**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 March 31, 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**

 

**Silicon Image, 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 ArquesAvenue****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 April 30, 2004 was 74,017,564 shares.

 

 

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**Silicon Image, Inc.****QuarterlyReport on Form 10-Q****ThreeMonths Ended****March 31,2004**

 

**Table of Contents**

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

 

**Item 1. Financial Statements**

 

**SiliconImage, Inc.****Condensed Consolidated Statements ofOperations****(inthousands, except per share amounts)****(unaudited)**

 

|                                             |   | **Three  Months Ended  March 31,** |   |
|--------------------------------------------------|--------|------------------------------------|--------|
|                                             |   | **2004**                           |   | **2003** |   |
|                                             |   |                               |   |   |   |
| Revenue:                                         |   |                               |   |   |   |
| Product                                          |   | $                                  | 32,050 |   | $ | 19,722 |   |
| Development, licensing and royalties             |   | 3,808                              |   | 4,954 |   |
| Total revenue                                    |   | 35,858                             |   | 24,676 |   |
|                                             |   |                               |   |   |   |
| Cost and operating expenses:                     |   |                               |   |   |   |
| Cost of revenue (1)                              |   | 14,515                             |   | 11,055 |   |
| Research and development (2)                     |   | 16,798                             |   | 8,963 |   |
| Selling, general and administrative (3)          |   | 11,650                             |   | 3,955 |   |
| Amortization of intangible assets                |   | 357                                |   | — |   |
| Patent defense costs                             |   | 165                                |   | 1,213 |   |
| Restructuring                                    |   | —                             |   | 986 |   |
| Total cost and operating expenses                |   | 43,485                             |   | 26,172 |   |
|                                             |   |                               |   |   |   |
| Loss from operations                             |   | (7,627                             | )      | (1,496 | ) |
| Gain on escrow settlement, net                   |   | —                             |   | 4,618 |   |
| Interest income and other, net                   |   | 84                                 |   | 109 |   |
| Income (loss) before provision for income  taxes |   | (7,543                             | )      | 3,231 |   |
|                                             |   |                               |   |   |   |
| Provision for income taxes                       |   | 317                                |   | — |   |
| Net income (loss)                                |   | $                                  | (7,860 | ) | $ | 3,231 |   |
|                                             |   |                               |   |   |   |
| Net income (loss) per share - basic              |   | $                                  | (0.11  | ) | $ | 0.05 |   |
| Net income (loss) per share - diluted            |   | $                                  | (0.11  | ) | $ | 0.04 |   |
|                                             |   |                               |   |   |   |
| Weighted average shares - basic                  |   | 72,328                             |   | 66,828 |   |
| Weighted average shares - diluted                |   | 72,328                             |   | 73,696 |   |

 

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(1)          Includesstock compensation expense (benefit) of $1.2 million and ($135,000) for thethree months ended March 31, 2004 and 2003, respectively.

 

(2)          Includesstock compensation expense of $6.2 million and $127,000 for the three monthsended March 31, 2004 and 2003, respectively.

 

(3)          Includesstock compensation expense (benefit) of $4.7 million and ($354,000) for thethree months ended March 31, 2004 and 2003, respectively.

 

See accompanying Notes to Unaudited Condensed Consolidated FinancialStatements.

 

1

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**SiliconImage, Inc.****Condensed Consolidated Balance Sheets****(inthousands, except share amounts)****(unaudited)**

 
|                                                                                                                                                                                          |   | **March 31,  2004** |    | **Dec. 31,  2003** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|---------|--------------------|--------|
| **Assets**                                                                                                                                                                                    |   |                |    |               |   |
| Current Assets:                                                                                                                                                                               |   |                |    |               |   |
| Cash and cash equivalents                                                                                                                                                                     |   | $                   | 40,199  |               | $      | 24,059 |   |
| Short-term investments                                                                                                                                                                        |   | 9,459               |    | 13,195             |   |
| Accounts receivable, net of allowances for  doubtful accounts of $722 at March 31 and $670 at December 31                                                                                     |   | 19,093              |    | 12,754             |   |
| Inventories                                                                                                                                                                                   |   | 9,618               |    | 10,312             |   |
| Prepaid expenses and other current assets                                                                                                                                                     |   | 2,309               |    | 2,703              |   |
| Total current assets                                                                                                                                                                          |   | 80,678              |    | 63,023             |   |
| Property and equipment, net                                                                                                                                                                   |   | 7,439               |    | 7,411              |   |
| Goodwill                                                                                                                                                                                      |   | 13,021              |    | 13,021             |   |
| Intangible assets, net                                                                                                                                                                        |   | 2,671               |    | 3,028              |   |
| Other assets                                                                                                                                                                                  |   | 1,181               |    | 1,259              |   |
| Total assets                                                                                                                                                                                  |   | $                   | 104,990 |               | $      | 87,742 |   |
|                                                                                                                                                                                          |   |                |    |               |   |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                 |   |                |    |               |   |
| Current Liabilities:                                                                                                                                                                          |   |                |    |               |   |
| Accounts payable                                                                                                                                                                              |   | $                   | 9,211   |               | $      | 6,442 |   |
| Accrued liabilities                                                                                                                                                                           |   | 8,823               |    | 8,726              |   |
| Deferred license revenue                                                                                                                                                                      |   | 4,906               |    | 1,175              |   |
| Debt obligations                                                                                                                                                                              |   | 1,234               |    | 1,732              |   |
| Deferred margin on sales to distributors                                                                                                                                                      |   | 9,162               |    | 7,274              |   |
| Total liabilities                                                                                                                                                                             |   | 33,336              |    | 25,349             |   |
|                                                                                                                                                                                          |   |                |    |               |   |
| Stockholders’ Equity:                                                                                                                                                                    |   |                |    |               |   |
| Common stock, par value $0.001; shares  authorized: 150,000,000 – March 31 and December 31; shares issued and  outstanding: 73,593,748 – March 31 and 72,367,129 – December 31 |   | 74                  |    | 72                 |   |
| Additional paid-in capital                                                                                                                                                                    |   | 260,205             |    | 243,171            |   |
| Unearned stock compensation                                                                                                                                                                   |   | (8,111              | )       | (8,196             | )      |
| Accumulated deficit                                                                                                                                                                           |   | (180,514            | )       | (172,654           | )      |
| Total stockholders’ equity                                                                                                                                                               |   | 71,654              |    | 62,393             |   |
| Total liabilities and stockholders’ equity                                                                                                                                               |   | $                   | 104,990 |               | $      | 87,742 |   |

 

See accompanying Notes to Unaudited Condensed Consolidated FinancialStatements.

 

2

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**SiliconImage, Inc.****Condensed Consolidated Statements ofCash Flows****(inthousands)****(unaudited)**

 
|                                                                                   |   | **Three  Months Ended  March 31,** |   |
|----------------------------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                                   |   | **2004**                           |   | **2003** |   |
|                                                                                   |   |                               |   |   |   |
| Cash flows from operating activities:                                                  |   |                               |   |   |   |
| Net income (loss)                                                                      |   | $                                  | (7,860 | ) | $ | 3,231 |   |
| Adjustments to reconcile net loss to cash  provided by (used in) operating activities: |   |                               |   |   |   |
| Depreciation and amortization                                                          |   | 1,150                              |   | 947 |   |
| Provision for doubtful accounts receivable                                             |   | 52                                 |   | 4 |   |
| Stock compensation expense (benefit)                                                   |   | 12,068                             |   | (362 | ) |
| Amortization of intangible assets                                                      |   | 357                                |   | — |   |
| Non-cash restructuring                                                                 |   | —                             |   | 646 |   |
| Non-cash gain on escrow settlement, before  cash costs                                 |   | —                             |   | (4,692 | ) |
| Changes in assets and liabilities:                                                     |   |                               |   |   |   |
| Accounts receivable                                                                    |   | (6,391                             | )      | (1,963 | ) |
| Inventories                                                                            |   | 694                                |   | 576 |   |
| Prepaid expenses and other assets                                                      |   | 472                                |   | 409 |   |
| Accounts payable                                                                       |   | 2,769                              |   | (1,981 | ) |
| Accrued liabilities and deferred license  revenue                                      |   | 3,828                              |   | (2,141 | ) |
| Deferred margin on sales to distributors                                               |   | 1,888                              |   | 164 |   |
| Cash provided by (used in) operating  activities                                       |   | 9,027                              |   | (5,162 | ) |
|                                                                                   |   |                               |   |   |   |
| Cash flows from investing activities:                                                  |   |                               |   |   |   |
| Proceeds from sales of short-term  investments                                         |   | 12,281                             |   | 5,693 |   |
| Purchases of short-term investments                                                    |   | (8,545                             | )      | (2,600 | ) |
| Purchases of property and equipment                                                    |   | (1,178                             | )      | (1,282 | ) |
| Cash provided by investing activities                                                  |   | 2,558                              |   | 1,811 |   |
|                                                                                   |   |                               |   |   |   |
| Cash flows from financing activities:                                                  |   |                               |   |   |   |
| Proceeds from issuances of common stock,  net                                          |   | 5,053                              |   | 2,653 |   |
| Repayment of stockholders’ notes  receivable, net                                 |   | —                             |   | 109 |   |
| Repayments of debt obligations                                                         |   | (498                               | )      | (699 | ) |
| Cash provided by financing activities                                                  |   | 4,555                              |   | 2,063 |   |
|                                                                                   |   |                               |   |   |   |
| Net increase (decrease) in cash and cash  equivalents                                  |   | 16,140                             |   | (1,288 | ) |
| Cash and cash equivalents – beginning of  period                                  |   | 24,059                             |   | 26,263 |   |
| Cash and cash equivalents – end of period                                         |   | $                                  | 40,199 |   | $ | 24,975 |   |
|                                                                                   |   |                               |   |   |   |
| Supplemental cash flow information:                                                    |   |                               |   |   |   |
| Financing of property and equipment                                                    |   | $                                  | — |   | $ | 383 |   |
| Cash payments for taxes                                                                |   | $                                  | 217    |   | $ | — |   |

 

See accompanying Notes to Unaudited Condensed Consolidated FinancialStatements.

 

3

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**Silicon Image, Inc.Notes to Unaudited CondensedConsolidated Financial StatementsMarch 31, 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 March 31, 2004 and theconsolidated results of the Company’s operations and cash flows for the threemonths ended March 31, 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 current presentation. Results ofoperations for the three months ended March 31, 2004 are not necessarilyindicative of future operating results.

 

2.               RecentAccounting Pronouncements

 

InJanuary 2003, the Financial Accounting Standards Board (“FASB”) issuedInterpretation Number (“FIN”) 46, “Consolidation of Variable Interest Entities.”In general, a variable interest entity is a corporation, partnership, trust, orany other legal structure used for business purposes that either (a) doesnot have equity investors with voting rights or (b) has equity investorsthat do not provide sufficient financial resources for the entity to supportits activities. FIN 46 requires certain variable interest entities to beconsolidated by the primary beneficiary of the entity if the investors do nothave the characteristics of a controlling financial interest or do not havesufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support from other parties. The consolidationrequirements of FIN 46 apply immediately to variable interest entities createdafter January 31, 2003. Certain of the disclosure requirements apply toall financial statements issued after January 31, 2003, regardless of whenthe variable interest entity was established. The effective dates of certainelements of FIN 46 have been deferred. We do not believe that the adoption ofthis standard will have a material impact on our consolidated financialstatements.

 

In December 2003, theSecurities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB)No. 104, *Revenue Recognition (“SAB 104”).*SAB104 revises or rescinds portions of the interpretive guidance included in Topic13 of the codification of staff accounting bulletins in order to make thisinterpretive guidance consistent with current authoritative accounting andauditing guidance and SEC rules and regulations. The adoption of SAB 104 had noeffect on our results of operations or financial condition.

 

Stock-BasedCompensation

 

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

 

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

 

4

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|                                                                                                           |   | **Three  Months Ended  March 31,** |   |
|----------------------------------------------------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                                                           |   | **2004**                           |   | **2003** |   |
| Net income (loss) - as reported                                                                                |   | $                                  | (7,860 | ) | $ | 3,231 |   |
| Stock-based employee compensation expense  determined using fair value method                                  |   | (5,137                             | )      | (6,020 | ) |
| Stock-based employee compensation cost  (benefit)  included in the  determination of net loss as reported |   | 9,286                              |   | (721 | ) |
| Pro forma net loss                                                                                             |   | $                                  | (3,711 | ) | $ | (3,510 | ) |
|                                                                                                           |   |                               |   |   |   |   |   |
| Basic net loss per share—pro forma                                                                        |   | $                                  | (0.05  | ) | $ | (0.05 | ) |
| Basic net income (loss) per share—as  reported                                                            |   | $                                  | (0.11  | ) | $ | 0.05 |   |
|                                                                                                           |   |                               |   |   |   |
| Diluted net loss per share—pro forma                                                                      |   | $                                  | (0.05  | ) | $ | (0.05 | ) |
| Diluted net income (loss) per share—as  reported                                                          |   | $                                  | (0.11  | ) | $ | 0.04 |   |

 

Theweighted average grant-date fair value of our stock options was $6.65 and $4.31for the three months ended March 31, 2004 and 2003, respectively. These valueswere estimated using the Black-Scholes pricing model with the followingassumptions:

 
|           |   | **Three  Months Ended  March 31** |   |
|----------------|--------|-----------------------------------|--------|
|           |   | **2004**                          |   | **2003** |   |
|           |   |                              |   |   |   |
| Expected life  |   | 5.0                               |   | 5.0 |   |
| Interest rate  |   | 3.0                               | %      | 3.1 | % |
| Volatility     |   | 90                                | %      | 90 | % |
| Dividend yield |   | —                            |   | — |   |

 

The weightedaverage, grant-date fair value of stock purchase rights granted under ourEmployee Stock Purchase Plan was $2.69 and $2.76 for the three months endedMarch 31, 2004 and 2003, respectively. These values were estimated using theBlack-Scholes pricing model with the following assumptions:

 
|                  |   | **Three  Months Ended  March 31** |   |
|-----------------------|--------|-----------------------------------|--------|
|                  |   | **2004**                          |   | **2003** |   |
|                  |   |                              |   |   |   |
| Expected life (years) |   | 1.5                               |   | 1.5 |   |
| Interest rate         |   | 1.2                               | %      | 1.3 | % |
| Volatility            |   | 90                                | %      | 90 | % |
| Dividend yield        |   | —                            |   | — |   |

 

3.               NetIncome (Loss) Per Share

 

Basicnet income (loss) per share is computed using the weighted-average number ofcommon shares outstanding during the period, excluding shares subject torepurchase, and diluted net income (loss) per share is computed using theweighted-average number of common shares and diluted equivalents outstandingduring the period, if any, determined using the treasury stock method. Thefollowing table sets forth the computation of basic and diluted net income(loss) per share (in thousands, except per share amounts):

 

5

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|                                                                       |   | **Three  Months Ended  March 31,** |   |
|----------------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                       |   | **2004**                           |   | **2003** |   |
|                                                                       |   |                               |   |   |   |
| Net income (loss)                                                          |   | $                                  | (7,860 | ) | $ | 3,231 |   |
|                                                                       |   |                               |   |   |   |
| Weighted average shares                                                    |   | 73,108                             |   | 66,938 |   |
| Unvested common shares subject to  repurchase                              |   | (780                               | )      | (110 | ) |
| Weighted average common shares outstanding  for basic net income per share |   | 72,328                             |   | 66,828 |   |
| Weighted-average common shares for diluted  net income (loss) per share    |   | 72,328                             |   | 73,696 |   |
| Basic net income (loss) per share                                          |   | $                                  | (0.11  | ) | $ | 0.05 |   |
| Diluted net income (loss) per share                                        |   | $                                  | (0.11  | ) | $ | 0.04 |   |

 

The followingis a reconciliation of the weighted-average common shares used to calculate basicnet income per share to the weighted-average common shares used to calculatediluted net income per share for the three months ended March 31, 2003 (inthousands):

 
| Weighted-average common shares for basic  net income per share                       |   | 66,828 |   |
|--------------------------------------------------------------------------------------|--------|--------|--------|
| Weighted-average dilutive stock  options outstanding under the treasury stock method |   | 6,776  |   |
| Unvested common shares subject to  repurchase                                        |   | 92     |   |
| Weighted-average common shares  for diluted net income per share                     |   | 73,696 |   |

 

Had we generated netincome for the three month period ended March 31, 2004, the number of weightedaverage securities outstanding that would have been added to weighted averageshares for purposes of calculating diluted earnings per share would havebeen  (in thousands):

 
|                                         |   | **March 31,  2004** |   |
|----------------------------------------------|--------|---------------------|--------|
| Unvested common stock subject  to repurchase |   | 780                 |   |
| Stock options                                |   | 10,307              |   |
| Total                                        |   | 11,087              |   |

 

Asa result of our net loss for the three-months ended March 31, 2004, all commonshare equivalents would have been anti-dilutive and have therefore beenexcluded from the diluted net loss per share calculation. The weighted averagesecurities that were anti-dilutive and excluded from our calculation of dilutednet income (loss) per share were approximately 20,411,000 and 8,600,000 for thethree-month periods ended March 31, 2004 and 2003, respectively.

 

4.                   BalanceSheet Components

 
|                                 |   | **March 31,  2004** |   | **Dec. 31,  2003** |   |
|--------------------------------------|--------|---------------------|--------|--------------------|--------|
|                                 |   | **(in  thousands)** |   |
|                                 |   |                |   |               |   |
| Inventories:                         |   |                |   |               |   |
| Raw materials                        |   | $                   | 2,865  |               | $      | 3,128 |   |
| Work in process                      |   | 2,985               |   | 2,532              |   |
| Finished goods                       |   | 3,768               |   | 4,652              |   |
|                                 |   | $                   | 9,618  |               | $      | 10,312 |   |
| Accrued liabilities:                 |   |                |   |               |   |
| Accrued payroll and related expenses |   | $                   | 3,021  |               | $      | 2,533 |   |
| Restructuring accrual                |   | 1,648               |   | 1,875              |   |
| Accrued legal fees                   |   | 1,099               |   | 1,137              |   |
| Warranty accrual                     |   | 351                 |   | 271                |   |
| Other accrued liabilities            |   | 2,704               |   | 2,910              |   |
|                                 |   | $                   | 8,823  |               | $      | 8,726 |   |

 

6

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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 on historicalexperience.  Warranty accrual activityfor the three months ended March 31, 2004 and 2003 was as follows (inthousands):

 
|                                               |   | **2004** |   | **2003** |   |
|----------------------------------------------------|--------|----------|--------|----------|--------|
| Balance at January 1                               |   | $        | 271    |     | $      | 223 |   |
| Provision for warranties issued during the  period |   | 130      |   | 50       |   |
| Cash and other settlements made during the  period |   | (50      | )      | (50      | )      |
| Balance at March 31                                |   | $        | 351    |     | $      | 223 |   |

 

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 and Disclosure(an amendment of FASB Statement No. 123).” Expense associated with stock-basedcompensation is amortized over the vesting period of the individual award usingan accelerated method, as described in Financial Accounting Standards BoardInterpretation No. 28.

 

We arerequired to determine the fair value of stock option grants to non-employeesand 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.

 

The followingtable summarizes the components of our stock compensation expense (benefit) forthe three months ended March 31, 2004 and 2003 (in thousands):

 
|                                            |   | **Three Months Ended  March 31,** |   |
|-------------------------------------------------|--------|-----------------------------------|--------|
|                                            |   | **2004**                          |   | **2003** |   |
|                                            |   |                              |   |   |   |
| Options granted to employees                    |   | $                                 | 31     |   | $ | 222 |   |
| Options granted to non-employees                |   | 1,503                             |   | 359 |   |
| Option repricings                               |   | 10,121                            |   | (1,358 | ) |
| Options assumed in connection with acquisitions |   | 413                               |   | 415 |   |
| Stock compensation expense (benefit)            |   | $                                 | 12,068 |   | $ | (362 | ) |

 

The repricingexpense for the three months ended March 31, 2004 was higher relative to thethree month period ended March 31, 2003, as our average stock price duringthe three months ended March 31, 2004 was higher. During the three months endedMarch 31, 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 March31, 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 certain

 

7

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projects from our developmentplan, to phase out or de-emphasize certain existing products and to integratethe operations of two acquired companies—CMD Technology (“CMD”) and SiliconCommunication 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 product andtechnology 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 ofmodified stock options, an expected loss on leased facilities of $500,000 andfixed asset write-downs of $50,000. In addition, we reversed $286,000 of unearnedcompensation, a component of stockholders’ equity, for unvested stock optionsthat were cancelled in connection 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.

 

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 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 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 identifiabletangible and intangible assets other than goodwill (also based primarily onexpected future cash flows), and compared the unallocated fair value of thebusiness to the carrying value of goodwill. To the extent goodwill exceeded theunallocated fair value of the business, an impairment expense was recognized.

 

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InDecember 2002, we revised our estimate of the loss we expect to incur onsubleased facilities and recorded a restructuring expense of $1.5 million. Realestate market conditions deteriorated in the fourth quarter of 2002, causing usto reassess the length of time it would take to find tenants and the fair valuelease rate of our available space. As of 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 primarilyin engineering and operations functions. Because of this workforce reduction,we recorded 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.

 

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 March 31, 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                        |   | (4                               | )      | (223                   | )      | —                |   | (227      | )      |
| Balance as of March 31, 2004         |   | $                                | 33     |                   | $      | 1,615                 |   | $         | — |   | $ | 1,648 |   |

 

7.                                             DebtFacility

 

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 March 31,2004) 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 bearsinterest at 5% and requires monthly payments through its maturity in February 2005.As of March 31, 2004, $1,234,000 was outstanding under these term loans. Ourdebt facilities contain certain quarterly and annual financial

 

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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 March 31, 2004. During the period ended March 31, 2004, we entered intoan agreement to extend this debt facility by way of a revolving line of creditwith an availability of up to $10.0 million, and an equipment line of credit ofup to $3.0 million. Borrowings under the revolving line are limited to thelesser of $10.0 million or 80% of eligible accounts receivable as defined inthe loan agreement. This revolving line of credit expires in March 2005and bears interest at either prime plus 0.25% or LIBOR plus 2.75%, at ouroption. Equipment advances pursuant to the equipment line of credit areavailable to us through August 2004 and will be repayable in twenty fourequal monthly installments commencing September 1, 2004 bearing interestat either prime or LIBOR plus 2.5%, at our option. Quarterly and annualfinancial covenants are contained within this revised agreement. No amountshave been drawn down against this line of credit as at March 31, 2004. As ofMarch 31, 2004, we were in compliance with all covenants.

 

8.                                       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 against Genesiswith the International Trade Commission of the United States government (“ITC”)for unlawful trade practices related to the importation of articles infringingour patent (the “ITC investigation”). The actions sought injunctions to haltthe importation, 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 FederalSuit. Our motion to dismiss was granted on February 7, 2002. We filed anamended complaint in the Federal Suit as of February 28, 2002, adding aclaim for infringement of our U.S. patent number 5,974,464. In April 2002,Genesis answered and made counterclaims against us for non-infringement, license,patent invalidity, fraud, antitrust, unfair competition and 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 Courtgranted our motion to interpret the MOU in the manner we requested, and ruledthat Genesis 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. ThroughMarch 31, 2004, we have spent approximately $10.6 million on this matterand expect to continue to incur significant legal costs through at least thefourth quarter 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

 

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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 effect onour 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 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 have been 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 purport to sue the individual defendants onbehalf of Silicon Image. The lawsuit alleges 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. The lawsuit further alleges that such a restatement would bedue to breaches by the individual defendants of their fiduciary duties toSilicon Image; that certain of the individual defendants are liable to SiliconImage for insider trading under California law; and that the individualdefendants are liable to Silicon Image for mismanagement, abuse of control, andwaste. Before filing suit, the plaintiffs did not make a demand upon the boardof directors to pursue any such claims directly on behalf of Silicon Image. Followingthe announcement by the Audit Committee of Silicon Image’s Board of Directorsthat it has completed its examination and that it has concluded that no changesto Silicon Image’s previously announced financial results are required, theCompany agreed to provide plaintiffs with certain specified informationconcerning the examination.  Plaintiffsagreed to dismiss the lawsuit following their good-faith review of suchinformation to confirm the independence, scope and adequacy of theexamination.  Although the Company,acting through the Audit Committee of its Board of Directors, provided thespecified information, plaintiffs have failed to discuss the lawsuit.  As a result, the Company has filed across-complaint for breach of contract, seeking an order discussing thederivative action and awarding the Company its attorneys fees. The individualdefendants believe the lawsuit is without merit, and they intend to defend theaction vigorously if plaintiffs do not dismiss it. Plaintiffs may seek to amendthe complaint, and we cannot predict what claims plaintiffs might assert insuch an amended complaint.

 

Silicon Imageand certain of its officers have been named as defendants in consolidatedsecurities class action litigation captioned “In re Silicon Image, Inc.Securities Litigation, No. C-03-5579 JW PVT”, commenced onDecember 11, 2003 and pending in the United States District Court for theNorthern District of California. Plaintiffs filed the action on behalf of aputative class of shareholders who purchased Silicon Image stock betweenApril 15, 2002 and November 15, 2003. The lawsuit alleges thatSilicon Image had materially overstated its licensing revenue, net income andfinancial results during this time period, and that Silicon Image was beingforced to restate its financial results. Following the announcement by theAudit Committee of Silicon Image’s Board of Directors that it has completed itsexamination and that it has concluded that no changes to Silicon Image’spreviously announced financial results are required, the plaintiffs dismissedthe 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.

 

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9.                                       Customerand Geographic Information

 

Revenue bygeographic area was as follows (in thousands):

 

|          |   | **Three  Months Ended  March 31,** |   |
|---------------|--------|------------------------------------|--------|
|          |   | **2004**                           |   | **2003** |   |
| Taiwan        |   | $                                  | 9,457  |   | $ | 9,814 |   |
| Japan         |   | 7,540                              |   | 2,594 |   |
| United States |   | 9,569                              |   | 6,774 |   |
| Hong Kong     |   | 1,489                              |   | 1,519 |   |
| Korea         |   | 1,730                              |   | 1,120 |   |
| Other         |   | 6,073                              |   | 2,855 |   |
|          |   | $                                  | 35,858 |   | $ | 24,676 |   |

 

Revenue byproduct line was as follows (in thousands):

 

|                                 |   | **Three  Months Ended  March 31,** |   |
|--------------------------------------|--------|------------------------------------|--------|
|                                 |   | **2004**                           |   | **2003** |   |
| PC                                   |   | $                                  | 9,667  |   | $ | 8,793 |   |
| Consumer Electronics                 |   | 11,367                             |   | 3,250 |   |
| Storage products                     |   | 11,016                             |   | 7,679 |   |
| Development, licensing and royalties |   | 3,808                              |   | 4,954 |   |
|                                 |   | $                                  | 35,858 |   | $ | 24,676 |   |

 

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

 

|                 |   | **Three  Months Ended  March 31,** |   |
|----------------------|--------|------------------------------------|--------|
|                 |   | **2004**                           |   | **2003** |   |
| PC                   |   | $                                  | 9,680  |   | $ | 8,944 |   |
| Consumer Electronics |   | 12,282                             |   | 4,298 |   |
| Storage products     |   | 13,896                             |   | 11,434 |   |
|                 |   | $                                  | 35,858 |   | $ | 24,676 |   |

 

For eachperiod presented, substantially all long-lived assets were located withinthe United States.

 

For the threemonths ended March 31, 2004, one customer generated 15% of our revenue andanother customer generated 11% of our revenue, and as of March 31, 2004, twocustomers represent 16% and 14% of gross accounts receivable. For the threemonths ended March 31, 2003, one customer generated 12% of our revenue and twocustomers each generated 10% of our revenue. At December 31, 2003, three customers represented 17%, 12% and 10% ofgross accounts receivable.

 

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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 ofintangible assets are as follows (in thousands):

 
|                                            |   | **March 31,  2004**         |   | **December  31, 2003**        |   |
|-------------------------------------------------|--------|-----------------------------|--------|-------------------------------|--------|
|                                            |   | **Gross  Carrying  Amount** |   | **Accumulated  Amortization** |   | **Gross  Carrying  Amount** |   | **Accumulated  Amortization** |   |
|                                            |   |                        |   |                          |   |   |   |   |   |
| Intangible assets subject to amortization:      |   |                        |   |                          |   |   |   |   |   |
| Acquired technology                             |   | $                           | 1,780  |                          | $      | (497 | ) | $ | 1,780 |   | $ | (375 | ) |
| Non-compete agreement                           |   | 1,849                       |   | (625                          | )      | 1,849 |   | (472 | ) |
| Assembled workforce                             |   | 502                         |   | (338                          | )      | 502 |   | (256 | ) |
|                                            |   | $                           | 4,131  |                          | $      | (1,460 | ) | $ | 4,131 |   | $ | (1,103 | ) |
| Intangible assets not subject to  amortization: |   |                        |   |                          |   |   |   |   |   |
| Goodwill                                        |   | $                           | 13,021 |                          | $      | — |   | $ | 13,021 |   | $ | — |   |

 

Estimated future amortizationexpense for our intangible assets is as follows for fiscal years endingDecember 31 (in thousands):

 
| 2004   |   | 988   |   |
|--------|--------|-------|--------|
| 2005   |   | 1,097 |   |
| 2006   |   | 508   |   |
| 2007   |   | 78    |   |
|   |   | $     | 2,671  |   |
|        |        |       |        |  |

 

The amortization expense for the three monthsended March 31, 2004 and 2003 was $357,000 and 0, respectively.

 

12.           Income taxes

 

For the firstquarter of fiscal 2004, we provided an income tax provision of $317,000. Thisincludes approximately $217,000 relating to taxes payable in a foreignjurisdiction relating to licensing revenues received from that jurisdiction. Inaddition, we have provided approximately $100,000 relating to other incometaxes in certain foreign jurisdictions and for estimated alternative minimumtax in the United States. As of March 31, 2004, we have net operating losscarryforward for federal income tax purposes of approximately $71.4 million andsuch loss carryforwards, which will expire in various years through 2023, willbe available to offset our future taxable income. We continue to maintain afull valuation allowance for all deferred tax assets given uncertainty as torealization. As such the income tax provision for the three months ended March31, 2004, is not reflective of our fully taxed rate.

 

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 

 

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of the Silicon Image commonstock issued to the principal shareholders of CMD was held in two separateescrow pools as collateral for the indemnification obligations of theseshareholders. We previously made indemnification claims against these escrowpools for the release of escrow shares with a value of approximately $5.4million, which claims were contested by the principal shareholders of CMD. OnFebruary 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 quarter of 2003.

 

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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 ofvarious factors, including the risks outlined elsewhere in this report. Readersare urged to carefully review and consider the various disclosures made bySilicon Image, Inc. in this report and in our other reports filed with the SECthat attempt to advise interested parties of the risks and factors that mayaffect our 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*.*

 

                Silicon Image’s strategy entails establishingindustry-standard, high-speed digital interfaces and building market momentumand leadership through its first-to-market, standards-based IC products.Further leveraging its strong IP portfolio, the company broadens marketadoption of the Digital Visual Interface (DVI), High-Definition MultimediaInterface (HDMI) and Serial ATA (SATA) interfaces by licensing its proven IPcores to companies providing advanced system-on-a-chip solutions incorporatingthese interfaces. Licensing, in addition to creating revenue and return onengineering investment in market segments we choose not to address, createsproducts complementary to our own that expand the markets for our products andhelp to improve industry wide interoperability.

 

                Silicon Image is a leader in the globalPC/display arena with its innovative PanelLink® digital interconnecttechnology, which enables an all-digital connection between PC host systems anddigital displays such as LCD monitors, plasma displays and projectors.PanelLink technology is the basis for the DVI industry standard the companypioneered and remains the most popular DVI implementation with more than 42million 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 generated27% of our revenue in the first three months of 2004 and 35.6% of our revenuesin the first three months of 2003 (including licensing revenues, thesepercentages were 27% and 36.2% for the first three months of 2004 and 2003,respectively).

 

Leveraging ourcore technology and standards-setting expertise, Silicon Image is a leadingforce in advancing the adoption of HDMI (High Definition Multimedia Interface),the new digital interface standard for the consumer electronics market.Introduced by founders Hitachi, Matsushita (Panasonic), Philips, Silicon Image,Sony, Thomson and Toshiba, HDMI enables the distribution of uncompressed,high-definition video and multi-channel audio in a single, all-digitalinterface that dramatically simplifies cabling. Silicon Image’s HDMI technologyis marketed under the PanelLink CinemaTM brand and includes High-bandwidthDigital Content Protection (HDCP), which is supported by certain Hollywoodstudios as the technology of choice for the secure distribution of premiumcontent over certain digital connections. The PanelLink Cinema chip and thefirst HDMI-compliant silicon are on the market and are featured in the world’sfirst consumer electronics products with HDMI functionality.

 

Products soldinto the CE market have been increasing as a percentage of our total revenuesand generated 31.7% of our total revenues in the first three months of 2004,compared to 13.2% of our total revenues for the first

 

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three months of 2003 (includinglicensing revenues, these numbers were 34.3% and 17.4% for the first threemonths of 2004 and 2003 respectively). Our CE products offer a securableinterface for transmission of digital video and audio to consumer devices, suchas digital TVs and DVD players. Demand for these products will be drivenprimarily by the adoption rate of new technologies, such as High-DefinitionMultimedia Interface (“HDMI”) and High-Bandwidth Digital Content Protection (“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 advancedfeatures and capabilities such as Native Command Queuing, port multipliercapability and ATAPI support. Silicon Image also supplies high-performance,low-power Fibre Channel Serializer/Deserializer (SerDes) to leading switchmanufacturers.

 

Products soldinto the storage market, as a percentage of our total revenues, generated 30.7%of our revenue in the first three months of 2004, compared to 31.1% of ourrevenue in the first three months of 2003 (including licensing revenues it was38.8% and 46.3% of our revenue for the first three months of 2004 and 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.

 

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 90 days of acceptance. Certainlicensing agreements provide for royalty payments based on agreed upon royaltyrates. Such rates can be fixed or variable depending on the terms of theagreement. 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.

 

Our licensingactivity is complementary to our product sales because we believe this activitycan help us monetize our intellectual property as well as accelerate adoptioncurves associated with our technology. Most of our licenses include a field ofuse restriction that prevents the licensee from building a chip in directcompetition with those market segments we have chosen to pursue. Revenue fromdevelopment, licensing and royalties accounted for 10.6% and 20.1% of ourrevenues, and represented 16.9% and 36.7% of our total gross margin, for thethree months ended March 31, 2004 and 2003, respectively. Licensing contractsare complex and depend upon many factors including completion of milestones,allocation of values to delivered items, and customer acceptances. Although weattempt to make these factors predictable, many of these factors requiresignificant judgments.

 

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 March 31, 2004, we had an accumulated deficit of$180.5 million.

 

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-

 

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speed transmission technologyfor data storage applications, and DVDO, a provider of digital video processingsystems for the CE market.

 

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 achieveddouble-digit sequential revenue growth in each fiscal quarter, resulting inrecord annual revenue of $81.5 million, which was a 57% increase from 2001revenue levels. We also began to see the benefits of our diversificationstrategy, which resulted in establishing a presence in the CE and storagemarkets. Additionally, we were able to successfully leverage our intellectualproperty to generate $6.7 million of development, licensing and royaltyrevenue. We also focused on improving our profitability and reducing our cashusage.

 

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.

 

**Outlook**

 

We expect 2004revenue to increase from the level achieved in 2003, and believe our revenue inthe second quarter of 2004 will grow 8-13% sequentially from the first 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 computersand graphics cards containing our products increase during the year. Second, inthe CE market we have had a number of important design wins, some which beginmass production in early 2004 and we expect the production of other designsalready in mass production to increase during the year. 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 fromperiod to period and may continue to do so in the future; because of their highmargin content 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 expect ouroverall gross margins to decline 100-200 basis points in the second quarter of2004, relative to the first quarter of 2004 primarily as a result of additionalprice pressures and product mix. However, we expect our gross margin percentage 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”), especially for products inthe PC market, and higher manufacturing overhead spending to support increasedproduction levels for products in all three of our markets.

 

Excludingnon-cash charges for stock compensation expense, we expect the dollar amount ofour R&D expense in the second quarter of 2004 to increase approximately 10- 20% from the first quarter of 2004. R&D expense will

 

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be incurred for enhancements toexisting products and for further development of technology related to consumerelectronics and storage applications. Excluding non-cash charges for stockcompensation expense, we expect the dollar amount of our SG&A expense todecrease by approximately 5 - 10% during the second quarter of 2004, primarilyas a result of the reduced costs associated with the Audit Committeeexamination. 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 future periodsas a result of previous stock option repricings, stock options assumed inconnection 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.

 

During 2004and future periods, we may also incur non-cash expenses for the impairment oramortization of intangible assets.

 

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 47% of our revenue in the first quarter of2004 and 40% of our revenue in 2003. Additionally, the percentage of revenue generated through distributorstends to be significant, since many OEM’s rely upon third party manufacturersor distributors to provide purchasing and inventory management functions. Inthe first quarter of 2004, 44% of our revenue was generated throughdistributors, compared to 36% in 2003. Our licensing revenue is not generatedthrough distributors, and to the extent licensing revenue increases faster thanproduct revenues, we would expect a decrease in the percentage of our totalrevenues generated through distributors.

 

A significantportion of our revenue is generated from products sold overseas. Sales tocustomers in Asia, including distributors, generated 71% of our revenue in thefirst quarter of 2004 and 2003, respectively. The reason for our geographicalconcentration in Asia is that most of our products are part of flat paneldisplays, graphic cards and motherboards, the majority of which aremanufactured in Asia. The percentage of our revenue derived from any country isdependent upon where our end customers choose to manufacture their products.Accordingly, variability in our geographic revenue is not necessarilyindicative of any geographic trends, but rather is the combined effect of newdesign wins and changes in customer manufacturing locations. All revenue todate has been denominated in U.S. dollars.

 

In 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 atMarch 31, 2004 was $2.9 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 require customeracceptance of deliverables, in which case we would defer recognition of revenueuntil the licensee has accepted the deliverables and either payment has beenreceived or is expected within 90 days of acceptance. Certain licensingagreements provide for royalty payments based on agreed upon royalty rates.Such rates can be fixed or variable depending on the terms of the agreement.The amount of revenue we recognize is determined based on a time period or onthe agreed-upon royalty rate, extended by the number of units shipped by thecustomer. To determine the number of units shipped, we rely upon actual royaltyreports from our customers when available, and rely upon estimates in lieu ofactual royalty reports when we have a sufficient history base of receivingroyalties from a specific customer for us to make an estimate based onavailable information from the licensee such as quantities held, manufacturedand other information. These estimates for royalties necessarily involve theapplication of management judgment. As a result of our use of estimates,period-to-period numbers are “trued-up” in the following period to reflectactual 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 reviewcollectibility 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 March 31, 2004, we had $19.8million 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’s forecastof customer demand. Customer demand is dependent on many factors and requiresus to use significant judgment in our forecasting process. We must also makeassumptions regarding the rate at which new products will be accepted in themarketplace and the rate at which customers will transition from older productsto newer products. Generally, inventories in excess of six months demand arewritten down to zero and the related provision is recorded as a cost ofrevenue. While we endeavor to accurately predict demand and stock commensurateinventory levels, we may record unanticipated material inventory write-downs inthe 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. An impairment test was not performed in the three month period endedMarch 31, 2004, as no event has occurred that would provide an indication ofimpairment.

 

*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 numerousassumptions and estimates, such as the market value of the space and the timeit will take to sublease the space. Our estimates are based on historicalexperience, input from 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 of Operationsfor the Three Months Ended March 31, 2004 Compared to Results of Operations forthe Three Months Ended March 31, 2003**

 

REVENUE

 
|                                 |   | **Three  months ended March 31,** |   |     |   |
|--------------------------------------|--------|-----------------------------------|--------|----------|--------|
|                                 |   | **2004**                          |   | **2003** |   | **Change** |   |
|                                 |   | **Dollars in  thousands**         |   |     |   |
| Personal Computers                   |   | $                                 | 9,667  |     | $      | 8,793 |   | 9.9 | % |
| Consumer Electronics                 |   | 11,367                            |   | 3,250    |   | 249.8 | % |
| Storage products                     |   | 11,016                            |   | 7,679    |   | 43.5 | % |
| Product revenue                      |   | 32,050                            |   | 19,722   |   | 62.5 | % |
| Percentage of total revenue          |   | 89.4                              | %      | 79.9     | %      | 9.5 | pts  |
| Development, licensing and royalties |   | 3,808                             |   | 4,954    |   | (23.1% | ) |
| Percentage of total revenue          |   | 10.6                              | %      | 20.1     | %      | (9.5pts | ) |
| Total revenue                        |   | $                                 | 35,858 |     | $      | 24,676 |   | 45.3 | % |

 

REVENUE (with development,licensing and royalty revenues, collectively licensing revenues, by productline)

 
|                 |   | **Three months ended March 31,** |       |     |   |
|----------------------|--------|----------------------------------|------------|----------|--------|
|                 |   | **2004**                         | ** ** | **2003** |   | **Change** |   |
|                 |   | **Dollars in thousands**         |       |     |   |
| Personal Computers   |   | $                                | 9,680      |     | $      | 8,944 |   | 8.2 | % |
| Consumer Electronics |   | 12,282                           |       | 4,298    |   | 185.8 | % |
| Storage products     |   | 13,896                           |       | 11,434   |   | 21.5 | % |
| Total revenue        |   | $                                | 35,858     |     | $      | 24,676 |   | 45.3 | % |

 

Revenue was $35.9 million forthe first quarter of 2004, an increase of 45.3% from the year ago quarter. Theincrease in revenue is primarily due to increased sales of CE products, whichcontributed an additional $8.1 million ($8.0 million including licensing) ofrevenue, increased sales of storage products, which contributed an additional$3.3 million ($2.5 million including licensing) in revenue, and increased salesof PC products, which contributed $0.9 million ($0.7 million, includinglicensing), offset by a $1.1 million decrease in overall licensing revenue. 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 weakness in the PC market. We license our technology in each ofour areas of business, but usually limit the scope of the license to marketareas that are complementary to our products sales and that do not directlycompete with our direct product offerings. The decrease in development,licensing and royalty revenues as a component of total revenues was primarilydue to the inherently uneven nature of our licensing revenues.

 

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**COSTOF REVENUE AND GROSS MARGIN**

 
|                                                                               |   | **Three months ended March 31,** |   |     |   |
|------------------------------------------------------------------------------------|--------|----------------------------------|--------|----------|--------|
|                                                                               |   | **2004**                         |   | **2003** |   | **Change** |   |
|                                                                               |   | **Dollars in thousands**         |   |     |   |
| Product gross margin (excluding licensing revenue)                                 |   | $                                | 17,535 |     | $      | 8,667 |   |   |   |
| Percentage of product revenue                                                      |   | 54.7                             | %      | 43.9     | %      | 10.8 | pts |
| Gross margin                                                                       |   | 21,343                           |   | 13,621   |   |   |   |
| Percentage of total revenue                                                        |   | 59.5                             | %      | 55.2     | %      | 4.3 | pts |
| Stock compensation expense                                                         |   | 1,152                            |   | (135     | )      |   |   |
| Product gross margin (excluding stock compensation expense and  licensing revenue) |   | 18,687                           |   | 8,532    |   |   |   |
| Percentage of product revenue                                                      |   | 58.3                             | %      | 43.3     | %      | 15 | pts |
| Gross margin (excluding stock compensation expense)                                |   | $                                | 22,495 |     | $      | 13,486 |   |   |   |
| Percentage of total revenue                                                        |   | 62.7                             | %      | 54.7     | %      | 8 | pts |

 

Cost of revenueconsists primarily of costs incurred to manufacture, assemble and test ourproducts, as well as related overhead costs. Gross margin (revenue minus costof revenue, as a percentage of revenue was 59.5%, and 55.2% for the three monthperiods ended March 31, 2004 and 2003, respectively), and excluding non-cashstock compensation expense (benefit), was 62.7% and 54.7% for the three-monthperiods ended March 31, 2004 and 2003, respectively. The increase in grossmargin is attributable primarily to the effect of leverage on higher volume,lower manufacturing costs, higher pricing during the first quarter of 2004, andthe impact, during the first quarter of 2003, of certain yield and qualityissues related to certain new products and higher sales of storage IC products,which have lower margins relative to our other volume products. Non-cashstock compensation expense (benefit) associated with cost of revenue was $1.2million and $(135,000) for the three-month periods ended March 31, 2004 and2003, respectively.

 

**OPERATINGEXPENSES**

 
|                                             |                                 | **Three months ended March 31,** |   |     |   |
|--------------------------------------------------|--------------------------------------|----------------------------------|--------|----------|--------|
|                                             |                                 | **2004**                         |   | **2003** |   | **Change** |   |
|                                             |                                 | **Dollars in thousands**         |   |     |   |
| Research and development (1)                     |                                 | $                                | 10,585 |     | $      | 8,837 |   | 19.8 | % |
| Percentage of total revenue                      |                                 | 29.5                             | %      | 35.8     | %      | (6.3 | )pts |
| Selling, general and administrative (2)          |                                 | 6,947                            |   | 4,308    |   | 61.3 | % |
| Percentage of total revenue                      |                                 | 19.4                             | %      | 17.5     | %      | 1.9 | pts |
| Stock compensation expense                       |                                 | 12,068                           |   | (362     | )      | 3433.7 | % |
| Percentage of total revenue                      |                                 | 33.7                             | %      | -1.5     | %      | 35.2 | pts |
| Amortization of intangible assets                |                                 | 357                              |   | —   |   | 100.0 | % |
| Percentage of total revenue                      |                                 | 1.0                              | %      |     |   |   |   |
| Restructuring                                    |        | —                           |   | 986      |   | (100.0 | )% |
| Patent defense and acquisition integration costs |                                 | 165                              |   | 1,213    |   | (86.4 | )% |
| Interest income and other, net                   |                                 | 84                               |   | 109      |   | (22.9 | )% |
| Gain on escrow settlement, net                   |                                 | $                                | — |     | $      | 4,618 |   | (100.0 | )% |

 

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(1)               Excludesnon-cash stock compensation expense of $6.2 million and $127,000 for the threemonth periods ended March 31, 2004 and 2003, respectively

 

(2)               Excludesnon-cash stock compensation expense (benefit) of $4.7 million and $(354,000)for the three month periods ended March 31, 2004 and 2003, respectively

 

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*Research and Development.  *R&Dexpense consists primarily of compensation and related costs for employees,fees for independent contractors, the cost of software tools used for designingand testing our products, and costs associated with prototype materials.R&D expense, excluding non-cash stock compensation expense, was $10.6million, or 29.5% of revenue, for the first quarter of 2004, compared to $8.8million, or 35.8% of revenue, for the first quarter of 2003. The increase in2004 was primarily due to an increase in the number of R&D projects tosupport the multiple markets in which we operate, as well as additionalpersonnel, including personnel from TransWarp Networks, which we acquiredduring the second quarter of 2003. R&D excludes non-cash stock compensationexpense of $6.2 million and $127,000 for the three-month periods ended March31, 2004 and 2003, respectively. Including stock compensation expense, R&Dexpense was $16.8 million and $9.0 million or 46.8% and 36.4% of revenue forthe three month periods ended March 31, 2004 and 2003, respectively. Excludingnon-cash charges for stock compensation expense, we expect the dollar amount ofour R&D expense in the second quarter of 2004 to increase approximately 10- 20% from the first quarter of 2004.

 

*Selling, General and Administrative.  *SG&Aexpense consists primarily of employee compensation and benefits, salescommissions, and marketing and promotional expenses. Excluding non-cash stockcompensation expense, SG&A expense was $6.9 million, or 19.4% of revenuefor the first quarter of 2004, compared to $4.3 million, or 17.5% of revenuefor the first quarter of 2003. The increase in spending for 2004 can beattributed to the increased headcount to support the increased rate of growthof the Company, and approximately $1.0 million incurred during the firstquarter of 2004 relating to the costs associated with the Audit Committeeexamination. SG&A excludes non-cash stock compensation expense (benefit) of$4.7 million and $(354,000) for the three-month periods ended March 31, 2004 and2003, respectively. Including stock compensation expense, SG&A expense was$11.6 million and $4.0 million or 32.5% and 16.0% of revenue for the threemonth periods ended March 31, 2004 and 2003, respectively. Excluding non-cashcharges for stock compensation expense, we expect the dollar amount of ourSG&A expense to decrease by approximately 15 - 20% during the secondquarter of 2004.

 

*Stock Compensation.  *Stockcompensation expense (benefit) was $12.1 million or 33.7% of revenue for thefirst quarter of 2004 and $(362,000) or (1.5)% of revenue for the three monthperiod ended March 31, 2003. The increase in total stock compensation can beattributed primarily to the higher stock price during the first quarter of 2004and the resultant impact on expense relating to our repriced options offset tosome extent by a decrease in expense associated with the options granted inconnection with acquisitions and a decline in the number of options subject tovariable 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$17.8 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 quarter ended March 31, 2004.

 

*Amortization of Intangible Assets.  *Duringthe first quarter of 2004, we recorded amortization of intangible assetsamounting to $357,000, relating to intangible assets on our balance sheet,pursuant to our acquisition of Transwarp Netwoks, Inc. during the secondquarter of 2003. We did not have any expense relating to amortization ofintangible assets during the three-month period ended March 31, 2003.

 

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

 

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-cash severance-relatedcosts 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 options thatwere 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 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 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 recordedrestructuring expense of $986,000 in the first quarter of 2003, consisting ofcash severance-related costs of $340,000 and non-cash severance-related costsof $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 a tenant,the sublease 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 of November 2005.The following table presents restructuring activity for 2001 throughMarch 31, 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                        |   | (4                          | )      | (223                   | )      | —                |   | (227      | )      |
| Balance as of March 31, 2004         |   | $                           | 33     |                   | $      | 1,615                 |   | $         | — |   | $ | 1,648 |   |

 

*Patent defense costs.  *Patentdefense costs were $0.2 million for the first quarter of 2004 compared to $1.2million during the same period in 2003. Patent defense costs are related to thelawsuit we filed against Genesis in April 2001, and acquisitionintegration costs represent costs incurred to integrate CMD and SCL. Thedecrease in 2004 compared to 2003 is attributable to a lower level of activityduring the first quarter of 2004. However, we expect to incur significantpatent defense costs through at least the fourth quarter of 2004. The amount oflegal fees incurred in 2004 will depend on the duration of the litigation, aswell as the nature and extent of the litigation activities. We are not able toaccurately estimate the amount of legal fees we will incur.

 

*Interest Income and other, net.  *Thisprincipally includes interest income and interest expense. The net amount was$84,000 for the first quarter of 2004, compared to $109,000 for the firstquarter of 2003. The decrease is principally due the lower interest ratesduring 2004, offset by higher cash balances and lower debt balances.

 

*Gain on escrow settlement, net.  *Duringthe quarter ended March 31, 2003, we recognized a net gain of $4.6 millionassociated with the settlement of an escrow claim against the principal sellingshareholders of CMD.

 

*Provision for Income Taxes.  *Forthe quarter ended March 31, 2004, we have recorded a provision for income taxesof $317,000. This includes approximately $217,000 relating to withholding taxespayable in connection with our licensing contracts, and a provision of $100,000relating to taxes in foreign jurisdictions where we have recently commencedoperations and estimated provision for U.S. alternative minimum taxes for thefiscal year ending December 31, 2004. At March 31, 2004, we had a netoperating loss carryforward for federal income tax purposes of approximately$71.4 million that expires in various years through 2023. These future taxbenefits have not been recognized as an asset on our balance sheet due touncertainties surrounding our ability to generate sufficient taxable income infuture periods to realize these tax benefits. Under the Tax Reform Act of 1986,the amounts of, and benefits from, net operating loss carryforwards may berestricted or limited in certain circumstances. We do not expect to be subjectto these restrictions or limitations.

 

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**LIQUIDITY,CAPITAL RESOURCES AND FINANCIAL CONDITION**

 
|                                                    |   | **March 31,  2004**              |   | **December 31,  2003** |   | **Change** |   |
|---------------------------------------------------------|--------|----------------------------------|--------|------------------------|--------|------------|--------|
|                                                    |   | **Dollars in thousands**         |   |                   |   |
| Cash and cash equivalents                               |   | $                                | 40,199 |                   | $      | 24,059     |   | $ | 16,140 |   |
| Short term investments                                  |   | 9,459                            |   | 13,195                 |   | (3,736     | )      |
| Total cash, cash equivalents and short term investments |   | 49,658                           |   | 37,254                 |   | 12,404     |   |
|                                                    |   |                             |   |                   |   |       |   |
| Percentage of total assets                              |   | 47.3                             | %      | 42.5                   | %      | 4.8 pts    |   |
|                                                    |   |                             |   |                   |   |       |   |
| Total current assets                                    |   | 80,678                           |   | 63,023                 |   | 17,655     |   |
| Total current liabilities                               |   | 33,336                           |   | 25,349                 |   | 7,987      |   |
| Working capital                                         |   | $                                | 47,342 |                   | $      | 37,674     |   | $ | 9,668 |   |
|                                                    |   |                             |   |                   |   |       |   |
|                                                    |   | **Three months ended March 31,** |   |
|                                                    |   | **2004**                         |   | **2003**               |   | **Change** |   |
|                                                    |   |                             |   |                   |   |       |   |
| Cash provided by (used in) operating activities         |   | $                                | 9,027  |                   | $      | (5,162     | )      | $ | 14,189 |   |
| Cash provided by investing activities                   |   | 2,558                            |   | 1,811                  |   | 747        |   |
| Cash provided by financing activities                   |   | 4,555                            |   | 2,063                  |   | 2,492      |   |
| Net increase (decrease) in cash and cash equivalents    |   | $                                | 16,140 |                   | $      | (1,288     | )      | $ | 17,428 |   |

 

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 and cash flows from operations. AtMarch 31, 2004, we had $47.3 million of working capital and $49.7 millionof cash, cash equivalents and short-term investments. If we are not able togenerate cash from operating activities, stock option exercises, and proceedsfrom sales of shares under our employee stock purchase plan, we will liquidateshort-term investments or, to the extent available, utilize credit arrangementsto 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 $19.1 million at March 31, 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 March2004 versus during December 2003. The days of sales outstanding (“DSO”) was 49days at March 31, 2004, compared to 38 days at December 31, 2003. Theincrease in the DSO days is primarily as a result of the increase in the March2004 versus December 2003 distributor shipments. We expect the DSO days to bein the 45-50 days range during the second quarter of 2004.

 

Inventoriesdecreased to $9.6 million at March 31, 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 5.6 as at March 31, 2004 from 5.1 as atDecember 31, 2003. Inventory turns are computed on an annualized basis,and are a measure of the number of times inventory is replenished during theyear. Our inventory turns increased primarily due to higher business volume duringthe first quarter of 2004 and lower inventory balances as at March 31, 2004. Weexpect this measure to be at the 5.0 to 5.5 level during the second quarter of2004.

 

Accountspayable and accrued liabilities increased to $9.2 million and $13.7 million,respectively, at March 31, 2004 from $6.4 million and $9.9 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 primarily due to an increase in deferredlicense revenue of $3.7 million.

 

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Deferredmargin on sales to distributors increased to $9.2 million at March 31,2004 from $7.3 million at December 31, 2003. The increase is principallydue to the effect of increased distributor related shipments at March 31, 2004compared to December 31, 2003.

 

*Operating activities*

 

Operatingactivities generated $9.0 million of cash during the first quarter of 2004. Forthe first quarter of 2004, our net income excluding depreciation, stockcompensation expense, amortization of intangible assets was $5.7 million.Increases in accounts payable, accrued liabilities, deferred margin on sales todistributors and decreases in inventories, prepaid expenses and other assetsoffset by an increase in accounts receivable contributed $3.3 million.Operating activities used $5.2 million of cash during the first quarter of2003.  During the first quarter of 2003,our net loss excluding depreciation, stock compensation expense, a non-cashgain on escrow settlement and the non-cash portion of our restructuring chargeswas $230,000, which accounts for some of the cash used in operatingactivities.  Other uses of cash foroperating activities consisted of decreases in accounts payable and accruedliabilities of $4.1 million, and an increase in accounts receivable of $2.0million.  These uses of cash were offsetin part by a $409,000 decrease in prepaid expenses and other assets.

 

*Investing and financing activities*

 

Investingactivities provided $2.6 million and $1.8 million of cash during the threemonths ended March 31, 2004 and 2003. The source of cash for both periods wasnet proceeds from sales of short-term investments, partially offset by capitalexpenditures.

 

We generated$4.6 million and $2.1 million from financing activities during the three monthsended March 31, 2004 and 2003. Cash provided by financing activities in bothperiods was primarily from stock option exercises and proceeds from sales of sharesunder our employee stock purchase plan, partially offset by repayments of ourcapital 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 March 31,2004) 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 bearsinterest at 5% and requires monthly payments through its maturity inFebruary 2005. As of March 31, 2004, $1,234,000 was outstanding underthese term loans. 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 March 31, 2004.During the period ended March 31, 2004, we entered into an agreement to extendthis debt facility by way of a revolving line of credit with an availability ofup 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 throughAugust 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 downagainst this line of credit as at March 31, 2004. As of March 31, 2004, we werein compliance with all covenants.

 

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Future minimumpayments for our operating leases, debt and inventory related purchaseobligations outstanding at March 31, 2004 are as follows (in thousands):

 
|                             |   |      |   | **Payments due in**       |   |
|----------------------------------|--------|-----------|--------|-------------------------------------|--------|
| **Contractual obligations** |   | **Total** |   | **Less than 1 year** |   | **1-3 years** |   | **3-5 years** |   | **More than 5 years** |   |
| Debt obligations                 |   | $         | 1,234  |                                | $      | 1,234 |   | $ | — |   | $ | — |   | $ | — |   |
| Operating lease obligations      |   | 9,122     |   | 2,512                               |   | 3,104 |   | 2,064 |   | 1,442 |   |
| Inventory purchase obligations   |   | 5,734     |   | 5,734                               |   | — |   | — |   | — |   |
| Total                            |   | $         | 16,090 |                                | $      | 9,480 |   | $ | 3,104 |   | $ | 2,064 |   | $ | 1,442 |   |

 

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 $5-6 million during the remainder of the 2004 fiscal yearfor equipment, furniture and software.

 

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.

 

**Factors Affecting 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 orpart of 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 is early in theirlifecycle and is difficult to predict. The Digital Visual Interface (“DVI”)specification, which is based on technology developed by us and used in many ofour products, was first published in April 1999. We completed our firstgeneration of consumer electronics and storage IC products in mid-to-late 2001.In addition, the preliminary serial ATA specification was first published inAugust 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 $7.9 million for the three months ended March 31, 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 deals being completedfor any given period, the timing of which is not always predictable and isespecially susceptible to delay beyond the period in which completion isexpected, and our concentrated dependence on a few licensees in any period forsubstantial 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 mattersraised in that suit; and.

 

•                  any legalmatters resulting from the recent audit committee examination, in particularthe shareholder and derivative lawsuits against the company and its directorsand some of its officers.

 

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 willmaintain the confidentiality of our proprietary information. Licensingcontracts are complex and depend upon many factors including completion ofmilestones, allocation of values to delivered items, and customer acceptances.Many of these factors require significant judgments. Licensing revenues couldfluctuate significantly from period to period because it is heavily dependenton a few key deals being completed in a particular period, the timing of whichis difficult to predict. Because of their high margin content, licensingrevenues can have a disproportionate impact on gross margins and profitability.Also, generating revenue from licensing arrangements is a lengthy and complexprocess that may last beyond the period in which efforts begin, and once anagreement is in place, the timing of revenue recognition may be dependent oncustomer acceptance of deliverables, achievement of milestones, our ability totrack and report progress on contracts, customer commercialization of thelicensed technology, and other factors. In addition, in any period, ourexpectation of licensing revenue is or may be dependent on one or a fewlicenses being completed. Licensing that occurs in the course of actual orcontemplated litigation is subject to risk that the adversarial nature of thetransaction will 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 may require greater management time andcompany resources to implement and monitor. We incurred approximately $1.1million of costs associated with the Audit Committee examination in the fourthquarter of 2003 and an additional $1.0 million in the first quarter of 2004.These costs include payments made by us pursuant to indemnity agreementsbetween us and certain individuals. Pending litigation costs associated withthe examination cannot be accurately projected for the following quarters andcould be significant. In addition, measures being implemented as a result ofthis examination, previously described in our 2003 Form 10-K, may adverselyaffect our operations.

 

Further, certainof our officers and directors have been named as defendants in shareholderderivative litigation, which alleges, among other matters, that as a result ofthe examination, we will be required to restate our financial results for 2002and 2003 and that such a restatement would be due to breaches by the individualdefendants of the fiduciary duties to us. In addition, we and certain of ourofficers and directors have been named as defendants in securities class-actionlitigation, which alleges that we had materially overstated our licensingrevenue, net income and financial results during the time period fromApril 15, 2002 to November 15, 2003. Although the Audit Committee hascompleted its examination and concluded that no changes to our financial statementsor the results previously announced for the quarter ended September 30,2003, are required, these lawsuits may be amended or

 

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continued, or new suits may bebrought in connection with the delayed filing of the Form 10-Q or theAudit Committee’s examination. Such litigations could be time-consuming,require us to incur significant expenses and could divert our management’sattention and resources. In addition, any unfavorable outcome of any of such litigationcould adversely impact our business, financial condition and results ofoperations.

 

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 beforeDecember 31, 2004. Should we fail to timely make any such filing, NASDAQhas informed us that we will not be entitled to a new hearing with the NASDAQstaff and our common stock may be transferred to the NASDAQ SmallCap Market,provided we could demonstrate compliance with applicable maintenance criteriafor such market and an ability to sustain long-term compliance, or immediatelydelisted from the NASDAQ National Market. The NASDAQ staff has reserved theright to reconsider the terms of the foregoing exception permitting continuedlisting of our common stock upon a review of our publicly filed financialstatements or if any event, condition or circumstance that exists or developsthat would, in the opinion of the staff, make continued listing of our stockinadvisable or unwarranted.

 

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 processing solutionsdesigned by large original equipment manufacturers. We expect competition forHDMI products from the other HDMI founders and adopters, including Hitachi,Matsushita, Philips, Sony, Thomson and Toshiba. Toshiba and Matsushita have orare close to having working HDMI solutions.

 

In the storagemarket, our fibre channel products face competition from companies sellingsimilar discrete products, including Agilent, PMC Sierra and Vitesse, fromother fibre channel Serializer-Deserializer (“SerDes”) providers who licensetheir core technology, such as LSI Logic, and from companies that sell HostBust Adapters (“HBA”) controllers with integrated SerDes, such as QLogic andAgilent. In the future, our current or potential customers may also developtheir own proprietary 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

 

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intentions to develop serialATA controllers. We also compete against Intel and other motherboard chipsetmakers that have integrated serial ATA functionality into their chipsets.

 

Our parallel ATAproducts 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 development relationshipswith current or potential customers and may be able to leverage their existingrelationships to discourage these customers from purchasing products from us orpersuade them to replace our storage products with theirs. Many of ourcompetitors have longer operating histories, greater presence in key markets,better name recognition, access to larger customer bases and significantlygreater financial, sales and marketing, manufacturing, distribution, technicaland other resources than we do. In addition, some of our competitors couldmerge (for example, Genesis and Pixelworks announced, and then terminated, sucha merger), which may enhance their market presence. As a result, they may beable to adapt more quickly to new or emerging technologies and customer requirements,or devote more resources to the promotion and sale of their products. We cannotassure you that we can compete successfully against current or potentialcompetitors, or that competition will not reduce our revenue and increase ourlosses.

 

**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. The 2003 DVI adoption rate is estimatedto be in the range of 15-20%. Adoption of the DVI specification may be affectedby the availability of computer components able to communicate DVI-compliantsignals, such as transmitters, receivers, connectors and cables necessary toimplement the specification. Other specifications may also emerge that couldadversely affect the acceptance of the DVI specification. For example, a numberof companies 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 oremerging technologies within the PC industry. The PC industry has slowed andthe adoption 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

 

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emerging technologies withinthe PC industry, which experienced a slowdown in growth during the second halfof 2000 that has continued through 2003. We cannot predict the duration orseverity of the downturn in the PC and display market, or in the generaleconomy, or its effect on our revenue and operating results, including theadoption of these new or emerging technologies. If the market for PCs andPC-related displays continues to grow at a slow rate or contracts whether dueto reduced demand from end users, macroeconomic conditions or other factors,our business and results of operations could be negatively affected.

 

Although 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.

 

**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 for phasingin digital television in the past. We cannot predict whether the FCC willfurther delay its rules relating to the digital television requirementsand timetables. In the event that additional regulatory activity, either in theUnited States or internationally, delay or postpone the transition to digitaltelevision beyond the anticipated time frame, that could reduce the demand forour 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.

 

**Ourability to increase sales of our products for display systems depends on hostsystem manufacturers including DVI-compliant transmitters in their systems.**

 

Our success inthe PC market depends on increasing sales of our receiver products to displaymanufacturers. To increase sales of our receiver products, we need computermanufacturers to incorporate DVI-compliant transmitters in their systems,making these systems digital-ready. During 2002, we introduced a low-costadd-in card that can be used in conjunction with Intel’s 845G chip set toprovide an all-digital connection to flat panels. Intel’s 845G chip set isintended to provide an all-digital path on the motherboard bus, and should makeit easier to provide digital video out. Use of Intel’s 845G chip set, or anydigital path chip set, is not universal and may not gain market acceptance. Ifcomputers are not digital-ready, they will not operate with digital displays,which will limit and may reduce the demand for our digital host and receiverproducts.

 

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**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 Intel orother motherboard manufacturers integrate the functionality of our products,such as serial ATA, into their chips and chip sets; and

 

•                  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.

 

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**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 months ended March 31, 2004,shipments to World Peace International, an Asian distributor, generated 15% ofour revenue, and shipments to Microtek, a distributor, generated 11% of ourrevenue. For the year ended December 31, 2003, shipments to World PeaceInternational, generated 15% of our revenue, and shipments to Weikeng, adistributor, generated 8% of our revenue. For the year ended December 31,2002, shipments to World Peace International generated 15% of our revenue, andshipments to Weikeng generated 11% of our revenue. In addition, an end-customermay buy through multiple distributors, contract manufacturers, and / ordirectly, which could create an even greater concentration. We cannot becertain that customers and key distributors that have accounted for significantrevenue in past periods, individually or as a group, will continue to sell ourproducts and generate revenue. As a result of this concentration of ourcustomers, our results of operations could be negatively affected if any of thefollowing occurs:

 

•                  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 generated44% of our revenue for the three months ended March 31, 2004, 42% of ourrevenue for the year ended December 31, 2003, and 42% of our revenue for theyear ended December 31, 2002. Selling through distributors reduces ourability to forecast sales and increases the complexity of 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 thefinancial condition and credit-worthiness of our distributors, many of whichare located outside of the United States, and the majority of which are notpublicly traded.

 

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

 

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**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.

 

Accomplishingall of this is extremely challenging, time-consuming and expensive and there isno assurance 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;

 

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•                  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 business andmaintain 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.

 

**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.Cyclicality has also accelerated decreases in average selling prices per unit.We may experience fluctuations in our future financial results because ofchanges in industry-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 these circumstancescould 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 the threemonths ended March 31, 2004, 73% of our revenue, and for the years endedDecember 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 payments madeto 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 be challenged,invalidated or circumvented and effective patent, copyright, trademark andtrade secret protection may be unavailable or limited in foreign countries. Itmay be possible for a third party to copy or otherwise obtain and use ourproducts or technology without authorization, develop similar technologyindependently or design around our patents in the United States and in otherjurisdictions. 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 afterreceipt of an assertion of infringement will cut off all commercialrelationships with the party making the assertion, thus making assertionsagainst suppliers, customers, and key business partners unwise. Accordingly, ifwe forgo making such claims, we may risk creating legal and equitable defensesfor 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 the next-generationdigital interface specification for consumer electronics products. Version 1.0of the specification was published for adoption on December 9, 2002. TheHDMI specification combines high-definition video and multi-channel audio inone digital interface and uses Silicon Image’s patented underlying TMDStechnology**,**optionally, along withIntel’s HDCP as the basis for the interface. The founders of the working grouphave signed a founder’s agreement in which each commits to license certainintellectual property to each other, and to adopters of the specification.

 

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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 arelative disadvantage.

 

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 our patentsto any third party who otherwise might be interested in acquiring rights to useour patents in such products. Finally, Intel could endorse competing products,including a competing digital interface, or develop its own proprietary digitalinterface. Any of these actions could substantially harm our business andresults 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 our officers and directors have beennamed as defendants in consolidated shareholder derivative litigation. Thelawsuit alleges that as a result of the examination conducted by our AuditCommittee, we will be required to restate our financial results for 2002 and2003. The lawsuit further alleges that such a restatement would be due tobreaches by the individual defendants of their fiduciary duties to us, thatcertain of the individual defendants are liable to us for insider trading underCalifornia law, and that the individual defendants are liable to us formismanagement, abuse of control, and waste. We and certain of our officers havealso been named as defendants in consolidated securities class actionlitigation. Plaintiffs filed the action on behalf of a putative class of shareholderswho purchased our stock between April 15, 2002 and November 15, 2003.The lawsuit alleges that we had materially overstated our licensing revenue,net income and financial results during this time period, and that were beingforced to restate our financial results. With the announcement by the AuditCommittee of Silicon Image’s Board of Directors that it has completed itsexamination and that it has concluded that no changes to Silicon Image’spreviously announced financial results are required, the securities classaction litigation has been dismissed but the shareholder derivative litigationhas not been dismissed and the plaintiffs may amend that complaint once as amatter of right.

 

We believethat claims against us are without merit and we intend to defend vigorouslyagainst them. These suits and any others that may be brought, even ifmeritless, could require us to incur expenses and could divert our management’sattention and resources. In addition, any unfavorable outcome of any of these litigationscould adversely impact our business, financial condition and results ofoperations.

 

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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 the unlawfultrade practices complaint was granted and we filed an amended complaint againstGenesis alleging infringement of two of our U.S. patents. These patents relateto our DVI receiver products, which generate a significant portion of ourrevenue. The amended complaint seeks a declaration that Genesis has infringedour patents, that Genesis’ behavior is not licensed, an injunction to halt theimportation, sale, manufacture and use of Genesis DVI receiver chips thatinfringe our patents, and monetary damages. In April 2002, Genesisanswered and made counterclaims against us for non-infringement, license,patent invalidity, fraud, antitrust, unfair competition and patent misuse. Wefiled a motion to dismiss certain of Genesis’s counterclaims. In addition, wefiled a motion to bifurcate trial of the counterclaims to the extent the courtdoes not dismiss them. In May 2002, the Court granted our motion todismiss certain of the counterclaims, with leave to amend. Genesis re-filedcounterclaims against us for fraud and patent misuse. We filed another motionto dismiss these counterclaims. In August 2002, the Court granted ourmotion and dismissed Genesis’s re-filed counterclaims with prejudice. InDecember 2002, the parties entered into a memorandum of understanding (“MOU”)to settle the case. In January, the parties presented different interpretationsof the MOU to the Court. On July 15, 2003, the Court granted our motion tointerpret the MOU in the manner we requested, and ruled that Genesis hadengaged in efforts to avoid its obligations under the MOU. On August 6,2003, the Court entered a final judgment order based on its July 15, 2003ruling. Under the final judgment order, Genesis was ordered to make asubstantial cash payment, and to make royalty payments; although Genesis hasmade and continues to make cash payments to the Court, it may not have made allthe payments that are required under the final judgment order. We filed motionsfor reimbursement of some of some of expenses, including some of our legalfees, and for modification and/or clarification of certain items of thejudgment, and to hold Genesis in contempt of Court for breaching the protectiveorder in the case by disclosing secret information to at least one of ourcompetitors. On December 19, 2003, the Court granted our motions in partand denied them in part: the court issued an amended judgment, and held Genesisin contempt of Court for breaching the protective order. On January 16,2004, Genesis filed 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 these patentsto develop products that might compete with ours. If we are unsuccessful inthis litigation, we could be unable to prevent Genesis or others from using thetechnology covered by these patents. Even if we prevail in this litigation,uncertainties regarding the outcome prior to that time may reduce demand forour products, or Genesis’s use of our technology in products that compete withour products may reduce demand or pricing for our products. In addition, evenif the MOU is upheld on appeal, future disputes may occur, including thoseregarding whether and what intellectual property licenses were granted and thescope of any such licenses and the royalty rates and payment terms for suchlicenses, whether the MOU was breached, whether consent was fraudulentlyobtained, and whether a merger partner may succeed to the rights and/or theobligations under the MOU. These disputes may result in additional costly andtime-consuming litigation or the license of additional elements of ourintellectual property for free.

 

Any 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 significantvendors or customers, to enter into cross licenses or non-assertion agreementsrelating to patents or other intellectual property. This permits thecross-licensee, or beneficiary of a non-assertion agreement, to use certain orall of our patents and/or certain other intellectual property for free tocompete 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.

 

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:

 

•                  improve operationaland 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 months ended March 31, 2004 and for the yearended December 31, 2003, customers and distributors located in Taiwangenerated 26% and 34% of our revenue, respectively, and customers anddistributors located in Japan generated 21% 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,electricity or transportation, limiting the production capacity of our outsidefoundries or the 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 implementing an enterprise resource platform**

 

We are in theprocess of implementing an enterprise resource platform (ERP) system, and ofhosting that system on our site. The system is comprised of hardware andsoftware, and services, all of which we acquired from vendors; however, we arealso customizing portions of the system with in-house resources. This requirescareful management of the skills and resources to implement the ERP system andto establish disaster recovery plans. If we are unsuccessful, or if thehardware or software should fail, we could lose access to the data needed tobook and fill customer orders, ship products, and produce financial reports,which would have a material adverse effect on our business.

 

**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 indemnify certain of our licensing agreements customers for anyexpenses or liabilities resulting from third-party claims of infringements ofpatent, trademark, trade secret, or copyright rights by the technology welicense.  Certain of theseindemnification provisions are 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.

 

 

**Item 3. Quantitative and Qualitative Disclosures About Market Risk**

 

**Interest Rate 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 wouldnot be expected to have a material effect on our near-term results ofoperations or financial condition. Our long-term capital leaseobligations bear interest at fixed rates; therefore, our results of operationswould not be affected by immediate changes in interest rates.  Also, components of our stock compensationexpense are tied to our stock price. Changes in our stock price can have a significant affect on the amountrecorded as stock compensation expense.

 

**Foreign CurrencyExchange 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 should not have amaterial effect on our future operating results or cash flows; however, a longterm change in foreign currency rates would likely result in increased wafer,packaging, assembly or testing costs.

 

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**Item 4. Controls and Procedures**

 

(a)           *Evaluationof Controls and Procedures*. We maintain disclosure controls and procedures (as such term is definedin Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, asamended (the “Exchange Act”)) that are designed to ensure that informationrequired to be disclosed in our Exchange Act reports is recorded, processed,summarized and reported within the time periods specified in the SEC’s rulesand forms, and that such information is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate, to allow timely decisions regarding required disclosure.

 

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 auditors that, in connection with the 2003year-end audit, they had identified a reportable condition relating to internalcontrols.  The evaluation also took intoaccount a written confirmation of the reportable condition recently provided byour auditors stating they were aware of deficiencies in the Company’s internalcontrol structure design related to the overall internal control environmentregarding our Chief Executive Officer’s communication and operating style andhis periodic involvement in revenue recognition discussions.  Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our controls andprocedures as of the end of the period covered by this report were effective,except that with respect to the reportable condition and as the number andcomplexity of licensing transactions increase, the Company’s controlenvironment could and should be enhanced, as discussed below:

 

(b)           *Changesin Internal Controls*.  As aresult of our own evaluation, as well as recommendations provided by the AuditCommittee we are in the process of implementing a series of internal measuresdesigned to enhance the Company’s overall internal control environment.  These measures include (i) restructuringsome reporting relationships among management and clarifying management rolesand responsibilities, (ii) improving communication within the management teamand between the management team and the Board of Directors, including the AuditCommittee, (iii) formalizing licensing review processes by requiring additionaldocumentation of items necessary for licensing revenue recognition decisionsand increasing the standardization of licensing deliverables and post-contractcustomer support for revenue recognition purposes, (iv) adding additionalresources and personnel to key control functions and (v) implementing trainingand compliance programs.  Implementationof the measures is underway, but will by its nature be an ongoing effort,subject to the review of our Board of Directors, Audit Committee and auditors.

 

## **Part II.  Other Information**

 

## **Item 1.  Legal Proceedings**

 

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 the counterclaims,with leave to amend. Genesis re-filed counterclaims against us for fraud andpatent misuse. We filed another motion to dismiss these counterclaims. InDecember 2002, the parties entered into a memorandum of understanding(MOU) to settle the case. In January, the parties presented differentinterpretations of the MOU to the Court. On July 15, 2003, the Courtgranted our motion to interpret the MOU in the manner we requested, and ruledthat Genesis 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. ThroughMarch 31, 2004, we have spent approximately $10.6 million on this matterand expect to continue to incur significant legal costs through at least thefourth quarter 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 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 have been 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 purport to sue the individual defendants onbehalf of Silicon Image. The lawsuit alleges 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. The lawsuit further alleges that such a restatement

 

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would be due to breaches by theindividual defendants of their fiduciary duties to Silicon Image; that certainof the individual defendants are liable to Silicon Image for insider tradingunder California law; and that the individual defendants are liable to SiliconImage for mismanagement, abuse of control, and waste. Before filing suit, theplaintiffs did not make a demand upon the board of directors to pursue any suchclaims directly on behalf of Silicon Image. Following the announcement by theAudit Committee of Silicon Image’s Board of Directors that it has completed itsexamination and that it has concluded that no changes to Silicon Image’spreviously announced financial results are required, the Company agreed toprovide plaintiffs with certain specified information concerning theexamination. Plaintiffs agreed to dismiss the lawsuit following theirgood-faith review of such information to confirm the independence, scope andadequacy of the examination. Although the Company, acting through the AuditCommittee of its Board of Directors, provided the specified information,plaintiffs have failed to dismiss the lawsuit. As a result, the Company hasfiled a cross-complaint for breach of contract, seeking an order dismissing thederivative action and awarding the Company its attorneys fees. The individualdefendants believe the lawsuit is without merit, and they intend to defend theaction vigorously if plaintiffs do not dismiss it. Plaintiffs may seek to amendthe complaint, and we cannot predict what claims plaintiffs might assert insuch an amended complaint.

 

Silicon Imageand certain of its officers have been named as defendants in consolidatedsecurities class action litigation captioned “In re Silicon Image, Inc.Securities Litigation, No. C-03-5579 JW PVT”, commenced onDecember 11, 2003 and pending in the United States District Court for theNorthern District of California. Plaintiffs filed the action on behalf of aputative class of shareholders who purchased Silicon Image stock betweenApril 15, 2002 and November 15, 2003. The lawsuit alleges that SiliconImage had materially overstated its licensing revenue, net income and financialresults during this time period, and that Silicon Image was being forced torestate its financial results. Following the announcement by the AuditCommittee of Silicon Image’s Board of Directors that it has completed itsexamination and that it has concluded that no changes to Silicon Image’spreviously announced financial results are required, the plaintiffs dismissedthe 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.  Changes in Securities and Use of Proceeds**

## ** **

In connectionwith our acquisition of Zillion Technologies, LLC, we are obligated under anexchange agreement to periodically issue to the two founders of Zillion sharesof our common stock as consideration for their membership interests in Zillionwhich we acquired and services provided pursuant to their employment agreementswith us.  The Zillion founders weregranted registration rights with respect to the shares to be issued under thisexchange agreement.  These issuances ofshares were made in reliance on an exemption from registration under Section4(2) of the Securities Act.  On March31, 2004, we issued 9,375 shares of our common stock to one of the Zillionfounders pursuant to the exchange agreement. The issuances of shares were made without general solicitation oradvertising and were only made to one individual.

 

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

## ** **

Notapplicable.

 

## **Item 4.  Submission of Matters to a Vote of SecurityHolders**

 

Notapplicable.

 

**Item5.  Other Information**

 

Notapplicable.

 

**Item 6. Exhibits and Reports on Form 8-K**

 

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(a)   Exhibits

 

Exhibit 10.35          Bonus Planfor Fiscal Year 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)   Reports on Form 8-K

 

On February23, 2004, we furnished a current report on Form 8-K to furnish under Item 12our press release and conference call transcript for the quarter and year endedDecember 31, 2003.

 

On March 3,2004, we filed a current report on Form 8-K to report under Item 5, tradingplans entered into by several officers and a member of the Board of Directorspursuant to Rule 10b5-1 under the Securities Exchange Act of 1934.

 

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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:  May 7, 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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