**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM10-Q**

 

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

 

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

 

**OR**

 

**o****TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from                  to                  **.

 

**Commission file number:  000-26887**

 

**SiliconImage, Inc.**

(Exact name of registrant as specified in itscharter)

 
| **Delaware**                                                    | ** ** | **77-0396307**                       |
|-----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer Identification No.) |

 

**1060 East Arques Avenue****Sunnyvale, California 94085**

(Address of principal executive offices andzip code)

 

**(408) 616-4000**

(Registrant’s telephone number, includingarea code)

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports) Yes ýNo o and (2) has been subject to such filingrequirements for the past 90 days Yes ýNo o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act). Yes ýNo o

 

The number of shares of the registrant’s Common Stock, $0.001 par valueper share, outstanding as of October 29, 2004 was 76,655,182 shares.

 

 

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

 

**Table of Contents**
| **Part I**         | **Financial Information (Unaudited)**                                                                            |       |
|--------------------|------------------------------------------------------------------------------------------------------------------|------------|
|               |                                                                                                             |       |
| Item 1             | Financial Statements                                                                                             |       |
|               |                                                                                                             |       |
|               | Condensed Consolidated Statements of  Operations for the three and nine months ended September 30, 2004 and 2003 |       |
|               |                                                                                                             |       |
|               | Condensed Consolidated Balance Sheets as of  September 30, 2004 and December 31, 2003                            |       |
|               |                                                                                                             |       |
|               | Condensed Consolidated Statements of Cash  Flows for the nine months ended September 30, 2004 and 2003           |       |
|               |                                                                                                             |       |
|               | Notes to Unaudited Condensed Consolidated  Financial Statements                                                  |       |
|               |                                                                                                             |       |
| Item 2             | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                      |       |
|               |                                                                                                             |       |
| Item 3             | Quantitative and Qualitative Disclosures  About Market Risk                                                      |       |
|               |                                                                                                             |       |
| Item 4             | Controls and Procedures                                                                                          |       |
|               |                                                                                                             |       |
| **Part II**        | **Other Information**                                                                                            |       |
|               |                                                                                                             |       |
| Item 1             | Legal Proceedings                                                                                                |       |
|               |                                                                                                             |       |
| Item 2             | Change in Securities and Use of Proceeds                                                                         |       |
|               |                                                                                                             |       |
| Item 3             | Defaults Upon Senior Securities                                                                                  |       |
|               |                                                                                                             |       |
| Item 4             | Submission of Matters to a Vote of Security  Holders                                                             |       |
|               |                                                                                                             |       |
| Item 5             | Other Information                                                                                                |       |
|               |                                                                                                             |       |
| Item 6             | Exhibits                                                                                                         |       |
|               |                                                                                                             |       |
| **Signatures**     | ** **                                                                                                       | ** ** |
| ** **         | ** **                                                                                                       | ** ** |
| **Certifications** |                                                                                                             |
|                    |                                                                                                                  |            |  |

 

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** **

**PartI.  Financial Information**

 

**Item1.  Financial Statements**

 

**SiliconImage, Inc.****CondensedConsolidated Statements of Operations****(in thousands, except per share and footnoteamounts)****(unaudited)**

 
| ** **                                       | ** ** | **Three Months Ended September 30** | ** ** | **Nine Months Ended September 30** | ** ** |
|--------------------------------------------------|------------|-------------------------------------|------------|------------------------------------|------------|
| ** **                                       | ** ** | **2004**                            | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                             |       |                                |       |                               |       |   |   |   |   |
| Revenue:                                         |       |                                |       |                               |       |   |   |   |   |
| Product                                          |       | $                                   | 41,474     |                               | $          | 22,447 |   | $ | 110,350 |   | $ | 61,914 |   |
| Development, licensing and royalties             |       | 6,394                               |       | 1,743                              |       | 16,737 |   | 11,284 |   |
| Total revenue                                    |       | 47,868                              |       | 24,190                             |       | 127,087 |   | 73,198 |   |
|                                             |       |                                |       |                               |       |   |   |   |   |
| Cost and operating expenses:                     |       |                                |       |                               |       |   |   |   |   |
| Cost of revenue (1)                              |       | 18,204                              |       | 11,487                             |       | 50,414 |   | 33,271 |   |
| Research and development (2)                     |       | 12,180                              |       | 10,080                             |       | 45,223 |   | 30,252 |   |
| Selling, general and administrative (3)          |       | 8,806                               |       | 4,225                              |       | 30,524 |   | 12,869 |   |
| Amortization of intangible assets                |       | 357                                 |       | 373                                |       | 1,070 |   | 746 |   |
| Patent defense costs                             |       | 222                                 |       | 160                                |       | 485 |   | 1,956 |   |
| Restructuring                                    |       | —                              |       | —                             |       | — |   | 986 |   |
| In-process research and development              |       | —                              |       | —                             |       | — |   | 5,482 |   |
| Total cost and operating expenses                |       | 39,769                              |       | 26,325                             |       | 127,716 |   | 85,562 |   |
|                                             |       |                                |       |                               |       |   |   |   |   |
| Income (loss) from operations                    |       | 8,099                               |       | (2,135                             | )          | (629 | ) | (12,364 | ) |
| Gain on escrow settlement, net                   |       | —                              |       | —                             |       | — |   | 4,618 |   |
| Interest income and other, net                   |       | 211                                 |       | 40                                 |       | 399 |   | 216 |   |
| Gain (loss) on derivative investment  security   |       | (64                                 | )          | —                             |       | 926 |   | — |   |
| Income (loss) before provision for income  taxes |       | 8,246                               |       | (2,095                             | )          | 696 |   | (7,530 | ) |
|                                             |       |                                |       |                               |       |   |   |   |   |
| Provision for income taxes .                     |       | 369                                 |       | —                             |       | 941 |   | — |   |
| Net income (loss)                                |       | $                                   | 7,877      |                               | $          | (2,095 | ) | $ | (245 | ) | $ | (7,530 | ) |
|                                             |       |                                |       |                               |       |   |   |   |   |
| Net income (loss) per share:                     |       |                                |       |                               |       |   |   |   |   |
| Basic                                            |       | $                                   | 0.11       |                               | $          | (0.03 | ) | $ | (0.00 | ) | $ | (0.11 | ) |
| Diluted                                          |       | $                                   | 0.09       |                               | $          | (0.03 | ) | $ | (0.00 | ) | $ | (0.11 | ) |
|                                             |       |                                |       |                               |       |   |   |   |   |
| Weighted average shares – basic             |       | 74,976                              |       | 69,803                             |       | 73,797 |   | 68,431 |   |
| Weighted average shares – diluted           |       | 85,890                              |       | 69,803                             |       | 73,797 |   | 68,431 |   |

 

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(1)                                  Includesstock compensation expense (benefit) of $(110,000) and $(14,000) for the threemonths ended September 30, 2004 and 2003, respectively, and $1,890,000 and$(71,000) for the nine months ended September 30, 2004 and 2003, respectively.  

 

(2)                                  Includesstock compensation expense of $595,000 and $1,026,000 for the three monthsended September 30, 2004 and 2003, respectively, and $11,584,000 and $2,993,000for the nine month periods ended September 30, 2004 and 2003, respectively.  

 

(3)                                  Includesstock compensation expense of $1,042,000 and $94,000 for the three months endedSeptember 30, 2004 and 2003, respectively, and $9,253,000 and $75,000 for thenine months ended September 30, 2004 and 2003, respectively.

 

See accompanying Notes to Unaudited CondensedConsolidated Financial Statements.

 

1

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**Silicon Image, Inc.**

**Condensed Consolidated Balance Sheets**

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

**(unaudited)**

 
| ** **                                                                                                                                                                                           | ** ** | **Sept. 30,  2004** | ** ** | **Dec. 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|--------------------|------------|
| **Assets**                                                                                                                                                                                           |       |                |       |               |       |
| Current Assets:                                                                                                                                                                                      |       |                |       |               |       |
| Cash and cash equivalents                                                                                                                                                                            |       | $                   | 62,508     |               | $          | 24,059 |   |
| Short-term investments                                                                                                                                                                               |       | 16,202              |       | 13,195             |       |
| Accounts receivable, net of allowances for  doubtful accounts of $745 at September 30 and $670 at December 31                                                                                        |       | 22,302              |       | 12,754             |       |
| Inventories                                                                                                                                                                                          |       | 14,038              |       | 10,312             |       |
| Prepaid expenses and other current assets                                                                                                                                                            |       | 2,008               |       | 2,703              |       |
| Total current assets                                                                                                                                                                                 |       | 117,058             |       | 63,023             |       |
| Property and equipment, net                                                                                                                                                                          |       | 8,562               |       | 7,411              |       |
| Goodwill                                                                                                                                                                                             |       | 13,021              |       | 13,021             |       |
| Intangible assets, net                                                                                                                                                                               |       | 1,958               |       | 3,028              |       |
| Other assets                                                                                                                                                                                         |       | 994                 |       | 1,259              |       |
| Total assets                                                                                                                                                                                         |       | $                   | 141,593    |               | $          | 87,742 |   |
|                                                                                                                                                                                                 |       |                |       |               |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                       |       |                |       |               |       |
| Current Liabilities:                                                                                                                                                                                 |       |                |       |               |       |
| Accounts payable                                                                                                                                                                                     |       | $                   | 11,852     |               | $          | 6,442 |   |
| Accrued liabilities                                                                                                                                                                                  |       | 12,115              |       | 8,726              |       |
| Deferred license revenue                                                                                                                                                                             |       | 1,257               |       | 1,175              |       |
| Debt obligations                                                                                                                                                                                     |       | 318                 |       | 1,732              |       |
| Deferred margin on sales to distributors                                                                                                                                                             |       | 12,428              |       | 7,274              |       |
| Total liabilities                                                                                                                                                                                    |       | 37,970              |       | 25,349             |       |
|                                                                                                                                                                                                 |       |                |       |               |       |
| Stockholders’ Equity:                                                                                                                                                                           |       |                |       |               |       |
| Common stock, par value $0.001; shares  authorized:150,000,000 – September 30 and December 31; shares issued and  outstanding: 76,287,802 – September 30 and 72,367,129 – December 31 |       | 76                  |       | 72                 |       |
| Additional paid-in capital                                                                                                                                                                           |       | 281,086             |       | 243,171            |       |
| Unearned stock compensation                                                                                                                                                                          |       | (7,857              | )          | (8,196             | )          |
| Accumulated deficit                                                                                                                                                                                  |       | (172,899            | )          | (172,654           | )          |
| Accumulated other comprehensive income                                                                                                                                                               |       | 3,217               |       | —             |       |
| Total stockholders’ equity                                                                                                                                                                      |       | 103,623             |       | 62,393             |       |
| Total liabilities and stockholders’ equity                                                                                                                                                      |       | $                   | 141,593    |               | $          | 87,742 |   |

 

See accompanying Notes to Unaudited CondensedConsolidated Financial Statements.

 

2

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**SiliconImage, Inc.Condensed Consolidated Statementsof Cash Flows(in thousands)(unaudited)**

 
| ** **                                                                             | ** ** | **Nine Months Ended Sept. 30** | ** ** |
|----------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                             | ** ** | **2004**                       | ** ** | **2003** | ** ** |
|                                                                                   |       |                           |       |   |   |
| ***Cash flows from operating  activities:***                                           |       |                           |       |   |   |
| Net loss                                                                               |       | $                              | (245       | ) | $ | (7,530 | ) |
| Adjustments to reconcile net loss to cash  provided by (used in) operating activities: |       |                           |       |   |   |
| Depreciation and amortization                                                          |       | 3,631                          |       | 3,321 |   |
| Amortization of intangible assets                                                      |       | 1,070                          |       | 746 |   |
| Provision for doubtful accounts receivable                                             |       | 75                             |       | 101 |   |
| Stock compensation expense                                                             |       | 22,727                         |       | 2,997 |   |
| Non-cash restructuring                                                                 |       | —                         |       | 646 |   |
| In-process research and development expense                                            |       | —                         |       | 5,482 |   |
| Non-cash gain on escrow settlement, before  cash costs                                 |       | —                         |       | (4,692 | ) |
| Gain on derivative investment security                                                 |       | (926                           | )          | — |   |
| Changes in assets and liabilities, net of  amounts acquired:                           |       |                           |       |   |   |
| Accounts receivable                                                                    |       | (9,623                         | )          | (5,256 | ) |
| Inventories                                                                            |       | (3,726                         | )          | (1,657 | ) |
| Prepaid expenses and other assets                                                      |       | 960                            |       | 1,408 |   |
| Accounts payable                                                                       |       | 5,410                          |       | (2,525 | ) |
| Accrued liabilities and deferred license  revenue                                      |       | 3,441                          |       | (3,938 | ) |
| Deferred margin on sales to distributors                                               |       | 5,154                          |       | 2,029 |   |
| Cash provided by (used in) operating  activities                                       |       | 27,948                         |       | (8,868 | ) |
|                                                                                   |       |                           |       |   |   |
| ***Cash flows from investing  activities:***                                           |       |                           |       |   |   |
| Proceeds from sales and maturities of short-term  investments                          |       | 21,807                         |       | 4,622 |   |
| Purchases of short-term investments                                                    |       | (20,641                        | )          | (7,005 | ) |
| Acquisition costs, net of cash acquired                                                |       | —                         |       | 3 |   |
| Net purchases of property and equipment                                                |       | (4,782                         | )          | (3,981 | ) |
| Cash used in investing activities                                                      |       | (3,616                         | )          | (6,361 | ) |
|                                                                                   |       |                           |       |   |   |
| ***Cash flows from financing  activities:***                                           |       |                           |       |   |   |
| Proceeds from issuances of common stock,  net                                          |       | 15,531                         |       | 7,026 |   |
| Proceeds from repayment of stockholders’  notes receivable                        |       | —                         |       | 109 |   |
| Repayments of capital lease and debt  obligations                                      |       | (1,414                         | )          | (1,922 | ) |
| Cash provided by financing activities                                                  |       | 14,117                         |       | 5,213 |   |
|                                                                                   |       |                           |       |   |   |
| **Net  increase (decrease) in cash and cash equivalents**                              |       | 38,449                         |       | (10,016 | ) |
| Cash and cash equivalents — beginning of  period                                  |       | 24,059                         |       | 26,263 |   |
| Cash and cash equivalents — end of period                                         |       | $                              | 62,508     |   | $ | 16,247 |   |
|                                                                                   |       |                           |       |   |   |
| **Supplemental  cash flow information:**                                               |       |                           |       |   |   |
| Cash payment for taxes                                                                 |       | $                              | 262        |   | $ | — |   |
| **Supplemental non-cash investing and  financing activities:**                         |       |                           |       |   |   |
| Financing of property and equipment                                                    |       | $                              | —     |   | $ | 383 |   |
| Stock and options issued in connection with the Transwarp acquisition                  |       | $                              | —     |   | $ | 14,371 |   |
| Unrealized gain on equity investments, net of tax                                      |       | $                              | 4,173      |   | $ | — |   |

 

See accompanying Notes to Unaudited CondensedConsolidated Financial Statements.

 

3

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**SiliconImage, Inc.Notes to Unaudited CondensedConsolidated Financial StatementsSeptember 30, 2004**

 

1.               Basisof Presentation

 

In the opinion of management, the accompanying unaudited condensedconsolidated financial statements of Silicon Image, Inc. included herein havebeen prepared on a basis consistent with our December 31, 2003 auditedfinancial statements and include all adjustments, consisting of normalrecurring adjustments, necessary to fairly state the consolidated financialposition of Silicon Image and its subsidiaries (collectively, the “Company”) atSeptember 30, 2004 and the consolidated results of the Company’s operations andcash flows for the three and nine months ended September 30, 2004 and2003.  All significant intercompanyaccounts and transactions have been eliminated. These interim financial statements should be read in conjunction withthe audited financial statements and notes thereto included in our Form 10-Kfor the fiscal year ended December 31, 2003. Certain comparative amounts have been reclassified to conform with thecurrent presentation. These reclassifications have no impact on the reportedresults of operations for any period presented. Results of operations for thethree and nine months ended September 30, 2004 are not necessarily indicativeof future operating results.

 

2.               RecentAccounting Pronouncements

 

In January 2003, the Financial Accounting Standards Board (“FASB”)issued Interpretation Number (“FIN”) 46, “Consolidation of Variable InterestEntities.” In general, a variable interest entity is a corporation,partnership, trust, or any other legal structure used for business purposesthat either (a) does not have equity investors with voting rights or(b) has equity investors that do not provide sufficient financialresources for the entity to support its activities. FIN 46 requires certainvariable interest entities to be consolidated by the primary beneficiary of theentity if the investors do not have the characteristics of a controllingfinancial interest or do not have sufficient equity at risk for the entity tofinance its activities without additional subordinated financial support fromother parties. The consolidation requirements of FIN 46 apply immediately tovariable interest entities created after January 31, 2003. Certain of thedisclosure requirements apply to all financial statements issued afterJanuary 31, 2003, regardless of when the variable interest entity wasestablished. The adoption of this standard had no impact on our consolidatedfinancial statements.

 

In March 2004, theEmerging Issues Task Force (“EITF”) reached a consensus on Issue No. 03-1,“The Meaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments.” EITF 03-1 provides guidance on other-than-temporary impairmentmodels for marketable debt and equity securities accounted for under SFASNo. 115, “Accounting for Certain Investments in Debt and EquitySecurities,” and SFAS No. 124, “Accounting for Certain Investments Held byNot-for-Profit Organizations,” and non-marketable equity securities accountedfor under the cost method. The EITF developed a basic three-step model toevaluate whether an investment is other-than-temporarily impaired. Theprovisions of EITF 03-1 are effective for this third quarter of fiscal 2004 andwill be applied prospectively to all current and future investments. Theadoption of EITF 03-1 did not have a material effect on our results ofoperations or financial condition.

 

Stock-BasedCompensation

 

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

 

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

 

4

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| ** **                                                                                                | ** ** | **Three Months Ended**  | ** ** | **Nine Months Ended**   | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                                                                | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
|                                                                                                      |       |                    |       |                    |       |   |   |   |   |
| Net income (loss) — as reported                                                                      |       | $                       | 7,877      |                    | $          | (2,095 | ) | $ | (245 | ) | $ | (7,530 | ) |
| Stock-based employee compensation expense  included in the determination of net income (loss) as reported |       | (46                     | )          | 865                     |       | 16,133 |   | 1,814 |   |
| Stock-based employee compensation expense  determined using fair value method                             |       | (5,639                  | )          | (5,125                  | )          | (16,009 | ) | (16,738 | ) |
| Pro forma net income (loss)                                                                               |       | $                       | 2,192      |                    | $          | (6,355 | ) | $ | (121 | ) | $ | (22,454 | ) |
|                                                                                                      |       |                    |       |                    |       |   |   |   |   |
| Basic and diluted net income (loss) per  share — pro forma                                           |       | $                       | 0.03       |                    | $          | (0.09 | ) | $ | (0.00 | ) | $ | (0.33 | ) |
| Basic net income (loss) per share — as  reported                                                     |       | $                       | 0.11       |                    | $          | (0.03 | ) | $ | (0.00 | ) | $ | (0.11 | ) |
| Diluted net income (loss) per share — as  reported                                                   |       | $                       | 0.09       |                    | $          | (0.03 | ) | $ | (0.00 | ) | $ | (0.11 | ) |

 

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

 
| ** **                  | ** ** | **Three Months Ended September 30** | ** ** | **Nine Months Ended September 30** | ** ** |
|-----------------------------|------------|-------------------------------------|------------|------------------------------------|------------|
| ** **                  | ** ** | **2004**                            | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|                        |       |                                |       |                               |       |   |   |   |   |
| Expected life (years)       |       | 5                                   |       | 5                                  |       | 5 |   | 5 |   |
| Interest rate               |       | 3.4                                 | %          | 3.1                                | %          | 3.1 | % | 3.4 | % |
| Volatility                  |       | 90                                  | %          | 90                                 | %          | 90 | % | 90 | % |
| Dividend yield              |       | —                              |       | —                             |       | — |   | — |   |
| Weighted average fair value |       | $                                   | 8.24       |                               | $          | 3.71 |   | $ | 7.55 |   | $ | 4.11 |   |
|                             |            |                                     |            |                                    |            |  |  |  |  |  |  |  |  |

 

The weighted average, grant-date fair value of stock purchase rightsgranted under our Employee Stock Purchase Plan and the assumptions used are asfollows:

 
| ** **                             | ** ** | **Three Months Ended September 30** | ** ** | **Nine Months Ended September 30** | ** ** |
|----------------------------------------|------------|-------------------------------------|------------|------------------------------------|------------|
| ** **                             | ** ** | **2004**                            | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                   |       |                                |       |                               |       |   |   |   |   |
| Expected life (years)                  |       | 1.5                                 |       | 1.5                                |       | 1.5 |   | 1.5 |   |
| Interest rate                          |       | 1.2                                 | %          | 1.7                                | %          | 1.2 | % | 1.7 | % |
| Dividend yield                         |       | —                              |       | —                             |       | — |   | — |   |
| Volatility                             |       | 65                                  | %          | 90                                 | %          | 70 | % | 90 | % |
| Weighted average grant date fair value |       | $                                   | 2.88       |                               | $          | 2.93 |   | $ | 2.69 |   | $ | 2.76 |   |
|                                        |            |                                     |            |                                    |            |  |  |  |  |  |  |  |  |

 

Comprehensive income (loss)

 

The components of comprehensive income (loss),were as follows (in millions): 

 
| ** **                                      | ** ** | **Three Months Ended**  | ** ** | **Nine Months Ended**   | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
|                                            |       |                    |       |                    |       |   |   |   |   |
| Net income (loss)                               |       | $                       | 7,877      |                    | $          | (2,095 | ) | $ | (245 | ) | $ | (7,530 | ) |
| Change in unrealized value on investments,  net |       | (726                    | )          | —                  |       | 3,217 |   | — |   |
|                                            |       | $                       | 7,151      |                    | $          | (2,095 | ) | $ | 2,972 |   | $ | (7,530 | ) |

 

The only component of accumulated other comprehensive income is thechange in the unrealized value of available for sale investments.

 

5

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3.                                       NetIncome (Loss) Per Share

 

Basic earnings (loss) per share is computed using theweighted-average number of common shares outstanding during the period,adjusted to exclude any unvested shares subject to repurchase. Diluted earnings(loss) per share is computed using the weighted-average number of common sharesused for the basic calculation, plus dilutive stock options outstanding duringthe period, determined using the treasury stock method.

 

We reported net income for the three months ended September30, 2004 and net loss for the nine months ended September 30, 2004 and for thethree and nine months ended September 30, 2003. The following tables sets forththe computation of basic and diluted net income (loss) per share (in thousands,except per share amounts):

 

**For the three-month period ended September30, 2004:**

 
| Net income                                                                           |   | $      | 7,877  |   |
|--------------------------------------------------------------------------------------|--------|--------|--------|--------|
|                                                                                 |   |   |   |
| Weighted average common shares for basic net income per share                        |   | 74,976 |   |
|                                                                                 |   |   |   |
| Weighted average dilutive stock options outstanding under the  treasury stock method |   | 10,196 |   |
|                                                                                 |   |   |   |
| Unvested common shares subject to repurchase                                         |   | 718    |   |
|                                                                                 |   |   |   |
| Weighted average common shares for diluted net income per share                      |   | 85,890 |   |
|                                                                                 |   |   |   |
| Net income per share – basic                                                    |   | $      | 0.11   |   |
| Net income per share – diluted                                                  |   | $      | 0.09   |   |

 

 
| ** **                                          | ** ** | **Three Months Ended  September 30** | ** ** | **Nine Months Ended September 30** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                          | ** ** | **2003**                             | ** ** | **2004**                           | ** ** | **2003** | ** ** |
|                                                |       |                                 |       |                               |       |   |   |
| Net loss                                            |       | $                                    | (2,095     | )                                  | $          | (245 | ) | $ | (7,530 | ) |
|                                                |       |                                 |       |                               |       |   |   |
| Weighted average shares                             |       | 70,645                               |       | 74,534                             |       | 69,001 |   |
|                                                |       |                                 |       |                               |       |   |   |
| Less: unvested common shares subject to  repurchase |       | (842                                 | )          | (737                               | )          | (570 | ) |
| Weighted average common shares outstanding          |       | 69,803                               |       | 73,797                             |       | 68,431 |   |
| Basic and diluted net loss per share                |       | $                                    | (0.03      | )                                  | $          | (0.00 | ) | $ | (0.11 | ) |

 

Hadwe generated net income for the three and nine month periods ended September30, 2003 and for the nine months ended September 30, 2004, the number ofweighted average securities outstanding that would have been added to weightedaverage shares for purposes of calculating diluted earnings per share wouldhave been  (in thousands):

 
| ** **                                  | ** ** | **Three Months  Ended  September 30** | ** ** | **Nine Months Ended  September 30** | ** ** |
|---------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                  | ** ** | **2003**                              | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| Unvested common stock subject to repurchase |       | 811                                   |       | 789                                 |       | 408 |   |
| Stock options                               |       | 5,780                                 |       | 10,113                              |       | 6,532 |   |
| Total                                       |       | 6,591                                 |       | 10,902                              |       | 6,940 |   |

 

The weighted-average securities that were anti-dilutive and excludedfrom our calculation of diluted net income (loss) per share were approximately1,794,000 and 20,603,000 for the three month periods ended September 30, 2004and 2003, respectively and approximately 20,227,000 and 21,364,000 for the ninemonth periods ended September 30, 2004 and 2003, respectively.

 

6

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4.                                       BalanceSheet Components 

 
| ** **                           | ** ** | **September 30,  2004** | ** ** | **Dec. 31,  2003** | ** ** |
|--------------------------------------|------------|-------------------------|------------|--------------------|------------|
| ** **                           | ** ** | **(in thousands)**      | ** ** |
| Inventories:                         |       |                    |       |               |       |
| Raw materials                        |       | $                       | 4,128      |               | $          | 3,128 |   |
| Work in process                      |       | 4,315                   |       | 2,532              |       |
| Finished goods                       |       | 5,595                   |       | 4,652              |       |
|                                 |       | $                       | 14,038     |               | $          | 10,312 |   |
| Accrued liabilities:                 |       |                    |       |               |       |
| Accrued payroll and related expenses |       | $                       | 5,987      |               | $          | 2,533 |   |
| Restructuring accrual                |       | 1,301                   |       | 1,875              |       |
| Accrued legal fees                   |       | 689                     |       | 1,137              |       |
| Warranty accrual                     |       | 351                     |       | 271                |       |
| Other accrued liabilities            |       | 3,787                   |       | 2,910              |       |
|                                 |       | $                       | 12,115     |               | $          | 8,726 |   |

 

Warranty Accrual

 

At the time of revenue recognition, we provide an accrual for estimatedcosts to be incurred pursuant to our warranty obligation. Our estimate is basedprimarily on historical experience. Warranty accrual activity for the nine months ended September 30, 2004and 2003 were as follows (in thousands): 

 

| ** **                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
| Balance at January 1            |       | $        | 271        |     | $          | 223 |   |
| Provision                       |       | 200      |       | 580      |       |
| Cash and other settlements made |       | (120     | )          | (532     | )          |
| Balance at September 30         |       | $        | 351        |     | $          | 271 |   |

 

7

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5.                                       Stock-BasedCompensation  

 

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

 

We are required to determine the fair value of stock option grants tonon-employees and to record the amount as an expense over the period duringwhich services are provided to us. Management calculates the fair value ofthese stock option grants using the Black-Scholes model, which requires us toestimate the life of the stock option, the volatility of our stock, anappropriate risk-free interest rate, and our dividend yield. The calculation offair value is highly sensitive to the expected life of the stock option and thevolatility of our stock, both of which we estimate based primarily onhistorical experience.  

 

The following table summarizes the components of our stock compensationexpense for the three and nine months ended September 30, 2004 and 2003 (inthousands): 

 

| ** **                                       | ** ** | **Three Months Ended  September 30** | ** ** | **Nine Months Ended  September 30** | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                       | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Options granted to employees                     |       | $                                    | 855        |                                | $          | 42 |   | $ | 906 |   | $ | 322 |   |
| Options granted to non-employees                 |       | 1,454                                |       | 389                                 |       | 4,220 |   | 1,173 |   |
| Option repricings (employees and  non-employees) |       | (1,047                               | )          | (139                                | )          | 16,609 |   | (970 | ) |
| Options assumed in connection with  acquisitions |       | 265                                  |       | 814                                 |       | 992 |   | 2,472 |   |
| Stock compensation expense                       |       | $                                    | 1,527      |                                | $          | 1,106 |   | $ | 22,727 |   | $ | 2,997 |   |

 

The expense relating to options granted to non-employees for the threeand nine-month periods ended September 30, 2004 is higher relative to thecomparable periods ended September 30, 2003, and the repricing expense for thenine-month period ended September 30, 2004 is higher relative to the comparableperiod ended September 30, 2003 as our average stock price was higher for thethree and nine-month periods ended September 30, 2004 (the average stock pricefor the three and nine months ended September 30, 2004 was $11.59 and $11.07,respectively, compared to $5.22 and $5.40, respectively,  for the three and nine months ended September30, 2003). The decline in the repricing expense for the three months endedSeptember 30, 2004 was due to the closing market price as of September 30, 2004being lower than the closing market price as of June 30, 2004 ($12.64 as ofSeptember 30, 2004, compared to $13.11 as of June 30, 2004). The optionsgranted to employees includes a $0.8 million charge recorded in the thirdquarter of 2004 relating to the modification (pertaining to change in vestingterms upon entering into an amended agreement with one employee and upon thedeath of another employee) of certain option grants. During the nine-monthperiod ended September 30, 2003, we modified options for employeesinvoluntarily terminated in connection with our restructuring program. A chargeof $646,000 for these modifications is included in restructuring expense forthe period ended September 30, 2003.  

 

6.                                     Restructuringactivities  

 

In connection with our restructuring activities (as more fullydescribed in note 3 to our consolidated financial statements included in ourForm 10-K for the year ended December 31, 2003), we have recorded restructuringcharges in the years 2001 and 2002.  

 

In March 2003, we reorganized parts of the marketing and productengineering activities of the company into lines of business for personalcomputer (“PC”), consumer electronics (“CE”) and storage products to enable usto better manage our long-term growth potential. The central engineering,sales, manufacturing, and general and administrative activities were notorganized into the line of business structure. In connection with thisreorganization, we reduced our workforce by 27 people, or approximately 10%.These reductions were primarily in engineering and operations functions. Becauseof this workforce reduction, we recorded restructuring expense of $986,000 inthe first quarter of 2003, consisting of cash severance-related costs of$340,000 and non-cash severance-related costs of $646,000, representing theintrinsic value of modified stock options.

 

8

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Severance related costs were determined based on the amount of paypeople received that was not for services performed and by measuring theintrinsic value of stock options that were modified to the benefit ofterminated employees. For those employees terminated in the three month periodending March 31, 2003, the remaining service period from the communicationdate did not exceed 60 days. The expected loss on leased facilities resulted fromour plan to consolidate our remaining workforce to the extent practicable andsublease any excess space. To determine the expected loss, we compared ourlease and operating costs for the space to our estimate of the net amount wewould be able to recover by subleasing the space. This estimate was based on anumber of assumptions, including the length of time it will take to secure atenant, the sublease rate per square foot, the cost of necessary improvementsor modifications and real estate broker commissions.  

 

Severance and benefits payments are substantially complete. Leasepayments will be made in the form of cash through the end of the related leaseterm of November 2005. The following table presents restructuring activityfor the nine-month periods ended September 30, 2004 and 2003 (in thousands): 

 
| ** **                    | ** ** | **2004**                 | ** ** | **2003**  | ** ** |
|-------------------------------|------------|--------------------------|------------|-----------|------------|
| **Severance and****Benefits** | ** ** | **Leased****facilities** | ** ** | **Total** | ** ** | **Severance and****Benefits** | ** ** | **Leased****facilities** | ** ** | **Total** | ** ** |
|                          |       |                     |       |      |       |   |   |   |   |   |   |   |   |
| Balance as of January 1       |       | $                        | 37         |      | $          | 1,838 |   | $ | 1,875 |   | $ | 138 |   | $ | 2,598 |   | $ | 2,736 |   |
| Provision                     |       | —                   |       | —    |       | — |   | 986 |   | — |   | 986 |   |
| Cash payments                 |       | (5                       | )          | (569      | )          | (574 | ) | (434 | ) | (551 | ) | (985 | ) |
| Non - cash activity           |       | —                   |       | —    |       | — |   | (646 | ) | — |   | (646 | ) |
| Balance as of September 30    |       | $                        | 32         |      | $          | 1,269 |   | $ | 1,301 |   | $ | 44 |   | $ | 2,047 |   | $ | 2,091 |   |
|                               |            |                          |            |           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

7.                                       DebtFacility  

 

In October 2002, we entered into a $3.6 million term loan torefinance $3.1 million of debt acquired in connection with our acquisition ofCMD and $500,000 of other bank debt. This loan bears interest at prime (4.75%at September 30, 2004) plus 0.25% and requires monthly payments through itsmaturity of October 1, 2004. During the nine months ended September 30,2003, we borrowed $383,000 to finance certain capital equipment. This term loanbears interest at 5% and requires monthly payments through its maturity inFebruary 2005. As of September 30, 2004, $318,000 was outstanding underthese term loans. 

 

During the period ended March 31, 2004, we entered into a new debtfacility by way of a revolving line of credit with an availability of up to$10.0 million, and an equipment line of credit of up to $3.0 million.Borrowings under the revolving line are limited to the lesser of $10.0 millionor 80% of eligible accounts receivable as defined in the loan agreement. Thisrevolving line of credit expires in March 2005 and bears interest ateither prime plus 0.25% or LIBOR plus 2.75%, at our option. No amounts havebeen drawn down against this line of credit as at September 30, 2004. Equipmentadvances pursuant to the equipment line of credit were available to us throughAugust 2004, however no amounts were drawn down against this line and itexpired in accordance with its terms. Our credit facilities contain quarterlyand annual financial covenants. As of September 30, 2004, we were in compliancewith all covenants. 

 

9

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8.                                       LegalProceedings  

 

On April 24, 2001, we filed suit in the U.S. District Court forthe Eastern District of Virginia against Genesis Microchip Corp. and GenesisMicrochip, Inc. (collectively, “Genesis”) for infringement of our U.S.patent number 5,905,769 (USDC E.D. Virginia Civil Action No.: CA-01-266-R) (the“Federal Suit”). On April 24, 2001, we also filed a complaint againstGenesis with the International Trade Commission of the United States government(“ITC”) for unlawful trade practices related to the importation of articlesinfringing our patent (the “ITC investigation”). The actions sought injunctionsto halt the importation, sale, manufacture and use of Genesis DVI receiver chipsthat infringe our patent, and monetary damages. We voluntarily moved to dismissthe ITC investigation, with notice that we would proceed directly in theFederal Suit. Our motion to dismiss was granted on February 7, 2002. Wefiled an amended complaint in the Federal Suit as of February 28, 2002,adding a claim for infringement of our U.S. patent number 5,974,464. InApril 2002, Genesis answered and made counterclaims against us fornon-infringement, license, patent invalidity, fraud, antitrust, unfair competitionand patent misuse. Also in April 2002, we filed a motion to dismisscertain of Genesis’s counterclaims. In addition, we filed a motion to bifurcatetrial of the counterclaims to the extent the court does not dismiss them. InMay 2002, the Court granted our motion to dismiss certain of thecounterclaims, with leave to amend. Genesis re-filed counterclaims against usfor fraud and patent misuse. We filed another motion to dismiss thesecounterclaims, which the Court granted with prejudice on August 6, 2002. InDecember 2002, the parties entered into a memorandum of understanding(MOU) to settle the case. When the parties failed to reach agreement on afinal, definitive agreement as required by the MOU, in January 2003, theparties filed motions with the Court to enforce their respectiveinterpretations of the MOU. On July 15, 2003, the Court granted our motionto interpret the MOU in the manner we requested, and ruled that Genesis hadengaged in efforts to avoid its obligations under the MOU. On August 6,2003, the Court entered a final judgment based on its July 15, 2003ruling. Under the final judgment order, Genesis was ordered to make asubstantial cash payment, and to make royalty payments; although Genesis hasmade a cash payment to the Court, it has not made all the payments that arerequired under the final judgment order. We filed motions for reimbursement ofsome of our expenses, including some of our legal fees, and for modificationand/or clarification of certain items of the judgment, and to hold Genesis incontempt of Court for breaching the protective order in the case by disclosingsecret information to at least one of our competitors. On December 19,2003, the Court granted our motions in part and denied them in part: the courtissued an amended judgment, and held Genesis in contempt of Court for breachingthe protective order. Under the amended judgment, Genesis was ordered to make a substantialcash payment, royalty payments, and interest; although Genesis has made andcontinues to make cash payments to the Court, it may not have made all thepayments that are required under the amended judgment. The Court has not ruledon pending motions regarding the disposition of the money held by the Court. OnJanuary 16, 2004, Genesis filed a notice of appeal. On August 26, 2004,the parties completed the filing of their respective appeal briefs. On October26, 2004, the Court of Appeals for the Federal Circuit issued an order settingthe oral arguments for the appeal on December 7, 2004. To date, we have notreceived any cash payments nor have we recognized any revenue associated withthis litigation. Due to the continuing and contentious nature of thislitigation, we will not record any income or revenue related to this matteruntil the litigation is complete and all other income and revenue recognitioncriteria have been satisfied. Management intends to prosecute our positionvigorously until this matter is resolved. Through September 30, 2004, we havespent approximately $10.9 million on this matter and expect to continue toincur legal costs that could be significant until the matter is resolved.  

 

Silicon Image, certain officers and directors, and Silicon Image’sunderwriters have been named as defendants in a securities class action lawsuitcaptioned Gonzales v. Silicon Image, et al., No. 01 CV 10903 (SDNY 2001)pending in Federal District Court for the Southern District of New York. Thelawsuit alleges that all defendants were part of a scheme to manipulate theprice of Silicon Image’s stock in the aftermarket following Silicon Image’sinitial public offering in October 1999. Response to the complaint anddiscovery in this action on behalf of Silicon Image and individual defendantshas been stayed by order of the court. The lawsuit is proceeding as part of acoordinated action of over 300 such cases brought by plaintiffs in the SouthernDistrict of New York. Pursuant to a tolling agreement, individual defendantshave been dropped from the suit for the time being. In February 2003, theCourt denied the underwriters’ motion to dismiss and ordered that the case mayproceed against issuers including against Silicon Image. A proposed settlementhas been negotiated and has received preliminary approval by the Court. In theevent that the settlement is granted final approval, we do not expect it tohave a material effect on our results of operations or financial position. Inthe event that the settlement is not approved, we could not accurately predictthe outcome the litigation, but we intend to defend this matter vigorously. 

 

10

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Silicon Image, certain officers and directors, and Silicon Image’sunderwriters were named as defendants in a securities class action lawsuitcaptioned Liu v. Credit Suisse First Boston Corp., et al., No. 03-20459(S.D. Fla. 2003) pending in Federal District Court for the Southern District ofFlorida. The plaintiff filed an action on behalf of a putative class ofshareholders who purchased stock from some or all of approximately 50 issuerswhose public offerings were underwritten by Credit Suisse First Boston. Thelawsuit alleges that Silicon Image and certain officers were part of a schemeby Credit Suisse First Boston to artificially inflate the price of SiliconImage’s stock through the dissemination of allegedly false analysts’ reports.Silicon Image has not been served with a copy of the complaint. The plaintiffin this matter has filed an amended complaint in which Silicon Image, and thenamed officers, were dropped as defendants. We believe that the proposedsettlement described above, if granted approval, would encompass the claims inthis case. We believe that these claims were without merit and, if revived, andnot subject to the settlement, we would defend this matter vigorously.  

 

Certain officers and directors of Silicon Image were named asdefendants in consolidated shareholder derivative litigation, captioned “In reSilicon Image, Inc. Derivative Litigation, No. 1:03CV010302”,commenced on December 4, 2003 and pending in the Superior Court ofCalifornia, County of Santa Clara. The plaintiffs purported to sue theindividual defendants on behalf of Silicon Image. The lawsuit alleged that as aresult of the recently completed examination conducted by the Audit Committee ofSilicon Image’s Board of Directors, Silicon Image would be required to restateits financial results for 2002 and 2003. On June 22, 2004, the plaintiffsdismissed the lawsuit.  

 

Silicon Image and certain of its officers were named as defendants inconsolidated securities class action litigation captioned “In re SiliconImage, Inc. Securities Litigation, No. C-03-5579 JW PVT”, commencedon December 11, 2003 and pending in the United States District Court forthe Northern District of California. Plaintiffs filed the action on behalf of aputative class of shareholders who purchased Silicon Image stock betweenApril 15, 2002 and November 15, 2003. The lawsuit alleged thatSilicon Image had materially overstated its licensing revenue, net income andfinancial results during this time period, and that Silicon Image was beingforced to restate its financial results. Following the announcement by theAudit Committee of Silicon Image’s Board of Directors that it had completed itsexamination and that it had concluded that no changes to Silicon Image’spreviously announced financial results were required, the plaintiffs dismissedthe lawsuit in March 2004.  

 

In addition, we have been named as defendants in a number of judicialand administrative proceedings incidental to our business and may be namedagain from time to time. We intend to defend such matters vigorously, andalthough adverse decisions or settlements may occur in one or more of suchcases, the final resolution of these matters, individually or in the aggregate,is not expected to have a material adverse effect on our results of operationsor financial position.

 

9.                                       Customerand Geographic Information

 

Revenue bygeographic area was as follows (in thousands): 

 
| ** **    | ** ** | **Three Months Ended September 30** | ** ** | **Nine Months Ended September 30** | ** ** |
|---------------|------------|-------------------------------------|------------|------------------------------------|------------|
| ** **    | ** ** | **2004**                            | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|          |       |                                |       |                               |       |   |   |   |   |
| Taiwan        |       | $                                   | 10,742     |                               | $          | 6,926 |   | $ | 33,717 |   | $ | 25,362 |   |
| Japan         |       | 10,096                              |       | 3,772                              |       | 25,468 |   | 9,395 |   |
| United States |       | 14,278                              |       | 7,419                              |       | 35,577 |   | 20,760 |   |
| Hong Kong     |       | 1,633                               |       | 1,538                              |       | 4,413 |   | 4,516 |   |
| Korea         |       | 1,770                               |       | 1,624                              |       | 5,343 |   | 3,748 |   |
| Other         |       | 9,349                               |       | 2,911                              |       | 22,569 |   | 9,417 |   |
|          |       | $                                   | 47,868     |                               | $          | 24,190 |   | $ | 127,087 |   | $ | 73,198 |   |

 

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

 
| ** **                           | ** ** | **Three Months Ended  September 30** | ** ** | **Nine Months Ended  September 30** | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                           | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                 |       |                                 |       |                                |       |   |   |   |   |
| PC                                   |       | $                                    | 10,296     |                                | $          | 8,270 |   | $ | 30,370 |   | $ | 24,416 |   |
| Consumer Electronics                 |       | 22,249                               |       | 7,628                               |       | 49,563 |   | 15,942 |   |
| Storage products                     |       | 8,929                                |       | 6,549                               |       | 30,417 |   | 21,556 |   |
| Development, licensing and royalties |       | 6,394                                |       | 1,743                               |       | 16,737 |   | 11,284 |   |
|                                 |       | $                                    | 47,868     |                                | $          | 24,190 |   | $ | 127,087 |   | $ | 73,198 |   |
|                                      |            |                                      |            |                                     |            |  |  |  |  |  |  |  |  |  |

 

11

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Revenue by product line, including development, licensing androyalties, was as follows (in thousands): 

 
| ** **           | ** ** | **Three Months Ended  September 30** | ** ** | **Nine Months Ended  September 30** | ** ** |
|----------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **           | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                 |       |                                 |       |                                |       |   |   |   |   |
| PC                   |       | $                                    | 10,473     |                                | $          | 9,127 |   | $ | 30,632 |   | $ | 26,978 |   |
| Consumer Electronics |       | 26,987                               |       | 7,980                               |       | 60,519 |   | 19,296 |   |
| Storage products     |       | 10,408                               |       | 7,083                               |       | 35,936 |   | 26,924 |   |
|                 |       | $                                    | 47,868     |                                | $          | 24,190 |   | $ | 127,087 |   | $ | 73,198 |   |
|                      |            |                                      |            |                                     |            |  |  |  |  |  |  |  |  |  |

 

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

 

For the three months ended September 30, 2004, two customers generated15.7% and 13.1%, respectively, of our total revenues. For the nine months endedSeptember 30, 2004, two customers generated 13.9% and 12.3%, respectively, ofour total revenues, and as of September 30, 2004, three customers eachrepresented 18.2%, 12.7% and 12.2%, respectively, of gross accounts receivable. 

 

For the three months ended September 30, 2003, two customers eachgenerated 15.0% and 10.9%, respectively, of our total revenue. For the ninemonths ended September 30, 2003, one customer generated 14.1% of our totalrevenue and, as of September 30, 2003, one customer represented 18.4% of grossaccounts receivable.  

 

10.                                 Guarantees  

 

Certain of our licensing agreements indemnify our customers for anyexpenses or liabilities resulting from claimed infringements of patent,trademark or copyright by third parties related to the intellectual propertycontent of our products. Certain of these indemnification provisions areperpetual from execution of the agreement and in some instances, the maximumamount of potential future indemnification is not limited. To date, we have notpaid any such claims or been required to defend any lawsuits with respect toany claim. However, there can be no assurance that such claims will not befiled in the future.  

 

11.                                 Goodwill and Intangible Assets, net  

 

Components of intangible assets are as follows (in thousands): 

 
| ** **                                      | ** ** | **September 30, 2004**      | ** ** | **December 31, 2003**         | ** ** |
|-------------------------------------------------|------------|-----------------------------|------------|-------------------------------|------------|
| ** **                                      | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** |
|                                            |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Intangible assets subject to amortization:      |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
|                                            |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Acquired technology                             |       | $                           | 1,780      |                          | $          | (741 | ) | $ | 1,039 |   | $ | 1,780 |   | $ | (375 | ) | $ | 1,405 |   |
| Non-compete agreement                           |       | 1,849                       |       | (930                          | )          | 919 |   | 1,849 |   | (472 | ) | 1,377 |   |
| Assembled workforce                             |       | 502                         |       | (502                          | )          | — |   | 502 |   | (256 | ) | 246 |   |
|                                            |       | $                           | 4,131      |                          | $          | (2,173 | ) | $ | 1,958 |   | $ | 4,131 |   | $ | (1,103 | ) | $ | 3,028 |   |
|                                            |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Intangible assets not subject to  amortization: |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
|                                            |       |                        |       |                          |       |   |   |   |   |   |   |   |   |
| Goodwill                                        |       | $                           | 13,021     |                          | $          | — |   | $ | 13,021 |   | $ | 13,021 |   | $ | — |   | $ | 13,021 |   |

 

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

 
| 2004   |   | 275   |   |
|--------|--------|-------|--------|
| 2005   |   | 1,097 |   |
| 2006   |   | 508   |   |
| 2007   |   | 78    |   |
|   |   | $     | 1,958  |   |
|        |        |       |        |  |

 

The amortizationexpense for the three month periods ended September 30, 2004 and 2003 was$357,000 and $373,000, respectively and for the nine month periods endedSeptember 30, 2004 and 2003 was $1,070,000 and $746,000, respectively.

 

12

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12.                                 Incometaxes  

 

*Provision for Income Taxes.  *Forthe three and nine month periods ended September 30, 2004, we recorded aprovision for income taxes of $369,000 and $941,000, respectively. Theprovision for the nine month period ended September 30, 2004, includesapproximately $262,000 relating to withholding taxes payable in connection withour licensing contracts. The three and nine-month provisions relate primarilyto taxes in foreign jurisdictions where we have recently commenced operationsand estimated provision for U.S. alternative minimum taxes for the fiscal yearending December 31, 2004. At December 31, 2003, we had a net operating losscarryforward for federal income tax purposes of approximately$75.1 million and such loss carryforwards, which will expire in variousyears through 2023, will be available to offset our future taxable income. Wecontinue to maintain a full valuation allowance for all deferred tax assetsgiven uncertainty as to realization through the generation of future taxableincome.  

 

13.                                 Escrow Settlement  

 

On August 7, 2002, we filed a demand for arbitration with the AmericanArbitration Association, file #74 Y 117 01399 02 GAP, against the principalshareholders of CMD Technology (“CMD”) relating to shares held in escrow inconnection with our acquisition of CMD. Pursuant to agreements by which weacquired CMD, a portion of the Silicon Image common stock issued to theprincipal shareholders of CMD was held in two separate escrow pools ascollateral for the indemnification obligations of these shareholders. Wepreviously made indemnification claims against these escrow pools for therelease of escrow shares with a value of approximately $5.4 million, whichclaims were contested by the principal shareholders of CMD. On February 28, 2003,we and the principal shareholders of CMD entered into a settlement agreementand mutual release, pursuant to which our indemnification claims were resolved.As a result of the settlement, we received 949,780 of the escrowed shares,valued at approximately $4.7 million, and recorded a net non-operating gain of$4.6 million for the nine-month period ended September 30, 2003.  

 

14.                                 Acquisition of Transwarp Networks, Inc  

 

InApril 2003, we acquired TransWarp Networks, Inc. (“TWN”), a development stageenterprise. Through this transaction, we acquired certain intellectual propertyand engineering expertise that will enable us to broaden our storage productofferings and to develop more advanced storage products. TWN was acquired bymeans of a merger, pursuant to which all outstanding shares of TWN’s capitalstock were exchanged for shares of Silicon Image’s common stock. In addition,all outstanding options to purchase TWN common stock were converted intooptions to purchase Silicon Image’s common stock. In accordance with EITF IssueNo. 98-3, “Determining Whether a Nonmonetary Transaction Involves Receipt ofProductive Assets or of a Business”, this transaction was accounted for as apurchase of assets.  

 

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

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

 

13

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The total purchase price was revised from $14.7 million to $14.5million during the quarter ended September 30, 2003, to reflect actual expensesrelating to legal fees incurred in connection with the acquisition of TWN.  

 

The assembled workforce will be amortized over 18 months. Developedtechnology and the non-compete agreement will be amortized over a period ofthree years (the length of the non-compete agreement), and core technology willbe amortized over a period of four years. Unearned compensation will beamortized over the remaining employee vesting period, which ranges from 27 monthsto 57 months.  

 

The value allocalted to in-process research and development (“IPR&D”) was calculated using established valuation techniquesaccepted in the high technology industry. These techniques give considerationto relevant market sizes and growth factors, expected industry trends, theanticipated nature and timing of new product introductions by us and by ourcompetitors, individual product sales cycles, and the estimated lives of eachof the product’s underlying technology. The value of IPR&D reflects therelative value and contribution of the acquired research and development. Indetermining the value assigned to IPR&D, we considered the R&D’s stageof completion, the complexity of the work completed to date, the difficulty ofcompleting the remaining development, costs already incurred, and the projectedcost to complete the project. A discount rate of 30% was used to determine thenet present value of estimated cash flows for this project.  

 

The values assigned to core technology and developedtechnology were based upon discounted cash flows related to the existingproduct’s projected income stream. Elements of the projected income streamincludes revenue, cost of sales, SG&A expenses and R&D expenses. Thediscount rates used in the present value calculations range from 20% to 25% andwere generally derived from a weighted average cost of capital, adjusted upwardto reflect the additional risks inherent in the development life cycle.  Such risksinclude the useful life ofthe technology, profitability levels of the technology, and the uncertainty ofthe technology advances that are known at the date of the acquisition. Based onour annual impairment test performed for 2003, we concluded that there was noimpairment in fiscal 2003. However, there can be no assurance that we will notincur charges for impairment in the future. An impairment test was notperformed in the three and nine months ended September 30, 2004, as no eventhas occurred that would provide an indication of impairment.  

 

Assembled workforce was valued based on the estimated coststo replace the existing staff, including recruiting, hiring and training costsfor employees in all categories, and to fully deploy a work force of similarsize and skill to the same level of productivity as the existing work force.  

 

The value of the non-compete agreement wasbased on the Income Approach, which measures the difference between cash flowsgenerated assuming the existence of the non-compete agreement (assuming nocompetition exists for the individuals covered by the non-compete) and the cashflows assuming competition. The resulting net cash flows were discounted usinga discount rate of 25%.  

 

15.                                 Unrealizedgain on equity investments  

 

In October 2000, as consideration for the transfer of certaintechnology, we received from Leadis Technology Inc. (“Leadis”), a developmentstage privately controlled enterprise, 300,000 shares of preferred stock and aderivative warrant to purchase 75,000 shares of the Company’s common stock.These shares were valued at zero due to the early stage of Leadis’ developmentand other uncertainty as to the value of realization of this investment. Duringthe quarter ended June 30, 2004, Leadis completed an initial public offering ofits stock. In connection with the initial public offering the preferred stockwas converted into common stock on a 1:1 basis. In connection with the initialpublic offering, we are subject to a lock-up agreement whereby we arerestricted from selling the stock and the common stock underlying the warrantfor a period of six months ending December 2004, (for the duration of thelock-up period we are also restricted from engaging in hedging or othertransactions which would result in or lead to the sale or disposition of theshares underlying the derivative warrant). For the three and six month periodsended June 30, 2004, we valued the warrant using the Black-Scholes model andrecorded a gain of approximately $990,000. On September 16, 2004, we netexercised the derivative warrant for equivalent shares of common stock (74,397shares), and based on the price of the stock at that date, recorded a loss of$64,000 on these shares. 

 

Our 374,397 Leadis common shares will be marked to market (as anavailable for sale security), with any resulting gain/loss recorded as othercomprehensive income (loss) until sold or considered impaired on other than atemporary basis. Our typical practice has been not to hold shares forinvestment purposes.  The value of ourcommon stock holding in Leadis was determined to be approximately $4.2 millionas of September 30, 2004, based on Leadis’s closing market price at that date.This amount is classified as short-term investments and the amount of therelated unrealized gain, net of tax, in the amount of $3,217,000, is includedin accumulated other comprehensive income. Based on the market value of Leadisstock as of November 1, 2004, the value of our holding as of that date,compared to the value as at September 30, 2004, declined by approximately $1.1million.

 

14

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

 

*This report contains forward-lookingstatements within the meaning of Section 21E of the Securities and Exchange Actof 1934 and Section 27A of the Securities Act of 1933. These forward-lookingstatements involve a number of risks and uncertainties, including thoseidentified in the section of this Form 10-Q entitled “Factors Affecting FutureResults,” that may cause actual results to differ materially from thosediscussed in, or implied by, such forward-looking statements. Forward-lookingstatements within this Form 10-Q are identified by words such as “believes,”“anticipates,” “expects,” “intends,” “may,” “will” and other similarexpressions. However, these words are not the only means of identifying suchstatements. In addition, any statements that refer to expectations, projectionsor other characterizations of future events or circumstances are forward-lookingstatements. We undertake no obligation to publicly release the results of anyrevisions to these forward-looking statements that may be made to reflectevents or circumstances occurring subsequent to the filing of this Form 10-Qwith the SEC. Our actual results could differ materially from those anticipatedin, or implied by, forward-looking statements as a result of various factors,including the risks outlined elsewhere in this report. Readers are urged tocarefully 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 toadvise interested parties of the risks and factors that may affect ourbusiness.*  

 

**Overview**  

 

Silicon Image is a leader in multi-gigabit semiconductor solutions forthe secure transmission, storage and display of rich digital media. Thecompany’s mission is to be the leader in defining the architectures,intellectual property (IP) and semiconductor technology required to buildsecure digital content delivery systems. To ensure that rich digital content isalways available on any device, consumer electronics (CE), PC and storagedevices must be architected for content compatibility and interoperability*.*  

 

Silicon Image’s strategy entails establishing industry-standard,high-speed digital interfaces and building market momentum and leadershipthrough its first-to-market, standards-based IC products. Further leveragingits strong IP portfolio, the company broadens market adoption of the Digital VisualInterface (DVI), High-Definition Multimedia Interface (HDMI) and Serial ATA(SATA) interfaces by licensing its proven IP cores to companies providingadvanced system-on-a-chip solutions incorporating these interfaces. Licensing,in addition to creating revenue and return on engineering investment in marketsegments we choose not to address, creates products complementary to our ownthat expand the markets for our products and help to improve industry wideinteroperability.  

 

Silicon Image is a leader in the global PC/display arena with itsinnovative PanelLink® digital interconnect technology, which enablesan all-digital connection between PC host systems and digital displays such asLCD monitors, plasma displays and projectors. PanelLink technology is the basisfor the DVI industry standard the company pioneered and remains the mostpopular DVI implementation with more than 45 million units shipped to date.  

 

In 2000, in order to decrease our absolute dependence on the PCbusiness, we embarked upon a plan to diversify into the CE and storage markets.Products sold into the PC market have been declining as a percentage of ourtotal revenues and generated 21.5% and 23.9% of our revenues for the three andnine month periods ended September 30, 2004, respectively and 34.2% and 33.4%of our revenues for the three and nine month periods ended September 30, 2003,respectively (if we include licensing revenues, these percentages would be21.9% and 24.1% for the three and nine month periods ended September 30, 2004,respectively and 37.7% and 36.9% for the three and nine month periods endedSeptember 30, 2003, respectively). We expect our PC revenues (includinglicensing) to decline by approximately 10% in the fourth quarter of 2004 andremain basically flat until the second half of 2005.  

 

Leveraging our core technology and standards-setting expertise, SiliconImage is a leading force in advancing the adoption of HDMI (High DefinitionMultimedia Interface), the new digital interface standard for the consumer electronicsmarket. Introduced by founders Hitachi, Matsushita (Panasonic), Phillips,Silicon Image, Sony, Thomson and Toshiba, HDMI enables the distribution ofuncompressed, high-definition video and multi-channel audio in a single,all-digital interface that dramatically simplifies cabling. Silicon Image’sHDMI technology is marketed under the PanelLink CinemaTM brand and includesHigh-bandwidth Digital Content Protection (HDCP), which is supported by certainHollywood studios as the technology of choice for the secure distribution ofpremium content over certain digital connections. The PanelLink Cinema chipsare the first HDMI-compliant silicon in the market and are featured in manyleading consumer electronics products that are now available in the market.  

 

Products sold into the CE market have been increasing as a percentageof our total revenues and generated 46.5% and 39.0% of our total revenues forthe three and nine month periods ended September 30, 2004, respectively,compared to 31.5% and 21.8% of our total revenues for the three and nine monthsended September 30, 2003, respectively, (if we include licensing revenues,these numbers would be 56.4% and 47.6% for the three and nine months endedSeptember 30, 2004, respectively, and 33.0% and 26.4% for the three and ninemonths ended September 30, 2003, respectively). Our CE products offer a secureinterface for transmission of digital video and audio to consumer devices, suchas digital TVs and DVD players. Demand for these products will be drivenprimarily by the adoption rate of the new technology, High-DefinitionMultimedia Interface (“HDMI”). 

 

15

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In the fourth quarter we expect revenues from our CE business to growby approximately 10% compared to the third quarter and expect licensingrevenues from CE to decline to approximately $2.0 million in the fourth quartercompared to $4.7 million for the third quarter. We expect the product portionof our CE revenues to grow 40-50% during 2005. 

 

In the storage market, Silicon Image has assumed a leadership role inSerial ATA (“SATA”), the new high-bandwidth, point-to-point interface that isreplacing Parallel ATA in desktop storage and making inroads in the enterprisearena due to its price/performance. Silicon Image is a leading supplier ofdiscrete SATA devices with multiple motherboard and add-in-card design wins.Silicon Image’s SATALinkTM-branded solutions are fully SATA-compliant and offeradvanced features and capabilities such as Native Command Queuing, portmultiplier capability and ATAPI support. Silicon Image also supplieshigh-performance, low-power Fibre Channel Serializer/Deserializer (SerDes) toleading switch manufacturers.  

 

In September 2004, Silicon Image introduced its SteelVine storagearchitecture that is expected to serve the storage needs of the ConsumerElectronics and small to medium business markets with a system-on-a-chipimplementation of the SATA interface.  Productssold into the storage market, as a percentage of our total revenues, generated18.7% and 23.9% of our revenue for the three and nine months ended September30, 2004, respectively, and 27.1% and 29.4% for the three and nine months endedSeptember 30, 2003, respectively (if we include licensing revenues, thesenumbers were 21.7% and 28.3% for the three and nine months ended September 30,2004, respectively and 29.3% and 36.8% for the three and nine months endedSeptember 30, 2003, respectively). Demand for our storage semiconductorproducts is dependent upon the rate at which interface technology transitionsfrom parallel to serial, market acceptance of our SteelVine architecture andproducts derived therefrom, and the extent to which SATA and fibre channelfunctionality are integrated into chip sets and controllers offered by othercompanies, which would make our discrete devices unnecessary. We expect ourstorage revenues (including licensing) to increase from the third quarter by$2.0 to $2.5 million in the fourth quarter of 2004. Storage product revenuesare expected to grow 40-50% in fiscal year 2005.  

 

License revenue is recognized when an agreement with a licensee exists,the price is fixed or determinable, delivery or performance has occurred, andcollection is reasonably assured. Generally, we expect to meet these criteriaand recognize revenue at the time we deliver the agreed-upon items. However, wemay defer recognition of revenue until cash is received if collection is notreasonably assured at the time of delivery. A number of our license agreementsrequire customer acceptance of deliverables, in which case we would deferrecognition of revenue until the licensee has accepted the deliverables andeither payment has been received or is expected within approximately 90 days ofacceptance. Certain licensing agreements provide for royalty payments based onagreed upon royalty rates. Such rates can be fixed or variable depending on theterms of the agreement. The amount of revenue we recognize is determined basedon a time period or on the agreed-upon royalty rate, extended by the number ofunits shipped by the customer. To determine the number of units shipped, werely upon actual royalty reports from our customers when available and relyupon estimates in lieu of actual royalty reports when we have a sufficienthistory base of receiving royalties from a specific customer to make anestimate based on available information from the licensee such as quantitiesheld, manufactured and other information. These estimates for royaltiesnecessarily involve the application of management judgment. As a result of ouruse of estimates, period-to-period numbers are “trued-up” in the followingperiod to reflect actual units shipped. To date, such “true-up” adjustmentshave not been significant. In cases where royalty reports and other informationare not available to allow us to estimate royalty revenue, we recognize revenueonly when royalty payments are received. Development revenue is recognized whenproject milestones have been completed and acknowledged by the other party tothe development agreement and collection is reasonably assured. In certaininstances, we recognize development revenue using the lesser of non-refundablecash received or the results of using a proportional performance measure.  

 

Our licensing activity is complementary to our product sales and ithelps us to monetize our intellectual property and accelerate market adoptioncurves associated with our technology. Most of our licenses include a field ofuse restriction that prevents the licensee from building a chip in directcompetition with those market segments we have chosen to pursue. Revenue fromdevelopment, licensing and royalties accounted for 13.4% and 13.2% of ourrevenues for the three and nine months ended September 30, 2004, respectively,and 7.2% and 15.4% for the three and nine months ended September 30, 2003,respectively, and represented 21.6% and 21.8% of our total gross margin for thethree and nine months ended September 30, 2004, respectively, and 13.7% and28.3% for the three and nine months ended September 30, 2003, respectively.Licensing contracts are complex and depend upon many factors includingcompletion of milestones, allocation of values to delivered items, and customeracceptances. Although we attempt to make these factors predictable, many ofthese factors require significant judgments. The Company expects totallicensing revenues to be flat in the fourth quarter compared to the thirdquarter and to grow 10-15% in fiscal year 2005. 

 

16

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In October 1999, we raised approximately $48 million in our initialpublic offering. We have incurred losses in all but two quarterly periods sinceour inception and, as of September 30, 2004, we had an accumulated deficit of$172.9 million.  

 

During 2003, we achieved significant growth, resulting in record annualrevenue of $103.5 million, representing a 27% increase compared to 2002. Wewere also able to continue to take advantage of our diversification strategyeffectively, which resulted in our being able to expand our presence in the CEand storage markets, both of which we expect will experience significant growthrates during the next several years. Additionally, we were able to successfullyleverage our intellectual property to generate $14.2 million of development,licensing and royalty revenue.  

 

**Outlook**  

 

We believe our revenue in the fourth quarter of 2004 will remain flatcompared to the third quarter of 2004. We expect first quarter 2005 totalrevenues to be down 5 to 10 percent from the fourth quarter 2004 levels.  We expect that product revenues will declineslightly in the first quarter of 2005 before returning to double digit growthrates.

 

We expect our overall gross margin, as a percent of revenues, toimprove by 150 to 200 basis points in the fourth quarter compared to the thirdquarter of 2004 as a result of cost improvements offset by the effect of flatto lower licensing revenues and the effect of declining average selling prices(“ASPs”). Our licensing revenues are expected to be in the range of $6.0 - $6.5million in the fourth quarter compared to $6.4 million in the third quarter of2004. Overall gross margin rates are expected to increase in 2004 from 2003levels as a result of higher licensing and royalty revenue, for which there isno associated cost of sales, manufacturing cost reductions on certain of ourhigher volume products, leverage on higher unit volume and shifts in productmix whereby sales of higher margin CE products will grow faster than our PC orstorage product lines that have lower gross margins. We expect that thesepositive effects will be partially offset by declining average selling prices,and higher manufacturing overhead spending to support increased productionlevels for products in all three of our markets.  

 

Excluding non-cash charges for stock compensation expense, our totaloperating expenses were $19.2 million for the third quarter of 2004. We expectthese operating expenses in total to remain flat during the fourth quarter of2004.  

 

Excluding non-cash charges for stock compensation expense, we expectthe dollar amount of our R&D expense in the fourth quarter of 2004 to be inthe range of $11.5 - $12.0 million compared to $11.6 million for the thirdquarter of 2004. R&D expense will be incurred for enhancements to existingproducts and for further new product development in all three product lines. 

 

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Excluding non-cash charges for stock compensation expense, we expectthe dollar amount of our SG&A expense during the fourth quarter of 2004 tobe in the range of $7.3 - $7.8 million compared to $7.8 million for the thirdquarter of 2004. We cannot predict the R&D or SG&A expenses includingthe non-cash charges for stock compensation expense, which will fluctuate withchanges in our stock price and volatility. 

 

We expect to incur substantial non-cash stock compensation expense in2004 and future periods as a result of previous stock option repricings, stockoptions assumed in connection with our prior acquisitions, the issuance ofstock options to consultants, and modifications to stock options. We may alsoincur non-cash stock compensation expense in connection with futureacquisitions. The amount of stock compensation expense in each period willfluctuate with changes in our stock price and volatility.  

 

We will also incur legal fees in the fourth quarter of 2004 inconjunction with our patent infringement lawsuit against Genesis, and otheroutstanding litigation. The amount of legal fees incurred will depend on theduration of the litigation, as well as the nature and extent of the litigationactivities. We are not able to accurately estimate the amount of legal fees wewill incur with respect to this matter; however, we do expect to incursubstantial amounts through at least the first half of 2005.  

 

**Commitments, Contingencies and Concentrations**  

 

Historically, a relatively small number of customers and distributorshave generated a significant portion of our revenue. For instance, our top fivecustomers, including distributors, generated 50.2% and 46.7% of our revenue forthe three and nine months ended September 30, 2004, respectively, and 46% and44% of our revenue for the three and nine months ended September 30, 2003,respectively.  Additionally, thepercentage of revenue generated through distributors tends to be significant,since many OEM’s rely upon third party manufacturers or distributors to providepurchasing and inventory management functions. For the three and nine monthsended September 30, 2004, 46.9% and 43.6%, respectively, of our revenue was generatedthrough distributors, compared to 41.2% and 38.5%, respectively, for thecomparable period of 2003. Our licensing revenue is not generated throughdistributors, and to the extent licensing revenue increases faster than productrevenues, we would expect a decrease in the percentage of our total revenuesgenerated through distributors.  

 

A significant portion of our revenue is generated from products soldoverseas. Sales to customers in Asia, including distributors, generated 67% and68% of our revenue in the three and nine months ended September 30, 2004, and66% and 68% for each of the three and nine month periods ended September 30,2003. The reason for our geographical concentration in Asia is that most of ourproducts are part of flat panel displays, graphic cards and motherboards, themajority of which are manufactured in Asia. The percentage of our revenuederived from any country is dependent upon where our end customers choose tomanufacture their products. Accordingly, variability in our geographic revenueis not necessarily indicative of any geographic trends, but rather is thecombined effect of new design wins and changes in customer manufacturinglocations. All revenue to date has been denominated in U.S. dollars.  

 

In September 1998, we entered into an agreement with Intel to developand promote the adoption of a digital display interface specification. Inconnection with this agreement, we granted Intel a warrant to purchase 285,714shares of our common stock at $1.75 per share. Under the same agreement, wegranted Intel a warrant to purchase 285,714 shares of our common stock at $0.18per share upon achievement of a specified milestone that was reached during thefirst quarter of 1999. Both of these warrants were exercised in May 2001. Additionally,if a second specified milestone is achieved, which we do not believe is likely,we would be required to grant Intel a third warrant to purchase 285,714 sharesof our common stock at $0.18 per share. The estimated fair value of the warrantat September 30, 2004 would have been $3.6 million.  

 

**Critical Accounting Policies**  

 

The preparation of financial statements in conformity with generallyaccepted accounting principles requires management to make estimates andassumptions that affect amounts reported in our consolidated financialstatements and accompanying notes. We base our estimates on historicalexperience and all known facts and circumstances that we believe are relevant.Actual results may differ materially from our estimates. We believe thefollowing accounting policies to be most critical to an understanding of ourfinancial condition and results of operations because they require us to makeestimates, assumptions, and judgments about matters that are inherentlyuncertain. Our critical accounting estimates include those regarding (1)revenue recognition, (2) allowance for doubtful accounts receivable, (3)Inventories, (4) Long-lived assets, (5) goodwill, (6) deferred tax assets, (7)accrued liabilities, (8) stock-based compensation expense, and (9) legalmatters. For a discussion of the critical accounting estimates, see “Item 7.Management’s Discussion and Analysis of Financial Condition and Results ofOperations — Critical Accounting Policies” in our Annual Report on Form 10-Kfor the year ended December 31, 2003. 

 

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**Results of Operations for the Three and NineMonths Ended September 30, 2004 Compared to Results of Operations for the Threeand Nine Months Ended September 30, 2003**  

 

REVENUE 

 
| ** **                                                                                                     | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |       |
|----------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|------------|
| ** **                                                                                                     | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |   |
|                                                                                                           |       |                                 |       |                                |       |       |   |   |   |   |   |   |   |   |
| Personal Computers                                                                                             |       | $                                    | 10,296     |                                | $          | 8,270      |   | 24.5 | % | $ | 30,370 |   | $ | 24,416 |   | 24.4 | % |   |
| Consumer Electronics                                                                                           |       | 22,249                               |       | 7,628                               |       | 191.7      | % | 49,563 |   | 15,942 |   | 210.9 | % |   |
| Storage Products                                                                                               |       | 8,929                                |       | 6,549                               |       | 36.3       | % | 30,417 |   | 21,556 |   | 41.1 | % |   |
| Product revenue                                                                                                |       | 41,474                               |       | 22,447                              |       | 84.8       | % | 110,350 |   | 61,914 |   | 78.2 | % |   |
| Percentage of total revenue                                                                                    |       | 86.6                                 | %          | 92.8                                | %          | (6.2       | )pts | 86.8 | % | 84.6 | % | 2.2 | pts |   |
| Development, licensing and royalties                                                                           |       | 6,394                                |       | 1,743                               |       | 266.8      | % | 16,737 |   | 11,284 |   | 48.3 | % |   |
| Percentage of total revenue                                                                                    |       | 13.4                                 | %          | 7.2                                 | %          | 6.2        | pts | 13.2 | % | 15.4 | % | (2.2 | )pts |   |
| Total Revenue                                                                                                  |       | $                                    | 47,868     |                                | $          | 24,190     |   | 97.9 | % | $ | 127,087 |   | $ | 73,198 |   | 73.6 | % |
|                                                                                                           |       |                                 |       |                                |       |       |   |   |   |   |   |   |   |   |   |   |   |
| REVENUE (with  development, licensing and royalty revenues, collectively licensing revenues,  by product line) |
|                                                                                                           |
| ** **                                                                                                     | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |       |
| ** **                                                                                                     | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |   |
| ** **                                                                                                     | ** ** | ** **                           | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |   |
| Personal Computers                                                                                             |       | $                                    | 10,473     |                                | $          | 9,127      |   | 14.7 | % | $ | 30,632 |   | $ | 24,978 |   | 13.5 | % |   |
| Consumer Electronics                                                                                           |       | 26,987                               |       | 7,980                               |       | 238.2      | % | 60,519 |   | 19,296 |   | 213.6 | % |   |
| Storage Products                                                                                               |       | 10,408                               |       | 7,083                               |       | 46.9       | % | 35,936 |   | 26,924 |   | 33.5 | % |   |
| Total Revenue                                                                                                  |       | $                                    | 47,868     |                                | $          | 24,190     |   | 97.9 | % | $ | 127,087 |   | $ | 73,198 |   | 73.6 | % |
|                                                                                                                |            |                                      |            |                                     |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Revenues were $47.9 million and $127.1 million for the three andnine-month periods ended September 30, 2004, respectively, and this representedan increase of 97.9% and 73.6%, relative to comparable periods of 2003. Allelements of revenue grew for both the three and nine-month periods endedSeptember 30, 2004, compared to similar periods in 2003. The increases in theCE and storage products are primarily attributable to our new productofferings, adoption of our technologies, as well as the overall growth in thesemarkets, resulting in increased volumes. The relatively lower level of increasein demand for our PC products, is attributable to loss of market share dueprimarily to integration and an overall lower growth rate in the PC market in general.We license our technology in each of our areas of business, but usually limitthe scope of the license to market areas that are complementary to our productssales and that do not directly compete with our direct product offerings. Theincrease during the three-month period and a decrease during the nine-monthperiod ended September 30, 2004 in development, licensing and royalty revenuesas a component of total revenues was primarily due to the rapid adoption ofHDMI products in advance of HDMI related licensing revenues. Licensing revenuesare inherently lumpy and their timing can be uncertain to predict. However, itis our expectation that licensing and royalty revenues for the fourth quarterof 2004 will be in the $6.0 - $6.5 million range. For the fourth quarter of2004, relative to the third quarter, we expect overall revenues (includinglicensing) to remain flat. Fourth quarter product revenues (excluding licensingrevenues) are projected to increase 10% for CE, and decline 10% for bothstorage and PC. 

 

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**COST OF REVENUE AND GROSS MARGIN**

 
| ** **                                                                         | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
|                                                                               |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |
| Product gross margin (excluding licensing revenue)                                 |       | $                                    | 23,270     |                                | $          | 10,960 |   | 112.3 | % | $ | 59,936 |   | $ | 28,643 |   | 109.3 | % |
| Percentage of product revenue                                                      |       | 56.1                                 | %          | 48.8                                | %          | 7.3 | pts | 54.3 | % | 46.3 | % | 8.0 | pts |
| Total gross margin                                                                 |       | 29,664                               |       | 12,703                              |       | 133.5 | % | 76,674 |   | 39,927 |   | 92.0 | % |
| Percentage of total revenue                                                        |       | 62.0                                 | %          | 52.5                                | %          | 9.5 | pts | 60.3 | % | 54.5 | % | 5.8 | pts |
| Stock compensation expense                                                         |       | (110                                 | )          | (14                                 | )          | 685.7 | % | 1,890 |   | (71 | ) | (2,762.0 | )% |
| Product gross margin (excluding stock compensation  expense and licensing revenue) |       | 23,160                               |       | 10,946                              |       | 111.6 | % | 61,826 |   | 28,572 |   | 116.4 | % |
| Percentage of product revenue                                                      |       | 55.8                                 | %          | 48.8                                | %          | 7.0 | pts | 56.0 | % | 46.1 | % | 9.9 | pts |
| Total gross margin (excluding stock compensation  expense)                         |       | 29,554                               |       | 12,689                              |       | 132.9 | % | 78,564 |   | 39,856 |   | 97.1 | % |
| Percentage of total revenue                                                        |       | 61.7                                 | %          | 52.5                                | %          | 9.2 | pts | 61.8 | % | 54.4 | % | 7.4 | pts |
|                                                                                    |            |                                      |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

Cost of revenue consists primarily of costs incurred to manufacture,assemble and test our products, as well as related overhead costs. Gross margin(revenue minus cost of revenue), as a percentage of revenue, was 62.0%, and60.3% for the three and nine month periods ended September 30, 2004,respectively, and 52.5% and 54.5% for the three and nine month periods endedSeptember 30, 2003, respectively. Gross margin, excluding non-cash stockcompensation expense (benefit), was 61.7% and 61.8% for the three and ninemonth periods ended September 30, 2004, respectively, and 52.5% and 54.4% forthe three and nine month periods ended September 30, 2003, respectively. Theincrease in gross margin is attributable primarily to the effect of higher licensingrevenues, leverage on higher volume, manufacturing costs reductions andimproved product mix whereby higher margin CE products represented a increasedproportion of our revenue relative to our lower margin PC and storage products.These were partially offset by the impact of a change in estimate for productmargins related to inventory in the distributor channel during the first halfof 2004, higher inventory provision in the third quarter of 2004, and lowerproduct pricing. Non-cash stock compensation expense (benefit) associatedwith cost of revenue was $(110,000) and $1.9 million for the three and ninemonth periods ended September 30, 2004, respectively, and $(14,000) and($71,000) for the three and nine month periods ended September 30, 2003, respectively.

** **

**OPERATING EXPENSES**

 
| ** **                                               | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                               | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **Change** | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
|                                                     |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |
| Research and development (1)                             |       | $                                    | 11,585     |                                | $          | 9,054 |   | 28.0 | % | $ | 33,639 |   | $ | 27,259 |   | 23.4 | % |
| Percentage of total revenue                              |       | 24.2                                 | %          | 37.4                                | %          | (13.2 | )pts | 26.5 | % | 37.2 | % | (10.7 | )pts |
| Selling, general and administrative(2)                   |       | 7,764                                |       | 4,131                               |       | 87.9 | % | 21,271 |   | 12,794 |   | 66.3 | % |
| Percentage of total revenue                              |       | 16.2                                 | %          | 17.1                                | %          | (0.9 | )pts | 16.7 | % | 17.5 | % | (0.8 | )pts |
| Total stock compensation expense(incl  amount from COGS) |       | 1,527                                |       | 1,106                               |       | 38.1 | % | 22,727 |   | 2,997 |   | 658.3 | % |
| Percentage of total revenue                              |       | 3.2                                  | %          | 4.6                                 | %          | (1.4 | )pts | 17.9 | % | 4.1 | % | 13.8 | pts |
| Amortization of intangible assets                        |       | 357                                  |       | 373                                 |       | (4.3 | )% | 1,070 |   | 746 |   | 43.4 | % |
| Patent defense and acquisition integration costs         |       | 222                                  |       | 160                                 |       | 38.8 | % | 485 |   | 1,956 |   | (75.2 | )% |
| Restructuring                                            |       | —                               |       | —                              |       |   | N/M | — |   | 986 |   | (100.0 | )% |
| In-process research and development                      |       | —                               |       | —                              |       |   | N/M | — |   | 5,482 |   | (100.0 | )% |
| Gain on escrow settlement, net                           |       | —                               |       | —                              |       |   | N/M | — |   | 4,618 |   | (100.0 | )% |
| Interest income and other, net                           |       | 211                                  |       | 40                                  |       | 427.5 | % | 399 |   | 216 |   | 84.7 | % |
| Gain(loss) on derivative investment  security            |       | (64                                  | )          | —                              |       | (100.0 | )% | 926 |   | — |   | 100.0 | % |
|                                                          |            |                                      |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

N/M = Not meaningful  

 

(1)                                  Excludesnon-cash stock compensation expense of $595,000 and $1.0 million for the threemonths ended September 30, 2004 and 2003, respectively and $11.6 million and$3.0 million for the nine month periods ended September 30, 2004 and 2003,respectively.  

 

(2)                                  Excludesnon-cash stock compensation expense of $1.0 million and $94,000 for the threemonth periods ended September 30, 2004 and 2003, respectively and $9.3 millionand $75,000 for the nine month periods ended September 30, 2004 and 2003,respectively. 

 

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*Research and Development.  *R&Dexpense consists primarily of compensation and related costs for employees,fees for independent contractors, the cost of software tools used for designingand testing our products, and costs associated with prototype materials.R&D expense including stock compensation expense was $12.2 million or 25.4%of revenue and $45.2 million or 35.6% of revenue for the three and nine monthperiods ended September 30, 2004, respectively, and $10.1 million or 41.7% ofrevenue and $30.3 million or 41.3% of revenue, for the three and nine monthsended September 30, 2003, respectively. R&D expense, excluding non-cashstock compensation expense, was $11.6 million, or 24.2% of revenue and $33.6million or 26.5% of revenue for the three and nine month periods ended September30, 2004, respectively, and $9.1 million or 37.4% of revenue and $27.3 millionor 37.2% of revenue for the three and nine months ended September 30, 2003,respectively. The increase in 2004, without the effect of stock compensationexpense, was primarily due to an increase in the number of R&D projects tosupport the multiple markets in which we operate, as well as additionalpersonnel, including personnel from TransWarp Networks, which we acquiredduring the second quarter of 2003. Excluding non-cash charges for stockcompensation expense, we expect the dollar amount of our R&D expense in thefourth quarter of 2004 to be approximately $11.5 - $12.0 million.  

 

*Selling, General and Administrative.  *SG&Aexpense consists primarily of employee compensation and benefits, salescommissions, and marketing and promotional expenses. Including non-cash stockcompensation expense, SG&A expense was $8.8 million or 18.4% of revenue and$30.5 million or 24.0% of revenue for the three and nine months ended September30, 2004, respectively and $4.2 million or 17.5% of revenue and $12.9 millionor 17.6% of revenue for the three and nine months ended September 30, 2003,respectively. Excluding non-cash stock compensation expense, SG&A expensewas $7.8 million or 16.2% of revenue and $21.3 million or 16.7% of revenue forthe three and nine months ended September 30, 2004, respectively, and $4.1million or 17.1% of revenue and $12.8 million or 17.5% of revenue for the threeand nine months ended September 30, 2003, respectively. The increase inspending for 2004, without the effect of stock compensation expense, can beattributed to the increased headcount to support the increased rate of growthof the Company, approximately $1.0 million incurred during the first half of 2004relating to the costs associated with the Audit Committee examination andapproximately $455,000 and $580,000 for the three and nine months endedSeptember 30, 2004, relating to our preparation for Sarbanes-Oxley Section 404.Excluding non-cash charges for stock compensation expense, we expect the dollaramount of our SG&A expense to be in the range of $7.3 - $7.8 million, inthe fourth quarter of 2004.  

 

*Stock Compensation.  *Stockcompensation expense was $1.5 million or 3.2% of revenue and $22.7 million or17.9% of revenue for the three and nine month periods ended September 30, 2004,respectively and $1.1 million or 4.6% of revenue and $3.0 million or 4.1% ofrevenue for the three and nine months ended September 30, 2003, respectively.The increase in total stock compensation can be attributed primarily to thehigher stock price during the first nine months of 2004 and the resultantimpact on expense relating to our repriced options offset to some extent by adecrease in expense associated with the options granted in connection withacquisitions and a decline in the number of options subject to variableaccounting, as certain older options expire. For the three and nine monthperiods ended September 30, 2004, we recorded a one-time expense ofapproximately $0.8 million relating to certain option modifications (pertainingto change in vesting terms upon entering into an amended employment agreementwith one employee and upon the death of another employee) made in the thirdquarter of 2004.  

 

We will incur substantial non-cash stock compensation expense in futureperiods as a result of (1) the issuance of, or modifications to,restricted stock awards and stock option grants to employees and consultants,(2) the stock option repricing programs we implemented in 2000 and 2001,and (3) amortization of our existing unearned compensation balance. Sincethe expense associated with our stock option repricings and stock optionsissued to consultants is dependent on our stock price and volatility, stockcompensation expense may fluctuate significantly from period to period. Todate, we have recognized over $24.3 million of expense in connection with ourstock option repricings, and this may continue to be a significant component ofour stock compensation expense in future periods if our stock pricesignificantly exceeds the average stock price for the period ended September30, 2004. Due to its volatility, we cannot estimate our stock compensationexpense for the fourth quarter of 2004.  

 

*Amortization of Intangible Assets.  *Forthe three and nine months period ended September 30, 2004, we recordedamortization of intangible assets amounting to $357,000 and $1,070,000,respectively, relating to intangible assets on our balance sheet, pursuant toour acquisition of Transwarp Netwoks, Inc. during the second quarter of 2003.We recorded $373,000 and $746,000 relating to amortization of intangible assets for the three andnine-month periods ended September 30, 2003. We expect the amortization expensefor the fourth quarter of 2004 to be approximately $275,000.  

 

*Restructuring.   *In connection with our restructuring activities (as more fully described in ourForm 10-K for the year ended December 31, 2003), we have recorded restructuringcharges in the years 2001 and 2002. In March 2003, we reorganized parts ofthe marketing and product engineering activities of the company into lines ofbusiness for personal computer (“PC”), consumer electronics (“CE”) and storageproducts to enable us to better manage our long-term growth potential. Thecentral engineering, sales, manufacturing, and general and administrativeactivities were not organized into the line of business structure. Inconnection with this reorganization, we reduced our workforce by 27 people, orapproximately 10%. These reductions were primarily in engineering and operationsfunctions. Because of this workforce reduction, we recorded restructuringexpense of $986,000 in the first quarter of 2003, consisting of cashseverance-related costs of $340,000 and non-cash severance-related costs of$646,000, representing the intrinsic value of modified stock options. 

 

21

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Severance related costs were determined based on the amount of paypeople received that was not for services performed and by measuring theintrinsic value of stock options that were modified to the benefit ofterminated employees. For those employees terminated in the three month periodending March 31, 2003, the remaining service period from the communicationdate did not exceed 60 days. The expected loss on leased facilities resultedfrom our plan to consolidate our remaining workforce to the extent practicableand sublease any excess space. To determine the expected loss, we compared ourlease and operating costs for the space to our estimate of the net amount we wouldbe able to recover by subleasing the space. This estimate was based on a numberof assumptions, including the length of time it will take to secure a tenant,the sublease rate per square foot, the cost of necessary improvements ormodifications and real estate broker commissions.  

 

Severance and benefits payments are substantially complete. Leasepayments will be made in the form of cash through the end of the related leaseterm of November 2005. The following table presents restructuring activityfor nine-month periods ended September 30, 2004 and 2003 (in thousands): 

 
| ** **                 | ** ** | **2004**                    | ** ** | **2003**               | ** ** |
|----------------------------|------------|-----------------------------|------------|------------------------|------------|
| ** **                 | ** ** | **Severance and  Benefits** | ** ** | **Leased  facilities** | ** ** | **Total** | ** ** | **Severance and  Benefits** | ** ** | **Leased  facilities** | ** ** | **Total** | ** ** |
|                       |       |                        |       |                   |       |   |   |   |   |   |   |   |   |
| Balance as of January 1    |       | $                           | 37         |                   | $          | 1,838 |   | $ | 1,875 |   | $ | 138 |   | $ | 2,598 |   | $ | 2,736 |   |
| Provision                  |       | —                      |       | —                 |       | — |   | 986 |   | — |   | 986 |   |
| Cash payments              |       | (5                          | )          | (569                   | )          | (574 | ) | (434 | ) | (551 | ) | (985 | ) |
| Non-cash activity          |       | —                      |       | —                 |       | — |   | (646 | ) | — |   | (646 | ) |
| Balance as of September 30 |       | $                           | 32         |                   | $          | 1,269 |   | $ | 1,301 |   | $ | 44 |   | $ | 2,047 |   | $ | 2,091 |   |

 

*Patent defense costs.  *Patentdefense costs were $222,000 and $485,000 for the three and nine months endedSeptember 30, 2004, respectively, compared to $160,000 and $2.0 million,respectively, for the comparable periods of 2003. Patent defense costs arerelated to the lawsuit we filed against Genesis in April 2001. Thedecrease in 2004 compared to 2003 is attributable to a lower level of activityduring the first nine months of 2004. However, we expect to incur additionaldefense costs until the matter is resolved. The amount of legal fees incurredin future periods will depend on the duration of the litigation, as well as thenature and extent of the litigation activities. We are not able to accuratelyestimate the amount of legal fees we will incur, but the amount could besignificant.  

 

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

 

*Interest Income and other, net.  *Thisprincipally includes interest income and interest expense. The net amount was$211,000 and $399,000 for the three and nine-month periods ended September 30,2004, respectively, compared to $40,000 and $216,000 for the three andnine-month periods ended September 30, 2003, respectively. The increase isprincipally due to higher cash balances and lower debt balances offset by thelower interest rates during 2004. We expect our interest income for the fourthquarter of 2004 to be approximately $250,000.

 

*Gain(loss) on derivative investment security.*We recorded a loss of $64,000 and a gain of $926,000,respectively, for the three and nine-months ended September 30, 2004, relatingto a derivative investment security. This relates to common stock warrants acquired in connection with atransaction with Leadis Technology Inc. (as described in Note 15 to theaccompanying unaudited condensed consolidated financial statements). OnSeptember 16, 2004, we exercised the common stock warrants. Our equityinvestment in Leadis ongoing will be included in our short-term investments onour balance sheet, until our holding of the 374,397 shares are sold. We arerestricted from selling the Leadis shares until December 2004. Our typicalpractice is not to hold shares for investment purposes. Based on the marketvalue of Leadis stock as of November 1, 2004, the value of our holding as ofthat date, compared to the value as at September 30, 2004, declined byapproximately $1.1 million.  

 

*Provision for Income Taxes.  *Forthe three and nine month periods ended September 30, 2004, we recordedprovision of income taxes of $369,000 and $941,000, respectively. These amountsinclude approximately $262,000 relating to withholding taxes payable inconnection with our licensing contracts. The three and nine-month provisionsrelate primarily to taxes in foreign jurisdictions where we have recentlycommenced operations and estimated provision for U.S. alternative minimum taxesfor the fiscal year ending December 31, 2004. At December 31, 2003, we had anet operating loss carryforward for federal income tax purposes ofapproximately $75.1 million that expires in various years through 2023.These future tax benefits have not been recognized as an asset on our balancesheet due to uncertainties surrounding our ability to generate sufficienttaxable income in future periods to realize these tax benefits. Under the TaxReform Act of 1986, the amounts of, and benefits from, net operating losscarryforwards may be restricted or limited in certain circumstances. 

 

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**LIQUIDITY, CAPITAL RESOURCES AND FINANCIAL CONDITION**   

 
| ** **                                               | ** ** | **September 30, 2004**   | ** ** | **December 31, 2003** | ** ** | **Change** | ** ** |
|----------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|------------|------------|
| ** **                                               | ** ** | **Dollars in thousands** | ** ** | ** **            | ** ** |
| Cash and cash equivalents                                |       | $                        | 62,508     |                  | $          | 24,059     |       | $ | 38,449 |   |
| Short term investments                                   |       | 16,202                   |       | 13,195                |       | 3,007      |       |
| Total cash, cash equivalents and short term  investments |       | 78,710                   |       | 37,254                |       | 41,456     |       |
|                                                     |       |                     |       |                  |       |       |       |
| Percentage of total assets                               |       | 55.6                     | %          | 42.5                  | %          | 13.1       | pts        |
|                                                     |       |                     |       |                  |       |       |       |
| Total current assets                                     |       | 117,058                  |       | 63,023                |       | 54,035     |       |
| Total current liabilities                                |       | 37,970                   |       | 25,349                |       | 12,621     |       |
| Working capital                                          |       | $                        | 79,088     |                  | $          | 37,674     |       |   | 41,414 |   |

 
| ** **                                            | ** ** | **Nine months ended September 30,** | ** ** | ** ** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------|------------|------------|------------|
| ** **                                            | ** ** | **2004**                            | ** ** | **2003**   | ** ** | **Change** | ** ** |
|                                                  |       |                                |       |       |       |   |   |
| Cash provided by (used in) operating  activities      |       | $                                   | 27,948     |       | $          | (8,868 | ) | $ | 36,816 |   |
| Cash used in investing activities                     |       | (3,616                              | )          | (6,361     | )          | 2,745 |   |
| Cash provided by financing activities                 |       | 14,117                              |       | 5,213      |       | 8,904 |   |
| Net increase (decrease) in cash and cash  equivalents |       | $                                   | 38,449     |       | $          | (10,016 | ) | $ | 48,465 |   |

 

Since our inception, we have financed our operations through acombination of private sales of convertible preferred stock, our initial publicoffering, lines of credit, capital lease financing, proceeds from sale of stockunder our stock plans and cash flows from operations. At September 30, 2004, wehad $79.1 million of working capital, which included $78.7 million of cash,cash equivalents and short-term investments. If we are not able to generatecash from operating activities, stock option exercises, and proceeds from salesof shares under our employee stock purchase plan, we will liquidate short-terminvestments or, to the extent available, utilize credit arrangements to meetour cash needs.  

 

*Working capital*  

 

The principal components of the current assets and liabilities and ananalysis of the same is given below:  

 

Net accounts receivable increased to $22.3 million at September 30,2004 from $12.8 million at December 31, 2003. The increase is primarilydue to increased sales volume and in particular a $5.6 million increase indistributor shipments during September 2004 versus our ending balance atDecember 2003 as the third quarter is usually a stronger quarter compared tothe fourth quarter. The days sales outstanding (“DSO”) was 43 days at September30, 2004, compared to 38 days at December 31, 2003. The increase in theDSO days is primarily as a result of the increase in distributor shipments inSeptember 2004 as compared to December 2003. We expect the DSO days to be inthe 43-47 days range during the fourth quarter of 2004.  

 

Inventories increased to $14.0 million at September 30, 2004 from $10.3million at December 31, 2003. The increase is attributable to the overallincreased business volume. Our inventory turn rate improved to 5.2 as atSeptember 30, 2004 from 5.1 as at December 31, 2003. Inventory turns arecomputed on an annualized basis, and are a measure of the number of timesinventory is replenished during the year. Our inventory turns increasedprimarily due to higher business volume during the third quarter of 2004 offsetin part by the higher inventory balance as of September 30, 2004. We expectthis measure to be around the 5.3 — 5.8 turns range during the fourth quarterof 2004.  

 

Accounts payable and accrued liabilities increased to $11.9 million and$12.1 million, respectively, at September 30, 2004 from $6.4 million and $8.7 million,respectively, at December 31, 2003. The increase in accounts payable wasprimarily due to increased inventory purchases and the timing of when payablesbecame due and were processed. The increase in accrued liabilities is due to acompanywide bonus accrual of $2.5 million, and increased scale of operationsand consequently increased expenditure levels. 

 

23

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 Deferred margin on sales todistributors increased to $12.4 million at September 30, 2004 from $7.3 millionat December 31, 2003. The increase is the net result of increaseddistributor related shipments at September 30, 2004 compared toDecember 31, 2003, improved margins and changes in product mix.  

 

*Operating activities*  

 

Operating activities generated $27.9 million of cash during the firstnine months of 2004. For the first nine months of 2004, our net incomeexcluding depreciation, stock compensation expense, amortization of intangibleassets, provision for doubtful accounts receivable, offset by our gain onderivative investment security was $26.4 million. Increases in accountspayable, accrued liabilities and deferred license revenue, deferred margin onsales to distributors and decrease in prepaid expenses and other assets offsetby an increase in accounts receivable and inventories contributed $1.6 million.Operating activities used $8.9 million of cash during the first nine months of2003.  During the first nine months of2003, our net loss excluding depreciation, stock compensation expense, non-cashgain on escrow settlement, in-process research and development expense and thenon-cash portion of our restructuring charges was $1.2 million.  The decreases in accounts payable and accruedliabilities and increases in accounts receivable and inventories of $13.4million were the primary uses of cash. These uses were offset by an increase inthe deferred margin on sales to distributors and decrease in prepaid and otherassets of $3.4 million.  

 

*Investing and financing activities*  

 

Investing activities used $3.6 million for the nine months endedSeptember 30, 2004 and used $6.4 million for the nine months ended September30, 2003. The use of cash for both periods were capital expenditures andpurchases of short-term investments, offset by net proceeds from sales ofshort-term investments.  

 

We generated $14.1 million and $5.2 million from financing activitiesduring the nine months ended September 30, 2004 and 2003. Cash provided byfinancing activities in both periods was primarily from stock option exercisesand proceeds from sales of shares under our employee stock purchase plan,partially offset by repayments of our capital leases and other obligations.  

 

*Debt and Lease Obligations*  

 

In October 2002, we entered into a $3.6 million term loan torefinance $3.1 million of debt acquired in connection with our acquisition ofCMD and $500,000 of other bank debt. This loan bears interest at prime (4.75%at September 30, 2004) plus 0.25% and requires monthly payments through itsmaturity of October 1, 2004. During the nine months ended September 30,2003, we borrowed $383,000 to finance certain capital equipment. This term loanbears interest at 5% and requires monthly payments through its maturity inFebruary 2005. As of September 30, 2004, $318,000 was outstanding underthese term loans. 

 

During the period ended March 31, 2004, we entered into a new debtfacility by way of a revolving line of credit with an availability of up to$10.0 million, and an equipment line of credit of up to $3.0 million.Borrowings under the revolving line are limited to the lesser of $10.0 millionor 80% of eligible accounts receivable as defined in the loan agreement. Thisrevolving line of credit expires in March 2005 and bears interest ateither prime plus 0.25% or LIBOR plus 2.75%, at our option. No amounts havebeen drawn down against this line of credit as at September 30, 2004. Equipmentadvances pursuant to the equipment line of credit were available to us throughAugust 2004, however no amounts were drawn down against this line and itexpired in accordance with its terms. Our debt facilities contain quarterly andannual financial covenants. As of September 30, 2004, we were in compliancewith all covenants. 

 

24

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

 

 
| ** **                       | ** ** | ** ** | ** ** | **Payments due in**       | ** ** |
|----------------------------------|------------|------------|------------|-------------------------------------|------------|
| **Contractual obligations** | ** ** | **Total**  | ** ** | **Less than 1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than 5 years** | ** ** |
| Debt obligations                 |       | $          | 318        |                                | $          | 318 |   | $ | — |   | $ | — |   | $ | — |   |
| Operating lease obligations      |       | 7,284      |       | 2, 646                              |       | 2,408 |   | 2,137 |   | 93 |   |
| Inventory purchase obligations   |       | 3,049      |       | 3,049                               |       | — |   | — |   | — |   |
| Total                            |       | $          | 10,651     |                                | $          | 6,013 |   | $ | 2,408 |   | $ | 2,137 |   | $ | 93 |   |
|                                  |            |            |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Future minimum lease payments under operating leases have not beenreduced by expected sublease rental income or by the amount of ourrestructuring accrual that relates to leased facilities.  

 

We plan to spend approximately $2-2.5 million during the remainder ofthe 2004 fiscal year for equipment, furniture and software.  

 

Based on our estimated cash flows, we believe our existing cash andshort-term investments are sufficient to meet our capital and operatingrequirements for at least the next 12 months. Our future operating and capitalrequirements depend on many factors, including the levels at which we generateproduct revenue and related margins, the extent to which we generate cashthrough stock option exercises and proceeds from sales of shares under ouremployee stock purchase plan, the timing and extent of development, licensingand royalty revenues, investments in inventory and accounts receivable, thecost of securing access to adequate manufacturing capacity, our operatingexpenses, including legal and patent defense costs, and general economicconditions. In addition, cash may be required for future acquisitions should wechoose to pursue any. To the extent existing resources and cash from operationsare insufficient to support our activities, we may need to raise additionalfunds through public or private equity or debt financing. These funds may notbe available, or if available, we may not be able to obtain them on termsfavorable to us.  

 

**Factors Affecting Future Results**  

 

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

 

**We operate in rapidly evolving markets, whichmakes it difficult to evaluate our future prospects.**  

 

The revenue and income potential of our business and the markets we serveare early in their lifecycle and is difficult to predict. The Digital VisualInterface (“DVI”) specification, which is based on technology developed by usand used in many of our products, was first published in April 1999. Wecompleted our first generation of consumer electronics and storage IC productsin mid-to-late 2001. In addition, the preliminary serial ATA specification wasfirst published in August 2001 and the High Definition MultimediaInterface (“HDMI”) specification was first released in December 2002.Accordingly, we face risks and difficulties frequently encountered by companiesin new and rapidly evolving markets. If we do not successfully address theserisks and difficulties, our results of operations could be negatively affected.  

 

**We have a history of losses and may notbecome profitable.** 

 

We have incurred net losses in each fiscal year since our inception,including net losses of $0.2 million for the nine months ended September 30,2004, and $12.8 million and $40.1 million for the years endedDecember 31, 2003 and 2002, respectively. We may continue to incur netlosses for the foreseeable future. Accordingly, we may not achieve and sustainprofitability. 

 

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**Our quarterly operating results may fluctuatesignificantly and are difficult to predict.**

 

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

 

•                                          thegrowth, evolution and rate of adoption of industry standards for our keymarkets, including digital-ready PCs and displays, consumer electronics andstorage devices; 

 

•                                            thefact that our licensing revenue is heavily dependent on a few key licensingtransactions being completed for any given period, the timing of which is notalways predictable and is especially susceptible to delay beyond the period inwhich completion is expected, and our concentrated dependence on a fewlicensees in any period for substantial portions of our expected licensingrevenue; 

 

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

 

•                                          averageselling prices of our products, which are influenced by competition andtechnological advancements, among other factors;

 

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

 

•                                          theavailability of other semiconductors or other key components that are requiredto produce a complete solution for the customer; usually, we supply one of manynecessary components; 

 

•                                          thecost of components for our products and prices charged by the third parties whomanufacture, assemble and test our products; 

 

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

 

•                                          thenature and extent of litigation activities, particularly our patentinfringement suit against Genesis, and any subsequent legal proceedings relatedto the matters raised in that suit; and. 

 

•                                          anylegal matters resulting from the recent audit committee examination. 

 

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

 

**Our future quarterly operating results arehighly dependent upon how well we manage our business.**

 

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

 

•                                          ourability to manage product introductions and transitions, including enteringinto new market segments; 

 

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

 

•                                          ourability to close licensing deals and timely make deliverables and milestones onwhich recognition of revenue often depends; 

 

•                                          ourability to engineer customer solutions that adhere to industry standards in atimely, cost-effective manner; 

 

•                                          ourability to achieve acceptable manufacturing yields and develop automated testprograms within a reasonable time frame for our new products; 

 

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

 

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•                                          ourability to monitor the activities of our licensees to ensure compliance withlicense restrictions and remittance of royalties;  

 

•                                          ourability to structure our organization to enable achievement of our operatingobjectives and to meet the needs of our customers and markets;  

 

•                                          thesuccess of the distribution channels through which we choose to sell ourproducts; and  

 

•                                          ourability to manage expense and inventory levels. 

 

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

 

**The licensing component of our businessstrategy increases business risk and volatility.**  

 

Part of our business strategy is to license certain of ourtechnology to companies that address markets in which we do not want todirectly participate. We have limited experience marketing and selling our technologyon a licensing basis. In conjunction with the business strategy we adopted inlate 2001, we signed our first license contract in December 2001, and havesigned others since then. There can be no assurance that additional companieswill be interested in licensing our technology on commercially favorable termsor at all. We also cannot ensure that companies who license our technology willintroduce and sell products incorporating our technology, will accuratelyreport royalties owed to us, will pay agreed upon royalties, will honor agreedupon market restrictions, will not infringe upon or misappropriate ourintellectual property and will maintain the confidentiality of our proprietaryinformation. Licensing contracts are complex and depend upon many factorsincluding completion of milestones, allocation of values to delivered items,and customer acceptances. Many of these factors require significant judgments.Licensing revenues could fluctuate significantly from period to period becauseit is heavily dependent on a few key deals being completed in a particularperiod, the timing of which is difficult to predict. Because of their highmargin content, licensing revenues can have a disproportionate impact on grossmargins and profitability. Also, generating revenue from licensing arrangementsis a lengthy and complex process that may last beyond the period in whichefforts begin, and once an agreement is in place, the timing of revenuerecognition may be dependent on customer acceptance of deliverables, achievementof milestones, our ability to track and report progress on contracts, customercommercialization of the licensed technology, and other factors. In addition,in any period, our expectation of licensing revenue is or may be dependent onone or a few licenses being completed. Licensing that occurs in the course ofactual or contemplated litigation is subject to risk that the adversarialnature of the transaction will induce non-compliance or non-payment. Theaccounting rules associated with recognizing revenue from licensingtransactions are increasingly complex and subject to interpretation. Due tothese factors, the amount of license revenue recognized in any period maydiffer significantly from our expectations. 

 

**We face additional risks and costs as aresult of the delayed filing of our quarterly report on Form 10-Q for thequarter ended September 30, 2003 and our recent Audit Committeeexamination.**  

 

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

 

In addition, we have been informed by the NASDAQ staff that the continuedlisting of our common stock is conditioned on our timely filing of all periodicreports under the Securities Exchange Act of 1934, such as our annual report onForm 10-K, quarterly reports on Form 10-Q, and current reports onForm 8-K, for all reporting periods ending on or beforeDecember 31, 2004. Should we fail to timely make any such filing, NASDAQhas informed us that we will not be entitled to a new hearing with the NASDAQstaff and our common stock may be transferred to the NASDAQ SmallCap Market,provided we could demonstrate compliance with applicable maintenance criteriafor such market and an ability to sustain long-term compliance, or immediatelydelisted from the NASDAQ National Market. The NASDAQ staff has reserved theright to reconsider the terms of the foregoing exception permitting continuedlisting of our common stock upon a review of our publicly filed financialstatements or if any event, condition or circumstance that exists or developsthat would, in the opinion of the staff, make continued listing of our stockinadvisable or unwarranted. 

 

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

 

The PC, CE and storage markets in which we operate are intenselycompetitive. These markets are characterized by rapid technological change,evolving standards, short product life cycles and declining selling prices. Ourdisplay products face competition from a number of sources, including analogsolutions, DVI-based solutions, dual (analog and DVI based) solutions and otherdigital interface solutions. We expect competition in the display market toincrease. For example, Analog Devices, ATI, Broadcom, Chrontel, GenesisMicrochip, Explore Tech, National Semiconductor, Novatek, nVidia, Phillips,Pixelworks, SIS, Smart ASIC, ST Microelectronics, Sunplus, Texas Instruments,Thine, and Weltrend, are shipping products or have announced intentions tointroduce products and/or other digital interface solutions that we expect willcompete with our PanelLink products. Other companies have announced DVI-basedsolutions and we expect that additional companies are likely to enter themarket. Current or potential customers, including our own licensees, may alsodevelop solutions that could compete with us, directly or indirectly, such asthe integration of a DVI transmitter into a graphics processing unit orintegration of a DVI receiver into a monitor controller.  

 

In the CE market, our digital interface products are used to connectcable set-top boxes, satellite set-top boxes and DVD players to digitaltelevisions. These products incorporate DVI and High-bandwidth Digital ContentProtection (“HDCP”), or HDMI with or without HDCP support. Companies that haveannounced or are shipping DVI-HDCP solutions include Texas Instruments (“TI”),Toshiba, Panasonic, Mstar, Thine, Broadcom and Genesis Microchip (“Genesis”).In addition, our video processing products face competition from products soldby AV Science, Broadcom, Focus Enhancements, Genesis, Mediamatics, MicronasSemiconductor, Oplus, Phillips, Pixelworks and Trident. We also compete, insome instances, against in-house processing solutions designed by largeoriginal equipment manufacturers. We expect competition for HDMI products fromthe other HDMI founders and adopters, including Hitachi, Matsushita, Phillips,Sony, Thomson and Toshiba. Toshiba and Matsushita have or are close to havingworking HDMI solutions. 

 

In the storage market, our fibre channel products face competition fromcompanies selling similar discrete products, including PMC Sierra and Vitesse,from other fibre channel Serializer-Deserializer (“SerDes”) providers wholicense their core technology, such as LSI Logic, and from companies that sellHost Bust Adapters (“HBA”) controllers with integrated SerDes, such as QLogicand Agilent. In the future, our current or potential customers may also developtheir own proprietary solutions that may include integration of SerDes.  

 

Our serial ATA products compete with similar products from Marvell andPromise. In addition, other companies such as Adaptec, APT, ATI, Intel, LSILogic, ServerWorks and Vitesse, have developed or announced intentions todevelop serial ATA controllers. We also compete against Intel and othermotherboard chipset makers that have integrated serial ATA functionality intotheir chipsets.  

 

Our parallel ATA products compete with similar products from Promiseand Highpoint. Our RAID controller board products face competition from Mylex,Infortrend, and Chaparral.  

 

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

 

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**Growth of the market for our PC productsdepends on the widespread adoption and use of the DVI specification.**

 

Our success is largely dependent upon the rapid and widespread adoptionof the DVI specification, which defines a high-speed data communication linkbetween computers and digital displays. We cannot predict the rate at whichmanufacturers of computers and digital displays will adopt the DVIspecification. The adoption of DVI has been slower than we originallyanticipated. The DVI adoption rate in the PC market was reported to beapproximately 25%,12%, and, 7% in 2003, 2002 and 2001, respectively. Reportedlythe Q3 2004 DVI adoption rate in the PC market is approximately 46%. Adoptionof the DVI specification may be affected by the availability of computercomponents able to communicate DVI-compliant signals, such as transmitters,receivers, connectors and cables necessary to implement the specification.Other specifications may also emerge that could adversely affect the acceptanceof the DVI specification. For example, a number of companies have promotedalternatives to the DVI specification using other interface technologies, suchas low voltage differential signaling, or LVDS. Further delays in thewidespread adoption of the DVI specification could reduce acceptance of ourproducts, limit or reduce our revenue growth and increase our losses.

 

**Our success depends on the growth of thedigital display market.**

 

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

 

•                  thenumber of digital-ready computers that are being produced and consumer demandfor these computers;

 

•                  therate at which display manufacturers replace analog or non-compliant DVIinterfaces with fully DVI-compliant interfaces;

 

•                  theavailability of cost-effective semiconductors that implement a fullyDVI-compliant interface; and

 

•                  improvementsto analog technology, which may decrease consumer demand for our digitaldisplay products.

 

In order for the digital display market to grow, digital displays mustbe widely available and affordable to consumers. In the past, the supply ofdigital displays, such as flat panels, has been cyclical and consumers havebeen very price sensitive. Also, some manufacturers have implemented DVIinterfaces that are not fully DVI-compliant. These interfaces often interferewith the operability of our products which function best with a fullyDVI-compliant interface. Our ability to sustain or increase our revenue may belimited should there not be an adequate supply of, or demand for, affordabledigital displays with DVI-compliant interfaces.

 

**A significant amount of our revenue isassociated with the adoption of new or emerging technologies within the PCindustry. The PC industry has slowed and the adoption of these new technologiesmay not occur as planned.**

 

A large portion of our revenue is directly or indirectly related to thePC industry and the adoption of new or emerging technologies within the PCindustry. Accordingly, we are highly dependent on the adoption of new oremerging technologies within the PC industry, which experienced a slowdown ingrowth during the second half of 2000 that has continued through 2004. Wecannot predict the duration or severity of the downturn in the PC and displaymarket, or in the general economy, or its effect on our revenue and operatingresults, including the adoption of these new or emerging technologies. If themarket for PCs and PC-related displays continues to grow at a slow rate orcontracts whether due to reduced demand from end users, macroeconomicconditions or other factors, our business and results of operations could benegatively affected.

 

Although we are attempting to broaden our product offerings to includemore products in the consumer electronics and storage markets, there can be noguarantee that we will succeed in this effort. To date, we have achievedreasonable success, but if we fail to consistently achieve design wins in theconsumer electronics and storage markets, we will remain highly dependent onour PC related products for the PC industry.

 

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**Demand for our consumer electronics productsis dependent on the adoption and widespread use of the HDMI specification.**

 

Our success in the consumer electronics market is largely dependentupon the rapid and widespread adoption of the HDMI specification, whichcombines high-definition video and multi-channel audio in one digital interfaceand uses our patented underlying transition minimized differential signaling(“TMDS”®)****technology, andoptionally Intel’s HDCP technology, as the basis for the interface. Version 1.0of the specification was published for adoption in December 2002 andversion 1.1 of the specification was published for adoption in May 2004. Wecannot predict the rate at which manufacturers will adopt the HDMIspecification or if the specification will be adopted at all. Adoption of theHDMI specification may be affected by the availability of consumer products,such as DVD players and televisions, and of computer components that implementthis new interface. Other competing specifications may also emerge that couldadversely affect the acceptance of the HDMI specification. Delays in thewidespread adoption of the HDMI specification could reduce acceptance of ourproducts, limit or reduce our revenue growth and increase our losses.

 

We believe that the adoption of our CE products may be affected in partby U.S. and International regulations relating to digital television, cable,satellite and over-the-air digital transmissions, specifically regulationsrelating to the transition from analog to digital television. The FederalCommunications Commission (“FCC”) has adopted rules governing thetransition from analog to digital television, which includerules governing the requirements for television sets sold in the UnitedStates designed to speed the transition to digital television. The FCC hasdelayed such requirements and timetables for phasing in digital television inthe past. We cannot predict whether the FCC will further delay itsrules relating to the digital television requirements and timetables. Inthe event that additional regulatory activity, either in the United States orinternationally, delay or postpone the transition to digital television beyondthe anticipated time frame, that could reduce the demand for our CE products.

 

In addition, we believe that the rate of HDMI adoption may beaccelerated by FCC rules requiring that after July 2005 high-definitionset top boxes distributed by cable operators include a DVI or HDMI interfaceand that as of certain phase-in dates televisions marketed or labeled as“digital cable ready” include a DVI or HDMI interface. However, we cannotpredict whether these rules will be amended prior to phase in or that theirphase-in dates will not be pushed back or otherwise delayed. In the event thatmandatory use of a DVI or HDMI interface were to be delayed beyond thecurrently anticipated time frame or not required at all, that could reduce thedemand for our CE products, which would adversely affect our business.

 

                                                Webelieve that the adoption of HDMI may be affected by the availability of highquality digital content to devices equipped with HDMI or DVI interfaces. Typicallyhigh quality digital content is made available to devices equipped with HDMI orDVI interfaces through high-definition television or digital televisiondistribution channels. To the extent that the availability of such content isdelayed or not made available by the content owners or broadcasters anddistributors of such content then demand for HDMI products could be delayed orreduced.

 

**Our success depends on the development andgrowth of markets for products based on new and emerging storage technologies.**

 

Our product development efforts in the storage market are focused onthe development of products using new interface technologies such as fibrechannel and serial ATA. The markets for these new interface technologies are atan early stage of development, and there can be no assurance that they willreplace other storage interfaces that are now widely used, such as parallel ATAand SCSI. The potential size and rate of development of these markets areuncertain and will depend on many factors, including:

 

•                  therate at which manufacturers of storage subsystems adopt new interfacetechnologies, which may be more costly to implement than existing interfacetechnologies until volumes are sufficient to bring costs to competitive levels;

 

•                  theavailability of cost-effective semiconductors and components for storagesubsystems, such as serial ATA-enabled hard drives and serial ATA enabledoptical drives (CD and DVD), that implement new interface technologies for thestorage market;

 

•                  whetherand to the degree Intel or other motherboard manufacturers integrate thefunctionality of our products, such as serial ATA, into their chips and chipsets; and

 

•                  improvementto existing storage interface technologies such as parallel ATA and SCSI, orthe introduction of other new storage interface technologies, either of whichmay decrease consumer demand for our storage products.

 

 

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In particular, the rate of implementation of the serial ATA interfacewill depend on how quickly drive manufacturers, motherboard and PC providersand chipmakers are able to resolve technical communication and functionalityissues to enable a “plug and play” environment in which a computer system isautomatically able to recognize and configure storage devices. Resolution ofthese issues could be time-consuming, and will depend in good measure on theability of chipmakers to incorporate the required high-speed serial datatransfer capabilities into their semiconductors without sacrificing manufacturingyields.

 

Any delay in acceptance of new interface technologies, or a reductionin the growth or size of the market for systems based on serial ATA or fibrechannel technologies, would limit sales of our storage products and reduce ourrevenue. Any delay in the availability of serial ATA compatible drives oracceleration of serial ATA or fibre channel SerDes integration efforts bymotherboard or storage controller manufacturers may also reduce our revenue.

 

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

 

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

 

                                                Withrespect to our product offerings based upon the SteelVine architecture, therecan be no assurance such product offerings will achieve the desired level ofmarket acceptance in the anticipated timeframes or that such product offeringswill be successful. Furthermore, there can be no assurance that we will be ableto introduce these products into the marketplace on a timely basis and ourinability to do so may adversely impact our ability to be successful with thisline of products and would adversely affect our business. It is anticipated thatthe products based upon the SteelVine architecture will be sold into marketsthat the Company has no experience selling into. Furthermore, there is noestablished market for these products. There can be no assurance that theCompany will be able to successfully market and sell the products based uponthe SteelVine architecture and failure to do so would adversely affect ourbusiness.

 

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

 

Substantially all of our sales are made on the basis of purchaseorders, rather than long-term agreements. In addition, our customers may cancelor reschedule purchase orders. We purchase inventory components and build ourproducts according to our estimates of customer demand. This process requiresus to make multiple assumptions, including volume and timing of customer demandfor each product, manufacturing yields and product quality. If we overestimatecustomer demand or product quality or under estimate manufacturing yields, wemay build products that we may not be able to sell at an acceptable price or atall. As a result, we would have excess inventory, which would increase ourlosses. Additionally, if we underestimate customer demand or if sufficientmanufacturing capacity is unavailable, we will forego revenue opportunities orincur significant costs for rapid increases in production, lose market shareand damage our customer relationships.

 

**Our lengthy sales cycle can result in a delaybetween incurring expenses and generating revenue, which could harm ouroperating results.**

 

Because our products are based on new technology and standards, alengthy sales process, typically requiring several months or more, is oftenrequired before potential customers begin the technical evaluation of ourproducts. This technical evaluation can exceed nine months before the potentialcustomer informs us whether we have achieved a design win, which is not abinding commitment to purchase our products. After achieving a design win, itcan then be an additional nine months before a customer commences volumeshipments of systems incorporating our products, if at all. Given our lengthysales cycle, we may experience a delay between the time we incur expendituresand the time we generate revenue, if any. As a result, our operating resultscould be seriously harmed if a significant customer reduces or delays orders,or chooses not to release products incorporating our products.

 

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

 

Historically, a relatively small number of customers and distributorshave generated a significant portion of our revenue. For the three and ninemonths ended September 30, 2004, shipments to World Peace International, anAsian distributor, generated 15.7% and 13.9% of our revenue, respectively andshipments to Microtek, a distributor, generated 13.1% and 12.3% of our revenue,respectively. For the year ended December 31, 2003, shipments to World PeaceInternational, generated 15% of our revenue, and shipments to Weikeng, adistributor, generated 8% of our revenue. In addition, an end-customer may buythrough multiple distributors, contract manufacturers, and / or directly, whichcould create an even greater concentration. We cannot be certain that customersand key distributors that have accounted for significant revenue in pastperiods, individually or as a group, will continue to sell our products andgenerate revenue. As a result of this concentration of our customers, ourresults of operations could be negatively affected if any of the followingoccurs:

 

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•                  oneor more of our customers, including distributors, becomes insolvent or goes outof business;

•                  oneor more of our key customers or distributors significantly reduces, delays orcancels orders; or

•                  oneor more significant customers selects products manufactured by one of ourcompetitors for inclusion in their future product generations.

 

Due to our participation in multiple markets, our customer base hasbroadened significantly and we therefore anticipate being less dependent on arelatively small number of customers to generate revenue. However, as productmix fluctuates from quarter to quarter, we may become more dependent on a smallnumber of customers or a single customer for a significant portion of ourrevenue in a particular quarter, the loss of which could adversely affect ouroperating results.

 

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

 

Many original equipment manufacturers rely on third-party manufacturersor distributors to provide inventory management and purchasing functions.Distributors generated 47% and 44% of our revenue for the three and nine monthsended September 30, 2004, respectively, 42% of our revenue for the year endedDecember 31, 2003, and 42% of our revenue for the year ended December 31,2002. Selling through distributors reduces our ability to forecast sales andincreases the complexity of our business, requiring us to:

 

•                  managea more complex supply chain;

 

•                  monitorand manage the level of inventory of our products at each distributor;

 

•                  estimatethe impact of credits, return rights, price protection and unsold inventory atdistributors; and

 

•                  monitorthe financial condition and credit-worthiness of our distributors, many ofwhich are located outside of the United States, and the majority of which arenot publicly traded.

 

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

 

**Our success depends on the development andintroduction of new products, which we may not be able to do in a timely mannerbecause the process of developing high-speed semiconductor products is complexand costly.**

 

The development of new products is highly complex, and we haveexperienced delays, some of which exceeded one year, in the development andintroduction of new products on several occasions in the past. We have recentlyintroduced new storage products for the consumer electronics and small andmedium business markets and we expect to introduce new consumer electronics,storage and DVI products in the future. As our products integrate new, moreadvanced functions, they become more complex and increasingly difficult todesign, manufacture and debug. Successful product development and introductiondepends on a number of factors, including, but not limited to:

 

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

 

•                  developmentof advanced technologies and capabilities, and new products that satisfycustomer requirements;

 

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

 

•                  timelycompletion and introduction of new product designs;

 

•                  managementof product life cycles;

 

•                  useof leading-edge foundry processes and achievement of high manufacturing yieldsand low cost testing; and

 

•                  marketacceptance of new products.

 

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Accomplishing all of this is extremely challenging, time-consuming andexpensive and there is no assurance that we will succeed. Product developmentdelays may result from unanticipated engineering complexities, changing marketor competitive product requirements or specifications, difficulties inovercoming resource limitations, the inability to license third partytechnology or other factors. Competitors and customers may integrate thefunctionality of our products into their products that would reduce demand forour products. If we are not able to develop and introduce our productssuccessfully and in a timely manner, our costs could increase or our revenuecould decrease, both of which would adversely affect our operating results. Inaddition, it is possible that we may experience delays in generating revenuefrom these products or that we may never generate revenue from these products.We must work with a semiconductor foundry and with potential customers tocomplete new product development and to validate manufacturing methods andprocesses to support volume production and potential re-work. Each of thesesteps may involve unanticipated difficulties, which could delay productintroduction and reduce market acceptance of the product. In addition, thesedifficulties and the increasing complexity of our products may result in the introductionof products that contain defects or that do not perform as expected, whichwould harm our relationships with customers and our ability to achieve marketacceptance of our new products. There can be no assurance that we will be ableto achieve design wins for our planned new products, that we will be able tocomplete development of these products when anticipated, or that these productscan be manufactured in commercial volumes at acceptable yields, or that anydesign wins will produce any revenue. Failure to develop and introduce newproducts, successfully and in a timely manner, may adversely affect our resultsof operations.

 

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

 

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

 

•                  difficultyand increased costs in assimilating employees, including our possible inabilityto keep and retain key employees of the acquired business;

 

•                  disruptionof our ongoing business;

 

•                  discoveryof undisclosed liabilities of the acquired companies and legal disputes withfounders or shareholders of acquired companies;

 

•                  inabilityto successfully incorporate acquired technology and operations into ourbusiness and maintain uniform standards, controls, policies and procedures;

 

•                  inabilityto commercialize acquired technology; and

 

•                  theneed to take impairment charges or write-downs with respect to acquired assets.

 

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

 

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

 

In the past, the semiconductor industry has been characterized by significantdownturns and wide fluctuations in supply and demand. For example, demand inthe semiconductor industry rose to record levels in 1999, and then declineduntil recently when it appears to be recovering. The industry has alsoexperienced significant fluctuations in anticipation of changes in generaleconomic conditions. This cyclicality has led to significant fluctuations inproduct demand and in the foundry, test and assembly capacity of third partysuppliers. Production capacity for fabricated semiconductors are subject toallocation, whereby not all of our production requirements would be met. Thismay impact our ability to meet demand and could also increase our productioncosts. Cyclicality has also accelerated decreases in average selling prices perunit. We may experience fluctuations in our future financial results because ofchanges in industry-wide conditions.

 

**We depend on third-party sub-contractors tomanufacture, assemble and test nearly all of our products, which reduces ourcontrol over the production process.**

 

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

 

•                  reducedcontrol over delivery schedules, quality assurance, manufacturing yields andproduction costs;

 

•                  lackof guaranteed production capacity or product supply;

 

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

 

•                  ourability to transition to alternate sources if services are unavailable fromprimary suppliers.

 

In addition, our semiconductor products are assembled and tested byseveral independent subcontractors. We do not have a long-term supply agreementwith our subcontractors, and instead obtain production services on a purchaseorder basis. Our outside sub-contractors have no obligation to supply productsto us for any specific period of time, in any specific quantity or at anyspecific price, except as set forth in a particular purchase order. Ourrequirements represent a small portion of the total production capacity of ouroutside foundries, assembly and test facilities and our sub-contractors mayreallocate capacity to other customers even during periods of high demand forour products. These foundries may allocate or move production of our productsto different foundries under their control, even in different locations, whichmay be time consuming, costly, and difficult, have an adverse affect onquality, yields, and costs, and require us and/or our customers to re-qualifythe products, which could open up design wins to competition and result in theloss of design wins and design-ins. If our subcontractors are unable orunwilling to continue manufacturing our products in the required volumes, atacceptable quality, yields and costs, and in a timely manner, our business willbe substantially harmed. As a result, we would have to identify and qualifysubstitute contractors, which would be time-consuming, costly and difficult.This qualification process may also require significant effort by ourcustomers, and may lead to re-qualification of parts, opening up design wins to

 

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competition, and loss of design wins and design-ins. Any of thesecircumstances could substantially harm our business. In addition, ifcompetition for foundry, assembly and test capacity increases, our productcosts may increase and we may be required to pay significant amounts or makesignificant 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 intothe production cycle or, in some cases, after the product has been shipped.**

 

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

 

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

 

Although we test our products before shipment, they are complex and maycontain defects and errors. In the past we have encountered defects and errorsin our products. Because our products are sometimes integrated with productsfrom other vendors, it can be difficult to identify the source of anyparticular problem. Delivery of products with defects or reliability, qualityor compatibility problems, may damage our reputation and our ability to retainexisting customers and attract new customers. In addition, product defects anderrors could result in additional development costs, diversion of technicalresources, delayed product shipments, increased product returns, warranty andproduct liability claims against us that may not be fully covered by insurance.Any of these circumstances could substantially harm our business.

 

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

 

A substantial portion of our business is conducted outside of theUnited States. As a result, we are subject to foreign business, political andeconomic risks. Nearly all of our products are manufactured in Taiwan orelsewhere in Asia, and for the three and nine months ended September 30, 2004, 70.2%and 72% of our revenue, respectively, and for the years ended December 31,2003, 2002, and 2001 74%, 72%, and 79% of our revenue respectively wasgenerated from customers and distributors located outside of the United States,primarily in Asia. We anticipate that sales outside of the United States willcontinue to account for a substantial portion of our revenue in future periods.Accordingly, we are subject to international risks, including, but not limitedto:

 

•                  difficultiesin managing from afar;

 

•                  politicaland economic instability, including international tension in Iraq, Korea andthe China Strait and lack of normal diplomatic relationships between the UnitedStates and Taiwan;

 

•                  lessdeveloped infrastructures in newly industrializing countries;

 

•                  susceptibilityof foreign areas to terrorist attacks;

 

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

 

•                  biasagainst foreign, especially American, companies;

 

•                  difficultiesin collecting accounts receivable;

 

•                  expenseand difficulties in protecting our intellectual property in foreignjurisdictions;

 

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

 

•                  exposureto possible litigation or claims in foreign jurisdictions; and

 

•                  competitionfrom foreign-based suppliers and the existence of protectionist laws andbusiness practices that favor these suppliers, such as withholding taxes onpayments made to us.

 

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These risks could adversely affect our business and our results ofoperations. In addition, original equipment manufacturers that design oursemiconductors into their products sell them outside of the United States. Thisexposes us indirectly to foreign risks. Because sales of our products aredenominated exclusively in United States dollars, relative increases in thevalue of the United States dollar will increase the foreign currency priceequivalent of our products, which could lead to a change in the competitivenature of these products in the marketplace. This in turn could lead to areduction in sales and profits.

 

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

 

We rely on a combination of patent, copyright, trademark, mask work andtrade secret laws, as well as nondisclosure agreements and other methods, toprotect our proprietary technologies. We have been issued patents and have anumber of pending patent applications. However, we cannot assure you that anypatents will be issued as a result of any applications or, if issued, that anyclaims allowed will protect our technology. In addition, we do not file patentapplications on a worldwide basis, meaning we do not have patent protection insome jurisdictions. It is possible that existing or future patents may bechallenged, invalidated or circumvented and effective patent, copyright,trademark and trade secret protection may be unavailable or limited in foreigncountries. It may be possible for a third party to copy or otherwise obtain anduse our products or technology without authorization, develop similartechnology independently or design around our patents in the United States andin other jurisdictions. It is also possible that some of our existing or newlicensing relationships will enable other parties to use our intellectualproperty to compete against us. Legal actions to enforce intellectual propertyrights tend to be lengthy and expensive, and the outcome often is notpredictable. As a result, despite our efforts and expenses, we may be unable toprevent others from infringing upon or misappropriating our intellectualproperty, which could harm our business. In addition, practicality also limitsour assertion of intellectual property rights. Patent litigation is expensiveand its results are often unpredictable. Assertion of intellectual propertyrights often results in counterclaims for perceived violations of thedefendant’s intellectual property rights and/or antitrust claims. Certainparties after receipt of an assertion of infringement will cut off allcommercial relationships with the party making the assertion, thus makingassertions against suppliers, customers, and key business partners risky. If weforgo making such claims, we may run the risk of creating legal and equitabledefenses for an infringer.

 

**Our participation in the Digital DisplayWorking Group requires us to license some of our intellectual property forfree, which may make it easier for others to compete with us in the DVI PCmarket.**

 

We are a promoter of the DDWG, which published and promotes the DVIspecification. Our strategy includes establishing the DVI specification as theindustry standard, promoting and enhancing this specification and developingand marketing products based on this specification and future enhancements. Asa result:

 

•                  wemust license for free specific elements of our intellectual property to othersfor use in implementing the DVI specification; and

 

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

 

Accordingly, companies that implement the DVI specification in theirproducts can use specific elements of our intellectual property for free tocompete with us.

 

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

 

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

 

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Our strategy includes establishing the HDMI specification as theindustry standard, promoting and enhancing this specification and developingand marketing products based on this specification and future enhancements. Asa result:

 

•                  wemust license specific elements of our intellectual property to others for usein implementing the HDMI specification; and

 

•                  wemay license additional intellectual property as the HDMI founders grouppromotes enhancements to the HDMI specification.

 

Accordingly, companies that implement the HDMI specification in theirproducts can use specific elements of our intellectual property to compete withus. Although there will be license fees and royalties associated with theadopters agreements, there can be no assurance that such license fees androyalties will adequately compensate us for having to license our intellectualproperty. Fees and royalties received during the early years of adoption willbe used to cover costs we incur to promote the HDMI standard and to develop andperform interoperability tests; in addition, after an initial period, the HDMIfounders may reallocate the license fees and royalties amongst themselves toreflect each founder’s relative contribution of intellectual property to theHDMI specification.

 

**Our success depends on managing ourrelationship with Intel.**

 

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

 

•                  Intelhas been an investor of ours;

 

•                  Inteland we have been parties to a business cooperation agreement;

 

•                  Inteland we are parties to a patent cross-license;

 

•                  Inteland we worked together to develop HDCP;

 

•                  AnIntel subsidiary has the exclusive right to license HDCP, of which we are alicensee;

 

•                  Inteland we were two of the original founders of the Digital Display Working Group(“DDWG”);

 

•                  Intelis a promoter of the serial ATA working group, of which we are a contributor;

 

•                  Intelis a supplier to us and a customer for our products;

 

•                  Webelieve that Intel has the market presence to drive adoption of DVI and serialATA by making them widely available in its chip sets and motherboards, whichcould affect demand for our products;

 

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

 

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

 

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

 

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

 

•                  Intelmay enter into or continue relationships with our competitors that can put usat a relative disadvantage.

 

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

 

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

 

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

 

**We are and may continue to become the targetof securities class action suits and derivative suits which could result insubstantial costs and divert management attention and resources.**

 

Securities class action suits are often brought against companies,particularly technology companies, following periods of volatility in themarket price of their securities. Defending against these suits, even ifmeritless, can result in substantial costs to us and could divert the attentionof our management. We and certain of our officers and directors, together withcertain investment banks, have been named as defendants in a securities classaction suit filed against us on behalf of purchasers of our securities betweenOctober 5, 1999 and December 6, 2000. It is alleged that theprospectus related to our initial public offering was misleading because itfailed to disclose that the underwriters of our initial public offering hadsolicited and received excessive commissions from certain investors in exchangefor agreements by investors to buy our shares in the aftermarket forpredetermined prices. Due to inherent uncertainties in litigation, we cannotaccurately predict the outcome of this litigation; however, a proposedsettlement has been negotiated and has received preliminary approval by theCourt. In the event that the settlement is not granted final approval, webelieve that these claims are without merit and we intend to defend vigorouslyagainst them. We and certain of our officers, together with certain investmentbanks and their current or former employees, were named as defendants in asecurities class action suit filed against us on behalf of a putative class ofshareholders who purchased stock from some or all of approximately 50 issuerswhose public offerings were underwritten by Credit Suisse First Boston. Thelawsuit alleges that Silicon Image and certain officers were part of a schemeby Credit Suisse First Boston to artificially inflate the price of SiliconImage’s stock through the dissemination of allegedly false analysts’ reports.The plaintiff in this matter has filed an amended complaint in which Silicon Image,and the named officers, were dropped as defendants. We believe that thesettlement described above, if approved, would encompass the claims in thiscase. We believe that these claims were without merit and, if revived, and notsubject to the settlement, we intend to defend vigorously against them. 

 

Certain of our officers and directors were named as defendants inconsolidated shareholder derivative litigation. The lawsuit alleged that as aresult of the examination conducted by our Audit Committee, we would have beenrequired to restate our financial results for 2002 and 2003. The lawsuitfurther alleges that such a restatement would be due to breaches by theindividual defendants of their fiduciary duties to us, that certain of theindividual defendants are liable to us for insider trading under Californialaw, and that the individual defendants are liable to us for mismanagement,abuse of control, and waste. We and certain of our officers were also named asdefendants in consolidated securities class action litigation. Plaintiffs filedthe action on behalf of a putative class of shareholders who purchased ourstock between April 15, 2002 and November 15, 2003. The lawsuitalleges that we had materially overstated our licensing revenue, net income andfinancial results during this time period, and that were being forced torestate our financial results. With the announcement by the Audit Committee ofSilicon Image’s Board of Directors that it has completed its examination andthat it has concluded that no changes to Silicon Image’s previously announcedfinancial results are required, both the securities class action litigation andthe shareholder derivative litigation have been dismissed.

 

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**We are currently engaged in intellectualproperty litigation that is time-consuming and expensive to prosecute. We maybecome engaged in additional intellectual property litigation that could betime-consuming, maybe be expensive to prosecute or defend, and could adverselyaffect our ability to sell our product.**

 

In recent years, there has been significant litigation in the UnitedStates and in other jurisdictions involving patents and other intellectualproperty rights. This litigation is particularly prevalent in the semiconductorindustry, in which a number of companies aggressively use their patentportfolios to bring infringement claims. In addition, in recent years, therehas been an increase in the filing of so-called “nuisance suits,” alleginginfringement of intellectual property rights. These claims may be asserted ascounterclaims in response to claims made by a company alleging infringement ofintellectual property rights. These suits pressure defendants into enteringsettlement arrangements to quickly dispose of such suits, regardless of merit.In addition, as is common in the semiconductor industry, from time to time wehave been notified that we may be infringing certain patents or otherintellectual property rights of others. Responding to such claims, regardlessof their merit, can be time consuming, result in costly litigation, divertmanagement’s attention and resources and cause us to incur significantexpenses. As each claim is evaluated, we may consider the desirability ofentering into settlement or licensing agreements. No assurance can be giventhat settlements will occur or that licenses can be obtained on acceptableterms or that litigation will not occur. In the event there is a temporary orpermanent injunction entered prohibiting us from marketing or selling certainof our products, or a successful claim of infringement against us requiring usto pay damages or royalties to a third party, and we fail to develop or licensea substitute technology, our business, results of operations or financial conditioncould be materially adversely affected.

 

In April 2001, we filed suit against Genesis Microchip forinfringement of one of our U.S. patents. At that time, we also filed acomplaint against Genesis for unlawful trade practices related to the importationof articles infringing our patent. In February 2002, our motion to dismissthe unlawful trade practices complaint was granted and we filed an amendedcomplaint against Genesis alleging infringement of two of our U.S. patents.These patents relate to our DVI receiver products, which generate a significantportion of our revenue. The amended complaint seeks a declaration that Genesishas infringed our patents, that Genesis’ behavior is not licensed, aninjunction to halt the importation, sale, manufacture and use of Genesis DVIreceiver chips that infringe our patents, and monetary damages. InApril 2002, Genesis answered and made counterclaims against us fornon-infringement, license, patent invalidity, fraud, antitrust, unfaircompetition and patent misuse. We filed a motion to dismiss certain ofGenesis’s counterclaims. In addition, we filed a motion to bifurcate trial ofthe counterclaims to the extent the court does not dismiss them. InMay 2002, the Court granted our motion to dismiss certain of the counterclaims,with leave to amend. Genesis re-filed counterclaims against us for fraud andpatent misuse. We filed another motion to dismiss these counterclaims. InAugust 2002, the Court granted our motion and dismissed Genesis’s re-filedcounterclaims with prejudice. In December 2002, the parties entered into amemorandum of understanding (“MOU”) to settle the case. When the parties failedto reach agreement on a final, definitive agreement as required by the MOU, inJanuary 2003, the parties filed motions with the Court to enforce theirrespective interpretations of the MOU. On July 15, 2003, the Court grantedour motion to interpret the MOU in the manner we requested, and ruled thatGenesis had engaged in efforts to avoid its obligations under the MOU. OnAugust 6, 2003, the Court entered a final judgment order based on itsJuly 15, 2003 ruling. Under the final judgment order, Genesis was orderedto make a substantial cash payment, and to make royalty payments; althoughGenesis has made and continues to make cash payments to the Court, it may nothave made all the payments that are required under the final judgment order. Wefiled motions for reimbursement of some of our expenses, including some of ourlegal fees, and for modification and/or clarification of certain items of thejudgment, and to hold Genesis in contempt of Court for breaching the protectiveorder in the case by disclosing secret information to at least one of ourcompetitors. On December 19, 2003, the Court granted our motions in partand denied them in part: the court issued an amended judgment, and held Genesisin contempt of Court for breaching the protective order. On January 16,2004, Genesis filed a notice of appeal. On August 26, 2004, the partiescompleted the filing of their respective appeal briefs. On October 26, 2004,the Court of Appeals for the Federal Circuit issued an order setting the oralarguments for the appeal on December 7, 2004. 

 

There can be no assurance that Genesis will not undertake furtherefforts to avoid its obligations under the MOU, and that further proceedings(lawsuits, contempt citations, etc.) against Genesis, and certain of itsexecutives, its counsel, and others may not be required to obtain compliance orto obtain redress for non-compliance. There can be no assurance that anappellate court will uphold the Court’s rulings or the MOU. There can be noassurance that further delays or noncompliance will not occur. The Court’srulings of July 15, 2003 and December 19, 2003 indicate that Genesisviolated certain provisions of the MOU, and of the protective order in thecase, including disclosure of confidential information to Pixelworks. OnAugust 5, 2003, Genesis and Pixelworks issued a joint press releaseterminating their proposed merger. In that press release, Genesis andPixelworks jointly stated that “Pixelworks has confirmed that prior to signingthe merger agreement, it reviewed the Memorandum of

 

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Understanding that purported to settle the lawsuit between GenesisMicrochip and Silicon Image, Inc.” While this litigation, including theappeal or any possible derivative proceedings, is pending, Genesis may use thetechnology covered by these patents to evelop products that might compete withours. If we are unsuccessful in this litigation, we could be unable to preventGenesis or others from using the technology covered by these patents. Even ifwe prevail in this litigation, uncertainties regarding the outcome prior tothat time may reduce demand for our products, or Genesis’s use of ourtechnology in products that compete with our products may reduce demand orpricing for our products. In addition, even if the MOU is upheld on appeal,future disputes may occur, including those regarding whether and what intellectualproperty licenses were granted and the scope of any such licenses and theroyalty rates and payment terms for such licenses, whether the MOU wasbreached, whether consent was fraudulently obtained, and whether a mergerpartner may succeed to the rights and/or the obligations under the MOU. Thesedisputes may result in additional costly and time-consuming litigation or thelicense of additional elements of our intellectual property for free.

 

Any potential intellectual property litigation against us could alsoforce us to do one or more of the following:

 

•                  stopselling products or using technology that contain the allegedly infringingintellectual property;

 

•                  attemptto obtain a license to the relevant intellectual property, which license maynot be available on reasonable terms or at all; and

 

•                  attemptto redesign products that contain the allegedly infringing intellectualproperty.

 

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

 

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

 

Many companies have significant patent portfolios or key specificpatents, or other intellectual property in areas in which we compete. Many ofthese companies appear to have policies of imposing cross-licenses on otherparticipants in their markets, which may include areas in which we compete. Asa result, we have been required, either under pressure of litigation or bysignificant vendors or customers, to enter into cross licenses or non-assertionagreements relating to patents or other intellectual property. This permits thecross-licensee, or beneficiary of a non-assertion agreement, to use certain orall of our patents and/or certain other intellectual property for free tocompete with us.

 

**We must attract and retain qualifiedpersonnel to be successful, and competition for qualified personnel isincreasing in our market.**

 

Our success depends to a significant extent upon the continuedcontributions of our key management, technical and sales personnel, many of whowould be difficult to replace. The loss of one or more of these employees couldharm our business. Although we have entered into a limited number of employmentcontracts with certain executive officers, we generally do not have employmentcontracts with our key employees. We do not have key person life insurance forany of our key personnel. Our success also depends on our ability to identify,attract and retain qualified technical, sales, marketing, finance andmanagerial personnel. Competition for qualified personnel is particularlyintense in our industry and in our location. This makes it difficult to retainour key personnel and to recruit highly qualified personnel. We haveexperienced, and may continue to experience, difficulty in hiring and retainingcandidates with appropriate qualifications. To be successful, we need to hirecandidates with appropriate qualifications and retain our key executives andemployees.

 

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

 

On August 18,2004, we announced that the Company’s Chief Financial Officer, Robert G.Gargus, plans to retire from the company. Mr. Gargus intends to remain in hiscurrent position until a new CFO is hired and an orderly transition has takenplace. The new CFO search will likely commence after the new CEO is hired. Thetiming of CFO searches and execution of orderly CFO transitions can beuncertain in general, and could result in organizational disruption. Inaddition, on August 18, 2004, we also announced that the Board of Directorsnamed Dale Brown, the Company’s Corporate Controller, as the Company’s ChiefAccounting Officer.

 

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The volatility of our stock price has had an impact on our ability tooffer competitive equity-based incentives to current and prospective employees,thereby affecting our ability to attract and retain highly qualified technicalpersonnel. If these adverse conditions continue, we may not be able to hire orretain highly qualified employees in the future and this could harm ourbusiness. In addition, new regulations adopted by The NASDAQ National Marketrequiring shareholder approval for all stock option plans, as well as newregulations adopted by the New York Stock Exchange prohibiting NYSE memberorganizations from giving a proxy to vote on equity compensation plans unlessthe beneficial owner of the shares has given voting instructions, could make itmore difficult for us to grant options to employees in the future. There havebeen several proposals on whether and /or how to account for stock options. Tothe extent that new regulations make it more difficult or expensive to grantoptions to employees, we may incur increased cash compensation costs or find itdifficult to attract, retain and motivate employees, either of which could harmour business.

 

We use contractors to provide services to the company, which ofteninvolves contractual complexity, tax and employment law compliance, and beingsubject to audits and other governmental actions. We have been audited for ourcontracting policies in the past, and may be in the future. Burdening ourability to freely use contractors to provide services to the company mayincrease the expense of obtaining such services, and/or require us todiscontinue using contractors and attempt to find, interview, and hireemployees to provide similar services. Such potential employees may not beavailable in a reasonable time, or at all, or may not be hired without unduecost.

 

**Industry cycles may strain our management andresources.**

 

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

 

•                  improveoperational and financial systems;

 

•                  trainand manage our employee base;

 

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

 

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

 

•                  adjustspending levels according to prevailing market conditions.

 

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

 

**Our operations and the operations of oursignificant customers, third-party wafer foundries and third-party assembly andtest subcontractors are located in areas susceptible to natural disasters.**

 

Our operations are headquartered in the San Francisco Bay Area, whichis susceptible to earthquakes, and the operations of CMD, which we acquired,are based in the Los Angeles area, which is also susceptible to earthquakes.TSMC and UMC, the outside foundries that produce the majority of oursemiconductor products, are located in Taiwan. Advanced SemiconductorEngineering, or ASE, one of the subcontractors that assembles and tests oursemiconductor products, is also located in Taiwan. For the three and ninemonths ended September 30, 2004 and for the year ended December 31, 2003,customers and distributors located in Taiwan generated 22%, 29% and 34% of ourrevenue, respectively, and customers and distributors located in Japangenerated 21%, 19% and 15% of our revenue, respectively. For the year endedDecember 31, 2002, customers and distributors located in Taiwan generated34% of our revenue and customers and distributors located in Japan generated12% of our revenue. Both Taiwan and Japan are susceptible to earthquakes,typhoons and other natural disasters.

 

Our business would be negatively affected if any of the followingoccurred:

 

•                  anearthquake or other disaster in the San Francisco Bay Area or the Los Angelesarea damaged our facilities or disrupted the supply of water or electricity toour headquarters or our Irvine facility;

 

•                  anearthquake, typhoon or other disaster in Taiwan or Japan resulted in shortagesof water, electricity or transportation, limiting the production capacity ofour outside foundries or the ability of ASE to provide assembly and testservices;

 

•                  anearthquake, typhoon or other disaster in Taiwan or Japan damaged the facilitiesor equipment of our customers and distributors, resulting in reduced purchasesof our products; or

 

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•                  anearthquake, typhoon or other disaster in Taiwan or Japan disrupted theoperations of suppliers to our Taiwanese or Japanese customers, outsidefoundries or ASE, which in turn disrupted the operations of these customers,foundries or ASE and resulted in reduced purchases of our products or shortagesin our product supply.

 

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

 

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

 

**Provisions of our charter documents andDelaware law could prevent or delay a change in control, and may reduce themarket price of our common stock.**

 

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

 

•                  authorizingthe issuance of preferred stock without stockholder approval;

 

•                  providingfor a classified board of directors with staggered, three-year terms;

 

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

 

•                  providingthe board of directors the opportunity to expand the number of directorswithout notice to stockholders;

 

•                  prohibitingcumulative voting in the election of directors;

 

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

 

•                  limitingthe persons who may call special meetings of stockholders; and

 

•                  prohibitingstockholder actions by written consent.

 

Provisions of Delaware law also may discourage, delay or preventsomeone from acquiring or merging with us.

 

**The price of our stock fluctuatessubstantially and may continue to do so.**

 

The stock market has experienced extreme price and volume fluctuationsthat have affected the market valuation of many technology companies, includingSilicon Image. These factors, as well as general economic and politicalconditions, may materially and adversely affect the market price of our commonstock in the future. The market price of our common stock has fluctuatedsignificantly and may continue to fluctuate in response to a number of factors,including, but not limited to:

 

•                  actualor anticipated changes in our operating results;

 

•                  changesin expectations of our future financial performance;

 

•                  changesin market valuations of comparable companies in our markets;

 

•                  changesin market valuations or expectations of future financial performance of ourvendors or customers;

 

•                  changesin our key executives and technical personnel; and

 

•                  announcementsby us or our competitors of significant technical innovations, design wins,contracts, standards or acquisitions.

 

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

 

**We are in the process of implementing anenterprise resource platform**

 

We are in the process of updating our enterprise resource platform(ERP) system. The system is comprised of hardware and software, and services,all of which we acquired from vendors; which we are customizing portions of thesystem with in-house resources. This requires careful management of the skillsand resources to update our ERP system and establish the disaster recoveryplans. If we are unsuccessful, or if the hardware or software updates shouldfail, we could lose access to the data needed to book and fill customer orders,ship products, and produce financial reports, which would have a materialadverse effect on our business.

 

**Continued terrorist attacks or war could leadto further economic instability and adversely affect our operations, results ofoperations and stock price.**

 

The United States has taken, and continues to take, military actionagainst terrorism and has engaged in war with Iraq and currently has an occupationforce there and in Afghanistan. In addition, the current nuclear arms crises inNorth Korea and Iran could escalate into armed hostilities or war. Acts ofterrorism or armed hostilities may disrupt or result in instability in thegeneral economy and financial markets and in consumer demand for the OEM’sproducts that incorporate our products. Disruptions and instability in thegeneral economy could reduce demand for our products or disrupt the operationsof our customers, suppliers, distributors and contractors, many of whom arelocated in Asia, which would in turn adversely affect our operations andresults of operations. Disruptions and instability in financial markets couldadversely affect our stock price. Armed hostilities or war in South Korea coulddisrupt the operations of the research and development contractors we utilizethere, which would adversely affect our research and development capabilitiesand ability to timely develop and introduce new products and productimprovements.

 

**We have recently established offices in Japanand the Republic of Korea (South Korea)**

 

We have recently established offices in Japan and South Korea.Accordingly, we are subject to risks, including, but not limited to:

 

•                  being subject to Japanese and SouthKorean tax laws and potentially liable for paying taxes in Japan and SouthKorea;

 

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

 

•                  wehave and will enter into employment agreements in connection with hiringpersonnel for the Japanese and South Korean offices and are governed by theprovisions of the Japanese and South Korean labor laws; and

 

•                  theoperations of the local office are and will be subject to the provisions of otherlocal laws and regulations.

 

**We indemnify certain of our licensingcustomers against infringement.**

 

We indemnify certain of our licensing agreements customers for anyexpenses or liabilities resulting from third-party claims of infringements ofpatent, trademark, trade secret, or copyright rights by the technology welicense.  Certain of theseindemnification provisions are perpetual from execution of the agreement and,in some instances,

 

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the maximum amount of potential future indemnification is not limited.To date, we have not paid any such claims or been required to defend anylawsuits with respect to any claim. In the event that we were required todefend any lawsuits with respect to our indemnification obligations, or to payany claim, our results of operations could be materially adversely affected.

 

# **We may be unable to comply with theprovisions of Section 404 of the Sarbanes-Oxley Act**

 

Ifthe Company is unable to complete its assessment as to the adequacy of itsinternal control over financial reporting as of December 31, 2004 and futureyear-ends as required by Section 404 of the Sarbanes-Oxley Act of 2002,investors could lose confidence in the reliability of the Company's financialstatements, which could result in a decrease in the value of the Company'sCommon Stock.

 

Asdirected by Section 404 of the Sarbanes-Oxley Act of 2002, the Securities andExchange Commission adopted rules requiring public companies to include areport of management on the company's internal control over financial reportingin their annual reports on Form 10-K. This report is required to contain an assessment by management of theeffectiveness of such company's internal controls over financial reporting. Inaddition, the public accounting firm auditing a public company's financialstatements must attest to and report on management's assessment of theeffectiveness of the company's internal controls over financial reporting.While the Company is expending significant resources in developing thenecessary documentation and testing procedures required by Section 404, thereis a significant risk that the Company will not comply with all of therequirements imposed by Section 404.  If theCompany fails to implement required new or improved controls, it may be unableto comply with the requirements of Section 404 in a timely manner.  This could result in a loss of confidence inthe reliability of the Company's financial statements, which could cause themarket price of the Company's common stock to decline and make it moredifficult for the Company to raise additional capital if needed to finance itsoperations.

 

## **We may be unable to comply with changes inrules and guidelines associated with Section 404 compliance**

 

Requirements imposed by Section 404 and the COSO rules or guidelinesassociated with measuring compliance are likely to change in the future.  This may require the Company to continue toexpend significant resources and time in order to stay compliant.  Additionally, the Company is growing rapidly,and faces a rapidly changing and highly competitive market place.  These factors can result in changes ininternal organization and processes, and can present challenges to ongoing compliancewith these evolving requirements. As a result, compliance in any period cannotbe viewed as an assurance that we will continue to be compliant in anysubsequent period.  

 

**Item3.  Quantitative and QualitativeDisclosures About Market Risk**

 

**Interest Rate Risk**

 

Our cash equivalents and short-term investments consist primarilyof fixed-income securities that are subject to interest rate risk andwill decline in value if interest rates increase. Due to the short duration ofour cash equivalents and short-term investments, an immediate 10% changein interest rates would not be expected to have a material effect on our near-termresults of operations or financial condition. Our long-term capital leaseobligations bear interest at fixed rates; therefore, our results of operationswould not be affected by immediate changes in interest rates.  Also, components of our stock compensationexpense are tied to our stock price. Changes in our stock price can have a significant effect on the amountrecorded as stock compensation expense. 

 

## **Equity Security Price Risk**

 

Changes in the market price of Leadis Technology Inc. market price willimpact the valuation of our investment in this company. Based on the marketvalue of Leadis stock as of November 1, 2004, the value of our holding as ofthat date, compared to September 30, 2004, declined by approximately $1.1million. 

 

 

**Foreign Currency Exchange Risk**

 

All of our sales are denominated in U.S. dollars, and substantially allof our expenses are incurred in U.S. dollars, thus limiting our exposure toforeign currency exchange risk. We currently do not enter into forward exchangecontracts to hedge exposures denominated in foreign currencies and do not usederivative financial instruments for trading or speculative purposes. Theeffect of an immediate 10% change in foreign currency exchange rates could havea material effect on our future operating results or cash flows; however, along-term change in foreign currency rates could result in increased wafer,packaging, assembly or testing costs.

 

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** **

**Item 4. Controls and Procedures**

 

(a)                                  *Evaluation of Controlsand Procedures*.  Wemaintain disclosure controls and procedures (as such term is defined in Rules13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended(the “Exchange Act”)) that are designed to ensure that information required tobe disclosed in our Exchange Act reports is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms, and thatsuch information is accumulated and communicated to our management, includingour Chief Executive Officer, Chief Financial Officer, and Chief AccountingOfficer as appropriate, to allow timely decisions regarding requireddisclosure.

 

As required by Rule 13a-15(b) and 15d-15(b)under the Exchange Act, we carried out an evaluation, under the supervision andwith the participation of our management, including our Chief ExecutiveOfficer, Chief Financial Officer, and Chief Accounting Officer, of the effectivenessof our disclosure controls and procedures at the end of the fiscal quartercovered by this report.  The evaluation took into account the conduct ofand results of the Audit Committee examination completed in February 2004, thesubsequent enhancements to the Company’s control environment described below,and the receipt of notice from the Company’s independent auditors that, inconnection with the 2003 year-end audit, they had identified a reportablecondition relating to internal controls.  The evaluation also took intoaccount the written confirmation of the reportable condition provided by ourauditors stating they were aware of deficiencies in the Company’s internalcontrol structure design related to the overall internal control environmentregarding our Chief Executive Officer’s communication and operating style andhis periodic involvement in revenue recognition discussions.  Based uponthat evaluation our Chief Executive Officer, Chief Financial Officer, and ChiefAccounting Officer have concluded that our controls and procedures as of theend of the period covered by this report were effective in ensuring that all material informationrequired to be disclosed in the reports the Company files and submits under theSecurities and Exchange Act of 1934 has been made known to them on a timelybasis and that such information has been properly recorded, processed,summarized and reported, as required, and that withrespect to the reportable condition,, the Company’s control environment couldbe further enhanced, as discussed below:

 

(b)                                 *Changes in InternalControls*.  Asa result of our own evaluation, as well as recommendations provided by theAudit Committee we have implemented a series of internal measures designed toenhance the Company’s overall internal control environment.  Thesemeasures included (i) restructuring some reporting relationships amongmanagement and clarifying management roles and responsibilities, (ii) improvingcommunication within the management team and between the management team andthe Board of Directors, including the Audit Committee,  (iv) adding additional resources andpersonnel to key control functions and (v) implementing training and complianceprograms.  Many of these measures by their nature represent an ongoingprocess that will be subject to continuing evaluation and evolution based uponchanging business conditions and subject to review by our Board of Directors,Audit Committee and auditors. In addition, the Company has announced plans torecruit a new chief executive officer and separate the roles of Chairman andchief executive officer, and has made significant progress towards this goalduring the third quarter of fiscal 2004. Finally, in connection with itsdocumentation and testing in preparation for Sarbanes Oxley Section 404reporting and attestation, the Company has identified, made and is making anumber of additional enhancements to its documentation and processes tostrengthen its internal control systems, none of which have materiallyaffected, or are expected to materially affect, our internal control overfinancial reporting. 

 

*Sarbanes-Oxley Section 404Compliance*

 

Section404 of the Sarbanes-Oxley Act of 2002 (the “Act”) will require the Company toinclude an internal control report from management in its Annual Report on Form10-K for the year ended December 31, 2004 and in subsequent Annual Reportsthereafter. The internal control report must include the following: (1) astatement of management’s responsibility for establishing and maintaining adequateinternal control over financial reporting, (2) a statement identifying theframework used by management to conduct the required evaluation of theeffectiveness of the Company’s internal control over financial reporting, (3)management’s assessment of the effectiveness of the Company’s internal controlover financial reporting as of December 31, 2004, including a statement as towhether or not internal control over financial reporting is effective, and (4)a statement that the Company’s independent auditors have issued an attestationreport on management’s assessment of internal control over financial reporting.

 

Managementacknowledges its responsibility for establishing and maintaining internalcontrols over financial reporting and seeks to continually improve thosecontrols. In addition, in order to achieve compliance with Section 404 of theAct within the required timeframe, the Company has been conducting a process todocument and evaluate its internal controls over financial reporting since2003. In this regard, the Company has dedicated internal resources, engagedoutside consultants and adopted a detailed work plan to: (i) assess anddocument the adequacy of internal control over financial reporting; (ii) takesteps to improve control processes where required; (iii) validate throughtesting that controls are functioning as documented; and (iv) implement acontinuous reporting and improvement process for internal control overfinancial reporting. The Company believes its process for documenting, evaluatingand monitoring its internal control over financial reporting is consistent withthe objectives of Section 404 of the Act. 

 

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Inpreparation for Sarbanes Oxley Section 404 requirements the Company has expendedsignificant resources and time in documenting and testing its internalcontrols. The nature of the ongoing 404 attestation requirements requirerecurring testing and remediation as a means of continuous improvement.  The Company’s testing to date has identifiedseveral areas which have been and or are in the process of being remediated. 

 

It should be noted that any system of controls, however well designedand operated, can provide only reasonable, and not absolute, assurance that theobjectives of the control system are met. In addition, the design of anycontrol system is based in part upon certain assumptions about the likelihoodof future events. Because of these and other inherent limitations of controlsystems, there can be no assurance that any design will succeed in achievingits stated goals under all potential future conditions, regardless of howremote.

 

## **Part II.  Other Information**

 

## **Item 1.  Legal Proceedings**

 

On April 24, 2001, we filed suit in the U.S. District Court forthe Eastern District of Virginia against Genesis Microchip Corp. and GenesisMicrochip, Inc. (collectively, “Genesis”) for infringement of our U.S.patent number 5,905,769 (USDC E.D. Virginia Civil Action No.: CA-01-266-R) (the“Federal Suit”). On April 24, 2001, we also filed a complaint againstGenesis with the International Trade Commission of the United States government(“ITC”) for unlawful trade practices related to the importation of articlesinfringing our patent (the “ITC investigation”). The actions sought injunctionsto halt the importation, sale, manufacture and use of Genesis DVI receiverchips that infringe our patent, and monetary damages. We voluntarily moved todismiss the ITC investigation, with notice that we would proceed directly inthe Federal Suit. Our motion to dismiss was granted on February 7, 2002.We filed an amended complaint in the Federal Suit as of February 28, 2002,adding a claim for infringement of our U.S. patent number 5,974,464. InApril 2002, Genesis answered and made counterclaims against us fornon-infringement, license, patent invalidity, fraud, antitrust, unfaircompetition and patent misuse. Also in April 2002, we filed a

 

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motion to dismiss certain of Genesis’s counterclaims. In addition, wefiled a motion to bifurcate trial of the counterclaims to the extent the courtdoes not dismiss them. In May 2002, the Court granted our motion todismiss certain of the counterclaims, with leave to amend. Genesis re-filedcounterclaims against us for fraud and patent misuse. We filed another motionto dismiss these counterclaims,  whichthe Court granted with prejudice on August 6, 2002. In December 2002, theparties entered into a memorandum of understanding (MOU) to settle the case.When the parties failed to reach agreement on a final, definitive agreement asrequired by the MOU, in January 2003, the parties filed motions with the Courtto enforce their respective interpretations of the MOU. On July 15, 2003,the Court granted our motion to interpret the MOU in the manner we requested,and ruled that Genesis had engaged in efforts to avoid its obligations underthe MOU. On August 6, 2003, the Court entered a final judgment based onits July 15, 2003 ruling. Under the final judgment order, Genesis wasordered to make a substantial cash payment, and to make royalty payments;although Genesis has made a cash payment to the Court, it has not made all thepayments that are required under the final judgment order. We filed motions forreimbursement of some of our expenses, including some of our legal fees, andfor modification and/or clarification of certain items of the judgment, and tohold Genesis in contempt of Court for breaching the protective order in thecase by disclosing secret information to at least one of our competitors. OnDecember 19, 2003, the Court granted our motions in part and denied themin part: the court issued an amended judgment, and held Genesis in contempt ofCourt for breaching the protective order. Under the amended judgment, Genesis wasordered to make a substantial cash payment, royalty payments, and interest;although Genesis has made and continues to make cash payments to the Court, itmay not have made all the payments that are required under the amendedjudgment. The Court has not ruled on pending motions regarding the dispositionof the money held by the Court. On January 16, 2004, Genesis fileda notice of appeal. On August 26, 2004, the parties completed the filing oftheir respective appeal briefs. On October 26, 2004, the Court of Appeals forthe Federal Circuit issued an order setting the oral arguments for the appealon December 7, 2004. To date, we have not received any cash payments nor havewe recognized any revenue associated with this litigation. Due to thecontinuing and contentious nature of this litigation, we will not record anyincome or revenue related to this matter until the litigation is complete andall other income and revenue recognition criteria have been satisfied.Management intends to prosecute our position vigorously until this matter isresolved. Through September 30, 2004, we have spent approximately $10.9 millionon this matter and expect to continue to incur significant legal costs untilthe matter is resolved.

 

Silicon Image, certain officers and directors, and Silicon Image’sunderwriters have been named as defendants in a securities class action lawsuitcaptioned Gonzales v. Silicon Image, et al., No. 01 CV 10903 (SDNY 2001)pending in Federal District Court for the Southern District of New York. Thelawsuit alleges that all defendants were part of a scheme to manipulate theprice of Silicon Image’s stock in the aftermarket following Silicon Image’sinitial public offering in October 1999. Response to the complaint anddiscovery in this action on behalf of Silicon Image and individual defendantshas been stayed by order of the court. The lawsuit is proceeding as part of acoordinated action of over 300 such cases brought by plaintiffs in the SouthernDistrict of New York. Pursuant to a tolling agreement, individual defendantshave been dropped from the suit for the time being. In February 2003, theCourt denied the underwriters’ motion to dismiss and ordered that the case mayproceed against issuers including against Silicon Image. A proposed settlementhas been negotiated and has received preliminary approval by the Court. In theevent that the settlement is granted final approval, we do not expect it tohave a material effect on our results of operations or financial position. Inthe event that the settlement is not approved, we could not accurately predictthe outcome the litigation, but we intend to defend this matter vigorously.

 

Silicon Image, certain officers and directors, and Silicon Image’sunderwriters were named as defendants in a securities class action lawsuitcaptioned Liu v. Credit Suisse First Boston Corp., et al., No. 03-20459(S.D. Fla. 2003) pending in Federal District Court for the Southern District ofFlorida. The plaintiff filed an action on behalf of a putative class ofshareholders who purchased stock from some or all of approximately 50 issuerswhose public offerings were underwritten by Credit Suisse First Boston. Thelawsuit alleges that Silicon Image and certain officers were part of a schemeby Credit Suisse First Boston to artificially inflate the price of SiliconImage’s stock through the dissemination of allegedly false analysts’ reports.Silicon Image has not been served with a copy of the complaint. The plaintiffin this matter has filed an amended complaint in which Silicon Image, and thenamed officers, were dropped as defendants. We believe that the proposedsettlement described above, if granted final approval, would encompass theclaims in this case. We believe that these claims were without merit and, if revived,and not subject to the settlement, we would defend this matter vigorously.

 

Certain officers and directors of Silicon Image were named asdefendants in consolidated shareholder derivative litigation, captioned “In reSilicon Image, Inc. Derivative Litigation, No. 1:03CV010302”,commenced on December 4, 2003 and pending in the Superior Court ofCalifornia, County of Santa Clara. The plaintiffs purported to sue theindividual defendants on behalf of Silicon Image. The lawsuit alleged that as aresult of the recently completed examination conducted by the Audit Committeeof Silicon Image’s Board of Directors, Silicon Image will be required torestate its financial results for 2002 and 2003. On June 22, 2004, theplaintiffs dismissed the lawsuit.

 

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Silicon Image and certain of its officers were named as defendants inconsolidated securities class action litigation captioned “In re SiliconImage, Inc. Securities Litigation, No. C-03-5579 JW PVT”, commencedon December 11, 2003 and pending in the United States District Court forthe Northern District of California. Plaintiffs filed the action on behalf of aputative class of shareholders who purchased Silicon Image stock betweenApril 15, 2002 and November 15, 2003. The lawsuit alleges thatSilicon Image had materially overstated its licensing revenue, net income andfinancial results during this time period, and that Silicon Image was beingforced to restate its financial results. Following the announcement by theAudit Committee of Silicon Image’s Board of Directors that it has completed itsexamination and that it has concluded that no changes to Silicon Image’spreviously announced financial results are required, the plaintiffs dismissedthe lawsuit in March 2004.

 

## **In addition, we have been named as defendants in anumber of judicial and administrative proceedings incidental to our businessand may be named again from time to time. We intend to defend such mattersvigorously, and although adverse decisions or settlements may occur in one ormore of such cases, the final resolution of these matters, individually or inthe aggregate, is not expected to have a material adverse effect on our resultsof operations or financial position.**

 

The amount of legal fees we incur with respect to the litigationmatters described above will depend on the duration of our litigation matters,as well as the nature and extent of the litigation activities. We are not ableto accurately estimate the amount of legal fees we will incur in 2004 withrespect to the litigation matters described above, however, we do expect toincur substantial amounts until the matters are resolved.

 

## **Item 2.  Changes in Securities and Use of Proceeds**

## ** **

Not applicable

 

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

## ** **

Not applicable.

 

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

** **

Not applicable.

** **

**Item5.  Other Information**

 

Not applicable.

 

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** **

**Item6.  Exhibits**

 
|   |   |
|--------|--------|
|   |   |
|   | 10.1   | Amended and  Restated Employment Offer letter of Steve Tirado, dated April 1, 2004 |
|   |   |   |
|   | 10.2   | Employment  Offer Letter of Patrick Reutens, dated September 20, 2004 |
|   |   |   |
|   | 10.3   | Description  of death benefits for Parviz Khodi (incorporated by reference to Item 1.01 of  the Form 8-K filed by the registrant on Oct. 1, 2004).  The registrant has not executed a written  document with Mr. Khodi’s estate providing for such benefits and  accordingly, contrary to the Form 8-K, no document amending vesting terms of  Mr. Khodi’s stock option agreements is filed herewith. |
|   |   |   |
|   | 31.1   | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
|   |   |   |
|   | 31.2   | Certification  under Section 302 of the Sarbanes-Oxley Act of 2002. |
|   |   |   |
|   | 32.1   | Certification  pursuant to 12 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
|   |   |   |
|   | 32.1   | Certification  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

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**Signatures**

 

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

 
| Dated:  November 5, 2004 | Silicon Image, Inc.                                 |
|-------------------------------|-----------------------------------------------------|
|                          |                                                |
| * *                      | */s/  Robert G. Gargus*                        | * * |
|                          | Robert G. Gargus                                    |
|                          | Vice President Finance and Administration and Chief |
|                          | Financial Officer                                   |
|                          | (Principal Financial and Accounting Officer)        |

 

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