price no less than 110% of the fair value on the date of grant as determined by the Board of Directors. Options generally vest over a four-year period
(25% at the end of the first year from date of grant and1/36of the remaining shares per month over the next 36 months) and are exercisable for a period of ten years from the date of grant.



Certain grants are immediately exercisable and are subject to repurchase by
us upon the termination of the optionees employment at the original exercise price until the shares have vested. At December 31, 2004 and 2003, 1,854,481 and 3,391,517 shares, respectively, issued and outstanding under the 2003 Plan were
subject to repurchase by us.



We recorded $24.3 million of
deferred stock-based compensation during the period from inception through December 31, 2003 related to the issuance of stock options to purchase 7,363,741 shares of our common stock at a weighted average exercise price of $0.56 per share. Prior to
our initial public offering, our Board of Directors determined the fair value of options granted since there was no public market that could be used to establish a current value. During the registration process of our initial public offering, the
fair value of certain options was calculated using the midpoint of an anticipated price range of our stock in connection with the offering. This valuation methodology resulted in a deferred stock-based compensation charge, which is included in the
financial statements as a reduction of stockholders equity and is being amortized on a straight-line basis over the relevant vesting period of each award. We recorded amortization of deferred stock-based compensation of $5.0 million and $5.4
million for the year ended December 31, 2004 and the period from inception through December 31, 2003, respectively.



A summary of changes in our options to purchase common stock for the period from inception to December 31, 2004 is as follows:



|                                                 |  |                  |   |  |                         |  |                              |      
|------------------------------------------------ |  | ---------------- | - |  | ----------------------- |  | ---------------------------- | -----
|                                                 |  | Number ofOptions |   |  | Range ofExercise Prices |  | WeightedAverageExercisePrice
|Granted                                          |  | 7,363,741        |   |  | $0.01-$8.37             |  | $                            | 0.56 
|Exercised                                        |  | (3,827,397       | ) |  | 0.01-1.97               |  |                              | 0.11 
|Forfeited or expired                             |  |                 |   |  |                        |  |                              |     
|                                                 |  |                  |   |  |                         |  |                              |      
|Options outstanding at December 31, 2003         |  | 3,536,344        |   |  | 0.01-8.37               |  |                              | 1.05 
|                                                 |  |                  |  
|Granted                                          |  | 373,750          |   |  | 3.81-13.06              |  |                              | 10.97
|Exercised                                        |  | (181,793         | ) |  | 0.01                    |  |                              | 0.01 
|Forfeited or expired                             |  | (37,517          | ) |  | 1.97                    |  |                              | 1.97 
|                                                 |  |                  |   |  |                         |  |                              |      
|Options outstanding at December 31, 2004         |  | 3,690,784        |   |  | $0.01-$13.06            |  |                              | 2.10 
|                                                 |  |                  |   |  |                         |  |                              |      
|Options exercisable at December 31, 2004         |  | 2,075,383        |   |  |                         |  | $                            | 1.75 
|                                                 |  |                  |   |  |                         |  |                              |      
|Options available for grant at December 31, 2004 |  | 1,330,026        |   |  |                         |  |                              |      
|                                                 |  |                  |   |  |                         |  |                              |      



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##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The following table summarizes information concerning outstanding and exercisable options at
December 31, 2004:



|                        |  |                     |  |                                           |  |                               |       |                  |           |                               |   |     
|----------------------- |  | ------------------- |  | ----------------------------------------- |  | ----------------------------- | ----- | ---------------- | --------- | ----------------------------- | - | ----
|Options Outstanding     |  | Options Exercisable
|Range ofExercise Prices |  | Number ofOptions    |  | Weighted AverageRemainingContractual Life |  | WeightedAverageExercise Price |       | Numberof Options |           | WeightedAverageExercise Price
|                        |  |                     |  | (in years)                                |  |                               |       |                  |           |                              
|$0.01                   |  | 1,624,207           |  | 8.75                                      |  | $                             | 0.01  |                  | 382,556   |                               | $ | 0.01
|0.67                    |  | 1,102,072           |  | 8.88                                      |  |                               | 0.67  |                  | 1,102,072 |                               |   | 0.67
|1.97                    |  | 322,005             |  | 8.89                                      |  |                               | 1.97  |                  | 322,005   |                               |   | 1.97
|3.81-5.01               |  | 75,000              |  | 9.70                                      |  |                               | 4.62  |                  |          |                               |   |    
|8.37                    |  | 268,750             |  | 8.97                                      |  |                               | 8.37  |                  | 268,750   |                               |   | 8.37
|12.00-13.06             |  | 298,750             |  | 9.13                                      |  |                               | 12.56 |                  |          |                               |   |    
|                        |  |                     |  |                                           |  |                               |       |                  |           |                               |   |     
|$0.01-$13.06            |  | 3,690,784           |  | 8.86                                      |  | $                             | 2.10  |                  | 2,075,383 |                               | $ | 1.75
|                        |  |                     |  |                                           |  |                               |       |                  |           |                               |   |     



During the year ended
December 31, 2004, 181,793 vested options were exercised by employee holders. 37,517 options held by a former employee were forfeited after not being exercised within an agreed-upon period of time after that employees retirement.



Predecessor Company Stock Options



In May 1991, the Predecessor Company established the 1991 Stock Option Plan
and reserved 110,559 shares of its $.01 par value common stock for issuance under this plan. Options vested at various amounts over three years after the date granted and expired ten years after the date granted.



On July 17, 1992, the Predecessor Company established the 1992 Stock Option
Plan and reserved 42,712 shares of its $.01 par value common stock for issuance under this plan. Options vested at various amounts over three years after the date granted and expired ten years after the date granted.



On September 5, 1997, the Predecessor Company established the 1997 Stock
Option Plan and reserved 5,817 shares of its $.01 par value common stock for issuance under this plan. Options vested at various amounts over three years after the date granted and expired ten years after the date granted.



On November 16, 2000, the Predecessor Company established the 2000 Long Term
Incentive Plan and reserved 150,000 shares of its $.01 par value common stock for issuance under this plan. Options vested at various amounts as established by the Predecessor Companys Board of Directors and expired ten years after the date
granted.



The Predecessor Companys stock option plans
provided for the grant of incentive options to employees. The exercise price of the Predecessor Companys previously outstanding options was the fair value of a share of the Predecessor Companys common stock on the date of grant, except
for certain grants that were subject to variable accounting.



As a result of the acquisition, all of the Predecessor Companys outstanding unvested stock options became immediately vested due to existing change-of-control provisions. In connection with the acquisition, we purchased 187,741
Predecessor Company stock options for $5.9 million, net of their respective exercise prices, and this amount paid was included in the total purchase price of the Predecessor Company.



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##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



A summary of changes in common stock options for the Predecessor Company for the year ended December
31, 2002 and for the period from January 1, 2003 to August 20, 2003 is as follows:



|                                               |  |                  |   |  |                         |  |                              |      
|---------------------------------------------- |  | ---------------- | - |  | ----------------------- |  | ---------------------------- | -----
|                                               |  | Number ofOptions |   |  | Range ofExercise Prices |  | WeightedAverageExercisePrice
|Options outstanding at December 31, 2001       |  | 184,799          |   |  | $5.00-$101.73           |  | $                            | 28.57
|Granted                                        |  | 57,925           |   |  | 20.00-44.07             |  |                              | 20.21
|Exercised                                      |  | (14,803          | ) |  | 5.00-10.00              |  |                              | 7.46 
|Forfeited or expired                           |  | (14,325          | ) |  | 20.00-65.90             |  |                              | 50.36
|                                               |  |                  |   |  |                         |  |                              |      
|Options outstanding at December 31, 2002       |  | 213,596          |   |  | 10.00-101.73            |  |                              | 26.30
|                                               |  |                  |  
|Granted                                        |  | 412              |   |  | 30.00                   |  |                              | 30.00
|Exercised                                      |  | (12,645          | ) |  | 10.00-20.00             |  |                              | 10.16
|Forfeited or expired                           |  | (6,872           | ) |  | 10.00-33.77             |  |                              | 21.34
|Purchased or forfeited in business combination |  | (194,491         | ) |  | 10.00-101.73            |  |                              | 27.53
|                                               |  |                  |   |  |                         |  |                              |      
|Options outstanding at August 20, 2003         |  |                 |   |  | $                      |  | $                            |     
|                                               |  |                  |   |  |                         |  |                              |      



On March 1, 2001, the
Predecessor Company cancelled 7,699 common stock options with an exercise price of $101.73. In April and June 2001, the Predecessor Company issued replacement awards for a portion of those common stock options with an exercise price of $33.77. In
accordance with the FASB Interpretation No. 44, the replaced options were subject to variable accounting until they were exercised, forfeited, or expired unexercised. During 2002, 7,449 of the replacement options were forfeited. The Predecessor
Company recorded compensation expense, net of recovery for all variable options of $0 and $42,000, for the year ended December 31, 2002 and the period from January 1, 2003 to August 20, 2003, respectively, related to the replacement options.



Common Stock Warrant



In October 2003, we issued a warrant to purchase 21,500 shares of common
stock to a charitable foundation at $0.67 per share. The warrant is exercisable by the warrant holder at any time prior to October 24, 2010. The fair value of the warrant was estimated using the Black-Scholes pricing model with the following
assumptions: expected volatility of 98.0%; expected life of 7 years; expected dividend yield of 0.0%; and the risk-free interest rate of 3.0%. During the period ended December 31, 2003, the warrant was recorded at its fair market value of
approximately $225,000 and expensed to selling, general and administrative expenses in the consolidated statement of operations.



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##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



17. Income Taxes



The components of the provision for income taxes were as follows (in thousands):



|                           |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |      
|-------------------------- |  | -------------------------- | ------ | - | --------------------------------------- | - | ------ | ------------------------------------------ |  | - | -------------------------- | - |  | - | -----
|                           |  | Staktek Holdings, Inc.     |        |   | Predecessor Company                    
|                           |  | Year EndedDecember 31,2004 |        |   | Period fromInception toDecember 31,2003 |   |        | Period fromJanuary 1,2003 toAugust 20,2003 |  |   | Year EndedDecember 31,2002
|Current:                   |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |      
|Federal                    |  | $                          | 6,274  |   |                                         | $ | 1,486  |                                            |  | $ | 4,466                      |   |  | $ | 4,080
|Foreign                    |  |                            | 5,302  |   |                                         |   | 1,064  |                                            |  |   | 2,146                      |   |  |   | 768  
|State                      |  |                            | 231    |   |                                         |   | 31     |                                            |  |   | 102                        |   |  |   | 82   
|                           |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |      
|Total current              |  |                            | 11,807 |   |                                         |   | 2,581  |                                            |  |   | 6,714                      |   |  |   | 4,930
|Deferred:                  |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |      
|Federal                    |  |                            | (6,411 | ) |                                         |   | (1,887 | )                                          |  |   | 159                        |   |  |   | 1,480
|Foreign                    |  |                            |       |   |                                         |   |       |                                            |  |   |                           |   |  |   |     
|State                      |  |                            | (128   | ) |                                         |   | (38    | )                                          |  |   | (12                        | ) |  |   | 29   
|                           |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |      
|Total deferred             |  |                            | (6,539 | ) |                                         |   | (1,925 | )                                          |  |   | 147                        |   |  |   | 1,509
|                           |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |      
|Provision for income taxes |  | $                          | 5,268  |   |                                         | $ | 656    |                                            |  | $ | 6,861                      |   |  | $ | 6,439
|                           |  |                            |        |   |                                         |   |        |                                            |  |   |                            |   |  |   |      



Foreign taxes include
withholdings on royalties from customers located in foreign countries.



Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our
deferred taxes as of December 31 are as follows (in thousands):



|                              |  |                        |         |   |      |   |         |  
|----------------------------- |  | ---------------------- | ------- | - | ---- | - | ------- | -
|                              |  | Staktek Holdings, Inc. |        
|                              |  | 2004                   |         |   | 2003 |  
|Deferred tax assets:          |  |                        |         |   |      |   |         |  
|Depreciation and amortization |  | $                      | 73      |   |      | $ | 519     |  
|Deferred compensation         |  |                        | 967     |   |      |   |        |  
|Accrued liabilities and other |  |                        | 307     |   |      |   | 193     |  
|                              |  |                        |         |   |      |   |         |  
|                              |  |                        | 1,347   |   |      |   | 712     |  
|Deferred tax liabilities:     |  |                        |         |   |      |   |         |  
|Acquired intangibles          |  |                        | (10,466 | ) |      |   | (16,771 | )
|Deductible patent expense     |  |                        | (165    | ) |      |   | (11     | )
|Prepaid expenses              |  |                        | (78     | ) |      |   | (71     | )
|                              |  |                        |         |   |      |   |         |  
|                              |  |                        | (10,709 | ) |      |   | (16,853 | )
|                              |  |                        |         |   |      |   |         |  
|Net deferred tax liability    |  | $                      | (9,362  | ) |      | $ | (16,141 | )
|                              |  |                        |         |   |      |   |         |  



Undistributed earnings
of the Companys foreign subsidiaries are considered to be permanently reinvested and, accordingly, no provision for U.S. federal and/or state income taxes has been provided thereon.



The exercise of certain of our stock options results in compensation which is includable in the taxable income of the
exercising option holder and deductible by us for federal and state income tax purposes. Such compensation results from increases in the fair market value of the our common stock subsequent to the date of grant of the exercised stock options and, in
accordance with APB No. 25, such compensation is not recognized as



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##### Index to Financial Statements

STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



an expense for financial accounting purposes; however, the related tax benefits are recorded as an increase to additional paid-in capital. During the year
ended December 31, 2004, our option-related tax deductions did not exceed our book stock compensation, and therefore no increase to additional paid-in capital was recorded.



Our provision for income taxes differs from the expected tax expense (benefit) amount computed by applying the statutory
federal income tax rate of 35% to income (loss) before income taxes primarily as a result of the following (in thousands):



|                                                                                 |  |                            |       |                                         |                     |        |                                            |  |                            |       |  |   |      
|-------------------------------------------------------------------------------- |  | -------------------------- | ----- | --------------------------------------- | ------------------- | ------ | ------------------------------------------ |  | -------------------------- | ----- |  | - | -----
|                                                                                 |  | Staktek Holdings, Inc.     |       |                                         | Predecessor Company
|                                                                                 |  | Year EndedDecember 31,2004 |       | Period fromInception toDecember 31,2003 |                     |        | Period fromJanuary 1,2003 toAugust 20,2003 |  | Year EndedDecember 31,2002
|Computed at federal statutory rate                                               |  | $                          | 4,576 |                                         | $                   | (1,616 | )                                          |  | $                          | 5,718 |  | $ | 6,288
|State taxes, net of federal benefit                                              |  |                            | 100   |                                         |                     | 12     |                                            |  |                            | 133   |  |   | 126  
|Amortization of deferred stock-based compensation and stock compensation expense |  |                            | 542   |                                         |                     | 1,983  |                                            |  |                            |      |  |   |     
|Non-deductible and non-taxable items                                             |  |                            | 6     |                                         |                     | 258    |                                            |  |                            | 992   |  |   | 11   
|Other                                                                            |  |                            | 44    |                                         |                     | 19     |                                            |  |                            | 18    |  |   | 14   
|                                                                                 |  |                            |       |                                         |                     |        |                                            |  |                            |       |  |   |      
|Provision for income taxes                                                       |  | $                          | 5,268 |                                         | $                   | 656    |                                            |  | $                          | 6,861 |  | $ | 6,439
|                                                                                 |  |                            |       |                                         |                     |        |                                            |  |                            |       |  |   |      



18. Employee Benefits



Full-time employees become eligible for health care
benefits effective the second day of service. We offer all full-time employees partially subsidized health, dental and vision coverage. In addition, on the second day of service all full-time employees receive at our expense life insurance,
accidental death coverage, workers compensation coverage, and short- and long-term disability coverage.



401(k) Plan



We have, and the Predecessor Company had, a voluntary defined contribution retirement plan (401(k) Plan) qualifying under Section 401(k) of
the Internal Revenue Code of 1986. Under the 401(k) Plan, eligible employees may defer up to 25% of their annual compensation subject to maximum limitations. The requirements for eligibility include 90 days of service. Under the provisions of the
401(k) Plan, we make, and the Predecessor Company made, contributions in amounts as determined by the Board of Directors, subject to certain limitations. Our contributions related to the 401(k) Plan were approximately $0.5 million, $0.1 million,
$0.3 million and $0.4 million for the year ended December 31, 2004, for the period from inception to December 31, 2003, for the period from January 1, 2003 to August 20, 2003, and for the year ended December 31, 2002, respectively.



Profit-Sharing Plan



We have, and the Predecessor Company had, a quarterly profit-sharing plan
under which eligible employees may receive a percentage of their base pay, including overtime, in additional compensation. Typically, we make these payments within 30 days after the end of the quarter in which the profit-sharing compensation is
earned. Individual awards are computed based upon a combination of corporate and individual goals. Total profit-sharing expense was approximately $2.1 million, $1.0 million, $1.5 million and $1.6 million for the year ended December 31, 2004, for the
period from inception to December 31, 2003, for the period from January 1, 2003 to August 20, 2003, and for the year ended December 31, 2002, respectively.



19. Restructuring



In September 2002, in connection with managements decision to open a production facility in Mexico, the Predecessor Company purchased a building and
land in Reynosa, Mexico and initiated a plan to reduce its



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STAKTEK HOLDINGS, INC.



NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS(Continued)



workforce at its primary location in Austin, Texas. As a result, approximately 100 employees, primarily manufacturing employees, received termination
benefits, including severance and retention bonuses. The restructuring was completed in mid-2003.



As of December 31, 2002, severance benefits of approximately $0.3 million were recorded in Business restructuring and acquisition expense. Retention
benefits were charged to expense as incurred. The changes in the Companys restructuring accrual are as follows (in thousands):



|                                           |  |   |      |  
|------------------------------------------ |  | - | ---- | -
|Restructuring accrual at December 31, 2001 |  | $ |     |  
|Restructuring expenses accrued             |  |   | 306  |  
|Payments of restructuring expenses         |  |   |     |  
|                                           |  |   |      |  
|Restructuring accrual at December 31, 2002 |  |   | 306  |  
|Restructuring expenses accrued             |  |   | 537  |  
|Payments of restructuring expenses         |  |   | (843 | )
|                                           |  |   |      |  
|Restructuring accrual at December 31, 2003 |  | $ |     |  
|                                           |  |   |      |  



20. Geographic Information



The Company considers its business activities to
constitute a single segment. Following is a summary of our revenues by geographic region (in thousands):



|               |  |                            |        |                                         |   |                                             |  |                            |        |  |   |       
|-------------- |  | -------------------------- | ------ | --------------------------------------- | - | ------------------------------------------- |  | -------------------------- | ------ |  | - | ------
|               |  | Staktek Holdings, Inc.     |        | Predecessor Company                    
|               |  | Year EndedDecember 31,2004 |        | Period fromInception toDecember 31,2003 |   | Period fromJanuary 1, 2003to August 20,2003 |  | Year EndedDecember 31,2002
|Revenue:       |  |                            |        |                                         |   |                                             |  |                            |        |  |   |       
|North America: |  |                            |        |                                         |   |                                             |  |                            |        |  |   |       
|United States  |  | $                          | 30,472 |                                         | $ | 14,232                                      |  | $                          | 22,353 |  | $ | 12,511
|Canada         |  |                            | 5,143  |                                         |   | 3,661                                       |  |                            | 6,805  |  |   | 8,464 
|Europe:        |  |                            |        |                                         |   |                                             |  |                            |        |  |   |       
|Germany        |  |                            | 4,838  |                                         |   | 2,172                                       |  |                            | 1,500  |  |   | 18,190
|Italy          |  |                            | 1,320  |                                         |   | 953                                         |  |                            | 850    |  |   | 1,123 
|Other          |  |                            | 345    |                                         |   |                                            |  |                            |       |  |   |      
|Asia:          |  |                            |        |                                         |   |                                             |  |                            |        |  |   |       
|Korea          |  |                            | 31,508 |                                         |   | 6,204                                       |  |                            | 12,625 |  |   | 6,728 
|               |  |                            |        |                                         |   |                                             |  |                            |        |  |   |       
|Total          |  | $                          | 73,626 |                                         | $ | 27,222                                      |  | $                          | 44,133 |  | $ | 47,016
|               |  |                            |        |                                         |   |                                             |  |                            |        |  |   |       



At December 31, we had
physical assets consisting of cash and net property and equipment located at our manufacturing facility in Reynosa, Mexico as follows (in thousands):



|                            |  |      |       |      |   |      
|--------------------------- |  | ---- | ----- | ---- | - | -----
|                            |  | 2004 |       | 2003
|Cash                        |  | $    | 343   |      | $ | 334  
|Property and equipment, net |  |      | 1,945 |      |   | 2,025
|                            |  |      |       |      |   |      
|Total                       |  | $    | 2,288 |      | $ | 2,359
|                            |  |      |       |      |   |      



Our manufacturing
operations are concentrated in a facility located primarily in Reynosa, Mexico. As a result of this geographic concentration, a disruption in the manufacturing process resulting from a natural disaster or other unforeseen event could have a material
adverse effect on our financial position and results of operations.



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##### Index to Financial Statements

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH AUDITORS ON ACCOUNTING AND FINANCIAL DISCLOSURE.



None.



ITEM 9A. CONTROLS AND PROCEDURES



The Securities and Exchange Commission (the SEC) defines the term disclosure controls and procedures to mean a companys controls and other procedures that are designed to ensure that information required to be
disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the SECs rules and forms. Our chief executive officer and chief
financial officer have concluded, based upon the evaluation of the effectiveness of our disclosure controls and procedures by our management, as of the end of the period covered by this annual report, that our disclosure controls and procedures were
effective for this purpose.



It should be noted that in
designing and evaluating our disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives.
A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met due to numerous factors, ranging from errors to conscious acts of an individual, or
individuals acting together. In addition, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of inherent limitations in a
cost-effective control system, misstatements due to error and/or fraud may occur and not be detected.



ITEM 9B. OTHER INFORMATION



None.



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PART III



ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT



The information set forth in the Proxy Statement to be delivered to stockholders in connection with our Annual Meeting of Stockholders to be held on April 21, 2005 under the headings Board Structure and
Compensation, Proposal 1: Election of Directors, Executive Officers, and Section 16(a) Beneficial Ownership Reporting Compliance is incorporated herein by reference.



ITEM 11. EXECUTIVE COMPENSATION



The information set forth in the Proxy Statement under the headings Board Structure and Compensation  Director Compensation Arrangements and Executive Compensation and Other Information is incorporated herein
by reference.



ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS



The information set forth in the Proxy Statement under the headings Proposal 2: Approval of Employee Stock Purchase Plan and Stock
Ownership is incorporated herein by reference.



ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS



The information set forth in the Proxy Statement under the heading Certain Relationships and Related Transactions is incorporated herein by reference.



ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES



The information set forth in the Proxy Statement under the heading Independent Auditors is incorporated herein by reference.



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PART IV



ITEM 15. Exhibits and Financial Statement Schedules



(a) 1. Financial Statements



See Index to Financial Statements under Item 8 on page 46.



(a) 2. Financial Statement Schedules



All schedules
are omitted because they are not applicable or are not required or the information required to be set forth therein is included in the consolidated financial statement or notes thereto.



(b) Exhibits



The following documents are incorporated by reference or included in this report:



|          |  |                                                                                                                                                       
|--------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------
|2.1*      |  | Agreement and Plan of Merger, dated July 7, 2003, among Staktek Holdings, Inc., SC Merger Sub, Inc. and Staktek Corporation                           
|          | 
|2.2**     |  | Agreement and Plan of Merger, dated July 7, 2003, among Staktek Holdings, Inc., SC Merger Sub, Inc., Research Applications, Inc. and C.A. Rundell, Jr.
|          | 
|3.1***    |  | Amended and Restated Certificate of Incorporation                                                                                                     
|          | 
|3.2**     |  | Amended and Restated Bylaws                                                                                                                           
|          | 
|4.1       |  | Reference is made to Exhibits 3.1 and 3.2 for provisions defining the rights of equity holders                                                        
|          | 
|4.2***    |  | Specimen certificate for shares of common stock of Staktek Holdings, Inc.                                                                             
|          | 
|10.1*     |  | Staktek Holdings, Inc. 2003 Stock Option Plan, as amended to date                                                                                     
|          | 
|10.2*     |  | Letter Agreement, dated August 19, 2003, among Staktek Holdings, Inc. and Austin Ventures, regarding management rights                                
|          | 
|10.3*     |  | Amended and Restated Registration Rights Agreement, dated November 24, 2003, among Staktek Holdings, Inc. and Austin Ventures                         
|          | 
|10.4.1*** |  | Agreement, dated June 1, 2000, among Samsung Electronics Co., Ltd., Samsung Semiconductor, Inc. and Staktek Corporation                               
|          | 
|10.4.2   |  | First Amendment to Agreement, dated June 9, 2000, among Samsung Electronics Co., Ltd., Samsung Semiconductor, Inc. and Staktek Corporation            
|          | 
|10.5*     |  | Lease Agreement, dated December 1, 2003, among Staktek Group L.P. and 8900 Shoal Creek                                                                
|          | 
|10.6.1*   |  | Executive Employment Agreement, dated August 20, 2003, among Staktek Corporation and James W. Cady                                                    
|          | 
|10.6.2*   |  | Executive Employment Agreement, dated August 20, 2003, among Staktek Corporation and David G. Boone                                                   
|          | 
|10.6.3**  |  | Amendment No. 1 to Executive Employment Agreement, dated November 19, 2003, among Staktek Corporation and David G. Boone                              
|          | 
|10.6.4*   |  | Executive Employment Agreement, dated August 20, 2003, among Staktek Corporation and Charles R. Earnhart                                              
|          | 
|10.6.5*   |  | Executive Employment Agreement, dated August 20, 2003, among Staktek Corporation and William D. Askins                                                



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|           |  |                                                                                                                        
|---------- |  | -----------------------------------------------------------------------------------------------------------------------
|10.6.6*    |  | Executive Employment Agreement, dated August 20, 2003, among Staktek Corporation and Albert V. Saucedo                 
|           | 
|10.6.7*    |  | Executive Employment Agreement, dated November 17, 2003, among Staktek Corporation and W. Kirk Patterson               
|           | 
|10.6.8**   |  | Executive Employment Agreement, dated December 18, 2003, among Staktek Corporation and Stephanie A. Lucie              
|           | 
|10.6.9**   |  | Form of Staktek Holdings, Inc. key management bonus plan                                                               
|           | 
|10.6.10*** |  | Amendment No. 2 to Executive Employment Agreement, dated January 14, 2004, among Staktek Corporation and David G. Boone
|           | 
|10.7*      |  | Form of Indemnification Agreement for Staktek Holdings, Inc.s directors and officers                                  
|           | 
|10.8*      |  | Staktek Holdings, Inc. Profit Sharing Plan                                                                             
|           | 
|10.9       |  | Staktek Holdings, Inc. Medical Retiree Plan                                                                            
|           | 
|14.1       |  | Code of Ethics                                                                                                         
|           | 
|21.1*      |  | List of Subsidiaries                                                                                                   
|           | 
|23.1       |  | Consent of Independent Registered Public Accounting Firm                                                               
|           | 
|24.1       |  | Power of Attorney (See Page 82 of this Form 10-K)                                                                      
|           | 
|31.1       |  | Certificate of the Chief Executive Officer pursuant to 18 U.S.C. §1350 (Section 302 of the Sarbanes-Oxley Act of 2002).
|           | 
|31.2       |  | Certificate of the Chief Financial Officer pursuant to 18 U.S.C. §1350 (Section 302 of the Sarbanes-Oxley Act of 2002).
|           | 
|32.1       |  | Certificate of the Chief Executive Officer pursuant to 18 U.S.C. §1350 (Section 906 of the Sarbanes-Oxley Act of 2002).
|           | 
|32.2       |  | Certificate of the Chief Financial Officer pursuant to 18 U.S.C. §1350 (Section 906 of the Sarbanes-Oxley Act of 2002).

---

|* | Incorporated by reference to Registration Statement on Form S-1 (File No. 333-110806) dated November 26, 2003.
|- | --------------------------------------------------------------------------------------------------------------



|** | Incorporated by reference to Amendment No. 2 to Registration Statement on Form S-1 (File No. 333-110806) dated January 6, 2004.
|-- | -------------------------------------------------------------------------------------------------------------------------------



|*** | Incorporated by reference to Amendment No. 3 to Registration Statement on Form S-1 (File No. 333-110806) dated January 20, 2004.
|--- | --------------------------------------------------------------------------------------------------------------------------------



| | Incorporated by reference to Amendment No. 1 to Registration Statement on Form S-1 (File No. 333-110806) dated January 6, 2004.
|- | -------------------------------------------------------------------------------------------------------------------------------



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SIGNATURES



Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.



STAKTEK HOLDINGS, INC.By:

/S/    JAMES W.
CADYJames W. Cady President and Chief Executive Officer Date: March 9, 2005


By:

/S/    W. KIRK
PATTERSONW. Kirk Patterson Vice President and Chief Financial Officer Date: March 9, 2005




KNOW BY THESE
PRESENT, that each person whose signature appears below constitutes and appoints each of James W. Cady and W. Kirk Patterson, his attorney-in-fact, with the power of substitution, for him in any and all capacities, to sign any amendments to this
report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of the attorney-in-fact, or his substitute or
substitutes, may do or cause to be done by virtue hereof.



Pursuant to the requirements of the Securities Act of 1934, as amended, this Registration Statement has been signed by the following persons in the capacities and on the dates indicated:



|                                          |  |                                                                                         |  |              
|----------------------------------------- |  | --------------------------------------------------------------------------------------- |  | -------------
|Name                                      |  | Title                                                                                   |  | Date         
|                                          |  |                                                                                        
|/S/    JAMES W.
CADYJames W. Cady         |  | President and Chief Executive Officer (principal executive officer)                     |  | March 9, 2005
|                                          |  |                                                                                        
|/S/    W. KIRK
PATTERSONW. Kirk
Patterson |  | Vice President and Chief Financial Officer (principal accounting and financial officer) |  | March 9, 2005
|                                          |  |                                                                                        
|/S/    JOSEPH C.
ARAGONAJoseph C.
Aragona |  | Chairman of the Board of Directors                                                      |  | March 9, 2005
|                                          |  |                                                                                        
|/S/    HARVEY B.
CASHHarvey B.
Cash       |  | Director                                                                                |  | March 9, 2005
|                                          |  |                                                                                        
|/S/    CLARK W.
JERNIGANClark W.
Jernigan |  | Director                                                                                |  | March 9, 2005
|                                          |  |                                                                                        
|/S/    EDWARD E.
OLKKOLAEdward E.
Olkkola |  | Director                                                                                |  | March 9, 2005
|                                          |  |                                                                                        
|/S/    MORTON L.
TOPFERMorton L.
Topfer   |  | Director                                                                                |  | March 9, 2005
|                                          |  |                                                                                        
|/S/    A. TRAVIS
WHITEA. Travis
White     |  | Director                                                                                |  | March 9, 2005



82