**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**ý****QUARTERLY REPORT UNDERSECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended June 30, 2004**

 

**OR**

 

**o****TRANSITION REPORTPURSUANT 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)

 

Indicate bycheck 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 was requiredto file such reports) Yes ýNo o and (2) has been subject to such filingrequirements for the past 90 days Yes ýNo o

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange Act). Yes ýNo o

 

The number ofshares of the registrant’s Common Stock, $0.001 par value per share,outstanding as of July 30, 2004 was 75,238,552 shares.

 

 

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**Silicon Image, Inc.****Quarterly Report on Form 10-Q****Three and****Six MonthsEnded****June 30, 2004**

 

**Table ofContents**

 
| **Part I** | **Financial Information (Unaudited)** | ** **                                                                                                 |
|------------|---------------------------------------|------------------------------------------------------------------------------------------------------------|
|       |                                  |
|       | Item 1                                | Financial Statements                                                                                       |   |
|       |                                  |                                                                                                       |   |
|       |                                  | Condensed Consolidated Statements of  Operations for the three and six months ended June 30, 2004 and 2003 |   |
|       |                                  |                                                                                                       |   |
|       |                                  | Condensed Consolidated Balance Sheets as of  June 30, 2004 and December 31, 2003                           |   |
|       |                                  |                                                                                                       |   |
|       |                                  | Condensed Consolidated Statements of Cash  Flows for the six months ended June 30, 2004 and 2003           |   |
|       |                                  |                                                                                                       |   |
|       |                                  | 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**                        |                                                                                                       |
|       |                                  |                                                                                                       |   |
|       | **Certifications**                    |                                                                                                       |
|            |                                       |                                                                                                            |  |  |  |  |

 

----

 

**PartI.  Financial Information**

 

**Item1.  Financial Statements**

 

**Silicon Image, Inc.****CondensedConsolidated Statements of Operations****(in thousands, except per share amounts)****(unaudited)**

 
| ** **                              | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** |
|-----------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                              | ** ** | **2004**                       | ** ** | **2003**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                    |       |                           |       |                         |       |   |   |   |   |
| Revenue:                                |       |                           |       |                         |       |   |   |   |   |
| Product                                 |       | $                              | 36,826     |                         | $          | 19,745 |   | $ | 68,876 |   | $ | 39,467 |   |
| Development, licensing and royalties    |       | 6,535                          |       | 4,587                        |       | 10,343 |   | 9,541 |   |
| Total revenue                           |       | 43,361                         |       | 24,332                       |       | 79,219 |   | 49,008 |   |
|                                    |       |                           |       |                         |       |   |   |   |   |
| Cost and operating expenses:            |       |                           |       |                         |       |   |   |   |   |
| Cost of revenue (1)                     |       | 17,695                         |       | 10,729                       |       | 32,210 |   | 21,784 |   |
| Research and development (2)            |       | 16,245                         |       | 11,209                       |       | 33,043 |   | 20,172 |   |
| Selling, general and administrative (3) |       | 10,067                         |       | 4,689                        |       | 21,718 |   | 8,644 |   |
| Amortization of intangible assets       |       | 357                            |       | 373                          |       | 713 |   | 373 |   |
| Patent defense costs                    |       | 98                             |       | 583                          |       | 263 |   | 1,796 |   |
| Restructuring                           |       | —                         |       | —                       |       | — |   | 986 |   |
| In-process research and development     |       | —                         |       | 5,482                        |       | — |   | 5,482 |   |
| Total cost and operating expenses       |       | 44,462                         |       | 33,065                       |       | 87,947 |   | 59,237 |   |
|                                    |       |                           |       |                         |       |   |   |   |   |
| Loss from operations                    |       | (1,101                         | )          | (8,733                       | )          | (8,728 | ) | (10,229 | ) |
| Gain on escrow settlement, net          |       | —                         |       | —                       |       | — |   | 4,618 |   |
| Interest income and other, net          |       | 104                            |       | 67                           |       | 188 |   | 176 |   |
| Gain on derivative investment security  |       | 990                            |       | —                       |       | 990 |   | — |   |
| Loss before provision for income taxes  |       | (7                             | )          | (8,666                       | )          | (7,550 | ) | (5,435 | ) |
|                                    |       |                           |       |                         |       |   |   |   |   |
| Provision for income taxes              |       | 255                            |       | —                       |       | 572 |   | — |   |
| Net loss                                |       | $                              | (262       | )                            | $          | (8,666 | ) | $ | (8,122 | ) | $ | (5,435 | ) |
|                                    |       |                           |       |                         |       |   |   |   |   |
| Net loss per share:                     |       |                           |       |                         |       |   |   |   |   |
| Basic and diluted                       |       | $                              | (0.00      | )                            | $          | (0.13 | ) | $ | (0.11 | ) | $ | (0.08 | ) |
|                                    |       |                           |       |                         |       |   |   |   |   |
| Weighted average shares                 |       | 73,352                         |       | 69,012                       |       | 72,934 |   | 68,085 |   |

 

----

(1)          Includesstock compensation expense (benefit) of $849,000 and $78,000 for the threemonths ended June 30, 2004 and 2003, respectively, and $2,000,000 and ($57,000)for the six months ended June 30, 2004 and 2003, respectively.

 

(2)          Includesstock compensation expense of $4,776,000 and $1,841,000 for the three monthsended June 30, 2004 and 2003, respectively, and $10,989,000 and $1,967,000 forthe six month periods ended June 30, 2004 and 2003, respectively.

 

(3)          Includesstock compensation expense (benefit) of $3,507,000 and $334,000 for the threemonths ended June 30, 2004 and 2003, respectively, and $8,211,000 and ($19,000)for the six months ended June 30, 2004 and 2003, respectively.

 

See accompanying Notes to Unaudited Condensed Consolidated FinancialStatements.

 

1

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**Silicon Image, Inc.****Condensed ConsolidatedBalance Sheets****(in thousands, except share amounts)****(unaudited)**

 
| ** **                                                                                                                                                                                  | ** ** | **June 30,****2004** | ** ** | **Dec. 31,****2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|----------------------|------------|
| **Assets**                                                                                                                                                                                  |       |                 |       |                 |       |
| Current Assets:                                                                                                                                                                             |       |                 |       |                 |       |
| Cash and cash equivalents                                                                                                                                                                   |       | $                    | 41,618     |                 | $          | 24,059 |   |
| Short-term investments                                                                                                                                                                      |       | 24,502               |       | 13,195               |       |
| Accounts receivable, net of allowances for  doubtful accounts of $722 at June 30 and $670 at December 31                                                                                    |       | 20,183               |       | 12,754               |       |
| Inventories                                                                                                                                                                                 |       | 9,937                |       | 10,312               |       |
| Prepaid expenses and other current assets                                                                                                                                                   |       | 2,243                |       | 2,703                |       |
| Total current assets                                                                                                                                                                        |       | 98,483               |       | 63,023               |       |
| Property and equipment, net                                                                                                                                                                 |       | 8,057                |       | 7,411                |       |
| Goodwill                                                                                                                                                                                    |       | 13,021               |       | 13,021               |       |
| Intangible assets, net                                                                                                                                                                      |       | 2,315                |       | 3,028                |       |
| Other assets                                                                                                                                                                                |       | 1,070                |       | 1,259                |       |
| Total assets                                                                                                                                                                                |       | $                    | 122,946    |                 | $          | 87,742 |   |
|                                                                                                                                                                                        |       |                 |       |                 |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                                               |       |                 |       |                 |       |
| Current Liabilities:                                                                                                                                                                        |       |                 |       |                 |       |
| Accounts payable                                                                                                                                                                            |       | $                    | 9,274      |                 | $          | 6,442 |   |
| Accrued liabilities                                                                                                                                                                         |       | 11,131               |       | 8,726                |       |
| Deferred license revenue                                                                                                                                                                    |       | 2,065                |       | 1,175                |       |
| Debt obligations                                                                                                                                                                            |       | 863                  |       | 1,732                |       |
| Deferred margin on sales to distributors                                                                                                                                                    |       | 11,738               |       | 7,274                |       |
| Total liabilities                                                                                                                                                                           |       | 35,071               |       | 25,349               |       |
|                                                                                                                                                                                        |       |                 |       |                 |       |
| Stockholders’ Equity:                                                                                                                                                                  |       |                 |       |                 |       |
| Common stock, par value $0.001; shares  authorized: 150,000,000 – June 30 and December 31; shares issued and  outstanding: 74,676,542 – June 30 and 72,367,129 – December 31 |       | 75                   |       | 72                   |       |
| Additional paid-in capital                                                                                                                                                                  |       | 272,688              |       | 243,171              |       |
| Unearned stock compensation                                                                                                                                                                 |       | (8,055               | )          | (8,196               | )          |
| Accumulated deficit                                                                                                                                                                         |       | (180,776             | )          | (172,654             | )          |
| Accumulated other comprehensive income                                                                                                                                                      |       | 3,943                |       | —               |       |
| Total stockholders’ equity                                                                                                                                                             |       | 87,875               |       | 62,393               |       |
| Total liabilities and stockholders’ equity                                                                                                                                             |       | $                    | 122,946    |                 | $          | 87,742 |   |

 

See accompanying Notes to Unaudited Condensed Consolidated FinancialStatements.

 

2

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**Silicon Image, Inc.****CondensedConsolidated Statements of Cash Flows****(in thousands)****(unaudited)**

 
| ** **                                                                             | ** ** | **Six Months Ended June 30** | ** ** |
|----------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                             | ** ** | **2004**                     | ** ** | **2003** | ** ** |
|                                                                                   |       |                         |       |   |   |
| ***Cash flows from  operating activities:***                                           |       |                         |       |   |   |
| Net loss                                                                               |       | $                            | (8,122     | ) | $ | (5,435 | ) |
| Adjustments to reconcile net loss to cash  provided by (used in) operating activities: |       |                         |       |   |   |
| Depreciation and amortization                                                          |       | 2,329                        |       | 2,210 |   |
| Amortization of intangible assets                                                      |       | 713                          |       | 373 |   |
| Provision for doubtful accounts receivable                                             |       | 52                           |       | — |   |
| Stock compensation expense                                                             |       | 21,200                       |       | 1,891 |   |
| Non-cash restructuring                                                                 |       | —                       |       | 646 |   |
| In-process research and development expense                                            |       | —                       |       | 5,482 |   |
| Non-cash gain on escrow settlement, before  cash costs                                 |       | —                       |       | (4,692 | ) |
| Gain on derivative investment security                                                 |       | (990                         | )          | — |   |
| Changes in assets and liabilities, net of  amounts acquired:                           |       |                         |       |   |   |
| Accounts receivable                                                                    |       | (7,481                       | )          | (4,142 | ) |
| Inventories                                                                            |       | 375                          |       | (90 | ) |
| Prepaid expenses and other assets                                                      |       | 649                          |       | 1,259 |   |
| Accounts payable                                                                       |       | 2,832                        |       | (632 | ) |
| Accrued liabilities and deferred license  revenue                                      |       | 3,265                        |       | (2,374 | ) |
| Deferred margin on sales to distributors                                               |       | 4,464                        |       | (140 | ) |
| Cash provided by (used in) operating  activities                                       |       | 19,286                       |       | (5,644 | ) |
|                                                                                   |       |                         |       |   |   |
| ***Cash flows from  investing activities:***                                           |       |                         |       |   |   |
| Proceeds from sales and maturities of  short-term investments                          |       | 13,281                       |       | 7,295 |   |
| Purchases of short-term investments                                                    |       | (19,625                      | )          | (3,559 | ) |
| Acquisition costs, net of cash acquired                                                |       | —                       |       | 3 |   |
| Net purchases of property and equipment                                                |       | (2,975                       | )          | (2,560 | ) |
| Cash provided by (used in) investing  activities                                       |       | (9,319                       | )          | 1,179 |   |
|                                                                                   |       |                         |       |   |   |
| ***Cash flows from  financing activities:***                                           |       |                         |       |   |   |
| Proceeds from issuances of common stock,  net                                          |       | 8,461                        |       | 4,658 |   |
| Proceeds from repayment of stockholders’  notes receivable                        |       | —                       |       | 109 |   |
| Repayments of capital lease and debt  obligations                                      |       | (869                         | )          | (1,378 | ) |
| Cash provided by financing activities                                                  |       | 7,592                        |       | 3,389 |   |
|                                                                                   |       |                         |       |   |   |
| **Net increase (decrease) in cash and cash  equivalents**                              |       | 17,559                       |       | (1,076 | ) |
| Cash and cash equivalents — beginning of  period                                  |       | 24,059                       |       | 26,263 |   |
| Cash and cash equivalents — end of period                                         |       | $                            | 41,618     |   | $ | 25,187 |   |
|                                                                                   |       |                         |       |   |   |
| **Supplemental cash flow information:**                                                |       |                         |       |   |   |
| Cash payment for  taxes                                                                |       | $                            | 262        |   | $ | — |   |
| **Supplemental  non-cash investing and financing activities:**                         |       |                         |       |   |   |
| Financing of property and equipment                                                    |       | $                            | —     |   | $ | 383 |   |
| Stock and options  issued in connection with the Transwarp acquisition                 |       | $                            | —     |   | $ | 14,371 |   |
| Unrealized gain  on equity investment, net of tax                                      |       | $                            | 3,943      |   | $ | — |   |

 

See accompanying Notes to Unaudited Condensed Consolidated FinancialStatements.

 

3

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**Silicon Image, Inc.Notes to Unaudited CondensedConsolidated Financial StatementsJune 30, 2004**

 

1.               Basisof Presentation

 

In the opinionof management, the accompanying unaudited condensed consolidated financialstatements of Silicon Image, Inc. included herein have been prepared on a basisconsistent with our December 31, 2003 audited financial statements and includeall adjustments, consisting of normal recurring adjustments, necessary tofairly state the consolidated financial position of Silicon Image and itssubsidiaries (collectively, the “Company”) at June 30, 2004 and theconsolidated results of the Company’s operations and cash flows for the threeand six months ended June 30, 2004 and 2003. All significant intercompany accounts and transactions have beeneliminated.  These interim financialstatements should be read in conjunction with the audited financial statementsand notes thereto included in our Form 10-K for the fiscal year ended December31, 2003.  Certain comparative amountshave been reclassified to conform with the current presentation. Thesereclassifications have no impact on the reported results of operations for anyperiod presented. Results of operations for the three and six months ended June30, 2004 are not necessarily indicative of future operating results.

 

2.               RecentAccounting Pronouncements

 

InJanuary 2003, the Financial Accounting Standards Board (“FASB”) issuedInterpretation 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) has equity investors that do not provide sufficient financialresources for the entity to support its activities. FIN 46 requires certainvariable interest entities to be consolidated by the primary beneficiary of theentity if the investors do not have the characteristics of a controllingfinancial interest or do not have sufficient equity at risk for the entity tofinance its activities without additional subordinated financial support fromother parties. The consolidation requirements of FIN 46 apply immediately to variableinterest entities created after January 31, 2003. Certain of thedisclosure requirements apply to all financial statements issued afterJanuary 31, 2003, regardless of when the variable interest entity wasestablished. The adoption of this standard had no impact on our consolidatedfinancial statements.

 

In March 2004, the Emerging Issues Task Force(“EITF”) reached a consensus on Issue No. 03-1, “The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments.”EITF 03-1 provides guidance on other-than-temporary impairment models formarketable debt and equity securities accounted for under SFAS No. 115,“Accounting for Certain Investments in Debt and Equity Securities,” and SFASNo. 124, “Accounting for Certain Investments Held by Not-for-ProfitOrganizations,” and non-marketable equity securities accounted for under thecost method. The EITF developed a basic three-step model to evaluate whether aninvestment is other-than-temporarily impaired. The provisions of EITF 03-1 willbe effective for our third quarter of fiscal 2004 and will be appliedprospectively to all current and future investments. We do not expect theadoption of EITF 03-1 to have a material effect on our results of operations orfinancial condition.

 

Stock-BasedCompensation

 

Excludingcertain re-pricings, we account for stock-based awards to employees anddirectors using the intrinsic value method of accounting in accordance withAccounting Principles Board Opinion No. 25, “Accounting for Stock Issued toEmployees” (“APB 25”). Under the intrinsic value method, if the exercise priceof our employee stock options equals the market price of the underlying stockon the date of grant, no compensation expense is recognized.

 

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 netincome (loss) would have been as follows (in thousands, except per shareamounts):

 

4

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| ** **                                                                                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                       | ** ** | **June 30, 2004**      | ** ** | **June 30, 2003**    | ** ** | **June 30, 2004** | ** ** | **June 30, 2003** | ** ** |
|                                                                                             |       |                   |       |                 |       |   |   |   |   |
| Net loss — as reported                                                                      |       | $                      | (262       | )                    | $          | (8,666 | ) | $ | (8,122 | ) | $ | (5,435 | ) |
| Stock-based employee compensation expense  included in the determination of net loss as reported |       | 6,893                  |       | 1,360                |       | 16,179 |   | 949 |   |
| Stock-based employee compensation expense  determined using fair value method                    |       | (5,233                 | )          | (5,586               | )          | (10,370 | ) | (11,606 | ) |
|                                                                                             |       |                   |       |                 |       |   |   |   |   |
| Pro forma net income (loss)                                                                      |       | $                      | 1,398      |                 | $          | (12,892 | ) | $ | (2,313 | ) | $ | (16,092 | ) |
|                                                                                             |       |                   |       |                 |       |   |   |   |   |
| Basic and diluted net income (loss) per  share — pro forma                                  |       | $                      | 0.02       |                 | $          | (0.19 | ) | $ | (0.03 | ) | $ | (0.24 | ) |
| Basic and diluted net loss per share — as  reported                                         |       | $                      | (0.00      | )                    | $          | (0.13 | ) | $ | (0.11 | ) | $ | (0.08 | ) |

 

The weighted average grant-date fair value was estimatedusing the Black-Scholes pricing model with the following assumptions:

 
| ** **                  | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** |
|-----------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                  | ** ** | **2004**                       | ** ** | **2003**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|                        |       |                           |       |                         |       |   |   |   |   |
| Expected life (years)       |       | 5                              |       | 5                            |       | 5 |   | 5 |   |
| Interest rate               |       | 3.0                            | %          | 3.0                          | %          | 3.0 | % | 3.0 | % |
| Volatility                  |       | 90                             | %          | 90                           | %          | 90 | % | 90 | % |
| Dividend yield              |       | —                         |       | —                       |       | — |   | — |   |
| Weighted average fair value |       | $                              | 8.37       |                         | $          | 3.69 |   | $ | 7.39 |   | $ | 4.15 |   |
|                             |            |                                |            |                              |            |  |  |  |  |  |  |  |  |

 

The weightedaverage, grant-date fair value of stock purchase rights granted under ourEmployee Stock Purchase Plan and the assumptions used are as follows:

 
| ** **                             | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** |
|----------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                             | ** ** | **2004**                       | ** ** | **2003**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                   |       |                           |       |                         |       |   |   |   |   |
| Expected life (years)                  |       | 1.5                            |       | 1.5                          |       | 1.5 |   | 1.5 |   |
| Interest rate                          |       | 1.2                            | %          | 1.3                          | %          | 1.2 | % | 1.3 | % |
| Dividend yield                         |       | —                         |       | —                       |       | — |   | — |   |
| Volatility                             |       | 73                             | %          | 90                           | %          | 73 | % | 90 | % |
| Weighted average grant date fair value |       | $                              | 2.88       |                         | $          | 2.93 |   | $ | 2.69 |   | $ | 2.76 |   |
|                                        |            |                                |            |                              |            |  |  |  |  |  |  |  |  |

 

Comprehensiveincome (loss)

 

The componentsof comprehensive income (loss), net of related taxes, were as follows: 

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                      | ** ** | **June 30, 2004**      | ** ** | **June 30, 2003**    | ** ** | **June 30, 2004** | ** ** | **June 30, 2003** | ** ** |
|                                            |       |                   |       |                 |       |   |   |   |   |
| Net loss                                        |       | $                      | (262       | )                    | $          | (8,666 | ) | $ | (8,122 | ) | $ | (5,435 | ) |
| Change in unrealized value on investments,  net |       | 3,943                  |       | —               |       | 3,943 |   | — |   |
|                                            |       | $                      | 3,681      |                 | $          | (8,666 | ) | $ | (4,179 | ) | $ | (5,435 | ) |

 

The only component of accumulated other comprehensive income is thechange in the unrealized value of investments, net of tax (see Note 15).

 

3.               NetLoss Per Share

 

Basic net loss per share is computed using theweighted-average number of common shares outstanding during the period,excluding shares subject to repurchase, and diluted net loss per share iscomputed using the weighted-average number of common shares and dilutedequivalents outstanding during the period, if any, determined using thetreasury stock method. The following table sets forth the computation of basicand diluted net loss per share (in thousands, except per share amounts):

 

5

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| ** **                                          | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** |
|-----------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                          | ** ** | **2004**                       | ** ** | **2003**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                |       |                           |       |                         |       |   |   |   |   |
| Net loss                                            |       | $                              | (262       | )                            | $          | (8,666 | ) | $ | (8,122 | ) | $ | (5,435 | ) |
|                                                |       |                           |       |                         |       |   |   |   |   |
| Weighted average shares                             |       | 74,101                         |       | 69,491                       |       | 73,683 |   | 68,380 |   |
|                                                |       |                           |       |                         |       |   |   |   |   |
| Less: unvested common shares subject to  repurchase |       | (749                           | )          | (479                         | )          | (749 | ) | (295 | ) |
| Weighted average common shares outstanding          |       | 73,352                         |       | 69,012                       |       | 72,934 |   | 68,085 |   |
| Basic and diluted net loss per share                |       | $                              | (0.00      | )                            | $          | (0.13 | ) | $ | (0.11 | ) | $ | (0.08 | ) |

 

Had we generated net income for the three and sixmonth periods ended June 30, 2004 and 2003, the number of weighted averagesecurities outstanding that would have been added to weighted average sharesfor purposes of calculating diluted earnings per share would have been  (in thousands):

 
| ** **                                  | ** ** | **Three Months Ended  June 30** | ** ** | **Six Months Ended  June 30** | ** ** |
|---------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                  | ** ** | **2004**                        | ** ** | **2003**                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| Unvested common stock subject to repurchase |       | 749                             |       | 468                           |       | 749 |   | 281 |   |
| Stock options                               |       | 10,773                          |       | 6,612                         |       | 10,284 |   | 6,915 |   |
| Total                                       |       | 11,522                          |       | 7,080                         |       | 11,033 |   | 7,196 |   |

 

As a result ofour losses for the three and six month periods ended June 30, 2004 and 2003,all common share equivalents would have been anti-dilutive and have thereforebeen excluded from the diluted net loss per share calculation. The weightedaverage securities that were anti-dilutive and excluded from our calculation ofdiluted net loss per share were approximately 20,413,000 and 21,843,000 for thethree month periods ended June 30, 2004 and 2003, respectively andapproximately 20,412,000 and 22,002,000 for the six month periods ended June30, 2004 and 2003, respectively.

 

4.                   BalanceSheet Components

 
| ** **                           | ** ** | **June 30,  2004** | ** ** | **Dec. 31,  2003** | ** ** |
|--------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                           | ** ** | **(in thousands)** | ** ** |
| ** **                           |       |               |       |               |       |
| Inventories:                         |       |               |       |               |       |
| Raw materials                        |       | $                  | 2,167      |               | $          | 3,128 |   |
| Work in process                      |       | 3,229              |       | 2,532              |       |
| Finished goods                       |       | 4,541              |       | 4,652              |       |
|                                 |       | $                  | 9,937      |               | $          | 10,312 |   |
| Accrued liabilities:                 |       |               |       |               |       |
| Accrued payroll and related expenses |       | $                  | 5,206      |               | $          | 2,533 |   |
| Restructuring accrual                |       | 1,417              |       | 1,875              |       |
| Accrued legal fees                   |       | 978                |       | 1,137              |       |
| Warranty accrual                     |       | 351                |       | 271                |       |
| Other accrued liabilities            |       | 3,179              |       | 2,910              |       |
|                                 |       | $                  | 11,131     |               | $          | 8,726 |   |

 

Warranty Accrual

 

At the time ofrevenue recognition, we provide an accrual for estimated costs to be incurredpursuant to our warranty obligation. Our estimate is based primarily onhistorical experience.  Warranty accrualactivity for the six months ended June 30, 2004 and 2003 was as follows (inthousands):

 
| ** **                                         | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------|------------|----------|------------|----------|------------|
| Balance at January 1                               |       | $        | 271        |     | $          | 223 |   |
| Provision for warranties issued during the  period |       | 200      |       | 50       |       |
| Cash and other settlements made during the  period |       | (120     | )          | (50      | )          |
| Balance at June 30                                 |       | $        | 351        |     | $          | 223 |   |

 

6

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5.                   Stock-BasedCompensation

 

We account forstock-based compensation arrangements in accordance with the provisions ofAccounting Principles Board Opinion No. 25 (APB 25), “Accounting for StockIssued to Employees,” and related interpretations, and comply with thedisclosure provisions of Statement of Financial Accounting Standard No. 148(SFAS No. 148), “Accounting for Stock-Based Compensation—Transition andDisclosure (an amendment of FASB Statement No. 123).” Expense associated withstock-based compensation is amortized over the vesting period of the individualaward using an accelerated method, as described in Financial AccountingStandards Board Interpretation No. 28.

 

We are requiredto determine the fair value of stock option grants to non-employees and torecord the amount as an expense over the period during which services areprovided to us. Management calculates the fair value of these stock optiongrants using the Black-Scholes model, which requires us to estimate the life ofthe stock option, the volatility of our stock, an appropriate risk-freeinterest rate, and our dividend yield. The calculation of fair value is highlysensitive to the expected life of the stock option and the volatility of ourstock, both of which we estimate based primarily on historical experience.

 

The followingtable summarizes the components of our stock compensation expense for the threeand six months ended June 30, 2004 and 2003 (in thousands):

 
| ** **                                       | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** |
|--------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                       | ** ** | **2004**                       | ** ** | **2003**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Options granted to employees                     |       | $                              | 20         |                         | $          | 58 |   | $ | 51 |   | $ | 280 |   |
| Options granted to non-employees                 |       | 1,263                          |       | 425                          |       | 2,766 |   | 784 |   |
| Option repricings                                |       | 7,535                          |       | 527                          |       | 17,656 |   | (831 | ) |
| Options assumed in connection with  acquisitions |       | 314                            |       | 1,243                        |       | 727 |   | 1,658 |   |
| Stock compensation expense                       |       | $                              | 9,132      |                         | $          | 2,253 |   | $ | 21,200 |   | $ | 1,891 |   |

 

The repricingexpense for the three and six month periods ended June 30, 2004 was higherrelative to the three and six month periods ended June 30, 2003, as our averagestock price during the three and six month periods ended June 30, 2004 washigher (the average stock price for the three and six months ended June 30,2004 was $11.49 and $10.80, respectively compared to $5.48 and $5.49 for thethree and six months ended June 30, 2003). During the three months ended March31, 2003, we modified options for employees involuntarily terminated inconnection with our restructuring program. A charge of $646,000 for thesemodifications is included in restructuring expense for the period ended June30, 2003.

 

6.             Asset impairment and restructuringactivities

 

During thethird quarter of 2001, we began a program to focus our business on products andtechnology, including those obtained through acquisitions, in which we have, orbelieve we can achieve, a market leadership position. As part of this program,we decided to cancel numerous products under development, to remove certainprojects from our development plan, to phase out or de-emphasize certainexisting products and to integrate the operations of two acquired companies—CMDTechnology (“CMD”) and Silicon Communication Lab (“SCL”).

 

In connectionwith this program, we reduced our workforce in the fourth quarter of 2001 by approximately60 people, or 20%. This workforce reduction was the initial step in eliminatingduplicate positions that resulted from our acquisitions, and also representedthe elimination of other positions based on our new product and technologyfocus. Positions were eliminated from all functional areas—operations, R&Dand SG&A. Because of this workforce reduction, we recorded a restructuringexpense of $1.5 million in the fourth quarter of 2001, consisting of cashseverance-related costs of $599,000, non-cash severance-related costs of$303,000 representing the intrinsic value of modified stock options, anexpected loss on leased facilities of $500,000 and fixed asset write-downs of$50,000. In addition, we reversed $286,000 of unearned compensation, a componentof stockholders’ equity, for unvested stock options that were cancelled inconnection with employee terminations.

 

For 2001, werecorded $29.9 million of expense for the impairment of goodwill and intangibleassets recorded in connection with the acquisitions of DVDO and CMD. DVDOgoodwill and intangible assets became impaired primarily as a result of ourdecision to phase out or de-emphasize certain existing digital video processingproducts and to cease funding of certain digital video processing developmentprojects. Additionally, prevailing economic and industry conditions and thedeparture of certain key DVDO employees during the quarter endedSeptember 30, 2001 also contributed to the impairment expense of $13.9million. We recorded impairment expense of $16.0 million in the fourth quarterof 2001 related to goodwill and intangible assets recorded in connection withour CMD acquisition. This impairment resulted from a decrease in our initialestimate of future revenue from CMD’s products.

 

7

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In the firstquarter of 2002, we implemented a second workforce reduction in connection withthe program discussed above, eliminating an additional 35 positions, or 13% ofour workforce. Positions were eliminated from all functional areas. Thisreduction resulted from the continued integration of acquired companies, aswell as continued execution of our product and technology strategy, whereby wedecided to phase out the legacy storage subsystem board products we acquiredfrom CMD and to develop new board products only if we believed it wouldfacilitate or accelerate the use of our storage semiconductor products. Inconnection with this workforce reduction, we recorded a restructuring expenseof $2.2 million in the first quarter of 2002, consisting of cashseverance-related costs of $198,000, non-cash severance-related costs of$318,000 representing the intrinsic value of modified stock options, anexpected loss on leased facilities of $1.2 million and fixed asset write-downsof $500,000 for assets to be disposed of. In addition, we reversed $76,000 of unearned compensation, a componentof stockholders’ equity, for unvested stock options that were cancelled inconnection with employee terminations.

 

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 connectionwith our decision to stop selling board products and to transition to alicensing model, we assessed recoverability of our intangible assets subject toamortization in accordance with SFAS No. 144. During the quarter endedSeptember 30, 2002, an impairment expense of $749,000 was recognized for acquiredtechnology and $60,000 was recognized for patent and other intangible assets,based upon our projection of significantly reduced future cash flows.Additionally, we reduced our estimate of the useful lives of the remainingintangible assets subject to amortization such that these assets were fullyamortized by the end of 2002. We also tested the carrying value of goodwill forimpairment in accordance with SFAS No. 142. As a result of our impairment test,a goodwill impairment expense of $4.4 million was recognized during the secondquarter of 2002. To determine the amount of the impairment, we estimated thefair value of our storage systems business based primarily on expected futurecash flows. We then reduced this amount by the fair value of identifiable tangibleand intangible assets other than goodwill (also based primarily on expectedfuture cash flows), and compared the unallocated fair value of the business tothe carrying value of goodwill. To the extent goodwill exceeded the unallocatedfair value of the business, an impairment expense was recognized.

 

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 December 31, 2003, our expectedloss on subleased facilities was based on estimated sublease income ofapproximately $1.0 million over the remaining lease terms. To the extent we areunable to generate $1.0 million of sublease income, our future results ofoperations and financial condition will be negatively affected.

 

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,and general and administrative activities were not organized into the line ofbusiness structure. In connection with this reorganization, we reduced ourworkforce by 27 people, or approximately 10%. These reductions were primarily inengineering and operations functions. Because of this workforce reduction, werecorded restructuring expense of $986,000 in the first quarter of 2003,consisting of cash severance-related costs of $340,000 and non-cashseverance-related costs of $646,000, representing the intrinsic value ofmodified stock options.

 

8

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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.

 

Severance andbenefits payments are substantially complete. Lease payments will be made inthe form of cash through the end of the related lease term ofNovember 2005. The following table presents restructuring activity for2001 through June 30, 2004 (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                        |       | (441                        | )          | (760                   | )          | —           |       | (1,201    | )          |
| Non-cash activity                    |       | (646                        | )          | —                 |       | —           |       | (646      | )          |
| Balance as of December 31, 2003 |       | $                           | 37         |                   | $          | 1,838            |       | $         | —     |   | $ | 1,875 |   |
| Cash payments                        |       | (5                          | )          | (453                   | )          | —           |       | (458      | )          |
| Balance as of June 30, 2004          |       | $                           | 32         |                   | $          | 1,385            |       | $         | —     |   | $ | 1,417 |   |

 

7.                                       DebtFacility

 

In October 2002, weentered into a $3.6 million term loan to refinance $3.1 million of debtacquired in connection with our acquisition of CMD and $500,000 of other bankdebt. This loan bears interest at prime (4.0% at June 30, 2004) plus 0.25% andrequires monthly payments through its maturity of October 1, 2004. Duringthe six months ended June 30, 2003, we borrowed $383,000 to finance certaincapital equipment. This term loan bears interest at 4.75% and requires monthlypayments through its maturity in February 2005. As of June 30, 2004,$863,000 was outstanding under all our debt arrangements. Our debt facilitiescontain certain quarterly and annual financial covenants with which we mustcomply. In the fourth fiscal quarter of 2003, we fell out of compliance withthe lending institution’s quarterly covenants regarding providing periodicfinancial statements. We were granted a waiver from the lending institution andwere not in default of the loan agreement. Due to the nature of the underlyingcovenants, we have classified all amounts outstanding as current liabilities asof June 30, 2004. During the period ended March 31, 2004, we entered into anagreement to extend this debt facility by way of a revolving line of credit withan availability of up to $10.0 million, and an equipment line of credit of upto $3.0 million. Borrowings under the revolving line are limited to the lesserof $10.0 million or 80% of eligible accounts receivable as defined in the loanagreement. This revolving line of credit expires in March 2005 and bearsinterest at either prime plus 0.25% or LIBOR plus 2.75%, at our option.Equipment advances pursuant to the equipment line of credit are available to usthrough August 2004 and will be repayable in twenty four equal monthlyinstallments commencing September 1, 2004 bearing interest at either primeor LIBOR plus 2.5%, at our option. Quarterly and annual financial covenants arecontained within this revised agreement. No amounts have been drawn down againstthis line of credit as at June 30, 2004. As of June 30, 2004, we were incompliance with all covenants.

 

9

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8.                                       LegalProceedings

 

OnApril 24, 2001, we filed suit in the U.S. District Court for the Eastern Districtof 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”). OnApril 24, 2001, we also filed a complaint against Genesis with theInternational Trade Commission of the United States government (“ITC”) forunlawful trade practices related to the importation of articles infringing ourpatent (the “ITC investigation”). The actions sought injunctions to halt theimportation, sale, manufacture and use of Genesis DVI receiver chips thatinfringe our patent, and monetary damages. We voluntarily moved to dismiss theITC investigation, with notice that we would proceed directly in the Federal Suit.Our motion to dismiss was granted on February 7, 2002. We filed an amendedcomplaint in the Federal Suit as of February 28, 2002, adding a claim forinfringement of our U.S. patent number 5,974,464. In April 2002, Genesisanswered and made counterclaims against us for non-infringement, license,patent invalidity, fraud, antitrust, unfair competition and patent misuse. Alsoin April 2002, we filed a motion to dismiss certain of Genesis’scounterclaims. In addition, we filed a motion to bifurcate trial of thecounterclaims to the extent the court does not dismiss them. In May 2002,the Court granted our motion to dismiss certain of the counterclaims, withleave to amend. Genesis re-filed counterclaims against us for fraud and patentmisuse. 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, the parties presented differentinterpretations of the MOU to the Court. On July 15, 2003, the Court grantedour 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 itsJuly 15, 2003 ruling. Under the final judgment order, Genesis was orderedto make a substantial cash payment, and to make royalty payments; althoughGenesis has made a cash payment to the Court, it has not made all the paymentsthat are required under the final judgment order. We filed motions forreimbursement of some of our expenses, including some of our legal fees, andfor modification and/or clarification of certain items of the judgment, and tohold Genesis in contempt of Court for breaching the protective order in thecase by disclosing secret information to at least one of our competitors. OnDecember 19, 2003, the Court granted our motions in part and denied themin part: the court issued an amended judgment, and held Genesis in contempt ofCourt for breaching the protective order. Under the amended judgment, Genesis wasordered to make a substantial cash payment, royalty payments, and interest;although Genesis has made and continues to make cash payments to the Court, itmay not have made all the payments that are required under the amendedjudgment. The Court has not ruled on pending motions regarding the dispositionof the money held by the Court. On January 16, 2004, Genesis fileda notice of appeal. To date, we have not received any cash payments nor have werecognized any revenue associated with this litigation. Due to the continuingand contentious nature of this litigation, we will not record any income orrevenue related to this matter until the litigation is complete and all otherincome and revenue recognition criteria have been satisfied. Management intendsto prosecute our position vigorously until this matter is resolved. ThroughJune 30, 2004, we have spent approximately $10.7 million on this matter andexpect to continue to incur legal costs through at least the fourth quarter of2004 that could be significant.

 

Silicon Image,certain officers and directors, and Silicon Image’s underwriters have beennamed as defendants in a securities class action lawsuit captioned Gonzales v.Silicon Image, et al., No. 01 CV 10903 (SDNY 2001) pending in FederalDistrict Court for the Southern District of New York. The lawsuit alleges thatall defendants were part of a scheme to manipulate the price of Silicon Image’sstock in the aftermarket following Silicon Image’s initial public offering inOctober 1999. Response to the complaint and discovery in this action onbehalf of Silicon Image and individual defendants has been stayed by order ofthe court. The lawsuit is proceeding as part of a coordinated action of over300 such cases brought by plaintiffs in the Southern District of New York.Pursuant to a tolling agreement, individual defendants have been dropped fromthe suit for the time being. In February 2003, the Court denied theunderwriters’ motion to dismiss and ordered that the case may proceed againstissuers including against Silicon Image. A proposed settlement has beennegotiated that has yet to be reviewed and approved by the Court. In the eventthat the settlement is approved, we do not expect it to have a material effecton our results of operations or financial position. In the event that thesettlement is not approved, we could not accurately predict the outcome thelitigation, but we intend to defend this matter vigorously.

 

10

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Silicon Image,certain officers and directors, and Silicon Image’s underwriters were named asdefendants in a securities class action lawsuit captioned Liu v. Credit SuisseFirst Boston Corp., et al., No. 03-20459 (S.D. Fla. 2003) pending inFederal District Court for the Southern District of Florida. The plaintifffiled an action on behalf of a putative class of shareholders who purchasedstock from 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 the proposed settlement described above, ifapproved, would encompass the claims in this case. We believe that these claimswere without merit and, if revived, and not subject to the settlement, we woulddefend this matter vigorously.

 

Certainofficers and directors of Silicon Image were named as defendants in consolidatedshareholder derivative litigation, captioned “In re Silicon Image, Inc.Derivative Litigation, No. 1:03CV010302”, commenced on December 4,2003 and pending in the Superior Court of California, County of Santa Clara.The plaintiffs purported to sue the individual defendants on behalf of SiliconImage. The lawsuit alleged that as a result of the recently completedexamination conducted by the Audit Committee of Silicon Image’s Board ofDirectors, Silicon Image would be required to restate its financial results for2002 and 2003. On June 22, 2004, the plaintiffs dismissed the lawsuit.

 

Silicon Imageand certain of its officers were named as defendants in consolidated securitiesclass action litigation captioned “In re Silicon Image, Inc. Securities Litigation,No. C-03-5579 JW PVT”, commenced on December 11, 2003 and pending inthe United States District Court for the Northern District of California.Plaintiffs filed the action on behalf of a putative class of shareholders whopurchased Silicon Image stock between April 15, 2002 and November 15,2003. The lawsuit alleged that Silicon Image had materially overstated itslicensing revenue, net income and financial results during this time period,and that Silicon Image was being forced to restate its financial results.Following the announcement by the Audit Committee of Silicon Image’s Board ofDirectors that it had completed its examination and that it had concluded thatno changes to Silicon Image’s previously announced financial results wererequired, the plaintiffs dismissed the lawsuit.

 

In addition,we have been named as defendants in a number of judicial and administrativeproceedings incidental to our business and may be named again from time totime. We intend to defend such matters vigorously, and although adversedecisions or settlements may occur in one or more of such cases, the finalresolution of these matters, individually or in the aggregate, is not expectedto have a material adverse effect on our results of operations or financialposition.

 

9.                                       Customerand Geographic Information

 

Revenue bygeographic area was as follows (in thousands):

 
| ** **    | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** |
|---------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **    | ** ** | **2004**                       | ** ** | **2003**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|          |       |                           |       |                         |       |   |   |   |   |
| Taiwan        |       | $                              | 13,518     |                         | $          | 8,622 |   | $ | 22,975 |   | $ | 18,437 |   |
| Japan         |       | 7,832                          |       | 3,029                        |       | 15,372 |   | 5,623 |   |
| United States |       | 11,730                         |       | 6,567                        |       | 21,299 |   | 13,341 |   |
| Hong Kong     |       | 1,291                          |       | 1,459                        |       | 2,780 |   | 2,978 |   |
| Korea         |       | 1,843                          |       | 1,004                        |       | 3,573 |   | 2,125 |   |
| Other         |       | 7,147                          |       | 3,651                        |       | 13,220 |   | 6,504 |   |
|          |       | $                              | 43,361     |                         | $          | 24,332 |   | $ | 79,219 |   | $ | 49,008 |   |

 

Revenue byproduct line was as follows (in thousands):

 
| ** **                           | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** |
|--------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | **2004**                       | ** ** | **2003**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                 |       |                           |       |                         |       |   |   |   |   |
| PC                                   |       | $                              | 10,407     |                         | $          | 7,136 |   | $ | 20,074 |   | $ | 15,929 |   |
| Consumer Electronics                 |       | 15,947                         |       | 5,255                        |       | 27,314 |   | 8,505 |   |
| Storage products                     |       | 10,472                         |       | 7,354                        |       | 21,488 |   | 15,033 |   |
| Development, licensing and royalties |       | 6,535                          |       | 4,587                        |       | 10,343 |   | 9,541 |   |
|                                 |       | $                              | 43,361     |                         | $          | 24,332 |   | $ | 79,219 |   | $ | 49,008 |   |

 

11

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Revenue byproduct line, including development, licensing and royalties, was as follows(in thousands):

 
| ** **           | ** ** | **Three Months Ended June 30** | ** ** | **Six Months Ended June 30** | ** ** |
|----------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **           | ** ** | **2004**                       | ** ** | **2003**                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|                 |       |                           |       |                         |       |   |   |   |   |
| PC                   |       | $                              | 10,480     |                         | $          | 8,689 |   | $ | 20,160 |   | $ | 17,632 |   |
| Consumer Electronics |       | 21,272                         |       | 7,209                        |       | 33,554 |   | 11,508 |   |
| Storage products     |       | 11,609                         |       | 8,434                        |       | 25,505 |   | 19,868 |   |
|                 |       | $                              | 43,361     |                         | $          | 24,332 |   | $ | 79,219 |   | $ | 49,008 |   |

 

For eachperiod presented, substantially all long-lived assets were located within theUnited States.

 

For the threemonths ended June 30, 2004, three customers each generated 12.1%, 11.3% and10.5% of our revenue. For the six months ended June 30, 2004, two customersgenerated 12.9% and 11.8% of our revenue, and three customers each represented9.0%, 8.6% and 8.4% of gross accounts receivable.

 

For the threemonths ended June 30, 2003, two customers each generated 15.0% and 12.0% of ourrevenue. For the six months ended June 30, 2003, two customers each generated13.7% and 11.0% of our revenue and, as of June 30, 2003, four customers eachrepresented 12.8%, 9.9%, 8.4% and 8.2% of gross accounts receivable.

 

10.                                 Guarantees

 

Certain of ourlicensing agreements indemnify our customers for any 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 futureindemnification is not limited. To date, we have not paid any such claims orbeen required to defend any lawsuits with respect to any claim. However, therecan be no assurance that such claims will not be filed in the future.

 

11.           Intangible Assets, net

 

Components of intangible assets are asfollows (in thousands):

 
| ** **                                      | ** ** | **June 30, 2004**           | ** ** | **December 31, 2003**         | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **                                      | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** |
|                                            |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Intangible assets subject to amortization :     |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Acquired technology                             |       | $                           | 1,780      |                          | $          | (618 | ) | $ | 1,162 |   | $ | 1,780 |   | $ | (375 | ) | $ | 1,405 |   |
| Non-compete agreement                           |       | 1,849                       |       | (778                          | )          | 1,071 |   | 1,849 |   | (472 | ) | 1,377 |   |
| Assembled workforce                             |       | 502                         |       | (420                          | )          | 82 |   | 502 |   | (256 | ) | 246 |   |
|                                            |       | $                           | 4,131      |                          | $          | (1,816 | ) | $ | 2,315 |   | $ | 4,131 |   | $ | (1,103 | ) | $ | 3,028 |   |
|                                            |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Intangible assets not subject to  amortization: |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Goodwill                                        |       | $                           | 13,021     |                          | $          | — |   | $ | 13,021 |   | $ | 13,021 |   | $ | — |   | $ | 13,021 |   |

 

Estimated future amortization expense for our intangible assets is asfollows for fiscal years ending December 31 (in thousands):

 
| 2004   | ** ** | 632   | ** ** |
|--------|------------|-------|------------|
| 2005   |       | 1,097 |       |
| 2006   |       | 508   |       |
| 2007   |       | 78    |       |
|   |       | $     | 2,315      |   |
|        |            |       |            |  |

 

The amortization expense for the three monthperiods ended June 30, 2004 and 2003 was $357,000 and $373,000, respectivelyand for the six month periods ended June 30, 2004 and 2003 was $713,000 and$373,000, respectively.

 

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12.           Income taxes

 

*Provision for Income Taxes.  *Forthe three and six month periods ended June 30, 2004, we recorded a provisionfor income taxes of $255,000 and $572,000, respectively. These amounts includeapproximately $45,000 and $262,000 relating to withholding taxes payable inconnection with our licensing contracts, and a provision of $210,000 and$310,000 relating to taxes in foreign jurisdictions where we have recentlycommenced operations and estimated provision for U.S. alternative minimum taxesfor the fiscal year ending December 31, 2004. At June 30, 2004, we had a netoperating loss carryforward for federal income tax purposes of approximately$72.8 million and such loss carryforwards, which will expire in variousyears through 2023, will be available to offset our future taxable income. Wecontinue to maintain a full valuation allowance for all deferred tax assetsgiven uncertainty as to realization.

 

13.                                 Escrow Settlement

 

On August 7,2002, we filed a demand for arbitration with the American ArbitrationAssociation, file #74 Y 117 01399 02 GAP, against the principal shareholders ofCMD Technology (“CMD”)relating to shares held in escrow in connection with our acquisition of CMD.Pursuant to agreements by which we acquired CMD, a portion of the Silicon Imagecommon stock issued to the principal shareholders of CMD was held in twoseparate escrow pools as collateral for the indemnification obligations ofthese shareholders. We previously made indemnification claims against theseescrow pools for the release of escrow shares with a value of approximately$5.4 million, which claims were contested by the principal shareholders of CMD.On February 28, 2003, we and the principal shareholders of CMD entered into asettlement agreement and mutual release, pursuant to which our indemnificationclaims were resolved. As a result of the settlement, we received 949,780 of theescrowed shares, valued at approximately $4.7 million, and recorded a netnon-operating gain of $4.6 million in the first half of 2003.

 

14.           Acquisition of Transwarp Networks, Inc

 

In April 2003, we acquiredTransWarp Networks, Inc. (“TWN”), a development stage enterprise. Through thistransaction, we acquired certain intellectual property and engineeringexpertise that will enable us to broaden our storage product offerings and todevelop more advanced storage products. TWN was acquired by means of a merger,pursuant to which all outstanding shares of TWN’s capital stock were exchangedfor shares of Silicon Image’s common stock. In addition, all outstandingoptions to purchase TWN common stock were converted into options to purchaseSilicon 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 of assets.

 

The total purchase price wasapproximately $14.5 million, consisting of the issuance of approximately 2.5million shares of Silicon Image common stock, valued at $11.4 million, 0.8million shares of Silicon Image common stock that may be issued upon exerciseof options, valued at $3.0 million, and transaction costs of $0.1 million. Thepurchase price was allocated as follows (in thousands):

 
| 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 |       |

 

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The total purchase pricewas revised from $14.7 million to $14.5 million during the quarter endedSeptember 30, 2003, to reflect actual expenses relating to legal fees incurredin connection with the acquisition of TWN.

 

The assembled workforcewill be amortized over 18 months. Developed technology and the non-competeagreement will be amortized over a period of three years (the length of thenon-compete agreement), and core technology will be amortized over a period offour years. Unearned compensation will be amortized over the remaining employeevesting period, which ranges from 27 months to 57 months.

 

The value allocated toin-process research and development (“IPR&D”) was calculated usingestablished valuation techniques accepted in the high technology industry.These techniques give consideration to relevant market sizes and growthfactors, expected industry trends, the anticipated nature and timing of newproduct introductions by us and by our competitors, individual product salescycles, and the estimated lives of each of the product’s underlying technology.The value of IPR&D reflects the relative value and contribution of theacquired research and development. In determining the value assigned toIPR&D, we considered the R&D’s stage of completion, the complexity ofthe work completed to date, the difficulty of completing the remainingdevelopment, costs already incurred, and the projected cost to complete theproject. A discount rate of 30% was used to determine the net present value ofestimated cash flows for this project.

 

The valuesassigned to core technology and developed technology were based upon discountedcash flows related to the existing product’s projected income stream. Elementsof the projected income stream includes revenue, cost of sales, SG&Aexpenses and R&D expenses. The discount rates used in the present valuecalculations range from 20% to 25% and were generally derived from a weightedaverage cost of capital, adjusted upward to reflect the additional risksinherent in the development life cycle. Such risks include the useful life of the technology, profitabilitylevels of the technology, and the uncertainty of the technology advances thatare 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.

 

Thevalue of the non-compete agreement was based on the Income Approach, whichmeasures the difference between cash flows generated assuming the existence ofthe non-compete agreement (assuming no competition exists for the individualscovered by the non-compete) and the cash flows assuming competition. Theresulting net cash flows were discounted using a discount rate of 25%.

Based on ourannual impairment test performed for 2003, we concluded that there was noimpairment in fiscal 2003. However, there can be no assurance that we will notincur charges for impairment in the future. An impairment test was notperformed in the three and six months ended June 30, 2004, as no event hasoccurred that would provide an indication of impairment.

 

15.                                   Unrealized gain onequity investments

 

In October 2000,as consideration for the transfer of certain non-marketable technology, wereceived from Leadis’ Technology Inc. (“Leadis”), a development stage privatelycontrolled enterprise, 300,000 shares of preferred stock and a derivativewarrant to purchase 75,000 shares of the Company’s common stock. These shareswere valued at zero due to the early stage of Leadis’s development, lack ofavailable financial information and other uncertainties as to the realizationof this investment. During the quarter ended June 30, 2004, Leadis completed aninitial public offering of its stock. In connection with the initial publicoffering the preferred stock was converted into common stock on a 1:1 basis. Inconnection with the initial public offering, we are subject to a lock-upagreement whereby we are restricted from selling the stock and the common stockunderlying the warrant for a period of six months (for the duration of thelock-up period we are also restricted from engaging in hedging or othertransactions which would result in or lead to the sale or disposition of theshares underlying the derivative warrant). The value of the common stock wasdetermined to be $4.0 million as of June 30, 2004, based on Leadis’s closingmarket price at that date.This amount is classified within short-terminvestments and the amount of the related unrealized gain, net of taxes, in theamount of $3,943,000, is included in accumulated other comprehensive income.For future periods, any changes to the value of the stock will be reflected throughour accumulated other comprehensive income (loss).

 

The derivativewarrant was valued using the Black-Scholes model, and the value as of June 30,2004 was determined to be $990,000. This amount is included in our consolidatedstatement of operations for the quarter ended June 30, 2004. For futureperiods, until the derivative warrant is exercised, any changes to the value ofthis instrument will be adjusted through our statement of operations. Uponexercising the warrant into common stock, and until the shares are sold, anychanges to the value of the stock would be reflected through accumulated othercomprehensive income (loss).

 

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**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

*This report contains forward-lookingstatements within the meaning of Section 21E of the Securities and Exchange Actof 1934 and Section 27A of the Securities Act of 1933. These forward-lookingstatements involve a number of risks and uncertainties, including thoseidentified in the section of this Form 10-Q entitled “Factors Affecting FutureResults,” that may cause actual results to differ materially from thosediscussed in, or implied by, such forward-looking statements. Forward-lookingstatements within this Form 10-Q are identified by words such as “believes,”“anticipates,” “expects,” “intends,” “may,” “will” and other similarexpressions. However, these words are not the only means of identifying suchstatements. In addition, any statements that refer to expectations, projectionsor other characterizations of future events or circumstances areforward-looking statements. We undertake no obligation to publicly release theresults of any revisions to these forward-looking statements that may be madeto reflect events or circumstances occurring subsequent to the filing of thisForm 10-Q with the SEC. Our actual results could differ materially from thoseanticipated in, or implied by, forward-looking statements as a result of variousfactors, including the risks outlined elsewhere in this report. Readers areurged to carefully review and consider the various disclosures made by SiliconImage, Inc. in this report and in our other reports filed with the SEC thatattempt to advise interested parties of the risks and factors that may affectour business.*

 

**Overview**

 

Silicon Imageis a leader in multi-gigabit semiconductor solutions for the securetransmission, storage and display of rich digital media. The company’s missionis to be the leader in defining the architectures, intellectual property (IP)and semiconductor technology required to build secure digital content deliverysystems. To ensure that rich digital content is always available on any device,consumer electronics (CE), PC and storage devices must be architected forcontent compatibility and interoperability*.*

 

SiliconImage’s strategy entails establishing industry-standard, high-speed digitalinterfaces and building market momentum and leadership through itsfirst-to-market, standards-based IC products. Further leveraging its strong IPportfolio, the company broadens market adoption of the Digital Visual Interface(DVI), High-Definition Multimedia Interface (HDMI) and Serial ATA (SATA)interfaces by licensing its proven IP cores to companies providing advancedsystem-on-a-chip solutions incorporating these interfaces. Licensing, inaddition to creating revenue and return on engineering investment in marketsegments we choose not to address, creates products complementary to our ownthat expand the markets for our products and help to improve industry wideinteroperability.

 

Silicon Imageis a leader in the global PC/display arena with its innovative PanelLink®digital interconnect technology, which enables an all-digital connectionbetween PC host systems and digital displays such as LCD monitors, plasmadisplays and projectors. PanelLink technology is the basis for the DVI industrystandard the company pioneered and remains the most popular DVI implementationwith more than 45 million units shipped to date.

 

In 2000, inorder to decrease our absolute dependence on the PC business, we embarked upona plan to diversify into the CE and storage markets. Products sold into the PCmarket have been declining as a percentage of our total revenues and generated24.0% and 25.3% of our revenue in the first three and six months of 2004,respectively and 29.3% and 32.5% of our revenues in the first three and sixmonths of 2003, respectively (if we include licensing revenues, thesepercentages would be 24.2% and 25.4% for the first three and six months of2004, respectively and 35.7% and 36.0% for the first three and six months 2003,respectively).

 

Leveraging ourcore technology and standards-setting expertise, Silicon Image is a leadingforce in advancing the adoption of HDMI, the new digital interface standard forthe consumer electronics market. Introduced by founders Hitachi, Matsushita(Panasonic), Philips, Silicon Image, Sony, Thomson and Toshiba, HDMI enablesthe distribution of uncompressed, high-definition video and multi-channel audioin a single, all-digital interface that dramatically simplifies cabling.Silicon Image’s HDMI technology is marketed under the PanelLink CinemaTM brandand includes High-bandwidth Digital Content Protection (HDCP), which issupported by certain Hollywood studios as the technology of choice for thesecure distribution of premium content over certain digital connections. ThePanelLink Cinema chips are the first HDMI-compliant silicon in the market andare featured in many leading consumer electronics products that are nowavailable in the market.

 

Products soldinto the CE market have been increasing as a percentage of our total revenuesand generated 36.8% and 34.5% of our total revenues in the three and six monthsended June 30, 2004, respectively, compared to 21.6% and 17.4% of our totalrevenues for the

 

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three and six months ended June30, 2003, respectively, (if we include licensing revenues, these numbers wouldbe 49.1% and 42.4% for the three and six months ended June 30, 2004,respectively, and 29.6% and 23.5% for the three and six months ended June 30,2003, respectively). Our CE products offer a secure interface for transmissionof digital video and audio to consumer devices, such as digital TVs and DVDplayers. Demand for these products will be driven primarily by the adoptionrate of new technologies, such as HDMI and High-Bandwidth Digital ContentProtection (“HDCP”).

 

In the storagemarket, Silicon Image has assumed a leadership role in Serial ATA (“SATA”), thenew high-bandwidth, point-to-point interface that is replacing Parallel ATA indesktop storage and making inroads in the enterprise arena due to itsprice/performance. Silicon Image is a leading supplier of discrete SATA deviceswith hundreds of motherboard and add-in-card design wins. Silicon Image’sSATALinkTM-branded solutions are fully SATA-compliant and offer advanced featuresand capabilities such as Native Command Queuing, port multiplier capability andATAPI support. Silicon Image also supplies high-performance, low-power FibreChannel Serializer/Deserializer (SerDes) to leading switch manufacturers.

 

Products soldinto the storage market, as a percentage of our total revenues, generated 24.2%and 27.1% of our revenue for the three and six months ended June 30, 2004,respectively, and 30.2% and 30.7% for the three and six months ended June 30,2003, respectively (if we include licensing revenues, these numbers were 26.8%and 32.2% for the three and six months ended June 30, 2004, respectively and34.7% and 40.5% for the three and six months ended June 30, 2003,respectively). Demand for our storage semiconductor products is dependent uponthe rate at which interface technology transitions from parallel to serial, andthe extent to which SATA and fibre channel functionality are integrated intochip sets and controllers offered by other companies, which would make ourdiscrete devices unnecessary. We expect our storage revenues (includinglicensing) to decline from the second quarter by $1.5 to $2.0 million in thethird quarter of 2004.

 

Licenserevenue is recognized when an agreement with a licensee exists, the price isfixed or determinable, delivery or performance has occurred, and collection isreasonably assured. Generally, we expect to meet these criteria and recognizerevenue at the time we deliver the agreed-upon items. However, we may deferrecognition of revenue until cash is received if collection is not reasonablyassured at the time of delivery. A number of our license agreements requirecustomer acceptance of deliverables, in which case we would defer recognitionof revenue until the licensee has accepted the deliverables and either paymenthas been received or is expected within approximately 90 days of acceptance.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 a timeperiod or on the agreed-upon royalty rate, extended by the number of unitsshipped by the customer. To determine the number of units shipped, we rely uponactual royalty reports from our customers when available and rely uponestimates in lieu of actual royalty reports when we have a sufficient historybase of receiving royalties from a specific customer to make an estimate basedon available information from the licensee such as quantities held,manufactured and other information. These estimates for royalties necessarilyinvolve the application of management judgment. As a result of our use ofestimates, period-to-period numbers are “trued-up” in the following period toreflect actual units shipped. To date, such “true-up” adjustments have not beensignificant. In cases where royalty reports and other information are notavailable to allow us to estimate royalty revenue, we recognize revenue onlywhen royalty payments are received. Development revenue is recognized whenproject milestones have been completed and acknowledged by the other party tothe development agreement and collection is reasonably assured. In certaininstances, we recognize development revenue using the lesser of non-refundablecash received or the results of using a proportional performance measure.

 

Our licensingactivity is complementary to our product sales and it helps us to monetize ourintellectual property and accelerate market adoption curves associated with ourtechnology. Most of our licenses include a field of use restriction thatprevents the licensee from building a chip in direct competition with thosemarket segments we have chosen to pursue. Revenue from development, licensingand royalties accounted for 15.1% and 13.1% of our revenues for the three andsix months ended June 30, 2004, respectively, and 18.9% and 19.5% for the threeand six months ended June 30, 2003, respectively, and represented 25.5% and22.0% of our total gross margin for the three and six months ended June 30,2004, respectively, and 33.7% and 35.0% for the three and six months ended June30, 2003, respectively. Licensing contracts are complex and depend upon manyfactors including completion of milestones, allocation of values to delivereditems, and customer acceptances. Although we attempt to make these factorspredictable, many of these factors require significant judgments.

 

Prior to 2000we focused most of our efforts on the sale and development of PanelLinktransmitters, receivers and controllers for the PC/Display market. In 2000, webegan focusing our resources on entering two new markets, storage and CE, whichwe believed would grow significantly and in which we believed we could applyour technology and expertise in high-speed serial interfaces. During 2000, weacquired Zillion, a developer of high-speed transmission technology for datastorage applications, and DVDO, a provider of digital video processing systemsfor the CE market.

 

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In 2001, wefocused on accelerating our entry into the CE and storage markets, leveragingour IP into licensing revenue, and restructuring the company to improveprofitability. During 2001, we acquired CMD, a provider of storage subsystemsand semiconductors designed for storage area networks, and SCL, a provider ofmixed-signal and high-speed circuit designs.

 

During 2002, we achieved double-digitsequential revenue growth in each fiscal quarter, resulting in record annualrevenue of $81.5 million, which was a 57% increase from 2001 revenue levels. Wealso began to see the benefits of our diversification strategy, which resultedin establishing a presence in the CE and storage markets. Additionally, we wereable to successfully leverage our intellectual property to generate $6.7million of development, licensing and royalty revenue. We also focused onimproving our profitability and reducing our cash usage.

 

During 2003,we achieved significant growth, resulting in record annual revenue of $103.5million, representing a 27% increase compared to 2002. We were also able tocontinue to take advantage of our diversification strategy effectively, whichresulted in our being able to expand our presence in the CE and storagemarkets, both of which we expect will experience significant growth ratesduring the next several years. Additionally, we were able to successfullyleverage our intellectual property to generate $14.2 million of development,licensing and royalty revenue.

 

InOctober 1999, we raised approximately $48 million in our initial publicoffering. We have incurred losses in all but one quarterly period since ourinception and, as of June 30, 2004, we had an accumulated deficit of $180.8million.

 

**Outlook**

 

We expect 2004revenue to increase from the level achieved in 2003, and believe our revenue inthe third quarter of 2004 will grow 5-10% sequentially from the second quarterof 2004.

 

We believe ourexpected revenue growth during 2004 will be driven by several factors. First,DVI adoption rates are expected to increase as demand for notebook computers,motherboards, and graphics cards containing our products increase during theyear. Second, in the CE market we have seen a number of design wins begin toramp as they go into production and we continue to be successful in winningimportant design wins scheduled for production in 2005. As the CE industrycontinues to transition to an all-digital solution, we expect the marketplacefor our products to grow significantly. Third, Serial ATA adoption rates areexpected to increase. Lastly, we expect our licensing market to continue to beattractive and as our licensing base grows, we also expect to see an increasein royalty revenues. Licensing revenues have fluctuated significantly from periodto period and may continue to do so in the future; because of their high margincontent they can have a disproportionate impact on gross margins andprofitability.

 

Among thefactors that may cause our actual results to differ materially from thoseanticipated by our assumptions include the rate at which the PC market adoptsDVI, acceptance of all digital solutions in the PC market, use of DVI as areplacement for LVDS in the PC notebook market, CE market acceptance of our DVIwith HDCP and HDMI products, the rate at which the storage market for 2 Gbfibre channel switches grows and serial ATA technology adoption, consumerdemand in the PC and CE markets, the availability of serial ATA-enabled harddrives and other peripherals, whether and how quickly OEMs are able tointegrate transmitters in their graphics chips and serial ATA functionalityinto their chip sets, our ability to leverage our intellectual property intolicensing revenue and the ability of our semiconductor foundry vendors tomanufacture our products in commercial volumes at an acceptable cost and in atimely manner. In addition, our revenue remains subject to competition andgeneral economic and market conditions, none of which can be accuratelypredicted.

 

We expectthird quarter 2004 overall gross margins, as a percent of revenues, to berelatively unchanged compared to the second quarter of 2004. Although, weexpect licensing revenues to decline to $5.0 million during the third quarterof 2004, compared to $6.5 million during the second quarter of 2004, we expectour gross margin percentage to remain flat for the remainder of the calendaryear. Overall gross margin rates are expected to increase in 2004 from 2003levels as a result of higher licensing and royalty revenue, for which there isno associated cost of sales, manufacturing cost reductions on certain of ourhigher volume products, higher unit volume and shifts in product mix wherebyhigher margin CE products will grow faster than our PC or storage product linesthat have lower gross margins. We expect that these positive effects will beoffset by declining average selling prices (“ASPs”), and higher manufacturingoverhead spending to support increased production levels for products in allthree of our markets.

 

Excludingnon-cash charges for stock compensation expense, we expect the dollar amount ofour R&D expense in the third quarter of 2004 to increase approximately 9 -13%, or approximately $1.0 - $1.5 million, from the second quarter of 2004.R&D expense will be incurred for enhancements to existing products and forfurther new product development in all three product lines.

 

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Excluding non-cash charges forstock compensation expense, we expect the dollar amount of our SG&A expenseduring the third quarter of 2004 to remain flat relative to the second quarterof 2004. We cannot predict the R&D or SG&A expenses including thenon-cash charges for stock compensation expense, which will fluctuate withchanges in our stock price and volatility.

 

We expect toincur substantial non-cash stock compensation expense in 2004 and futureperiods as a result of previous stock option repricings, stock options assumedin connection with our prior acquisitions, the issuance of stock options toconsultants, and modifications to stock options. We may also incur non-cashstock compensation expense in connection with future acquisitions. The amountof stock compensation expense in each period will fluctuate with changes in ourstock price and volatility.

 

We will alsoincur legal fees in 2004 in conjunction with our patent infringement lawsuitagainst Genesis, and other outstanding litigation. The amount of legal feesincurred will depend on the duration of the litigation, as well as the natureand extent of the litigation activities. We are not able to accurately estimatethe amount of legal fees we will incur with respect to this matter; however, wedo expect to incur substantial amounts through at least the fourth quarter of2004.

 

**Commitments,Contingencies and Concentrations**

 

Historically,a relatively small number of customers and distributors have generated asignificant portion of our revenue. For instance, our top five customers,including distributors, generated 49% and 45.6% of our revenue for the threeand six months ended June 30, 2004, respectively, and 45% and 42.5% of ourrevenue for the three and six months ended June 30, 2003, respectively.  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. For the three and six months ended June 30,2004, 39.5% and 41.5%, respectively, of our revenue was generated throughdistributors, compared to 39.5% and 37.6%, respectively, for the comparableperiod of 2003. Our licensing revenue is not generated through distributors,and to the extent licensing revenue increases faster than product revenues, wewould expect a decrease in the percentage of our total revenues generatedthrough distributors.

 

A significantportion of our revenue is generated from products sold overseas. Sales tocustomers in Asia, including distributors, generated 68% and 69% of our revenuein the three and six months ended June 30, 2004, and 68% for the each of thethree and six month periods ended June 30, 2003. The reason for ourgeographical concentration in Asia is that most of our products are part offlat panel displays, 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 September1998, we entered into an agreement with Intel to develop and promote theadoption of a digital display interface specification. In connection with thisagreement, we granted Intel a warrant to purchase 285,714 shares of our commonstock at $1.75 per share. Under the same agreement, we granted Intel a warrantto purchase 285,714 shares of our common stock at $0.18 per share uponachievement of a specified milestone that was reached during the first quarterof 1999. Both of these warrants were exercised in May 2001. Additionally, if asecond specified milestone is achieved, which we do not believe is likely, wewould be required to grant Intel a third warrant to purchase 285,714 shares ofour common stock at $0.18 per share. The estimated fair value of the warrant atJune 30, 2004 was $3.7 million.

 

**CriticalAccounting Policies**

 

Thepreparation of financial statements in conformity with generally acceptedaccounting principles requires management to make estimates and assumptionsthat affect amounts reported in our consolidated financial statements andaccompanying notes. We base our estimates on historical experience and allknown facts and circumstances that we believe are relevant. Actual results maydiffer materially from our estimates. We believe the following accountingpolicies to be most critical to an understanding of our financial condition andresults of operations because they require us to make estimates, assumptionsand judgments about matters that are inherently uncertain.

 

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*Revenue recognition*

 

For productssold directly to end-users, or to distributors that do not receive priceconcessions and do not have rights of return, we recognize revenue uponshipment and title transfer if we believe collection is reasonably assured.Reserves for sales returns and allowances are estimated based primarily onhistorical experience and are provided at the time of shipment. The amount ofsales returns and allowances has not been, and is not expected to be, material.

 

The majorityof our products are sold to distributors with agreements allowing for priceconcessions and product returns. We recognize revenue based on our bestestimate of when the distributor sold the product to its end customer based onpoint of sales reports received from our distributors. Due to the timing ofreceipt of these reports, we recognize distributor sell-through usinginformation that lags quarter end by one month. Revenue is not recognized uponshipment since, due to various forms of price concessions, the sales price isnot substantially fixed or determinable at that time. Price concessions arerecorded when incurred, which is generally at the time the distributor sellsthe product to an end-user. Additionally, these distributors have contractualrights to return products, up to a specified amount for a given period of time.Revenue is earned when the distributor sells the product to an end-user, atwhich time our sales price to the distributor becomes fixed. Our revenue ishighly dependent on receiving pertinent and accurate data from our distributorsin a timely fashion. Distributors provide us periodic data regarding theproduct, price, quantity, and end customer on their shipments as well as thequantities of our products they still have in stock. In determining theappropriate amount of revenue to recognize, we use this data and apply judgmentin reconciling differences between their reported inventories and activities.If distributors incorrectly report their inventories or activities, or if ourjudgment is in error, it could lead to inaccurate reporting of our revenues andincome.

 

Licenserevenue is recognized when an agreement with a licensee exists, the price isfixed or determinable, delivery or performance has occurred, and collection isreasonably assured. Generally, we expect to meet these criteria and recognizerevenue at the time we deliver the agreed-upon items. However, we may deferrecognition of revenue until cash is received if collection is not reasonablyassured at the time of delivery. A number of our license agreements requirecustomer acceptance of deliverables, in which case we would defer recognitionof revenue until the licensee has accepted the deliverables and either paymenthas been received or is expected within approximately 90 days of acceptance.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 a timeperiod or on the agreed-upon royalty rate, extended by the number of unitsshipped by the customer. To determine the number of units shipped, we rely uponactual royalty reports from our customers when available, and rely uponestimates in lieu of actual royalty reports when we have a sufficient historybase of receiving royalties from a specific customer for us to make an estimatebased on available information from the licensee such as quantities held,manufactured and other information. These estimates for royalties necessarilyinvolve the application of management judgment. As a result of our use ofestimates, period-to-period numbers are “trued-up” in the following period toreflect actual units shipped. To date, such “true-up” adjustments have not beensignificant. In cases where royalty reports and other information are notavailable to allow us to estimate royalty revenue, we recognize revenue onlywhen royalty payments are received. Development revenue is recognized whenproject milestones have been completed and acknowledged by the other party tothe development agreement, and collection is reasonably assured. In certaininstances, we recognize development revenue using the lesser of non-refundablecash received or the results of using a proportional performance measure. Ourlicense revenue recognition depends upon many factors including completion ofmilestones, allocation of values to delivered items and customer acceptances.Many of these factors require significant judgments, and if our judgment is inerror it could lead to inaccurate reporting of our revenues and income.

 

*Allowance for Doubtful Accounts Receivable*

 

We reviewcollect-ability of accounts receivable on an on-going basis and provide anallowance for amounts we estimate will not be collectible. During our review,we consider our historical experience, the age of the receivable balance, thecredit-worthiness of the customer, and the reason for the delinquency.Write-offs to date have not been material. At June 30, 2004, we had $20.2million of gross accounts receivable and an allowance for doubtful accounts of$722,000. While we endeavor to accurately estimate the allowance, we may recordunanticipated write-offs in the future.

 

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*Inventories*

 

We recordinventories at the lower of standard cost, determined on a first-in first-outbasis, or market. Standard cost approximates actual cost. Provisions arerecorded for excess and obsolete inventory, and are estimated based on acomparison of the quantity and cost of inventory on hand to management’sforecast of customer demand. Customer demand is dependent on many factors andrequires us to use significant judgment in our forecasting process. We mustalso make assumptions regarding the rate at which new products will be acceptedin the marketplace and the rate at which customers will transition from olderproducts to newer products. Generally, inventories in excess of six monthsdemand are written down to zero and the related provision is recorded as a costof revenue. While we endeavor to accurately predict demand and stockcommensurate inventory levels, we may record unanticipated material inventorywrite-downs in the future.

 

*Long-Lived Assets*

 

Considerationpaid in connection with acquisitions is required to be allocated to the assets,including identifiable intangible assets, and liabilities acquired. Acquiredassets and liabilities are recorded based on our estimate of fair value, whichrequires significant judgment with respect to future cash flows and discountrates.

 

For certainlong-lived assets, primarily fixed assets and intangible assets, we arerequired to estimate the useful life of the asset and recognize its cost as anexpense over the useful life. We use the straight-line method to depreciatelong-lived assets. We regularly compare the carrying value of long-lived assetsto our projection of future undiscounted cash flows attributable to such assetsand in the event that the carrying value exceeds the future undiscounted cashflows, we record an impairment charge against income equal to the excess of thecarrying value over the asset’s fair value. Predicting future cash flowsattributable to a particular asset is difficult, and requires the use ofsignificant judgment.

 

*Goodwill*

 

We adopted theStatement of Financial Accounting Standard No.142 (SFAS 142), “Goodwill andOther Intangible Assets” on January 1, 2002. This standard requires thatgoodwill no longer be amortized, and instead, be tested for impairment on aperiodic basis. The process of evaluating the potential impairment of goodwillis highly subjective and requires significant judgment at many points duringthe analysis. In estimating the fair value of the business, we make estimatesand judgments about the future cash flows. Although our cash flow forecasts arebased on assumptions that are consistent with the plans and estimates we areusing to manage our business, there is significant judgment in determining suchfuture cash flows. We also consider market capitalization (adjusted forunallocated monetary assets such as cash, marketable debt securities and debt)on the date we perform the analysis. Based on our annual impairment testperformed for 2003, we concluded that there was no impairment of goodwill infiscal 2003. However, there can be no assurance that we will not incur chargesfor impairment of goodwill in the future, which could adversely affect ourearnings. The Company reviews impairment once a year usually at the end of thefiscal year and no events have occurred that would indicate an impairment has occurred.

 

*Deferred Tax Assets*

 

We account forincome taxes using an asset and liability approach, which requires recognitionof deferred tax assets and liabilities for the expected future tax consequencesof events that have been recognized in our financial statements, but have notbeen reflected in our taxable income. A valuation allowance is established toreduce deferred tax assets to their estimated realizable value. Therefore, weprovide a valuation allowance to the extent we do not believe it is more likelythan not that we will generate sufficient taxable income in future periods torealize the benefit of our deferred tax assets. To date, as a result of ourrecurring losses we have provided a 100% valuation allowance against all of ourdeferred tax assets. Predicting future taxable income is difficult, andrequires the use of significant judgment.

 

*Accrued Liabilities*

 

Certain of ouraccrued liabilities are based largely on estimates. For instance, we record aliability on our balance sheet each period for the estimated cost of goods andservices rendered to us, for which we have not received an invoice.Additionally, a component of our restructuring accrual related to a loss weexpect to incur for excess leased facility space is based on numerous assumptionsand estimates, such as the market value of the space and the time it will taketo sublease the space. Our estimates are based on historical experience, inputfrom sources

 

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outside the company, and otherrelevant facts and circumstances. Actual amounts could differ materially fromthese estimates.

 

Certain of ourlicensing agreements indemnify our customers for expenses or liabilitiesresulting from claimed infringements of patent, trademark or copyright by thirdparties related to intellectual property content of our products. Certain ofthese indemnification provisions are perpetual from execution of the agreementand, in some instances; the maximum amount of potential future indemnificationis not limited. To date, we have not paid any such claims or been required todefend any lawsuits with respect to a claim.

 

*Stock-Based Compensation Expense*

 

We arerequired to determine the fair value of stock option grants to non-employees,and to record the amount as an expense over the period during which servicesare provided to us. Management calculates the fair value of these stock optiongrants using the Black-Scholes model, which requires us to estimate the life ofthe stock option, the volatility of our stock, an appropriate risk-freeinterest rate, and our dividend yield. The calculation of fair value is highlysensitive to the expected life of the stock option and the volatility of ourstock, both of which we estimate based primarily on historical experience.

 

*Legal Matters*

 

We are subjectto various legal proceedings and claims, either asserted or unasserted. Weevaluate, among other factors, the degree of probability of an unfavorableoutcome and reasonably estimate the amount of the loss. Significant judgment isrequired in both the determination of the probability and as to whether anexposure can be reasonably estimated. When we determine that it is probablethat a loss has been incurred, the effect is recorded promptly in theconsolidated financial statements. Although the outcome of these claims cannotbe predicted with certainty, we do not believe that any of the existing legalmatters will have a material adverse effect on our financial condition andresults of operations. However, significant changes in legal proceedings andclaims or the factors considered in the evaluation of those matters could havea material adverse effect on our business, financial condition and results ofoperations.

 

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**Results ofOperations for the Three and Six Months Ended June 30, 2004 Compared to Resultsof Operations for the Three and Six Months Ended June 30, 2003**

 

**REVENUE**

 
| ** **                           | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                           | ** ** | **2004**                        | ** ** | **2003**                      | ** ** | **Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
|                                 |       |                            |       |                          |       |   |   |   |   |   |   |   |   |
| Personal Computers                   |       | $                               | 10,407     |                          | $          | 7,136 |   | 45.8 | % | $ | 20,074 |   | $ | 15,929 |   | 26.0 | % |
| Consumer Electronics                 |       | 15,947                          |       | 5,255                         |       | 203.5 | % | 27,314 |   | 8,505 |   | 221.2 | % |
| Storage Products                     |       | 10,472                          |       | 7,354                         |       | 42.4 | % | 21,488 |   | 15,033 |   | 42.9 | % |
| Product revenue                      |       | 36,826                          |       | 19,745                        |       | 86.5 | % | 68,876 |   | 39,467 |   | 74.5 | % |
| Percentage of total revenue          |       | 84.9                            | %          | 81.1                          | %          | 3.8 | pts | 86.9 | % | 80.5 | % | 6.4 | pts |
| Development, licensing and royalties |       | 6,535                           |       | 4,587                         |       | 42.5 | % | 10,343 |   | 9,541 |   | 8.4 | % |
| Percentage of total revenue          |       | 15.1                            | %          | 18.9                          | %          | (3.8 | )pts | 13.1 | % | 19.5 | % | (6.4 | )pts |
| Total Revenue                        |       | $                               | 43,361     |                          | $          | 24,332 |   | 78.2 | % | $ | 79,219 |   | $ | 49,008 |   | 61.6 | % |

 

**REVENUE**(with development, licensing and royalty revenues, collectively licensingrevenues, by product line)

 
| ** **           | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **           | ** ** | **2004**                        | ** ** | **2003**                      | ** ** | **Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
|                 |       |                            |       |                          |       |   |   |   |   |   |   |   |   |
| Personal Computers   |       | $                               | 10,480     |                          | $          | 8,689 |   | 20.6 | % | $ | 20,160 |   | $ | 17,632 |   | 14.3 | % |
| Consumer Electronics |       | 21,272                          |       | 7,209                         |       | 195.1 | % | 33,554 |   | 11,508 |   | 191.6 | % |
| Storage Products     |       | 11,609                          |       | 8,434                         |       | 37.6 | % | 25,505 |   | 19,868 |   | 28.4 | % |
| Total Revenue        |       | $                               | 43,361     |                          | $          | 24,332 |   | 78.2 | % | $ | 79,219 |   | $ | 49,008 |   | 61.6 | % |

 

Revenues were $43.4 million and$79.2 million for the three and six month periods ended June 30, 2004,respectively, and this represented an increase of 78.2% and 61.6%, relative tocomparable periods of 2003. All elements of revenue grew for both the three andsix month periods ended June 30, 2004, compared to similar periods in 2003. Theincreases in the CE and storage products are primarily attributable to our newproduct offerings, as well as the overall growth in these markets, resulting inincreased volumes. The relatively lower level of increase in demand for our PCproducts, is attributable to loss of market share due primarily to integrationand an overall lower growth rate in the PC market in general. We license ourtechnology in each of our areas of business, but usually limit the scope of thelicense to market areas that are complementary to our products sales and thatdo not directly compete with our direct product offerings. The decrease indevelopment, licensing and royalty revenues as a component of total revenueswas primarily due to the inherently uneven nature of our licensing revenues andincreases in revenue of our product offerings as a percentage of our totalrevenue. We expect overall revenues (including licensing) to increase byapproximately 5-10% from second quarter levels, and included within this,storage revenues (including licensing) are expected to decrease byapproximately 13-17%, during the third quarter of 2004, relative to the secondquarter.

 

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**COSTOF REVENUE AND GROSS MARGIN**

 
| ** **                                                                                   | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                                                                   | ** ** | **2004**                        | ** ** | **2003**                      | ** ** | **Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
|                                                                                         |       |                            |       |                          |       |   |   |   |   |   |   |   |   |
| Product gross margin (excluding licensing  revenue)                                          |       | $                               | 19,131     |                          | $          | 9,016 |   |   |   | $ | 36,666 |   | $ | 17,683 |   |   |   |
| Percentage of product revenue                                                                |       | 51.9                            | %          | 45.7                          | %          | 6.2 | pts | 53.2 | % | 44.8 | % | 8.4 | pts |
| Gross margin                                                                                 |       | 25,666                          |       | 13,603                        |       |   |   | 47,009 |   | 27,224 |   |   |   |
| Percentage of total revenue                                                                  |       | 59.2                            | %          | 55.9                          | %          | 3.3 | pts | 59.3 | % | 55.6 | % | 3.7 |  pts |
| Stock compensation expense (benefit)                                                         |       | 849                             |       | 78                            |       |   |   | 2,000 |   | (57 | ) |   |   |
| Product gross margin (excluding stock  compensation expense (benefit) and licensing revenue) |       | 19,980                          |       | 9,094                         |       |   |   | 38,666 |   | 17,626 |   |   |   |
| Percentage of product revenue                                                                |       | 54.3                            | %          | 46.1                          | %          | 8.2 | pts | 56.1 | % | 44.7 | % | 11.4 | pts |
| Gross margin (excluding stock compensation  expense (benefit))                               |       | $                               | 26,515     |                          | $          | 13,681 |   |   |   | $ | 49,009 |   | $ | 27,167 |   |   |   |
| Percentage of total revenue                                                                  |       | 61.1                            | %          | 56.2                          | %          | 4.9 | pts | 61.9 | % | 55.4 | % | 6.5 | pts |

 

Cost ofrevenue consists primarily of costs incurred to manufacture, assemble and testour products, as well as related overhead costs. Gross margin (revenue minuscost of revenue), as a percentage of revenue, was 59.2%, and 59.3% for thethree and six month periods ended June 30, 2004, respectively, and 55.9% and55.6% for the three and six month periods ended June 30, 2003, respectively).Gross margin, excluding non-cash stock compensation expense (benefit), was61.1% and 61.9% for the three and six month periods ended June 30, 2004,respectively, and 56.2% and 55.4% for the three and six month periods endedJune 30, 2003, respectively. The increase in gross margin is attributable primarilyto the effect of leverage on higher volume, lower manufacturing costs, andimproved product mix. These were partially offset by the impact of a change inestimate for product margins related to inventory in the distributor channelduring the first half of 2004, and lower product pricing. Non-cash stockcompensation expense (benefit) associated with cost of revenue was $849,000 and$2.0 million for the three and six month periods ended June 30, 2004,respectively, and $78,000 and ($57,000) for the three and six month periodsended June 30, 2003, respectively.

 

**OPERATINGEXPENSES**

 
| ** **                              | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                              | ** ** | **2004**                        | ** ** | **2003**                      | ** ** | **Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
|                                    |       |                            |       |                          |       |   |   |   |   |   |   |   |   |
| Research and development (1)            |       | $                               | 11,469     |                          | $          | 9,368 |   | 22.4 | % | $ | 22,054 |   | $ | 18,205 |   | 21.1 | % |
| Percentage of total revenue             |       | 26.5                            | %          | 38.5                          | %          |   |   | 27.8 | % | 37.1 | % |   |   |
| Selling, general and administrative (2) |       | 6,560                           |       | 4,355                         |       | 50.6 | % | 13,507 |   | 8,663 |   | 55.9 | % |
| Percentage of total revenue             |       | 15.1                            | %          | 17.9                          | %          |   |   | 17.1 | % | 17.7 | % |   |   |
| Stock compensation expense              |       | 9,132                           |       | 2,253                         |       | 305.3 | % | 21,200 |   | 1,891 |   | 1021.1 | % |
| Percentage of total revenue             |       | 21.1                            | %          | 9.3                           | %          |   |   | 26.8 | % | 3.9 | % |   |   |
| Amortization of intangible assets       |       | 357                             |       | 373                           |       | (4.3 | )% | 713 |   | 373 |   | 91.2 | % |
| Patent defense costs                    |       | 98                              |       | 583                           |       | (83.2 | )% | 263 |   | 1,796 |   | (85.4 |  )% |
| Restructuring                           |       | —                          |       | —                        |       | N/M |   | — |   | 986 |   | (100.0 | )% |
| In-process research and development     |       | —                          |       | 5,482                         |       | (100.0 | )% | — |   | 5,482 |   | (100.0 | )% |
| Gain on escrow settlement, net          |       | —                          |       | —                        |       | N/M |   | — |   | 4,618 |   | (100.0 | )% |
| Interest income and other, net          |       | 104                             |       | 67                            |       | 55.2 | % | 188 |   | 176 |   | 6.8 | % |
| Gain on derivative investment security  |       | $                               | 990        |                          | $          | — |   | 100.0 | % | $ | 990 |   | $ | — |   | 100.0 | % |

 

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(1)               Excludesnon-cash stock compensation expense of $4.8 million and $1.8 million for thethree months ended June 30, 2004 and 2003, respectively and $10.9 million and$2.0 million for the six month periods ended June 30, 2004 and 2003,respectively.

 

(2)               Excludesnon-cash stock compensation expense (benefit) of $3.5 million and $334,000 forthe three month periods ended June 30, 2004 and 2003, respectively and $8.2million and ($19,000) for the six month periods ended June 30, 2004 and 2003,respectively.

 

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*Research and Development. *R&D expenseconsists primarily of compensation and related costs for employees, fees forindependent contractors, the cost of software tools used for designing andtesting our products, and costs associated with prototype materials. R&Dexpense including stock compensation expense was 16.2 million or 37.5% ofrevenue and $33.0 million or 41.7% of revenue for the three and six monthperiods ended June 30, 2004, respectively, and $11.2 million or 46.1% ofrevenue and $20.2 million or 41.2% of revenue, for the three and six monthsended June 30, 2003, respectively. R&D expense, excluding non-cash stockcompensation expense, was $11.5 million, or 26.5% of revenue and $22.1 millionor 27.8% of revenue for the three and six month periods ended June 30, 2004,respectively, and $9.4 million or 38.5% of revenue and $18.2 million or 37.1%of revenue for the three and six months ended June 30, 2003, respectively. Theincrease in 2004, without the effect of stock compensation expense, wasprimarily due to an increase in the number of R&D projects to support the multiplemarkets in which we operate, as well as additional personnel, includingpersonnel from TransWarp Networks, which we acquired during the second quarterof 2003. Excluding non-cash charges for stock compensation expense, we expectthe dollar amount of our R&D expense in the third quarter of 2004 toincrease approximately 9 - 13%, or approximately $1.0 - $1.5 million, from thesecond quarter of 2004.

 

*Selling, General and Administrative. *SG&A expenseconsists primarily of employee compensation and benefits, sales commissions,and marketing and promotional expenses. Including non-cash stock compensationexpense, SG&A expense was $10.1 million or 23.2% of revenue and $21.7million or 27.4% of revenue for the three and six months ended June 30, 2004,respectively and $4.7 million or 19.3% of revenue and $8.6 million or 17.6% ofrevenue for the three and six months ended June 30, 2003, respectively.Excluding non-cash stock compensation expense, SG&A expense was $6.6million or 15.1% of revenue and $13.5 million or 17.1% of revenue for the threeand six months ended June 30, 2004, respectively, and $4.4 million or 17.9% ofrevenue and $8.7 million or 17.7 % of revenue for the three and six monthsended June 30, 2003, respectively. The increase in spending for 2004, withoutthe effect of stock compensation expense, can be attributed to the increasedheadcount to support the increased rate of growth of the Company, andapproximately $1.0 million incurred during the first half of 2004 relating tothe costs associated with the Audit Committee examination. Excluding non-cashcharges for stock compensation expense, we expect the dollar amount of ourSG&A expense to remain relatively flat during the third quarter of 2004.

 

*Stock Compensation. *Stock compensationexpense was $9.1 million or 21.1% of revenue and $21.2 million or 26.8% ofrevenue for the three and six month periods ended June 30, 2004, respectivelyand $2.3 million or 9.3% of revenue and $1.9 million or 3.9% of revenue for thethree and six months ended June 30, 2004, respectively. The increase in totalstock compensation can be attributed primarily to the higher stock price duringthe first half of 2004 and the resultant impact on expense relating to ourrepriced options offset to some extent by a decrease in expense associated withthe options granted in connection with acquisitions and a decline in the numberof options subject to variable accounting, as certain older options expire.

 

We will incursubstantial non-cash stock compensation expense in future periods as a resultof (1) the issuance of, or modifications to, restricted stock awards andstock option grants to employees and consultants, (2) the stock optionrepricing programs we implemented in 2000 and 2001, and (3) amortizationof our existing unearned compensation balance. Since the expense associatedwith our stock option repricings and stock options issued to consultants isdependent on our stock price and volatility, stock compensation expense mayfluctuate significantly from period to period. To date, we have recognized over$25.3 million of expense in connection with our stock option repricings, andthis may continue to be a significant component of our stock compensationexpense in future periods if our stock price significantly exceeds the averagestock price for the period ended June 30, 2004. Due to its volatility, wecannot forecast our stock compensation expense for the third quarter of 2004.

 

*Amortization of Intangible Assets. *For the three andsix months period ended June 30, 2004, we recorded amortization of intangibleassets amounting to $357,000 and $713,000, respectively, relating to intangibleassets on our balance sheet, pursuant to our acquisition of Transwarp Netwoks,Inc. during the second quarter of 2003. We recorded $373,000 relating toamortization of intangible assets for each of the three and six-month periodsended June 30, 2003. We expect the amortization expense for the third quarterof 2004 to be approximately $357,000.

 

*Restructuring. *During the thirdquarter of 2001, we began a program to focus our business on products andtechnology, including those obtained through acquisitions, in which we have, orbelieve we can achieve, a market leadership position. As part of this program,we decided to cancel numerous products under development, to remove certainprojects from our development plan, to phase out or de-emphasize certainexisting products and to integrate the operations of two acquired companies—CMDTechnology (“CMD”) and Silicon Communication Lab (“SCL”).

 

In connectionwith this program, we reduced our workforce in the fourth quarter of 2001 byapproximately 60 people, or 20%. This workforce reduction was the initial stepin eliminating duplicate positions that resulted from our acquisitions, andalso represented the elimination of other positions based on our new productand technology focus. Positions were eliminated from all functionalareas—operations, R&D and SG&A. Because of this workforce reduction, werecorded a restructuring expense of $1.5 million in the fourth quarter of 2001,consisting of cash severance-related costs of $599,000, non-cashseverance-related costs of $303,000 representing the intrinsic value of

 

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modified stock options, anexpected loss on leased facilities of $500,000 and fixed asset write-downs of$50,000. In addition, we reversed $286,000 of unearned compensation, acomponent of stockholders’ equity, for unvested stock options that werecancelled in connection with employee terminations.

 

In the firstquarter of 2002, we implemented a second workforce reduction in connection withthe program discussed above, eliminating an additional 35 positions, or 13% ofour workforce. Positions were eliminated from all functional areas. Thisreduction resulted from the continued integration of acquired companies, aswell as continued execution of our product and technology strategy, whereby wedecided to phase out the legacy storage subsystem board products we acquiredfrom CMD and to develop new board products only if we believed it wouldfacilitate or accelerate the use of our storage semiconductor products. Inconnection with this workforce reduction, we recorded a restructuring expenseof $2.2 million in the first quarter of 2002, consisting of cashseverance-related costs of $198,000, non-cash severance-related costs of$318,000 representing the intrinsic value of modified stock options, anexpected loss on leased facilities of $1.2 million and fixed asset write-downsof $500,000 for assets to be disposed of. In addition, we reversed $76,000 ofunearned compensation, a component of stockholders’ equity, for unvested stockoptions that were cancelled in connection with employee terminations.

 

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 connectionwith our decision to stop selling board products and to transition to alicensing model, we assessed recoverability of our intangible assets subject toamortization in accordance with SFAS No. 144. During the quarter endedSeptember 30, 2002, an impairment expense of $749,000 was recognized foracquired technology and $60,000 was recognized for patent and other intangibleassets, based upon our projection of significantly reduced future cash flows.Additionally, we reduced our estimate of the useful lives of the remainingintangible assets subject to amortization such that these assets were fully amortizedby the end of 2002. We also tested the carrying value of goodwill forimpairment in accordance with SFAS No. 142. As a result of our impairmenttest, a goodwill impairment expense of $4.4 million was recognized during thesecond quarter of 2002. To determine the amount of the impairment, we estimatedthe fair value of our storage systems business based primarily on expectedfuture cash flows. We then reduced this amount by the fair value ofidentifiable tangible and intangible assets other than goodwill (also basedprimarily on expected future cash flows), and compared the unallocated fairvalue of the business to the carrying value of goodwill. To the extent goodwillexceeded the unallocated fair value of the business, an impairment expense wasrecognized.

 

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 December 31, 2003, our expectedloss on subleased facilities was based on estimated sublease income ofapproximately $1.0 million over the remaining lease terms. To the extent we areunable to generate $1.0 million of sublease income, our future results ofoperations and financial condition will be negatively affected.

 

InMarch 2003, we reorganized parts of the marketing and product engineeringactivities of the company into lines of business for PC, CE and storageproducts to enable us to better manage our long-term growth potential. Thecentral engineering, sales, manufacturing, and general and administrativeactivities were not organized into 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 recorded restructuringexpense of $986,000 in the first quarter of 2003, consisting of cashseverance-related costs of $340,000 and non-cash severance-related costs 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

 

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period from the communicationdate did not exceed 60 days. The expected loss on leased facilities resultedfrom our plan to consolidate our remaining workforce to the extent practicableand sublease any excess space. To determine the expected loss, we compared ourlease and operating costs for the space to our estimate of the net amount wewould be able to recover by subleasing the space. This estimate was based on anumber of assumptions, including the length of time it will take to secure atenant, the sublease rate per square foot, the cost of necessary improvementsor modifications and real estate broker commissions. The fixed assetwrite-downs in 2001 and 2002 were determined based on the estimated fair valueof assets, primarily computer hardware and software that would no longer beutilized after the employees’ termination dates.

 

Severance andbenefits payments are substantially complete. Lease payments will be made inthe form of cash through the end of the related lease term ofNovember 2005. The following table presents restructuring activity for2001 through June 30, 2004 (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                        |       | (441                        | )          | (760                   | )          | —           |       | (1,201    | )          |
| Non-cash activity                    |       | (646                        | )          | —                 |       | —           |       | (646      | )          |
| Balance as of December 31, 2003 |       | $                           | 37         |                   | $          | 1,838            |       | $         | —     |   | $ | 1,875 |   |
| Cash payments                        |       | (5                          | )          | (453                   | )          | —           |       | (458      | )          |
| Balance as of June 30, 2004          |       | $                           | 32         |                   | $          | 1,385            |       | $         | —     |   | $ | 1,417 |   |

 

*Patent defense costs.  *Patentdefense costs were $0.1 million and $0.3 million for the three and six monthsended June 30, 2004, respectively, compared to $0.6 million and $1.8 million,respectively, for the comparable periods of 2003. Patent defense costs arerelated to the lawsuit we filed against Genesis in April 2001. Thedecrease in 2004 compared to 2003 is attributable to a lower level of activityduring the first half of 2004. However, we expect to incur additional patentdefense costs through at least the fourth quarter of 2004. The amount of legalfees incurred in 2004 will depend on the duration of the litigation, as well asthe nature and extent of the litigation activities. We are not able toaccurately estimate the amount of legal fees we will incur, but the amount couldbe significant.

 

*Gain on escrow settlement, net.  *Duringthe six-month period ended June 30, 2003, we recognized a net gain of $4.6million associated with the settlement of an escrow claim against the principalselling shareholders of CMD.

 

*Interest Income and other, net.  *Thisprincipally includes interest income and interest expense. The net amount was$104,000 and $188,000 for the three and six-month periods ended June 30, 2004,respectively, compared to $67,000 and $176,000 for the three and six monthperiods ended June 30, 2003, respectively. The increase is principally due tohigher cash balances and lower debt balances offset by the lower interest ratesduring 2004.

 

*Gain on derivative investment security.*Werecorded a gain of $990,000 for the three and six months ended June 30, 2004,relating to a derivative investment security. This relates to common stock warrants acquired in connection with atransaction with Leadis Technology Inc. (as described in Note 15 to theunaudited condensed consolidated financial statements). In the future, we willcontinue to adjust any changes to the valuation of this instrument through ourstatement of operations (until the warrant is exercised and/or the restrictionon the sale of the underlying shares is removed and such shares are sold).

 

*Provision for Income Taxes.  *Forthe three and six month periods ended June 30, 2004, we recorded provision ofincome taxes of $255,000 and $572,000, respectively. These amounts includeapproximately $45,000 and $262,000 relating to withholding taxes payable inconnection with our licensing contracts, and a provision of $210,000 and$310,000 relating to taxes in foreign jurisdictions where we have recentlycommenced operations and estimated provision for U.S. alternative minimum taxesfor the fiscal year ending December 31, 2004. At June 30, 2004, we had a netoperating loss carryforward for federal income tax purposes of approximately$72.8 million that expires in various years through 2023. These future taxbenefits have not been recognized as an asset on our balance sheet due to uncertaintiessurrounding our ability to generate sufficient taxable income in future periodsto realize these tax benefits. Under the Tax Reform Act of 1986, the amountsof, and benefits from, net operating loss carryforwards may be restricted orlimited in certain circumstances.

 

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**LIQUIDITY, CAPITAL RESOURCES AND FINANCIAL CONDITION**

 
| ** **                                               | ** ** | **June 30, 2004**        | ** ** | **December 31, 2003** | ** ** | **Change** | ** ** |
|----------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|------------|------------|
| ** **                                               | ** ** | **Dollars in thousands** | ** ** | ** **            | ** ** |
|                                                     |       |                     |       |                  |       |       |       |
| Cash and cash equivalents                                |       | $                        | 41,618     |                  | $          | 24,059     |       | $ | 17,559 |   |
| Short term investments                                   |       | 24,502                   |       | 13,195                |       | 11,307     |       |
| Total cash, cash equivalents and short term  investments |       | 66,120                   |       | 37,254                |       | 28,866     |       |
|                                                     |       |                     |       |                  |       |       |       |
| Percentage of total assets                               |       | 53.8                     | %          | 42.5                  | %          | 11.3       | pts   |
|                                                     |       |                     |       |                  |       |       |       |
| Total current assets                                     |       | 98,483                   |       | 63,023                |       | 35,460     |       |
| Total current liabilities                                |       | 35,071                   |       | 25,349                |       | 9,722      |       |
| Working capital                                          |       | $                        | 63,412     |                  | $          | 37,674     |       | $ | 25,738 |   |

 
|                                                  |   | **Six months ended June 30,** | ** ** | **Change** |       |
|-------------------------------------------------------|--------|-------------------------------|------------|------------|------------|
|                                                  |   | **2004**                      | ** ** | **2003**   | ** ** | ** ** |   |
|                                                  |   |                          |       |       |       |   |   |
| Cash provided by (used in) operating  activities      |   | $                             | 19,286     |       | $          | (5,644 | ) | $ | 24,930 |   |
| Cash provided by (used in) investing  activities      |   | (9,319                        | )          | 1,179      |       | (10,498 | ) |
| Cash provided by financing activities                 |   | 7,592                         |       | 3,389      |       | 4,203 |   |
| Net increase (decrease) in cash and cash  equivalents |   | $                             | 17,559     |       | $          | (1,076 | ) | $ | 18,635 |   |

 

Since ourinception, we have financed our operations through a combination of privatesales of convertible preferred stock, our initial public offering, lines ofcredit, capital lease financing, proceeds from sale of stock under our stockplans and cash flows from operations. At June 30, 2004, we had $63.4 million ofworking capital, which included $66.1 million of cash, cash equivalents andshort-term investments. If we are not able to generate cash from operatingactivities, stock option exercises, and proceeds from sales of shares under ouremployee stock purchase plan, we will liquidate short-term investments or, tothe extent available, utilize credit arrangements to meet our cash needs.

 

*Working capital*

 

The principalcomponents of the current assets and liabilities and an analysis of the same isgiven below:

 

Net accountsreceivable increased to $20.2 million at June 30, 2004 from $12.8 million atDecember 31, 2003. The increase is primarily due to increased sales volumeand in particular a $3 million increase in distributor shipments during June2004 versus our ending balance at December 2003. The days sales outstanding(“DSO”) was 42 days at June 30, 2004, compared to 38 days at December 31,2003. The increase in the DSO days is primarily as a result of the increase inthe June 2004 versus December 2003 distributor shipments. We expect the DSOdays to be in the 42-46 days range during the third quarter of 2004.

 

Inventoriesdecreased to $9.9 million at June 30, 2004 from $10.3 million atDecember 31, 2003. The decrease is attributable to increased businessvolume and a general tightening of available foundry capacities. Our inventoryturn rate increased to 7.1 as at June 30, 2004 from 5.1 as at December 31,2003. Inventory turns are computed on an annualized basis, and are a measure ofthe number of times inventory is replenished during the year. Our inventoryturns increased primarily due to higher business volume during the secondquarter of 2004 and lower inventory balances as of June 30, 2004. We expectthis measure to be around the 6.0 level during the third quarter of 2004.

 

Accountspayable and accrued liabilities increased to $9.3 million and $11.1 million,respectively, at June 30, 2004 from $6.4 million and $8.7 million,respectively, at December 31, 2003. The increase in accounts payable wasdue to the timing of when payables became due and were processed, and theincrease in accrued liabilities is consistent with the increased scale ofoperations and consequently increased expenditure levels.

 

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Deferredmargin on sales to distributors increased to $11.7 million at June 30, 2004from $7.3 million at December 31, 2003. The increase is principally due tothe effect of increased distributor related shipments at June 30, 2004 comparedto December 31, 2003.

 

*Operating activities*

 

Operatingactivities generated $19.3 million of cash during the first half of 2004. Forthe first half of 2004, our net income excluding depreciation, stockcompensation expense, amortization of intangible assets, offset by our gain onderivative investment security was $15.2 million. Increases in accountspayable, accrued liabilities and deferred license revenue, deferred margin onsales to distributors and decreases in inventories, prepaid expenses and otherassets offset by an increase in accounts receivable contributed $4.1 million.Operating activities used $5.7 million of cash during the first half of2003.  During the first half of 2003, ournet loss excluding depreciation, stock compensation expense, non-cash gain onescrow settlement, in-process research and development expense and the non-cashportion of our restructuring charges was $475,000, which accounts for some ofthe cash provided by operating activities. The decreases in accounts payable, accrued liabilities and deferredlicense revenue and deferred margin on sales to distributors of $3.1 million,and an increase in accounts receivable and inventory of $4.2 million were theprimary uses of cash.  These uses of cashwere offset by a $1.3 million decrease in prepaid expenses and other assets.

 

*Investing and financing activities*

 

Investingactivities used $9.3 million for the six months ended June 30, 2004 andprovided $1.2 million for the six months ended June 30, 2003. The source ofcash for both periods were net proceeds from sales of short-term investments,offset by capital expenditures and purchases of short-term investments.

 

We generated$7.6 million and $3.4 million from financing activities during the six monthsended June 30, 2004 and 2003. Cash provided by financing activities in bothperiods was primarily from stock option exercises and proceeds from sales ofshares under our employee stock purchase plan, partially offset by repaymentsof our capital leases and other obligations.

 

*Debt and Lease Obligations*

 

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 June 30, 2004)plus 0.25% and requires monthly payments through its maturity ofOctober 1, 2004. During the three months ended March 31, 2003, weborrowed $383,000 to finance certain capital equipment. This term loan bears interestat 4.75% and requires monthly payments through its maturity inFebruary 2005. As of June 30, 2004, $863,000 was outstanding under all ourdebt arrangements. Our debt facilities contain certain quarterly and annualfinancial covenants with which we must comply. In the fourth fiscal quarter of2003, we fell out of compliance with the lending institution’s quarterlycovenants regarding providing periodic financial statements. We were granted awaiver from the lending institution and were not in default of the loanagreement. Due to the nature of the underlying covenants, we have classifiedall amounts outstanding as current liabilities as of June 30, 2004. During theperiod ended March 31, 2004, we entered into an agreement to extend this debtfacility by way of a revolving line of credit with an availability of up to$10.0 million, and an equipment line of credit of up to $3.0 million.Borrowings under the revolving line are limited to the lesser of $10.0 millionor 80% of eligible accounts receivable as defined in the loan agreement. Thisrevolving line of credit expires in March 2005 and bears interest ateither prime plus 0.25% or LIBOR plus 2.75%, at our option. Equipment advancespursuant to the equipment line of credit are available to us through August 2004and will be repayable in twenty four equal monthly installments commencingSeptember 1, 2004 bearing interest at either prime or LIBOR plus 2.5%, atour option. Quarterly and annual financial covenants are contained within thisrevised agreement. No amounts have been drawn down against this line of creditas at June 30, 2004. As of June 30, 2004, we were in compliance with allcovenants.

 

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Future minimum payments for our operating leases, debt and inventoryrelated purchase obligations outstanding at June 30, 2004 are as follows (inthousands):

 
| ** **                       | ** ** | ** ** | ** ** | **Payments due in**                 | ** ** |
|----------------------------------|------------|------------|------------|-------------------------------------|------------|
| **Contractual obligations** | ** ** | **Total**  | ** ** | **Less than 1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than 5 years** | ** ** |
| Debt obligations                 |       | $          | 863        |                                | $          | 863 |   | $ | — |   | $ | — |   | $ | — |   |
| Operating lease obligations      |       | 8,498      |       | 2, 515                              |       | 2,727 |   | 2,079 |   | 1,177 |   |
| Inventory purchase obligations   |       | 11,418     |       | 11,418                              |       | — |   | — |   | — |   |
| Total                            |       | $          | 20,779     |                                | $          | 14,796 |   | $ | 2,727 |   | $ | 2,079 |   | $ | 1,177 |   |

 

Future minimumlease payments under operating leases have not been reduced by expectedsublease rental income or by the amount of our restructuring accrual thatrelates to leased facilities.

 

We plan tospend approximately $3-4 million during the remainder of the 2004 fiscal yearfor equipment, furniture and software.

 

As a result ofa delayed filing of our third quarter 2003 Form 10-Q, for the quarterended September 30, 2003, we will be ineligible to register our securities onForm S-3 for sale by us or resale by others until we have timely filed allperiodic reports under the Securities Exchange Act of 1934 for one year. We mayuse the Form S-1 to raise capital or complete acquisitions, which couldincrease transaction costs and adversely affect our ability to raise capital orcomplete acquisitions of other companies during this period

 

Based on ourestimated cash flows, we believe our existing cash and short-term investmentsare sufficient to meet our capital and operating requirements for at least thenext 12 months. Our future operating and capital requirements depend on manyfactors, including the levels at which we generate product revenue and relatedmargins, the extent to which we generate cash through stock option exercisesand proceeds from sales of shares under our employee stock purchase plan, thetiming and extent of development, licensing and royalty revenues, investmentsin inventory and accounts receivable, the cost of securing access to adequatemanufacturing capacity, our operating expenses, including legal and patentdefense costs, and general economic conditions. In addition, cash may berequired for future acquisitions should we choose to pursue any. To the extentexisting resources and cash from operations are insufficient to support ouractivities, we may need to raise additional funds through public or privateequity or debt financing. These funds may not be available, or if available, wemay not be able to obtain them on terms favorable to us.

 

**FactorsAffecting Future Results**

 

*You should carefully consider the followingrisk factors, together with all other information contained or incorporated byreference in this filing, before you decide to purchase shares of our commonstock. These factors could cause our future results to differ materially fromthose 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 or partof your investment.*

 

**Weoperate in rapidly evolving markets, which makes it difficult to evaluate ourfuture prospects.**

 

The revenueand income potential of our business and the markets we serve are early intheir lifecycle and is difficult to predict. The Digital Visual Interface(“DVI”) specification, which is based on technology developed by us and used inmany of our products, was first published in April 1999. We completed ourfirst generation of consumer electronics and storage IC products in mid-to-late2001. In addition, the preliminary serial ATA specification was first publishedin August 2001 and the High Definition Multimedia Interface (“HDMI”)specification was first released in December 2002. Accordingly, we facerisks and difficulties frequently encountered by companies in new and rapidlyevolving markets. If we do not successfully address these risks anddifficulties, our results of operations could be negatively affected.

 

**Wehave a history of losses and may not become profitable.**

 

We haveincurred net losses in each fiscal year since our inception, including netlosses of $8.1 million for the six months ended June 30, 2004, and $12.8million and $40.1 million for the years ended December 31, 2003 and2002, respectively. We expect to continue to incur net losses for theforeseeable future. Accordingly, we may not achieve and sustain profitability.

 

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**Ourquarterly operating results may fluctuate significantly and are difficult topredict.**

 

Our quarterlyoperating results are likely to vary significantly in the future based on anumber of factors over which we have little or no control. These factorsinclude, but are not limited to:

 

•                  the growth,evolution and rate of adoption of industry standards for our key markets,including digital-ready PCs and displays, consumer electronics and storagedevices;

 

•                  the fact thatour licensing revenue is heavily dependent on a few key licensing transactionsbeing completed for any given period, the timing of which is not alwayspredictable and is especially susceptible to delay beyond the period in whichcompletion is expected, and our concentrated dependence on a few licensees inany period for substantial portions of our expected licensing revenue;

 

•                  competitivepressures, such as the ability of competitors to successfully introduceproducts that are more cost-effective or that offer greater functionality thanour products, including by integrating into their products functionalityoffered by our products, and the prices set by competitors for their products,and the potential for alliances, combinations, mergers and acquisitions amongour competitors;

 

•                  average sellingprices of our products, which are influenced by competition and technologicaladvancements, among other factors;

 

•                  governmentregulations regarding the timing and extent to which digital content must bemade available to consumers;

 

•                  the availabilityof other semiconductors or other key components that are required to produce acomplete solution for the customer; usually, we supply one of many necessarycomponents;

 

•                  the cost ofcomponents for our products and prices charged by the third parties whomanufacture, assemble and test our products;

 

•                  fluctuations inthe price of our common stock, which drive a substantial portion of ournon-cash stock compensation expense;

 

•                  the nature andextent of litigation activities, particularly our patent infringement suitagainst Genesis, and any subsequent legal proceedings related to the matters raisedin that suit; and

 

•                  any legalmatters resulting from the recent audit committee examination.

 

Because wehave little or no control over these factors****and/ortheir magnitude, our operating results are difficult to predict. Anysubstantial adverse change in any of these factors could negatively affect ourbusiness and results of operations.

 

**Ourfuture quarterly operating results are highly dependent upon how well we manageour business.**

 

Our quarterlyoperating results may fluctuate based on how well we manage our business. Someof the factors that may affect how well we manage our business include thefollowing:

 

•                  our ability tomanage product introductions and transitions;

 

•                  our ability tosuccessfully manage our business in multiple markets such as PC, storage andCE;

 

•                  our ability toclose licensing deals and timely make deliverables and milestones on whichrecognition of revenue often depends;

 

•                  our ability toengineer customer solutions that adhere to industry standards in a timely,cost-effective manner;

 

•                  our ability toachieve acceptable manufacturing yields and develop automated test programswithin a reasonable time frame for our new products;

 

•                  our ability tomanage joint projects, design services, and our supply chain partners;

 

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•                  our ability tomonitor the activities of our licensees to ensure compliance with licenserestrictions and remittance of royalties;

 

•                  our ability tostructure our organization to enable achievement of our operating objectivesand to meet the needs of our customers and markets;

 

•                  the success ofthe distribution channels through which we choose to sell our products; and

 

•                  our ability tomanage expense and inventory levels.

 

If we fail to effectively manage our business, this could adverselyaffect our results of operations.

 

**Thelicensing component of our business strategy increases business risk andvolatility.**

 

Part ofour business strategy is to license certain of our technology to companies thataddress markets in which we do not want to directly participate. We havelimited experience marketing and selling our technology on a licensing basis.In conjunction with the business strategy we adopted in late 2001, we signedour first license contract in December 2001, and have signed others sincethen. There can be no assurance that additional companies will be interested inlicensing our technology on commercially favorable terms or at all. We alsocannot ensure that companies who license our technology will introduce and sellproducts incorporating our technology, will accurately report royalties owed tous, will pay agreed upon royalties, will honor agreed upon market restrictions,will not infringe upon or misappropriate our intellectual property and will maintainthe confidentiality of our proprietary information. Licensing contracts arecomplex and depend upon many factors including completion of milestones,allocation of values to delivered items, and customer acceptances. Many ofthese factors require significant judgments. Licensing revenues could fluctuatesignificantly from period to period because it is heavily dependent on a fewkey deals being completed in a particular period, the timing of which isdifficult to predict. Because of their high margin content, licensing revenuescan have a disproportionate impact on gross margins and profitability. Also,generating revenue from licensing arrangements is a lengthy and complex processthat may last beyond the period in which efforts begin, and once an agreementis in place, the timing of revenue recognition may be dependent on customeracceptance of deliverables, achievement of milestones, our ability to track andreport progress on contracts, customer commercialization of the licensedtechnology, and other factors. In addition, in any period, our expectation oflicensing revenue is or may be dependent on one or a few licenses beingcompleted. Licensing that occurs in the course of actual or contemplatedlitigation is subject to risk that the adversarial nature of the transactionwill induce non-compliance or non-payment. The accounting rules associatedwith recognizing revenue from licensing transactions are increasingly complexand subject to interpretation. Due to these factors, the amount of licenserevenue recognized in any period may differ significantly from ourexpectations.

 

**Weface additional risks and costs as a result of the delayed filing of ourquarterly report on Form 10-Q for the quarter ended September 30,2003 and our recent Audit Committee examination.**

 

As a result ofthe delayed filing of our Form 10-Q for the quarter endedSeptember 30, 2003, and the Audit Committee’s examination, we haveexperienced additional risks and costs. The Audit Committee’s examination hasbeen time-consuming, required us to incur additional expenses and has affectedmanagement’s attention and resources. Further, the measures to strengtheninternal controls being implemented have and may require greater managementtime and company resources to implement and monitor. We incurred approximately$1.1 million of costs associated with the Audit Committee examination in thefourth quarter of 2003 and an additional $1.0 million in the first half of2004. These costs include payments made by us pursuant to indemnity agreementsbetween us and certain individuals. Measures being implemented as a result ofthis examination, previously described in our 2003 Form 10-K, may adverselyaffect our operations.

 

In addition,we have been informed by the NASDAQ staff that the continued listing of ourcommon stock is conditioned on our timely filing of all periodic reports underthe Securities Exchange Act of 1934, such as our annual report onForm 10-K, quarterly reports on Form 10-Q, and current reports onForm 8-K, for all reporting periods ending on or before December 31,2004. Should we fail to timely make any such filing, NASDAQ has informed usthat we will not be entitled to a new hearing with the NASDAQ staff and ourcommon stock may be transferred to the NASDAQ SmallCap Market, provided wecould demonstrate compliance with applicable maintenance criteria for suchmarket and an ability to sustain long-term compliance, or immediately delistedfrom the NASDAQ National Market. The NASDAQ staff has reserved the right toreconsider the terms of the foregoing exception permitting continued listing ofour common stock upon a review of our publicly filed financial statements or ifany event, condition or circumstance that exists or develops that would, in theopinion of the staff, make continued listing of our stock inadvisable orunwarranted.

 

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Finally, as aresult of our delayed filing of our Form 10-Q, we will be ineligible toregister our securities on Form S-3 for sale by us or resale by othersuntil we have timely filed all periodic reports under the Securities ExchangeAct of 1934 for one year. The Company may use Form S-1 to raise capital orcomplete acquisitions, which could increase transaction costs and adverselyaffect our ability to raise capital or complete acquisitions of other companiesduring this period.

 

**Weface intense competition in our markets, which may lead to reduced revenue fromsales of our products and increased losses.**

 

The PC, CE andstorage markets in which we operate are intensely competitive. These marketsare characterized by rapid technological change, evolving standards, shortproduct life cycles and declining selling prices. Our display products facecompetition from a number of sources, including analog solutions, DVI-basedsolutions, dual (analog and DVI based) solutions and other digital interfacesolutions. We expect competition in the display market to increase. Forexample, 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 and/orother digital interface solutions that we expect will compete with ourPanelLink products. Other companies have announced DVI-based solutions and weexpect that additional companies are likely to enter the market. Current orpotential customers, including our own licensees, may also develop solutionsthat could compete with us, directly or indirectly, such as the integration ofa DVI transmitter into a graphics processing unit or integration of a DVIreceiver into a monitor controller.

 

In the CEmarket, our digital interface products are used to connect cable set-top boxes,satellite set-top boxes and DVD players to digital televisions. These productsincorporate DVI and High-bandwidth Digital Content Protection (“HDCP”), or HDMIwith or without HDCP support. Companies that have announced or are shippingDVI-HDCP solutions include Texas Instruments (“TI”), Thine, Broadcom andGenesis Microchip (“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. Toshiba andMatsushita have or are close to having working HDMI solutions.

 

In the storagemarket, our fibre channel products face competition from companies selling similardiscrete products, including Agilent, PMC Sierra and Vitesse, from other fibrechannel Serializer-Deserializer (“SerDes”) providers who license their coretechnology, such as LSI Logic, and from companies that sell Host Bust Adapters(“HBA”) controllers with integrated SerDes, such as QLogic and Agilent. In thefuture, our current or potential customers may also develop their ownproprietary solutions that may include integration of SerDes.

 

Our serial ATAproducts compete with similar products from Marvell and Promise. In addition,other companies such as Adaptec, APT, ATI, Intel, LSI Logic, ServerWorks andVitesse, have developed or announced intentions to develop serial ATAcontrollers. We also compete against Intel and other motherboard chipset makersthat have integrated serial ATA functionality into their chipsets.

 

Our parallelATA products compete with similar products from Promise and Highpoint. Our RAIDcontroller board products face competition from Mylex, Infortrend, andChaparral.

 

Some of thesecompetitors have already established supplier or joint developmentrelationships with current or potential customers and may be able to leveragetheir existing relationships to discourage these customers from purchasingproducts from us or persuade them to replace our storage products with theirs.Many of our competitors have longer operating histories, greater presence inkey markets, better name recognition, access to larger customer bases andsignificantly greater financial, sales and marketing, manufacturing,distribution, technical and other resources than we do. In addition, some ofour competitors could merge (for example, Genesis and Pixelworks announced, andthen terminated, such a merger), which may enhance their market presence. As aresult, they may be able to adapt more quickly to new or emerging technologiesand customer requirements, or devote more resources to the promotion and saleof their products. We cannot assure you that we can compete successfullyagainst current or potential competitors, or that competition will not reduceour revenue and increase our losses.

 

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**Growthof the market for our PC products depends on the widespread adoption and use ofthe DVI specification.**

 

Our success islargely dependent upon the rapid and widespread adoption of the DVIspecification, which defines a high-speed data communication link betweencomputers and digital displays. We cannot predict the rate at whichmanufacturers of computers and digital displays will adopt the DVIspecification. To date, relatively few systems implementing all of theelectrical and mechanical aspects of the DVI specification have been shipped.The DVI adoption rate in the PC market was reported to be approximately 12%, and,7% in 2002 and 2001, respectively. Reportedly the 2003 DVI adoption rate isestimated to be in the range of 15-20% and the Q1 2004 adoption rate isapproximately 37%. 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.

 

**Oursuccess depends on the growth of the digital display market.**

 

Our PCbusiness depends on the growth of the digital display market. The potentialsize of the digital display market and its rate of development are uncertainand will depend on many factors, including:

 

•                  the number ofdigital-ready computers that are being produced and consumer demand for thesecomputers;

 

•                  the rate atwhich display manufacturers replace analog or non-compliant DVI interfaces withfully DVI-compliant interfaces;

 

•                  the availabilityof cost-effective semiconductors that implement a fully DVI-compliantinterface; and

 

•                  improvements toanalog technology, which may decrease consumer demand for our digital displayproducts.

 

In order forthe digital display market to grow, digital displays must be widely availableand affordable to consumers. In the past, the supply of digital displays, suchas flat panels, has been cyclical and consumers have been very price sensitive.Also, some manufacturers have implemented DVI interfaces that are not fullyDVI-compliant. These interfaces often interfere with the operability of ourproducts which function best with a fully DVI-compliant interface. Our abilityto sustain or increase our revenue may be limited should there not be anadequate supply of, or demand for, affordable digital displays with fullyDVI-compliant interfaces.

 

**Asignificant amount of our revenue is associated with the adoption of new or emergingtechnologies within the PC industry. The PC industry has slowed and theadoption of these new technologies may not occur as planned.**

 

A largeportion of our revenue is directly or indirectly related to the PC industry andthe adoption of new or emerging technologies within the PC industry.Accordingly, we are highly dependent on the adoption of new or emergingtechnologies within the PC industry, which experienced a slowdown in growthduring the second half of 2000 that has continued through 2004. We cannotpredict the duration or severity of the downturn in the PC and display market,or in the general economy, or its effect on our revenue and operating results,including the adoption of these new or emerging technologies. If the market forPCs and PC-related displays continues to grow at a slow rate or contractswhether due to reduced demand from end users, macroeconomic conditions or otherfactors, our business and results of operations could be negatively affected.

 

Although weare attempting to broaden our product offerings to include more products forthe consumer electronics and storage markets, there can be no guarantee that wewill succeed in this effort. To date, we have achieved reasonable success, butif we fail to consistently achieve design wins in the consumer electronics andstorage markets, we will remain highly dependent on the PC industry.

 

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**Demandfor our consumer electronics products is dependent on the adoption andwidespread use of the HDMI 1.0 specification.**

 

Our success inthe consumer electronics market is largely dependent upon the rapid andwidespread adoption of the HDMI 1.0 specification, which combineshigh-definition video and multi-channel audio in one digital interface and usesour patented underlying transition minimized differential signaling (“TMDS”®)****technology, and optionally Intel’s HDCPtechnology, as the basis for the interface. Version 1.0 of the specificationwas published for adoption on December 9, 2002. We cannot predict the rateat which manufacturers will adopt the HDMI specification or if thespecification will be adopted at all. Adoption of the HDMI specification may beaffected by the availability of consumer products, such as DVD players andtelevisions, and of computer components that implement this new interface.Other competing specifications may also emerge that could adversely affect theacceptance of the HDMI specification. Delays in the widespread adoption of theHDMI specification could reduce acceptance of our products, limit or reduce ourrevenue growth and increase our losses.

 

We believethat the adoption of our CE products may be affected in part by U.S. andInternational regulations relating to digital television, cable, satellite andover-the-air digital transmissions, specifically regulations relating to thetransition from analog to digital television. The Federal CommunicationsCommission (“FCC”) has adopted rules governing the transition from analogto digital television, which include rules governing the requirements fortelevision sets sold in the United States designed to speed the transition todigital television. The FCC has delayed such requirements and timetables forphasing in digital television in the past. We cannot predict whether the FCCwill further delay its rules relating to the digital televisionrequirements and timetables. In the event that additional regulatory activity,either in the United States or internationally, delay or postpone thetransition to digital television beyond the anticipated time frame, that couldreduce the demand for our CE products.

 

In addition,we believe that the rate of HDMI adoption may be accelerated by the proposedFCC rules requiring that all high-definition set top boxes distributed bycable operators include a DVI or HDMI interface and that all CE productsmarketed or labeled as “digital cable ready” include a DVI or HDMI interface.However, we cannot predict whether the proposed rules will be adopted intheir current form or when any final rules will be put into effect. In theevent that mandatory use of a DVI or HDMI interface were to be delayed beyondthe currently anticipated time frame or not required at all, that could reducethe demand for our CE products, which would adversely affect our business.

 

**Oursuccess depends on the development and growth of markets for products based onnew 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 ofdevelopment, and there can be no assurance that they will replace other storageinterfaces that are now widely used, such as parallel ATA and SCSI. Thepotential size and rate of development of these markets are uncertain and willdepend on many factors, including:

 

•                  the rate atwhich manufacturers of storage subsystems adopt new interface technologies,which may be more costly to implement than existing interface technologiesuntil volumes are sufficient to bring costs to competitive levels;

 

•                  the availabilityof cost-effective semiconductors and components for storage subsystems, such asserial ATA-enabled hard drives and serial ATA enabled optical drives (CD andDVD), that implement new interface technologies for the storage market;

 

•                  whether and tothe degree Intel or other motherboard manufacturers integrate the functionalityof our products, such as serial ATA, into their chips and chip sets; and

 

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•                  improvement toexisting storage interface technologies such as parallel ATA and SCSI, or theintroduction of other new storage interface technologies, either of which maydecrease consumer demand for our storage products.

 

In particular,the rate of implementation of the serial ATA interface will depend on howquickly drive manufacturers, motherboard and PC providers and chipmakers areable to resolve technical communication and functionality issues to enable a“plug and play” environment in which a computer system is automatically able torecognize and configure storage devices. Resolution of these issues could betime-consuming, and will depend in good measure on the ability of chipmakers toincorporate the required high-speed serial data transfer capabilities intotheir semiconductors without sacrificing manufacturing yields.

 

Any delay inacceptance of new interface technologies, or a reduction in the growth or sizeof the market for systems based on serial ATA or fibre channel technologies,would limit sales of our storage products and reduce our revenue. Any delay inthe availability of serial ATA compatible drives or acceleration of serial ATAor fibre channel SerDes integration efforts by motherboard or storagecontroller manufacturers may also reduce our revenue.

 

We havepromulgated a SATALite specification to which we have invited key industrymembers to participate. This program includes certain licenses to ourtechnology that we hope will increase market acceptance of our serial ATAproducts. There can be no assurance that this program will succeed, or thatSATALite participants will not use our technology to compete against us.

 

To date, wehave achieved a number of design wins for our serial ATA and fibre channelstorage products. Even after we have achieved a design win from an OriginalEquipment Manufacturer (OEM), we may not realize any revenue, or significantrevenue, from that OEM since a design win is not a binding commitment topurchase our products and the OEM may not achieve market acceptance for theirproduct. Further delay in serial ATA-enabled drive availability may lead OEMsto re-open their designs and designs we have won may be subject to being lost,which could reduce our revenue and increase our operating expenses in competingto re-win designs.

 

**Wedo not have long-term commitments from our customers and we allocate resourcesbased on our estimates of customer demand.**

 

Substantiallyall of our sales are made on the basis of purchase orders, rather thanlong-term agreements. In addition, our customers may cancel or reschedulepurchase orders. We purchase inventory components and build our productsaccording to our estimates of customer demand. This process requires us to makemultiple assumptions, including volume and timing of customer demand for eachproduct, manufacturing yields and product quality. If we overestimate customerdemand or product quality or under estimate manufacturing yields, we may buildproducts that we may not be able to sell at an acceptable price or at all. As aresult, we would have excess inventory, which would increase our losses.Additionally, if we underestimate customer demand or if sufficientmanufacturing capacity is unavailable, we will forego revenue opportunities orincur significant costs for rapid increases in production, lose market shareand damage our customer relationships.

 

**Ourlengthy sales cycle can result in a delay between incurring expenses andgenerating revenue, which could harm our operating results.**

 

Because ourproducts are based on new technology and standards, a lengthy sales process,typically requiring several months or more, is often required before potentialcustomers begin the technical evaluation of our products. This technicalevaluation can exceed nine months before the potential customer informs uswhether we have achieved a design win, which is not a binding commitment topurchase our products. After achieving a design win, it can then be anadditional nine months before a customer commences volume shipments of systemsincorporating our products, if at all. Given our lengthy sales cycle, we mayexperience a delay between the time we incur expenditures and the time wegenerate revenue, if any. As a result, our operating results could be seriouslyharmed if a significant customer reduces or delays orders, or chooses not torelease products incorporating our products.

 

**Wedepend on a few key customers and the loss of any of them could significantlyreduce our revenue.**

 

Historically,a relatively small number of customers and distributors have generated asignificant portion of our revenue. For the three and six months ended June 30,2004, shipments to World Peace International, an Asian distributor, generated 11.3%and 12.9% of our revenue, respectively and shipments to Microtek, adistributor, generated 12.1% and 11.8% of our revenue, respectively. For theyear ended December 31, 2003, shipments to World Peace International, generated15% of our revenue, and shipments to Weikeng, a distributor, generated 8% ofour revenue. For the year ended December 31, 2002, shipments to WorldPeace International generated 15% of our revenue, and shipments to Weikenggenerated 11% of our revenue. In addition, an end-customer may buy throughmultiple distributors, contract manufacturers, and / or directly, which couldcreate an even greater concentration. We cannot be certain that customers andkey distributors that have accounted for significant revenue in past periods,individually or as a group, will continue to sell our products and generaterevenue. As a result of this concentration of our customers, our results ofoperations could be negatively affected if any of the following occurs:

 

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•                  one or more ofour customers, including distributors, becomes insolvent or goes out ofbusiness;

 

•                  one or more ofour key customers or distributors significantly reduces, delays or cancelsorders; or

 

•                  one or moresignificant customers selects products manufactured by one of our competitorsfor inclusion in their future product generations.

 

Due to ourparticipation in multiple markets, our customer base has broadenedsignificantly and we therefore anticipate being less dependent on a relativelysmall number of customers to generate revenue. However, as product mixfluctuates from quarter to quarter, we may become more dependent on a smallnumber of customers or a single customer for a significant portion of ourrevenue in a particular quarter, the loss of which could adversely affect ouroperating results.

 

**Wesell our products through distributors, which limits our direct interactionwith our customers, therefore reducing our ability to forecast sales andincreasing the complexity of our business.**

 

Many originalequipment manufacturers rely on third-party manufacturers or distributors toprovide inventory management and purchasing functions. Distributors generated39% and 41% of our revenue for the three and six months ended June 30, 2004,respectively, 42% of our revenue for the year ended December 31, 2003, and 42%of our revenue for the year ended December 31, 2002. Selling throughdistributors reduces our ability to forecast sales and increases the complexityof our business, requiring us to:

 

•                  manage a morecomplex supply chain;

 

•                  monitor andmanage the level of inventory of our products at each distributor;

 

•                  estimate theimpact of credits, return rights, price protection and unsold inventory atdistributors; and

 

•                  monitor the financialcondition and credit-worthiness of our distributors, many of which are locatedoutside of the United States, and the majority of which are not publiclytraded.

 

Any failure tomanage these challenges could disrupt or reduce sales of our products and unfavorablyimpact our financial results.

 

**Oursuccess depends on the development and introduction of new products, which wemay not be able to do in a timely manner because the process of developinghigh-speed semiconductor products is complex and costly.**

 

Thedevelopment of new products is highly complex, and we have experienced delays,some of which exceeded one year, in the development and introduction of newproducts on several occasions in the past. In 2001 and 2002, we announced ourfirst products for the storage market and we expect to introduce new consumerelectronics, storage and DVI products in the future. As our products integratenew, more advanced functions, they become more complex and increasinglydifficult to design, manufacture and debug. Successful product development andintroduction depends on a number of factors, including, but not limited to:

 

•                  accurateprediction of market requirements and evolving standards, includingenhancements to existing standards such as DVI, HDCP and SATA, and developmentand adoption of new or emerging standards such as HDMI, or significantmodifications to existing standards such as SATA II;

 

•                  development ofadvanced technologies and capabilities, and new products that satisfy customerrequirements;

 

•                  competitors’ andcustomers’ integration of the functionality of our products into theirproducts, which puts pressure on us to continue to develop and introduce newproducts with new functionality;

 

•                  timelycompletion and introduction of new product designs;

 

•                  management ofproduct life cycles;

 

•                  use ofleading-edge foundry processes and achievement of high manufacturing yields andlow cost testing; and

 

•                  marketacceptance of new products.

 

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Accomplishing allof this is extremely challenging, time-consuming and expensive and there is noassurance that we will succeed. Product development delays may result fromunanticipated engineering complexities, changing market or competitive productrequirements or specifications, difficulties in overcoming resourcelimitations, the inability to license third party technology or other factors.Competitors and customers may integrate the functionality of our products intotheir products that would reduce demand for our products. If we are not able todevelop and introduce our products successfully and in a timely manner, ourcosts could increase or our revenue could decrease, both of which wouldadversely affect our operating results. In addition, it is possible that we mayexperience delays in generating revenue from these products or that we maynever generate revenue from these products. We must work with a semiconductorfoundry and with potential customers to complete new product development and tovalidate manufacturing methods and processes to support volume production andpotential re-work. Each of these steps may involve unanticipated difficulties,which could delay product introduction and reduce market acceptance of theproduct. In addition, these difficulties and the increasing complexity of ourproducts may result in the introduction of products that contain defects orthat do not perform as expected, which would harm our relationships withcustomers and our ability to achieve market acceptance of our new products.There can be no assurance that we will be able to achieve design wins for ourplanned new products, that we will be able to complete development of theseproducts when anticipated, or that these products can be manufactured incommercial volumes at acceptable yields, or that any design wins will produceany revenue. Failure to develop and introduce new products, successfully and ina timely manner, may adversely affect our results of operations.

 

**Wehave made acquisitions in the past and may make acquisitions in the future, ifadvisable, and these acquisitions involve numerous risks.**

 

Our growthdepends upon market growth and our ability to enhance our existing products andintroduce new products on a timely basis. One of the ways we develop newproducts and enter new markets is through acquisitions. In 2000, we completedthe acquisitions of Zillion and DVDO, and in 2001, we completed theacquisitions of CMD and SCL. In April 2003, we acquired TWN. We mayacquire additional companies or technologies. Acquisitions involve numerousrisks, including, but not limited to, the following:

 

•                  difficulty andincreased costs in assimilating employees, including our possible inability tokeep and retain key employees of the acquired business;

 

•                  disruption ofour ongoing business;

 

•                  discovery ofundisclosed liabilities of the acquired companies and legal disputes withfounders or shareholders of acquired companies;

 

•                  inability tosuccessfully incorporate acquired technology and operations into our businessand maintain uniform standards, controls, policies and procedures;

 

•                  inability tocommercialize acquired technology; and

 

•                  the need to takeimpairment charges or write-downs with respect to acquired assets.

 

No assurancecan be given that our prior acquisitions or our future acquisitions, if any,will be successful or provide the anticipated benefits, or that they will notadversely affect our business, operating results or financial condition.Failure to manage growth effectively and to successfully integrate acquisitionsmade by us could materially harm our business and operating results.

 

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**Thecyclical nature of the semiconductor industry may create constrictions in ourfoundry, test and assembly capacity.**

 

In the past,the semiconductor industry has been characterized by significant downturns andwide fluctuations in supply and demand. For example, demand in thesemiconductor industry rose to record levels in 1999, and then declined untilrecently 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 fabricated semiconductors are subject to allocation,whereby not all of our production requirements would be met. This may impactour ability to meet demand and could also increase our production costs. Cyclicalityhas also accelerated decreases in average selling prices per unit. We mayexperience fluctuations in our future financial results because of changes inindustry-wide conditions.

 

**Wedepend on third-party sub-contractors to manufacture, assemble and test nearlyall of our products, which reduces our control over the production process.**

 

We do not ownor operate a semiconductor fabrication facility. We rely on TaiwanSemiconductor Manufacturing Company (“TSMC”), an outside foundry, to producethe vast majority all of our semiconductor products. We also rely on Kawasaki,UMC and Atmel, for outside foundry services, and on Amkor and ASE to testcertain of our semiconductor products. Our reliance on independent foundries,assembly and test facilities involves a number of significant risks, including,but not limited to:

 

•                  reduced controlover delivery schedules, quality assurance, manufacturing yields and productioncosts;

 

•                  lack ofguaranteed production capacity or product supply;

 

•                  lack ofavailability of, or delayed access to, next-generation or key processtechnologies; and

 

•                  our ability totransition to alternate sources if services are unavailable from primarysuppliers.

 

In addition,our semiconductor products are assembled and tested by several independentsubcontractors. We do not have a long-term supply agreement with oursubcontractors, and instead obtain production services on a purchase orderbasis. Our outside sub-contractors have no obligation to supply products to usfor any specific period of time, in any specific quantity or at any specificprice, except as set forth in a particular purchase order. Our requirementsrepresent a small portion of the total production capacity of our outsidefoundries, assembly and test facilities and our sub-contractors may reallocatecapacity to other customers even during periods of high demand for ourproducts. These foundries may allocate or move production of our products todifferent foundries under their control, even in different locations, which maybe time consuming, costly, and difficult, have an adverse affect on quality,yields, and costs, and require us and/or our customers to re-qualify theproducts, which could open up design wins to competition and result in the lossof design wins and design-ins. If our subcontractors are unable or unwilling tocontinue manufacturing our products in the required volumes, at acceptablequality, yields and costs, and in a timely manner, our business will besubstantially harmed. As a result, we would have to identify and qualifysubstitute contractors, which would be time-consuming, costly and difficult.This qualification process may also require significant effort by ourcustomers, and may lead to re-qualification of parts, opening up design wins to

 

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competition, and loss of designwins and design-ins. Any of these circumstances could substantially harm ourbusiness. In addition, if competition for foundry, assembly and test capacityincreases, our product costs may increase and we may be required to paysignificant amounts or make significant purchase commitments to secure accessto production services.

 

**Thenature of our production process is complex, which reduces identification ofproblems until well into the production cycle or, in some cases, after theproduct has been shipped.**

 

Themanufacture of semiconductors is a complex process, and it is often difficultfor semiconductor foundries to achieve acceptable product yields. Productyields depend on both our product design and the manufacturing processtechnology unique to the semiconductor foundry. Since low yields may resultfrom either design or process difficulties, identifying problems can often onlyoccur well into the production cycle, when an actual product exists that can beanalyzed and tested.

 

Further, weonly test our products after they are assembled, as their high-speed naturemakes earlier testing difficult and expensive. As a result, defects often arenot discovered until after assembly. This could result in a substantial numberof defective products being assembled and tested or shipped, thus lowering ouryields and increasing our costs. These risks could result in product shortagesor increased costs of assembling, testing or even replacing our products.

 

Although wetest our products before shipment, they are complex and may contain defects anderrors. In the past we have encountered defects and errors in our products.Because our products are sometimes integrated with products from other vendors,it can be difficult to identify the source of any particular problem. Deliveryof products with defects or reliability, quality or compatibility problems, maydamage our reputation and our ability to retain existing customers and attractnew customers. In addition, product defects and errors could result inadditional development costs, diversion of technical resources, delayed productshipments, increased product returns, warranty and product liability claimsagainst us that may not be fully covered by insurance. Any of thesecircumstances could substantially harm our business.

 

**Weface foreign business, political and economic risks because a majority of ourproducts and our customers’ products are manufactured and sold outside of theUnited States.**

 

A substantialportion of our business is conducted outside of the United States. As a result,we are subject to foreign business, political and economic risks. Nearly all ofour products are manufactured in Taiwan or elsewhere in Asia, and for each of thethree and six months ended June 30, 2004, 73% of our revenue, and for the yearsended December 31, 2003, 2002, and 2001 74%, 72%, and 79% of our revenuerespectively was generated from customers and distributors located outside ofthe United States, primarily in Asia. We anticipate that sales outside of theUnited States will continue to account for a substantial portion of our revenuein future periods. Accordingly, we are subject to international risks,including, but not limited to:

 

•                  difficulties inmanaging from afar;

 

•                  political andeconomic instability, including international tension in Iraq, Korea and theChina Strait and lack of normal diplomatic relationships between the UnitedStates and Taiwan;

 

•                  less developedinfrastructures in newly industrializing countries;

 

•                  susceptibilityof foreign areas to terrorist attacks;

 

•                  susceptibilityto interruptions of travel, including those due to international tensions(including the war in and occupation of Iraq), the SARS and Avian Flu epidemics(particularly affecting the Asian markets we serve), and the financialinstability and bankruptcy of major air carriers;

 

•                  bias againstforeign, especially American, companies;

 

•                  difficulties incollecting accounts receivable;

 

•                  expense anddifficulties in protecting our intellectual property in foreign jurisdictions;

 

•                  difficulties incomplying with multiple, conflicting and changing laws and regulations,including export requirements, tariffs, import duties, visa restrictions,environmental laws and other barriers;

 

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•                  exposure topossible litigation or claims in foreign jurisdictions; and

 

•                  competition fromforeign-based suppliers and the existence of protectionist laws and businesspractices that favor these suppliers, such as withholding taxes on paymentsmade to us.

 

These riskscould adversely affect our business and our results of operations. In addition,original equipment manufacturers that design our semiconductors into theirproducts sell them outside of the United States. This exposes us indirectly toforeign risks. Because sales of our products are denominated exclusively inUnited States dollars, relative increases in the value of the United Statesdollar will increase the foreign currency price equivalent of our products,which could lead to a reduction in sales and profits in that country.

 

**Thesuccess of our business depends upon our ability to adequately protect ourintellectual property.**

 

We rely on acombination of patent, copyright, trademark, mask work and trade secret laws,as well as nondisclosure agreements and other methods, to protect ourproprietary technologies. We have been issued patents and have a number ofpending patent applications. However, we cannot assure you that any patentswill be issued as a result of any applications or, if issued, that any claimsallowed will protect our technology. In addition, we do not file patentapplications on a worldwide basis, meaning we do not have patent protection insome jurisdictions. It is possible that existing or future patents may bechallenged, 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 new licensingrelationships will enable other parties to use our intellectual property tocompete against us. Legal actions to enforce intellectual property rights tendto be lengthy and expensive, and the outcome often is not predictable. As aresult, despite our efforts and expenses, we may be unable to prevent othersfrom infringing upon or misappropriating our intellectual property, which couldharm our business. In addition, practicality also limits our assertion ofintellectual property rights. Patent litigation is expensive and its resultsare often unpredictable. Assertion of intellectual property rights oftenresults in counterclaims for perceived violations of the defendant’sintellectual property rights and/or antitrust claims. Certain parties after receiptof an assertion of infringement will cut off all commercial relationships withthe party making the assertion, thus making assertions against suppliers,customers, and key business partners risky. If we forgo making such claims, wemay run the risk of creating legal and equitable defenses for an infringer.

 

**Ourparticipation in the Digital Display Working Group requires us to license someof our intellectual property for free, which may make it easier for others tocompete with us in the DVI PC market.**

 

We are apromoter of the DDWG, which published and promotes the DVI specification. Ourstrategy includes establishing the DVI specification as the industry standard,promoting and enhancing this specification and developing and marketingproducts based on this specification and future enhancements. As a result:

 

•                  we must licensefor free specific elements of our intellectual property to others for use inimplementing the DVI specification; and

 

**•**                  we may licenseadditional intellectual property for free as the DDWG promotes enhancements tothe DVI specification.

 

Accordingly,companies that implement the DVI specification in their products can usespecific elements of our intellectual property for free to compete with us.

 

**Ourparticipation as a founder in the working group developing HDMI requires us tolicense some of our intellectual property, which may make it easier for othersto compete with us in the market.**

 

InApril 2002, together with Sony, Philips, Thomson, Toshiba, Matsushita andHitachi, we announced the formation of a working group to define thenext-generation digital interface specification for consumer electronicsproducts. Version 1.0 of the specification was published for adoption onDecember 9, 2002. The HDMI specification combines high-definition videoand multi-channel audio in one digital interface and uses Silicon Image’spatented underlying TMDS technology**,**optionally,along with Intel’s HDCP as the basis for the interface. The founders of theworking group have signed a founder’s agreement in which each commits tolicense certain intellectual property to each other, and to adopters of thespecification.

 

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Our strategyincludes establishing the HDMI specification as the industry standard,promoting and enhancing this specification and developing and marketingproducts based on this specification and future enhancements. As a result:

 

•                  we must licensespecific elements of our intellectual property to others for use inimplementing the HDMI specification; and

 

•                  we may licenseadditional intellectual property as the HDMI founders group promotesenhancements to the HDMI specification.

 

Accordingly,companies that implement the HDMI specification in their products can usespecific elements of our intellectual property to compete with us. Althoughthere will be license fees and royalties associated with the adoptersagreements, there can be no assurance that such license fees and royalties willadequately compensate us for having to license our intellectual property. Feesand royalties received during the early years of adoption will be used to covercosts we incur to promote the HDMI standard and to develop and performinteroperability tests; in addition, after an initial period, the HDMI foundersmay reallocate the license fees and royalties amongst themselves to reflecteach founder’s relative contribution of intellectual property to the HDMIspecification.

 

**Oursuccess depends on managing our relationship with Intel.**

 

Intel has adominant role in many of the markets in which we compete, such as PCs andstorage, and is a growing presence in the CE market. We have a multi-facetedrelationship with Intel that is complex and requires significant managementattention, including:

 

•                  Intel has beenan investor of ours;

 

•                  Intel and wehave been parties to a business cooperation agreement;

 

•                  Intel and we areparties to a patent cross-license;

 

•                  Intel and weworked together to develop HDCP;

 

•                  An Intelsubsidiary has the exclusive right to license HDCP, of which we are a licensee;

 

•                  Intel and wewere two of the original founders of the Digital Display Working Group(“DDWG”);

 

•                  Intel is apromoter of the serial ATA working group, of which we are a contributor;

 

•                  Intel is asupplier to us and a customer for our products;

 

•                  We believe thatIntel has the market presence to drive adoption of DVI and serial ATA by makingthem widely available in its chip sets and motherboards, which could affectdemand for our products;

 

**•**                  We believe thatIntel has the market presence to affect adoption of HDMI by either endorsingthe technology or promulgating a competing standard, which could affect demandfor our products;

 

•                  Intel maypotentially integrate the functionality of our products, including fibrechannel, serial ATA or DVI, into its own chips and chip sets, therebydisplacing demand for some of our products;

 

•                  Intel may designnew technologies that would require us to re-design our products forcompatibility, thus increasing our R&D expense and reducing our revenue;

 

•                  Intel’stechnology, including its 845G chip set, may lower barriers to entry to otherparties who may enter the market and compete with us; and

 

•                  Intel may enterinto or continue relationships with our competitors that can put us at a relativedisadvantage.

 

Ourcooperation and competition with Intel can lead to positive benefits if managedeffectively. If our relationship with Intel is not managed effectively, itcould seriously harm our business, negatively affect our revenue, and increaseour operating expenses.

 

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**Wehave granted Intel rights with respect to our intellectual property, whichcould allow Intel to develop products that compete with ours or otherwisereduce the value of our intellectual property.**

 

We haveentered into a patent cross-license agreement with Intel in which each of usgranted the other a license to use the grantor’s patents, except for identifiedtypes of products. We believe that the scope of our license to Intel excludesour current products and anticipated future products. Intel could, however,exercise its rights under this agreement to use our patents to develop andmarket other products that compete with ours, without payment to us.Additionally, Intel’s rights to our patents could reduce the value of ourpatents to any third party who otherwise might be interested in acquiringrights to use our patents in such products. Finally, Intel could endorsecompeting products, including a competing digital interface, or develop its ownproprietary digital interface. Any of these actions could substantially harmour business and results of operations.

 

**Weare and may continue to become the target of securities class action suits andderivative suits which could result in substantial costs and divert managementattention and resources.**

 

Securitiesclass action suits are often brought against companies, particularly technologycompanies, following periods of volatility in the market price of theirsecurities. Defending against these suits, even if meritless, can result insubstantial costs to us and could divert the attention of our management. Weand certain of our officers and directors, together with certain investmentbanks, have been named as defendants in a securities class action suit filedagainst us on behalf of purchasers of our securities between October 5,1999 and December 6, 2000. It is alleged that the prospectus related toour initial public offering was misleading because it failed to disclose thatthe underwriters of our initial public offering had solicited and receivedexcessive commissions from certain investors in exchange for agreements byinvestors to buy our shares in the aftermarket for predetermined prices. Due toinherent uncertainties in litigation, we cannot accurately predict the outcomeof this litigation; however, a proposed settlement has been negotiated that hasyet to be reviewed and approved by the Court. In the event that the settlementis not approved, we believe that these claims are without merit and we intendto defend vigorously against them. We and certain of our officers, togetherwith certain investment banks and their current or former employees, were namedas defendants in a securities class action suit filed against us on behalf of aputative class of shareholders who purchased stock from some or all ofapproximately 50 issuers whose public offerings were underwritten by CreditSuisse First Boston. The lawsuit alleges that Silicon Image and certainofficers were part of a scheme by Credit Suisse First Boston to artificiallyinflate the price of Silicon Image’s stock through the dissemination ofallegedly false analysts’ reports. The plaintiff in this matter has filed anamended complaint in which Silicon Image, and the named officers, were droppedas defendants. We believe that the settlement described above, if approved,would encompass the claims in this case. We believe that these claims werewithout merit and, if revived, and not subject to the settlement, we intend todefend vigorously against them.

 

Certain of ourofficers and directors were named as defendants in consolidated shareholderderivative litigation. The lawsuit alleged that as a result of the examinationconducted by our Audit Committee, we would have been required to restate ourfinancial results for 2002 and 2003. The lawsuit further alleges that such arestatement would be due to breaches by the individual defendants of theirfiduciary duties to us, that certain of the individual defendants are liable tous for insider trading under California law, and that the individual defendantsare liable to us for mismanagement, abuse of control, and waste. We and certainof our officers were also named as defendants in consolidated securities classaction litigation. Plaintiffs filed the action on behalf of a putative class ofshareholders who purchased our stock between April 15, 2002 andNovember 15, 2003. The lawsuit alleges that we had materially overstatedour licensing revenue, net income and financial results during this timeperiod, and that were being forced to restate our financial 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, both thesecurities class action litigation and the shareholder derivative litigationhave been dismissed.

 

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**Weare currently engaged in intellectual property litigation that istime-consuming and expensive to prosecute. We may become engaged in additionalintellectual property litigation that could be time-consuming, maybe beexpensive to prosecute or defend, and could adversely affect our ability tosell our product.**

 

In recentyears, there has been significant litigation in the United States and in otherjurisdictions involving patents and other intellectual property rights. Thislitigation is particularly prevalent in the semiconductor industry, in which anumber of companies aggressively use their patent portfolios to bringinfringement claims. In addition, in recent years, there has been an increasein the filing of so-called “nuisance suits,” alleging infringement ofintellectual property rights. These claims may be asserted as counterclaims inresponse to claims made by a company alleging infringement of intellectualproperty rights. These suits pressure defendants into entering settlementarrangements to quickly dispose of such suits, regardless of merit. Inaddition, as is common in the semiconductor industry, from time to time we havebeen notified that we may be infringing certain patents or other intellectualproperty rights of others. Responding to such claims, regardless of theirmerit, can be time consuming, result in costly litigation, divert management’sattention and resources and cause us to incur significant expenses. As eachclaim is evaluated, we may consider the desirability of entering intosettlement or licensing agreements. No assurance can be given that settlementswill occur or that licenses can be obtained on acceptable terms or thatlitigation will not occur. In the event there is a temporary or permanentinjunction entered prohibiting us from marketing or selling certain of ourproducts, or a successful claim of infringement against us requiring us to paydamages or royalties to a third party, and we fail to develop or license asubstitute technology, our business, results of operations or financialcondition could be materially adversely affected.

 

InApril 2001, we filed suit against Genesis Microchip for infringement ofone of our U.S. patents. At that time, we also filed a complaint againstGenesis for unlawful trade practices related to the importation of articlesinfringing our patent. In February 2002, our motion to dismiss theunlawful trade practices complaint was granted and we filed an amendedcomplaint against Genesis alleging infringement of two of our U.S. patents.These patents relate to our DVI receiver products, which generate a significantportion of our revenue. The amended complaint seeks a declaration that Genesishas infringed our patents, that Genesis’ behavior is not licensed, aninjunction to halt the importation, sale, manufacture and use of Genesis DVI receiverchips that infringe our patents, and monetary damages. In April 2002,Genesis answered and made counterclaims against us for non-infringement,license, patent invalidity, fraud, antitrust, unfair competition and patentmisuse. We filed a motion to dismiss certain of Genesis’s counterclaims. Inaddition, we filed a motion to bifurcate trial of the counterclaims to theextent the court does not dismiss them. In May 2002, the Court granted ourmotion to dismiss certain of the counterclaims, with leave to amend. Genesisre-filed counterclaims against us for fraud and patent misuse. We filed anothermotion to dismiss these counterclaims. In August 2002, the Court grantedour motion and dismissed Genesis’s re-filed counterclaims with prejudice. In December 2002,the parties entered into a memorandum of understanding (“MOU”) to settle thecase. In January, the parties presented different interpretations of the MOU tothe Court. On July 15, 2003, the Court granted our motion to interpret theMOU in the manner we requested, and ruled that Genesis had engaged in effortsto avoid its obligations under the MOU. On August 6, 2003, the Courtentered a final judgment order based on its July 15, 2003 ruling. Underthe final judgment order, Genesis was ordered to make a substantial cashpayment, and to make royalty payments; although Genesis has made and continuesto make cash payments to the Court, it may not have made all the payments thatare required under the final judgment order. We filed motions for reimbursementof some of some of expenses, including some of our legal fees, and formodification and/or clarification of certain items of the judgment, and to holdGenesis in contempt of Court for breaching the protective order in the case bydisclosing secret information to at least one of our competitors. OnDecember 19, 2003, the Court granted our motions in part and denied themin part: the court issued an amended judgment, and held Genesis in contempt ofCourt for breaching the protective order. On January 16, 2004, Genesisfiled a notice of appeal.

 

There can beno assurance that Genesis will not undertake further efforts to avoid itsobligations under the MOU, and that further proceedings (lawsuits, contemptcitations, etc.) against Genesis, and certain of its executives, its counsel,and others may not be required to obtain compliance or to obtain redress fornon-compliance. There can be no assurance that an appellate court will upholdthe Court’s rulings or the MOU. There can be no assurance that further delaysor noncompliance will not occur. The Court’s rulings of July 15, 2003 andDecember 19, 2003 indicate that Genesis violated certain provisions of theMOU, and of the protective order in the case, including disclosure ofconfidential information to Pixelworks. On August 5, 2003, Genesis andPixelworks issued a joint press release terminating their proposed merger. Inthat press release, Genesis and Pixelworks jointly stated that “Pixelworks hasconfirmed that prior to signing the merger agreement, it reviewed theMemorandum of

 

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Understanding that purported tosettle the lawsuit between Genesis Microchip and Silicon Image, Inc.”While this litigation, including the appeal or any possible derivativeproceedings, is pending, Genesis can use the technology covered by thesepatents to develop products that might compete with ours. If we areunsuccessful in this litigation, we could be unable to prevent Genesis orothers from using the technology covered by these patents. Even if we prevailin this litigation, uncertainties regarding the outcome prior to that time mayreduce demand for our products, or Genesis’s use of our technology in productsthat compete with our products may reduce demand or pricing for our products.In addition, even if the MOU is upheld on appeal, future disputes may occur,including those regarding whether and what intellectual property licenses weregranted and the scope of any such licenses and the royalty rates and paymentterms for such licenses, whether the MOU was breached, whether consent wasfraudulently obtained, and whether a merger partner may succeed to the rightsand/or the obligations under the MOU. These disputes may result in additionalcostly and time-consuming litigation or the license of additional elements ofour intellectual property for free.

 

Any potentialintellectual property litigation against us could also force us to do one ormore of the following:

 

•                  stop sellingproducts or using technology that contain the allegedly infringing intellectualproperty;

 

•                  attempt toobtain a license to the relevant intellectual property, which license may notbe available on reasonable terms or at all; and

 

•                  attempt toredesign products that contain the allegedly infringing intellectual property.

 

If we take anyof these actions, we may be unable to manufacture and sell our products. We maybe exposed to liability for monetary damages, the extent of which would be verydifficult to accurately predict. In addition, we may be exposed to customerclaims, for potential indemnity obligations, and to customer dissatisfactionand a discontinuance of purchases of our products while the litigation ispending. Any of these consequences could substantially harm our business andresults of operations.

 

**Wehave entered into, and may again be required to enter into, patent or otherintellectual property cross-licenses.**

 

Many companieshave significant patent portfolios or key specific patents, or otherintellectual property in areas in which we compete. Many of these companiesappear to have policies of imposing cross-licenses on other participants intheir markets, which may include areas in which we compete. As a result, wehave been required, either under pressure of litigation or by significant vendorsor customers, to enter into cross licenses or non-assertion agreements relatingto patents or other intellectual property. This permits the cross-licensee, orbeneficiary of a non-assertion agreement, to use certain or all of our patentsand/or certain other intellectual property for free to compete with us.

 

**Wemust attract and retain qualified personnel to be successful, and competitionfor qualified personnel is increasing in our market.**

 

Our successdepends to a significant extent upon the continued contributions of our keymanagement, technical and sales personnel, many of who would be difficult toreplace. The loss of one or more of these employees could harm our business.Although we have entered into a limited number of employment contracts withcertain executive officers, we generally do not have employment contracts withour key employees. We do not have key person life insurance for any of our keypersonnel. Our success also depends on our ability to identify, attract andretain qualified technical, sales, marketing, finance and managerial personnel.Competition for qualified personnel is particularly intense in our industry andin our location. This makes it difficult to retain our key personnel and torecruit highly qualified personnel. We have experienced, and may continue toexperience, difficulty in hiring and retaining candidates with appropriatequalifications. To be successful, we need to hire candidates with appropriatequalifications and retain our key executives and employees.

 

On June 24,2004, we announced that we had initiated a search for a new CEO, as part of atransition in which Dr. David Lee would maintain an active role in the companyas full-time chairman of the board, focusing on the development and delivery ofthe company’s long-term vision and strategy. We do not know when this searchwill be concluded. CEO searches and transitions can be uncertain, and canresult in organizational disruption.

 

The volatilityof our stock price has had an impact on our ability to offer competitiveequity-based incentives to current and prospective employees, thereby affectingour ability to attract and retain highly qualified technical personnel. Ifthese adverse conditions continue, we may not be able to hire or retain highlyqualified employees in the future and this could harm our business. Inaddition, new regulations adopted by The NASDAQ National Market requiringshareholder approval for all stock option plans, as well as new regulationsadopted by the New York Stock Exchange prohibiting NYSE member organizationsfrom giving a proxy to vote on equity compensation

 

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plans unless the beneficialowner of the shares has given voting instructions, could make it more difficultfor us to grant options to employees in the future. There have been severalproposals on whether and /or how to account for stock options. To the extentthat new regulations make it more difficult or expensive to grant options toemployees, we may incur increased cash compensation costs or find it difficultto attract, retain and motivate employees, either of which could harm ourbusiness.

 

We usecontractors to provide services to the company, which often involvescontractual complexity, tax and employment law compliance, and being subject toaudits and other governmental actions. We have been audited for our contractingpolicies in the past, and may be in the future. Burdening our ability to freelyuse contractors to provide services to the company may increase the expense ofobtaining such services, and/or require us to discontinue using contractors andattempt to find, interview, and hire employees to provide similar services.Such potential employees may not be available in a reasonable time, or at all,or may not be hired without undue cost.

 

**Industrycycles may strain our management and resources.**

 

Cycles ofgrowth and contraction in our industry may strain our management and resources.To manage these industry cycles effectively, we must:

 

•                  improveoperational and financial systems;

 

•                  train and manageour employee base;

 

•                  successfullyintegrate operations and employees of businesses we acquire or have acquired;

 

•                  attract,develop, motivate and retain qualified personnel with relevant experience; and

 

•                  adjust spendinglevels according to prevailing market conditions.

 

If we cannot manage industry cycleseffectively, our business could be seriously harmed.

 

**Ouroperations and the operations of our significant customers, third-party waferfoundries and third-party assembly and test subcontractors are located in areassusceptible to natural disasters.**

 

Our operationsare headquartered in the San Francisco Bay Area, which is susceptible toearthquakes, and the operations of CMD, which we acquired, are based in the LosAngeles area, which is also susceptible to earthquakes. TSMC and UMC, theoutside foundries that produce the majority of our semiconductor products, arelocated in Taiwan. Advanced Semiconductor Engineering, or ASE, one of thesubcontractors that assembles and tests our semiconductor products, is alsolocated in Taiwan. For the three and six months ended June 30, 2004 and for theyear ended December 31, 2003, customers and distributors located in Taiwangenerated 31%, 29% and 34% of our revenue, respectively, and customers anddistributors located in Japan generated 18%, 19% and 15% of our revenue,respectively. For the year ended December 31, 2002, customers anddistributors located in Taiwan generated 34% of our revenue and customers anddistributors located in Japan generated 12% of our revenue. Both Taiwan andJapan are susceptible to earthquakes, typhoons and other natural disasters.

 

Our businesswould be negatively affected if any of the following occurred:

 

•                  an earthquake orother disaster in the San Francisco Bay Area or the Los Angeles area damagedour facilities or disrupted the supply of water or electricity to ourheadquarters or our Irvine facility;

 

•                  an earthquake,typhoon or other disaster in Taiwan or Japan resulted in shortages of water, electricityor transportation, limiting the production capacity of our outside foundries orthe ability of ASE to provide assembly and test services;

 

•                  an earthquake,typhoon or other disaster in Taiwan or Japan damaged the facilities orequipment of our customers and distributors, resulting in reduced purchases ofour products; or

 

•                  an earthquake,typhoon or other disaster in Taiwan or Japan disrupted the operations ofsuppliers to our Taiwanese or Japanese customers, outside foundries or ASE,which in turn disrupted the operations of these customers, foundries or ASE andresulted in reduced purchases of our products or shortages in our productsupply.

 

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**Changesin environmental rules and regulations could increase our costs and reduceour revenue.**

 

Severaljurisdictions are considering whether to implement rules that wouldrequire that certain products, including semiconductors, be made lead-free. Weanticipate that some jurisdictions may finalize and enact such requirements.Some jurisdictions are also considering whether to require abatement ordisposal obligations for products made prior to the enactment of any suchrules. Although several of our products are available to customers in alead-free condition, most of our products are not lead-free. Any requirementthat would prevent or burden the development, manufacture or sales oflead-containing semiconductors would likely reduce our revenue for suchproducts and would require us to incur costs to develop substitute lead-freereplacement products, which may take time and may not always be economically ortechnically feasible, and may require disposal of non-compliant inventory. Inaddition, any requirement to dispose or abate previously sold products wouldrequire us to incur the costs of setting up and implementing such a program.

 

**Provisionsof our charter documents and Delaware law could prevent or delay a change incontrol, and may reduce the market price of our common stock.**

 

Provisions ofour certificate of incorporation and bylaws may discourage, delay or prevent amerger or acquisition that a stockholder may consider favorable. Theseprovisions include:

 

•                  authorizing theissuance of preferred stock without stockholder approval;

 

•                  providing for aclassified board of directors with staggered, three-year terms;

 

•                  requiringadvance notice of stockholder nominations for the board of directors;

 

•                  providing theboard of directors the opportunity to expand the number of directors withoutnotice to stockholders;

 

•                  prohibitingcumulative voting in the election of directors;

 

•                  requiringsuper-majority voting to amend some provisions of our certificate ofincorporation and bylaws;

 

•                  limiting thepersons who may call special meetings of stockholders; and

 

•                  prohibitingstockholder actions by written consent.

 

Provisions ofDelaware law also may discourage, delay or prevent someone from acquiring ormerging with us.

 

**Theprice of our stock fluctuates substantially and may continue to do so.**

 

The stockmarket has experienced extreme price and volume fluctuations that have affectedthe market valuation of many technology companies, including Silicon Image.These factors, as well as general economic and political conditions, maymaterially and adversely affect the market price of our common stock in thefuture. The market price of our common stock has fluctuated significantly andmay continue to fluctuate in response to a number of factors, including, butnot limited to:

 

•                  actual oranticipated changes in our operating results;

 

•                  changes inexpectations of our future financial performance;

 

•                  changes inmarket valuations of comparable companies in our markets;

 

•                  changes inmarket valuations or expectations of future financial performance of ourvendors or customers;

 

•                  changes in ourkey executives and technical personnel; and

 

•                  announcements byus or our competitors of significant technical innovations, design wins,contracts, standards or acquisitions.

 

Due to thesefactors, the price of our stock may decline. In addition, the stock marketexperiences volatility that is often unrelated to the performance of particularcompanies. These market fluctuations may cause our stock price to declineregardless of our performance.

 

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**Weare in the process of updating an enterprise resource platform**

 

We are in theprocess of updating our enterprise resource platform (ERP) system. The systemis comprised of hardware and software, and services, all of which we acquiredfrom vendors; which we are customizing portions of the system with in-houseresources. This requires careful management of the skills and resources toupdate our ERP system and establish the disaster recovery plans. If we areunsuccessful, or if the hardware or software updates should fail, we could loseaccess to the data needed to book and fill customer orders, ship products, andproduce financial reports, which would have a material adverse effect on ourbusiness.

 

**Continuedterrorist attacks or war could lead to further economic instability andadversely affect our operations, results of operations and stock price.**

 

The UnitedStates has taken, and continues to take, military action against terrorism andhas engaged in war with Iraq and currently has an occupation force there and inAfghanistan. In addition, the current nuclear arms crises in North Korea andIran could escalate into armed hostilities or war. Acts of terrorism or armedhostilities may disrupt or result in instability in the general economy andfinancial markets and in consumer demand for the OEM’s products thatincorporate our products. Disruptions and instability in the general economycould reduce demand for our products or disrupt the operations of ourcustomers, suppliers, distributors and contractors, many of whom are located inAsia, which would in turn adversely affect our operations and results ofoperations. Disruptions and instability in financial markets could adverselyaffect our stock price. Armed hostilities or war in South Korea could disruptthe operations of the research and development contractors we utilize there,which would adversely affect our research and development capabilities andability to timely develop and introduce new products and product improvements.

 

**Wehave recently established an office in Japan**

 

We haverecently established an office in Japan. Accordingly, we are subject to risks,including, but not limited to:

 

•                  being subject to Japanese tax laws andpotentially liable for paying taxes in Japan;

 

•                  profits, if any,earned in Japan will be subject to local tax laws and may not be repatriable tothe United States;

 

•                  we have and willenter into employment agreements in connection with hiring personnel for theJapanese office and are governed by the provisions of the Japanese labor laws;and

 

•                  the operationsof the local office are and will be subject to the provisions of other locallaws and regulations.

 

**Wehave recently established an office in the Republic of Korea (South Korea)**

 

We haverecently established 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 lawsand potentially liable for paying taxes in South Korea;

 

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

 

•                  we have and willenter into employment agreements in connection with hiring personnel for theSouth Korea office and are governed by the provisions of the South Korean laborlaws; and

 

•                  the operationsof the local office are and will be subject to the provisions of other locallaws and regulations.

 

**Weindemnify certain of our licensing customers against infringement.**

 

We indemnifycertain of our licensing agreements customers for any expenses or liabilitiesresulting from third-party claims of infringements of patent, trademark, tradesecret, or copyright rights by the technology we license.  Certain of these indemnification provisionsare perpetual from execution of the agreement and, in some instances,

 

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the maximum amount of potentialfuture indemnification is not limited. To date, we have not paid any suchclaims or been required to defend any lawsuits with respect to any claim. Inthe event that we were required to defend any lawsuits with respect to ourindemnification obligations, or to pay any claim, our results of operationscould be materially adversely affected.

 

**Item3.  Quantitative and Qualitative DisclosuresAbout Market Risk**

 

**InterestRate Risk**

 

Our cashequivalents and short-term investments consist primarily of fixed-incomesecurities that are subject to interest rate risk and will decline in value ifinterest rates increase. Due to the short duration of our cash equivalents andshort-term investments, an immediate 10% change in interest rates would not beexpected to have a material effect on our near-term results of operations orfinancial condition. Our long-term capital lease obligations bear interest atfixed rates; therefore, our results of operations would not be affected byimmediate changes in interest rates. Also, components of our stock compensation expense are tied to our stockprice.  Changes in our stock price canhave a significant effect on the amount recorded as stock compensation expense.

 

## **EquitySecurity Price Risk**

 

Changes inLeadis’s market price will impact the valuation of our investment in Leadis.

 

**ForeignCurrency Exchange Risk**

 

All of oursales are denominated in U.S. dollars, and substantially all of our expensesare incurred in U.S. dollars, thus limiting our exposure to foreign currencyexchange risk. We currently do not enter into forward exchange contracts tohedge exposures denominated in foreign currencies and do not use derivativefinancial instruments for trading or speculative purposes. The effect of animmediate 10% change in foreign currency exchange rates could have a materialeffect on our future operating results or cash flows; however, a long termchange in foreign currency rates could result in increased wafer, packaging,assembly or testing costs.

 

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**Item4.  Controls and Procedures**

 

(a)           *Evaluation of Controls and Procedures*.  We maintain disclosure controls and procedures(as such term is defined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”)) that are designed toensure that information required to be disclosed in our Exchange Act reports isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms, and that such information is accumulated andcommunicated to our management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow timely decisions regarding requireddisclosure.

 

In designingand evaluating the disclosure controls and procedures, our managementrecognized that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and our management necessarily was required to apply itsjudgment in evaluating the cost-benefit relationship of possible controls andprocedures.

 

As required byRule 13a-15(b) and 15d-15(b) under the Exchange Act, we carried out anevaluation, under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures at the end of thefiscal quarter covered by this report. The evaluation took into account the conduct of and results of the AuditCommittee examination completed in February 2004, and the receipt of noticefrom the Company’s independent registered public accounting firm, in connectionwith the 2003 year-end audit, of a written confirmation of a reportablecondition relating to internal controls where the auditors stated they wereaware of deficiencies in the Company’s internal control structure designrelated to the overall internal control environment regarding our ChiefExecutive Officer’s communication and operating style and his periodicinvolvement in revenue recognition discussions. Based upon that evaluation, our Chief Executive Officer and ChiefFinancial Officer concluded that our controls and procedures as of the end ofthe period covered by this report were effective, except that with respect tothe reportable condition and as the number and complexity of licensingtransactions increase, the Company’s control environment could and should beenhanced, as discussed below.

 

(b)           *Changes in Internal Controls*.  As a result of our own evaluation, as well asrecommendations provided by the Audit Committee we are in the process ofimplementing a series of internal measures designed to enhance the Company’soverall internal control environment. These measures include (i) restructuring some reporting relationshipsamong management and clarifying management roles and responsibilities, (ii)improving communication within the management team and between the managementteam and the Board of Directors, including the Audit Committee, (iii)formalizing licensing review processes by requiring additional documentation ofitems necessary for licensing revenue recognition decisions and increasing thestandardization of licensing deliverables and post-contract customer supportfor revenue recognition purposes, (iv) adding additional resources andpersonnel to key control functions and (v) implementing training and complianceprograms.  Implementation of thesemeasures is underway, but will by its nature be an ongoing effort, subject tothe review of our Board of Directors, Audit Committee and auditors.

 

## **Part II.  OtherInformation**

## ** **

## **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 GenesisMicrochip, 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 a complaint againstGenesis with the International Trade Commission of the United States government(“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.We filed an amended complaint in the Federal Suit as of February 28, 2002,adding a claim for infringement of our U.S. patent number 5,974,464. InApril 2002, Genesis answered and made counterclaims against us fornon-infringement, license, patent invalidity, fraud, antitrust, unfaircompetition and patent misuse. Also in April 2002, we filed a

 

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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 December 2002, the parties entered into a memorandum ofunderstanding (MOU) to settle the case. In January, the parties presenteddifferent interpretations of the MOU to the Court. On July 15, 2003, theCourt granted our motion to interpret the MOU in the manner we requested, andruled that Genesis had engaged in efforts to avoid its obligations under theMOU. On August 6, 2003, the Court entered a final judgment based on itsJuly 15, 2003 ruling. Under the final judgment order, Genesis was orderedto make a substantial cash payment, and to make royalty payments; althoughGenesis has made a cash payment to the Court, it has not made all the paymentsthat are required under the final judgment order. We filed motions forreimbursement of some of our expenses, including some of our legal fees, andfor modification and/or clarification of certain items of the judgment, and tohold Genesis in contempt of Court for breaching the protective order in thecase by disclosing secret information to at least one of our competitors. OnDecember 19, 2003, the Court granted our motions in part and denied themin part: the court issued an amended judgment, and held Genesis in contempt ofCourt for breaching the protective order. Under the amended judgment, Genesis wasordered to make a substantial cash payment, royalty payments, and interest;although Genesis has made and continues to make cash payments to the Court, itmay not have made all the payments that are required under the amendedjudgment. The Court has not ruled on pending motions regarding the dispositionof the money held by the Court. On January 16, 2004, Genesis fileda notice of appeal. To date, we have not received any cash payments nor have werecognized any revenue associated with this litigation. Due to the continuingand contentious nature of this litigation, we will not record any income orrevenue related to this matter until the litigation is complete and all otherincome and revenue recognition criteria have been satisfied. Management intendsto prosecute our position vigorously until this matter is resolved. ThroughJune 30, 2004, we have spent approximately $10.7 million on this matter andexpect to continue to incur significant legal costs through at least the fourthquarter of 2004.

 

Silicon Image,certain officers and directors, and Silicon Image’s underwriters have beennamed as defendants in a securities class action lawsuit captioned Gonzales v.Silicon Image, et al., No. 01 CV 10903 (SDNY 2001) pending in FederalDistrict Court for the Southern District of New York. The lawsuit alleges thatall defendants were part of a scheme to manipulate the price of Silicon Image’sstock in the aftermarket following Silicon Image’s initial public offering inOctober 1999. Response to the complaint and discovery in this action onbehalf of Silicon Image and individual defendants has been stayed by order ofthe court. The lawsuit is proceeding as part of a coordinated action of over300 such cases brought by plaintiffs in the Southern District of New York.Pursuant to a tolling agreement, individual defendants have been dropped fromthe suit for the time being. In February 2003, the Court denied theunderwriters’ motion to dismiss and ordered that the case may proceed againstissuers including against Silicon Image. A proposed settlement has beennegotiated that has yet to be reviewed and approved by the Court. In the eventthat the settlement is approved, we do not expect it to have a material effecton our results of operations or financial position. In the event that thesettlement is not approved, we could not accurately predict the outcome thelitigation, but we intend to defend this matter vigorously.

 

Silicon Image,certain officers and directors, and Silicon Image’s underwriters were named asdefendants in a securities class action lawsuit captioned Liu v. Credit SuisseFirst Boston Corp., et al., No. 03-20459 (S.D. Fla. 2003) pending inFederal District Court for the Southern District of Florida. The plaintifffiled an action on behalf of a putative class of shareholders who purchasedstock from some or all of approximately 50 issuers whose public offerings were underwrittenby Credit Suisse First Boston. The lawsuit alleges that Silicon Image andcertain officers were part of a scheme by Credit Suisse First Boston toartificially 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 the proposed settlement described above, ifapproved, would encompass the claims in this case. We believe that these claimswere without merit and, if revived, and not subject to the settlement, we woulddefend this matter vigorously.

 

Certainofficers and directors of Silicon Image were named as defendants inconsolidated shareholder derivative litigation, captioned “In re SiliconImage, Inc. Derivative Litigation, No. 1:03CV010302”, commenced onDecember 4, 2003 and pending in the Superior Court of California, Countyof Santa Clara. The plaintiffs purported to sue the individual defendants onbehalf of Silicon Image. The lawsuit alleged that as a result of the recentlycompleted examination conducted by the Audit Committee of Silicon Image’s Boardof Directors, Silicon Image will be required to restate its financial resultsfor 2002 and 2003. On June 22, 2004, the plaintiffs dismissed the lawsuit.

 

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Silicon Imageand certain of its officers were named as defendants in consolidated securitiesclass action litigation captioned “In re Silicon Image, Inc. SecuritiesLitigation, No. C-03-5579 JW PVT”, commenced on December 11, 2003 andpending in the United States District Court for the Northern District of California.Plaintiffs filed the action on behalf of a putative class of shareholders whopurchased Silicon Image stock between April 15, 2002 and November 15,2003. The lawsuit alleges that Silicon Image had materially overstated itslicensing revenue, net income and financial results during this time period,and that Silicon Image was being forced to restate its financial results.Following the announcement by the Audit Committee of Silicon Image’s Board ofDirectors that it has completed its examination and that it has concluded thatno changes to Silicon Image’s previously announced financial results arerequired, the plaintiffs dismissed the lawsuit.

 

## **In addition, we have been namedas defendants in a number of judicial and administrative proceedings incidentalto our business and may be named again from time to time. We intend to defendsuch matters vigorously, and although adverse decisions or settlements mayoccur in one or more of such cases, the final resolution of these matters,individually or in the aggregate, is not expected to have a material adverseeffect on our results of operations or financial position.**

## ** **

The amount oflegal fees we incur with respect to the litigation matters described above willdepend on the duration of our litigation matters, as well as the nature andextent of the litigation activities. We are not able to accurately estimate theamount of legal fees we will incur in 2004 with respect to the litigationmatters described above, however, we do expect to incur substantial amountsthrough 2004.

 

## **Item 2.  Changesin Securities and Use of Proceeds**

 

Notapplicable.

 

## **Item 3. Defaults Upon Senior Securities**

 

Notapplicable.

 

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

 

We held our2004 Annual Meeting of Stockholders on May 25, 2004. The first mattervoted upon at the meeting was the election of two Class II directors toserve until the 2007 Annual Meeting of Stockholders. At the meeting, DavidHodges and Christopher Paisley were elected as Class II directors by thefollowing votes:

 
| **Name**            | ** ** | **Shares  For** | ** ** | **Shares  Against** | ** ** | **Shares  Abstaining** | ** ** | **Shares  Withheld** | ** ** | **Broker  Non-Votes** | ** ** |
|---------------------|------------|-----------------|------------|---------------------|------------|------------------------|------------|----------------------|------------|-----------------------|------------|
| David Hodges        |       | 61,771,899      |       | —              |       | —                 |       | 976,626              |       | —                |       |
| Christopher Paisley |       | 61,396,933      |       | —              |       | —                 |       | 1,351,592            |       | —                |       |

 

Our board of directors consists of seven members andis divided into three classes, with each class consisting of two or moremembers and each class serving staggered three-year terms. The term of theClass III directors, who are currently David Courtney, David Lee andAndrew Rappaport, will expire at the 2005 Annual Meeting of Stockholders, andthe term of the Class I directors, who are currently Keith McAuliffe andDouglas Spreng, will expire at the 2006 Annual Meeting of Stockholders.

 

The second matter voted upon at the meeting was theratification of the appointment of PricewaterhouseCoopers LLP as independentaccountants of Silicon Image for the fiscal year ending December 31, 2004.At the meeting, the appointment of PricewaterhouseCoopers LLP as independentaccountants was ratified by the following vote:

 
| **Shares For** | ** ** | **Shares  Against** | ** ** | **Shares  Abstaining** | ** ** | **Shares  Withheld** | ** ** | **Broker  Non-Votes** | ** ** |
|----------------|------------|---------------------|------------|------------------------|------------|----------------------|------------|-----------------------|------------|
| 61,274,651     |       | 1,035,356           |       | 438,518                |       | —               |       | —                |       |

 

**Item 5. Other Information**

 

Notapplicable.

 

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**Item6.  Exhibits and Reports on Form 8-K**

 

(a)    Exhibits

 

10.01               LetterAgreement Between Robert Valiton and the Registrant dated April 17, 2004

 

31.1                                                   Certificationunder Section 302 of the Sarbanes-Oxley Act of 2002

 

31.2                                                   Certificationunder Section 302 of the Sarbanes-Oxley Act of 2002

 

32.1                                                   Certificationpursuant to 12 U.S.C. Section 1350, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002.

 

32.1                                                   Certificationpursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002.

 

(b)   Reportson Form 8-K

 

On April 5,2004, we filed a current report on Form 8-K to furnish under Item 12 our pressrelease revising the financial outlook for the quarter ended March 31, 2004.

 

On April 26,2004, we furnished a current report on Form 8-K to furnish under Item 12 ourpress release and conference call transcript for the quarter ended March 31,2004.

 

On June 4,2004, we filed a current report on Form 8-K to report under Item 5 that severalof our officers and a member of the Board of Directors entered into tradingplans intended to comply with Rule 10b5-1 under the Securities Exchange Act of1934.

 

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**Signatures**

 

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

 
| Dated:  August 6, 2004 | Silicon  Image, Inc.                                                    |
|-----------------------------|-------------------------------------------------------------------------|
|                        |                                                                    |
| * *                    | */s/  Robert  G. Gargus*                                      | * * |
|                        | Robert G.  Gargus                                                       |
|                        | Vice  President Finance and Administration and Chief  Financial Officer |
|                        | (Principal  Financial and Accounting Officer)                           |

 

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