**UNITEDSTATES****SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

| **ý**                                                                                                                                                                                                                                  |   | **QUARTERLY REPORT UNDER SECTION 13 OR 15(D) OF THE  SECURITIES EXCHANGE ACT OF 1934**        |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                        |   |                                                                                          |
| **For the quarterly period ended September 30, 2003**                                                                                                                                                                                       |
|                                                                                                                                                                                                                                        |   |                                                                                          |
| **OR**                                                                                                                                                                                                                                      |
|                                                                                                                                                                                                                                        |   |                                                                                          |
| **o**                                                                                                                                                                                                                                       |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                        |   |                                                                                          |
| **For the transition period from                    to                  .** |
|                                                                                                                                                                                                                                        |   |                                                                                          |
| **Commission file number:  000-26887**                                                                                                                                                                                                 |

 

**SiliconImage, Inc.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                     |   | **77-0396307**                       |
|------------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of   incorporation or organization) |   | (I.R.S. Employer Identification No.) |
|                                                             |   |                                 |
| **1060 East Arques Avenue   Sunnyvale, California 94085**        |
| (Address of principal executive offices and zip code)            |
|                                                             |   |                                 |
| **(408) 616-4000**                                               |
| (Registrant’s telephone number, including area code)        |

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports) Yes oNo  ý and(2) has been subject to such filing requirements for the past 90 days Yes ý No o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act). Yes ý No o

 

Thenumber of shares of the registrant’s Common Stock, $0.001 par value per share,outstanding as of October 31, 2003 was 71,628,311 shares.

 

 

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**Silicon Image, Inc.**

**Quarterly Report on Form 10-Q**

**Three and Nine Months Ended**

**September 30, 2003**

 

**Table of Contents**

 
| **Part I**     | **Financial  Information (Unaudited)**                                                                           |   |
|----------------|------------------------------------------------------------------------------------------------------------------|--------|
|           |                                                                                                             |   |
| Item 1         | Financial Statements                                                                                             |   |
|           |                                                                                                             |   |
|           | Condensed  Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2003 and 2002 |   |
|           |                                                                                                             |   |
|           | Condensed  Consolidated Balance Sheets as of September 30, 2003 and December 31, 2002                            |   |
|           |                                                                                                             |   |
|           | Condensed  Consolidated Statements of Cash Flows for the Nine Months Ended September 30,  2003 and 2002          |   |
|           |                                                                                                             |   |
|           | Notes  to Unaudited Condensed Consolidated Financial Statements                                                  |   |
|           |                                                                                                             |   |
| Item.2         | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                      |   |
|           |                                                                                                             |   |
| Item  3        | Quantitative  and Qualitative Disclosures About Market Risk                                                      |   |
|           |                                                                                                             |   |
| Item  4        | Controls  and Procedures                                                                                         |   |
|           |                                                                                                             |   |
| **Part II**    | **Other  Information**                                                                                           |   |
|           |                                                                                                             |   |
| Item 1         | Legal  Proceedings                                                                                               |   |
|           |                                                                                                             |   |
| Item 2         | Change in  Securities and Use of Proceeds                                                                        |   |
|           |                                                                                                             |   |
| Item 3         | Defaults Upon Senior  Securities                                                                                 |   |
|           |                                                                                                             |   |
| Item  4        | Submission  of Matters to a Vote of Security Holders                                                             |   |
|           |                                                                                                             |   |
| Item 5         | Other  Information                                                                                               |   |
|           |                                                                                                             |   |
| Item 6         | Exhibits and Reports  on Form 8-K                                                                                |   |
|           |                                                                                                             |   |
| **Signatures** |                                                                                                             |
|           |                                                                                                             |   |
| Exhibit Index  |                                                                                                             |
|           |                                                                                                             |   |
| Exhibit        | 31.1                                                                                                             |   |
|           |                                                                                                             |   |
| Exhibit        | 31.2                                                                                                             |   |
|           |                                                                                                             |   |
| Exhibit        | 32.1                                                                                                             |   |
|           |                                                                                                             |   |
| Exhibit        | 32.2                                                                                                             |   |

 

2

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**PartI.  Financial Information**

 

**Item1.  Financial Statements**

 

**Silicon Image, Inc.**

**Condensed Consolidated Statements of Operations**

**(in thousands, except per share and footnote amounts)**

**(unaudited)**

 
|                                             |   | **Three Months Ended September 30** |   | **Nine Months Ended September 30** |   |
|--------------------------------------------------|--------|-------------------------------------|--------|------------------------------------|--------|
|                                             |   | **2003**                            |   | **2002**                           |   | **2003** |   | **2002** |   |
|                                             |   |                                |   |                               |   |   |   |   |   |
| Revenue:                                         |   |                                |   |                               |   |   |   |   |   |
| Product                                          |   | $                                   | 22,447 |                               | $      | 19,855 |   | $ | 61,914 |   | $ | 54,682 |   |
| Development, licensing and royalties             |   | 1,743                               |   | 1,530                              |   | 11,284 |   | 3,062 |   |
| Total revenue                                    |   | 24,190                              |   | 21,385                             |   | 73,198 |   | 57,744 |   |
|                                             |   |                                |   |                               |   |   |   |   |   |
| Cost and operating expenses:                     |   |                                |   |                               |   |   |   |   |   |
| Cost of revenue (1)                              |   | 11,501                              |   | 9,797                              |   | 33,342 |   | 27,371 |   |
| Research and development (2)                     |   | 9,054                               |   | 8,580                              |   | 27,259 |   | 24,163 |   |
| Selling, general and administrative (3)          |   | 4,131                               |   | 3,982                              |   | 12,794 |   | 13,492 |   |
| Stock compensation expense                       |   | 1,106                               |   | 201                                |   | 2,997 |   | 7,586 |   |
| Amortization of goodwill and intangible assets   |   | 373                                 |   | 859                                |   | 746 |   | 2,625 |   |
| Patent defense and acquisition integration costs |   | 160                                 |   | 2,775                              |   | 1,956 |   | 4,164 |   |
| Restructuring                                    |   | —                              |   | —                             |   | 986 |   | 5,693 |   |
| In-process research and development              |   | —                              |   | —                             |   | 5,482 |   | — |   |
| Impairment of goodwill and intangible assets     |   | —                              |   | —                             |   | — |   | 5,200 |   |
| Total cost and operating expenses                |   | 26,325                              |   | 26,194                             |   | 85,562 |   | 90,294 |   |
|                                             |   |                                |   |                               |   |   |   |   |   |
| Loss from operations                             |   | (2,135                              | )      | (4,809                             | )      | (12,364 | ) | (32,550 | ) |
| Gain on escrow settlement, net                   |   | —                              |   | —                             |   | 4,618 |   | — |   |
| Interest income and other, net                   |   | 40                                  |   | 164                                |   | 216 |   | 597 |   |
|                                             |   |                                |   |                               |   |   |   |   |   |
| Net loss                                         |   | $                                   | (2,095 | )                                  | $      | (4,645 | ) | $ | (7,530 | ) | $ | (31,953 | ) |
|                                             |   |                                |   |                               |   |   |   |   |   |
| Net loss per share:                              |   |                                |   |                               |   |   |   |   |   |
| Basic and diluted                                |   | $                                   | (0.03  | )                                  | $      | (0.07 | ) | $ | (0.11 | ) | $ | (0.50 | ) |
|                                             |   |                                |   |                               |   |   |   |   |   |
| Weighted average shares                          |   | 69,803                              |   | 65,587                             |   | 68,431 |   | 63,912 |   |

 

(1)Excludes non-cash stock compensation expense (benefit) of $(14,000) and$(144,000) for the three months ended September 30, 2003 and 2002,respectively, and $(71,000) and $234,000 for the nine months ended September30, 2003 and 2002, respectively.

 

(2)Excludes non-cash stock compensation expense of $1.0 million and $687,000 forthe three months ended September 30, 2003 and 2002, respectively, and $3.0million and $5.7 million for the nine months ended September 30, 2003 and 2002,respectively.

 

(3)Excludes non-cash stock compensation expense (benefit) of $94,000 and$(342,000) for the three months ended September 30, 2003 and 2002,respectively, and $74,000 and $1.6 million for the nine months ended September30, 2003 and 2002, respectively.

 

*See accompanying Notes to the Unaudited CondensedConsolidated Financial Statements.*

 

3

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**Silicon Image, Inc.**

**Condensed Consolidated Balance Sheets**

**(in thousands, except share and per share amounts)**

**(unaudited)**

 
|                                                                                                                                                                                   |   | **Sept. 30,   2003** |   | **Dec. 31,   2002** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------|--------|---------------------|--------|
|                                                                                                                                                                                   |   |                 |   |                |   |
| **Assets**                                                                                                                                                                             |   |                 |   |                |   |
| Cash and cash equivalents                                                                                                                                                              |   | $                    | 16,247 |                | $      | 26,263 |   |
| Short-term investments                                                                                                                                                                 |   | 11,953               |   | 9,570               |   |
| Accounts receivable, net of allowance for doubtful  accounts of $620 at September 30 and $519 at December 31                                                                           |   | 16,744               |   | 11,589              |   |
| Inventories                                                                                                                                                                            |   | 8,958                |   | 7,301               |   |
| Prepaid expenses and other current assets                                                                                                                                              |   | 1,190                |   | 2,510               |   |
| Total current assets                                                                                                                                                                   |   | 55,092               |   | 57,233              |   |
|                                                                                                                                                                                   |   |                 |   |                |   |
| Property and equipment, net                                                                                                                                                            |   | 7,768                |   | 6,653               |   |
| Goodwill                                                                                                                                                                               |   | 13,021               |   | 13,021              |   |
| Intangible assets, net                                                                                                                                                                 |   | 3,385                |   | —              |   |
| Other assets                                                                                                                                                                           |   | 643                  |   | 709                 |   |
| Total assets                                                                                                                                                                           |   | $                    | 79,909 |                | $      | 77,616 |   |
|                                                                                                                                                                                   |   |                 |   |                |   |
| **Liabilities and Stockholders’  Equity**                                                                                                                                         |   |                 |   |                |   |
| Current Liabilities:                                                                                                                                                                   |   |                 |   |                |   |
| Accounts payable                                                                                                                                                                       |   | $                    | 7,821  |                | $      | 10,314 |   |
| Accrued liabilites                                                                                                                                                                     |   | 7,371                |   | 11,183              |   |
| Capital lease and debt obligations                                                                                                                                                     |   | 2,277                |   | 3,816               |   |
| Deferred margin on sales to distributors                                                                                                                                               |   | 6,162                |   | 4,133               |   |
| Total current liabilities                                                                                                                                                              |   | 23,631               |   | 29,446              |   |
|                                                                                                                                                                                   |   |                 |   |                |   |
| Shareholders’ Equity:                                                                                                                                                             |   |                 |   |                |   |
| Convertible preferred stock, par value $0.001;  5,000,000 shares authorized; no shares issued or outstanding                                                                           |   | —               |   | —              |   |
| Common stock, par value $0.001; shares authorized:  150,000,000 - September 30 and December 31; shares issued and outstanding:  71,034,139 - September 30 and 66,639,522 - December 31 |   | 71                   |   | 67                  |   |
| Additional paid-in capital                                                                                                                                                             |   | 232,076              |   | 214,459             |   |
| Notes receivable from stockholders                                                                                                                                                     |   | —               |   | (109                | )      |
| Unearned stock compensation                                                                                                                                                            |   | (8,495               | )      | (6,403              | )      |
| Accumulated deficit                                                                                                                                                                    |   | (167,374             | )      | (159,844            | )      |
| Total stockholders’ equity                                                                                                                                                        |   | 56,278               |   | 48,170              |   |
| Total liabilites and stockholders’ equity                                                                                                                                         |   | $                    | 79,909 |                | $      | 77,616 |   |

 

*See accompanying Notes to Unaudited CondensedConsolidated Financial Statements.*

 

4

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**Silicon Image, Inc.**

**Condensed Consolidated Statements of Cash Flows**

**(in thousands)**

**(unaudited)**

 
|                                                                     |   | **Nine Months Ended September 30** |   |
|--------------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                     |   | **2003**                           |   | **2002** |   |
|                                                                     |   |                               |   |   |   |
| ***Cash flows from  operating activities:***                             |   |                               |   |   |   |
| Net loss                                                                 |   | $                                  | (7,530 | ) | $ | (31,953 | ) |
| Adjustments to reconcile net loss to cash used in  operating activities: |   |                               |   |   |   |
| Stock compensation expense                                               |   | 2,997                              |   | 7,586 |   |
| Amortization of intangible assets                                        |   | 746                                |   | 2,625 |   |
| Non-cash restructuring                                                   |   | 646                                |   | 3,965 |   |
| Impairment of goodwill and intangible assets                             |   | —                             |   | 5,200 |   |
| In-process research and development expense                              |   | 5,482                              |   | — |   |
| Non-cash gain on escrow settlement, before cash  costs                   |   | (4,692                             | )      | — |   |
| Provision for doubtful accounts receivable                               |   | 101                                |   | 233 |   |
| Depreciation and amortization                                            |   | 3,321                              |   | 2,898 |   |
| Changes in assets and liabilities, net of amounts  acquired:             |   |                               |   |   |   |
| Accounts receivable                                                      |   | (5,256                             | )      | (2,166 | ) |
| Inventories                                                              |   | (1,657                             | )      | (567 | ) |
| Prepaid expenses and other assets                                        |   | 1,408                              |   | 1,021 |   |
| Accounts payable                                                         |   | (2,525                             | )      | 2,947 |   |
| Accrued liabilities                                                      |   | (3,938                             | )      | 997 |   |
| Deferred margin on sales to distributors                                 |   | 2,029                              |   | 879 |   |
| Cash used in operating activities                                        |   | (8,868                             | )      | (6,335 | ) |
|                                                                     |   |                               |   |   |   |
| ***Cash flows from  investing activities:***                             |   |                               |   |   |   |
| Proceeds from sales and maturities of short-term  investments            |   | 4,622                              |   | 10,370 |   |
| Purchases of short-term investments                                      |   | (7,005                             | )      | (955 | ) |
| Acquisition costs, net of cash acquired                                  |   | 3                                  |   | — |   |
| Net purchases of property and equipment                                  |   | (3,981                             | )      | (2,610 | ) |
| Cash provided by investing activities                                    |   | (6,361                             | )      | 6,805 |   |
|                                                                     |   |                               |   |   |   |
| ***Cash flows from  financing activities:***                             |   |                               |   |   |   |
| Proceeds from issuances of common stock, net                             |   | 7,026                              |   | 6,732 |   |
| Proceeds from repayment of stockholders’ notes  receivable          |   | 109                                |   | 60 |   |
| Repayments of capital lease and debt obligations                         |   | (1,922                             | )      | (1,483 | ) |
| Cash provided by financing activities                                    |   | 5,213                              |   | 5,309 |   |
|                                                                     |   |                               |   |   |   |
| **Net decrease in cash and cash  equivalents**                           |   | (10,016                            | )      | 5,779 |   |
| Cash and cash equivalents — beginning of period                     |   | 26,263                             |   | 18,946 |   |
| Cash and cash equivalents — end of period                           |   | $                                  | 16,247 |   | $ | 24,725 |   |
|                                                                     |   |                               |   |   |   |
| **Non-cash investing and financing  activities:**                        |   |                               |   |   |   |
| Financing of property and equipment                                      |   | $                                  | 383    |   | $ | — |   |
| Stock  and options issued in connection with the Transwarp acquisition   |   | $                                  | 14,371 |   | $ | — |   |

 

*See accompanying Notes to Unaudited CondensedConsolidated Financial Statements.*

 

5

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**Silicon Image, Inc.**

**Notes to Unaudited Condensed Consolidated FinancialStatements**

###### **September 30, 2003**

 

1.             Basis of Presentation

 

In the opinion of management, the unaudited condensed consolidatedfinancial statements of Silicon Image, Inc. included herein have been preparedon a basis consistent with our December 31, 2002 audited financial statementsand include all material adjustments, consisting of normal recurringadjustments, necessary to fairly state the consolidated financial position of SiliconImage and its subsidiaries (collectively, the “Company”) at September 30, 2003and the consolidated results of the Company’s operations and cash flows for thethree and nine months ended September 30, 2003 and 2002.  All intercompanyaccounts and transactions have been eliminated.  These interim financialstatements should be read in conjunction with our audited consolidatedfinancial statements and notes thereto included in our Form 10-K for the fiscalyear ended December 31, 2002.  Results of operations for the three andnine months ended September 30, 2003 are not necessarily indicative of futureoperating results.

 

As previously disclosed, the Company announced that it would delay thefiling of its quarterly report on Form 10-Q for the quarter endedSeptember 30, 2003 because anexamination had been commenced by its Audit Committee.  The Company’s Audit Committee, with the assistance of independent outsidecounsel and independent outside consultants, was examining certain matters,principally the Company’s recognition of revenue associated with its licensingtransactions****in2002 and 2003.

 

In February 2004, the Company’s Audit Committee completed itsexamination. During the course of the examination, the Audit Committee and itsoutside advisors conducted a thorough review of the Company’s licensingtransactions in 2002 and 2003, as well as a review of certain othermatters.  As a result of itsexamination, the Audit Committee concluded that no changes were required to theresults previously announced for the quarter ending September 30, 2003, or anyprior reporting period.  In its review,the Audit Committee concluded that there were no accounting irregularities andthat no member of the Company’s management engaged in misconduct in connectionwith the matters under examination.

 

During the course of its examination, the Audit Committee identifiedcertain areas in which the Company’s control environment should beimproved.  As a result, the Company,under the direction of the Audit Committee and the Board of Directors, istaking steps to strengthen the Company’s controls.  In connection with these steps, the Company is in the process ofrestructuring reporting relationships as they relate to licensing revenue; adoptinga policy requiring additional documentation of items necessary for licensingrevenue recognition decisions; increasing the standardization of licensingdeliverables and post-contract customer support for revenue recognitionpurposes; and formalizing its licensing deal review process.  The Company only began to report revenuesfrom licensing transactions in 2002. The enhancements to the Company’s controls are in part designed to helpthe Company adapt to the growing complexity and importance of this additionalcomponent of its business strategy.

 

The Company is also in the process of adopting internal proceduresdesigned to enhance the Company’s overall internal control environment and toincrease the level of communication within the management team and between themanagement team and the Board of Directors, including the Audit Committee.  The Company expects to receive and consideradditional recommendations designed to enhance its overall internal controlenvironment.  The Company believes thatthe steps it is taking and its continued monitoring and improvement of itsinternal controls are and will remain sufficient to ensure continued compliancewith law.

 

2.             Recent Accounting Pronouncements

 

In January 2003, the Financial Accounting Standards Board (“FASB”)issued Interpretation Number (“FIN”) 46, “Consolidation of Variable InterestEntities.”  In general, a variable interest entity is a corporation,partnership, trust, or any other legal structure used for business purposesthat either (a) does not have equity investors with voting rights or (b) hasequity investors that do not provide sufficient financial resources for theentity to support its activities. FIN 46 requires certain variable interestentities to be consolidated by the primary beneficiary of the entity if theinvestors do not have the characteristics of a controlling financial interestor do not have sufficient equity at risk for the entity to finance itsactivities without additional subordinated financial support from otherparties.  The consolidation requirements of FIN 46 apply immediately tovariable interest entities created after January 31, 2003.  Theconsolidation requirements apply to older entities as early as the first fiscalquarter of 2004.  Certain of the disclosure requirements apply to allfinancial statements issued after January 31, 2003, regardless of when thevariable interest entity was established.  The effective dates of certainelements of FIN 46 have been deferred.   We do not believe that theadoption of this standard will have a material impact on our consolidatedfinancial statements.

 

Stock-BasedCompensation

 

Weaccount for stock-based awards to employees and directors using the intrinsicvalue method of accounting in accordance with Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Underthe intrinsic value method, if the exercise price of our employee stock optionsequals the market price of the underlying stock on the date of grant, nocompensation expense is recognized in our Consolidated Statements ofOperations.

 

6

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Had we recorded compensation expense for our stock options based on thegrant-date fair value as prescribed by SFAS No. 123 and SFAS No. 148, our netloss would have been as follows (in thousands, except per share amounts):

 
|                                                                                                       |   | **Three Months Ended**   |   | **Nine Months Ended**    |   |
|------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|--------------------------|--------|
|                                                                                                       |   | **September 30,   2003** |   | **September 30,   2002** |   | **September 30,   2003** |   | **September 30,   2002** |   |
|                                                                                                       |   |                     |   |                     |   |   |   |   |   |
| Net loss — as reported                                                                                |   | $                        | (2,095 | )                        | $      | (4,645 | ) | $ | (7,530 | ) | $ | (31,953 | ) |
| Stock-based employee compensation expense (benefit)  included in the determination of net loss as reported |   | 865                      |   | (379                     | )      | 1,814 |   | 4,966 |   |
| Stock-based employee compensation expense  determined using fair value method                              |   | (5,125                   | )      | (5,997                   | )      | (16,738 | ) | (18,686 | ) |
|                                                                                                       |   |                     |   |                     |   |   |   |   |   |
| Pro forma net loss                                                                                         |   | $                        | (6,355 | )                        | $      | (11,021 | ) | $ | (22,454 | ) | $ | (45,673 | ) |
|                                                                                                       |   |                     |   |                     |   |   |   |   |   |
| Basic and diluted net loss per share — pro forma                                                      |   | $                        | (0.09  | )                        | $      | (0.17 | ) | $ | (0.33 | ) | $ | (0.71 | ) |
| Basic and diluted net loss per share — as reported                                                    |   | $                        | (0.03  | )                        | $      | (0.07 | ) | $ | (0.11 | ) | $ | (0.50 | ) |

 

Thegrant-date fair value of our stock options was $3.71 and $3.14 for the threemonths ended September 30, 2003 and 2002, respectively, and $4.11 and $3.82 forthe nine months ended September 30, 2003 and 2002, respectively. These valueswere estimated using the Black-Scholes pricing model with the followingassumptions:

 
|           |   | **Three  Months Ended September 30** |   | **Nine Months Ended September 30** |   |
|----------------|--------|--------------------------------------|--------|------------------------------------|--------|
|           |   | **2003**                             |   | **2002**                           |   | **2003** |   | **2002** |   |
|           |   |                                 |   |                               |   |   |   |   |   |
| Expected life  |   | 5                                    |   | 5                                  |   | 5 |   | 5 |   |
| Interest rate  |   | 3.1                                  | %      | 3.5                                | %      | 3.4 | % | 3.5 | % |
| Volatility     |   | 90                                   | %      | 90                                 | %      | 90 | % | 90 | % |
| Dividend yield |   | —                               |   | —                             |   | — |   | — |   |

 

The weighted average, grant-date fair value ofstock purchase rights granted under our Employee Stock Purchase Plan was $2.93and $2.70 for the three months ended September 30, 2003 and 2002, respectively,and $2.76 and $2.64 for the nine months ended September 30, 2003 and 2002,respectively. These values were estimated using the Black-Scholes pricing modelwith the following assumptions:

 
|                  |   | **Three Months Ended September 30** |   | **Nine Months Ended September 30** |   |
|-----------------------|--------|-------------------------------------|--------|------------------------------------|--------|
|                  |   | **2003**                            |   | **2002**                           |   | **2003** |   | **2002** |   |
|                  |   |                                |   |                               |   |   |   |   |   |
| Expected life (years) |   | 1.5                                 |   | 1.5                                |   | 1.5 |   | 1.5 |   |
| Interest rate         |   | 1.7                                 | %      | 1.8                                | %      | 1.7 | % | 2.0 | % |
| Dividend yield        |   | —                              |   | —                             |   | — |   | — |   |
| Volatility            |   | 90                                  | %      | 90                                 | %      | 90 | % | 90 | % |

 

3.             Net Loss Per Share

 

Basic net loss pershare is computed using the weighted-average number of common sharesoutstanding during the period, excluding shares subject to repurchase, anddiluted net loss per share is computed using the weighted-average number ofcommon shares and diluted equivalents outstanding during the period, if any,determined using the treasury stock method. The following table sets forth thecomputation of basic and diluted net loss per share (in thousands, except pershare amounts):

 
|                                               |   | **Three Months Ended September 30** |   | **Nine Months Ended September 30** |   |
|----------------------------------------------------|--------|-------------------------------------|--------|------------------------------------|--------|
|                                               |   | **2003**                            |   | **2002**                           |   | **2003** |   | **2002** |   |
|                                               |   |                                |   |                               |   |   |   |   |   |
| Net loss                                           |   | $                                   | (2,095 | )                                  | $      | (4,645 | ) | $ | (7,530 | ) | $ | (31,953 | ) |
|                                               |   |                                |   |                               |   |   |   |   |   |
| Weighted average shares                            |   | 70,645                              |   | 65,936                             |   | 69,001 |   | 64,476 |   |
|                                               |   |                                |   |                               |   |   |   |   |   |
| Less: unvested common shares subject to repurchase |   | (842                                | )      | (349                               | )      | (570 | ) | (564 | ) |
| Weighted average common shares outstanding         |   | 69,803                              |   | 65,587                             |   | 68,431 |   | 63,912 |   |
| Basic and diluted net loss per share               |   | $                                   | (0.03  | )                                  | $      | (0.07 | ) | $ | (0.11 | ) | $ | (0.50 | ) |

 

As a result of our netlosses, all common share equivalents would have been anti-dilutive and havetherefore been excluded from the diluted net loss per share calculation. Theweighted average securities that were anti-dilutive and excluded from our 

 

7

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calculationof diluted net loss per share were approximately 20,603,000 and 19,431,000 forthe three month periods ended September 30, 2003 and 2002, respectively, andapproximately 21,364,000 and 20,328,000 for the nine month periods ended September30, 2003 and 2002, respectively.

 

Had we generated net income for the three andnine month periods ended September 30, 2003 and 2002, the number of weightedaverage securities outstanding that would have been added to weighted averageshares for purposes of calculating diluted earnings per share would havebeen  (in thousands):

 
|                                        |   | **Three Months Ended  September 30** |   | **Nine Months Ended  September 30** |   |
|---------------------------------------------|--------|--------------------------------------|--------|-------------------------------------|--------|
|                                        |   | **2003**                             |   | **2002**                            |   | **2003** |   | **2002** |   |
| Unvested common stock subject to repurchase |   | 811                                  |   | 296                                 |   | 408 |   | 511 |   |
| Stock options                               |   | 5,780                                |   | 6,575                               |   | 6,532 |   | 9,292 |   |
| Total                                       |   | 6,591                                |   | 6,871                               |   | 6,940 |   | 9,803 |   |

 

 

4.             Balance Sheet Components (in thousands):

 

|                                 |   | **Sept. 30,  2003** |   | **Dec. 31,  2002** |   |
|--------------------------------------|--------|---------------------|--------|--------------------|--------|
| Inventories:                         |   |                |   |               |   |
| Raw materials                        |   | $                   | 2,918  |               | $      | 1,376 |   |
| Work in process                      |   | 2,553               |   | 2,487              |   |
| Finished goods                       |   | 3,487               |   | 3,438              |   |
|                                 |   | $                   | 8,958  |               | $      | 7,301 |   |
|                                 |   |                |   |               |   |
| Accrued liabilities:                 |   |                |   |               |   |
| Accrued payroll and related expenses |   | $                   | 1,674  |               | $      | 2,502 |   |
| Restructuring accrual                |   | 2,091               |   | 2,736              |   |
| Accrued legal fees                   |   | 611                 |   | 1,865              |   |
| Warranty accrual                     |   | 271                 |   | 223                |   |
| Other accrued liabilities            |   | 2,724               |   | 3,857              |   |
|                                 |   | $                   | 7,371  |               | $      | 11,183 |   |

 

Warranty Accrual

 

At the time of revenue recognition, weprovide an accrual for estimated costs to be incurred pursuant to our warrantyobligations.  Our estimate is basedprimarily on historical experience.  Warranty accrual activity for thenine months ended September 30, 2003 was as follows (in thousands):

 
| Balance  at January 1, 2003                       |   | $      | 223    |   |
|---------------------------------------------------|--------|--------|--------|--------|
| Provision for warranties issued during the period |   | 580    |   |
| Accruals related to pre-existing warranties       |   | — |   |
| Cash and other settlements made during the period |   | (532   | )      |
| Balance at September 30, 2003                     |   | $      | 271    |   |

 

5.             Stock-Based Compensation

 

We account for stock-based compensationarrangements in accordance with the provisions of APB 25 and related interpretations,and comply with the disclosure provisions of Statement of Financial AccountingStandard No. 148 (“SFAS No. 148”), “Accounting for Stock-BasedCompensation—Transition and Disclosure (an amendment of FASB Statement No.123).” Expense associated with stock-based compensation is amortized over thevesting period of the individual award using an accelerated method, asdescribed in Financial Accounting Standards Board Interpretation No. 28.

 

We are required to determine the fair value ofstock option grants to non-employees and to record the amount as an expenseover the period during which services are provided to us. Management calculatesthe fair value of these stock option grants using the Black-Scholes model,which requires us to estimate the life of the stock option, the volatility ofour stock, an appropriate risk-free interest rate, and our dividend yield. Thecalculation of fair value is highly sensitive to the expected life of the stockoption and the volatility of our stock, both of which we estimate basedprimarily on historical experience.

 

8

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The following table summarizes the componentsof our stock compensation expense (benefit) for the three and nine months endedSeptember 30, 2003 and 2002 (in thousands):

 

|                                            |   | **Three Months Ended   September 30** |   | **Nine Months Ended   September 30** |   |
|-------------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                                            |   | **2003**                              |   | **2002**                             |   | **2003** |   | **2002** |   |
| Options granted to employees                    |   | $                                     | 42     |                                 | $      | 260 |   | $ | 322 |   | $ | 941 |   |
| Options granted to non-employees                |   | 389                                   |   | 795                                  |   | 1,173 |   | 2,021 |   |
| Option repricings                               |   | (139                                  | )      | (1,525                               | )      | (970 | ) | 1,236 |   |
| Options assumed in connection with acquisitions |   | 814                                   |   | 671                                  |   | 2,472 |   | 3,388 |   |
| Stock compensation expense                      |   | $                                     | 1,106  |                                 | $      | 201 |   | $ | 2,997 |   | $ | 7,586 |   |

 

6.             Restructuring and Impairment Activities

 

Duringthe third quarter of 2001, we began a program to focus our business on productsand technology, including those obtained through acquisitions, in which wehave, or believe we can achieve, a market leadership position. As part of thisprogram, we decided to cancel numerous products under development, to removecertain projects from our development plan, to phase out or de-emphasizecertain existing products and to integrate the operations of two acquiredcompanies—CMD Technology (“CMD”) and Silicon Communication Lab (“SCL”).

 

Inconnection with this program, we reduced our workforce in the fourth quarter of2001 by approximately 60 people, or 20%. This workforce reduction was theinitial step in eliminating duplicate positions that resulted from ouracquisitions, and also represented the elimination of other positions based onour new product and technology focus. Positions were eliminated from allfunctional areas–operations, R&D and SG&A. Because of this workforcereduction, we recorded a restructuring expense of $1.5 million in the fourthquarter of 2001, consisting of cash severance-related costs of $599,000,non-cash severance-related costs of $303,000 representing the intrinsic valueof modified stock options, an expected loss on leased facilities of $500,000and fixed asset write-downs of $50,000. In addition, we reversed $286,000 ofunearned compensation, a component of stockholders’ equity, for unvested stockoptions that were cancelled in connection with employee terminations.

 

Inthe first quarter of 2002, we implemented a second workforce reduction inconnection with the program discussed above, eliminating an additional 35positions, or 13% of our workforce. Positions were eliminated from allfunctional areas. This reduction resulted from the continued integration ofacquired companies, as well as continued execution of our product andtechnology strategy, whereby we decided to phase out the legacy storagesubsystem board products we acquired from CMD and to develop new board productsonly if we believed it would facilitate or accelerate the use of our storagesemiconductor products. In connection with this workforce reduction, werecorded a restructuring expense of $2.2 million in the first quarter of 2002,consisting of cash severance-related costs of $198,000, non-cash severance-relatedcosts of $318,000 representing the intrinsic value of modified stock options,an expected loss on leased facilities of $1.2 million and fixed assetwrite-downs of $500,000 for assets to be disposed of. In addition, we reversed$76,000 of unearned compensation, a component of stockholders’ equity, forunvested stock options that were cancelled in connection with employeeterminations.

 

InApril 2002, we decided to transition to a licensing model for our storagesubsystem board products, whereby instead of developing, manufacturing andselling board products to facilitate or accelerate the use of our storagesemiconductor products, we would develop and license board designs in exchangefor license fees, royalties and the use of our semiconductor products. Inconnection with this decision, we implemented a third workforce reduction,eliminating 14 positions, or 5% of our workforce, and recorded a restructuringexpense of $3.5 million, consisting of cash severance-related costs of$450,000, non-cash severance-related costs of $1.6 million representing theintrinsic value of modified stock options and fixed asset write-downs of $1.5million for assets to be disposed of. We also reversed $302,000 of unearnedcompensation, a component of stockholders’ equity, for unvested stock optionsthat were cancelled in connection with employee terminations.

 

In connection with our decision to stopselling board products and to transition to a licensing model, we assessedrecoverability of our intangible assets subject to amortization in accordancewith SFAS No. 144. During the quarter ended September 30, 2002, an impairmentexpense of $749,000 was recognized for acquired technology and $60,000 wasrecognized for patent and other intangible assets, based upon our projection ofsignificantly reduced future cash flows. Additionally, we reduced our estimateof the useful lives of the remaining intangible assets subject to amortizationsuch that these assets were fully amortized by the end of 2002. We also testedthe carrying value of goodwill for impairment in accordance with SFAS No. 142.As a result of our impairment test, a goodwill impairment expense of $4.4million was recognized during the second quarter of 2002. To determine theamount of the impairment, we estimated the fair value of our storage systemsbusiness based primarily on expected future cash flows. We then reduced thisamount by the fair value of identifiable tangible and intangible assets otherthan goodwill (also based primarily on expected future cash flows), andcompared the unallocated fair value of the business to the carrying value ofgoodwill. To the extent goodwill exceeded the unallocated fair value of thebusiness, an impairment expense was recognized.

 

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InDecember 2002, we revised our estimate of the loss we expect to incur onsubleased facilities and recorded a restructuring expense of $1.5 million. Realestate market conditions deteriorated in the fourth quarter of 2002, causing usto reassess the length of time it would take to find tenants and the fair valuelease rate of our available space. As of September 30, 2003, our expected losson subleased facilities was based on estimated sublease income of approximately$1.0 million over the remaining lease terms. To the extent we are unable togenerate $1.0 million of sublease income, our future results of operations andfinancial condition will be negatively affected.

 

In March 2003, we reorganizedparts of the marketing and product engineering activities of the company intolines of business for personal computer (“PC”), consumer electronics (“CE”) andstorage products to enable us to better manage our long-term growthpotential.  The central engineering, sales,manufacturing, and general and administrative activities were not organizedinto the line of business structure.  Inconnection with this reorganization, we reduced our workforce by 27 people, orapproximately 10%.  These reductions were primarily in engineering andoperations functions.  Because of this workforce reduction, we recordedrestructuring expense of $1.0 million in the first quarter of 2003, consistingof cash severance-related costs of $340,000 and non-cash severance-relatedcosts of $646,000, representing the intrinsic value of modified stock options.

 

Severancerelated costs were determined based on the amount of pay people received thatwas not for services performed and by measuring the intrinsic value of stockoptions that were modified to the benefit of terminated employees. For thoseemployees terminated in the three month period ending March 31, 2003, theremaining service period from the communication date did not exceed 60 days.The expected loss on leased facilities resulted from our plan to consolidateour remaining workforce to the extent practicable and sublease any excessspace. To determine the expected loss, we compared our lease and operatingcosts for the space to our estimate of the net amount we would be able torecover by subleasing the space. This estimate was based on a number ofassumptions, including the length of time it will take to secure a tenant, thesublease rate per square foot, the cost of necessary improvements ormodifications and real estate broker commissions. The fixed asset write-downsin 2001 and 2002 were determined based on the estimated fair value of assets,primarily computer hardware and software that would no longer be utilized afterthe employees’ termination dates.

 

Severanceand benefits payments are substantially complete. Lease payments will be madein the form of cash through the end of the related lease term of November 2005.The following table presents restructuring activity for 2001 though September30, 2003 (in thousands):

 
|                             |   | **Severance  and Benefits** |   | **Leased  Facilities** |   | **Fixed Assets** |   | **Total** |   |
|----------------------------------|--------|-----------------------------|--------|------------------------|--------|------------------|--------|-----------|--------|
| 2001 provision                   |   | $                           | 902    |                   | $      | 500              |   | $         | 50     |   | $ | 1,452 |   |
| Cash payments                    |   | (191                        | )      | —                 |   | —           |   | (191      | )      |
| Non-cash activity                |   | (303                        | )      | (115                   | )      | —           |   | (418      | )      |
| Balance as of December 31, 2001  |   | 408                         |   | 385                    |   | 50               |   | 843       |   |
| 2002   provision            |   | 2,547                       |   | 2,633                  |   | 2,013            |   | 7,193     |   |
| Cash payments                    |   | (865                        | )      | (420                   | )      | —           |   | (1,285    | )      |
| Non-cash activity                |   | (1,952                      | )      | —                 |   | (2,063           | )      | (4,015    | )      |
| Balance as of December 31, 2002  |   | 138                         |   | 2,598                  |   | —           |   | 2,736     |   |
| 2003 provision                   |   | 986                         |   | —                 |   | —           |   | 986       |   |
| Cash payments                    |   | (434                        | )      | (551                   | )      | —           |   | (985      | )      |
| Non-cash activity                |   | (646                        | )      | —                 |   | —           |   | (646      | )      |
| Balance as of September 30, 2003 |   | $                           | 44     |                   | $      | 2,047            |   | $         | — |   | $ | 2,091 |   |

 

7.             Debt Facility

 

InOctober 2002, we entered into a $3.6 million term loan to refinance $3.1million of debt acquired in connection with our acquisition of CMD and $500,000of other bank debt. This loan bears interest at prime (4.0% at September 30,2003) plus 0.25% and requires monthly payments through its maturity of October1, 2004.  During the three months ended March 31, 2003, we borrowed$383,000 to finance certain capital equipment. This term loan bears interest at5% and requires monthly payments through its maturity in February 2005. As ofSeptember 30, 2003, $2,230,000 was outstanding under these term loans. Our debtfacilities contain certain quarterly and annual financial covenants with whichwe must comply. We were not in compliance with one of our quarterly covenantsregarding adjusted profitability, as defined in the loan agreement, at December31, 2002 and at September 30, 2003; however, we were granted a waiver from thelending institution and were not in default of the loan agreement. We haveclassified all amounts outstanding as current liabilities as of September 30,2003. In the fourth fiscal quarter of 2003, we fell out of compliance with thelending institution’s quarterly covenants regarding providing periodicfinancial statements and remain so at this time.  As a result, we may be required to repay the loan in full or ondemand.

 

8.             Legal Proceedings

 

On April 24, 2001, we filed suit in the U.S. District Court for theEastern District of Virginia against Genesis Microchip Corp. and GenesisMicrochip, Inc. (collectively, “Genesis”) for infringement of our U.S. patentnumber 5,905,769 (USDC E.D. 

 

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Virginia Civil Action No.:CA-01-266-R) (the “Federal Suit”). On April 24, 2001, we also filed a complaintagainst Genesis with the International Trade Commission of the United Statesgovernment (“ITC”) for unlawful trade practices related to the importation of articlesinfringing our patent (the “ITC investigation”). The actions sought injunctionsto halt the importation, sale, manufacture and use of Genesis DVI receiverchips that infringe our patent, and monetary damages. We voluntarily moved todismiss the ITC investigation, with notice that we would proceed directly inthe Federal Suit. Our motion to dismiss was granted on February 7, 2002. Wefiled an amended complaint in the Federal Suit as of February 28, 2002, addinga claim for infringement of our U.S. patent number 5,974,464. In April 2002,Genesis answered and made counterclaims against us for non-infringement,license, patent invalidity, fraud, antitrust, unfair competition and patentmisuse. Also in April 2002, we filed a motion to dismiss certain of Genesis’counterclaims. In addition, we filed a motion to bifurcate trial of thecounterclaims to the extent the court does not dismiss them. In May 2002, theCourt granted our motion to dismiss certain of the counterclaims, with leave toamend. Genesis re-filed counterclaims against us for fraud and patent misuse.We filed another motion to dismiss these counterclaims. In December 2002, theparties entered into a memorandum of understanding (MOU) to settle the case. InJanuary, the parties presented different interpretations of the MOU to theCourt.  On July 15, 2003, the Courtgranted our motion to interpret the MOU in the manner we requested, and ruled thatGenesis had engaged in efforts to avoid its obligations under the MOU. OnAugust 6, 2003, the Court entered a final judgment based on its July 15, 2003ruling.  Under the final judgment order,Genesis was ordered to make a substantial cash payment, and to make royaltypayments; although Genesis has made a cash payment to the Court, it has notmade all the payments that are required under the final judgment order. We havefiled motions for reimbursement of some of our expenses, including some of ourlegal fees, and for modification and/or clarification of certain items of thejudgment, and to hold Genesis in contempt of Court for breaching the protectiveorder in the case by disclosing secret information to at least one of ourcompetitors. On December 19, 2003, the Court granted our motions in part anddenied them in part: the court issued an amended judgment, and held Genesis incontempt of Court for breaching the protective order. On January 16, 2004,Genesis filed a notice of appeal.  Todate, we have not recognized any income or revenue associated with this matter.  Due to the continuing and contentious natureof this litigation, we will not record any income or revenue related to thismatter until the litigation is complete and all other income and revenuerecognition criteria have been satisfied. Management intends to prosecute ourposition vigorously until this matter is resolved. Through September 30, 2003,we have spent approximately $10.2 million on this matter and expect to continueto incur significant costs through at least the fourth quarter of 2004.

 

SiliconImage, certain officers and directors, and Silicon Image’s underwriters havebeen named as defendants in a securities class action lawsuit captionedGonzales v. Silicon Image, et al., No. 01 CV 10903 (SDNY 2001) pending inFederal District Court for the Southern District of New York. The lawsuitalleges that all defendants were part of a scheme to manipulate the price ofSilicon Image’s stock in the aftermarket following Silicon Image’s initialpublic offering in October 1999. Response to the complaint and discovery inthis action on behalf of Silicon Image and individual defendants has beenstayed by order of the court. The lawsuit is proceeding as part of acoordinated action of over 300 such cases brought by plaintiffs in the SouthernDistrict of New York. Pursuant to a tolling agreement, individual defendantshave been dropped from the suit for the time being. In February 2003, the Courtdenied the underwriters’ motion to dismiss and ordered that the case mayproceed against issuers including against Silicon Image. A proposed settlementhas been negotiated that has yet to be reviewed and approved by the Court.  In the event that the settlement isapproved, we do not expect it to have a material effect on our results ofoperations or financial position.  Inthe event that the settlement is not approved, we could not accurately predictthe outcome the litigation, but we intend to defend this matter vigorously.

 

SiliconImage, certain officers and directors, and Silicon Image’s underwriters havebeen named as defendants in a securities class action lawsuit captioned Liu v.Credit Suisse First Boston Corp., et al., No. 03-20459 (S.D. Fla. 2003) pendingin Federal District Court for the Southern District of Florida. Plaintiff filedan action on behalf of a putative class of shareholders who purchased stockfrom some or all of approximately 50 issuers whose public offerings wereunderwritten by Credit Suisse First Boston. The lawsuit alleges that SiliconImage and certain officers were part of a scheme by Credit Suisse First Bostonto artificially inflate the price of Silicon Image’s stock through thedissemination of allegedly false analysts’ reports. Silicon Image has not beenserved with a copy of the complaint. The plaintiff in this matter has filed anamended complaint in which Silicon Image, and the named officers, were droppedas defendants.  We believe that theproposed settlement described above, if approved, would encompass the claims inthis case. We believe that these claims were without merit and, if revived, andnot subject to the settlement, we would defend this matter vigorously.

 

Certain officers and directors of Silicon Image have been named asdefendants in consolidated shareholder derivative litigation, captioned “In reSilicon Image, Inc. Derivative Litigation, No. 1:03CV010302”, commenced onDecember 4, 2003 and pending in the Superior Court of California, County ofSanta Clara.  Plaintiffs purport to suethe individual defendants on behalf of Silicon Image.  The lawsuit alleges that as a result of the recently completedexamination conducted by the Audit Committee of Silicon Image’s Board ofDirectors, Silicon Image will be required to restate its financial results for2002 and 2003.  The lawsuit furtheralleges that such a restatement would be due to breaches by the individualdefendants of their fiduciary duties to Silicon Image; that certain of theindividual defendants are liable to Silicon Image for insider trading underCalifornia law; and that the individual defendants are liable to Silicon Imagefor mismanagement, abuse of control, and waste.  Before filing suit, plaintiffs did not make a demand upon theboard of directors to pursue any such claims directly on behalf of SiliconImage.  With the announcement by theAudit Committee of Silicon Image’s Board of Directors that it has completed itsexamination and that it has concluded that no changes to Silicon Image’spreviously announced financial results are required, the lawsuit may be moot inwhole or in part, although plaintiffs may amend the complaint once as a matterof right.  The individual defendantsbelieve the lawsuit is without merit, and they intend to 

 

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defend the action vigorously ifplaintiffs do not amend it.  We cannotpredict what claims plaintiffs might assert in an amended complaint.

 

Silicon Image and certain of its officers have been named as defendantsin consolidated securities class action litigation captioned “In re SiliconImage, Inc. Securities Litigation, No. C-03-5579 JW PVT”, commenced on December11, 2003 and pending in the United States District Court for the NorthernDistrict of California.  Plaintiffsfiled the action on behalf of a putative class of shareholders who purchasedSilicon Image stock between April 15, 2002 and November 15, 2003.  The lawsuit alleges that Silicon Image hadmaterially overstated its licensing revenue, net income and financial resultsduring this time period, and that Silicon Image was being forced to restate itsfinancial results.  With theannouncement by the Audit Committee of Silicon Image’s Board of Directors thatit has completed its examination and that it has concluded that no changes toSilicon Image’s previously announced financial results are required, thelawsuit may be moot in whole or in part, although plaintiffs may amend thecomplaint once as a matter of right.  Webelieve the lawsuit is without merit, and intend to defend the actionvigorously if plaintiffs do not amend it. We cannot predict what claims plaintiffs might assert in an amendedcomplaint.

 

Inaddition, we have been named as defendants in a number of judicial andadministrative proceedings incidental to our business and may be named againfrom time to time. We intend to defend such matters vigorously, and althoughadverse decisions or settlements may occur in one or more of such cases, thefinal resolution of these matters, individually or in the aggregate, is notexpected to have a material adverse effect on our results of operations orfinancial position.

 

9.             Customer and Geographic Information

 

Revenue by geographic areawas as follows (in thousands):

 
|          |   | **Three Months Ended September 30** |   | **Nine Months Ended September 30** |   |
|---------------|--------|-------------------------------------|--------|------------------------------------|--------|
|          |   | **2003**                            |   | **2002**                           |   | **2003** |   | **2002** |   |
|          |   |                                |   |                               |   |   |   |   |   |
| Taiwan        |   | $                                   | 6,926  |                               | $      | 6,944 |   | $ | 25,362 |   | $ | 19,583 |   |
| Japan         |   | 3,772                               |   | 2,881                              |   | 9,395 |   | 7,244 |   |
| United States |   | 7,419                               |   | 6,083                              |   | 20,760 |   | 16,264 |   |
| Hong Kong     |   | 1,538                               |   | 3,094                              |   | 4,516 |   | 6,708 |   |
| Korea         |   | 1,624                               |   | 1,575                              |   | 3,748 |   | 4,175 |   |
| Other         |   | 2,911                               |   | 808                                |   | 9,417 |   | 3,770 |   |
|          |   | $                                   | 24,190 |                               | $      | 21,385 |   | $ | 73,198 |   | $ | 57,744 |   |

 

For each period presented,substantially all long-lived assets were located within the United States.

 

Revenue by product line wasas follows (in thousands):

 
|                                 |   | **Three Months Ended  September 30** |   | **Nine Months Ended  September 30** |   |
|--------------------------------------|--------|--------------------------------------|--------|-------------------------------------|--------|
|                                 |   | **2003**                             |   | **2002**                            |   | **2003** |   | **2002** |   |
|                                 |   |                                 |   |                                |   |   |   |   |   |
| PC                                   |   | $                                    | 8,270  |                                | $      | 13,274 |   | $ | 24,416 |   | $ | 36,778 |   |
| Consumer Electronics                 |   | 7,628                                |   | 2,583                               |   | 15,942 |   | 6,089 |   |
| Storage IC                           |   | 6,250                                |   | 2,461                               |   | 19,634 |   | 7,042 |   |
| Storage Systems                      |   | 299                                  |   | 1,537                               |   | 1,922 |   | 4,773 |   |
| Development, licensing and royalties |   | 1,743                                |   | 1,530                               |   | 11,284 |   | 3,062 |   |
|                                 |   | $                                    | 24,190 |                                | $      | 21,385 |   | $ | 73,198 |   | $ | 57,744 |   |

 

Forthe three months ended September 30, 2003, two customers each generated 15% and11% of our revenue. For the nine months ended September 30, 2003, one customergenerated 14% of our revenue and, as of September 30, 2003, one customerrepresented 18% of gross accounts receivable.

 

Forthe three months ended September 30, 2002, one customer generated 15% of ourrevenue. For the nine months ended September 30, 2002, two customers eachgenerated 14% and 12% of our revenue.

 

10.           Guarantees

 

Certainof our licensing agreements indemnify our customers for expenses or liabilitiesresulting from claimed infringements of patent, trademark or copyright by thirdparties related to the intellectual property content of our products. Certainof these indemnification provisions are perpetual from execution of theagreement and, in some instances, the maximum amount of potential

 

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futureindemnification is not limited. To date, we have not paid any such claims orbeen required to defend any lawsuits with respect to a claim. However, therecan be no assurance that such claims will not be filed in the future.

 

11.           Acquisition

 

Transwarp Networks, Inc:

 

InApril 2003, we acquired TransWarp Networks, Inc. (“TWN”), a development stageenterprise. Through this transaction, we acquired certain intellectual propertyand engineering expertise to enable us to broaden our storage product offeringsand to develop more advanced storage products. TWN was acquired by means of amerger, pursuant to which all outstanding shares of TWN’s capital stock wereexchanged for shares of Silicon Image’s common stock. In addition, alloutstanding options to purchase TWN common stock were converted into options topurchase Silicon Image’s common stock. In accordance with EITF Issue No. 98-3,“Determining Whether a Nonmonetary Transaction Involves Receipt of ProductiveAssets or of a Business”, this transaction was accounted for as a purchase ofassets.

 

Thetotal purchase price was approximately $14.5 million, consisting of theissuance of approximately 2.5 million shares of Silicon Image common stock,valued at $11.4 million, 0.8 million shares of Silicon Image common stockissuable upon exercise of options, valued at $3.0 million, and transactioncosts of $0.1 million. The purchase price was allocated as follows (inthousands):

 
| Assembled workforce                 |   | $      | 502    |   |
|-------------------------------------|--------|--------|--------|--------|
|                                |   |   |   |
| Core technology                     |   | 1,251  |   |
|                                |   |   |   |
| Developed technology                |   | 529    |   |
|                                |   |   |   |
| In-process research and development |   | 5,482  |   |
|                                |   |   |   |
| Non-compete agreement               |   | 1,849  |   |
|                                |   |   |   |
| Net tangible assets acquired        |   | 93     |   |
|                                |   |   |   |
| Unearned compensation               |   | 4,819  |   |
|                                |   |   |   |
| Total                               |   | $      | 14,525 |   |

 

Thetotal purchase price was revised from $14.7 million to $14.5 million during thequarter ended September 30, 2003,  toreflect actual expenses relating to legal fees incurred in connection with theacquisition of TWN.

 

Theassembled workforce will be amortized over 18 months. Developed technology andthe non-compete agreement will be amortized over a period of three years (thelength of the non-compete agreement), and core technology will be amortizedover a period of four years. Unearned compensation will be amortized over theremaining employee vesting period, which ranges from 27 months to 57 months.

 

Thevalue allocated to in-process research and development (“IPR&D”) wascalculated using established valuation techniques accepted in the hightechnology industry. These techniques give consideration to relevant marketsizes and growth factors, expected industry trends, the anticipated nature andtiming of new product introductions by us and by our competitors, individualproduct sales cycles, and the estimated lives of each of the product’sunderlying technology. The value of IPR&D reflects the relative value andcontribution of the acquired research and development. In determining the valueassigned to IPR&D, we considered the R&D’s stage of completion, thecomplexity of the work completed to date, the difficulty of completing theremaining development, costs already incurred, and the projected cost tocomplete the project. As of the acquisition date, there was one identifieddevelopment project that met the necessary criteria – “Polaris.”  The value of this project was determined byestimating the future cash flows from the time it was expected to becommercially feasible, discounting the net cash flows to present value, andapplying a percentage of completion to the calculated values. The net cashflows from the identified project were based on estimates of revenue, cost ofrevenue, research and development expenses, selling, general and administrativeexpenses, and applicable income taxes. Revenue for Polaris is expected tocommence in 2004 and extend through 2007. A discount rate of 30% was used to determinethe net present value of estimated cash flows for this project. The percentageof completion for this project was based on research and development expensesincurred immediately prior to the acquisition as a percentage of the totalestimated research and development expenses required to bring this project totechnological feasibility. As of the date of the acquisition, we estimated thatPolaris was 17% complete, with total projected costs of approximately$3,250,000.

 

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Thevalues assigned to core technology and developed technology were based upondiscounted cash flows related to the existing product’s projected incomestream. Elements of the projected income stream includes revenue, cost ofsales, SG&A expenses and R&D expenses. The discount rates used in thepresent value calculations range from 20% to 25% and were generally derivedfrom a weighted average cost of capital, adjusted upward to reflect theadditional risks inherent in the development life cycle.  Such risks include the useful life of thetechnology, profitability levels of the technology, and the uncertainty of thetechnology advances that are known at the date of the acquisition.

 

Assembledworkforce was valued based on the estimated costs to replace the existingstaff, including recruiting, hiring and training costs for employees in allcategories, and to fully deploy a work force of similar size and skill to thesame level of productivity as the existing work force.

 

The value of the non-compete agreement was based on the incomeapproach, which measures the difference between cash flows generated assumingthe existence of the non-compete agreement (assuming no competition exists forthe individuals covered by the non-compete) and the cash flows assumingcompetition. The resulting net cash flows were discounted using a discount rateof 25%.

 

12.           IntangibleAssets, net

 

Componentsof intangible assets are as follows (in thousands):

 
|                                           |   | **September 30, 2003**        |   | **December 31, 2002**          |   |
|------------------------------------------------|--------|-------------------------------|--------|--------------------------------|--------|
|                                           |   | **Gross   Carrying   Amount** |   | **Accumulated   Amortization** |   | **Gross   Carrying   Amount** |   | **Accumulated   Amortization** |   |
|                                           |   |                          |   |                           |   |   |   |   |   |
| Intangible assets subject to amortization:     |   |                          |   |                           |   |   |   |   |   |
| Acquired technology                            |   | $                             | 1,780  |                           | $      | (253 | ) | $ | 10,726 |   | $ | (10,726 | ) |
| Non-compete agreement                          |   | 1,849                         |   | (319                           | )      | — |   | — |   |
| Assembled workforce                            |   | 502                           |   | (174                           | )      | — |   | — |   |
| Patents and other                              |   | —                        |   |                           |   | 2,599 |   | (2,599 | ) |
|                                           |   | $                             | 4,131  |                           | $      | (746 | ) | $ | 13,325 |   | $ | (13,325 | ) |
| Intangible assets not subject to amortization: |   |                          |   |                           |   |   |   |   |   |
| Goodwill                                       |   | $                             | 13,021 |                           | $      | — |   | $ | 13,021 |   | $ | — |   |

 

 

Estimatedfuture amortization expense for our intangible assets is as follows for fiscalyears ending December 31 (in thousands):

 
| 2003   |   | $     | 355    |   |
|--------|--------|-------|--------|--------|
| 2004   |   | 1,346 |   |
| 2005   |   | 1,098 |   |
| 2006   |   | 508   |   |
| 2007   |   | 78    |   |
|   |   | $     | 3,385  |   |

 

As of September 30, 2003, we reduced accruedliabilities and the amount of intangible assets subject to amortization byapproximately $147,000 to reflect actual expenses incurred in connection withthe acquisition of Transwarp Networks, Inc. This amount was allocated toindividual balances based on their relative values. We will perform animpairment review related to goodwill during the quarter ending December 31,2003.

 

13.           Escrow Settelment

 

On August 7, 2002, we filed a demand for arbitration with the AmericanArbitration Association, file #74 Y 117 01399 02 GAP, against the principalshareholders of CMD Technology (“CMD”) relating to shares held in escrow inconnection with our acquisition of CMD. Pursuant to agreements by which weacquired CMD, a portion of the Silicon Image common stock issued to theprincipal stockholders of CMD was held in two separate escrow pools ascollateral for the indemnification obligations of these shareholders. Wepreviously made indemnification claims against these escrow pools for therelease of escrow shares with a value of approximately $5.4 million, whichclaims were contested by the principal shareholders of CMD. On February 28,2003, we and the principal shareholders of CMD entered into a settlementagreement and mutual release, pursuant to which our indemnification claims wereresolved. As a result of the settlement, we received 949,780 of the escrowedshares, valued at approximately $4.7 million, and recorded a net non-operatinggain of $4.6 million in the first quarter of 2003.

 

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**Item2.  Management’s Discussion and Analysis of Financial Condition andResults of Operations**

 

*This report contains forward-looking statements withinthe meaning of Section 21E of the Securities and Exchange Act of 1934 and Section27A of the Securities Act of 1933. These forward-looking statements involve anumber of risks and uncertainties, including those identified in the section ofthis Form 10-Q entitled “Factors Affecting Future Results,” that may causeactual results to differ materially from those discussed in, or implied by,such forward-looking statements. Forward-looking statements within this Form10-Q are identified by words such as “believes,” “anticipates,” “expects,”“intends,” “may,” “will” and other similar expressions. However, these wordsare not the only means of identifying such statements. In addition, anystatements that refer to expectations, projections or other characterizationsof future events or circumstances are forward-looking statements. We undertakeno obligation to publicly release the results of any revisions to theseforward-looking statements that may be made to reflect events or circumstancesoccurring subsequent to the filing of this Form 10-Q with the SEC. Our actualresults could differ materially from those anticipated in, or implied by,forward-looking statements as a result of various factors, including the risksoutlined elsewhere in this report. Readers are urged to carefully review andconsider the various disclosures made by Silicon Image, Inc. in this report andin our other reports filed with the SEC that attempt to advise interestedparties of the risks and factors that may affect our business.*

 

**Audit Committee Examination**

 

As previously disclosed, the Company announced that it would delay thefiling of its quarterly report on Form 10-Q for the quarter endedSeptember 30, 2003 because anexamination had been commenced by its Audit Committee.  The Company’s Audit Committee, with the assistance of independent outsidecounsel and independent outside consultants, was examining certain matters,principally the Company’s recognition of revenue associated with its licensingtransactions****in2002 and 2003.

 

In February 2004, the Company’s Audit Committee completed itsexamination. During the course of the examination, the Audit Committee and itsoutside advisors conducted a thorough review of the Company’s licensingtransactions in 2002 and 2003, as well as a review of certain othermatters.  As a result of itsexamination, the Audit Committee concluded that no changes were required to theresults previously announced for the quarter ending September 30, 2003, or anyprior reporting period.  In its review,the Audit Committee concluded that there were no accounting irregularities andthat no member of the Company’s management engaged in misconduct in connectionwith the matters under examination.

 

During the course of its examination, the Audit Committee identifiedcertain areas in which the Company’s control environment should beimproved.  As a result, the Company,under the direction of the Audit Committee and the Board of Directors, istaking steps to strengthen the Company’s controls.  In connection with these steps, the Company is in the process ofrestructuring reporting relationships as they relate to licensing revenue;adopting a policy requiring additional documentation of items necessary forlicensing revenue recognition decisions; increasing the standardization oflicensing deliverables and post-contract customer support for revenue recognitionpurposes; and formalizing its licensing deal review process.  The Company only began to report revenuesfrom licensing transactions in 2002. The enhancements to the Company’s controls are in part designed to helpthe Company adapt to the growing complexity and importance of this additionalcomponent of its business strategy.

 

The Company is also in the process of adopting internal proceduresdesigned to enhance the Company’s overall internal control environment and toincrease the level of communication within the management team and between themanagement team and the Board of Directors, including the Audit Committee.  The Company expects to receive and consideradditional recommendations designed to enhance its overall internal controlenvironment.  The Company believes thatthe steps it is taking and its continued monitoring and improvement of itsinternal controls are and will remain sufficient to ensure continued compliancewith law.

 

**Overview**

 

Silicon Image designs, develops and markets semiconductor products forapplications that require high-bandwidth, cost-effective solutions forhigh-speed digital data communications. The markets into which we sell ourproducts are personal computer (“PC”), consumer electronics (“CE”) and storage.

 

Products sold into the PC market have been declining as a percentage ofour total revenues and generated 33% of our revenue in the first nine months of2003, 58% of our revenue in 2002, and 64% of our revenue in the first ninemonths of 2002.

 

Our PC products are based on PanelLink technology, which is ourproprietary implementation of the Digital Visual Interface (“DVI”) specification that defines ahigh-speed serial data communication link between computers and digitaldisplays. The display portion of the PC market remains predominantly analog ordual-interface, which is capable of receiving either an analog or digitalsignal. We do not offer an analog or dual-interface solution, but do partnerwith other companies to sell multiple-chip solutions into the dual-interfacemarket. These multiple-chip solutions are typically limited to higher end,larger displays operating at resolutions of SXGA and above. In addition, wehave licensed certain of our technologies to companies for use in makingproducts for the dual-interface market. We believe that the display portion ofthe PC market will eventually transition to a pure digital solution, whichshould result in an expansion of the market suited to our product offering.

 

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Products sold into the CE market have been increasing as a percentageof our total revenues and generated 22% of our revenue in the first nine monthsof 2003, 11% of our revenue in 2002, and 11% of our revenue in the first ninemonths of 2002. Our CE products offer a secure digital video and audiotransmission for consumer devices, such as digital TVs and DVD players. Demandfor these products will be driven primarily by the adoption rate of newtechnologies, such as DVI with High-Bandwidth Digital Content Protection (“HDCP”), and industry standards, such asHigh-Definition Multimedia Interface (“HDMI”).

 

Semiconductor products sold into the storage market have beenincreasing as a percentage of our total revenues and generated 27% of ourrevenue in the first nine months of 2003, 15% of our revenue in 2002, and 12%of our revenue in the first nine months of 2002. Demand for our storagesemiconductor products is dependent upon the rate at which interface technologytransitions from parallel to serial, and the extent to which serial ATA andfibre channel functionality are integrated into chip sets and controllersoffered by other companies, which would make our discrete devices unnecessary.

 

Sales of storage subsystems products generated 3% of our revenue in thefirst nine months of 2003, 8% of our revenue in 2002, and 8% of our revenue inthe first nine months of 2002. We are phasing out our subsystems products anddo not plan on developing, manufacturing and selling new subsystems products inthe future. Therefore, we expect sales of such products to represent less than2% of our revenue in 2003. In conjunction with our decision to phase out ourstorage systems products, we decided to design products for and/or license ourtechnology to third parties in this market.

 

We also derive revenue from licensing our intellectual property.License revenue is recognized when an agreement with a licensee exists, theprice is fixed or determinable, delivery or performance has occurred, andcollection is reasonably assured. Generally, we expect to meet these criteriaand recognize revenue at the time we deliver the agreed-upon items. However, wemay defer recognition of revenue until cash is received if collection is notreasonably assured at the time of delivery, and we may enter into agreementsrequiring customer acceptance of deliverables, in which case we would deferrecognition of revenue until the licensee has accepted the deliverables.Certain licensing agreements provide for royalty payments based on agreed uponroyalty rates. Such rates can be fixed or variable depending on the terms ofthe agreement. The amount of revenue we recognize is determined based on theagreed-upon royalty rate, extended by the number of units shipped by thecustomer. To determine the number of units shipped, we rely upon actual royaltyreports from our customers when available and rely upon estimates in lieu ofactual royalty reports when we have a sufficient history base of receivingroyalties from a specific customer for us to make an estimate based onavailable information from the licensee such as quantities held, manufacturedand other information. These estimates for royalties necessarily involve theapplication of management judgment.  Asa result of our use of estimates, period-to-period numbers are “trued” up inthe following period to reflect actual units shipped. To date, such “true up”adjustments have not been significant. In cases where royalty reports and otherinformation are not available to allow us to estimate royalty revenue, werecognize revenue only when royalty payments are received.

 

Our licensing activity is complementary to our product sales because webelieve this activity can help accelerate adoption curves associated with ourtechnology. Revenue from development, licensing and royalties accounted for 15%and 5% of our revenue for the nine months ended September 30, 2003 and 2002,respectively. We expect licensing and royalties to account for approximately10% to 15% of our revenue for the foreseeable future. Licensing contracts arecomplex and depend upon many factors including completion of milestones,allocation of values to delivered items, and customer acceptances.  Although we attempt to make these factorspredictable, many of these factors require significant judgments.  Licensing revenues could fluctuatesignificantly from period to period and because of their high margin contentthey can have a disproportionate impact on gross margins and profitability.

 

In October 1999, we raised approximately $48 million in our initialpublic offering. We have incurred losses in all but one quarterly period sinceour inception and, as of September 30, 2003, we had an accumulated deficit of$167 million.

 

Prior to 2000 we focused most of our efforts on the sale anddevelopment of PanelLink transmitters, receivers and controllers for thePC/Display market.  In 2000, we beganfocusing our resources on entering two new markets, storage and consumerelectronics (CE) , which we believed would grow significantly and in which webelieved we could apply our technology and expertise in high-speed serialinterfaces. During 2000, we acquired Zillion, a developer of high-speedtransmission technology for data storage applications, and DVDO, a provider ofdigital video processing systems for the CE market.

 

In 2001, we focused on accelerating our entry into the CE and storagemarkets, leveraging our IP into licensing revenue and restructuring the companyto improve profitability. During 2001, we acquired CMD, a provider of storagesubsystems and semiconductors designed for storage area networks, and SCL, aprovider of mixed-signal and high-speed circuit designs.

 

During 2002, we achieved double-digit revenue growth in each fiscalquarter, resulting in record annual revenue of $81.5 million, which was a 57%increase from 2001 revenue levels. We also began to see the benefits of ourdiversification strategy, which resulted in establishing a presence in the CEand storage markets, both of which are expected to experience strong growthrates during the next several years. Additionally, we were able to successfullyleverage our intellectual property to generate $6.7 million of development andlicensing revenue.  We also focused on improving our profitability andreducing our cash usage rate.

 

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A large portion of the company’s sucess is dependent upon the adoptionof emerging technologies inherent in its product offerings.  During the first nine months of 2003 thecompany’s revemue growth rate slowed as we experienced delays in the adoptionof the SATA technology and a loss of market share in PC/Display relatedproducts that migrated either to integrated solutions or to competitivealternatives. The CE business continued to exhibit strong revenue growth duringthis period as the implementation of DVI based solutions combined with HDMIadoption in the CE market exceeded expectations. We continue to focus onrevenue growth opportunities and improving profitability.

 

On April 7, 2003, we issued approximately 2,501,000 shares of commonstock in exchange for all outstanding shares of TransWarp Networks (“TWN”) capital stock, and converted alloutstanding TWN options into options to purchase approximately 760,000 sharesof our common stock.  The purchase price for this acquisition wasapproximately $14.5 million.  Approximately 392,000 shares of our issuedcommon stock will be held in escrow for a period of eighteen months ascollateral for indemnity obligations of the principal TWN stockholders.   We also assumed TWN’s 2002 StockOption / Stock Issuance Plan, under which a reserve of approximately 116,000shares of our common stock remained available for future issuance. Thistransaction has been accounted for as an asset purchase. We expensed $5.5 millionof in-process research and development and recorded tangible and intangibleassets of $4.3 million in connection with this transaction.

 

On July 15, 2003, the Federal District Court in Richmond, Virginia,upheld our interpretation of a previously agreed upon Memorandum ofUnderstanding (MOU) with Genesis. On August 6, 2003, the Court entered a finaljudgment based on its July 15, 2003 ruling. Under the final judgement order,Genesis was ordered to make a substantial cash payment, and make royaltypayments; althoughGenesis has made some cash payment to the Court, it has not made all thepayments that are required under the final judgment order. We have filedmotions for reimbursement of some of our expenses, including some of our legalfees, and for modification and/or clarification of certain items of thejudgment, and to hold Genesis in contempt of Court for breaching the protectiveorder in the case by disclosing secret information to at least one of ourcompetitors.  On December 19, 2003, theCourt granted our motions in part and denied them in part: the court issued anamended judgment, and held Genesis in contempt of Court for breaching theprotective order.  On January 16, 2004,Genesis filed a notice of appeal.  Todate we have not recognized any income or revenue associated with the matter.Under the settlement agreement, Genesis was granted a license for the right touse certain non-necessary patent claims referred to in the DVI AdoptersAgreement. In addition, upon Genesis’ becoming a signatory to the HDMI AdoptersAgreement, Genesis will be granted a license for the right to use these claimsas part of their HDMI implementation. Genesis also was granted a license toexpand use of certain DVI-related patent claims to the consumer electronicsmarketplace.

 

**Commitments, Contingencies and Concentrations**

 

Historically, a relatively small number of customers and distributorshave generated a significant portion of our revenue. For instance, our top fivecustomers, including distributors, generated 46% of our revenue in the thirdquarter of 2003, 44% of our revenue during the first three quarters of 2003,and 41% of our revenue in 2002.  Additionally, the percentage of revenuegenerated through distributors tends to be significant, since many OEM’s relyupon third party manufacturers or distributors to provide purchasing andinventory management functions. In the third quarter of 2003, 41% of ourrevenue was generated through distributors, compared to 42% in 2002.

 

A significant portion of our revenue is generated from products soldoverseas. Sales to customers in Asia, including distributors, generated 66% ofour revenue in the third quarter of 2003, compared to 67% of our revenue in thesecond quarter of 2003, and 64% of our revenue in 2002. The reason for our geographicalconcentration in Asia is that most of our products are part of flat paneldisplays, graphic cards and motherboards, the majority of which aremanufactured in Asia. The percentage of our revenue derived from any country isdependent upon where our end customers choose to manufacture their products.Accordingly, variability in our geographic revenue is not necessarilyindicative of any geographic trends, but rather is the combined effect of newdesign wins and changes in customer manufacturing locations. All revenue todate has been denominated in U.S. dollars.

 

In September 1998, we entered into an agreement with Intel to developand promote the adoption of a digital display interface specification. Inconnection with this agreement, we granted Intel a warrant to purchase 285,714shares of our common stock at $1.75 per share. Under the same agreement, wegranted Intel a warrant to purchase 285,714 shares of our common stock at $0.18per share upon achievement of a specified milestone that was reached during thefirst quarter of 1999. Both of these warrants were exercised in May 2001.Additionally, if a second specified milestone is achieved, which we do notbelieve is likely, we would be required to grant Intel a third warrant topurchase 285,714 shares of our common stock at $0.18 per share. The estimatedfair value of such a warrant at September 30, 2003 would be $1.2 million.

 

Ourlease and debt obligations as of September 30, 2003 are consistent with theinformation presented in our Form 10-K for the fiscal year ended December 31,2002.

 

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**Recent Accounting Pronouncements**

 

In January 2003, the Financial Accounting Standards Board (“FASB”)issued Interpretation Number (“FIN”) 46, “Consolidation of Variable InterestEntities.”  In general, a variable interest entity is a corporation,partnership, trust, or any other legal structure used for business purposesthat either (a) does not have equity investors with voting rights or (b) hasequity investors that do not provide sufficient financial resources for theentity to support its activities. FIN 46 requires certain variable interestentities to be consolidated by the primary beneficiary of the entity if theinvestors do not have the characteristics of a controlling financial interestor do not have sufficient equity at risk for the entity to finance itsactivities without additional subordinated financial support from otherparties.  The consolidation requirements of FIN 46 apply immediately to variableinterest entities created after January 31, 2003.  The consolidationrequirements apply to older entities as early as the first fiscal quarter of2004.  Certain of the disclosure requirements apply to all financialstatements issued after January 31, 2003, regardless of when the variableinterest entity was established.  The effective dates of certain elementsof FIN 46 have been deferred.   We do not believe that the adoptionof this standard will have a material impact on our consolidated financialstatements.

 

**Results of Operations for the Three and Nine MonthsEnded September 30, 2003, Compared to Results of Operations for the Threeand Nine Months Ended September 30, 2002**

 

*Revenue.   *Revenue was $24.2 million for the three monthsended September 30, 2003, compared to $21.4 million for the three monthsended September 30, 2002, an increase of 13%. Revenue was$73.2 million for the nine months ended September 30, 2003, comparedto $57.7 million for the nine months ended September 30, 2002, an increase of 27%.The $15.5 million increase in revenue during the nine month periods isprimarily due to increased licensing activity, which contributed an additional$8.2 million of revenue. Increased licensing activity contributed $0.2million of the $2.8 million increase in revenue for the three months endedSeptember 30, 2003. The company licenses its technology in each of its threeareas of business but usually limits the scope of the license to market areasthat are complementary to our product sales and that do not directly competewith our direct product offerings. The remainder of the increase is primarilyattributable to our new product offerings in consumer electronics and storage,as well as overall growth in these markets. The effect of these increases was partiallyoffset by a decrease in demand for our PC products, which can be attributed toweak overall demand for PC’s and to a higher level of integration of ourtechnology by our customers, which eliminates the need for our discreteproducts, and decreased revenue from our storage subsystems products, whichresulted from our decision to phase out this product line.

 

*Cost of revenue.   *Cost of revenue consists primarily of costsincurred to manufacture, assemble, test and ship our products, as well as relatedoverhead costs and provisions for warranty obligations and excess and obsoleteinventories. Cost of revenue excludes non-cash stock compensation expense(benefit) of $(14,000) and $(144,000) for the three months ended September 30,2003 and 2002, respectively, and $(71,000) and $234,000 for the nine monthsended September 30, 2003 and 2002, respectively. Including stock compensationexpense, our cost of revenue and gross margin (revenue minus cost of revenue,as a percentage of revenue) would have been $11.5 million, or 52.5%, and $9.7million, or 54.9%, for the three month periods ended September 30, 2003 and2002, respectively, and $33.3 million, or 54.5% of revenue, and $27.6 million,or 52.2% of revenue, for the nine months ended September 30, 2003 and 2002,respectively. Excluding stock compensation expense, gross margin increased to54.4% for the nine month period ended September 30, 2003, from 52.6% for thesame period in 2002. This increase is attributable primarily to increasedlicensing revenue, which has no associated cost of sales, and, to a lesserextent, reduced sales of storage subsystems products which are lower marginproducts than our PC and CE products. These factors were offset by declines inaverage selling prices (“ASP’s”),first half of the year yield and quality issues related to certain newproducts, and increased sales of storage IC products, which have lower marginsthan PC and CE products.  Gross marginexcluding licensing and non-cash stock compensation was $10.9 million, or 45% ofrevenue for the three months ended September 30, 2003, and $28.6 million, or39% for the nine months ended September 30, 2003.  The comparable 2002 numbers are $10.1 million, or 47% of revenuefor the the three months ended September 30, 2002, and $27.3 million, or and47% of revenue for the three months ended September 30, 2002.

 

*Research and development (“R&D*”)*.   *R&D consists primarily of compensation andrelated costs for employees, fees for independent contractors and developmenttools and materials. R&D expense was $9.1 million, or 37.4% ofrevenue, and $8.6 million, or 40.1% of revenue, for the three months endedSeptember 30, 2003 and 2002, respectively. R&D expense was$27.3 million, or 37.2% of revenue, and $24.2 million, or 41.8% ofrevenue, for the nine months ended September 30, 2003 and 2002,respectively.  The increase inabsolute dollars in both periods was primarily due to an increase in the numberof R&D projects to support the multiple markets in which we operate, aswell as additional personnel, including personnel from Transwarp Networks.R&D excludes non-cash stock compensation expense of $1.0 million and$687,000 for the three months ended September 30, 2003 and 2002,respectively. Including stock compensation expense, R&D would have been$10.1 million and $9.3 million, or 41.7% and 43.3% of revenue, forthe three months ended September 30, 2003 and 2002, respectively. R&Dexpense excludes $3.0 million and $5.7 million of non-cash stockcompensation expense for the nine months ended September 30, 2003 and2002, respectively. Including stock compensation expense, R&D expense wouldhave been $30.3 million and $29.9 million, or 41.3% and 51.7% ofrevenue, for the nine months ended September 30, 2003 and 2002, respectively.

 

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*Selling, general and administrative.*   SG&A consists primarilyof employee compensation and benefits, sales commissions, and marketing andpromotional expenses. SG&A expense was $4.1 million, or 17.1% ofrevenue, and $4.0 million, or 18.6% of revenue, for the three months endedSeptember 30, 2003 and 2002, respectively. SG&A expense was$12.8 million, or 17.5% of revenue, and $13.5 million, or 23.4% ofrevenue, for the nine months ended September 30, 2003 and 2002, respectively.The increase in absolute dollars for the three months ended September 30, 2003can be attributed to increased headcount that has been added to support thecompany’s growth. The decrease in absolute dollars for the nine months endedSeptember 30, 2003 was primarily due to a decrease in headcount as headcountwas reduced throughout 2002 to eliminate duplicate positions and to align ourcost structure with expected revenue levels. SG&A excludes non-cash stockcompensation expense (benefit) of $94,000 and $(342,000) for the three monthsended September 30, 2003 and 2002, respectively. Including stockcompensation expense, SG&A expense would have been $4.2 million and$3.6 million, or 17.5% and 17.0% of revenue, for the three months endedSeptember 30, 2003 and 2002, respectively. SG&A excludes non-cashstock compensation expense of $74,000 and $1.6 million for the nine monthsended September 30, 2003 and 2002, respectively. Including stock compensationexpense, SG&A expense would have been $12.9 million and$15.1 million, or 17.6% and 26.2% of revenue, for the nine months endedSeptember 30, 2003 and 2002, respectively.

 

*Stock compensation expense (benefit).*   Stock compensation expensewas $1.1 million, or 4.6% of revenue, and $201,000, or 0.9% of revenue, for thethree months ended September 30, 2003 and 2002, respectively. Stockcompensation expense was $3.0 million, or 4.1% of revenue, and $7.6million, or 13.1% of revenue, for the nine months ended September 30, 2003and 2002, respectively. The increase in expense for the three month periods wasdue primarily to a higher stock price, which resulted in more expenseassociated with our repriced options. The decrease in expense for the ninemonth periods can be attributed primarily to our stock price being higher in2002 than it was in 2003 which generated expense associated with our stockoption repricings, as well as to a decrease in expense associated with optionsgranted to employees and options assumed in connection with acquisitions, ascertain options became fully expensed and did not generate as much expense in2003.

 

The following table summarizes the components of our stock compensationexpense (benefit) for the three and nine month periods ended September 30,2003 and 2002 (in thousands):

 
|                                            |   | **Three Months Ended September 30** |       | **Nine Months Ended September 30** |       |
|-------------------------------------------------|--------|-------------------------------------|------------|------------------------------------|------------|
|                                            |   | **2003**                            |       | **2002**                           |       | **2003** |   | **2002** |   |
|                                            |   |                                | ** ** |                               | ** ** |   | ** ** |   | ** ** |
| Options granted to employees                    |   | $                                   | 42         |                               | $          | 260 |   | $ | 322 |   | $ | 941 |   |
| Options granted to non-employees                |   | 389                                 |       | 795                                |       | 1,173 |   | 2,021 |   |
| Option repricings                               |   | (139                                | )          | (1,525                             | )          | (970 | ) | 1,236 |   |
| Options assumed in connection with acquisitions |   | 814                                 |       | 671                                |       | 2,472 |   | 3,388 |   |
| Stock compensation expense                      |   | $                                   | 1,106      |                               | $          | 201 |   | $ | 2,997 |   | $ | 7,586 |   |

 

Wewill incur substantial non-cash stock compensation expense in future periods asa result of (1) the issuance of, or modifications to, restricted stockawards and stock option grants to employees and non-employees, (2) therepricing programs we implemented in 2000 and 2001, and (3) amortizationof our existing unearned compensation balance. Since the expense associatedwith our option repricings and grants to non-employees is dependent on ourstock price, it will fluctuate from period to period and may increasesignificantly.

 

*Amortization of intangible assets.*   For the three months endedSeptember 30, 2003, we recorded $373,000 of expense for the amortizationof intangible assets recorded in connection with our acquisition of TWN’sassets. This compares to expense of $859,000 for the three months endedSeptember 30, 2002. For the nine months ended September 30, 2003 and2002, we recorded amortization expense of $746,000 and $2.6 million,respectively. The decrease for both periods is attributable to a lower amountof amortizable intangibles.

 

*Patent defense and acquisition integration costs.*   Patent defense andacquisition integration costs were $160,000 and  $2.0 million for the three and nine months endedSeptember 30, 2003, compared to $2.8 million and $4.2 million for thethree and nine months ended September 30, 2002. Patent defense costs werehigher during 2002 primarily as a result of a higher level of legal activityassociated with the patent infringement lawsuit we filed against GenesisMicrochip in April 2001. Acquisition integration costs represent costsincurred to integrate CMD and were not significant for any period presented.

 

*Restructuring.* During the first quarter of 2002, weimplemented a workforce reduction in connection with the program we began inthe third quarter of 2001, eliminating 35 positions or 13% of our workforce.Positions were eliminated from all functional areas – operations, R&D andSG&A. This reduction resulted from the continued integration of recentlyacquired companies, as well as continued execution of our product andtechnology strategy, whereby we decided to phase out the legacy storagesubsystem board products we acquired from CMD and to develop new board productsonly if we believed it would facilitate or accelerate the use of our storagesemiconductor products. In connection with this workforce reduction, werecorded restructuring expense in the first quarter of 2002 of $2.2 million,consisting of cash severance-related costs of $198,000, non-cashseverance-related costs of $318,000 representing the intrinsic value ofmodified stock options, an expected loss on leased facilities of $1.2 millionand fixed asset write-downs of $500,000 for assets to be disposed of. Inaddition, we reversed $76,000 of unearned compensation, a component of 

 

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stockholders’ equity, for unvested stockoptions that were cancelled in connection with employee terminations. Sincesome of the affected employees had termination dates in the second quarter of2002, we recorded additional expense at that time for the modification of theirstock options.

 

InApril 2002, we decided to transition to a licensing model for our storagesubsystem board products, whereby instead of developing, manufacturing andselling board products to facilitate or accelerate the use of our storagesemiconductor products, we develop and license board designs in exchange forlicense fees, royalties and the use of our semiconductor products. Inconnection with this decision, we implemented a third workforce reduction,eliminating 14 positions, or 5%, of our workforce and recorded a restructuringexpense of $3.5 million, consisting of cash severance-related costs of$450,000, non-cash severance-related costs of $1.6 million representing theintrinsic value of modified stock options and fixed asset write-downs of $1.5million. We also reversed $302,000 of unearned compensation, a component ofstockholders’ equity, for unvested stock options that were cancelled inconnection with employee terminations.

 

InMarch 2003, we reorganized parts of the marketing and product engineeringactivities of the company into lines of business for personal computer (“PC”),consumer electronics (“CE”) and storage products to enable us to better manageour long-term growth potential The central engineering, sales, manufacturing , andgeneral and administrative activities were not organized into the line ofbusiness structure.  Inconnection with this reorganization, we reduced our workforce by 27 people, orapproximately 10%.  These reductions were primarily in R&D andoperations functions.  Because of this workforce reduction, we recorded arestructuring expense of $1.0 million in the first quarter of 2003, consistingof cash severance-related costs of $340,000, and non-cash severance-relatedcosts of $646,000, representing the intrinsic value of modified stock options.

 

Severance-relatedcosts were determined based on the amount of pay people received that was notfor services performed and by measuring the intrinsic value of stock optionsthat were modified to the benefit of terminated employees.  The expectedloss on leased facilities resulted from our plan to consolidate our remainingworkforce to the extent practicable and sublease any excess space.  Todetermine the expected loss, we compared our lease and operating costs for thespace to our estimate of the net amount we would be able to recover bysubleasing the space.  This estimate was based on a number of assumptions,including the length of time it will take to secure a tenant, the sublease rateper square foot, the cost of necessary improvements or modifications, and realestate broker commissions.  The fixed asset write-downs in 2001 and 2002were determined based on the estimated fair value of assets, primarily computerhardware and software, that would no longer be utilized after the employees’termination date.

 

Severance and benefits payments are substantially complete. Leasepayments will be made in the form of cash through the end of the related leaseterm of November 2005. The following table presents restructuring activity for2001 though September 30, 2003 (in thousands):

 
|                             |   | **Severance   and Benefits** |   | **Leased   Facilities** |   | **Fixed Assets** |   | **Total** |   |
|----------------------------------|--------|------------------------------|--------|-------------------------|--------|------------------|--------|-----------|--------|
| 2001 provision                   |   | $                            | 902    |                    | $      | 500              |   | $         | 50     |   | $ | 1,452 |   |
| Cash payments                    |   | (191                         | )      | —                  |   | —           |   | (191      | )      |
| Non-cash activity                |   | (303                         | )      | (115                    | )      | —           |   | (418      | )      |
| Balance as of December 31, 2001  |   | 408                          |   | 385                     |   | 50               |   | 843       |   |
| 2002   provision            |   | 2,547                        |   | 2,633                   |   | 2,013            |   | 7,193     |   |
| Cash payments                    |   | (865                         | )      | (420                    | )      | —           |   | (1,285    | )      |
| Non-cash activity                |   | (1,952                       | )      | —                  |   | (2,063           | )      | (4,015    | )      |
| Balance as of December 31, 2002  |   | 138                          |   | 2,598                   |   | —           |   | 2,736     |   |
| 2003 provision                   |   | 986                          |   | —                  |   | —           |   | 986       |   |
| Cash payments                    |   | (434                         | )      | (551                    | )      | —           |   | (985      | )      |
| Non-cash activity                |   | (646                         | )      | —                  |   | —           |   | (646      | )      |
| Balance as of September 30, 2003 |   | $                            | 44     |                    | $      | 2,047            |   | $         | — |   | $ | 2,091 |   |

 

*Impairment of goodwill and intangible assets.*   In the second quarter of2002, we decided to transition to a licensing model for our storage subsystemboard products, whereby instead of developing, manufacturing and selling boardproducts to facilitate or accelerate the use of our storage semiconductorproducts, we develop and license board designs in exchange for license fees,royalties and the use of our semiconductor products. This decisionresulted in a decrease to our estimate of future cash flows from theseproducts, which in turn resulted in a $5.2 million impairment of goodwilland intangible assets acquired in connection with our acquisition of CMD.

 

*In-process research and development (IPR&D).*   During the quarter endedJune 30, 2003, we completed the acquisition of the assets of TWN and recorded aone-time expense of $5.5 million for in-process research and development.  As of the acquisition date, there was oneidentified development project that met the necessary criteria – “Polaris”. Thevalue of this project was determined by estimating the future cash flows fromthe time it was expected to be commercially feasible, discounting the net cashflows to present value, and applying a percentage of completion to thecalculated values. The net cash flows from the identified project were based onestimates of revenue, cost of revenue, research and development expenses,selling, general and administrative expenses, and 

 

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applicable income taxes. Revenue for Polarisis expected to commence in 2004 and extend through 2007. We based our revenueprojections on estimates of market size and growth, expected trends intechnology and the expected timing of new product introductions by ourcompetitors and us. The discount rate used for this project was 30%, which we believeis appropriate based on the risk associated with technology that is not yetcommercially feasible. The percentage of completion for this project was basedon research and development expenses incurred immediately prior to theacquisition as a percentage of the total estimated research and developmentexpenses required to bring this project to technological feasibility. As of thedate of the acquisition, we estimated that Polaris was 17% complete, with totalprojected costs of approximately $3,250,000.

 

Giventhe uncertainties of the commercialization process, we cannot assure you thatdeviations from our estimates will not occur. We believe there is a reasonablechance of realizing the economic return expected from the acquired in-processtechnology. However, there is a risk associated with the realization ofbenefits related to commercialization of an in-process project due to rapidlychanging customer needs, complexity of technology and growing competitivepressures. Therefore, we cannot assure you that any project will achievecommercial success. Failure to successfully commercialize an in-process projectwould result in the loss of the expected economic return inherent in the fairvalue allocation.

 

*Gain on escrow settlement, net. *During the quarter ended March 31, 2003, we recognized a net gain of$4.6 million associated with settlement of an escrow claim against the sellingshareholders of a company we acquired in 2001.

 

*Interest Income and other, net.*   Net interest income andother decreased to $40,000 for the three months ended September 30, 2003,from $164,000 for the three months ended September 30, 2002. Net interestincome and other decreased to $216,000 for the nine months endedSeptember 30, 2003, from $597,000 for the nine months ended September 30,2002. The decrease in both periods is primarily due to lower interest ratesand, to a lesser extent, a decrease in our cash and investment balances.

 

*Provision for income taxes.*   We did not record aprovision for income taxes in the three or nine months ended September 30,2003 or September 30, 2002, as we did not generate book or taxable incomeduring those periods.

 

At September 30, 2003, we had a net operating loss carryforwardfor federal income tax purposes of approximately $65.0 million thatexpires in various years through 2022. These future tax benefits have not beenrecognized as an asset on our balance sheet due to uncertainties surroundingour ability to generate sufficient taxable income in future periods to realizethe benefits. Under the Tax Reform Act of 1986, the amounts of, and benefitsfrom, net operating loss carryforwards may be restricted or limited in certaincircumstances. We do not expect to be subject to these restrictions orlimitations.

 

**Liquidity and Capital Resources**

 

AtSeptember 30, 2003, we had $31.5 million of working capital including$28.2 million of cash, cash equivalents and short-term investments.  The amount of cash, cash equivalents andshort-term investments decreased from $35.8 million at December 31, 2002.

 

Operatingactivities used $8.9 million of cash during the nine months ended September 30,2003, and $6.3 million of cash during the nine months endedSeptember 30, 2002.  During thenine months ended September 30, 2003, net income, excluding depreciation,stock compensation expense, amortization of intangible assets, non-cashrestructuring charges, non-cash gains on escrow settlement, and the non-cashcharge relating to in-process research and development, was $970,000. Increasesin accounts receivable, inventories, and decreases in accounts payable andaccrued liabilities, used $13.4 million of cash, which was partially offset by$3.4 million of cash provided by decreased prepaid expenses and other assetsand an increase in deferred margin on sales to distributors.  The increase in accounts receivable wasrelated to the concentration of billings in the latter part of the quarter,timing of licensing collections, and an increase in shipments to distributorsfor which revenue is deferred until sold through by the distributors.  During the nine months ended September 30,2002, net loss, excluding depreciation, stock compensation expense,amortization and impairment of intangible assets, and non-cash restructuringcharges, was $9.7 million, which accounts for most of the cash used inoperating activities during this period. Other uses of cash from operatingactivities during this period included increases of  $1.9 million in accounts receivable and $567,000 in inventories.These uses were offset by increases of $2.9 million, $997,000 and $879,000 inaccounts payable, accrued expenses and deferred margin, respectively.

 

Weused $6.4 million of cash for investing activities during the nine months endedSeptember 30, 2003, and generated $6.8 million of cash from investingactivities during the nine months ended September 30, 2002.  In 2003, the primary uses of cash were netpurchases of short-term investments of $2.4 million and capital expenditures of$4.0 million.  In 2002, the primarysource of cash was net proceeds from purchases and sales of short-terminvestments of $9.4 million, offset by capital expenditures of $2.6 million.

 

Financingactivities provided $5.2 million of cash during the nine months ended September30, 2003, and $5.3 million of cash during the nine months endedSeptember 30, 2002. Cash provided by financing activities in both periodswas primarily from stock option exercises and proceeds from sales of sharesunder our employee stock purchase plan, partially offset by repayments of ourcapital lease and other obligations.

 

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Our contractual obligations at September 30, 2003, and the effectsuch obligations are expected to have on our liquidity and cash flow in futureperiods, have not changed materially since December 31, 2002 as describedin our Form 10-K.

 

InOctober 2002, we entered into a $3.6 million term loan to refinance $3.1million of debt acquired in connection with our acquisition of CMD and $500,000of other bank debt. This loan bears interest at prime (4.0% at September 30,2003) plus 0.25% and requires monthly payments through its maturity of October1, 2004.  During the three months ended March 31, 2003, we borrowed$383,000 to finance certain capital equipment.  This term loan bears interestat 5% and requires monthly payments through its maturity in February2005. As of September 30, 2003, $2,230,000 was outstanding under theseterm loans.  We are currently innegotiations with interested parties for a line of credit and expect to enterinto a line of credit for up to $10 million in the near future.  For the next six months no borrowings arecontemplated for the new line of credit. Our debt facilities contain certainquarterly and annual financial covenants with which we must comply. We were notin compliance with one of our quarterly covenants regarding adjustedprofitability, as defined in the loan agreement, at December 31, 2002 and atSeptember 30, 2003; however, we were granted a waiver from the lendinginstitution and were not in default of the loan agreement. We have classifiedall amounts outstanding as current liabilities as of September 30, 2003.  In the fourth fiscal quarter of 2003, wefell out of compliance with the lending institution’s quarterly covenantsregarding providing periodic financial statements and remain so at this time.We expect to get a waiver from the lender subsequent to the filing of this Form10-Q.  If unsuccessful, we may berequired to repay the loan in full or on demand.

 

Basedon our expected cash usage, we believe our existing cash and short-terminvestment balance is sufficient to meet our capital and operating requirementsfor at least the next 12 months. Operating and capital requirements dependon many factors, including the levels at which we generate revenue and maintainmargins, inventory and accounts receivable, the cost of securing access toadequate manufacturing capacity and our operating expenses. To the extentexisting resources and cash from operations are insufficient to support our activities,we may need to raise additional funds through public or private equity or debtfinancing. These funds may not be available, or if available, we may not beable to obtain them on terms favorable to our stockholders or us.

 

**RISK FACTORS**

 

*You should carefully consider the following riskfactors, together with all other information contained or incorporated byreference in this prospectus, before you decide to purchase shares of ourcommon stock. These factors could cause our future results to differ materiallyfrom those expressed in or implied by forward-looking statements made by us.Additional risks and uncertainties not presently known to us or that wecurrently deem immaterial may also harm our business. The trading price of ourcommon stock could decline due to any of these risks, and you may lose all orpart of your investment.*

 

**We operate in rapidly evolving markets, which makes itdifficult to evaluate our future prospects.**

 

The revenue and income potential of our business and the markets we serveis unproven. The Digital Visual Interface (“DVI”) specification, which is basedon technology developed by us and used in many of our products, was firstpublished in April 1999. We completed our first generation of consumerelectronics and storage IC products in mid-to-late 2001. In addition, thepreliminary serial ATA specification was first published in August 2001and the High Definition Multimedia Interface (“HDMI”) specification was firstreleased in December 2002. Accordingly, we face risks and difficultiesfrequently encountered by companies in new and rapidly evolving markets. If wedo not successfully address these risks and difficulties, our results ofoperations could be negatively affected.

 

**We have a history of losses and may not become profitable.**

 

Wehave incurred net losses in each fiscal year since our inception, including netlosses of $40.1 million and $76.1 million for the years endedDecember 31, 2002 and 2001, respectively, and a net loss of $7.5 millionfor the nine months ended September 30, 2003. We expect to continue to incurnet losses for the foreseeable future. Accordingly, we may not achieve andsustain profitability.

 

**Our quarterly operating results may fluctuate significantlyand are difficult to predict.**

 

Ourquarterly operating results are likely to vary significantly in the futurebased on a number of factors over which we have little or no control. Thesefactors include, but are not limited to:

 

•      the growth, evolution and rate of adoption ofindustry standards for our key markets, including digital-ready PCs anddisplays, consumer electronics and storage devices;

 

•      the fact that our licensing revenue is heavilydependent on a few key deals being completed for any given period, the timingof which is not always predictable and is especially susceptible to delaybeyond the period in which completion is expected, and our concentrateddependence on a few licensees in any period for substantial portions of ourexpected licensing revenue;

 

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•      competitive pressures, such as the ability of competitors tosuccessfully introduce products that are more cost-effective or that offergreater functionality than our products, including by integrating into theirproducts functionality offered by our products, and the prices set bycompetitors for their products, and the potential for alliances, combinations,mergers and acquisitions among our competitors;

 

•      average selling prices of our products, whichare influenced by competition and technological advancements, among otherfactors;

 

•      government regulations regarding the timingand extent to which digital content must be made available to consumers;

 

•      the availability of other semiconductors orother key components that are required to produce a complete solution for thecustomer; usually, we supply one of many necessary components;

 

•      the cost of components for our products andprices charged by the third parties who manufacture, assemble and test ourproducts;

 

•      fluctuations in the price of our common stock,which drive a substantial portion of our non-cash stock compensation expense;

 

•      the nature and extent of litigationactivities, particularly our patent infringement suit against Genesis, and anysubsequent legal proceedings related to the matters raised in that suit; and.

 

•      Any legal matters resulting from the internal investigation, inparticular the shareholder and derivative lawsuits against the company and itsdirectors and some of its officers.

 

Because we have little or no control over thesefactors****and/or their magnitude , our operating results are difficult to predict. Any substantialadverse change in any of these factors could negatively affect our business andresults of operations.

 

**Our future quarterly operating results are highly dependentupon how well we manage our business.**

 

Our quarterly operating results may fluctuate based onhow well we manage our business. Some of the factors that may affect how wellwe manage our business include the following:

 

•      our ability to manage product introductionsand transitions;

 

•      our ability to successfully manage ourbusiness in multiple markets such as PC, storage and CE;

 

•      our ability to close licensing deals and makedeliverables and milestones on which recognition of revenue often depends;

 

•      our ability to engineer solutions that adhereto industry standards in a timely, cost-effective manner;

 

•      our ability to achieve acceptablemanufacturing yields and develop automated test programs within a reasonabletime frame for our new products;

 

•      ourability to manage joint projects, design services, and our supply chainpartners;

 

•      our ability to monitor the activities of ourlicensees to ensure compliance with license restrictions and remittance ofroyalties;

 

•      our ability to structure our organization toenable achievement of our operating objectives and to meet the needs of ourcustomers and markets;

 

•      the success of the distribution channelsthrough which we choose to sell our products; and

 

•      our ability to manage expense and inventorylevels.

 

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If we fail to effectively manage our business, thiscould adversely affect our results of operations.

 

**The licensing component of our business strategy increasesbusiness risk and volatility.**

 

Part of our business strategy is to license certain of our technologyto companies that address markets in which we do not want to directlyparticipate. We have limited experience marketing and selling our technology ona licensing basis. In conjunction with the business strategy we adopted in late2001, we signed our first license contract in December 2001, and havesigned others since then.There can be no assurance that additional companieswill be interested in licensing our technology on commercially favorable termsor at all. We also cannot ensure that companies who license our technology willintroduce and sell products incorporating our technology, will accuratelyreport royalties owed to us, will pay agreed upon royalties, will not infringeupon or misappropriate our intellectual property and will maintain theconfidentiality of our proprietary information.  Licensing contracts are complex and depend upon many factorsincluding completion of milestones, allocation of values to delivered items,percentage of completion tracking, and customer acceptances.  Many of these factors require significantjudgments.  Licensing revenues couldfluctuate significantly from period to period because it is heavily dependenton a few key deals being completed in a particular period, the timing of whichis difficult to predict,  Because oftheir high margin content, licensing revenues can have a disproportionateimpact on gross margins and profitability. Also, generating revenue from licensing arrangements is a lengthy andcomplex process that may last beyond the period in which efforts begin, andonce an agreement is in place, the timing of revenue recognition may bedependent on customer acceptance of deliverables, achievement of milestones,our ability to track and report progress on license contracts, customercommercialization of the licensed technology, and other factors. In addition,in any period, our expectation of licensing revenue is or may be dependent onone or a few licenses being completed. Licensing that occurs in the course ofactual or contemplated litigation is subject to risk that the adversarialnature of the transaction will induce non-compliance or non-payment. Theaccounting rules associated with recognizing revenue from licensing transactionsare increasingly complex and subject to interpretation.  Due to these factors, the amount of licenserevenue recognized in any period may differ significantly from ourexpectations.

 

**We faceadditional risks and costs as a result of the delayed filing of this quarterlyreport on Form 10-Q.**

 

As a result of the delayed filing of this Form 10-Q and the AuditCommittee’s examination, we have experienced additional risks and costs.  The Audit Committee’s examination has beentime-consuming, required us to incur additional expenses and has affectedmanagement’s attention and resources. Further, the measures to strengthen internal controls being implementedmay require greater management time and company resources to implement andmonitor.  We incurred approximately $1.1million in costs associated with the Audit Committee examination in the fourthquarter of 2003 and may incur significant future costs associated with theAudit Committee examination.

 

Further, certain of our officers and directors have been named asdefendants in shareholder derivative litigation, which alleges, among othermatters, that as a result of the examination, we will be required to restateour financial results for 2002 and 2003 and that such a restatement would bedue to breaches by the individual defendants of the fiduciary duties tous.  In addition, we and certain of ourofficers and directors have been named as defendants in securities class-actionlitigation, which alleges that we had materially overstated our licensingrevenue, net income and financial results during the time period from April 15,2002 to November 15, 2003.  Although theAudit Committee has completed its examination and concluded that no changes toour financial statements or the results previously announced for the quarterending September 30, 2003, are required, these lawsuits may be amended orcontinued, or new suits may be brought in connection with the delayed filing ofthis Form 10-Q or the Audit Committee’s examination.  Such litigations could be time-consuming, require us to incursignificant expenses and could divert our management’s attention andresources.  In addition, any unfavorableoutcome of any of such litigation could adversely impact our business, financialcondition and results of operations.

 

In addition, we have been informed by the Nasdaq staff that thecontinued listing of our common stock is conditioned on our timely filing ofall periodic reports under the Securities Exchange Act of 1934, such as ourannual report on Form 10-K, quarterly reports on Form 10-Q, and current reportson Form 8-K, for all reporting periods ending on or before December 31,2004.  Should we fail to timely make anysuch filing, Nasdaq has informed us that we will not be entitled to a newhearing with the Nasdaq staff and our common stock may be transferred to theNasdaq SmallCap Market, provided we could demonstrate compliance withapplicable maintenance criteria for such market and an ability to sustainlong-term compliance, or immediately delisted from the Nasdaq NationalMarket.  The Nasdaq staff has reservedthe right to reconsider the terms of the foregoing exception permittingcontinued listing of our common stock upon a review of our publicly filedfinancial statements or if any event, condition or circumstance that exists ordevelops that would, in the opinion of the staff, make continued listing of ourstock inadvisable or unwarranted.

 

Finally, as a result of our delayed filing of this Form 10-Q, we willbe ineligible to register our securities on Form S-3 for sale by us or resaleby others until we have timely filed all periodic reports under the SecuritiesExchange Act of 1934 for one year.  Theinability to use Form S-3 could adversely affect our ability to raise capitalor complete acquisitions of other companies during this period.

 

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**We face intense competition in our markets, which may lead toreduced revenue from sales of our products and increased losses.**

 

The PC, CE and storage markets in which we operate areintensely competitive. These markets are characterized by rapid technologicalchange, evolving standards, short product life cycles and declining sellingprices. Our display products face competition from a number of sources,including analog solutions, DVI-based solutions, dual (analog and DVI based)solutions and other digital interface solutions. We expect competition in thedisplay market to increase. For example, Analog Devices, ATI, Broadcom,Chrontel, Genesis Microchip, Matrox, National Semiconductor, Novatek,nVidia, Phillips, Pixelworks, SIS, Smart ASIC, ST Microelectronics, Sunplus,Texas Instruments, Thine, and Weltrend, areshipping products or have announced intentions to introduce products that weexpect will compete with our PanelLink products. Other companies have announcedDVI-based solutions and we expect that additional companies are likely to enterthe market. Current or potential customers, including our own licensees, mayalso develop solutions that could compete with us, directly or indirectly, suchas the integration of a DVI transmitter into a graphics processing unit orintegration of a DVI receiver into a monitor controller.

 

In the CE market, our digital interface products areused to connect cable set-top boxes, satellite set-top boxes and DVD players todigital televisions. These products incorporate DVI and High-bandwidth DigitalContent Protection (“HDCP”), or HDMI with or without HDCP support. Companiesthat have announced or are shipping DVI-HDCP solutions include TI, Thine,Broadcom and Genesis. In addition, our video processing products facecompetition from products sold by AV Science, Broadcom, Focus Enhancements,Genesis, Mediamatics, Micronas Semiconductor, Oplus, Philips, Pixelworks andTrident. We also compete, in some instances, against in-house processingsolutions designed by large original equipment manufacturers. We expectcompetition for HDMI products from the other HDMI founders and adopters,including Hitachi, Matsushita, Philips, Sony, Thomson and Toshiba.

 

In the storage market, our Fibre Channel products facecompetition from companies selling similar discrete products, includingAgilent, PMC Sierra and Vitesse, from other Fibre ChannelSerializer-Deserializer (“SerDes”) providers who license their core technology,such as LSI Logic, and from companies that sell Host Bust Adapters (“HBA”)controllers with integrated SerDes, such as QLogic and Agilent. In the future,our current or potential customers may also develop their own proprietarysolutions that may include integration of SerDes.

 

Our serial ATA products compete with similar productsfrom Marvell and Promise. In addition, other companies such as Adaptec, APT,ATI, Intel, LSI Logic, ServerWorks and Vitesse, have developed or announcedintentions to develop serial ATA controllers. We also compete against Intel andother motherboard chipset makers that have integrated serial ATA functionalityinto their chipsets.

 

Ourparallel ATA products compete with similar products from Promise and Highpoint.Our RAID controller board products face competition from Mylex, Infortrend, andChaparral.

 

Some of these competitors have already establishedsupplier or joint development relationships with current or potential customersand may be able to leverage their existing relationships to discourage thesecustomers from purchasing products from us or persuade them to replace ourstorage products with theirs. Many of our competitors have longer operatinghistories, greater presence in key markets, better name recognition, access tolarger customer bases and significantly greater financial, sales and marketing,manufacturing, distribution, technical and other resources than we do. Inaddition, some of our competitors could merge (for example, Genesis andPixelworks announced, and then terminated, such a merger), which may enhancetheir market presence. As a result, they may be able to adapt more quickly tonew or emerging technologies and customer requirements, or devote moreresources to the promotion and sale of their products. We cannot assure youthat we can compete successfully against current or potential competitors, orthat competition will not reduce our revenue and increase our losses.

 

**Growth of the market for our PC products depends on thewidespread adoption and use of the DVI specification.**

 

Our success is largely dependent upon the rapidand widespread adoption of the DVI specification, which defines a high-speeddata communication link between computers and digital displays. We cannotpredict the rate at which manufacturers of computers and digital displays willadopt the DVI specification. To date, relatively few systems implementing allof the electrical and mechanical aspects of the DVI specification have beenshipped. The DVI adoption rate in the PC market increased to 12% in 2002, from7% in 2001. Adoption of the DVI specification may be affected by theavailability of computer components able to communicate DVI-compliant signals,such as transmitters, receivers, connectors and cables necessary to implementthe specification. Other specifications may also emerge that could adverselyaffect the acceptance of the DVI specification. For example, a number ofcompanies have promoted alternatives to the DVI specification using otherinterface technologies, such as low voltage differential signaling, or LVDS.Further delays in the widespread adoption of the DVI specification could reduceacceptance of our products, limit or reduce our revenue growth and increase ourlosses.

 

**Our success depends on the growth of the digital displaymarket.**

 

Our PC business depends on the growth of the digitaldisplay market. The potential size of the digital display market and its rateof development are uncertain and will depend on many factors, including:

 

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•      the number of digital-ready computers that arebeing produced and consumer demand for these computers;

 

•      the rate at which display manufacturersreplace analog or non-compliant DVI interfaces with fully DVI-compliant interfaces;

 

•      the availability of cost-effectivesemiconductors that implement a fully DVI-compliant interface; and

 

•      improvements to analog technology, which maydecrease consumer demand for our digital display products.

 

In order for the digital display market to grow,digital displays must be widely available and affordable to consumers. In thepast, the supply of digital displays, such as flat panels, has been cyclicaland consumers have been very price sensitive. Also, some manufacturers haveimplemented DVI interfaces that are not fully DVI-compliant. These interfacesoften interfere with the operability of our products which function best with afully DVI-compliant interface. Our ability to sustain or increase our revenuemay be limited should there not be an adequate supply of, or demand for,affordable digital displays with fully DVI-compliant interfaces.

 

**A significant amount of our revenue is associated with theadoption of new or emerging technologies within the PC industry. The PCindustry has slowed and the adoption of these new technologies may not occur asplanned.**

 

A large portion of our revenue is directly orindirectly related to the PC industry and the adoption of new or emergingtechnologies within the PC industry. Accordingly, we are highly dependent onthe adoption of new or emerging technologies within the PC industry, whichexperienced a slowdown in growth during the second half of 2000 that hascontinued through the third quarter of 2003. We cannot predict the duration orseverity of the downturn in the PC and display market, or in the generaleconomy, or its effect on our revenue and operating results, including theadoption of these new or emerging technologies. If the market for PCs andPC-related displays continues to grow at a slow rate or contracts whether dueto reduced demand from end users, macroeconomic conditions or other factors,our business and results of operations could be negatively affected.

 

Although we are attempting to broaden our productofferings to include more products for the consumer electronics and storagemarkets, there can be no guarantee that we will succeed in this effort. Todate, we have achieved reasonable success, but if we fail to consistentlyachieve design wins in the consumer electronics and storage markets, we willremain highly dependent on the PC industry.

 

**Demand for our consumer electronics products is dependent onthe adoption and widespread use of the HDMI 1.0 specification.**

 

Our success in the consumer electronics market islargely dependent upon the rapid and widespread adoption of the HDMI 1.0specification, which combines high-definition video and multi-channel audio inone digital interface and uses our patented underlying transition minimizeddifferential signaling (“TMDS”®)****technology,and optionally Intel’s HDCP technology, as the basis for the interface. Version1.0 of the specification was published for adoption on December 9, 2002.We cannot predict the rate at which manufacturers will adopt the HDMIspecification or if the specification will be adopted at all. Adoption of theHDMI specification may be affected by the availability of consumer products,such as DVD players and televisions, and of computer components that implementthis new interface. Other competing specifications may also emerge that couldadversely affect the acceptance of the HDMI specification. Delays in thewidespread adoption of the HDMI specification could reduce acceptance of ourproducts, limit or reduce our revenue growth and increase our losses.

 

**Our ability to increase sales of our products for displaysystems depends on host system manufacturers including DVI-complianttransmitters in their systems.**

 

Our success in the PC market depends on increasingsales of our receiver products to display manufacturers. To increase sales ofour receiver products, we need computer manufacturers to incorporateDVI-compliant transmitters in their systems, making these systemsdigital-ready. During 2002, we introduced a low-cost add-in card that can beused in conjunction with Intel’s 845G chip set to provide an all-digitalconnection to flat panels. Intel’s 845G chip set is intended to provide anall-digital path on the motherboard bus, and should make it easier to providedigital video out. Use of Intel’s 845G chip set, or any digital path chip set,is not universal and may not gain market acceptance. If computers are notdigital-ready, they will not operate with digital displays, which will limitand may reduce the demand for our digital host and receiver products.

 

**Our success depends on the development and growth of marketsfor products based on new and emerging storage technologies.**

 

Our productdevelopment efforts in the storage market are focused on the development ofproducts using new interface technologies such as fibre channel and serial ATA.The markets for these new interface technologies are at an early stage of

 

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development, and there can be no assurance that theywill replace other storage interfaces that are now widely used, such asparallel ATA and SCSI. The potential size and rate of development of thesemarkets are uncertain and will depend on many factors, including:

 

•      the rate at which manufacturers of storagesubsystems adopt new interface technologies, which may be more costly toimplement than existing interface technologies until volumes are sufficient tobring costs to competitive levels;

 

•      the availability of cost-effectivesemiconductors and components for storage subsystems, such as serial ATA-enabledhard drives and serial ATA enabled optical drives (CD and DVD), that implementnew interface technologies for the storage market;

 

•      whether Intel or other motherboardmanufacturers integrate the functionality of our products, such as serial ATA,into their chips and chip sets; and

 

•      improvement to existing storage interfacetechnologies such as parallel ATA and SCSI, or the introduction of other newstorage interface technologies, either of which may decrease consumer demandfor our storage products.

 

In particular, the rate of implementation of theserial ATA interface will depend on how quickly drive manufacturers,motherboard and PC providers and chipmakers are able to resolve technicalcommunication and functionality issues to enable a “plug and play” environmentin which a computer system is automatically able to recognize and configurestorage devices. Resolution of these issues could be time-consuming, and willdepend in good measure on the ability of chipmakers to incorporate the requiredhigh-speed serial data transfer capabilities into their semiconductors withoutsacrificing manufacturing yields.

 

Any delay in acceptance of new interface technologies,or a reduction in the growth or size of the market for systems based on serialATA or fibre channel technologies, would limit sales of our storage productsand reduce our revenue. Any delay in the availability of serial ATA compatibledrives or acceleration of serial ATA or fibre channel SerDes integrationefforts by motherboard or storage controller manufacturers may also reduce ourrevenue.

 

We have promulgated a SATALite specification to whichwe have invited key industry members to participate. This program includescertain licenses to our technology that we hope will increase market acceptanceof our serial ATA products. There can be no assurance that this program willsucceed, or that SATALite participants will not use our technology to competeagainst us.

 

To date, we have achieved a number of design wins forour serial ATA and fibre channel storage products. Even after we have achieveda design win from an Original Equipment Manufacturer (OEM), we may not realizeany revenue, or significant revenue, from that OEM since a design win is not abinding commitment to purchase our products and the OEM may not achieve marketacceptance for their product. Further delay in serial ATA-enabled driveavailability may lead OEMs to re-open their designs and designs we have won maybe subject to being lost, which could reduce our revenue and increase our operatingexpenses in competing to re-win designs.

 

**We do not have long-term commitments from our customers andwe allocate resources based on our estimates of customer demand.**

 

Substantially all of our sales are made on the basisof purchase orders, rather than long-term agreements. In addition, ourcustomers may cancel or reschedule purchase orders. We purchase inventorycomponents and build our products according to our estimates of customerdemand. This process requires us to make multiple assumptions, including volumeand timing of customer demand for each product, manufacturing yields andproduct quality. If we overestimate customer demand or product quality or underestimate manufacturing yields, we may build products that we may not be able tosell at an acceptable price or at all. As a result, we would have excessinventory, which would increase our losses. Additionally, if we underestimatecustomer demand or if sufficient manufacturing capacity is unavailable, we willforego revenue opportunities or incur significant costs for rapid increases inproduction, lose market share and damage our customer relationships.

 

**Our lengthy sales cycle can result in a delay betweenincurring expenses and generating revenue, which could harm our operatingresults.**

 

Because our products are based on new technology andstandards, a lengthy sales process, typically requiring several months or more,is often required before potential customers begin the technical evaluation ofour products. This technical evaluation can exceed nine months before thepotential customer informs us whether we have achieved a design win, which isnot a binding commitment to purchase our products.After achieving a design win,it can then be an additional nine months before a customer commences volumeshipments of systems incorporating our products, if at all. Given our lengthysales cycle, we may experience a

 

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delay between the time we incur expenditures and thetime we generate revenue, if any. As a result, our operating results could beseriously harmed if a significant customer reduces or delays orders, or choosesnot to release products incorporating our products.

 

**We depend on a few key customers and the loss of any of themcould significantly reduce our revenue.**

 

Historically, a relatively small number of customers and distributorshave generated a significant portion of our revenue. For the first nine monthsof 2003, shipments to World Peace International, an Asian distributor,generated 14% of our revenue. For the year ended December 31, 2002,shipments to World Peace International generated 15% of our revenue, andshipments to Weikeng, a distributor, generated 11% of our revenue. In addition,an end-customer may buy through multiple distributors, contract manufacturers,and / or directly, which could create an even greater concentration. We cannotbe certain that customers and key distributors that have accounted forsignificant revenue in past periods, individually or as a group, will continueto sell our products and generate revenue. As a result of this concentration ofour customers, our results of operations could be negatively affected if any ofthe following occurs:

 

•      one or more of our customers, includingdistributors, becomes insolvent or goes out of business;

 

•      one or more of our key customers ordistributors significantly reduces, delays or cancels orders; or

 

•      one or more significant customers selectsproducts manufactured by one of our competitors for inclusion in their futureproduct generations.

 

Due to our participation in multiple markets, ourcustomer base has broadened significantly and we therefore anticipate beingless dependent on a relatively small number of customers to generate revenue.However, as product mix fluctuates from quarter to quarter, we may become moredependent on a small number of customers or a single customer for a significantportion of our revenue in a particular quarter, the loss of which couldadversely affect our operating results.

 

**We sell our products through distributors, which limits ourdirect interaction with our customers, therefore reducing our ability toforecast sales and increasing the complexity of our business.**

 

Many original equipment manufacturers rely onthird-party manufacturers or distributors to provide inventory management andpurchasing functions. Distributors generated 39% of our revenue in the firstnine months of 2003, and 42% of our revenue for the year endedDecember 31, 2002. The decrease is as expected as our licensing revenue,which is direct, was a higher percentage of our revenue in the first ninemonths of 2003 than it was in 2002. Selling through distributors reduces ourability to forecast sales and increases the complexity of our business,requiring us to:

 

•      manage a more complex supply chain;

 

•      monitor and manage the level of inventory ofour products at each distributor;

 

•      estimate the impact of credits, return rights,price protection and unsold inventory at distributors; and

 

•      monitor the financial condition andcredit-worthiness of our distributors, many of which are located outside of theUnited States, and the majority of which are not publicly traded.

 

Any failure to manage these challenges could disruptor reduce sales of our products.

 

**Our success depends on the development and introduction ofnew products, which we may not be able to do in a timely anner because theprocess of developing high-speed semiconductor products is complex and costly.**

 

The development of new products is highly complex, andwe have experienced delays, some of which exceeded one year, in the developmentand introduction of new products on several occasions in the past. In 2001 and2002, we announced our first products for the storage market and we expect tointroduce new consumer electronics, storage and DVI products in the future. Asour products integrate new, more advanced functions, they become more complexand increasingly difficult to design, manufacture and debug. Successful productdevelopment and introduction depends on a number of factors, including, but notlimited to:

 

•      accurate prediction of market requirements andevolving standards, including enhancements to existing standards such as DVI,HDCP and SATA, and development and adoption of new or emerging standards such asHDMI, or significant modifications to existing standards such as SATA II;

 

•      development of advanced technologies andcapabilities, and new products that satisfy customer requirements;

 

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•      competitors’ and customers’ integration of the functionality of ourproducts into their products, which puts pressure on us to continue to developand introduce new products with new functionality;

 

•      timely completion and introduction of newproduct designs;

 

•      management of product life cycles;

 

•      use of leading-edge foundry processes andachievement of high manufacturing yields and low cost testing; and

 

•      market acceptance of new products.

 

Accomplishing all of this is extremely challenging,time-consuming and expensive and there is no assurance that we will succeed.Product development delays may result from unanticipated engineeringcomplexities, changing market or competitive product requirements orspecifications, difficulties in overcoming resource limitations, the inabilityto license third party technology or other factors. Competitors amd customersmay integrate the functionality of our products into their products which wouldreduce demand for our products.   If weare not able to develop and introduce our products successfully and in a timelymanner, our costs could increase or our revenue could decrease, both of whichwould adversely affect our operating results. In addition, it is possible thatwe may experience delays in generating revenue from these products or that wemay never generate revenue from these products. We must work with asemiconductor foundry and with potential customers to complete new productdevelopment and to validate manufacturing methods and processes to supportvolume production and potential re-work. Each of these steps may involveunanticipated difficulties, which could delay product introduction and reducemarket acceptance of the product. In addition, these difficulties and theincreasing complexity of our products may result in the introduction ofproducts that contain defects or that do not perform as expected, which wouldharm our relationships with customers and our ability to achieve marketacceptance of our new products. There can be no assurance that we will be ableto achieve design wins for our planned new products, that we will be able tocomplete development of these products when anticipated, or that these productscan be manufactured in commercial volumes at acceptable yields, or that anydesign wins will produce any revenue. Failure to develop and introduce newproducts, successfully and in a timely manner, may adversely affect our resultsof operations.

 

**We have made acquisitions in the past and may makeacquisitions in the future, if advisable, and these acquisitions involvenumerous risks.**

 

Our growth depends upon market growth and our abilityto enhance our existing products and introduce new products on a timely basis.One of the ways we develop new products and enter new markets is throughacquisitions. In 2000, we completed the acquisitions of Zillion and DVDO, andin 2001, we completed the acquisitions of CMD and SCL. In April 2003, weacquired TWN. We may acquire additional companies or technologies. Acquisitionsinvolve numerous risks, including, but not limited to, the following:

 

•      difficulty and increased costs in assimilatingemployees, including our possible inability to keep and retain key employees ofthe acquired business;

 

•      disruption of our ongoing business;

 

•      discovery of undisclosed liabilities of theacquired companies and legal disputes with founders or shareholders of acquiredcompanies;

 

•      inability to successfully incorporate acquiredtechnology and operations into our business and maintain uniform standards,controls, policies and procedures;

 

•      inability to commercialize acquiredtechnology; and

 

•      the need to take impairment charges or write-downs with respect toacquired assets.

 

No assurance can be given that our acquisitions ofZillion, DVDO, CMD, SCL or TWN, or our future acquisitions, if any, will besuccessful or provide the anticipated benefits, or that they will not adverselyaffect our business, operating results or financial condition. Failure tomanage growth effectively and to successfully integrate acquisitions made by uscould materially harm our business and operating results.

 

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**The cyclical nature of the semiconductor industry may createfluctuations in our foundry, test and assembly capacity.**

 

In the past, the semiconductor industry has beencharacterized by significant downturns and wide fluctuations in supply anddemand. For example, demand in the semiconductor industry rose to record levelsin 1999, and then declining until recently when it appears to be recovering.  The industry has also experiencedsignificant fluctuations in anticipation of changes in general economicconditions. This cyclicality has led to significant fluctuations in productdemand and in the foundry, test and assembly capacity of third party suppliers.Production capacity for semiconductors fabricated using 0.18 micron technologycould be subject to allocation, whereby not all of our production requirementswould be met. This may impact our ability to meet demand and could alsoincrease our production costs. Cyclicality has also accelerated decreases inaverage selling prices per unit. We may experience fluctuations in our futurefinancial results because of changes in industry-wide conditions.

 

**We depend on third-party sub-contractors to manufacture,assemble and test nearly all of our products, which reduces our control overthe production process.**

 

We do not own or operate a semiconductor fabricationfacility. We rely on Taiwan Semiconductor Manufacturing Company (“TSMC”), anoutside foundry, to produce the vast majority all of our semiconductorproducts. We also rely on Kawasaki, UMC and Atmel, for outside foundryservices, and on Amkor and ASE to test certain of our semiconductor products.Our reliance on independent foundries, assembly and test facilities involves anumber of significant risks, including, but not limited to:

 

•      reduced control over delivery schedules,quality assurance, manufacturing yields and production costs;

 

•      lack of guaranteed production capacity orproduct supply;

 

•      lack of availability of, or delayed access to,next-generation or key process technologies; and

 

•      our ability to transition to alternate sourcesif services are unavailable from primary suppliers.

 

In addition, our semiconductor products are assembledand tested by several independent subcontractors. We do not have a long-termsupply agreement with our subcontractors, and instead obtain productionservices on a purchase order basis. Our outside sub-contractors have noobligation to supply products to us for any specific period of time, in anyspecific quantity or at any specific price, except as set forth in a particularpurchase order. Our requirements represent a small portion of the totalproduction capacity of our outside foundries, assembly and test facilities andour sub-contractors may reallocate capacity to other customers even duringperiods of high demand for our products. These foundries may allocate or moveproduction of our products to different foundries under their control, even indifferent locations, which may be time consuming, costly, and difficult, havean adverse affect on quality, yields, and costs, and require us and/or ourcustomers to re-qualify the products, which could open up design wins tocompetition and result in the loss of design wins and design-ins. If oursubcontractors are unable or unwilling to continue manufacturing our productsin the required volumes, at acceptable quality, yields and costs, and in atimely manner, our business will be substantially harmed. As a result, we wouldhave to identify and qualify substitute contractors, which would betime-consuming, costly and difficult. This qualification process may alsorequire significant effort by our customers, and may lead to re-qualificationof parts, opening up design wins to competition, and loss of design wins anddesign-ins. Any of these circumstances could substantially harm our business.In addition, if competition for foundry, assembly and test capacity increases,our product costs may increase and we may be required to pay significantamounts or make significant purchase commitments to secure access to productionservices.

 

**The nature of our production process is complex, whichreduces identification of problems until well into the production cycle or, insome cases, after the product has been shipped.**

 

The manufacture of semiconductors is a complexprocess, and it is often difficult for semiconductor foundries to achieveacceptable product yields. Product yields depend on both our product design andthe manufacturing process technology unique to the semiconductor foundry. Sincelow yields may result from either design or process difficulties, identifyingyield problems can only occur well into the production cycle, when an actualproduct exists that can be analyzed and tested.

 

Further, we only test our products after they areassembled, as their high-speed nature makes earlier testing difficult andexpensive. As a result, defects often are not discovered until after assembly.This could result in a substantial number of defective products being assembledand tested or shipped, thus lowering our yields and increasing our costs. Theserisks could result in product shortages or increased costs of assembling,testing or even replacing our products.

 

Although we test our products before shipment, theyare complex and may contain defects and errors. In the past we have encountereddefects and errors in our products. Because our products are sometimesintegrated with products from other vendors, it can be difficult to identifythe source of any particular problem. Delivery of products with defects orreliability, quality or compatibility problems, may damage our reputation andour ability to retain existing customers and attract new customers. Inaddition, product defects and errors could result in additional developmentcosts, diversion of technical resources, delayed product shipments, increasedproduct returns, warranty and product liability claims against us that may notbe fully covered by insurance. Any of these circumstances could substantiallyharm our business.

 

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**We face foreign business, political and economic risksbecause a majority of our products and our customers’ products are manufacturedand sold outside of the United States.**

 

A substantial portion of our business is conductedoutside of the United States. As a result, we are subject to foreign business,political and economic risks. Nearly all of our products are manufactured inTaiwan or elsewhere in Asia, and for each of the nine months ended September30, 2003, and the year ended December 31, 2002, 72% of our revenue wasgenerated from customers and distributors located outside of the United States,primarily in Asia. We anticipate that sales outside of the United States willcontinue to account for a substantial portion of our revenue in future periods.Accordingly, we are subject to international risks, including, but not limitedto:

 

•      difficulties in managing from afar;

 

•      political and economic instability, includinginternational tension in Iraq, Korea and the China Strait and lack of normaldiplomatic relationships between the United States and Taiwan;

 

•      less developed infrastructures in newlyindustrializing countries;

 

•      susceptibility of foreign areas to terroristattacks;

 

•      susceptibility to interruptions of travel,including those due to international tensions (including the war in andoccupation of Iraq), the SARS and Avian Flu epidemics (particularly affectingthe Asian markets we serve), and the financial instability and bankruptcy ofmajor air carriers;

 

•      bias against foreign, especially American,companies;

 

•      difficulties in collecting accountsreceivable;

 

•      expense and difficulties in protecting ourintellectual property in foreign jurisdictions;

 

•      difficulties in complying with multiple,conflicting and changing laws and regulations, including export requirements,tariffs, import duties, visa restrictions, environmental laws and otherbarriers;

 

•      exposure to possible litigation or claims inforeign jurisdictions; and

 

•      competition from foreign-based suppliers andthe existence of protectionist laws and business practices that favor thesesuppliers, such as withholding taxes on payments made to us.

 

These risks could adversely affect our business andour results of operations. In addition, original equipment manufacturers thatdesign our semiconductors into their products sell them outside of the UnitedStates. This exposes us indirectly to foreign risks. Because sales of ourproducts are denominated exclusively in United States dollars, relativeincreases in the value of the United States dollar will increase the foreigncurrency price equivalent of our products, which could lead to a reduction insales and profits in that country.

 

**The success of our business depends upon our ability toadequately protect our intellectual property.**

 

We rely on a combination of patent, copyright,trademark, mask work and trade secret laws, as well as nondisclosure agreementsand other methods, to protect our proprietary technologies. We have been issuedpatents and have a number of pending patent applications. However, we cannotassure you that any patents will be issued as a result of any applications or,if issued, that any claims allowed will protect our technology. In addition, wedo not file patent applications on a worldwide basis, meaning we do not havepatent protection in some jurisdictions. It is possible that existing or futurepatents may be challenged, invalidated or circumvented and effective patent, copyright,trademark and trade secret protection may be unavailable or limited in foreigncountries. It may be possible for a third party to copy or otherwise obtain anduse our products or technology without authorization, develop similartechnology independently or design around our patents in the United States andin other jurisdictions. It is also possible that some of our existing or newlicensing relationships will enable other parties to use our intellectualproperty to compete against us. Legal actions to enforce intellectual propertyrights tend to be lengthy and expensive, and the outcome often is notpredictable. As a result, despite our efforts and expenses, we may be unable toprevent others from infringing upon or misappropriating our intellectual property,which could harm our business.  Inaddition, practicality also limits our assertion of intellectual propertyrights.  Patent litigation is expensiveand its results are often unpredictable. Assertion of intellectual property rights often results in counterclaimsfor

 

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perceived violations of the defendant’s intellectualproperty rights and/or antitrust claims. Certain parties after receipt of an assertion of infringement will cutoff all commercial relationships with the party making the assertion, thusmaking assertions against suppliers, customers, and key business partnersunwise.  Accordingly, if we forgo makingsuch claims, we may risk creating legal and equitable defenses for aninfringer.

 

**Our participation in the Digital Display Working Grouprequires us to license some of our intellectual property for free, which maymake it easier for others to compete with us in the DVI PC market.**

 

We are a promoter of the DDWG, which published and promotesthe DVI specification. Our strategy includes establishing the DVI specificationas the industry standard, promoting and enhancing this specification anddeveloping and marketing products based on this specification and futureenhancements. As a result:

 

•      we must license for free specific elements ofour intellectual property to others for use in implementing the DVIspecification; and

 

•      we may license additional intellectualproperty for free as the DDWG promotes enhancements to the DVI specification.

 

Accordingly, companies that implement the DVIspecification in their products can use specific elements of our intellectualproperty for free to compete with us.

 

**Our participation as a founder in the working groupdeveloping HDMI requires us to license some of our intellectual property, whichmay make it easier for others to compete with us in the market.**

 

In April 2002, together with Sony, Philips,Thomson, Toshiba, Matsushita and Hitachi, we announced the formation of aworking group to define the next-generation digital interface specification forconsumer electronics products. Version 1.0 of the specification was publishedfor adoption on December 9, 2002. The HDMI specification combineshigh-definition video and multi-channel audio in one digital interface and usesSilicon Image’s patented underlying TMDS technology **,**optionally, along with Intel’s HDCP as the basis for the interface. The foundersof the working group have signed a founder’s agreement in which each commits tolicense certain intellectual property to each other, and to adopters of thespecification.

 

Our strategy includes establishing the HDMIspecification as the industry standard, promoting and enhancing thisspecification and developing and marketing products based on this specificationand future enhancements. As a result:

 

•      we must license specific elements of ourintellectual property to others for use in implementing the HDMI specification;and

 

•      we may license additional intellectualproperty as the HDMI founders group promotes enhancements to the HDMIspecification.

 

Accordingly, companies that implement the HDMIspecification in their products can use specific elements of our intellectualproperty to compete with us. Although there will be license fees and royaltiesassociated with the adopters agreements, there can be no assurance that suchlicense fees and royalties will adequately compensate us for having to licenseour intellectual property. Fees and royalties received during the early yearsof adoption will be used to cover costs we incur to promote the HDMI standardand to develop and perform interoperability tests; in addition, after aninitial period, the HDMI founders may reallocate the license fees and royaltiesamongst themselves to reflect each founder’s relative contribution ofintellectual property to the HDMI specification.

 

**Our success depends on managing our relationship with Intel.**

 

Intel has a dominant role in many of the markets inwhich we compete, such as PCs and storage, and is a growing presence in the CEmarket. We have a multi-faceted relationship with Intel that is complex andrequires significant management attention, including:

 

•      Intel has been an investor of ours;

 

•      Intel and we have been parties to a businesscooperation agreement;

 

•      Intel and we are parties to a patentcross-license;

 

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•      Intel and we worked together to develop HDCP;

 

•      An Intel subsidiary has the exclusive right tolicense HDCP, of which we are a licensee;

 

•      Intel and we were two of the original foundersof the Digital Display Working Group (“DDWG”);

 

•      Intel is a promoter of the serial ATA workinggroup, of which we are a contributor;

 

•      Intel is a supplier to us and a customer forour products;

 

•      We believe that Intel has the power to driveadoption of DVI and serial ATA by making them widely available in its chip setsand motherboards, which could affect demand for our products;

 

•      We believe that Intel has the power to affectadoption of HDMI by either endorsing the technology or promulgating a competingstandard, which could affect demand for our products;

 

•      Intel may potentially integrate thefunctionality of our products, including fibre channel, serial ATA or DVI, intoits own chips and chip sets, thereby displacing demand for some of ourproducts;

 

•      Intel may design new technologies that wouldrequire us to re-design our products for compatibility, thus increasing ourR&D expense and reducing our revenue;

 

•      Intel’s technology, including its 845G chipset, may lower barriers to entry to other parties who may enter the market andcompete with us; and

 

•      Intel may enter into or continue relationshipswith our competitors that can put us at a relative disadvantage.

 

Our cooperation and competition with Intel can lead topositive benefits if managed effectively. If our relationship with Intel is notmanaged effectively, it could seriously harm our business, negatively affectour revenue, and increase our operating expenses.

 

**We have granted Intel rights with respect to our intellectualproperty, which could allow Intel to develop products that compete with ours orotherwise reduce the value of our intellectual property.**

 

We have entered into a patent cross-license agreementwith Intel in which each of us granted the other a license to use the grantor’spatents, except for identified types of products. We believe that the scope ofour license to Intel excludes our current products and anticipated futureproducts. Intel could, however, exercise its rights under this agreement to useour patents to develop and market other products that compete with ours,without payment to us. Additionally, Intel’s rights to our patents could reducethe value of our patents to any third party who otherwise might be interestedin acquiring rights to use our patents in such products. Finally, Intel couldendorse competing products, including a competing digital interface, or developits own proprietary digital interface. Any of these actions could substantiallyharm our business and results of operations.

 

**We are and may continue to become the target of securitiesclass action suits which could result in substantial costs and divertmanagement attention and resources.**

 

Securities class action suits are often broughtagainst companies, particularly technology companies, following periods ofvolatility in the market price of their securities. Defending against thesesuits, even if meritless, can result in substantial costs to us and coulddivert the attention of our management. We and certain of our officers anddirectors, together with certain investment banks, have been named asdefendants in a securities class action suit filed against us on behalf ofpurchasers of our securities between October 5, 1999 and December 6,2000. It is alleged that the prospectus related to our initial public offeringwas misleading because it failed to disclose that the underwriters of ourinitial public offering had solicited and received excessive commissions fromcertain investors in exchange for agreements by investors to buy our shares inthe aftermarket for predetermined prices. Due to inherent uncertainties inlitigation, we cannot accurately predict the outcome of this litigation;however, a proposed settlement has been negotiated that has yet to be reviewedand approved by the Court.  In the eventthat the settlement is not approved, we believe that these claims are withoutmerit and we intend to defend vigorously against them. We and certain of ourofficers, together with certain investment banks and their current or formeremployees, were named as defendants in a securities class action suit filedagainst us on behalf of a putative class of shareholders who purchased stockfrom some or all of approximately 50 issuers whose public offerings wereunderwritten by Credit Suisse First Boston. The lawsuit alleges that SiliconImage and certain officers were part of a scheme by Credit Suisse First Bostonto artificially inflate the price of Silicon Image’s stock through thedissemination of allegedly false

 

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analysts’ reports. The plaintiff in this matter hasfiled an amended complaint in which Silicon Image, and the named officers, weredropped as defendants.  We believe thatthe settlement described above, if approved, would encompass the claims in thiscase. We believe that these claims were without merit and, if revived, and notsubject to the settlement, we intend to defend vigorously against them. Certain of our officers and directors have been named as defendants in consolidatedshareholder derivative litigation.  Thelawsuit alleges that as a result of the examination conducted by our AuditCommittee, we will be required to restate our financial results for 2002 and2003.  The lawsuit further alleges thatsuch a restatement would be due to breaches by the individual defendants oftheir fiduciary duties to us, that certain of the individual defendants areliable to us for insider trading under California law, and that the individualdefendants are liable to us for mismanagement, abuse of control, and waste. We and certain of our officers have beennamed as defendants in consolidated securities class action litigation.  Plaintiffs filed the action on behalf of aputative class of shareholders who purchased our stock between April 15, 2002and November 15, 2003.  The lawsuitalleges that we had materially overstated our licensing revenue, net income andfinancial results during this time period, and that were being forced torestate our financial results. Webelieve that these claims are without merit and we intend to defend vigorouslyagainst them. However, these suits and any others that may be brought, even ifmeritless, could require us to incur expenses and could divert our management’sattention and resources. In addition, any unfavorable outcome of either ofthese litigations could adversely impact our business, financial condition andresults of operations.

 

**We are currently engaged in intellectual property litigationthat is time-consuming and expensive to prosecute. We may become engaged inadditional intellectual property litigation that could be time-consuming, maybebe expensive to prosecute or defend, and could adversely affect our ability tosell our product.**

 

In recent years, there has been significantlitigation in the United States and in other jurisdictions involving patentsand other intellectual property rights. This litigation is particularlyprevalent in the semiconductor industry, in which a number of companiesaggressively use their patent portfolios to bring infringement claims. Inaddition, in recent years, there has been an increase in the filing ofso-called “nuisance suits,” alleging infringement of intellectual propertyrights. These claims may be asserted as counterclaims in response to claims madeby a company alleging infringement of intellectual property rights. These suitspressure defendants into entering settlement arrangements to quickly dispose ofsuch suits, regardless of merit. In addition, as is common in the semiconductorindustry, from time to time we have been notified that we may be infringingcertain patents or other intellectual property rights of others. Responding tosuch claims, regardless of their merit, can be time consuming, result in costlylitigation, divert management’s attention and resources and cause us to incursignificant expenses. As each claim is evaluated, we may consider thedesirability of entering into settlement or licensing agreements. No assurancecan be given that settlements will occur or that licenses can be obtained onacceptable terms or that litigation will not occur. In the event there is atemporary or permanent injunction entered prohibiting us from marketing orselling certain of our products, or a successful claim of infringement againstus requiring us to pay damages or royalties to a third party, and we fail todevelop or license a substitute technology, our business, results of operationsor financial condition could be materially adversely affected.

 

In April 2001, we filed suit against Genesis Microchipfor infringement of one of our U.S. patents. At that time, we also filed acomplaint against Genesis for unlawful trade practices related to theimportation of articles infringing our patent. In February 2002, ourmotion to dismiss the unlawful trade practices complaint was granted and wefiled an amended complaint against Genesis alleging infringement of two of ourU.S. patents. These patents relate to our DVI receiver products, which generatea significant portion of our revenue. The amended complaint seeks a declarationthat Genesis has infringed our patents, that Genesis’s behavior is notlicensed, an injunction to halt the importation, sale, manufacture and use ofGenesis DVI receiver chips that infringe our patents, and monetary damages. InApril 2002, Genesis answered and made counterclaims against us fornon-infringement, license, patent invalidity, fraud, antitrust, unfaircompetition and patent misuse. We filed a motion to dismiss certain ofGenesis’s counterclaims. In addition, we filed a motion to bifurcate trial ofthe counterclaims to the extent the court does not dismiss them. InMay 2002, the Court granted our motion to dismiss certain of thecounterclaims, with leave to amend. Genesis re-filed counterclaims against usfor fraud and patent misuse. We filed another motion to dismiss thesecounterclaims. In August 2002, the Court granted our motion and dismissedGenesis’s re-filed counterclaims with prejudice. In December 2002, the partiesentered into a memorandum of understanding (“MOU”) to settle the case.  In January, the parties presented differentinterpretations of the MOU to the Court. On July 15, 2003, the Court granted our motion to interpret the MOU inthe manner we requested, and ruled that Genesis had engaged in efforts to avoidits obligations under the MOU.  OnAugust 6, 2003, the Court entered a final judgment order based on its July 15,2003 ruling.  Under the final judgmentorder, Genesis was ordered to make a substantial cash payment, and to makeroyalty payments; although Genesis has made some cash payment to the Court, ithas not made all the payments that are required under the final judgment order.We have filed motions for reimbursement of some of some of expenses, includingsome of our legal fees, and for modification and/or clarification of certainitems of the judgment, and to hold Genesis in contempt of Court for breachingthe protective order in the case by disclosing secret information to at leastone of our competitors.  On December 19,2003, the Court granted our motions in part and denied them in part: the courtissued an amended judgment, and held Genesis in contempt of Court for breachingthe protective order.  On January 16,2004, Genesis filed a notice of appeal.

 

There can be no assurance that Genesis will not undertake furtherefforts to avoid its obligations under the MOU, and that further proceedings(lawsuits, contempt citations, etc.) against Genesis, and certain of itsexecutives, its counsel, its former merger partner, Pixelworks, and others maynot be required to obtain compliance or to obtain redress fornon-compliance.  There can be noassurance that an appellate court will uphold the Court’s rulings or theMOU.  There can be no assurance thatfurther delays or

 

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noncompliance will not occur. The Court’s rulings of July 15, 2003 and December 19, 2003 indicate thatGenesis violated certain provisions of the MOU, and of the protective order inthe case, including disclosure of confidential information to Pixelworks.  On August 5, 2003, Genesis and Pixelworksissued a joint press release terminating their proposed merger. In that pressrelease, Genesis and Pixelworks jointly stated that “Pixelworks has confirmedthat prior to signing the merger agreement, it reveiwed the Memorandum ofUnderstanding that purported to settle the lawsuit between Genesis Microchipand Silicon Image, Inc.”  While thislitigation, including any appeal or any possible derivative proceedings, ispending, Genesis can use the technology covered by these patents to developproducts that might compete with ours. If we are unsuccessful in thislitigation, we could be unable to prevent Genesis or others from using thetechnology covered by these patents. Even if we prevail in this litigation,uncertainties regarding the outcome prior to that time may reduce demand forour products, or Genesis’ use of our technology in products that compete withour products may reduce demand or pricing for our products.. In addition, evenif the MOU is upheld on appeal, future disputes may occur, including thoseregarding whether and what intellectual property licenses were granted and thescope of any such licenses and the royalty rates and payment terms for suchlicenses, whether the MOU was breached, whether consent was fraudulentlyobtained, and whether a merger partner may succeed to the rights and/or theobligations under the MOU. These disputes may result in additional costly andtime-consuming litigation or the license of additional elements of ourintellectual property for free.

 

Any potential intellectual property litigation againstus could also force us to do one or more of the following:

 

•      stop selling products or using technology thatcontain the allegedly infringing intellectual property;

 

•      attempt to obtain a license to the relevantintellectual property, which license may not be available on reasonable termsor at all; and

 

•      attempt to redesign products that contain theallegedly infringing intellectual property.

 

If we take any of these actions, we may be unable tomanufacture and sell our products. We may be exposed to liability for monetarydamages, the extent of which would be very difficult to accurately predict. Inaddition, we may be exposed to customer claims, for potential indemnityobligations, and to customer dissatisfaction and a discontinuance of purchasesof our products while the litigation is pending. Any of these consequencescould substantially harm our business and results of operations.

 

**We have entered into, and may again be required to enterinto, patent or other intellectual property cross-licenses.**

 

Many companies have significant patentportfolios or key specific patents, or other intellectual property in areas inwhich we compete. Many of these companies appear to have policies of imposingcross-licenses on other participants in their markets, which may include areasin which we compete. As a result, we have been required, either under pressureof litigation or by significant vendors or customers, to enter into crosslicenses or non-assertion agreements relating to patents or other intellectualproperty. This permits the cross-licensee, or beneficiary of a non-assertionagreement, to use certain or all of our patents and/or certain otherintellectual property for free to compete with us.

 

**We must attract and retain qualified personnel to besuccessful, and competition for qualified personnel is increasing in ourmarket.**

 

Our success depends to a significant extent upon thecontinued contributions of our key management, technical and sales personnel,many of who would be difficult to replace. The loss of one or more of theseemployees could harm our business. Although we have entered into a limitednumber of employment contracts with certain executive officers, we generally donot have employment contracts with our key employees. We do not have key personlife insurance for any of our key personnel. Our success also depends on ourability to identify, attract and retain qualified technical, sales, marketing,finance and managerial personnel. Competition for qualified personnel isparticularly intense in our industry and in our location. This makes itdifficult to retain our key personnel and to recruit highly-qualifiedpersonnel. We have experienced, and may continue to experience, difficulty inhiring and retaining candidates with appropriate qualifications. To besuccessful, we need to hire candidates with appropriate qualifications andretain our key executives and employees.

 

The volatility of our stock price has had an impact onour ability to offer competitive equity-based incentives to current andprospective employees, thereby affecting our ability to attract and retainhighly qualified technical personnel. If these adverse conditions continue, wemay not be able to hire or retain highly qualified employees in the future andthis could harm our business. In addition, new regulations proposed by TheNASDAQ National Market requiring shareholder approval for all stock optionplans, as well as new regulations proposed by the New York Stock Exchangeprohibiting NYSE member organizations from giving a proxy to vote on equitycompensation plans unless the beneficial owner of the shares has given votinginstructions, could make it more difficult for us to grant options to employeesin the future. There have been several proposals on whether and /or how toaccount for stock options. To the extent that new regulations make it moredifficult or expensive to grant options to employees, we may incur increasedcash compensation costs or find it difficult to attract, retain and motivateemployees, either of which could harm our business.

 

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We use contractors to provide services to the company,which often involves contractual complexity, tax and employment law compliance,and being subject to audits and other governmental actions. We have beenaudited for our contracting policies in the past, and may be in the future.Burdening our ability to freely use contractors to provide services to thecompany may increase the expense of obtaining such services, and/or require usto discontinue using contractors and attempt to find, interview, and hireemployees to provide similar services. Such potential employees may not beavailable in a reasonable time, or at all, or may not be hired without unduecost.

 

**In the past, we implemented mandatory unpaid company-wideshutdowns as a cost reduction measure, but we may not continue to implementthese programs.**

 

In the last two fiscal years and in each of the four quarters of 2003,we implemented mandatory company-wide shutdowns. Although these shutdownperiods represent a cost savings to us, they may be perceived negatively by ourcustomers, vendors and employees. We currently intend to implement a company-wideshutdown during the fourth quarter of 2004. In addition, we may continue toimplement company-wide shutdowns in future periods, which may negatively impactemployee morale or the perception of our company by our customers and vendors.If we elect not to implement these shutdowns, our operating expenses willincrease.

 

**Our workforce reductions may seriously harm our business.**

 

In connection with the restructuring programwe began in the third quarter of 2001 to focus our business on products and technologyin which we have, or believe we can achieve, a leadership position, and thereorganization of the company in the first quarter of 2003 into lines ofbusiness, we have implemented four workforce reductions, eliminating a total of136 positions. As a result of the elimination of these positions, ourmarketing, sales and customer support capabilities could be reduced, ourability to respond to unexpected challenges may be impaired, we may becomedependent on a few key employees, and we may be unable to take advantage of newopportunities. These workforce reductions, or future workforce reductions, ifany, may reduce employee morale and create concern among existing employeesabout job security, which could lead to increased turnover. Workforce reductionsmay also raise concerns among customers, suppliers and other corporate partnersregarding our continued viability. Further, these workforce reductions maysubject us to the risk of litigation, which could be costly to defend, divertthe attention of management and subject us to possible liability for damages.

 

**Industry cycles may strain our management and resources.**

 

Cycles of growth and contraction in our industry maystrain our management and resources. To manage these industry cycleseffectively, we must:

 

•      improve operational and financial systems;

 

•      train and manage our employee base;

 

•      successfully integrate operations andemployees of businesses we acquire or have acquired;

 

•      attract, develop, motivate and retainqualified personnel with relevant experience; and

 

•      adjust spending levels according to prevailingmarket conditions.

 

If we cannotmanage industry cycles effectively, our business could be seriously harmed.

 

**Our operations and the operations of our significantcustomers, third-party wafer foundries and third-party assembly and testsubcontractors are located in areas susceptible to natural disasters.**

 

Our operations are headquartered in the SanFrancisco Bay Area, which is susceptible to earthquakes, and the operations ofCMD, which we acquired, are based in the Los Angeles area, which is alsosusceptible to earthquakes. TSMC and UMC, the outside foundries that producethe majority of our semiconductor products, are located in Taiwan. AdvancedSemiconductor Engineering, or ASE, one of the subcontractors that assembles andtests our semiconductor products, is also located in Taiwan. For the ninemonths ended September 30, 2003, customers and distributors located in Taiwangenerated 35% of our revenue and customers and distributors located in Japangenerated 13% of our revenue. For the nine months ended September 30, 2002,customers and distributors located in Taiwan generated 34% of our revenue andcustomers and distributors located in Japan generated 13% of our revenue. BothTaiwan and Japan are susceptible to earthquakes, typhoons and other naturaldisasters.

 

Our business would be negatively affected if any ofthe following occurred:

 

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•      an earthquake or other disaster in the SanFrancisco Bay Area or the Los Angeles area damaged our facilities or disruptedthe supply of water or electricity to our headquarters or our Irvine facility;

 

•      an earthquake, typhoon or other disaster inTaiwan or Japan resulted in shortages of water, electricity or transportation,limiting the production capacity of our outside foundries or the ability of ASEto provide assembly and test services;

 

•      an earthquake, typhoon or other disaster inTaiwan or Japan damaged the facilities or equipment of our customers anddistributors, resulting in reduced purchases of our products; or

 

•      an earthquake, typhoon or other disaster inTaiwan or Japan disrupted the operations of suppliers to our Taiwanese orJapanese customers, outside foundries or ASE, which in turn disrupted theoperations of these customers, foundries or ASE and resulted in reducedpurchases of our products or shortages in our product supply.

 

 

**Changes in environmental rules and regulations could increaseour costs and reduce our revenue.**

 

Several jurisdictions are considering whether toimplement rules that would require that certain products, includingsemiconductors, be made lead-free. We anticipate that some jurisdictions mayfinalize and enact such requirements. Some jurisdictions are also consideringwhether to require abatement or disposal obligations for products made prior tothe enactment of any such rules. Although several of our products are availableto customers in a lead-free condition, most of our products are not lead-free.Any requirement that would prevent or burden the development, manufacture orsales of lead-containing semiconductors would likely reduce our revenue forsuch products and would require us to incur costs to develop substitutelead-free replacement products, which may take time and may not always beeconomically or technically feasible, and may require disposal of non-compliantinventory. In addition, any requirement to dispose or abate previously-soldproducts would require us to incur the costs of setting up and implementingsuch a program.

 

**Provisions of our charter documents and Delaware law couldprevent or delay a change in control, and may reduce the market price of ourcommon stock.**

 

Provisions of our certificate of incorporation andbylaws may discourage, delay or prevent a merger or acquisition that astockholder may consider favorable. These provisions include:

 

•      authorizing the issuance of preferred stockwithout stockholder approval;

 

•      providing for a classified board of directorswith staggered, three-year terms;

 

•      prohibiting cumulative voting in the electionof directors;

 

•      requiring super-majority voting to amend someprovisions of our certificate of incorporation and bylaws;

 

•      limiting the persons who may call specialmeetings of stockholders; and

 

•      prohibiting stockholder actions by writtenconsent.

 

Provisions of Delaware law also may discourage, delayor prevent someone from acquiring or merging with us.

 

**The price of our stock fluctuates substantially and maycontinue to do so.**

 

The stock market has experienced extreme priceand volume fluctuations that have affected the market valuation of manytechnology companies, including Silicon Image. These factors, as well asgeneral economic and political conditions, may materially and adversely affectthe market price of our common stock in the future. The market price of ourcommon stock has fluctuated significantly and may continue to fluctuate inresponse to a number of factors, including, but not limited to:

 

•      actual or anticipated changes in our operatingresults;

 

•      changes in expectations of our futurefinancial performance;

 

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•      changes in market valuations of comparablecompanies in our markets;

 

•      changes in market valuations or expectationsof future financial performance of our vendors or customers;

 

•      changes in our key executives and technicalpersonnel; and

 

•      announcements by us or our competitors ofsignificant technical innovations, design wins, contracts, standards oracquisitions.

 

Due to these factors, the price of our stock maydecline. In addition, the stock market experiences volatility that is oftenunrelated to the performance of particular companies. These market fluctuationsmay cause our stock price to decline regardless of our performance.

 

##### **We are in theprocess of implementing an enterprise resource platform**

 

We are in the process of implementing an enterprise resource platform(ERP) system, and of hosting that system on our site.  The system is comprised of hardware and software, and services,all of which we acquired from vendors; however, we are also customizingportions of the system with in-house resources.  This requires careful management of the skills and resources toimplement the ERP system and to establish disaster recovery plans.  If we are unsuccessful, or if the hardwareor software should fail, we could lose access to the data needed to book andfill customer orders, ship products, and produce financial reports, which wouldhave a material adverse effect on our business.

 

 

**Continued terrorist attacks or war could lead to furthereconomic instability and adversely affect our operations, results of operationsand stock price.**

 

The United States has taken, and continues to take,military action against terrorism and has engaged in war with Iraq andcurrently has an occupation force there and in Afghanistan. In addition, thecurrent nuclear arms crises in North Korea and Iran could escalate into armedhostilities or war. Acts of terrorism or armed hostilities may disrupt orresult in instability in the general economy and financial markets and inconsumer demand for the OEM’s products that incorporate our products.Disruptions and instability in the general economy could reduce demand for ourproducts or disrupt the operations of our customers, suppliers, distributorsand contractors, many of whom are located in Asia, which would in turnadversely affect our operations and results of operations. Disruptions andinstability in financial markets could adversely affect our stock price. Armedhostilities or war in South Korea could disrupt the operations of the researchand development contractors we utilize there, which would adversely affect ourresearch and development capabilities and ability to timely develop andintroduce new products and product improvements.

 

##### **We are in theprocess of establishing an office in Japan**

 

We are in theprocess of establishing an office in Japan. Accordingly, we are subject torisks, including, but not limited to:

 

•      being subject to Japanese tax laws and potentially liable for payingtaxes in Japan;

•      profits,if any, earned in Japan will be subject to local tax laws and may not berepatriable to the U.S.;

•      wewill enter into employment agreements in connection with hiring personnel forthe Japanese office and will be governed by the provisions of the Japaneselabor laws; and

•      the operations of the local office will be subject to the provisionsof other local laws and regulations.

 

##### **We are in theprocess of establishing an office in the Republic of Korea (South Korea)**

 

We are in theprocess of establishing an office in the Republic of Korea (South Korea).Accordingly, we are subject to risks, including, but not limited to:

 

•      being subject to South Korean tax laws and potentially liable forpaying taxes in South Korea;

•      profits,if any, earned in South Korea will be subject to local tax laws and may not berepatriable to the U.S.;

•      wewill enter into employmentagreements in connection with hiring personnel for the South Korea office andwill be governed by the provisions of the South Korean labor laws; and

•      the operations of the local office will be subject to the provisionsof other local laws and regulations.

 

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**Item 3.  Quantitative and QualitativeDisclosures About Market Risk**

 

**Interest Rate Risk**

 

Our cash equivalents and short-terminvestments consist primarily of fixed-income securities that are subject tointerest rate risk and will decline in value if interest rates increase. Due tothe short duration of our cash equivalents and short-term investments, animmediate 10% change in interest rates would not be expected to have a materialeffect on our near-term results of operations or financial condition. Ourlong-term capital lease obligations bear interest at fixed rates; therefore,our results of operations would not be affected by immediate changes ininterest rates.  Also, components of our stock compensation expense aretied to our stock price.  Changes in our stock price can have a significanteffect on the amount recorded as stock compensation expense.

 

**Foreign Currency Exchange Risk**

 

All of our sales are denominated in U.S.dollars, and substantially all of our expenses are incurred in U.S. dollars,thus limiting our exposure to foreign currency exchange risk. We currently donot enter into forward exchange contracts to hedge exposures denominated inforeign currencies and do not use derivative financial instruments for tradingor speculative purposes. The effect of an immediate 10% change in foreigncurrency exchange rates should not have a material effect on our futureoperating results or cash flows; however, a long term change in foreigncurrency rates would likely result in increased wafer, packaging, assembly ortesting costs.

 

**Item 4.  Controlsand Procedures**

 

(a)   Evaluation of Controlsand Procedures.  We have carried outan evaluation, under the supervision and with the participation of ourmanagement, including our Chief Executive Officer and Chief Financial Officer,of the effectiveness of the design and operation of our disclosure controls andprocedures (as defined in Exchange Act Rule 13a-15 and 15(d)-15).  Theevaluation took into account the conduct of and results of the Audit Committeeexamination completed in February 2004, and the receipt of notice from theCompany’s independent auditors that, in connection with the 2003 year-endaudit, they have identified a reportable condition relating to internalcontrols.  Based upon that evaluation,our Chief Executive Officer and Chief Financial Officer concluded that ourcontrols and procedures as of the end of the period covered by this report wereeffective, except that as the number and complexity of licensing transactionsincrease, the Company’s control environment could and should be enhanced, asdiscussed below.

 

(b)   Changes in InternalControls.  The Company is in theprocess of restructuring reporting relationships as they relate to licensingrevenue; adopting a policy requiring additional documentation of itemsnecessary for licensing revenue recognition decisions; increasing thestandardization of licensing deliverables and post-contract customer supportfor revenue recognition purposes; and formalizing its licensing deal reviewprocess.  The Company is also in theprocess of adopting internal procedures designed to enhance the Company’soverall internal control environment and to increase the level of communicationwithin the management team and between the management team and the Board ofDirectors, including the Audit Committee.

 

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**Part II****.  Other Information**

 

**Item 1.  LegalProceedings**

 

OnApril 24, 2001, we filed suit in the U.S. District Court for the EasternDistrict of Virginia against Genesis Microchip Corp. and Genesis Microchip,Inc. (collectively, “Genesis”) for infringement of our U.S. patent number 5,905,769 (USDC E.D.Virginia Civil Action No.: CA-01-266-R) (the “Federal Suit”). On April 24, 2001, we also filed acomplaint against Genesis with the International Trade Commission of the UnitedStates government (“ITC”) forunlawful trade practices related to the importation of articles infringing ourpatent (the “ITC investigation”).The actions sought injunctions to halt the importation, sale, manufacture and useof Genesis DVI receiver chips that infringe our patent, and monetary damages.We voluntarily moved to dismiss the ITC investigation, with notice that wewould proceed directly in the Federal Suit. Our motion to dismiss was grantedon February 7, 2002. We filed an amended complaint in the Federal Suit as ofFebruary 28, 2002, adding a claim for infringement of our U.S. patent number5,974,464. In April 2002, Genesis answered and made counterclaims against usfor non-infringement, license, patent invalidity, fraud, antitrust, unfaircompetition and patent misuse. Also in April 2002, we filed a motion to dismisscertain of Genesis’ counterclaims. In addition, we filed a motion to bifurcatetrial of the counterclaims to the extent the court does not dismiss them. InMay 2002, the Court granted our motion to dismiss certain of the counterclaims,with leave to amend. Genesis re-filed counterclaims against us for fraud andpatent misuse. We filed another motion to dismiss these counterclaims. InDecember 2002, the parties entered into a memorandum of understanding (“MOU”)to settle the case.  In January, theparties presented different interpretations of the MOU to the Court.  On July 15, 2003, the Court granted ourmotion to interpret the MOU in the manner we requested, and ruled that Genesishad engaged in efforts to avoid its obligations under the MOU. On August 6,2003, the Court entered a final judgment based on its July 15, 2003 ruling.Under the final judgment order, Genesis was ordered to make a substantial cashpayment, and to make royalty payments; although Genesis has made a cash paymentto the Court, it has not made all the payments that are required under thefinal judgment order. We have filed motions for reimbursement of some of ourexpenses, including some of our legal fees, and for modification and/orclarification of certain items of the judgment, and to hold Genesis in contemptof Court for breaching the protective order in the case by disclosing secretinformation to at least one of our competitors, but there can be no assurancethat the Court will grant our motions. On December 19, 2003, the Court granted our motions in part and deniedthem in part: the court issued an amended judgment, and held Genesis incontempt of Court for breaching the protective order.  On January 16, 2004, Genesis filed a notice of appeal.  To date, we have not recognized any incomeor revenue associated with the matter. Due to the continuing and contentiousnature of this litigation, we will not record any income or revenue related tothis matter until the litigation is complete and all other income and revenuerecognition criteria have been satisfied. Genesis may appeal.   Management intends to prosecute ourposition vigorously until this matter is resolved. Through September 30, 2003,we have spent approximately $10.2 million on this matter and expect to continueto incur significant costs through at least the fourth quarter of 2004.

 

SiliconImage, certain officers and directors, and Silicon Image’s underwriters, havebeen named as defendants in a securities class action lawsuit captionedGonzales v. Silicon Image, et al., No. 01 CV 10903 (SDNY 2001) pending inFederal District Court for the Southern District of New York. The lawsuitalleges that all defendants were part of a scheme to manipulate the price ofSilicon Image’s stock in the aftermarket following Silicon Image’s initialpublic offering in October 1999. Response to the complaint and discovery inthis action on behalf of Silicon Image and individual defendants has beenstayed by order of the court. The lawsuit is proceeding as part of acoordinated action of over 300 such cases brought by plaintiffs in the SouthernDistrict of New York. Pursuant to a tolling agreement, individual defendantshave been dropped from the suit for the time being. In February 2003, the Courtdenied underwriters’ motion to dismiss and ordered that the case may proceedagainst issuers including against Silicon Image. A proposed settlement has beennegotiated that has yet to be reviewed and approved by the Court.  In the event that the settlement isapproved, we do not expect it to have a material effect on our results orfinancial position.  In the event that thesettlement is not approved, we could not accurately predict the outcome of thislitigation, but we intend to defend this matter vigorously.

 

SiliconImage, certain officers and directors, and Silicon Image’s underwriters havebeen named as defendants in a securities class action lawsuit captioned Liu v.Credit Suisse First Boston Corp., et al., No. 03-20459 (S.D. Fla. 2003) pendingin Federal District Court for the Southern District of Florida. Plaintiff filedan action on behalf of a putative class of shareholders who purchased stockfrom some or all of approximately 50 issuers whose public offerings wereunderwritten by Credit Suisse First Boston. The lawsuit alleges that SiliconImage and certain officers were part of a scheme by Credit Suisse First Bostonto artificially inflate the price of Silicon Image’s stock through the disseminationof allegedly false analysts’ reports. Silicon Image has not been served with acopy of the complaint. The plaintiff in this matter has filed an amendedcomplaint in which Silicon Image, and the named officers, were dropped asdefendants.  We believe that theproposed settlement described above, if approved, would encompass the claims inthis case. We believe that these claims are without merit and, if revived, andnot subject to the settlement, we would defend this matter vigorously.

 

Certain officers and directors of Silicon Image have been named asdefendants in consolidated shareholder derivative litigation, captioned “In reSilicon Image, Inc. Derivative Litigation, No. 1:03CV010302”, commenced onDecember 4, 2003 and pending in the Superior Court of California, County ofSanta Clara.  Plaintiffs purport to suethe individual defendants on behalf of Silicon Image.  The lawsuit alleges that as a result of the recently completedexamination conducted by the Audit Committee of Silicon Image’s Board ofDirectors, Silicon Image will be required to restate its financial results for2002 and 2003.  The lawsuit furtheralleges that such a restatement would be due to breaches by the individualdefendants of their fiduciary duties to Silicon Image;

 

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that certain of the individualdefendants are liable to Silicon Image for insider trading under Californialaw; and that the individual defendants are liable to Silicon Image formismanagement, abuse of control, and waste. Before filing suit, plaintiffs did not make a demand upon the board ofdirectors to pursue any such claims directly on behalf of Silicon Image.  With the announcement by the Audit Committeeof Silicon Image’s Board of Directors that it has completed its examination andthat it has concluded that no changes to Silicon Image’s previously announcedfinancial results are required, the lawsuit may be moot in whole or in part,although plaintiffs may amend the complaint once as a matter of right.  The individual defendants believe thelawsuit is without merit, and they intend to defend the action vigorously ifplaintiffs do not amend it.  We cannotpredict what claims plaintiffs might assert in an amended complaint.

 

Silicon Image and certain of its officers have been named as defendantsin consolidated securities class action litigation captioned “In re SiliconImage, Inc. Securities Litigation, No. C-03-5579 JW PVT”, commenced on December11, 2003 and pending in the United States District Court for the NorthernDistrict of California.  Plaintiffsfiled the action on behalf of a putative class of shareholders who purchasedSilicon Image stock between April 15, 2002 and November 15, 2003.  The lawsuit alleges that Silicon Image hadmaterially overstated its licensing revenue, net income and financial resultsduring this time period, and that Silicon Image was being forced to restate itsfinancial results.  With theannouncement by the Audit Committee of Silicon Image’s Board of Directors thatit has completed its examination and that it has concluded that no changes toSilicon Image’s previously announced financial results are required, thelawsuit may be moot in whole or in part, although plaintiffs may amend thecomplaint once as a matter of right.  Webelieve the lawsuit is without merit, and intend to defend the actionvigorously if plaintiffs do not amend it. We cannot predict what claims plaintiffs might assert in an amendedcomplaint.

 

Inaddition, we have been named as defendants in a number of judicial andadministrative proceedings incidental to our business and may be named againfrom time to time. We intend to defend, such matters vigorously, and althoughadverse decisions or settlements may occur in one or more of such cases, thefinal resolution of these matters, individually or in the aggregate, is notexpected to have a material adverse effect on our results of operations orfinancial position.

 

Theamount of legal fees we incur with respect to the litigation matters describedabove will depend on the duration of our litigation matters, as well as thenature and extent of the litigation activities. We are not able to accuratelyestimate the amount of legal fees we will incur in 2003 with respect to thelitigation matters described above; however, we do expect to incur substantialamounts through at least the fourth quarter of 2004.

 

**Item 2.  Changes in Securities and Use ofProceeds**

 

Inconnection with our acquisition of Zillion Technologies, LLC, we are obligatedunder an exchange agreement to periodically issue to the two founders ofZillion shares of our common stock as consideration for their membershipinterests in Zillion which we acquired and services provided pursuant to theiremployment agreements with us.  The Zillion founders were grantedregistration rights with respect to the shares to be issued under this exchangeagreement.  These issuances of shares were made in reliance on anexemption from registration under Section 4(2) of the Securities Act.  OnSeptember 30, 2003, we issued 18,750 shares of our common stock to the Zillionfounders pursuant to the exchange agreement.  The issuances of shares weremade without general solicitation or advertising and were only made to twoindividuals.

 

**Item 3.  DefaultsUpon Senior Securities**

 

Not applicable.

 

**Item 4.  Submission of Matters to a Vote ofSecurity Holders**

 

Notapplicable.

 

**Item 5.  OtherInformation**

 

Not applicable.

 

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**Item 6.  Exhibitsand Reports on Form 8-K**

 

(a)                  Exhibits

 
| **Exhibit Number** |   | **Exhibit Title**                                                                                                        |
|--------------------|--------|--------------------------------------------------------------------------------------------------------------------------|
| 31.1               |   | Certification under Section 302 of the  Sarbanes-Oxley Act of 2002.                                                      |
| 31.2               |   | Certification under Section 302 of the  Sarbanes-Oxley Act of 2002.                                                      |
| 32.1               |   | Certification pursuant to 18 U.S.C. Section  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2               |   | Certification pursuant to 18 U.S.C. Section  1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

(b)                 Reports on Form 8-K

 

On August 25, 2003, we filed a current report on Form 8-K to reportunder Item 5 that David Lee, our Chief Executive Officer and Chairman of theBoard, entered into a Rule 10b5-1 sales plan with Deutsche Bank Alex. Brown.

 

On September 2, 2003, we filed a current report on Form 8-K to reportunder Item 5 that Jaime Garcia-Meza, Parviz Khodi and Steve Tirado, our VicePresident of Worldwide Sales, our Vice President of Digital PC/Display Productsand our President, entered into a Rule 10b5-1 sales plans with UBS PaineWebber/Financial West Group, Credit Suisse First Boston Corporation and UBSPaine Webber/Financial West Group respectively.

 

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**Signatures**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
| Dated:  February 17, 2004 | Silicon  Image, Inc.                                                   |
|---------------------------|------------------------------------------------------------------------|
|                      |                                                                   |
|                      | */s/  Robert G. Gargus*                                           |   |
|                      | Robert  G. Gargus                                                      |
|                      | Vice  President Finance and Administration and Chief Financial Officer |
|                      | (Principal  financial officer and duly authorized officer)             |

 

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**EXHIBIT INDEX**

 
| **Exhibit Number** |   | **Exhibit Title**                                                                                                            |
|--------------------|--------|------------------------------------------------------------------------------------------------------------------------------|
| 31.1               |   | Certification under Section 302 of the  Sarbanes-Oxley Act of 2002.                                                          |
| 31.2               |   | Certification under Section 302 of the  Sarbanes-Oxley Act of 2002.                                                          |
| 32.1               |   | Certification by pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of  2002. |
| 32.2               |   | Certification by pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of  2002. |

 

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