UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-Q





x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For quarterly period ended: September 30, 2010ORo
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934





For the transition period from                            to





Commission File Number: 000-26887





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 I.D. Number)





1060 East Arques Avenue, Sunnyvale, California 94085


(Address of principal executive office)(Zip Code)





(408) 616-4000


(Registrant’s telephone number, including area code)





N/A


(Former name, former address and former fiscal year,


if changed since last report)





Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  YesxNoo





Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  YesoNox





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





Large accelerated filer    o
Accelerated filer   xNon-accelerated filer   o
Smaller reporting company   o(Do not check if a smaller reporting company)





Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  YesoNox





CLASS

OUTSTANDING AT September 30, 2010Common Stock, $0.001 par value

77,572,777








Silicon Image, Inc.


Form 10-Q for the quarter ended September 30, 2010





Table of Contents





Part I Financial Information
3Item 1 Financial Statements (Unaudited)
3Condensed Consolidated Balance Sheets as of September 30, 2010 and December 31, 2009
3Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2010 and 2009
4Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2010 and 2009
5Notes to Condensed Consolidated Financial Statements
6Item 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations
19Item 3 Quantitative and Qualitative Disclosures About Market Risk
27Item 4 Controls and Procedures
29Part II Other Information
29Item 1 Legal Proceedings
29Item 1A Risk Factors
29Item 2 Unregistered Sales of Equity Securities and Use of Proceeds
45Item 3 Defaults Upon Senior Securities
45Item 4 Reserved
45Item 5 Other Information
45Item 6 Exhibits
45Signature
46





EXHIBIT 31.01


EXHIBIT 31.02


EXHIBIT 32.01


EXHIBIT 32.02







2
 
 Table of Contents


Part I. Financial Information





Item 1. Financial Statements (Unaudited)





Silicon Image, Inc.


Condensed Consolidated Balance Sheets


(in thousands)


(unaudited)








September 30, 2010


December 31, 2009ASSETSCurrent Assets:Cash and cash equivalents

$
33,635


$
29,756Short-term investments


150,932



120,866Accounts receivable, net of allowances for doubtful accounts

$1,421 at September 30, 2010 and $1,428 at December 31, 2009


24,174



21,664Inventories


11,595



7,746Prepaid expenses and other current assets


5,624



27,512Deferred income taxes


168



284Total current assets


226,128



207,828Property and equipment, net


11,729



14,449Deferred income taxes, non-current


2,644



2,336Intangible and other assets, net


666



825Total assets

$
241,167


$
225,438LIABILITIES AND STOCKHOLDERS' EQUITYCurrent Liabilities:Accounts payable

$
16,242


$
10,141Accrued and other current liabilities


15,559



28,150Deferred margin on sales to distributors


10,303



2,944Deferred license revenue


4,610



3,111Total current liabilities


46,714



44,346Other long-term liabilities


10,810



9,573Total liabilities


57,524



53,919Commitments and contingencies (See Note9)Stockholders’ Equity:Common stock


94



93Additional paid-in capital


472,015



463,189Treasury stock


(107,731
)


(106,562
)Accumulated deficit


(182,141
)


(186,139
)Accumulated other comprehensive income


1,406



938Total stockholders’ equity


183,643



171,519Total liabilities and stockholders’ equity

$
241,167


$
225,438







See accompanying Notes to Condensed Consolidated Financial Statements.


3
 Table of Contents


Silicon Image, Inc.


Condensed Consolidated Statements of Operations


(in thousands, except per share amounts)


(unaudited)








Three months ended September 30,


Nine months ended September 30,2010


2009


2010


2009Revenue:Product

$
46,117


$
30,716


$
110,774


$
94,747Licensing


14,387



6,440



28,589



20,257Total revenue


60,504



37,156



139,363



115,004Cost of revenue and operating expenses:Cost of product revenue (1)


22,587



16,801



56,898



52,284Cost of licensing revenue


67



156



103



626Research and development (2)


13,583



17,807



40,379



53,160Selling, general and administrative (3)


11,691



17,222



34,862



43,615Restructuring expense (Note 5)


99



348



952



8,205Amortization of intangible assets


37



1,473



112



4,419Impairment of goodwill


-



-



-



19,210Total cost of revenue and operating expenses


48,064



53,807



133,306



181,519Income (loss) from operations


12,440



(16,651
)


6,057



(66,515
)Interest income and other, net


556



696



1,790



2,233Income (loss) before provision for income taxes


12,996



(15,955
)


7,847



(64,282
)Income tax  expense (benefit)


3,531



(444
)


3,849



(2,113
)Net income (loss)

$
9,465


$
(15,511
)

$
3,998


$
(62,169
)Net income (loss) per share – basic and diluted

$
0.12


$
(0.21
)

$
0.05


$
(0.83
)Weighted average shares – basic


77,210



75,053



76,649



74,763Weighted average shares – diluted


78,124



75,053



77,665



74,763(1) Includes stock-based compensation expense

$
127


$
363


$
456


$
806(2) Includes stock-based compensation expense

$
687


$
2,374


$
2,057


$
5,365(3) Includes stock-based compensation expense

$
936


$
4,911


$
3,382


$
9,255









See accompanying Notes to Condensed Consolidated Financial Statements.




4
 Table of Contents


Silicon Image, Inc.


Condensed Consolidated Statements of Cash Flows


(in thousands)


(unaudited)








Nine Months Ended September 30,2010


2009Cash flows from operating activities:Net income (loss)

$
3,998


$
(62,169
)Adjustments to reconcile net income (loss) to cash provided by (used in) operating activities:Stock-based compensation expense


5,895



15,426Depreciation


5,872



6,814Amortization of investment premium


2,170



2,351Provision for doubtful accounts


32



42Asset impairment due to restructuring


184



226Amortization of intangible assets


112



4,419Loss on disposal and retirement of property and equipment


18



178Realized gain on sale of short-term investments


(130
)


-Deferred income taxes


-



5,536Impairment of goodwill


-



19,210Tax deficiency from employee stock-based compensation plans


-



(1,711
)Gain on derivative transactions


-



(211
)Excess tax benefits from employee stock-based transactions


-



(32
)Changes in assets and liabilities:Accounts receivable


(2,506
)


(18,543
)Inventories


(3,849
)


237Prepaid expenses and other assets


22,747



(1,437
)Accounts payable


7,492



7,403Accrued and other liabilities


(12,908
)


(3,669
)Deferred margin on sales to distributors


7,359



(4,253
)Deferred license revenue


2,997



1,951Cash provided by (used in) operating activities


39,483



(28,232
)Cash flows from investing activities:Proceeds from sales of short-term investments


95,784



110,716Purchases of short-term investments


(128,003
)


(148,592
)Purchases of property and equipment


(3,570
)


(2,855
)Other investing activities


(749
)


-Proceeds from sale of property and equipment


-



120Cash used in investing activities


(36,538
)


(40,611
)Cash flows from financing activities:Proceeds from issuances of common stock, net


2,932



2,543Payments for vendor financed purchases of software and intangibles


(1,250
)


(1,250
)Repurchase of restricted stock units for income tax withholding


(1,169
)


(280
)Excess tax benefits from employee stock-based transactions


-



32Cash provided by financing activities


513



1,045Effect of exchange rate changes on cash and cash equivalents


421



267Net increase (decrease) in cash and cash equivalents


3,879



(67,531
)Cash and cash equivalents — beginning of period


29,756



95,414Cash and cash equivalents — end of period

$
33,635



27,883Supplemental cash flow information:Net cash refund  for income taxes

$
18,725


$
4,766Restricted stock units vested

$
3,246


$
780Property and equipment purchased but not paid for

$
502


$
167Unrealized net gain (loss) on short-term investments

$
(113
)

$
220




See accompanying Notes to Condensed Consolidated Financial Statements.


5
 Table of Contents


Silicon Image, Inc.


Notes to Condensed Consolidated Financial Statements


September 30, 2010


(unaudited)








1. Basis of Presentation





In the opinion of management, the accompanying unaudited condensed consolidated financial statements of Silicon Image, Inc. (the “Company”, “Silicon Image”, “we” or “our”) included herein have been prepared on a basis consistent with our December 31, 2009 audited financial statements and include all adjustments, consisting of normal recurring adjustments, necessary to fairly state the condensed consolidated balance sheets of Silicon Image and our subsidiaries as of  September 30, 2010 and December 31, 2009 and the related condensed consolidated statements of operations for the three and nine months ended September 30, 2010 and 2009 and the related condensed consolidated statements of cash flows for the nine months ended September 30, 2010 and 2009. All significant intercompany accounts and transactions have been eliminated. These interim financial statements should be read in conjunction with the audited financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009. Financial results for the three and nine months ended September 30, 2010 are not necessarily indicative of future financial results.








2. Recent Accounting Pronouncements





In October 2009, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2009-14, Software (Accounting Standards Codification (ASC) Topic 985) - Certain Revenue Arrangements That Include Software Elements, a consensus of the FASB Emerging Issues Task Force.  This guidance modifies the scope of ASC subtopic 965-605, Software-Revenue Recognition to exclude from its requirements (a) non-software components of tangible products and (b) software components of tangible products that are sold, licensed, or leased with tangible products when the software components and non-software components of the tangible product function together to deliver the tangible product’s essential functionality. This update requires expanded qualitative and quantitative disclosures and is effective for the Company’s first quarter of fiscal year 2011. However, early adoption is allowed.  The Company is currently evaluating the impact of adopting this update on its consolidated results of operations and financial position.




In October 2009, the FASB issued ASU No. 2009-13, Revenue Recognition (ASC Topic 605) - Multiple-Deliverable Revenue Arrangements, a consensus of the FASB Emerging Issues Task Force.  This guidance modifies the fair value requirements of ASC subtopic 605-25, Revenue Recognition-Multiple Element Arrangements by allowing the use of the “best estimate of selling price” in addition to vendor-specific objective evidence (VSOE) and verifiable objective evidence (VOE) (now referred to as TPE standing for third-party evidence) for determining the selling price of a deliverable. A vendor is now required to use its best estimate of the selling price when VSOE or TPE of the selling price cannot be determined. In addition, the residual method of allocating arrangement consideration is no longer permitted. This update requires expanded qualitative and quantitative disclosures and is effective for the Company’s first quarter of fiscal year 2011. However, early adoption is allowed.   The Company is currently evaluating the impact of adopting this update on its consolidated results of operations and financial position.




In January 2010, FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (ASC Topic 820) — Improving Disclosures About Fair Value Measurements. The ASU requires new disclosures about transfers into and out of Levels 1 and 2 and separate disclosures about purchases, sales, issuances, and settlements relating to Level 3 measurements. It also clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure fair value. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years.  Other than requiring additional disclosures, the adoption of this new guidance will not have a material impact on the Company’s consolidated results of operations and financial position.








3. Significant Accounting Policies





The preparation of financial statements in conformity with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ materially from these estimates. Areas where significant judgment and estimates are applied include revenue recognition, stock based compensation, short-term investments, allowance for doubtful accounts, inventory valuation, realization of long lived assets, income taxes, deferred income tax assets, accrued liabilities, guarantees, and legal matters. The condensed consolidated financial statements include the accounts of Silicon Image, Inc. and its subsidiaries after elimination of all intercompany balances and transactions.





For a discussion of the significant accounting policies, see Significant Accounting Policies in our Annual Report on Form 10-K for the year ended December 31, 2009.





6
 
 Table of Contents





4. Stock-Based Compensation


The Company has a share-based compensation program that provides its Board of Directors with broad discretion in creating equity incentives for employees, officers and non-employee board members. This program includes incentive and non-statutory stock option grants, restricted stock units (RSUs) and an automatic grant program for non-employee board members pursuant to which such individuals will receive option grants/RSUs at designated intervals over their period of board service. These awards are granted under various plans, all of which are stockholder approved. Stock option grants under the discretionary grant program generally vest as follows: 25% of the shares vest on the first anniversary of the vesting commencement date and the remaining 75% vest proportionately each month over the next 36 months of continued service. Stock option grants to non-employee members of the board vest monthly, over periods not to exceed four years. Some options provide for accelerated vesting if certain identified milestones are achieved, upon a termination of employment or upon a change in control of the Company. RSU grants generally vest over a one to four-year period. Additionally, the Employee Stock Purchase Plan (ESPP) allows employees to purchase shares of common stock at the lower of 85% of the fair market value on the commencement date of the six-month offering period or on the last day of the six-month offering period.





Valuation and Expense Information Under Stock-based Compensation





Share-based compensation expense recognized under FASB ASC No. 718-10-30, Initial Measurement of Stock Compensation,consists primarily of expenses for the share-based awards discussed above.





The fair value of each option grant is estimated on the date of grant using the Black-Scholes- Merton option valuation model and the straight-line attribution approach with the following assumptions:




Three months ended September 30,


Nine months ended September 30,2010


2009


2010


2009Employee stock option plans:Expected life in years (1)


4.2


none



4.2



4.7Expected volatility (2)


66.0
%

none



64.2
%


64.5
%Risk-free interest rate (3)


1.1
%

none



1.9
%


2.3
%Expected dividends (4)

none


none


none


noneWeighted average fair value

$
1.72


none


$
1.59


$
1.37Employee Stock Purchase Plan:Expected life in years (1)


0.5



0.5



0.5



0.5Expected volatility (2)


72.6
%


73.6
%


60.2
%


85.6
%Risk-free interest rate (3)


0.2
%


0.4
%


0.2
%


0.8
%Expected dividends (4)

none


none


none


noneWeighted average fair value

$
1.33


$
0.94


$
0.96


$
1.03





(1)

The expected life of the options represents the estimated period of time until exercised and is based on historical experience of similar awards, giving consideration to the contractual terms, vesting schedules, and expectations of future employee behavior. The expected term for the ESPP is based on the term of the purchase period.(2)

The volatility rate is based on the Company’s historical common stock volatility derived from historical stock price data for historical periods commensurate with the options’ expected life.(3)

The risk-free interest rate is based on the implied yield currently available on United States Treasury zero coupon issues with a term equal to the expected life at the date of grant of the options.(4)

The expected dividend is based on our history and expected dividend payouts. The expected dividend yield is zero as the Company has historically paid no dividends and does not anticipate dividends to be paid in the future.


As required by FASB ASC 718-10-35, Subsequent Measurement of Stock Compensation, management made an estimate of expected forfeitures and is recognizing stock-based compensation expense only for those equity awards expected to vest.





For the three months ended September 30, 2010 and 2009, 637,491 and 342,416 shares of common stock were purchased under the ESPP program, respectively. For the nine months ended September 30, 2010 and 2009, 1,233,976 and 887,045 shares of common stock were purchased under the ESPP program, respectively. At September 30, 2010, the Company had $389,000 of total unrecognized compensation expense, net of estimated forfeitures under the ESPP program. The unamortized compensation expense will be amortized on a straight-line basis over a period of approximately 4.5 months.




7
 
 Table of Contents




Stock Option Exchange Program





On August 4, 2010, the Company launched a voluntary stockholder-approved employee stock option exchange program (the “Exchange Program) to permit the Company’s eligible employees to exchange some or all of their outstanding options to purchase the Company’s common stock with an exercise price greater than or equal to $6.64 per share, whether vested or unvested, for a lesser number of new RSUs. Non-employee members of the Board of Directors and the Company’s named executive officers, including its chief financial officer, were not eligible to participate in the Exchange Program.


In accordance with the terms and conditions of the Exchange Program, on September 1, 2010 (the “Grant Date”),  the Company accepted outstanding options to purchase an aggregate of 3,988,947 shares of the Company’s common stock and issued, in exchange, an aggregate of 1,130,623 new RSUs. Of the 1,130,623 new RSUs, 1,039,393 will vest on the first anniversary of the Grant Date and 91,230 will vest on the second anniversary of the Grant Date. Each RSU granted in the Exchange Program represents the right to receive one share of the Company’s common stock upon vesting of the RSU. The new RSUs were issued from the Company’s 2008 Equity Incentive Plan.


The Exchange Program did not result in any significant incremental stock-based compensation expense.








Stock Options Activity





The following is a summary of activity under the Company’s stock option plans during the nine months ended September 30, 2010, excluding RSUs (in thousands, except weighted average exercise price):




Number of Shares


Weighted Average Exercise Price


Weighted Average Remaining Contractual Term in Years


Aggregate Intrinsic ValueOutstanding at January 1, 2010


9,644


$
8.51Granted


1,776



3.14Exercised


(166
)


1.95Options cancelled in the Exchange Program


(3,989
)


10.73Forfeitures and cancellations


(1,786
)


8.23Outstanding at September 30, 2010


5,479


$
5.44



5.40


$
4,712Ending vested and expected to vest at September 30, 2010


4,908


$
5.69



5.09


$
3,807Exercisable at September 30, 2010


3,306


$
6.72



3.77


$
1,578





The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value that option holders would have received had all option holders exercised their options on September 30, 2010. The aggregate intrinsic value is the difference between the Company's closing stock price on the last trading day of the third quarter of fiscal 2010 and the exercise price, multiplied by the number of outstanding or exercisable in-the-money options. The aggregate intrinsic value excludes the effect of stock options that have a zero or negative intrinsic value. The total pre-tax intrinsic value of options exercised, representing the difference between the market value of the Company’s common stock on the date of the exercise and the exercise price of each option, for the three and nine months ended September 30, 2010 was $395,000 and $405,000, respectively, and was insignificant for the three and nine months ended September 30, 2009 due to limited number of exercises during those periods.  The total grant date fair value of the options which vested during the three and nine months ended September 30, 2010 was $1.0 million and $4.0 million, respectively, and during the three and nine months ended September 30, 2009 was $3.5 million and $10.4 million, respectively.





At September 30, 2010, the total unrecognized pre-tax stock-based compensation expense related to stock options, which the Company expects to recognize over the remaining weighted-average vesting period of 3.09 years, was $4.2 million, net of estimated forfeitures.








8
 Table of Contents





Restricted Stock Units





The RSUs that the Company grants to its employees typically vest ratably over a certain period of time, subject to the employee’s continuing service to the Company over that period. RSUs granted to non-executive employees typically vest over a period of between two to four years. RSUs granted to executive officers typically vest over a period of between one and four years.





RSUs are converted into shares of the Company’s common stock upon vesting on a one-for-one basis. The cost of the RSUs is determined using the fair value of the Company’s common stock on the date of the grant. Compensation is recognized on a straight-line basis over the requisite service period of each grant adjusted for estimated forfeitures. Each RSU award granted from the 2008 Plan will reduce the number of reserves available for issuance by 1.5 shares.





Non-vested RSUs of September 30, 2010 and changes during the nine months ended September 30, 2010 were as follows (in thousands, except for the weighted-average grant date fair value per share):




Number of shares


Weighted- Average Grant Date Fair Value Per ShareOutstanding at January 1, 2010


2,719


$
3.45Granted


701



3.13Granted in the Exchange Program


1,131



3.82Vested


(1,195
)


3.74Forfeitures and cancellations


(661
)


3.27Outstanding at September 30, 2010


2,695


$
3.43





The total grant date fair value of the RSUs that vested during the three and nine months ended September 30, 2010 was $47,000 and $4.5 million, respectively, and $100,000 and $1.1 million for the three and nine months ended September 30, 2009, respectively.




At September 30, 2010, the total unrecognized pre-tax stock-based compensation expense related to non-vested RSUs, which the Company expects to recognize over the remaining weighted-average vesting period of 1.85 years, was $3.5 million, net of estimated forfeitures.





During the three months ended September 30, 2010 and 2009, the Company repurchased 2,979 and 13,542 shares of stock, respectively, for an aggregate value of $11,000 and $39,000, respectively, from employees upon the vesting of their RSUs that were granted under the Company’s 2008 Equity Incentive Plan to satisfy such employees’ minimum statutory tax withholding requirement. During the nine months ended September 30, 2010 and 2009, the Company repurchased 441,546 and 91,637 shares of stock, respectively, for an aggregate value of $1.2 million and $0.3 million, respectively.   The Company will continue to repurchase shares of stock from employees as their RSUs vest to satisfy the employees’ minimum statutory tax withholding requirement.





Stock-based Compensation Expense





The table below shows total stock-based compensation expense included in the Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2010 and 2009 (in thousands):




Three months ended September 30,


Nine months ended September 30,2010


2009


2010


2009Cost of sales

$
127


$
363


$
456


$
806Research and development


687



2,374



2,057



5,365Selling, general and administrative


936



4,911



3,382



9,255Stock-based compensation expense before income tax effects


1,750



7,648



5,895



15,426Income tax benefit


-



(2,304
)


-



(4,350
)Stock-based compensation expense after income tax effects

$
1,750


$
5,344


$
5,895


$
11,076




9
 
 Table of Contents






5. Restructuring Charges and Exit Costs





Restructuring Activities





For the nine months ended September 30, 2010, the Company recorded restructuring expense of approximately $1.0 million, which was primarily related to the future lease commitments on exited facilities, impairment of certain fixed assets, and legal and other restructuring related costs which were recorded as incurred.





Fiscal 2009 Restructuring Programs





In June and October 2009, the Company’s management approved and announced restructuring programs, which primarily included a reduction in force, to realign and focus the Company’s resources on its core competencies and to better align its revenues and expenses.





As of September 30, 2010, approximately $0.3 million of the costs associated with these restructuring programs remained unpaid.  This remaining unpaid balance primarily relates to costs associated with exited facilities, which will be substantially paid by November 2012.





Fiscal 2008 Restructuring Program





As of September 30, 2010, approximately $0.1 million of the costs associated with the restructuring plan announced in December 2008 remained unpaid. The outstanding liability under the 2008 restructuring program represents costs associated with exited facilities which will be substantially paid by July 2011.





The table below summarizes the Company’s restructuring activities for the nine months ended September 30, 2010 (in thousands):




Employee Severance and Benefits


Operating Lease Termination


Fixed Assets Impaired


TotalAccrued restructuring balance as of January 1, 2010

$
17,052


$
261


$
-


$
17,313Additional accruals


143



642



184



969Cash payments


(16,134
)


(555
)


-



(16,689
)Non-cash charges and adjustments


-



-



(184
)


(184
)Foreign currency adjustments


(1,057
)


-



-



(1,057
)Accrued restructuring balance as of September 30, 2010

$
4


$
348


$
-


$
352





10
 Table of Contents





6. Comprehensive Income (Loss)





The components of comprehensive income (loss), net of related taxes, were as follows (in thousands):




Three months ended September 30,


Nine months ended September 30,2010


2009


2010


2009Net income (loss)

$
9,465


$
(15,511
)

$
3,998


$
(62,169
)Effective portion of cashflow hedges


474



3



64



32Change in unrealized value of investments


169



140



(113
)


220Foreign currency translation adjustments


62



287



517



355Total comprehensive income (loss)

$
10,170


$
(15,081
)

$
4,466


$
(61,562
)








7. Net Income (Loss) Per Share





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





Three months ended September 30,


Nine months ended September 30,2010


2009


2010


2009Numerator:Net income (loss)

$
9,465


$
(15,511
)

$
3,998


$
(62,169
)Denominator:Weighted average oustanding shares used to compute basic net income (loss) per share


77,210



75,053



76,649



74,763Effect of dilutive securities


914



-



1,016



-Weighted average oustanding shares used to compute diluted net income (loss) per share


78,124



75,053



77,665



74,763Net income (loss) per share - basic and diluted

$
0.12


$
(0.21
)

$
0.05


$
(0.83
)





For the three and nine months ended September 30, 2010, approximately 8.1 million and 9.6 million weighted common stock equivalents, respectively, were excluded from the calculation of diluted net income per share because their inclusion would have been anti-dilutive.





As a result of the net loss for the three and nine months ended September 30, 2009, approximately 13.8  million and 13.6 million common stock equivalents for the three and nine months ended September 30, 2009, respectively, were excluded in the computation of diluted net loss per share because their effect would have been anti-dilutive.




11
 
 Table of Contents








8. Balance Sheet Components





The table below shows the components of the Company’s inventories, prepaid expense and other current assets, property and equipment,  accrued and other current liabilities and other long-term liabilities (in thousands).





September 30, 2010


December 31, 2009Inventories:Raw materials

$
2,983


$
2,800Work in process


3,058



916Finished goods


5,554



4,030Total inventories

$
11,595


$
7,746Prepaid expenses and other current assets:Interest receivable

$
1,386


$
1,395Prepaid software maintenance


755



2,384Income tax receivable


-



21,405Others


3,483



2,328Total prepaid and other current assets

$
5,624


$
27,512Property and equipmentComputers and software

$
21,701


$
21,614Equipment


29,503



27,050Furniture and fixtures


2,454



2,56453,658



51,228Less: accumulated depreciation


(41,929
)


(36,779
)Total property and equipment, net

$
11,729


$
14,449Accrued and other current liabilities:Accrued payroll and related expenses

$
4,437


$
2,826Accrued royalties


4,021



1,282Accrued income tax payable


1,024



-Accrued restructuring


352



17,313Others


5,725



6,729Total accrued and other current liabilities

$
15,559


$
28,150Other long-term liabilities:Non-current liability for uncertain tax positions

$
9,312


$
9,344Non-current deferred license revenue


1,498



-Other liabilities


-



229Total other long-term liabilities

$
10,810


$
9,573




12
 Table of Contents








9. Commitments and Contingencies





Legal Proceedings





On December 7, 2001, the Company and certain of its officers and directors were named as defendants, along with the underwriters of the Company’s initial public offering, in a securities class action lawsuit. The lawsuit alleges that the defendants participated in a scheme to inflate the price of the Company’s stock in its initial public offering and in the aftermarket through a series of misstatements and omissions associated with the offering. The lawsuit is one of several hundred similar cases pending in the Southern District of New York that have been consolidated by the court. In February 2003, the District Court issued an order denying a motion to dismiss by all defendants on common issues of law. In July 2003, the Company, along with over 300 other issuers named as defendants, agreed to a settlement of this litigation with plaintiffs. While the parties’ request for court approval of the settlement was pending, in December 2006 the United States Court of Appeals for the Second Circuit reversed the District Court’s determination that six focus cases could be certified as class actions. In April 2007, the Second Circuit denied plaintiffs’ petition for rehearing, but acknowledged that the District Court might certify a more limited class. At a June 26, 2007 status conference, the Court terminated the proposed settlement as stipulated among the parties. Plaintiffs filed an amended complaint on August 14, 2007. On September 27, 2007, plaintiffs filed a motion for class certification in the six focus cases, which was withdrawn on October 10, 2008. On November 13, 2007 defendants in the six focus cases filed a motion to dismiss the complaint for failure to state a claim, which the district court denied in March 2008. Plaintiffs, the issuer defendants (including the Company), the underwriter defendants, and the insurance carriers for the defendants, have engaged in mediation and settlement negotiations. The parties have reached a settlement agreement, which was submitted to the District Court for preliminary approval on April 2, 2009. As part of this settlement, the Company’s insurance carrier has agreed to assume the Company’s entire payment obligation under the terms of the settlement. On June 10, 2009, the District Court granted preliminary approval of the proposed settlement agreement. After a September 10, 2009 hearing, the District Court gave final approval to the settlement on October 5, 2009. Several objectors to the settlement have filed notices of appeal to the United States Court of Appeal for the Second Circuit from the District Court’s order granting final approval of the settlement. Although the District Court has granted final approval of the settlement agreement, there can be no guarantee that it will not be reversed on appeal. The Company believes that it has meritorious defenses to these claims. If the settlement is not implemented and the litigation continues against the Company, the Company would continue to defend against this action vigorously.





On July 31, 2007, the Company received a demand on behalf of alleged shareholder Vanessa Simmonds that its board of directors prosecute a claim against the underwriters of its initial public offering, in addition to certain unidentified officers, directors and principal shareholders as identified in the Company’s IPO prospectus, for violations of sections 16(a) and 16(b) of the Securities Exchange Act of 1934. In October 2007, a lawsuit was filed in the United States District Court for the Western District of Washington by Ms. Simmonds against certain of the underwriters of the Company’s initial public offering. The plaintiff alleges that the underwriters engaged in short-swing trades and seeks disgorgement of profits in amounts to be proven at trial from the underwriters. On February 25, 2008, Ms. Simmonds filed an amended complaint. The suit names the Company as a nominal defendant, contains no claims against the Company and seeks no relief from it. This lawsuit is one of more than fifty similar actions filed in the same court. On July 25, 2008, the underwriter defendants in the various actions filed a joint motion to dismiss the complaints for failure to state a claim. In addition, certain issuer defendants in the various actions filed a joint motion to dismiss the complaints for failure to state a claim. The parties entered into a stipulation, entered as an order by the court that the Company is not required to answer or otherwise respond to the amended complaint. Accordingly, the Company did not join the motion to dismiss filed by certain issuers. On March 12, 2009, the court dismissed the complaint in this lawsuit with prejudice. On April 10, 2009, the plaintiff filed a notice of appeal of the District Court’s order, and thereafter the underwriter defendants’ filed a cross appeal to a portion of the District Court’s order that dismissed thirty (30) of the cases without prejudice following the moving issuers’ motion to dismiss. On May 27, 2009, the Ninth Circuit issued an order stating that the cases were not selected for inclusion in the mediation program, and on May 22, 2009 issued an order granting the parties’ joint motion filed on May 22, 2009 to consolidate the 54 appeals and 30 cross-appeals. Briefing on the appeals and cross-appeals was completed on November 17, 2009. Oral argument in the Ninth Circuit was heard on October 5, 2010, and the Court could issue its decision at any time.





On June 9, 2010, the Company was named in a lawsuit, captioned “Red.com, Inc. dba Red Digital Camera v. Silicon Image, Inc.,” and filed in the Superior Court of California, Orange County by the plaintiff, Red.com.  The plaintiff alleges breach of contract, fraud and negligent misrepresentation based on the allegations that the Company breached a licensing agreement with the plaintiff.  At this time, the case is in the very early stages. The plaintiff filed an amended complaint on September 30, 2010, to which the Company has not yet responded. No hearings have been scheduled and no trial date has been set.  The Company intends to defend against plaintiff’s allegations vigorously.





In addition, the Company has been named as a defendant in a number of judicial and administrative proceedings incidental to its business and may be named again from time to time.





The Company intends to defend the above matters vigorously and although adverse decisions or settlements may occur 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 adverse effect on the Company’s results of operations, financial position or cash flows.




13


Table of Contents





Guarantees





Certain of the Company’s licensing agreements indemnify its customers for any expenses or liabilities resulting from claimed infringements of third party patents, trademarks or copyrights by its products. Certain of these indemnification provisions are perpetual from execution of the agreement and, in some instances; the maximum amount of potential future indemnification is not limited. To date, the Company has not paid any such claims or been required to defend any lawsuits with respect to any such claim.





Contractual Obligations and Off-Balance Sheet Arrangements





Our future operating lease commitments and R&D engineering services commitments at September 30, 2010 are as follows (in thousands):





Payments Due InTotal


Less Than

1 Year


1-3 YearsContractual Obligations:Engineering services commitments

$
5,094


$
4,074


$
1,020Operating lease obligations


2,731



2,271



460Total

$
7,825


$
6,345


$
1,480





Future minimum lease payments under operating leases have not been reduced by expected sub lease rental income from exited facilities.  The amount of restructuring accrual that relates to the exited facilities, however, has been appropriately deducted from the future minimum lease payments.





In December 2009, the Company entered into an R&D Engineering Services Agreement with an engineering services firm. The Company will pay the R&D engineering services firm a total of 6 million Euros over a two-year period from December 2009 to December 2011. As of September 30, 2010, the Company has outstanding commitments of 3.0 million Euros (approximately $4.1 million) under this agreement.





In March 2010, the Company entered into an engineering consulting agreement with an engineering consulting firm.  Under the agreement, the Company is committed to pay the engineering consulting firm a total of $1.6 million over a two-year period from March 2010 to December 2011 based on project milestones. As of September 30, 2010, the Company has outstanding commitments of approximately $1.0 million under this agreement.




The amounts above exclude liabilities under FASB ASC 740-10, “Income Taxes – Recognition section,”as the Company is unable to reasonably estimate the ultimate amount or timing of settlement.




14


Table of Contents








10. Customer and Geographic Information





The Company operates in one reportable operating segment, semiconductors and IP solutions for the secure storage, distribution and presentation of high-definition content. The Company’s Chief Executive Officer, who is considered to be the Company’s chief operating decision maker, reviews financial information presented on one operating segment basis for purposes of making operating decisions and assessing financial performance.





Revenue





Revenue by geographic area was as follows (in thousands):




Three months ended September 30,


Nine months ended September 30,2010


2009


2010


2009Japan

$
18,028


$
11,957


$
41,130


$
31,782Taiwan


13,963



9,063



29,176



29,282Korea


12,534



1,566



15,471



3,692United States


8,259



6,392



30,299



22,654Europe


3,526



4,170



12,047



13,411China


3,771



3,205



10,245



9,922Other


423



803



995



4,261Total revenue

$
60,504


$
37,156


$
139,363


$
115,004





The Company determines the geographic distribution of revenue using the customers’ “bill to address” location as specified in the customers’ agreements.





Revenue by product line was as follows (in thousands):




Three months ended September 30,


Nine months ended September 30,2010


2009


2010


2009Consumer Electronics

$
40,480


$
25,588


$
96,291


$
78,850Personal Computer


2,029



1,800



6,008



6,968Storage


3,608



3,328



8,475



8,929Licensing revenue


14,387



6,440



28,589



20,257Total revenue

$
60,504


$
37,156


$
139,363


$
115,004





For the three months ended September 30, 2010, four customers each represented 19.8%, 12.9%, 11.8% and 10.6% of the Company’s revenue. For the nine months ended September 30, 2010, three customers each represented 18.6%, 11.5% and 11.2% of the Company’s revenue.  At September 30, 2010, two customers each represented 20.4% and 11.1% of net accounts receivable.





For the three months ended September 30, 2009, two customers represented 16.3% and 10.6% of the Company’s revenue. For the nine months ended September 30, 2009, two customers each represented 12.8% and 10.3% of the Company’s revenue. At September 30, 2009, two customers each represented 11.6% and 11.1% of net accounts receivable.





Licensing revenue during the three and nine months ended September 30, 2010 included a settlement of prior period royalties as a result of the Company’s licensing audit activities of approximately $7.5 million and $5.9 million, respectively.  The recognition of these royalties in 2010 was the result of the Company’s audit activities completed during the three months ended September 30, 2010, including reaching an agreement regarding the amount and payment of royalties for the sales of licensed products through December 31, 2009.




15


Table of Contents








Property and Equipment





Approximately $8.5 million or 72.2% of the Company’s consolidated net property and equipment are located in the US and approximately $2.9 million or 25.1% are located in China.








11. Provision for Income Taxes





The Company recorded an income tax expense of $3.5 million and $3.8 million for the three and nine months ended September 30, 2010, respectively. The effective tax rates for the three and nine months ended September 30, 2010 were 27.2% and 49.0%, respectively, and were based on the Company’s projected taxable income for 2010, adjusted for the impact of certain discrete items for which the tax effect is recorded during the respective quarter that the event occurs. The difference between the provision for income taxes and the income tax determined by applying the statutory federal income tax rate of 35% was due primarily to change in valuation allowance, foreign taxes and state taxes.





The Company continued to maintain a valuation allowance as a result of uncertainties related to the realization of its net deferred tax assets at September 30, 2010.  The valuation allowance was established as a result of weighing all positive and negative evidence, including the Company’s cumulative loss over the past three years. The valuation allowance reflects the conclusion of management that it is more likely than not that benefits from certain deferred tax assets will not be realized. If actual results differ from these estimates or these estimates are adjusted in future periods, the valuation allowance may require adjustment which could materially impact the Company’s financial position and results of operations.





For the three and nine months ended September 30, 2009, the Company recorded an income tax benefit of $444,000 and $2.1 million, respectively. The effective tax rates for the three and nine months ended September 30, 2009 were 2.8% and 3.3%, respectively, and were based on the Company’s projected taxable income for 2009, adjusted for the impact of certain discrete items for which the tax effect is recorded during the respective quarter that the event occurs. The difference between the provision for income taxes and the income tax determined by applying the statutory federal income tax rate of 35% was due primarily to various forecasted items including tax exempt income, stock-based compensation expense, tax credits and foreign taxes, adjusted for certain discrete items recorded during the quarter.





The Company’s policy is to include interest and penalties related to unrecognized tax benefits within the provision for income taxes. The Company had interest and penalties of $113,000 and $287,000 for the three and nine months ended September 30, 2010, respectively, and approximately $100,000 and $273,000 for the three and nine months ended September 30, 2009, respectively.  The Company conducts business globally and, as a result, the Company and its subsidiaries file income tax returns in various jurisdictions throughout the world including with the U.S. federal and various U.S. state jurisdictions as well as with various foreign jurisdictions. In the normal course of business, the Company is subject to examination by taxing authorities throughout the world.







16
 Table of Contents







12. Fair Value Measurements





The determination of fair value is based upon the fair value framework established by FASB ASC No. 820-10-35, Fair Value Measurements and Disclosures – Subsequent Measurement(“ASC 820-10-35”). ASC 820-10-35 provides that a fair value measurement assumes that the transaction to sell an asset or transfer a liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. The carrying value of the Company’s cash and cash equivalents, accounts receivable, prepaid expenses and other current assets, accounts payable, accrued compensation, and other accrued liabilities, approximates fair market value due to the relatively short period of time to maturity. The fair value of investments is determined using quoted market prices for those securities or similar financial instruments.





ASC 820 establishes a consistent framework for measuring fair value whereby inputs used in valuation techniques are assigned a hierarchical level.  The assignment to a level is based on whether the market participant assumptions used in determining fair value are obtained from independent sources (observable inputs) or reflect the Company’s own assumptions of market participant valuation (unobservable inputs).  Categorization within the fair value hierarchy is determined by the lowest level of input that is significant to the fair value measurement. The following are the hierarchical levels of inputs to measure fair value:





Level 1
Quoted prices in active markets that are unadjusted and accessible at the measurement date for identical, unrestricted assets or liabilities;Level 2
Quoted prices for identical assets and liabilities in markets that are inactive; quoted prices for similar assets and liabilities in active markets; or significant inputs that are observable, either directly or indirectly; orLevel 3
Prices or valuations that require inputs that are both unobservable and significant to the fair value measurement.





The Company considers an active market to be one in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis, and views an inactive market as one in which there are few transactions for the asset or liability, the prices are not current, or price quotations vary substantially either over time or among market makers.




The table below presents the Company’s assets that are measured at fair value on a recurring basis by level within the fair value hierarchy as of September 30, 2010. As required by ASC 820-10-35, these are classified based on the lowest level of input that is significant to the fair value measurement (in thousands).





Fair value measurements using


AssetsLevel 1


Level 2


at fair valueCash equivalents:Money market funds

$
160


$
-


$
160Short-term investments:United States government agencies


19,262



-



19,262Money market funds


6,838



-



6,838Corporate securities


-



53,224



53,224Municipal securities


-



71,608



71,608Total short-term investments


26,100



124,832



150,932Total assets at fair value

$
26,260


$
124,832


$
151,092


Cash equivalents and short term investments in the above table excludes $33.5 million in cash held by the Company or in its accounts with investment fund managers as of September 30, 2010. During the three and nine months ended September 30, 2010, the Company held no direct investments in auction rate securities, collateralized debt obligations, structured investment vehicles or mortgage-backed securities.




Level 1assets consist of money market fund securities and U.S. government and agency securities. These instruments are generally classified within Level 1 of the fair value hierarchy because they are valued based on quoted market prices in active markets.





The Company classifies items in Level 2 if the financial asset or liability is valued using observable inputs. The Company uses observable inputs including quoted prices in active markets for similar assets or liabilities.  Level 2 assets include corporate and municipal securities. These investments are priced using observable inputs and valuation models which vary by asset class. The fair values of all of the Company’s investments in corporate and municipal securities are determined through the assistance of a third party pricing service.   For the short-term investments in the Company’s portfolio, multiple pricing sources are generally available.  The pricing service uses inputs from multiple industry standard data providers or other third party sources and various methodologies, such as weighting and models, to determine the appropriate price at the measurement date.





There were no transfers between Level 1 and Level 2 fair value hierarchies during the three and nine months ended September 30, 2010.





As of September 30, 2010, the Company did not hold financial assets which were recorded at fair value in the Level 3 category.





17
 Table of Contents








13.  Derivative Instruments





The Company accounts for derivative instruments in accordance with the provisions of FASB ASC No. 815-20-25, Derivatives and Hedging – Hedging Recognition.The Company recognizes derivative instruments as either assets or liabilities and measures those instruments at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. The Company’s derivatives are designated as cash flow hedges. For a derivative instrument designated as a cash flow hedge, the effective portion of the derivative’s gain  or loss is initially reported as a component of accumulated other comprehensive income and subsequently reclassified into earnings when the hedged exposure affects earnings. The ineffective portion of the gain (loss) is reported immediately in other income (expense) on the Company’s condensed consolidated statement of operations.





Silicon Image is a global company that is exposed to foreign currency exchange rate fluctuations in the normal course of its business. The Company has operations in the United States, Europe and Asia, however, a majority of its revenue, costs of revenue, expense and capital purchasing activities are being transacted in U.S. Dollars. As a corporation with international as well as domestic operations, the Company is exposed to changes in foreign exchange rates. These exposures may change over time and could have a material adverse impact on the Company’s financial results. Periodically, the Company uses foreign currency forward contracts to hedge certain forecasted foreign currency transactions relating to operating expenses. The Company does not enter into derivatives for speculative or trading purposes. The Company uses derivative instruments primarily to manage exposures to foreign currency fluctuations on forecasted cash flows and balances primarily denominated in Euro. The Company’s primary objective in holding derivatives is to reduce the volatility of earnings and cash flows associated with changes in foreign currency exchange rates. These derivatives are designated as cash flow hedges and have maturities of less than one year.





The derivatives expose the Company to credit and non performance risks to the extent that the counterparties may be unable to meet the terms of the agreement. The Company seeks to mitigate such risks by limiting the counterparties to major financial institutions. In addition, the potential risk of loss with any one counterparty resulting from this type of credit risk is monitored. Management does not expect material losses as a result of defaults by counterparties.





The amount of income recognized in other comprehensive income (“OCI”) on effective cashflow hedges as of September 30, 2010 and 2009 was insignificant. The amount of income reclassified from accumulated OCI to operating expenses for the three and nine months ended September 30, 2010 and 2009, and the amount of gain (loss) recognized in income on ineffective cashflow hedges for the three and nine months ended September 30, 2010 and 2009 were insignificant.





As of September 30, 2010, the outstanding foreign currency forward contracts had a notional value of approximately $2.9 million. The unrealized gain relating to the effective cashflow hedges recorded in accumulated other comprehensive income as part of stockholders' equity and accrued and other current asset in the condensed consolidated balance sheet as of September 30, 2010 was insignificant.




18


Table of Contents





Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations





This report contains forward-looking statements within the meaning of Section 21E of the Exchange Act and Section 27A of the Securities Act of 1933. These forward-looking statements involve a number of risks and uncertainties, including those identified in the section of this Form 10-Q entitled “Factors Affecting Future Results,” that may cause actual results to differ materially from those discussed in, or implied by, such forward-looking statements. Forward-looking statements within this Form 10-Q are identified by words such as “believes,” “anticipates,” “expects,” “intends,” “estimates,” “may,” “will” and variations of such words and other similar expressions. However, these words are not the only means of identifying such statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. We undertake no obligation to publicly release the results of any revisions to these forward-looking statements that may be made to reflect events or circumstances occurring subsequent to the filing of this Form 10-Q with the SEC except as required by securities regulations. Our actual results could differ materially from those anticipated in, or implied by, forward-looking statements as a result of various factors,  including the risks outlined elsewhere in this report. Readers are urged to carefully review and consider the various disclosures made by Silicon Image,  Inc. in this report and in our other reports filed with the SEC that attempt to advise interested parties of the risks and factors that may affect our business.





Silicon Image and the Silicon Image logo are trademarks, registered trademarks or service marks of Silicon Image, Inc. in the United States and/or other countries.  HDMI, the HDMI logo, and High-Definition Multimedia Interface are trademarks or registered trademarks of HDMI Licensing, LLC in the United States and/or other countries. MHL and the MHL logo are trademarks or registered trademarks of MHL, LLC in the United States and/or other countries. All other trademarks and registered trademarks are the property of their respective owners in the Unites States and/or other countries.








Company Overview





Silicon Image, Inc. is a technology innovator and a global leader developing high-bandwidth semiconductor and intellectual property (IP) solutions based on our innovative, digital interconnect technology. Our goal is to be the leader in the innovation, design, development and implementation of semiconductors and IP solutions for the secure storage, distribution and presentation of high-definition (HD) content in home and mobile environments. We are dedicated to the development and promotion of technologies, standards and products that facilitate the movement of digital content between and among digital devices across the consumer electronics (CE), personal computer (PC), mobile and storage markets.





We sell integrated and discrete semiconductor products as well as license IP solutions to consumer electronics, computing, display, storage and mobile manufacturers. Our product and IP portfolio includes solutions for high-definition television (HDTV), high-definition set-top boxes (STBs), high-definition Blu-ray players, mobile devices, high-definition game systems, consumer and enterprise storage products and PC display products.





We have worked with industry leaders to create industry standards such as the High-Definition Multimedia Interface (HDMITM) and Digital Visual Interface (DVITM) specifications for digital content delivery. We have been, and are likely to be in the future, significant contributors to broader standards specifications such as the Serial Advanced Technology Attachment (SATA) specification for PC & Enterprise storage applications. We actively promote and participate in working groups and consortiums to develop new standards such as the recently announced Mobile High-Definition Link (MHLTM) consortium chartered with creating a new HD mobile video standard and the Serial Port Memory Technology (SPMTTM) consortium which is working on serial connection standards for dynamic random access memory (DRAM). We capitalize on our leadership position through first-to-market, standards-based semiconductor and IP solutions. Our portfolio of IP solutions that we license to third parties for consumer electronics, PCs, multimedia, communications, mobile, networking and storage devices further leverages our expertise in these markets. In addition, through Simplay Labs, LLC, our wholly owned subsidiary, we offer one of the most robust and comprehensive test platforms in the consumer electronics industry. We utilize independent foundries and third-party subcontractors to develop, manufacture, assemble and test all of our semiconductor products.




19
 
 Table of Contents





Our customers are equipment manufacturers in each of our target markets — Consumer Electronics, Personal Computer, Mobile and Storage. Because we leverage our technologies across different markets, certain of our products may be incorporated into equipment used in multiple markets. We sell our products to original equipment manufacturers (OEMs) throughout the world using a direct sales force and through a network of distributors and manufacturer’s representatives. Our net revenue is generated principally by sales of our semiconductor products, with other revenues derived from IP core/design licensing and royalty fees from our patent licensing activities. We maintain relationships with the eco-system of companies that provide the products that drive digital content creation and consumption, including the major Hollywood studios, consumer electronics companies, retailers and service providers. To that end, we have developed relationships with Hollywood studios such as Universal, Warner Brothers, Disney and Fox and with major consumer electronics companies such as Nokia, Panasonic, Phillips, Samsung, Sharp, Sony and Toshiba. Through these and other relationships, we have formed a strong understanding of the requirements for storing, distributing and presenting HD digital video and audio in the home and mobile environments. We have also developed a substantial IP base for building the standards and products necessary to promote opportunities for our products.





Historically, we have grown our business by introducing and promoting the adoption of new standards and entering new markets. We collaborated with other companies and jointly developed the DVI and HDMI standards. Our first products addressed the PC market. Subsequently, we introduced products for a variety of CE market segments, including STB, game console and digital television (DTV) markets. More recently, we have focused our research and development activities and are developing products based on our innovative digital interconnect core technology for the mobile device market, including digital still cameras, HD camcorders, portable media players and smart phones.




Concentrations





Historically, a relatively small number of customers and distributors have generated a significant portion of our revenue. For instance, our top five customers, including distributors, generated 64.0% and 58.2% of our revenue for the three and nine months ended September 30, 2010, respectively, and 51.6% and 43.7% of our revenue for the three and nine months ended September 30, 2009, respectively. Additionally, the percentage of revenue generated through distributors tends to be significant, since many OEMs rely upon third party manufacturers or distributors to provide purchasing and inventory management services.  Revenue generated through distributors was 64.8% and 58.8% of our total revenue for the three and nine months ended September 30, 2010, respectively, and  61.2% and 61.1% of our total revenue for the three and nine months ended September 30, 2009, respectively.  Our licensing revenue is not generated through distributors, and to the extent licensing revenue increases faster than product revenue, we would expect a decrease in the percentage of our total revenue generated through distributors.




A significant portion of our revenue is generated from products sold overseas. Sales to customers in Asia, including distributors, represented 80.0% and 75.4% of our revenue for the three and nine months ended September 30, 2010, respectively and 71.6% and 68.4% for the three and nine months ended September 30, 2009, respectively.  The reason for the geographical concentration in Asia is that most of our products are components of consumer electronics, computer and storage products, the majority of which are manufactured in Asia. The percentage of our revenue derived from any country is dependent upon where our end customers choose to manufacture their products. Accordingly, variability in our geographic revenue is not necessarily indicative of any geographic trends, but rather is the combined effect of new design wins and changes in customer manufacturing locations. Primarily all revenue to date has been denominated in U.S. dollars.





Critical Accounting Policies





The preparation of financial statements in conformity with generally accepted accounting principles (GAAP) requires management to make estimates and assumptions that affect amounts reported in our condensed consolidated financial statements and accompanying notes. We base our estimates on historical experience and all known facts and circumstances that we believe are relevant. Actual results may differ materially from our estimates. We believe the following accounting policies to be most critical to an understanding of our financial condition and results of operations because they require us to make estimates, assumptions and judgments about matters that are inherently uncertain. Our critical accounting estimates include those regarding (1) revenue recognition, (2) allowance for doubtful accounts receivable, (3) inventories,  (4) income taxes, (5) accrued liabilities, (6) stock-based compensation expense, and (7) legal matters. For a discussion of the critical accounting estimates, see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies” in our Annual Report on Form 10-K for the year ended December 31, 2009.





20
 Table of Contents








Results of Operations





REVENUE




Three months ended September 30,


Nine months ended September 30,2010


2009


Change


2010


2009


Change(dollars in thousands)





(dollars in thousands)Product revenue

$
46,117


$
30,716



50.1
%

$
110,774


$
94,747



16.9
%Licensing revenue


14,387



6,440



123.4
%


28,589



20,257



41.1
%Total revenue

$
60,504


$
37,156



62.8
%

$
139,363


$
115,004



21.2
%




Three months ended September 30,


Nine months ended September 30,2010


2009


Change


2010


2009


Change(dollars in thousands)





(dollars in thousands)Consumer Electronics

$
40,480


$
25,588



58.2
%

$
96,291


$
78,850



22.1
%Personal Computers


2,029



1,800



12.7
%


6,008



6,968



-13.8
%Storage


3,608



3,328



8.4
%


8,475



8,929



-5.1
%Licensing revenue


14,387



6,440



123.4
%


28,589



20,257



41.1
%Total revenue

$
60,504


$
37,156



62.8
%

$
139,363


$
115,004



21.2
%





Total product revenue for the three months ended September 30, 2010 was $15.4 million or 50.1% higher than product revenue from the same period in 2009 primarily due to the recovering economy and increased demand for our CE, PC and Storage products. Revenue from our CE, PC and Storage products during the three months ended September 30, 2010 increased by 58.2%, 12.7% and 8.4%, respectively, compared to the same period in 2009.  Our unit shipments during the three months ended September 30, 2010 for CE, PC and Storage increased by 74.4%, 15.2% and 13.5%, respectively, compared to the same period in 2009. The higher unit shipments in our CE product line were primarily driven by increased demand for our port processors from the DTV market. Higher demand for our home theater and mobile products also contributed to the favorable results from our CE product line during the three months ended September 30, 2010 when compared to the same period in 2009.  The increase in unit shipments in our PC and Storage product lines was primarily due to the higher demand for our DVI and SATA products, respectively.  The impact of the 74.4% and 13.5% increase in unit shipments to our CE and Storage revenue, respectively, was partially offset by a 9.4% and 4.1% decrease in the average selling price of our CE and Storage products, respectively.





Total product revenue for the nine months ended September 30, 2010 was $16.0 million or 16.9% higher than the product revenue from the same period in 2009 due to the increased demand for our CE products, partially offset by the decrease in revenue from our PC and Storage products. Revenue from our CE products during the nine months ended September 30, 2010 increased by $17.4 million or 22.1% compared to the same period in 2009. The increase in our CE revenue was partially offset by the $0.9 million and $0.5 million decrease in revenue from our PC and Storage product lines, respectively, during the nine months ended September 30, 2010 compared to the same period in 2009.  The $17.4 million increase in our CE revenue was primarily driven by increasing customer demand for our CE products, which was evidenced by the 30.6% increase in unit shipments during the nine months ended September 30, 2010 compared to the same period in 2009. The higher unit shipments in our CE product line was primarily driven by the increased demand for our port processors from the DTV market coupled with higher demand for our home theater and mobile products.  The impact of the 30.6% increase in unit shipments to our CE revenue was partially offset by a 8.3% decrease in the average selling price of our CE products. The decrease in revenue from our PC and Storage product lines during the nine months ended September 30, 2010 compared to the same period in 2009 was primarily due to the decrease in unit shipments as well as in the average selling prices.





Our licensing activity is complementary to our product sales and helps us to monetize our intellectual property and accelerate market adoption curves associated with our technology.  IP licensing continues to represent an important part of our overall business.  Revenue from licensing accounted for 23.8% and 20.5% of our total revenue for the three and nine months ended September 30, 2010, respectively, and 17.3% and 17.6% of our total revenue for the three and nine months ended September 30, 2009, respectively. Licensing revenue during the three and nine months ended September 30, 2010 increased by $7.9 million and $8.3 million, respectively, compared to the same periods in 2009. The significantly higher licensing revenue during the three and nine months ended September 30, 2010 compared to the licensing revenue during the same periods in 2009 was primarily due to the $7.5 million and $5.9 million additional royalties we recorded during the three and nine months ended September 30, 2010, respectively, as a result of the completion of certain licensing audit activities during the three months ended September 30, 2010. Had it not been for this additional royalty revenue recognized during the three months ended September 30, 2010, licensing revenue for the three and nine months ended September 30, 2010 would have been relatively comparable with the licensing revenue in the same periods in 2009.




21


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COST OF REVENUE AND GROSS PROFIT




Three months ended September 30,


Nine months ended September 30,2010


2009


Change


2010


2009


Change(dollars in thousands)





(dollars in thousands)Cost of product revenue (1)

$
22,587


$
16,801



34.4
%

$
56,898


$
52,284



8.8
%Product gross profit

$
23,530


$
13,915



69.1
%

$
53,876


$
42,463



26.9
%Product gross profit margin


51.0
%


45.3
%






48.6
%


44.8
%(1) Includes stock-based compensation expense

$
127


$
363






$
456


$
806Cost of licensing revenue

$
67


$
156



-57.1
%

$
103


$
626



-83.5
%Licensing gross profit

$
14,320


$
6,284



127.9
%

$
28,486


$
19,631



45.1
%Licensing gross profit margin


99.5
%


97.6
%






99.6
%


96.9
%Total cost of revenue

$
22,654


$
16,957



33.6
%

$
57,001


$
52,910



7.7
%Total gross profit

$
37,850


$
20,199



87.4
%

$
82,362


$
62,094



32.6
%Total gross profit margin


62.6
%


54.4
%






59.1
%


54.0
%





Cost of revenue consists primarily of costs incurred to manufacture, assemble and test our products, and costs to license our technology which involves modification, customization or engineering services, as well as other overhead costs relating to the aforementioned costs including stock-based compensation expense. Our overall gross margin, as a percentage of revenue, was 62.6% and 59.1% for the three and nine months ended September 30, 2010, respectively, and 54.4% and 54.0% for the three and nine months ended September 30, 2009, respectively.  Total cost of revenue for the three and nine months ended September 30, 2010 increased by $5.7 million or 33.6% and $4.1 million or 7.7%, respectively, when compared to the total cost of revenue in the same periods in 2009. The increase in the total cost of revenue was primarily due to the growth in revenue volume during the same comparative periods.





Product gross margin for the three and nine months ended September 30, 2010 was 51.0% and 48.6%, respectively, compared to 45.3% and 44.8% for the three and nine months ended September 30, 2009, respectively. The 5.7% increase in product gross margin during the three months ended September 30, 2010 compared to the same period in 2009 was primarily attributable to approximately 2% wafer and testing cost reduction and the other 3.7% was due to better yields, better overhead absorption resulting from our higher revenue volume in 2010 than in 2009 and lower stock-based compensation expense. The 3.8% increase in product gross margin during the nine months ended September 30, 2010 compared to the same period in 2009 was primarily attributable to approximately 2% wafer and testing cost reduction and the other 1.8% was primarily due to better yields, better overhead absorption and lower stock-based compensation expense.




Our licensing gross margin for the three and nine months ended September 30, 2010 was 99.5% and 99.6%, respectively, compared to 97.6% and 96.9% for the three and nine months ended September 30, 2009, respectively.  Licensing gross margin during the three and nine months ended September 30, 2010 increased by 1.9% and 2.7%, respectively, compared to the same periods in 2009. The increase was primarily due to lower mix of IP customization projects during the three and nine months ended September 30, 2010 compared to the same periods in 2009.





Our overall gross margin for the three and nine months ended September 30, 2010 was 62.6% and 59.1%, respectively, compared to 54.4% and 54.0% for the three and nine months ended September 30, 2009, respectively. The increase in our overall gross margin was primarily due to the improvement in the product gross margins, which increased by 5.7% and 3.8% during the three and nine months ended September 30, 2010, respectively, when compared to the product gross margins in the same periods in 2009. The improvement in our licensing gross margins, which increased by 1.9% and 2.7% during the three and nine months ended September 30, 2010, respectively, when compared to the licensing gross margins in the same periods in 2009, also contributed favorably to our overall gross margin in 2010.




22
 
 Table of Contents






OPERATING EXPENSES








Three months ended September 30,


Nine months ended September 30,2010


2009


Change


2010


2009


Change(dollars in thousands)





(dollars in thousands)Research and development (1)

$
13,583


$
17,807



-23.7
%

$
40,379


$
53,160



-24.0
%Percentage of total revenue


22.4
%


47.9
%






29.0
%


46.2
%(1) Includes stock-based compensation expense

$
687


$
2,374






$
2,057


$
5,365





Research and Development (R&D).R&D expense consists primarily of employee compensation and benefits, fees for independent contractors, the cost of software tools used for designing and testing our products and costs associated with prototype materials. R&D expense for the three and nine months ended September 30, 2010 included a stock-based compensation expense of $0.7 million and $2.1 million, respectively, as compared to $2.4 million and $5.4 million for the three and nine months ended September 30, 2009, respectively. The stock-based compensation expense for the three and nine months ended September 30, 2010 was significantly lower than the expense in the same periods in 2009 primarily due to the $1.1 million cumulative adjustment we recognized during the three months ended September 30, 2009 related to the errors we identified as to how our third party software provider was calculating the stock-based compensation expense.  The lower headcount in 2010 compared to 2009 due to the restructuring programs in fiscal years 2008 and 2009 also contributed to the lower stock-based compensation expense in 2010 compared to 2009.  R&D expense for the three and nine months ended September 30, 2010 decreased by $4.2 million or 23.7% and $12.8 million or 24.0%, respectively, when compared to the R&D expense incurred in the same periods in 2009.  The decrease in R&D expense was primarily attributable to the decrease in stock-based compensation expense as previously mentioned and to our cost savings from the closure of our two R&D sites associated with the Germany restructuring in the fourth quarter of 2009. This restructuring was done with the objective of realigning our resources to our core competencies.  Due to the closure of our two R&D sites in Germany, we have engaged the services of certain R&D engineering companies in fiscal year 2010 and as a result, we incurred R&D engineering consulting fees of approximately $1.6 million and $4.1 million for the three and nine months ended September 30, 2010, respectively. These R&D consulting fees partially offset the decrease in R&D expense during the three and nine months ended September 30, 2010 when compared to the R&D expense incurred in the same periods in 2009.  Our R&D head count as of September 30, 2010 was 199 employees compared to the head count of 314 employees as of September 30, 2009.








Three months ended September 30,


Nine months ended September 30,2010


2009


Change


2010


2009


Change(dollars in thousands)





(dollars in thousands)Selling, general and administrative (1)

$
11,691


$
17,222



-32.1
%

$
34,862


$
43,615



-20.1
%Percentage of total revenue


19.3
%


46.4
%






25.0
%


37.9
%(1) Includes stock-based compensation expense

$
936


$
4,911






$
3,382


$
9,255





Selling, General and Administrative (SG&A). SG&A expense consists primarily of compensation, including stock-based compensation, sales commissions, professional fees, and marketing and promotional expenses. SG&A expense during the three and nine months ended September 30, 2010 was $5.5 million or 32.1% and $8.8 million or 20.1%, respectively, lower than the SG&A expense incurred in the same periods in 2009, primarily due to the nonrecurring charges that we incurred during the first nine months of fiscal year of 2009.  During the three months ended  September 30, 2009, we incurred approximately $2.0 million in professional fees associated with a potential strategic acquisition which we evaluated but decided not to pursue, $1.2 million compensation expense related to the compensation package provided to our former Chief Executive Officer upon his resignation in September 2009 and $2.6 million stock-based compensation expense cumulative adjustment pertaining to the errors we identified with respect to the stock-based compensation expense calculated by our third-party software.  Not considering the impact of these nonrecurring charges, SG&A expense for the nine months ended September 30, 2010 would have been $3.0 million lower than what was incurred in the same period in 2009, which was primarily attributable to the lower compensation related expenses resulting from the reduction in forces implemented in fiscal years 2008 and 2009. Our head count in our SG&A departments was 153 employees and 179 employees as of September 30, 2010 and 2009, respectively.




23
 
 Table of Contents









Three months ended September 30,


Nine months ended September 30,2010


2009


Change


2010


2009


Change(dollars in thousands)





(dollars in thousands)Amortization of intangible assets

$
37


$
1,473



-97.5
%

$
112


$
4,419



-97.5
%Percentage of total revenue


0.1
%


4.0
%






0.1
%


3.8
%





Amortization of Intangible Assets.The significant decrease in the amortization of intangible assets was primarily due to the impairment in 2009 of the intellectual property we had licensed from Sunplus Technology Co., Ltd.  and to the full amortization of certain intangible assets related to the sci-worx acquisition.




Three months ended September 30,


Nine months ended September 30,2010


2009


Change


2010


2009


Change(dollars in thousands)





(dollars in thousands)Income tax  expense (benefit)

$
3,531


$
(444
)


-895.3
%

$
3,849


$
(2,113
)


-282.2
%Percentage of total revenue


5.8
%


-1.2
%






2.8
%


-1.8
%





Provision for Income Taxes.We recorded an income tax expense of $3.5 million and $3.8 million for the three and nine months ended September 30, 2010, respectively.  The effective tax rates for the three and nine months ended September 30, 2010 were 27.2% and 49.0%, respectively, and were based on our projected taxable income for 2010, adjusted for the impact of certain discrete items for which the tax effect is recorded during the respective quarter that the event occurs. The difference between the provision for income taxes and the income tax determined by applying the statutory federal income tax rate of 35% was due primarily to change in valuation allowance, foreign taxes and state taxes.





For the three and nine months ended September 30, 2009, we recorded an income tax benefit of $444,000 and $2.1 million, respectively. The effective tax rates for the three and nine months ended September 30, 2009 were 2.8% and 3.3%, respectively and were based on our projected taxable income for 2009,  adjusted for the impact of certain discrete items for which the tax effect is recorded during the respective quarter that the event occurs. The difference between the provision for income taxes and the income tax determined by applying the statutory federal income tax rate of 35% was due primarily to various forecasted items including tax exempt income, stock-based compensation expense, tax credits and foreign taxes, adjusted for certain discrete items recorded during the quarter.








Recent Accounting Pronouncements





See Note 2, “Recent Accounting Pronouncements” in the Notes to Condensed Consolidated Financial Statements under Part I Item 1 of this report.





24
 Table of Contents








LIQUIDITY, CAPITAL RESOURCES AND FINANCIAL CONDITION





The following sections discuss the effects of changes in our balance sheet and cash flows, contractual obligations and other commitments on our liquidity and capital resources.





Cash and Cash Equivalents, Short-term Investments and Working Capital. The table below summarizes our cash and cash equivalents, investments and working capital and the related movements (in thousands).





September 30, 2010


December 31, 2009


ChangeCash and cash equivalents

$
33,635


$
29,756


$
3,879Short-term investments


150,932



120,866



30,066Total cash, cash equivalents and short-term investments

$
184,567


$
150,622


$
33,945Total current assets

$
226,128


$
207,828


$
18,300Total current liabilities


(46,714
)


(44,346
)


(2,368
)Working capital

$
179,414


$
163,482


$
15,932





At September 30, 2010, we had $179.4 million of working capital, including $184.5 million of cash, cash equivalents and short-term investments. Cash and cash equivalents and short-term investments increased by $33.9 million from $150.6 million as of December 31, 2009 to $184.5 million as of September 30, 2010 primarily due to net income tax refunds totaling to approximately $18.7 million and increased cash collections of receivables, partially offset by the $16.7 million cash used to pay our restructuring liability and by the cash used in operations during the nine months ended September 30, 2010.





The significant components of our working capital are cash and cash equivalents, short-term investments, accounts receivable, inventories  and prepaid expenses and other current assets, reduced by accounts payable, accrued and other current liabilities, deferred license revenue and deferred margin on sales to distributors. Working capital at September 30, 2010 increased by approximately $15.9 million when compared to the working capital at December 31, 2009 primarily due to the $18.3 million increase in operating assets, partially offset by the $2.4 million increase in operating liabilities. The significant increase in operating assets was primarily related to the $33.9 million increase in total cash, cash equivalents and short-term investments, $3.8 million increase in inventories and $2.5 million increase in net accounts receivable, partially offset by the $21.9 million decrease in prepaid expenses and other current assets. The $3.8 million increase in inventories was primarily due to the increasing demand for our products and the $2.5 million increase in net accounts receivable was mainly due to the increase in revenues. The $21.9 million decrease in prepaid expenses and other current assets was primarily attributed to the $18.7 million net income tax refunds.




We believe that our current cash, cash equivalents and short-term investment balances will be sufficient to meet our liquidity requirements for at least the next twelve months.





Summary of Cash Flows. The table below summarizes the cash and cash equivalents provided by (used in) in our operating, investing and financing activities (in thousands).





Nine Months Ended September 30,2010


2009


ChangeCash provided by (used in) operating activities

$
39,483


$
(28,232
)

$
67,715Cash used in investing activities


(36,538
)


(40,611
)


4,073Cash provided by financing activities


513



1,045



(532
)Effect of exchange rate changes on cash & cash equivalents


421



267



154Net increase (decrease) in cash and cash equivalents

$
3,879


$
(67,531
)

$
71,410





During the nine months ended September 30, 2010, cash and cash equivalents increased by $3.9 million primarily due to the cash generated from our operating activities of $39.5 million, partially offset by the cash used in our investing activities of $36.5 million.




25


Table of Contents








Operating Activities





The $39.5 million cash generated from our operating activities during the nine months ended September 30, 2010 was primarily due to net income, the decrease in prepaid expenses and other current assets and increase in operating liabilities, such as accounts payable, deferred license revenue and deferred margin on sales to distributors, partially offset by the increase in net accounts receivable and inventories and by the decrease in accrued and other liabilities.





Prepaid expenses and other current assets decreased by approximately $22.7 million primarily due to net income tax refunds during the nine months ended September 30, 2010 totaling to approximately $18.7 million. Accounts payable increased by $7.5 million mainly because of the increase in inventories and the timing of vendor invoices and payments. Deferred license revenue increased by $3.0 million primarily due to the new licensing agreements we entered into during the nine months ended September 30, 2010 and deferred margin on sales to distributors increased by $7.4 million, which was attributable to the increasing activities with our distributors driven by the increasing demand for our products.  Accrued and other liabilities decreased by $12.9 million primarily due to the $16.7 million payment of restructuring liability during the nine months ended September 30, 2010, partially offset by the increases in other accrued liabilities, such as accrued payroll and related expenses, which increased by $1.6 million, accrued royalties, which increased by $2.7 million and income tax payable, which increased by $1.0 million. The increase in accrued payroll and related expenses was attributable mainly to the bonus and sales commission accruals, which was a direct result of the significant increase in revenues during fiscal year 2010. The increase in accrued royalties was due to the share of the HDMI founders on the additional royalty revenue that we recognized during the three months ended September 30, 2010 resulting from the completion of the royalty audits during the three months ended September 30, 2010. The increase in the accrued income tax payable was primarily due to the income tax provision recorded during the three months ended September 30, 2010.





Investing Activities





The $36.5 million cash used in investing activities during the nine months ended September 30, 2010 was primarily due to net purchases of short-term investments of approximately $32.2 million,  net investment in property and equipment of approximately $3.6 million and other investing activities amounting to approximately $700,000. During the nine months ended September 30, 2010, we purchased $128.0 million and sold $95.8 million short-term investments.





We held no direct investments in auction rate securities, collateralized debt obligations, structured investment vehicles or mortgage-backed securities. We are not a capital-intensive business. Our purchases of property and equipment relate mainly to testing equipment, leasehold improvements and information technology infrastructure.





Financing Activities





The $0.5 million cash generated from our financing activities during the nine months ended September 30, 2010 was primarily due to the proceeds from issuances of common stock of approximately $2.9 million, partially offset by the cash used to repurchase restricted stock units for minimum statutory income tax withholding of approximately $1.2 million and $1.2 million final payment for our license of intellectual property from licensing agreement with Sunplus Technology Co., Ltd.





Commitments and Contractual Obligations





See Note 9, “Commitments and Contingencies,” in the Notes to Condensed Consolidated Financial Statements under Part I Item 1 of this report.





We purchase components from a variety of suppliers and use several contract manufacturers to provide manufacturing services for our products. During the normal course of business, in order to manage manufacturing lead times and help ensure adequate component supply, we enter into agreements with contract manufacturers and suppliers that either allow them to procure inventory based upon criteria as defined by us or that establish the parameters defining our requirements. In certain instances, these agreements allow us the option to cancel, reschedule, and adjust our requirements based on our business needs prior to firm orders being placed. Consequently, only a portion of our reported purchase commitments arising from these agreements are firm, non-cancelable, and unconditional commitments.




26


Table of Contents








Liquidity and Capital Resource Requirements





Based on our estimated cash flows, we believe that our existing cash and cash equivalents and short-term investments are sufficient to meet our capital and operating requirements for at least the next 12 months. Our future operating and capital requirements depend on many factors, including the levels at which we generate product revenue and related margins, the extent to which we generate cash through stock option exercises and proceeds from sales of shares under our employee stock purchase plan, the timing and extent of development, licensing and royalty revenue, investments in inventory and accounts receivable, the cost of securing access to adequate manufacturing capacity, our operating expenses, including legal and patent assertion costs, and general economic conditions. In addition, cash may be required for future acquisitions should we choose to pursue any. To the extent existing resources and cash from operations are insufficient to support our activities; we may need to raise additional funds through public or private equity or debt financing. These funds may not be available, or if available, we may not be able to obtain them on terms favorable to us.





Item 3. Quantitative and Qualitative Disclosures about Market Risk





Interest Rate Risk





The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. To achieve this objective, we maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including government and corporate securities and money market funds. These securities are classified as available for sale and consequently are recorded on the balance sheet at fair value with unrealized gains or losses reported as a separate component of accumulated other comprehensive income (loss). We also limit our exposure to interest rate and credit risk by establishing and monitoring clear policies and guidelines of our fixed income portfolios. The guidelines also establish credit quality standards, limits on exposure to any one issuer and limits on exposure to the type of instrument. Due to the limited duration and credit risk criteria established in our guidelines we do not expect the exposure to interest rate risk and credit risk to be material. If interest rates rise, the market value of our investments may decline, which could result in a realized loss if we are forced to sell an investment before its scheduled maturity. As of September 30, 2010, we had an investment portfolio of securities as reported in short-term investments, including those classified as cash and cash equivalents of approximately $151.1 million. A sensitivity analysis was performed on our investment portfolio as of September 30, 2010. This sensitivity analysis was based on a modeling technique that measures the hypothetical market value changes that would result from a parallel shift in the yield curve of plus 50, 100, or 150 basis points over a twelve-month time horizon.




0.5%

1.0%

1.5%$671,000

$1,342,000

$2,012,000





Financial instruments that potentially subject us to significant concentrations of credit risk consist primarily of cash equivalents and short-term investments and accounts receivable. A majority of our cash and investments are maintained with a major financial institutions headquartered in the United States. As part of our cash and investment management processes, we perform periodic evaluations of the credit standing of the financial institutions and we have not sustained any credit losses from investments held at these financial institutions. The counterparties to the agreements relating to our investment securities consist of various major corporations and financial institutions of high credit standing.





We perform on-going credit evaluations of our customers’ financial condition and may require collateral, such as letters of credit, to secure accounts receivable if deemed necessary. We maintain an allowance for potentially uncollectible accounts receivable based on our assessment of collectability.







27
 Table of Contents








Foreign Currency Exchange Risk





A majority of our revenue, expense, and capital purchasing activities are transacted in U.S. dollars. However, certain operating expenditures and capital purchases are incurred in or exposed to other currencies, primarily the British Pound, the Chinese Yuan, Euro, Japanese Yen, the South Korean Won and Taiwan Dollar. Additionally, many of our foreign distributors price our products in the local currency of the countries in which they sell. Therefore, significant strengthening or weakening of the U.S. dollar relative to those foreign currencies could result in reduced demand or lower U.S. dollar prices or vice versa, for our products, which would negatively affect our operating results. Cash balances held in foreign countries are subject to local banking laws and may bear higher or lower risk than cash deposited in the United States. The following represents the potential impact of a change in the value of the U.S. dollar compared to the foreign currencies which we use in our operations.  As of September 30, 2010 and 2009, cash held in foreign currencies was approximately $1.0 million and $2.2 million, respectively. The following represents the potential impact of a change in the value of the U.S. dollar compared to the British Pound, Chinese Yuan, Euro, Japanese Yen, South Korean Won and Taiwan Dollar during the nine months ended September 30, 2010 and 2009.  This sensitivity analysis aggregates our nine months activity in these currencies, translated to U.S. dollars, and applies a change in the U.S. dollar value of 5%, 7.5% and 10%.





September 30, 2010





5.0%

7.5%

10.0%$872,000

$1,307,000

$1,743,000





September 30, 2009





5.0%

7.5%

10.0%$1,280,000

$1,919,000

$2,559,000





Derivative Instruments





We have operations in the United States, Europe and Asia, however, a majority of our revenue, costs of sales, expense and capital purchasing activities are being transacted in U.S. Dollars. As a corporation with international as well as domestic operations, we are exposed to changes in foreign exchange rates. These exposures may change over time and could have a material adverse impact on our financial results. Periodically, we use foreign currency forward contracts to hedge certain forecasted foreign currency transactions relating to operating expenses.  We do not enter into derivatives for speculative or trading purposes. We use derivative instruments primarily to manage exposures to foreign currency fluctuations on forecasted cash flows and balances primarily denominated in Euro. Our primary objective in holding derivatives is to reduce the volatility of earnings and cash flows associated with changes in foreign currency exchange rates. These derivatives are designated as cash flow hedges and have maturities of less than one year. The effective portion of the derivative’s gain or loss is initially reported as a component of accumulated other comprehensive income and, upon occurrence of the forecasted transaction, is subsequently reclassified into the line item in the consolidated statements of operations to which the hedged transaction relates. We record any ineffectiveness of the hedging instruments in other income (expense) on our consolidated statements of operations.





Our derivatives expose us to credit and non performance risks to the extent that the counterparties may be unable to meet the terms of the agreement. We seek to mitigate such risks by limiting the counterparties to major financial institutions. In addition, the potential risk of loss with any one counterparty resulting from this type of credit risk is monitored. Management does not expect material losses as a result of defaults by counterparties.





As of September 30, 2010, the outstanding foreign exchange contracts had a total notional value of $2.9 million.  See Note 13 to the Consolidated Financial Statements for more detailed discussions on derivative transactions.





28
 Table of Contents








Item 4. Controls and Procedures





Evaluation of Disclosure Controls and Procedures





Based on our management’s evaluation (with the participation of our principal executive officer and principal financial officer), as of the end of the period covered by this report, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”)) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.





Changes in Internal Control over Financial Reporting





There was no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the third quarter of fiscal 2010 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.





Part II. Other Information





Item 1. Legal Proceedings





Please refer to Note 9 to our financial statements under Part I Item 1 financial statements.







Item 1A. Risk Factors





A description of the risk factors associated with our business is set forth below. You should carefully consider the following risk factors, together with all other information contained or incorporated by reference in this filing, before you decide to purchase shares of our common stock. These factors could cause our future results to differ materially from those expressed in or implied by forward-looking statements made by us. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also harm our business. The trading price of our common stock could decline due to any of these risks and you may lose all or part of your investment.





Our success depends on demand for our new products.





Our future growth and success depends on our ability to develop and bring to market on a timely basis new products, such as our HDMI port processors and products based on our new Mobile High-Definition Link Technology. There can be no assurance that we will be successful in developing and marketing these new or other future products. Moreover, there is no assurance that our new or future products will achieve the desired level of market acceptance in the anticipated timeframes or that any such new or future products will contribute significantly to our revenue. Our new products face significant competition from established companies that have been selling competitive products for longer periods of time than we have.




29


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





The development of new products is highly complex and we have experienced delays, some of which exceeded one year, in the development and introduction of new products on several occasions in the past. We have recently introduced new products and will continue to introduce new products in the future. As our products integrate new, more advanced functions, they become more complex and increasingly difficult to design, manufacture and debug. Successful product development and introduction depends on a number of factors, including, but not limited to:





·
accurate prediction of market requirements and the establishment of market standards and the evolution of existing standards, including enhancements or modifications to existing standards such as HDMI,  DVI, SATA, SPMT, and MHL;
 ·
identification of customer needs where we can apply our innovation and skills to create new standards or areas for product differentiation that improve our overall competitiveness either in an existing market or in a new market;
 ·
development of advanced technologies and capabilities and new products that satisfy customer requirements;
 ·
competitors’ and customers’ integration of the functionality of our products into their products, which puts pressure on us to continue to develop and introduce new products with new functionality;
 ·
timely completion and introduction of new product designs; correctly anticipating the market windows that will maximize acceptance of our products and then delivering the products to the markets within the required windows;
 ·
management of product life cycles;
 ·
use of leading-edge foundry processes, when use of such processes is required and achievement of high manufacturing yields and low cost testing;
 ·
market acceptance of new products; and
 ·
market acceptance of new architectures such as our input processors.




Accomplishing all of this is extremely challenging, time-consuming and expensive and there is no assurance that we will succeed. Product development delays may result from unanticipated engineering complexities, changing market or competitive product requirements or specifications, difficulties in overcoming resource constraints, the inability to license third-party technology or other factors. Competitors and customers may integrate the functionality of our products into their own products, thereby reducing demand for our products. If we are not able to develop and introduce our products successfully and in a timely manner, our costs could increase or our revenue could decrease, both of which would adversely affect our operating results. In addition, it is possible that we may experience delays in generating revenue from these products or that we may never generate revenue from these products. We must work with a semiconductor foundry and with potential customers to complete new product development and to validate manufacturing methods and processes to support volume production and potential re-work. Each of these steps may involve unanticipated difficulties, which could delay product introduction and reduce market acceptance of the product. In addition, these difficulties and the increasing complexity of our products may result in the introduction of products that contain defects or that do not perform as expected, which would harm our relationships with customers 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 our planned new products, that we will be able to complete development of these products when anticipated, or that these products can be manufactured in commercial volumes at acceptable yields, or that any design wins will produce any revenue. Failure to develop and introduce new products, successfully and in a timely manner, may adversely affect our results of operations.





Our annual and quarterly operating results may fluctuate significantly and are difficult to predict, particularly given adverse domestic and global economic conditions.





Our annual and quarterly operating results are likely to vary significantly in the future based on a number of factors many of which we have little or no control. These factors include, but are not limited to:




·
the growth, evolution and rate of adoption of industry standards for our key markets, including consumer electronics, digital-ready PCs and displays and storage devices and systems;
 ·
the fact that our licensing revenue is heavily dependent on a few key licensing transactions being completed for any given period, the timing of which is not always predictable and is especially susceptible to delay beyond the period in which completion is expected and our concentrated dependence on a few licensees in any period for substantial portions of our expected licensing revenue and profits;
 ·
the fact that our licensing revenue has been uneven and unpredictable over time and is expected to continue to be uneven and unpredictable for the foreseeable future, resulting in considerable fluctuation in the amount of revenue recognized in a particular quarter;
 ·
competitive pressures, such as the ability of competitors to successfully introduce products that are more cost-effective or that offer greater functionality than our products, including integration into their products of functionality offered by our products, the prices set by competitors for their products and the potential for alliances, combinations, mergers and acquisitions among our competitors;
 ·
average selling prices of our products, which are influenced by competition and technological advancements, among other factors;
 ·
government regulations regarding the timing and extent to which digital content must be made available to consumers;
 ·
the availability of other semiconductors or other key components that are required to produce a complete solution for the customer; usually, we supply one of many necessary components;
 ·
the cost of components for our products, including the cost of gold, and prices charged by the third parties who manufacture, assemble and test our products; and
 ·
fluctuations in market demand, one-time sales opportunities and sales goals, sometimes results in heightened sales efforts during a given period that may adversely affect our sales in future periods.


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




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Our annual and quarterly operating results are highly dependent upon how well we manage our business.





Our annual and quarterly operating results are highly dependent upon and may fluctuate based on how well we manage our business. Some of these factors include the following:


·
our ability to manage product introductions and transitions, develop necessary sales and marketing channels and manage other matters necessary to enter new market segments;


·
our ability to successfully manage our business in multiple markets such as CE, PC and storage, which may involve additional research and development, marketing or other costs and expenses;


·
our ability to enter into licensing deals when expected and make timely deliverables and milestones on which recognition of revenue often depends;


·
our ability to engineer customer solutions that adhere to industry standards in a timely and cost-effective manner;


·
our ability to achieve acceptable manufacturing yields and develop automated test programs within a reasonable time frame for our new products;


·
our ability to manage joint ventures and projects, design services and our supply chain partners;


·
our ability to monitor the activities of our licensees to ensure compliance with license restrictions and remittance of royalties;


·
our ability to structure our organization to enable achievement of our operating objectives and to meet the needs of our customers and markets;


·
the success of the distribution and partner channels through which we choose to sell our products and our ability to manage expenses and inventory levels; and


·
our ability to successfully maintain certain structural and various compliance activities in support of our global structure which in the long run, will result in certain operational benefits as well as achieve an overall lower tax rate.





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





Our business has been and may continue to be significantly impacted by the deterioration in worldwide economic conditions, and the current uncertainty in the outlook for the global economy makes it more likely that our actual results will differ materially from expectations.





Global credit and financial markets have experienced in the past and may experience in the future disruptions, including diminished liquidity and credit availability, declines in consumer confidence, declines in economic growth, increases in unemployment rates, and continued uncertainty about economic stability. Despite signs of improvement, there can be no assurance that there will not be renewed deterioration in credit and financial markets and confidence in economic conditions. These economic uncertainties affect businesses such as ours in a number of ways, making it difficult to accurately forecast and plan our future business activities. The continued or further tightening of credit in financial markets may lead consumers and businesses to postpone spending, which may cause our customers to cancel, decrease or delay their existing and future orders with us. In addition, financial difficulties experienced by our suppliers or distributors could result in product delays, increased accounts receivable defaults and inventory challenges. The volatility in the credit markets has severely diminished liquidity and capital availability. Our CE product revenue, which comprised approximately 90.0% and 88.5% of total revenue for the three and nine months ended September 30, 2010, respectively, and approximately 85.3% and 85.6% of total revenue for the three and nine months ended September 30, 2009, respectively, is dependent on continued demand for consumer electronics, including but not limited to, DTVs, STBs, DVDs and game consoles. The demand for overall consumer electronics has been and may continue to be adversely affected by economic downturns in the United States and around the world. As a result, the demand for our CE, PC and storage products and our operating results have been and may continue to be adversely affected accordingly. We cannot predict the timing, strength or duration of any economic disruption or subsequent economic recovery, worldwide, in the United States, in our industry, or in the consumer electronics market. These and other economic factors have had and may continue to have a material adverse effect on demand for our CE, PC and storage products and on our financial condition and operating results.





Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate debt securities may have their market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates. We may suffer losses in principal if we are forced to sell securities that decline in market value due to changes in interest rates. Recent adverse events in the global economy and in the credit markets could negatively impact our return on investment for these debt securities and thereby reduce the amount of cash and cash equivalents and investments on our balance sheet.





The licensing component of our business strategy increases business risk and volatility.





Part of our business strategy is to license intellectual property (IP) through agreements with companies whereby companies incorporate our IP into their respective technologies that address markets in which we do not want to directly participate. There can be no assurance that additional companies will be interested in purchasing our technology on commercially favorable terms or at all. We also cannot ensure that companies who purchase our technology will introduce and sell products incorporating our technology, will accurately report royalties owed to us, will pay agreed upon royalties, will honor agreed upon market restrictions, will not infringe upon or misappropriate our intellectual property and will maintain the confidentiality of our proprietary information. The IP agreements are complex and depend upon many factors including completion of milestones, allocation of values to delivered items and customer acceptances. Many of these factors require significant judgments. Licensing revenue could fluctuate significantly from period to period because it is heavily dependent on a few key deals being completed in a particular period, the timing of which is difficult to predict and may not match our expectations. Because of its high margin content, the licensing mix of our revenue can have a disproportionate impact on gross profit and profitability. Also, generating revenue from these arrangements is a lengthy and complex process that may last beyond the period in which efforts begin and once an agreement is in place, the timing of revenue recognition may be dependent on customer acceptance of deliverables, achievement of milestones, our ability to track and report progress on contracts, customer commercialization of the licensed technology and other factors. Licensing that occurs in connection with actual or contemplated litigation is subject to risk that the adversarial nature of the transaction will induce non-compliance or non-payment. The accounting rules associated with recognizing revenue from these transactions are increasingly complex and subject to interpretation. Due to these factors, the amount of license revenue recognized in any period may differ significantly from our expectations.




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





The CE, PC and storage markets in which we operate are intensely competitive. These markets are characterized by rapid technological change, evolving standards, short product life cycles and declining selling prices. We expect competition for many of our products to increase, as industry standards become widely adopted, as competitors reduce prices and offer products with greater levels of integration, and as new competitors enter our markets.





Our products face competition from companies selling similar discrete products and from companies selling products such as chipsets and system-on-a-chip solutions with integrated functionality. Our competitors include semiconductor companies that focus on the CE, display or storage markets, as well as major diversified semiconductor companies and we expect that new competitors will enter our markets. Current or potential customers, including our own licensees, may also develop solutions that could compete with us, including solutions that integrate the functionality of our products into their solutions. In addition, current or potential OEM customers may have internal semiconductor capabilities and may develop their own solutions for use in their products rather than purchasing them from companies such as us. Some of our competitors have already established supplier or joint development relationships with current or potential customers and may be able to leverage their existing relationships to discourage these customers from purchasing products from us or persuade them to replace our products with theirs. Many of our competitors have longer operating histories, greater presence in key markets, better name recognition, access to larger customer bases and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other resources than we do and as a result, they may be able to adapt more quickly to new or emerging technologies and customer requirements, or devote greater resources to the promotion and sale of their products. In particular, well-established semiconductor companies, such as Analog Devices, NXP, Broadcom, Intel, National Semiconductor and Texas Instruments and CE manufacturers, such as Panasonic, Sony, Samsung and Toshiba, may compete against us in the future. Some of our competitors could merge, which may enhance their market presence. Existing or new competitors may also develop technologies that more effectively address our markets with products that offer enhanced features and functionality, lower power requirements, greater levels of integration or lower cost. Increased competition has resulted in and is likely to continue to result in price reductions and loss of market share in certain markets. We cannot assure you that we can compete successfully against current or potential competitors, or that competition will not reduce our revenue and gross margins.







We operate in rapidly evolving markets, which makes it difficult to evaluate our future prospects.





The markets in which we compete are characterized by rapid technological change, evolving customer needs and frequent introductions of new products and standards. As we adjust to evolving customer requirements and technological advances, we may be required to further reposition our existing offerings and to introduce new products and services. We may not be successful in developing and marketing such new offerings, or we may experience difficulties that could delay or prevent the development and marketing of such new offerings. Moreover, new standards that compete with standards that we promote have been and in the future may be introduced from time to time, which could impact our success. Accordingly, we face risks and difficulties frequently encountered by companies in new and rapidly evolving markets. If we do not successfully address these risks and difficulties, our results of operations could be negatively affected.







We may experience difficulties in transitioning to smaller geometry process technologies or in achieving higher levels of design integration, which may result in reduced manufacturing yields, delays in product deliveries and increased expenses.





To remain competitive, we expect to continue to transition our semiconductor products to increasingly smaller line width geometries. This transition requires us to modify the manufacturing processes for our products and to redesign some products as well as standard cells and other integrated circuit designs that we may use in multiple products. We periodically evaluate the benefits, on a product-by-product basis, of migrating to smaller geometry process technologies to reduce our costs. Currently most of our products are manufactured in .18 micron and .13 micron, geometry processes. We are now designing a new product in 65 nanometer process technology and planning for the transition to smaller process geometries. In the past, we have experienced some difficulties in shifting to smaller geometry process technologies or new manufacturing processes, which resulted in reduced manufacturing yields, delays in product deliveries and increased expenses. The transition to 65 nanometer geometry process technology will result in significantly higher mask and prototyping costs, as well as additional expenditures for engineering design tools and related computer hardware. We may face similar difficulties, delays and expenses as we continue to transition our products to smaller geometry processes.





We are dependent on our relationships with our foundry subcontractors to transition to smaller geometry processes successfully. We cannot assure you that the foundries that we use will be able to effectively manage the transition in a timely manner, or at all, or that we will be able to maintain our existing foundry relationships or develop new ones. If any of our foundry subcontractors or we experience significant delays in this transition or fail to efficiently implement this transition, we could experience reduced manufacturing yields, delays in product deliveries and increased expenses, all of which could harm our relationships with our customers and our results of operations.




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We will have difficulty selling our products if customers do not design our products into their product offerings or if our customers’ product offerings are not commercially successful.





Our products are generally incorporated into our customers’ products at the design stage. As a result, we rely on equipment manufacturers to select our products to be designed into their products. Without these “design wins,” it is very difficult to sell our products. We often incur significant expenditures on the development of a new product without any assurance that an equipment manufacturer will select our product for design into its own product. Additionally, in some instances, we are dependent on third parties to obtain or provide information that we need to achieve a design win. Some of these third parties may be our competitors and, accordingly, may not supply this information to us on a timely basis, if at all. Once an equipment manufacturer designs a competitor’s product into its product offering, it becomes significantly more difficult for us to sell our products to that customer because changing suppliers involves significant cost, time, effort and risk for the customer. Furthermore, even if an equipment manufacturer designs one of our products into its product offering, we cannot be assured that its product will be commercially successful or that we will receive any revenue from that product. Sales of our products largely depend on the commercial success of our customers’ products. Our customers generally can choose at any time to stop using our products if their own products are not commercially successful or for any other reason. We cannot assure you that we will continue to achieve design wins or that our customers’ equipment incorporating our products will ever be commercially successful.





Our products typically have lengthy sales cycles. A customer may decide to cancel or change its product plans, which could cause us to lose anticipated sales. In addition, our average product life cycles tend to be short and, as a result, we may hold excess or obsolete inventory that could adversely affect our operating results.





After we have developed and delivered a product to a customer, the customer will usually test and evaluate our product prior to designing its own equipment to incorporate our product. Our customers generally need three months to over six months to test, evaluate and adopt our product and an additional three months to over nine months to begin volume production of equipment that incorporates our product. Due to this lengthy sales cycle, we may experience significant delays from the time we incur operating expenses and make investments in inventory until the time that we generate revenue from these products. It is possible that we may never generate any revenue from these products after incurring such expenditures. Even if a customer selects our product to incorporate into its equipment, we have no assurances that the customer will ultimately market and sell its equipment or that such efforts by our customer will be successful. The delays inherent in our lengthy sales cycle increase the risk that a customer will decide to cancel or change its product plans. Such a cancellation or change in plans by a customer could cause us to lose sales that we had anticipated. In addition, anticipated sales could be materially and adversely affected if a significant customer curtails, reduces or delays orders during our sales cycle or chooses not to release equipment that contains our products. Further, the combination of our lengthy sales cycles coupled with worldwide economic conditions could have a compounding negative impact on the results of our operations.





While our sales cycles are typically long, our average product life cycles tend to be short as a result of the rapidly changing technology environment in which we operate. As a result, the resources devoted to product sales and marketing may not generate material revenue for us and from time to time, we may need to write off excess and obsolete inventory. If we incur significant marketing expenses and investments in inventory in the future that if we are not able to recover and we are not able to compensate for those expenses, our operating results could be adversely affected. In addition, if we sell our products at reduced prices in anticipation of cost reductions but still hold higher cost products in inventory, our operating results would be harmed.




Our customers may not purchase anticipated levels of products, which can result in excess inventories.





We generally do not obtain firm, long-term purchase commitments from our customers and, in order to accommodate the requirements of certain customers, we may from time to time build inventory that is specific to that customer in advance of receiving firm purchase orders. The short-term nature of our customers’ commitments and the rapid changes in demand for their products reduce our ability to accurately estimate the future requirements of those customers. Should the customer’s needs shift so that they no longer require such inventory, we may be left with excessive inventories, which could adversely affect our operating results.




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





Historically, a relatively small number of customers and distributors have generated a significant portion of our revenue. For the three months ended September 30, 2010, shipments to Samsung Electronics, Microtek Corporation, Innotech Corporation and Edom Technology Company Ltd. accounted for 19.8%, 12.9%, 11.8% and 10.6% of our revenue, respectively. For the nine months ended September 30, 2010, shipments to Samsung Electronics, Innotech Corporation and Microtek Corporation accounted for 18.6%, 11.5% and 11.2% of our revenue, respectively. For the three months ended September 30, 2009, shipments to Microtek Corporation and EDOM Technology Company, Ltd. accounted for 16.3% and 10.6% of our revenue, respectively. For the nine months ended September 30, 2009, shipments to Microtek Corporation and Weikeng Industrial accounted for 12.8% and 10.3% of our revenue, respectively.  In addition, an end-customer may buy our products through multiple distributors, contract manufacturers and /or directly, which could create an even greater concentration. We cannot be certain that customers and key distributors that have accounted for significant revenue in past periods, individually or as a group, will continue to sell our products and generate revenue. As a result of this concentration of our customers, our results of operations could be negatively affected if any of the following occurs:




·
one or more of our customers, including distributors, becomes insolvent or goes out of business;


·
one or more of our key customers or distributors significantly reduces, delays or cancels orders; and/or


·
one or more significant customers selects products manufactured by one of our competitors for inclusion in their future product generations.





While our participation in multiple markets has broadened our customer base, as product mix fluctuates from quarter to quarter, we may become more dependent on a small number of customers or a single customer for a significant portion of our revenue in a particular quarter, the loss of which could adversely affect our operating results.




We sell our products through distributors, which limits our direct interaction with our end customers, therefore reducing our ability to forecast sales and increasing the complexity of our business.





Many original equipment manufacturers (“OEMs”) rely on third-party manufacturers or distributors to provide inventory management and purchasing functions. For the three and nine months ended September 30, 2010, distributors accounted for 64.8% and 58.8% of our revenue, respectively. Sales to distributors accounted for 61.2% and 61.1% of our revenue for the three and nine months ended September 30, 2009, respectively.  Selling through distributors reduces our ability to forecast sales and increases the complexity of our business, requiring us to:




·
manage a more complex supply chain;


·
monitor and manage the level of inventory of our products at each distributor;


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


·
monitor the financial condition and credit-worthiness of our distributors, many of which are located outside of the United States and the majority of which are not publicly traded.





Since we have limited ability to forecast inventory levels at our end customers, it is possible that there may be significant build-up of inventories in the distributor channel, with the OEM or the OEM’s contract manufacturer. Such a buildup could result in a slowdown in orders, requests for returns from customers, or requests to move out planned shipments. This could adversely impact our revenues and profits.





Any failure to manage these challenges could disrupt or reduce sales of our products and unfavorably impact our financial results.





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 Governmental action against companies located in offshore jurisdictions may lead to a reduction in the demand for our common shares.





Recent federal and state legislation has been proposed, and additional legislation may be proposed in the future which, if enacted, could have an adverse tax impact on both us and our shareholders. For example, the ability to defer taxes as a result of permanent investments offshore could be limited, thus raising our effective tax rate.




We have made acquisitions in the past and may make acquisitions in the future, and these acquisitions involve numerous risks.





Our growth depends upon market growth and our ability to enhance our existing products and introduce new products on a timely basis. Acquisitions of companies or intangible assets is a strategy we may use to develop new products and enter new markets. We may acquire additional companies or technologies in the future. Acquisitions involve numerous risks, including, but not limited to, the following:




·
difficulty and increased costs in assimilating employees, including our possible inability to keep and retain key employees of the acquired business;


·
disruption of our ongoing business;


·
discovery of undisclosed liabilities of the acquired companies and legal disputes with founders or shareholders of acquired companies;


·
inability to commercialize acquired technology; and


·
the need to take impairment charges or write-downs with respect to acquired assets.





No assurance can be given that our prior acquisitions or our future acquisitions, if any, will be successful or provide the anticipated benefits, or that they will not adversely affect our business, operating results or financial condition. Failure to manage growth effectively and to successfully integrate acquisitions made by us could materially harm our business and operating results.





For example, in January 2007, we completed the acquisition of sci-worx (Silicon Image, GmbH). In 2009, because of our decision to focus on discrete semiconductor products and related intellectual property, we decided to restructure our research and development operations resulting in the closure of our two sites in Germany.





Industry cycles may strain our management and resources.





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




·
improve operational and financial systems;


·
train and manage our employee base;


·
successfully integrate operations and employees of businesses we acquire or have acquired;


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


·
adjust spending levels according to prevailing market conditions.




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





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




The semiconductor industry is characterized by significant downturns and wide fluctuations in supply and demand. This cyclicality has led to significant fluctuations in product demand and in the foundry, test and assembly capacity of third-party suppliers. Production capacity for fabricated semiconductors is subject to allocation, whereby not all of our production requirements would be met. This may impact our ability to meet demand and could also increase our production costs and inventory levels. Cyclicality has also accelerated decreases in average selling prices per unit. We may experience fluctuations in our future financial results because of changes in industry-wide conditions. Our financial performance has been and may in the future be, negatively impacted by downturns in the semiconductor industry. In a downturn situation, we may incur substantial losses if there is excess production capacity or excess inventory levels in the distribution channel.




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





We do not own or operate a semiconductor fabrication facility. We rely on one third party semiconductor company overseas to produce substantially all of our semiconductor products. We also rely on outside assembly and test services to test all 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 control over delivery schedules, quality assurance, manufacturing yields and production costs;


·
lack of guaranteed production capacity or product supply, potentially resulting in higher inventory levels; and


·
lack of availability of, or delayed access to, next-generation or key process technologies.





We do not have a long-term supply agreement with all of our subcontractors and instead obtain production services on a purchase order basis. Our outside sub-contractors have no obligation to manufacture our products or supply products to us for any specific period of time, in any specific quantity, except as set forth in a particular purchase order. Our requirements represent a small portion of the total production capacity of our outside foundries, assembly and test facilities and our sub-contractors may reallocate capacity on short notice to other customers who may be larger and better financed than we are, who pay a higher price for the same service or who have long-term agreements with our sub-contractors, even during periods of high demand for our products. These foundries may allocate or move production of our products to different foundries under their control, even in different locations, which may be time consuming, costly and difficult, have an adverse affect on quality, yields and costs and require us and/or our customers to re-qualify the products, which could open up design wins to competition and result in the loss of design wins and design-ins. If our subcontractors are unable or unwilling to continue manufacturing our products in the required volumes, at acceptable quality, yields and costs and in a timely manner, our business will be substantially harmed. As a result, we would have to identify and qualify substitute sub-contractors, which would be time-consuming, costly and difficult; there is no guarantee that we would be able to identify and qualify such substitute sub­contractors on a timely basis or obtain commercially reasonable terms from them. This qualification process may also require significant effort by our customers and may lead to re-qualification of parts, opening up design wins to competition and loss of design wins and design-ins. Any of these circumstances could substantially harm our business. In addition, if competition for foundry, assembly and test capacity increases, our product costs may increase and we may be required to pay significant amounts or make significant purchase commitments to secure access to production services.




The complex nature of our production process, which can reduce yields and prevent identification of problems until well into the production cycle or, in some cases, after the product has been shipped.





The manufacture of semiconductors is a complex process and it is often difficult for semiconductor foundries to achieve acceptable product yields. Product yields depend on both our product design and the manufacturing process technology unique to the semiconductor foundry. Since low yields may result from either design or process difficulties, identifying problems can often only occur well into the production cycle, when an actual product exists that can be analyzed and tested.





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





Although we test our products before shipment, they are complex and may contain defects and errors. 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. Delivery of products with defects or reliability, quality or compatibility problems, may damage our reputation and our ability to retain existing customers and attract new customers. In addition, product defects and errors could result in additional development costs, diversion of technical resources, delayed product shipments, increased product returns, warranty and product liability claims against us that may not be fully covered by insurance. Any of these circumstances could substantially harm our business.





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We face foreign business, political and economic risks because a majority of our products and our customers’ products are manufactured and sold outside of the United States.





A substantial portion 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 of our products are manufactured in Taiwan or elsewhere in Asia. For the three and nine months ended September 30, 2010, approximately 86.3% and 78.3% of our revenue, respectively, was generated from customers and distributors located outside of the United States, primarily in Asia. We anticipate that sales outside of the United States will continue to account for a substantial portion of our revenue in future periods. In addition, we undertake various sales and marketing activities through regional offices in several other countries and we have significantly expanded our research and development operations outside of the United States. We intend to continue to expand our international business activities. Accordingly, we are subject to international risks, including, but not limited to:




·
political, social and economic instability;


·
exposure to different business practices and legal standards, particularly with respect to intellectual property;


·
natural disasters and public health emergencies;


·
nationalization of business and blocking of cash flows;


·
trade and travel restrictions;


·
the imposition of governmental controls and restrictions;


·
burdens of complying with a variety of foreign laws;


·
import and export license requirements and restrictions of the United States and each other country in which we operate;


·
unexpected changes in regulatory requirements;


·
foreign technical standards;


·
changes in taxation and tariffs;


·
difficulties in staffing and managing international operations;


·
fluctuations in currency exchange rates;


·
difficulties in collecting receivables from foreign entities or delayed revenue recognition;


·
expense and difficulties in protecting our intellectual property in foreign jurisdictions;


·
exposure to possible litigation or claims in foreign jurisdictions; and


·
potentially adverse tax consequences.





Any of the factors described above may have a material adverse effect on our ability to increase or maintain our foreign sales. In addition, original equipment manufacturers that design our semiconductors into their products sell them outside of the United States. This exposes us indirectly to foreign risks. Because sales of our products are denominated exclusively in United States dollars, relative increases in the value of the United States dollar will increase the foreign currency price equivalent of our products, which could lead to a change in the competitive nature of these products in the marketplace. This in turn could lead to a reduction in sales and profits.





Closure of our R&D sites in Germany may impact our product development efforts.





In 2009, we decided to restructure our research and development operations resulting in the closure of our two R&D sites in Germany. The decision to close these sites may have an unanticipated adverse impact on our product development efforts and product roadmap in the short- to mid-term as we transition these R&D engineering resources to new geographies. Such an impact could include adverse effects on our business, financial condition and operating results.




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The success of our business depends upon our ability to adequately protect our intellectual property.





We rely on a combination of patent, copyright, trademark, mask work and trade secret laws, as well as nondisclosure agreements and other methods, to protect our proprietary technologies. We have been issued patents and have a number of pending patent applications. However, we cannot assure you that any patents will be issued as a result of any applications or, if issued, that any claims allowed will protect our technology. In addition, we do not file patent applications on a worldwide basis, meaning we do not have patent protection in some jurisdictions. It may be possible for a third-party, including our licensees, to misappropriate our copyrighted material or trademarks. It is possible that existing or future patents may be challenged, invalidated or circumvented and effective patent, copyright, trademark and trade secret protection may be unavailable or limited in foreign countries. It may be possible for a third-party to copy or otherwise obtain and use our products or technology without authorization, develop similar technology independently or design around our patents in the United States and in other jurisdictions. It is also possible that some of our existing or new licensing relationships will enable other parties to use our intellectual property to compete against us. Legal actions to enforce intellectual property rights tend to be lengthy and expensive and the outcome often is not predictable. As a result, despite our efforts and expenses, we may be unable to prevent others from infringing upon or misappropriating our intellectual property, which could harm our business. In addition, practicality also limits our assertion of intellectual property rights. Patent litigation is expensive and its results are often unpredictable. Assertion of intellectual property rights often results in counterclaims for perceived violations of the defendant’s intellectual property rights and/or antitrust claims. Certain parties after receipt of an assertion of infringement will cut off all commercial relationships with the party making the assertion, thus making assertions against suppliers, customers and key business partners risky. If we forgo making such claims, we may run the risk of creating legal and equitable defenses for an infringer.





We generally enter into confidentiality agreements with our employees, consultants and strategic partners. We also try to control access to and distribution of our technologies, documentation and other proprietary information. Despite these efforts, internal or external parties may attempt to copy, disclose, obtain or use our products, services or technology without our authorization. Also, current or former employees may seek employment with our business partners, customers or competitors, and we cannot assure you that the confidential nature of our proprietary information will be maintained in the course of such future employment. Additionally, current, departing or former employees or third parties could attempt to penetrate our computer systems and networks to misappropriate our proprietary information and technology or interrupt our business. Because the techniques used by computer hackers and others to access or sabotage networks change frequently and generally are not recognized until launched against a target, we may be unable to anticipate, counter or ameliorate these techniques. As a result, our technologies and processes may be misappropriated, particularly in countries where laws may not protect our proprietary rights as fully as in the United States.





Our products may contain technology provided to us by other parties such as contractors, suppliers or customers. We may have little or no ability to determine in advance whether such technology infringes the intellectual property rights of a third party. Our contractors, suppliers and licensors may not be required to indemnify us in the event that a claim of infringement is asserted against us, or they may be required to indemnify us only up to a maximum amount, above which we would be responsible for any further costs or damages. In addition, we may have little or no ability to correct errors in the technology provided by such contractors, suppliers and licensors, or to continue to develop new generations of such technology. Accordingly, we may be dependent on their ability and willingness to do so. In the event of a problem with such technology, or in the event that our rights to use such technology become impaired, we may be unable to ship our products containing such technology, and may be unable to replace the technology with a suitable alternative within the time frame needed by our customers.





Our participation in working groups for the development and promotion of industry standards in our target markets, including the Digital Visual Interface and HDMI specifications, requires us to license some of our intellectual property for free or under specified terms and conditions, which may make it easier for others to compete with us in such markets.





A key element of our business strategy includes participation in working groups to establish industry standards in our target markets, promote and enhance specifications and develop and market products based on such specifications and future enhancements. We are a promoter of the Digital Display Working Group (DDWG), which published and promotes the DVI specification and a founder in the working group that develops and promotes the HDMI specification. In connection with our participation in such working groups:




·
we must license for free specific elements of our intellectual property to others for use in implementing the DVI specification; and we may license additional intellectual property for free as the DDWG promotes enhancements to the DVI specification; and


·
we must license specific elements of our intellectual property to others for use in implementing the HDMI specification and we may license additional intellectual property as the HDMI founders group promotes enhancements to the HDMI specification.





Accordingly, certain companies that implement the DVI and HDMI specifications in their products can use specific elements of our intellectual property to compete with us, in certain cases for free. Although in the case of the HDMI specification, there are annual fees and royalties associated with the adopters’ agreements, there can be no assurance that such annual fees and royalties will adequately compensate us for having to license our intellectual property. Fees and royalties received during the early years of adoption of HDMI will be used to cover costs we incur to promote the HDMI standard and to develop and perform interoperability tests; in addition, after an initial period during which we received all of the royalties associated with HDMI adopters’ agreements, in 2007, the HDMI founders reallocated the royalties to reflect each founder’s relative contribution of intellectual property to the HDMI specification. Our subsidiary no longer recognizes 100% of the HDMI adopter royalty revenues.





We intend to promote and continue to be involved and actively participate in other standard setting initiatives. For example, we also recently joined the Serial Port Memory Technology (SPMTTM) consortiumto develop and promote a new memory technology. Accordingly, we may license additional elements of our intellectual property to others for use in implementing, developing, promoting or adopting standards in our target markets, in certain circumstances at little or no cost. This may make it easier for others to compete with us in such markets. In addition, even if we receive license fees and/or royalties in connection with the licensing of our intellectual property, there can be no assurance that such license fees and/or royalties will adequately compensate us for having to license our intellectual property.




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Our success depends in part on our relationships with strategic partners and use of technologies





We have entered into and expect to continue to enter into strategic partnerships with third parties. Negotiating and performing under these strategic partnerships involves significant time and expense; we may not realize anticipated increases in revenue, standards adoption or cost savings; and these strategic partnerships may make it easier for the third parties to compete with us; any of which may have a negative effect our business and results of operations.





Strategic partnerships that we enter into with third parties may not result in the anticipated results. For example, in February 2007, we entered into a licensing agreement with Sunplus Technology Co., Ltd. (Sunplus), which granted us the rights to use and further develop advanced IP technology. Previously, we believed that the IP licensed under this agreement enhanced our ability to develop DTV technology and other related consumer product offerings. Based on the Company’s product strategy as of October 2009, we realized the IP obtained through the Sunplus agreement did not align with our product roadmap and during October 2009, we decided to write off our investment in Sunplus IP. This decision was prompted by a change in our product strategy due to market place and related competitive dynamics.




Our business may be impacted as a result of the adoption of competing standards and technologies by the broader market





The success of our business has been significantly related to our participation in standard setting organizations. From time to time, competing standards have been established which negatively impact the success of existing standards or jeopardize the creation of a new standard. DisplayPort is an example of a competing standard on a different technology base which has created an alternative high definition connectivity methodology in the PC space. This standard has been adopted by several large PC manufactures. While currently not as widely recognized as the HDMI standard, DisplayPort does represent a viable alternative to the HDMI standard. If DisplayPort should gain broader adoption, our HDMI business could be negatively impacted and our revenues could be reduced.




Our business is dependent on the continued adoption and widespread implementation of the HDMI specification.





Our success is largely dependent upon the continued adoption and widespread implementation of the HDMI specification. More than 75% of our revenue is derived from the sale of HDMI enabled products and the licensing of our HDMI technology. Our leadership in the market for HDMI-enabled products and intellectual property has been based on our ability to introduce first-to-market semiconductor and IP solutions to our customers and to continue to innovate within the standard. Therefore, our inability to be first to market with our HDMI enabled products and intellectual property or to continue to drive innovation in the HDMI specification could have an adverse impact on our business going forward. In addition, the establishment and adoption by the markets we sell into of a competing digital interconnect technology could have an adverse impact on our ability to sell our products and license our intellectual property and therefore our revenues and business.





As the agent for the HDMI specification, we derive revenue from the license fees paid by adopters, and as a founder we derive revenue from the royalties paid by the adopters of the HDMI technology. Any development that has the effect of lowering the number of adopters of the HDMI standard will negatively impact these license fees and royalties. Also, when the HDMI consortium was first formed, we received 100% of the royalties collected from HDMI adopters. During 2007, at a founders meeting, the founders decided to share the HDMI adopter’s royalty revenues among the various founders, such that we no longer receive all of the royalties. The allocation of license fees and royalty revenue among the HDMI founders is an issue that is reviewed and discussed by the founders from time to time. There can be no assurance that going forward we will continue to act as agent of the HDMI specification or to receive the share of HDMI license fees and royalties that we currently receive. If our share of these license fees and royalties is reduced, this decision will have a negative impact on our revenues.




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Our success depends on managing our relationship with Intel.





Intel has a dominant role in many of the markets in which we compete, such as PC and storage and is a growing presence in the CE market. We have a multi-faceted relationship with Intel that is complex and requires significant management attention, including:




·
Intel and Silicon Image have been parties to business cooperation agreements;


·
Intel and Silicon Image are parties to a patent cross-license;


·
Intel and Silicon Image worked together to develop HDCP;


·
an Intel subsidiary has the exclusive right to license HDCP, of which we are a licensee;


·
Intel and Silicon Image were two of the promoters of the DDWG;


·
Intel is a promoter of the SATA working group, of which we are a contributor;


·
Intel is a supplier to us and a customer for our products;


·
we believe that Intel has the market presence to drive adoption of SATA by making it widely available in its chipsets and motherboards, which could affect demand for our products;


·
we believe that Intel has the market presence to affect adoption of HDMI by either endorsing complementary technology or promulgating a competing standard, which could affect demand for our products;


·
Intel may potentially integrate the functionality of our products, including SATA, DVI, or HDMI into its own chips and chipsets, thereby displacing demand for some of our products;


·
Intel may design new technologies that would require us to re-design our products for compatibility, thus increasing our R&D expense and reducing our revenue;


·
Intel’s technology, including its 845G and later chipsets, may lower barriers to entry for other parties who may enter the market and compete with us; and


·
Intel may enter into or continue relationships with our competitors that can put us at a relative disadvantage.




Our cooperation and competition with Intel can lead to positive benefits, if managed effectively. If our relationship with Intel is not managed effectively, it could seriously harm our business, negatively affect our revenue and increase our operating expenses.




New Releases of Microsoft Windows® and Apple Mac OS® operating systems may render our chips inoperable





ICs targeted to PC, laptop, or netbook designs (whether running Microsoft Windows ®, Apple Mac OS® or Linux operating systems) often require device driver software to operate. This software is difficult to produce and requires various certifications such as Microsoft’s Windows Hardware Quality Labs (WHQL) before being released. Each new revision of an operating system may require a new software driver and associated testing/certification. Failure to produce this software can have a negative impact on our relation with Microsoft and/or Apple and may damage our reputation as a quality supplier of SATA and HDMI products in the eyes of end consumers.





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





We entered into a patent cross-license agreement with Intel in which each of us granted the other a license to use the patents filed by the grantor prior to a specified date, except for identified types of products. We believe that the scope of our license to Intel excludes our current products and anticipated future products. Intel could, however, exercise its rights under this agreement to use our patents to develop and market other products that compete with ours, without payment to us. Additionally, Intel’s rights to our patents could reduce the value of our patents to any third-party who otherwise might be interested in acquiring rights to use our patents in such products. Finally, Intel could endorse competing products, including a competing digital interface, or develop its own proprietary digital interface. Any of these actions could substantially harm our business and results of operations.




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We may become engaged in additional intellectual property litigation that could be time-consuming, may be expensive to prosecute or defend and could adversely affect our ability to sell our product.





In recent years, there has been significant litigation in the United States and in other jurisdictions involving patents and other intellectual property rights. This litigation is particularly prevalent in the semiconductor industry, in which a number of companies aggressively use their patent portfolios to bring infringement claims. In addition, in recent years, there has been an increase in the filing of so-called “nuisance suits,” alleging infringement of intellectual property rights. These claims may be asserted as counterclaims in response to claims made by a company alleging infringement of intellectual property rights. These suits pressure defendants into entering settlement arrangements to quickly dispose of such suits, regardless of merit. In addition, as is common in the semiconductor industry, from time to time we have been notified that we may be infringing certain patents or other intellectual property rights of others. Responding to such claims, regardless of their merit, can be time consuming, result in costly litigation, divert management’s attention and resources and cause us to incur significant expenses. As each claim is evaluated, we may consider the desirability of entering into settlement or licensing agreements. No assurance can be given that settlements will occur or that licenses can be obtained on acceptable terms or that litigation will not occur. In the event there is a temporary or permanent injunction entered prohibiting us from marketing or selling certain of our products, or a successful claim of infringement against us requiring us to pay damages or royalties to a third-party and we fail to develop or license a substitute technology, our business, results of operations or financial condition could be materially adversely affected.





Any potential intellectual property litigation against us or in which we become involved may be expensive and time-consuming and may divert our resources and the attention of our executives. It could also force us to do one or more of the following:




·
stop selling products or using technology that contains the allegedly infringing intellectual property;


·
attempt to obtain a license to the relevant intellectual property, which license may not be available on reasonable terms or at all; and


·
attempt to redesign products that contain the allegedly infringing intellectual property.





If we take any of these actions, we may be unable to manufacture and sell our products. We may be exposed to liability for monetary damages, the extent of which would be very difficult to accurately predict. In addition, we may be exposed to customer claims, for potential indemnity obligations and to customer dissatisfaction and a discontinuance of purchases of our products while the litigation is pending. Any of these consequences could substantially harm our business and results of operations.




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





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




We indemnify certain of our licensing customers against infringement.





We indemnify certain of our licensing agreements customers for any expenses or liabilities resulting from third-party claims of infringements of patent, trademark, trade secret, or copyright rights by the technology we license. Certain of these indemnification provisions are perpetual from execution of the agreement and, in some instances; the maximum amount of potential future indemnification is not limited. To date, we have not paid any such claims or been required to defend any lawsuits with respect to any claim. In the event that we were required to defend any lawsuits with respect to our indemnification obligations, or to pay any claim, our results of operations could be materially adversely affected.




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We must attract and retain qualified personnel to be successful and competition for qualified personnel is increasing in our market.





Our success depends to a significant extent upon the continued contributions of our key management, technical and sales personnel, many of who would be difficult to replace. The loss of one or more of these employees could harm our business. Although we have entered into a limited number of employment contracts with certain executive officers, we generally do not have employment contracts with our key employees. Our success also depends on our ability to identify, attract and retain qualified technical, sales, marketing, finance and managerial personnel. Competition for qualified personnel is particularly intense in our industry and in our location. This makes it difficult to retain our key personnel and to recruit highly qualified personnel. We have experienced and may continue to experience, difficulty in hiring and retaining candidates with appropriate qualifications. To be successful, we need to hire candidates with appropriate qualifications and retain our key executives and employees. Replacing departing executive officers and key employees can involve organizational disruption and uncertain timing.





The volatility of our stock price has had an impact on our ability to offer competitive equity-based incentives to current and prospective employees, thereby affecting our ability to attract and retain highly qualified technical personnel. If these adverse conditions continue, we may not be able to hire or retain highly qualified employees in the future and this could harm our business. In addition, regulations adopted by The NASDAQ Stock Market requiring shareholder approval for all stock option plans, as well as regulations adopted by the New York Stock Exchange prohibiting NYSE member organizations from giving a proxy to vote on equity compensation plans unless the beneficial owner of the shares has given voting instructions, could make it more difficult for us to grant options to employees in the future. In addition, FASB ASC No. 718-10, Stock Compensation,requires us to record compensation expense for options granted to employees. To the extent that new regulations make it more difficult or expensive to grant options to employees, we may incur increased cash compensation costs or find it difficult to attract, retain and motivate employees, either of which could harm our business.




If our internal control over financial reporting or disclosure controls and procedures are not effective, there may be errors in our financial statements that could require restatement or our filings may not be timely and investors may lose confidence in our reported financial information, which could lead to a decline in our stock price. While we have not identified any material weaknesses in the past three years, we cannot assure you that a material weakness will not be identified in the future.




Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate the effectiveness of our internal control over financial reporting as of the end of each year and to include a management report assessing the effectiveness of our internal control over financial reporting in each Annual Report on Form 10-K. Section 404 also requires our independent registered public accounting firm to report on, our internal control over financial reporting.




Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. Over time, controls may become inadequate because changes in conditions or deterioration in the degree of compliance with policies or procedures may occur. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.




As a result, we cannot assure you that significant deficiencies or material weaknesses in our internal control over financial reporting will not be identified in the future. Any failure to maintain or implement required new or improved controls, or any difficulties we encounter in their implementation, could result in significant deficiencies or material weaknesses, cause us to fail to timely meet our periodic reporting obligations, or result in material misstatements in our financial statements. Any such failure could also adversely affect the results of periodic management evaluations and annual auditor attestation reports regarding disclosure controls and the effectiveness of our internal control over financial reporting required under Section 404 of the Sarbanes-Oxley Act of 2002 and the rules promulgated thereunder. The existence of a material weakness could result in errors in our financial statements that could result in a restatement of financial statements, cause us to fail to timely meet our reporting obligations and cause investors to lose confidence in our reported financial information, leading to a decline in our stock price.




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We have experienced transitions in our management team, our board of directors in the past and may continue to do so in the future, which could result in disruptions in our operations and require additional costs.





We have experienced a number of transitions with respect to our board of directors and executive officers in recent quarters, including the following:


·
In December 2008, Dale Zimmerman resigned from his position as vice president of worldwide marketing.


·
In March 2009, Paul Dal Santo resigned from his position as chief operating officer.


·
In September 2009, Steve Tirado resigned from his positions as chief executive officer and director and Hal Covert was appointed as president and chief operating officer.


·
In January 2010, Camillo Martino was appointed as chief executive officer and director.


·
In January 2010, Harold Covert agreed to continue in his capacity as our president (but to no longer serve as chief financial officer or chief operating officer) during a transitional period through September 2010 and was also elected to the Board of Directors, to serve through September 2010.


·
In March 2010, J. Duane Northcuttresigned from his position as chief technology officer.


·
In April 2010, Noland Granberry was appointed as our Chief Financial Officer.


·
In April 2010, Sal Cobarresigned from his position as Vice President of Worldwide Sales.


·
In September 2010, Harold Covert resigned from his positions as president and director.





Any future transitions may result in disruptions in our operations and require additional costs.




We have been and may continue to become the target of securities class action suits and derivative suits which could result in substantial costs and divert management attention and resources.





Securities class action suits and derivative suits are often brought against companies, particularly technology companies, following periods of volatility in the market price of their securities. Defending against these suits, even if meritless, can result in substantial costs to us and could divert the attention of our management.





Our operations and the operations of our significant customers, third-party wafer foundries and third-party assembly and test subcontractors are located in are as susceptible to natural disasters.





Our operations are headquartered in the San Francisco Bay area, which is susceptible to earthquakes. TSMC, the outside foundry that produces the majority of our semiconductor products, is located in Taiwan. Siliconware Precision Industries Co. Ltd., or SPIL, Advanced Semiconductor Engineering, or ASE, and Amkor Taiwan are subcontractors located in Taiwan that assemble and test our semiconductor products. For the three and nine months period ended September 30, 2010 customers and distributors located in Japan generated 29.8% and 29.5% of our revenue, respectively, and customers and distributors located in Taiwan generated 23.1% and 20.9% of our revenue, respectively. For the three and nine months ended September 30, 2009, customers and distributors located in Japan accounted for 32.2% and 27.6% of our revenue, respectively and customers and distributors located in Taiwan generated 24.4% and 25.4% of our revenue, respectively.   Both Taiwan and Japan are susceptible to earthquakes, typhoons and other natural disasters.





Our business, including a potential reduction of revenues, would be negatively affected if any of the following occurred:


·
an earthquake or other disaster in the San Francisco Bay area or the Los Angeles area damaged our facilities or disrupted the supply of water or electricity to our headquarters 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 outside foundries or the ability of ASE to provide assembly and test services;


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


·
an earthquake, typhoon or other disaster in Taiwan or Japan disrupted the operations of suppliers to our Taiwanese or Japanese customers, outside foundries or ASE, which in turn disrupted the operations of these customers, foundries or ASE and resulted in reduced purchases of our products or shortages in our product supply.




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Terrorist attacks or war could lead to economic instability and adversely affect our operations, results of operations and stock price.





The United States has taken and continues to take, military action against terrorism and currently has troops in Iraq and in Afghanistan. In addition, the current tensions regarding nuclear arms in North Korea and Iran could escalate into armed hostilities or war. Acts of terrorism or armed hostilities may disrupt or result in instability in the general economy and financial markets and in consumer demand for the OEM’s products that incorporate our products. Disruptions and instability in the general economy could reduce demand for our products or disrupt the operations of our customers, suppliers, distributors and contractors, many of whom are located in Asia, which would in turn adversely affect our operations and results of operations. Disruptions and instability in financial markets could adversely affect our stock price. Armed hostilities or war in South Korea could disrupt the operations of the research and development contractors we utilize there, which would adversely affect our research and development capabilities and ability to timely develop and introduce new products and product improvements.




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





Several jurisdictions have implemented rules that would require that certain products, including semiconductors, be made “green,” which means that the products need to be lead free and be free of certain banned substances. All of our products are available to customers in a green format. While we believe that we are generally in compliance with existing regulations, such environmental regulations are subject to change and the jurisdictions may impose additional regulations which could require us to incur costs to develop replacement products. These changes will require us to incur cost or may take time or may not always be economically or technically feasible, or may require disposal of non-compliant inventory. In addition, any requirement to dispose or abate previously sold products would require us to incur the costs of setting up and implementing such a program.





Provisions of our charter documents and Delaware law could prevent or delay a change in control and may reduce the market price of our common stock.





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




·
authorizing the issuance of preferred stock without stockholder approval;


·
providing for a classified board of directors with staggered, three-year terms;


·
requiring advance notice of stockholder nominations for the board of directors;


·
providing the board of directors the opportunity to expand the number of directors without notice to stockholders;


·
prohibiting cumulative voting in the election of directors;


·
requiring super-majority voting to amend some provisions of our certificate of incorporation and bylaws;


·
limiting the persons who may call special meetings of stockholders; and


·
prohibiting stockholder actions by written consent.




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





The price of our stock fluctuates substantially and may continue to do so.




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




·
actual or anticipated changes in our operating results;




·
changes in expectations of our future financial performance;


·
changes in market valuations of comparable companies in our markets;


·
changes in market valuations or expectations of future financial performance of our vendors or customers;


·
changes in our key executives and technical personnel; and,


·
announcements by us or our competitors of significant technical innovations, design wins, contracts, standards or acquisitions.





Due to these factors, the price of our stock may decline. In addition, the stock market experiences volatility that is often unrelated to the performance of particular companies. These market fluctuations may cause our stock price to decline regardless of our performance.




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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds


None





Item 3. Defaults Upon Senior Securities





Not applicable.





Item 4.  Reserved








Item 5. Other Information





None.





Item 6. Exhibits





(a) Exhibits





3131.01
Certification of Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 20023131.02
Certification of Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 20023232.01**
Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 20023232.02**
Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002





___________





*
This exhibit is a management contract or compensatory plan or arrangement.**
This exhibit is being furnished, rather than filed, and shall not be deemed incorporated by reference into any filing of the registrant, in accordance with Item 601 of Regulation S-K.





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Signature








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








Dated: October 27, 2010
Silicon Image, Inc.








/s/ Noland GranberryNoland Granberry

Chief Financial Officer                      

(Principal  Financial Officer)










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Exhibit Index








3131.01
Certification of Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 20023131.02
Certification of Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 20023232.01**
Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 20023232.02**
Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002





____________





*
This exhibit is a management contract or compensatory plan or arrangement.**
This exhibit is being furnished, rather than filed, and shall not be deemed incorporated by reference into any filing of the registrant, in accordance with Item 601 of Regulation S-K.














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