** **

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

| **ý****QUARTERLY REPORT UNDER SECTION  13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                            |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                        |
| **For the quarterly period ended March 31, 2003**                                                                                                                                                                                           |
|                                                                                                                                                                                                                                        |
| **OR**                                                                                                                                                                                                                                      |
|                                                                                                                                                                                                                                        |
| **o****TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                          |
|                                                                                                                                                                                                                                        |
| **For the transition period from                    to                  .** |
|                                                                                                                                                                                                                                        |
| **Commission file number:  000-26887**                                                                                                                                                                                                 |

** **

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

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant 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 anaccelerated 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 value per share, outstanding as of April 30, 2003 was 69,393,266shares.

 

 

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**Silicon Image, Inc.**

**Quarterly Report on Form 10-Q**

**Three Months Ended**

**March 31, 2003**

 

**Table of Contents**

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

 

----

 

## **Part I.  Financial Information**

 

**Item1.  Financial Statements**

 

**Silicon Image, Inc.**

**Condensed Consolidated Statements ofOperations**

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

**(unaudited)**

 
|                                              |   | **Three  Months Ended  March 31,** |   |
|---------------------------------------------------|--------|------------------------------------|--------|
|                                              |   | **2003**                           |   | **2002** |   |
|                                              |   |                               |   |   |   |
| Revenue:                                          |   |                               |   |   |   |
| Product                                           |   | $                                  | 19,722 |   | $ | 16,605 |   |
| Development,  licensing and royalties             |   | 4,954                              |   | 482 |   |
| Total  revenue                                    |   | 24,676                             |   | 17,087 |   |
|                                              |   |                               |   |   |   |
| Cost  and operating expenses:                     |   |                               |   |   |   |
| Cost  of revenue(1)                               |   | 11,190                             |   | 8,486 |   |
| Research  and development(2)                      |   | 8,837                              |   | 7,378 |   |
| Selling,  general and administrative(3)           |   | 4,308                              |   | 4,934 |   |
| Stock  compensation expense (benefit)             |   | (362                               | )      | 10,451 |   |
| Amortization  of intangible assets                |   | —                             |   | 909 |   |
| Patent  defense and acquisition integration costs |   | 1,213                              |   | 706 |   |
| Restructuring                                     |   | 986                                |   | 2,193 |   |
|                                              |   |                               |   |   |   |
| Total  cost and operating expenses                |   | 26,172                             |   | 35,057 |   |
|                                              |   |                               |   |   |   |
| Loss  from operations                             |   | (1,496                             | )      | (17,970 | ) |
| Gain  on escrow settlement, net                   |   | 4,618                              |   | — |   |
| Interest  income and other, net                   |   | 109                                |   | 270 |   |
|                                              |   |                               |   |   |   |
| Net  income (loss)                                |   | $                                  | 3,231  |   | $ | (17,700 | ) |
|                                              |   |                               |   |   |   |
| Net  income (loss) per share - basic              |   | $                                  | 0.05   |   | $ | (0.28 | ) |
| Net  income (loss) per share - diluted            |   | $                                  | 0.04   |   | $ | (0.28 | ) |
|                                              |   |                               |   |   |   |
| Weighted  average shares - basic                  |   | 66,828                             |   | 63,360 |   |
| Weighted  average shares - diluted                |   | 73,696                             |   | 63,360 |   |

 

----

(1)          Excludes stockcompensation expense (benefit) of ($135,000) and $923,000 for the three monthsended March 31, 2003 and 2002, respectively.

 

(2)          Excludes stockcompensation expense of $127,000 and $5.9 million for the three months ended March31, 2003 and 2002, respectively.

 

(3)          Excludes stockcompensation expense (benefit) of ($354,000) and $3.6 million for the threemonths ended March 31, 2003 and 2002, respectively.

 

See accompanyingNotes to Unaudited Condensed Consolidated Financial Statements

 

1

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**Silicon Image, Inc.**

**Condensed Consolidated Balance Sheets**

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

(unaudited)

 
|                                                                                                                                                                                           |   | **March 31,  2003** |   | **Dec. 31,  2002** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|--------|--------------------|--------|
| **Assets**                                                                                                                                                                                     |   |                |   |               |   |
| Current  Assets:                                                                                                                                                                               |   |                |   |               |   |
| Cash  and cash equivalents                                                                                                                                                                     |   | $                   | 24,975 |               | $      | 26,263 |   |
| Short-term  investments                                                                                                                                                                        |   | 6,477               |   | 9,570              |   |
| Accounts  receivable, net of allowances for doubtful accounts of $523 at March 31 and  $519 at December 31                                                                                     |   | 13,548              |   | 11,589             |   |
| Inventories                                                                                                                                                                                    |   | 6,725               |   | 7,301              |   |
| Prepaid  expenses and other current assets                                                                                                                                                     |   | 2,134               |   | 2,510              |   |
| Total  current assets                                                                                                                                                                          |   | 53,859              |   | 57,233             |   |
| Property  and equipment, net                                                                                                                                                                   |   | 7,371               |   | 6,653              |   |
| Goodwill                                                                                                                                                                                       |   | 13,021              |   | 13,021             |   |
| Other  assets                                                                                                                                                                                  |   | 676                 |   | 709                |   |
| Total  assets                                                                                                                                                                                  |   | $                   | 74,927 |               | $      | 77,616 |   |
|                                                                                                                                                                                           |   |                |   |               |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                 |   |                |   |               |   |
| Current  Liabilities:                                                                                                                                                                          |   |                |   |               |   |
| Accounts  payable                                                                                                                                                                              |   | $                   | 8,333  |               | $      | 10,314 |   |
| Accrued  liabilities                                                                                                                                                                           |   | 9,042               |   | 11,183             |   |
| Capital  lease and other obligations                                                                                                                                                           |   | 3,500               |   | 3,816              |   |
| Deferred  margin on sales to distributors                                                                                                                                                      |   | 4,297               |   | 4,133              |   |
| Total  liabilities                                                                                                                                                                             |   | 25,172              |   | 29,446             |   |
|                                                                                                                                                                                           |   |                |   |               |   |
| Stockholders’  Equity:                                                                                                                                                                    |   |                |   |               |   |
| Common  stock, par value $0.001; shares authorized: 150,000,000 – March 31 and  December 31; shares issued and outstanding: 66,658,555 – March 31 and  66,639,522 – December 31 |   | 68                  |   | 67                 |   |
| Additional  paid-in capital                                                                                                                                                                    |   | 212,075             |   | 214,459            |   |
| Notes  receivable from stockholders                                                                                                                                                            |   | —              |   | (109               | )      |
| Unearned  stock compensation                                                                                                                                                                   |   | (5,775              | )      | (6,403             | )      |
| Accumulated  deficit                                                                                                                                                                           |   | (156,613            | )      | (159,844           | )      |
| Total  stockholders’ equity                                                                                                                                                               |   | 49,755              |   | 48,170             |   |
| Total  liabilities and stockholders’ equity                                                                                                                                               |   | $                   | 74,927 |               | $      | 77,616 |   |

 

See accompanyingNotes to Unaudited Condensed Consolidated Financial Statements

 

2

----

 

**Silicon Image, Inc.**

**Condensed Consolidated Statements ofCash Flows**

**(in thousands)**

**(unaudited)**

 
|                                                                     |   | **Three  Months Ended  March 31,** |   |
|--------------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                     |   | **2003**                           |   | **2002** |   |
|                                                                     |   |                               |   |   |   |
| Cash  flows from operating activities:                                   |   |                               |   |   |   |
| Net  income (loss)                                                       |   | $                                  | 3,231  |   | $ | (17,700 | ) |
| Adjustments  to reconcile net loss to cash used in operating activities: |   |                               |   |   |   |
| Stock  compensation expense (benefit)                                    |   | (362                               | )      | 10,451 |   |
| Amortization  of intangible assets                                       |   | —                             |   | 909 |   |
| Non-cash  restructuring                                                  |   | 646                                |   | 818 |   |
| Non-cash  gain on escrow settlement, before cash costs                   |   | (4,692                             | )      | — |   |
| Provision  for doubtful accounts                                         |   | 4                                  |   | 31 |   |
| Depreciation  and amortization                                           |   | 947                                |   | 997 |   |
| Changes  in assets and liabilities:                                      |   |                               |   |   |   |
| Accounts  receivable                                                     |   | (1,963                             | )      | (8 | ) |
| Inventories                                                              |   | 576                                |   | (377 | ) |
| Prepaid  expenses and other assets                                       |   | 409                                |   | 570 |   |
| Accounts  payable                                                        |   | (1,981                             | )      | (582 | ) |
| Accrued  liabilities                                                     |   | (2,141                             | )      | (95 | ) |
| Deferred  margin on sales to distributors                                |   | 164                                |   | 906 |   |
| Cash  used in operating activities                                       |   | (5,162                             | )      | (4,080 | ) |
|                                                                     |   |                               |   |   |   |
| Cash  flows from investing activities:                                   |   |                               |   |   |   |
| Proceeds  from sales of short-term investments                           |   | 5,693                              |   | 3,477 |   |
| Purchases  of short-term investments                                     |   | (2,600                             | )      | — |   |
| Purchases  of property and equipment                                     |   | (1,282                             | )      | (702 | ) |
| Cash  provided by investing activities                                   |   | 1,811                              |   | 2,775 |   |
|                                                                     |   |                               |   |   |   |
| Cash  flows from financing activities:                                   |   |                               |   |   |   |
| Proceeds  from issuances of common stock, net                            |   | 2,653                              |   | 3,029 |   |
| Repayment  of stockholders’ notes receivable                        |   | 109                                |   | — |   |
| Repayments  of capital lease and other obligations                       |   | (699                               | )      | (663 | ) |
| Cash  provided by financing activities                                   |   | 2,063                              |   | 2,366 |   |
|                                                                     |   |                               |   |   |   |
| Net  increase (decrease) in cash and cash equivalents                    |   | (1,288                             | )      | 1,061 |   |
| Cash  and cash equivalents – beginning of period                    |   | 26,263                             |   | 18,946 |   |
| Cash  and cash equivalents – end of period                          |   | $                                  | 24,975 |   | $ | 20,007 |   |
|                                                                     |   |                               |   |   |   |
| Non-cash  investing and financing activities:                            |   |                               |   |   |   |
| Financing  of property and equipment                                     |   | $                                  | 383    |   | $ | — |   |

 

See accompanyingNotes to Unaudited Condensed Consolidated Financial Statements

 

3

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**Silicon Image, Inc.**

**Notes to Unaudited CondensedConsolidated Financial Statements**

**March 31, 2003**

 

1.               Basis ofPresentation

 

In the opinion of management, the accompanyingunaudited condensed consolidated financial statements of Silicon Image, Inc.included herein have been prepared on a basis consistent with our December 31,2002 audited financial statements and include all material adjustments, consistingof normal recurring adjustments, necessary to fairly state the consolidatedfinancial position of Silicon Image and its subsidiaries (collectively, the“Company”) at March 31, 2003 and the consolidated results of the Company’soperations and cash flows for the three months ended March 31, 2003 and2002.  All intercompany accounts andtransactions 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, 2002. Results of operations for the three months ended March 31, 2003 are notnecessarily indicative of future operating results.

 

2.               Recent AccountingPronouncements

 

In June 2002, the Financial Accounting Standards Board(“FASB”) issued Statement of Financial Accounting Standards No. 146 (SFAS No.146), Accounting for Costs Associated with Exit or Disposal Activities. SFASNo. 146 addresses issues regarding the recognition, measurement and reportingof costs associated with exit and disposal activities, including restructuringactivities, costs related to terminating a contract that is not a capital leaseand termination benefits provided under a one-time benefit arrangement toinvoluntarily terminated employees. SFAS No. 146 requires that an expenseassociated with an exit or disposal activity be recognized when a liability isincurred, and that fair value be used for the initial measurement of theliability. SFAS No. 146 is effective for all exit or disposal activities thatare initiated after December 31, 2002. The restructuring charge we recorded inthe first quarter of 2003 was recognized in accordance with SFAS No. 146.  The adoption of SFAS No. 146 did not have asignificant effect on our results of operations or financial condition.

 

In November 2002, the FASB issued Interpretation No.45 (Interpretation 45), “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Guarantees of Indebtedness of Others. Interpretation 45clarifies disclosure, recognition and measurement requirements related tocertain guarantees. The disclosure requirements are effective for financialstatements issued after December 15, 2002 and the recognition and measurementrequirements are effective for guarantees issued or modified after December 31,2002. The adoption of Interpretation 45 did not have a significant effect onour results of operations or financial condition.  Refer to Note 4 for the required warranty disclosure.

 

In December 2002, the FASB issued Statement ofFinancial Accounting Standards No. 148 (SFAS No. 148), “Accounting forStock-Based Compensation—Transition and Disclosure”. SFAS No. 148 amends SFASNo. 123, “Accounting for Stock-Based Compensation”, to provide alternativemethods of transition for a voluntary change to the fair value based method ofaccounting for stock-based employee compensation. In addition, SFAS No. 148amends the disclosure requirements of SFAS No. 123 to require prominentdisclosures in both annual and interim financial statements about the method ofaccounting for stock-based employee compensation and the effect of the methodused on reported results. The transition guidance and annual disclosureprovisions of SFAS No. 148 are effective for fiscal years ending after December15, 2002. The interim disclosure provisions of SFAS No. 148 are effective forinterim periods beginning after December 15, 2002. We adopted the disclosurerequirements of SFAS No. 148 on December 31, 2002.

 

Had we recorded compensation cost for our optionsbased on the grant-date fair value as prescribed by SFAS No. 123 and SFAS No.148, our net income (loss) would have been as follows (in thousands):

 

4

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|                                                                                                           |   | **Three Months Ended****March 31,** |   |
|----------------------------------------------------------------------------------------------------------------|--------|-------------------------------------|--------|
|                                                                                                           |   | **2003**                            |   | **2002** |   |
| Net  income (loss) - as reported                                                                               |   | $                                   | 3,231  |   | $ | (17,700 | ) |
| Stock-based  employee compensation expense determined using fair value method                                  |   | (6,020                              | )      | (6,422 | ) |
| Stock-based  employee compensation cost (benefit)   included in the determination of net loss as reported |   | (721                                | )      | 9,850 |   |
| Pro  forma net loss                                                                                            |   | $                                   | (3,510 | ) | $ | (14,272 | ) |
|                                                                                                           |   |                                |   |   |   |   |   |
| Basic  net income (loss) per share—pro forma                                                              |   | $                                   | (0.05  | ) | $ | (0.23 | ) |
| Basic  net income (loss) per share—as reported                                                            |   | $                                   | 0.05   |   | $ | (0.28 | ) |
|                                                                                                           |   |                                |   |   |   |
| Diluted  net income (loss) per share—pro forma                                                            |   | $                                   | (0.05  | ) | $ | (0.23 | ) |
| Diluted  net income (loss) per share—as reported                                                          |   | $                                   | 0.04   |   | $ | (0.28 | ) |

 

3.               Net Income (Loss)Per Share

 

Basic earnings per share is computed using theweighted-average number of common shares outstanding during the period. Dilutedearnings per share is computed using the weighted-average number of commonshares and dilutive stock options, determined using the treasury stock method,outstanding during the period.

 

The following is a reconciliation of theweighted-average common shares used to calculate basic net income per share tothe weighted-average common shares used to calculate diluted net income pershare for the three months ended March 31, 2003 (in thousands):

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

 

The effect of dilutive stock options outstandingexcludes approximately 8.6 million stock options that were anti-dilutive fornet income per share calculations for the three months ended March 31, 2003.

 

Due to our net loss for the three months ended March31, 2002, all stock options outstanding as of March 31, 2002 would have beenanti-dilutive and were therefore excluded from the calculation of diluted netloss per share.  A total of 21.3 millionstock options were outstanding as of March 31, 2002.

 

4.                   Balance SheetComponents

 
|                                  |   | **March 31,  2003** |   | **Dec. 31,  2002** |   |
|---------------------------------------|--------|---------------------|--------|--------------------|--------|
|                                  |   | **(in  thousands)** |   |
|                                  |   |                |   |               |   |
| Inventories:                          |   |                |   |               |   |
| Raw  materials                        |   | $                   | 1,989  |               | $      | 1,376 |   |
| Work  in process                      |   | 2,497               |   | 2,487              |   |
| Finished  goods                       |   | 2,239               |   | 3,438              |   |
|                                  |   | $                   | 6,725  |               | $      | 7,301 |   |
|                                  |   |                |   |               |   |
| Accrued liabilities:                  |   |                |   |               |   |
| Accrued  payroll and related expenses |   | $                   | 1,740  |               | $      | 2,502 |   |
| Restructuring  accrual                |   | 2,882               |   | 2,736              |   |
| Accrued  legal fees                   |   | 1,182               |   | 1,865              |   |
| Warranty  accrual                     |   | 223                 |   | 223                |   |
| Other  accrued liabilities            |   | 3,015               |   | 3,857              |   |
|                                  |   | $                   | 9,042  |               | $      | 11,183 |   |

 

5

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Warranty Accrual

 

At the time of revenue recognition, we provide anaccrual for estimated costs to be incurred pursuant to our warranty obligation.Our estimate is based primarily on historical experience.  Warranty accrual activity for the threemonths ended March 31, 2003 was as follows (in thousands):

 
| Balance at January 1, 2003                         |   | $      | 223    |   |
|----------------------------------------------------|--------|--------|--------|--------|
| Provision  for warranties issued during the period |   | 50     |   |
| Accruals  related to pre-existing warranties       |   | — |   |
| Cash  and other settlements made during the period |   | (50    | )      |
| Balance  at March 31, 2003                         |   | $      | 223    |   |

 

5.                   Stock-BasedCompensation

 

We account for stock-based compensation arrangementsin accordance with the provisions of Accounting Principles Board Opinion No. 25(APB 25), “Accounting for Stock Issued to Employees,” and relatedinterpretations, and comply with the disclosure provisions of Statement ofFinancial Accounting Standard No. 148 (SFAS No. 148), “Accounting forStock-Based Compensation—Transition and Disclosure (an amendment of FASBStatement No. 123).” Expense associated with stock-based compensation isamortized over the vesting period of the individual award using an acceleratedmethod, as described in Financial Accounting Standards Board Interpretation No.28.

 

We are required to determine the fair value of stockoption grants to non-employees and to record the amount as an expense over theperiod during which services are provided to us. Management calculates the fairvalue of these stock option grants using the Black-Scholes model, which requiresus to estimate 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 ourstock compensation expense (benefit) for the three months ended March 31, 2003and 2002 (in thousands):

 
|                                            |   | **Three Months Ended  March 31,** |   |
|-------------------------------------------------|--------|-----------------------------------|--------|
|                                            |   | **2003**                          |   | **2002** |   |
|                                            |   |                              |   |   |   |
| Options granted to employees                    |   | $                                 | 222    |   | $ | 437 |   |
| Options granted to non-employees                |   | 359                               |   | 601 |   |
| Option repricings                               |   | (1,358                            | )      | 7,932 |   |
| Options assumed in connection with acquisitions |   | 415                               |   | 1,481 |   |
| Stock compensation expense (benefit)            |   | $                                 | (362   | ) | $ | 10,451 |   |

 

During the three months ended March 31, 2003, werecorded a credit of $1.4 million in connection with our stock optionrepricings since the fair market value of our stock as of March 31, 2003 wasless than our stock’s fair market value as of December 31, 2002.  During the three months ended March 31,2002, we recognized $7.9 million of expense relating to repriced stockoptions.  Expense or benefit for theincrease or decrease in the fair market value 

 

6

----

 

of our stock relative to the exercise price of the repriced options isrecognized immediately for vested options and is recognized over the remainingvesting period for unvested options using an accelerated method for employees.

 

During the three months ended March 31, 2003, wemodified options for employees involuntarily terminated in connection with ourrestructuring program. A charge of $646,000 for these modifications is includedin restructuring expense for the period ended March 31, 2003.

 

The weighted average, grant-date fair value of stockoptions granted during the three months ended March 31, 2003 and 2002 was $4.31and $4.07 per option, respectively. The grant-date fair value was estimatedusing the Black-Scholes pricing model with the following assumptions:

 

|                     |   | **Three Months  Ended  March 31,** |   |
|--------------------------|--------|------------------------------------|--------|
|                     |   | **2003**                           |   | **2002** |   |
|                     |   |                               |   |   |   |
| Expected  life (years)   |   | 5.0                                |   | 5.0 |   |
| Risk-free  interest rate |   | 3.1                                | %      | 3.5 | % |
| Dividend  yield          |   | —                             |   | — |   |
| Volatility               |   | 90                                 | %      | 90 | % |

 

The weighted average, grant-date fair value of stockpurchase rights granted under our Employee Stock Purchase Plan was $2.76 and$2.46 per share during the three months ended March 31, 2003 and 2002,respectively. The grant-date fair value was estimated using the Black-Scholes pricingmodel with the following assumptions:

 

** **

|                     |   | **Three Months  Ended  March 31,** |   |
|--------------------------|--------|------------------------------------|--------|
|                     |   | **2003**                           |   | **2002** |   |
|                     |   |                               |   |   |   |
| Expected  life (years)   |   | 1.5                                |   | 1.5 |   |
| Risk-free  interest rate |   | 1.3                                | %      | 1.7 | % |
| Dividend  yield          |   | —                             |   | — |   |
| Volatility               |   | 90                                 | %      | 90 | % |

 

6.               Restructuring andImpairment Activities

 

During the third quarter of 2001, we began a programto focus our business on products and technology, including those obtainedthrough acquisitions, in which we have, or believe we can achieve, a marketleadership position. As part of this program, we decided to cancel numerousproducts under development, to remove certain projects from our developmentplan, to phase out or de-emphasize certain existing products and to integratethe operations of two acquired companies—CMD Technology (CMD) and SiliconCommunication Lab (SCL).

 

In connection with this program, we reduced ourworkforce in the fourth quarter of 2001 by approximately 60 people, or 20%.This workforce reduction was the initial step in eliminating duplicatepositions that resulted from our acquisitions, and also represented theelimination of other positions based on our new product and technology focus.Positions were eliminated from all functional areas—operations, R&D andSG&A. Because of this workforce reduction, we recorded a restructuringexpense of $1.5 million in the fourth quarter of 2001, consisting of cashseverance-related costs of $599,000, non-cash severance-related costs of$303,000 representing the intrinsic value of modified stock options, anexpected loss on leased facilities of $500,000 and fixed asset write-downs of$50,000. In addition, we reversed $286,000 of unearned compensation, acomponent of stockholders’ equity, for unvested stock options that werecancelled in connection with employee terminations.

 

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In the first quarter of 2002, we implemented a secondworkforce reduction in connection with the program discussed above, eliminatingan additional 35 positions, or 13% of our workforce. Positions were eliminatedfrom all functional areas. This reduction resulted from the continuedintegration of acquired companies, as well as continued execution of ourproduct and technology strategy, whereby we decided to phase out the legacystorage subsystem board products we acquired from CMD and to develop new boardproducts only if we believed it would facilitate or accelerate the use of ourstorage semiconductor products. In connection with this workforce reduction, werecorded a restructuring expense of $2.2 million in the first quarter of 2002,consisting of cash severance-related costs of $198,000, non-cashseverance-related costs of $318,000 representing the intrinsic value ofmodified stock options, an expected loss on leased facilities of $1.2 millionand fixed asset write-downs of $500,000 for assets to be disposed of. Inaddition, we reversed $76,000 of unearned compensation, a component ofstockholders’ equity, for unvested stock options that were cancelled inconnection with employee terminations.

 

In April 2002, we decided to transition to a licensingmodel for our storage subsystem board products, whereby instead of developing,manufacturing and selling board products to facilitate or accelerate the use ofour storage semiconductor products, we would develop and license board designsin exchange for license fees, royalties and the use of our semiconductorproducts. In connection with this decision, we implemented a third workforcereduction, eliminating 14 positions, or 5% of our workforce, and recorded arestructuring expense of $3.5 million, consisting of cash severance-relatedcosts of $450,000, non-cash severance-related costs of $1.6 millionrepresenting the intrinsic value of modified stock options and fixed assetwrite-downs of $1.5 million for assets to be disposed of. We also reversed$302,000 of unearned compensation, a component of stockholders’ equity, forunvested stock options that were cancelled in connection with employeeterminations.

 

In connection with our decision to stop selling boardproducts and to transition to a licensing model, we assessed recoverability ofour intangible assets subject to amortization in accordance with SFAS No. 144.During the quarter ended June 30, 2002, an impairment expense of $749,000 wasrecognized for acquired technology and $60,000 was recognized for patent andother intangible assets, based upon our projection of significantly reducedfuture cash flows. Additionally, we reduced our estimate of the useful lives ofthe remaining intangible assets subject to amortization such that these assetswere fully amortized by the end of 2002. We also tested the carrying value ofgoodwill for impairment in accordance with SFAS No. 142 and used the servicesof a third party to assist with the analysis. As a result of our impairmenttest, a goodwill impairment expense of $4.4 million was recognized during thesecond quarter of 2002. To determine the amount of the impairment, we estimatedthe fair value of our storage systems business based primarily on expectedfuture cash flows. We then reduced this amount by the fair value ofidentifiable tangible and intangible assets other than goodwill (also basedprimarily on expected future cash flows), and compared the unallocated fairvalue of the business to the carrying value of goodwill. To the extent goodwillexceeded the unallocated fair value of the business, an impairment expense wasrecognized.

 

In December 2002, we revised our estimate of the losswe expect to incur on subleased facilities and recorded a restructuring expenseof $1.5 million. Real estate market conditions deteriorated in the fourthquarter of 2002, causing us to reassess the length of time it will take to findtenants and the fair value lease rate of our available space. As of December31, 2002, our expected loss on subleased facilities is based on estimatedsublease income of $1.6 million over the remaining lease terms. To the extentwe are unable to generate $1.6 million of sublease income, our future resultsof operations and financial condition will be negatively affected.

 

In March 2003, we reorganized the company into linesof business for PC, CE and Storage products to enable us to better manage ourlong-term growth potential.  Inconnection with this reorganization, we reduced our workforce by 27 people, orapproximately 10%.  These reductionswere primarily in engineering and operations functions.  Because of this workforce reduction, werecorded restructuring expense of $1.0 million in the first quarter of 2003,consisting of cash severance-related costs of $340,000 and non-cashseverance-related costs of $646,000, representing the intrinsic value ofmodified stock options.

 

Severance related costs were determined based on theamount of pay people received that was not for services performed and bymeasuring the intrinsic value of stock options that were modified to thebenefit of terminated employees. For those employees terminated in the threemonth period ending March 31, 2003, the remaining service period from thecommunication date did not exceed 60 days. The expected loss on leasedfacilities resulted from our plan to consolidate our remaining workforce to theextent practicable and sublease any excess space. To determine the expectedloss, we compared our lease and operating costs for the space to our estimateof

 

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the net amount we would be able to recover by subleasing the space.This estimate was based on a number of assumptions, including the length oftime it will take to secure a tenant, the sublease rate per square foot, thecost of necessary improvements or modifications and real estate brokercommissions. The fixed asset write-downs were determined based on the estimatedfair value of assets, primarily computer hardware and software that would no longerbe utilized after the employees’ termination dates.

 

We expect severance and benefits payments to becompleted by the second quarter of 2003. Lease payments will be made in theform of cash through the end of the related lease terms of July 2003 and November2005. The following table presents restructuring activity for 2001 though March31, 2003 (in thousands).

 
|                             |   | **Severance  and Benefits** |   | **Leased  Facilities** |   | **Fixed  Assets** |   | **Total** |   |
|----------------------------------|--------|-----------------------------|--------|------------------------|--------|-------------------|--------|-----------|--------|
| 2001  provision                  |   | $                           | 902    |                   | $      | 500               |   | $         | 50     |   | $ | 1,452 |   |
| Cash  payments                   |   | (191                        | )      | —                 |   | —            |   | (191      | )      |
| Non-cash  activity               |   | (303                        | )      | (115                   | )      | —            |   | (418      | )      |
| Balance  as of December 31, 2001 |   | 408                         |   | 385                    |   | 50                |   | 843       |   |
| 2002  provision                  |   | 2,547                       |   | 2,633                  |   | 2,013             |   | 7,193     |   |
| Cash  payments                   |   | (865                        | )      | (420                   | )      | —            |   | (1,285    | )      |
| Non-cash  activity               |   | (1,952                      | )      | —                 |   | (2,063            | )      | (4,015    | )      |
| Balance  as of December 31, 2002 |   | 138                         |   | 2,598                  |   | —            |   | 2,736     |   |
| 2003  provision                  |   | 986                         |   | —                 |   | —            |   | 986       |   |
| Cash  payments                   |   | (24                         | )      | (170                   | )      | —            |   | (194      | )      |
| Non-cash  activity               |   | (646                        | )      | —                 |   | —            |   | (646      | )      |
| Balance  as of March 31, 2003    |   | $                           | 454    |                   | $      | 2,428             |   | $         | — |   | $ | 2,882 |   |

 

As of March 31, 2003 and December 31, 2002, 31 and 4terminated employees, respectively, had not yet received their severancepayments.

 

7.               Debt Facility

 

In October 2002, we entered into a new debt facilitythat includes a revolving line of credit of up to $7.5 million, a term loan of$3.6 million, and equipment advances of $1.0 million. Borrowings under therevolving line are limited to the lesser of $7.5 million or our borrowing baseof 80% of eligible accounts receivable. The revolving line has a maturity date ofSeptember 26, 2003. There were no borrowings outstanding under this line atMarch 31, 2003. The $3.6 million term loan refinanced $3.1 million of debtacquired in connection with our acquisition of CMD and $500,000 of other bankdebt, and requires monthly payments through its maturity of October 1,2004.  During the three months endedMarch 31, 2003, we borrowed $383,000 under the equipment advances portion ofthe facility.  This term loan bearsinterest at 5% and requires monthly payments through its maturity in February2005.  Equipment advances were availableto us through March 31, 2003; therefore, the unused portion of this facility of$617,000 expired as of March 31, 2003. All borrowings under the revolving line and the $3.6 million term loanare at prime (4.25% at March 31, 2003) plus 0.25%, and the facility is securedby substantially all of our assets, excluding intellectual property. Thisfacility contains certain quarterly and annual financial covenants with whichwe must comply. We were not in compliance with one of the quarterly covenantsat December 31, 2002; however, we were granted a waiver from the lendinginstitution and were not in default of the loan agreement. As of March 31,2003, we were in compliance with all of our financial covenants. However, sincewe were not in compliance at December 31, 2002, and cannot be assured we willbe in compliance in the future, we have classified all amounts outstandingunder the credit agreement as current liabilities as of March 31, 2003.

 

8.               Legal Proceedings

 

On April 24, 2001, we filed suit in the U.S. DistrictCourt for the Eastern District of Virginia against Genesis Microchip Corp. andGenesis Microchip, Inc. (collectively, Genesis) for infringement of our U.S.patent number 5,905,769 (USDC E.D. Virginia Civil Action No.: CA-01-266-R) (theFederal Suit). On April 24, 2001, we also filed a complaint against Genesiswith the International Trade Commission of the United States government

 

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(ITC) for unlawful trade practices related to the importation ofarticles infringing our patent (the ITC investigation). The actions soughtinjunctions to halt the importation, sale, manufacture and use of Genesis DVIreceiver chips that infringe our patent, and monetary damages. We voluntarilymoved to dismiss the ITC investigation, with notice that we would proceeddirectly in the Federal Suit. Our motion to dismiss was granted on February 7,2002. We filed an amended complaint for the Federal Suit as of February 28,2002. In April 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 motion to dismisscertain of Genesis’ counterclaims. In addition, we filed a motion to bifurcatetrial of the counterclaims to the extent the court does not dismiss them. InMay 2002, the Court granted our motion to dismiss certain of the counterclaims,with leave to amend. Genesis re-filed counterclaims against us for fraud andpatent misuse. We filed another motion to dismiss these counterclaims. InAugust 2002, the Court granted our motion and dismissed Genesis’ counterclaimswithout leave to amend. In September 2002, we filed a motion for summary judgment,upon which the Court has yet to rule. In October 2002, both parties filedseveral more motions for summary judgment, upon which the Court has yet torule. Several dispositive motions have subsequently been filed under seal andwere heard by the Court in March 2003; the Court has yet to rule on thesemotions. Depending on the outcome of such motions, a trial date may be set, thecase may be dismissed, or other orders may be entered. Management intends toprosecute our position vigorously until this matter is resolved. Through March31, 2003, we have spent approximately $9.4 million on this matter and expect tocontinue to incur significant costs through at least the second quarter of2003.

 

Silicon Image, certain officers and directors, andSilicon Image’s underwriters have been named as defendants in a securitiesclass action lawsuit captioned Gonzales v. Silicon Image, et al., No. 01 CV10903 (SDNY 2001) pending in Federal District Court for the Southern Districtof New York. The lawsuit alleges that all defendants were part of a scheme tomanipulate the price of Silicon Image’s stock in the aftermarket followingSilicon Image’s initial public offering in October 1999. Response to thecomplaint and discovery in this action on behalf of Silicon Image andindividual defendants has been stayed by order of the court. The lawsuit isproceeding as part of a coordinated action of over 300 such cases brought byplaintiffs in the Southern District of New York. Pursuant to a tollingagreement, individual defendants have been dropped from the suit for the timebeing. In February 2003, the Court denied underwriters’ motion to dismiss andordered that the case may proceed against issuers including against SiliconImage. At this time, we cannot predict the outcome of this lawsuit; however, weintend to defend this matter vigorously.

 

Silicon Image, certain officers and directors, andSilicon Image’s underwriters have been named as defendants in a securitiesclass action lawsuit captioned Liu v. Credit Suisse First Boston Corp., et al.,No. 03-20459 (S.D. Fla. 2003) pending in Federal District Court for theSouthern District of Florida. Plaintiff filed an action on behalf of a putativeclass of shareholders who purchased stock from some or all of approximately 50issuers whose public offerings were underwritten by Credit Suisse First Boston.The lawsuit alleges that Silicon Image and certain officers were part of ascheme by Credit Suisse First Boston to artificially inflate the price ofSilicon Image’s stock through the dissemination of allegedly false analysts’reports. Silicon Image has not been served with a copy of the complaint. Atthis time, we cannot predict the outcome of this lawsuit; however, we intend todefend this matter vigorously.

 

On August 7, 2002, we filed a demand for arbitrationwith the American Arbitration Association, file #74 Y 117 01399 02 GAP, againstthe principal shareholders of CMD Technology (CMD) relating to shares held inescrow in connection with our acquisition of CMD. Pursuant to agreements bywhich we acquired CMD, a portion of the Silicon Image common stock issued tothe principal 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 settlementagreement and mutual release, pursuant to which our indemnification claims wereresolved. As a result of the settlement, we received 949,780 of the escrowedshares, valued at approximately $4.7 million, and recorded a net non-operating gainof $4.6 million in the first quarter of 2003.

 

In addition, we are involved in a number of judicialand administrative proceedings incidental to our business. We intend toprosecute or defend, as appropriate, such matters vigorously, and although adversedecisions or settlements may occur in one or more of such cases, the finalresolution of these matters, individually or in the aggregate, is not expectedto have a material adverse effect on our results of operations or financialposition.

 

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The amount of legal fees we incur with respect to thelitigation matters described above will depend on the duration of ourlitigation matters, as well as the nature and extent of the litigationactivities. We are not able to accurately estimate the amount of legal fees wewill incur in 2003 with respect to the litigation matters described above,however, we do expect to incur substantial amounts through at least the firsthalf of 2003.

 

9.               Customer andGeographic Information

 

Revenue by geographic area was as follows (inthousands):

 

|          |   | **Three Months Ended  March 31,** |   |
|---------------|--------|-----------------------------------|--------|
|          |   | **2003**                          |   | **2002** |   |
| Taiwan        |   | $                                 | 9,814  |   | $ | 6,085 |   |
| Japan         |   | 2,594                             |   | 2,167 |   |
| United States |   | 6,774                             |   | 4,527 |   |
| Hong Kong     |   | 1,519                             |   | 1,571 |   |
| Korea         |   | 1,120                             |   | 1,068 |   |
| Other         |   | 2,855                             |   | 1,669 |   |
|          |   | $                                 | 24,676 |   | $ | 17,087 |   |

 

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

 

|                                  |   | **Three Months Ended  March 31,** |   |
|---------------------------------------|--------|-----------------------------------|--------|
|                                  |   | **2003**                          |   | **2002** |   |
| PC                                    |   | $                                 | 8,793  |   | $ | 11,745 |   |
| Consumer  Electronics                 |   | 3,250                             |   | 1,409 |   |
| Storage  IC                           |   | 6,635                             |   | 1,604 |   |
| Storage  Systems                      |   | 1,044                             |   | 1,847 |   |
| Development,  licensing and royalties |   | 4,954                             |   | 482 |   |
|                                  |   | $                                 | 24,676 |   | $ | 17,087 |   |

 

 

For each periodpresented, substantially all long-lived assets were located within the UnitedStates.

 

For the three months ended March 31, 2003, one customergenerated 12% of our revenue and two customers each generated 10% of ourrevenue. As of March 31, 2003, one customer represented 12% of gross accountsreceivable. For the three months ended March 31, 2002, three customersgenerated 17%, 14% and 11% of our revenue. At December 31, 2002, two customers represented 13% and 10% of grossaccounts receivable.

 

10.         Guarantees

 

Certain of our licensing agreements indemnify our customers for any expenses orliabilities resulting from claimed infringements of patent, trademark orcopyright by third parties related to the intellectual property content of ourproducts. Certain of these indemnification provisions are perpetual fromexecution of the agreement and, in some instances, the maximum amount ofpotential future indemnification is not limited. To date, we have not paid anysuch claims or been required to defend any lawsuits with respect to any claim.However, there can be no assurance that such claims will not be filed in thefuture.

 

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11.         Business Combination

 

On April 7 2003, we issued approximately 2,500,817shares of common stock in exchange for all of the outstanding shares ofTransWarp Networks (TransWarp) capital stock, and converted all outstandingTransWarp options into options to purchase approximately 760,145 shares of ourcommon stock.  We currently estimatethat the purchase price of this acquisition will be approximately $14.7million.  Approximately 391,579 sharesof our common stock issued will be held in escrow for a period of eighteenmonths as collateral for indemnity obligations of the principal TransWarpstockholders.****** We also assumed TransWarp’s  2002 Stock Option / Stock Issuance Plan,under which a reserve of approximately 116,461 shares of our common stockremained available for future issuance as of April 7, 2003. This transactionwill be recorded during the quarter ended June 30, 2003 using the purchasemethod of accounting. The operating results of TransWarp will be combined withour results from the date of acquisition.

 

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## **Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

*Thisreport contains forward-looking statements within the meaning of Section 21E ofthe Securities and Exchange Act of 1934 and Section 27A of the Securities Actof 1933. These forward-looking statements involve a number of risks anduncertainties, including those identified in the section of this Form 10-Qentitled “Factors Affecting Future Results,” that may cause actual results todiffer materially from those discussed in, or implied by, such forward-lookingstatements. Forward-looking statements within this Form 10-Q are identified bywords such as “believes,” “anticipates,” “expects,” “intends,” “may,” “will”and other similar expressions. However, these words are not the only means ofidentifying such statements. In addition, any statements that refer toexpectations, projections or other characterizations of future events orcircumstances are forward-looking statements. We undertake no obligation topublicly release the results of any revisions to these forward-lookingstatements that may be made to reflect events or circumstances occurringsubsequent to the filing of this Form 10-Q with the SEC. Our actual resultscould differ materially from those anticipated in, or implied by,forward-looking statements as a result of various factors, including the risksoutlined elsewhere in this report. Readers are urged to carefully review andconsider the various disclosures made by Silicon Image, Inc. in this report andin our other reports filed with the SEC that attempt to advise interestedparties of the risks and factors that may affect our business.*

 

## **Overview**

 

Silicon Image designs, develops and marketssemiconductor products for applications that require high-bandwidth,cost-effective solutions for high-speed digital data communications. Themarkets into which we sell our products are personal computer (PC), consumer electronics(CE) and storage.

 

Products sold into the PC market generated 36% of ourrevenue in the first quarter of 2003, 58% of our revenue in 2002, and 69% ofour revenue in the first quarter of 2002.

 

Our products in the PC market are based on PanelLink technology,which is our proprietary implementation of the digital visual interface (DVI)specification that defines a high-speed serial data communication link betweencomputers and digital displays. Despite sluggish growth in the host portion ofthe PC market and a movement among graphic card manufacturers to eliminate theneed for discrete transmitters by integrating transmitter functionality intotheir graphic chips, we expect accelerated DVI adoption to result in increasedoverall demand for discrete transmitters. The display portion of the PC marketremains predominantly analog or dual-interface, which is capable of receivingeither an analog or digital signal. We do not offer an analog or dual-interfacesolution, but do partner with other companies to sell multiple-chip solutionsinto the dual-interface market. These multiple-chip solutions are typicallylimited to higher end, larger displays operating at resolutions of SXGA andabove. In addition, we have licensed certain of our technologies to companiesfor use in making products for the dual-interface market. We believe that thedisplay portion of the PC market will eventually transition to a pure digitalsolution that could result in an expansion in the market suited to our productoffering.

 

Products sold into the CE market generated 13% of ourrevenue in the first quarter of 2003, 11% of our revenue in 2002, and 8% of ourrevenue in the first quarter of 2002. Our CE products offer a secure digitalvideo and audio transmission for consumer devices such as digital TVs and DVDplayers. Demand for these products will be driven primarily by the adoptionrate of new technologies and industry standards, such as DVI with HDCP andHDMI, respectively.

 

Semiconductor products sold into the storage marketgenerated 27% of our revenue in the first quarter of 2003, 15% of our revenuein 2002, and 9% of our revenue in the first quarter of 2002. Demand for ourstorage products is dependent upon the rate at which interface technologytransitions from parallel to serial, and the extent to which serial ATA andfibre channel functionality are integrated into chip sets and controllersoffered by other companies, making our discrete devices unnecessary.

 

Sales of storage subsystems products generated 4% ofour revenue in the first quarter of 2003, 8% of our revenue in 2002, and 11% ofour revenue in the first quarter of 2002. We are phasing out our subsystemsproducts and do not plan on developing, manufacturing and selling newsubsystems products in the future. Therefore, we expect sales of such productsto represent less than 2% of our revenue in 2003. In conjunction with ourdecision to

 

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phase out our storage systems products and change primarily to alicensing business model, we decided to design products and / or license ourtechnology to third parties in this market.

 

We also derive revenue from licensing our intellectualproperty. Our licensing activity is complementary to our product sales and webelieve this activity can help accelerate adoption curves associated with ourtechnology. We expect licensing and royalties to account for 10% to 15% of ourrevenue over the next few years.

 

From our inception in 1995 through the first half of1997, we were engaged primarily in developing our first generation PanelLinkdigital transmitter and receiver products, developing our high-speed digitalinterconnect technology, establishing our digital interface technology as anopen standard, and building strategic customer and foundry relationships.During that period, we derived substantially all of our revenue from contractsproviding for the joint development of technologies for high-speed digitalcommunication and intelligent panel controllers for flat panel displays, aswell as from licensing our high-speed digital interconnect technology.

 

In the third quarter of 1997, we began volumeshipments of our first generation PanelLink digital transmitter and receiverproducts. Since that time, we have derived most of our revenue from the sale ofPanelLink products and we have introduced several new generations oftransmitter and receiver products providing higher speed and increasedfunctionality. In 1999, we began shipping our first generation digital displaycontroller product. Our digital display controller products integrate ourreceiver with digital image processing and display controller technology, whichenables development of intelligent displays for the mass-market.

 

In October 1999, we raised approximately $48 millionin our initial public offering. We have incurred losses in each year and mostquarterly periods since our inception and as of March 31, 2003, we had anaccumulated deficit of $156.6 million.

 

In 2000, we began focusing our resources on enteringtwo new markets, storage and CE, which we believed would grow significantly andin which we believed we could apply our technology and expertise in high-speedserial interfaces. During 2000, we acquired Zillion, a developer of high-speedtransmission technology for data storage applications, and DVDO, a provider ofdigital video processing systems for the CE market.

 

In 2001, we focused on accelerating our entry into theCE and storage markets, leveraging our IP into licensing revenue andrestructuring the company to improve profitability. During 2001, we acquiredCMD, a provider of storage subsystems and semiconductors designed for storagearea networks, and SCL, a provider of mixed-signal and high-speed circuitdesigns.

 

During 2002, we achieved double-digit revenue growthin each fiscal quarter, resulting in record annual revenue of $81.5 million,which was a 57% increase from 2001 revenue levels. We also began to see thebenefits of our diversification strategy, which resulted in establishing a keypresence in the CE and storage markets, both of which we expect to experiencesignificant growth rates during the next several years. Additionally, we wereable to successfully leverage our intellectual property to generate $6.7million of development and licensing revenue. We also focused on improving our profitability and reducing our cashusage rate. Our cash and short-term investments declined by $5.4 million in2002, versus $19.0 million in 2001.

 

On April 7 2003, we issued approximately 2,500,817shares of common stock in exchange for all of the outstanding shares ofTransWarp Networks (TransWarp) capital stock, and converted all outstandingTransWarp options into options to purchase approximately 760,145 shares of ourcommon stock.  We currently estimatethat the purchase price of this acquisition will be approximately $14.7million.  Approximately 391,579 sharesof our common stock issued will be held in escrow for a period of eighteenmonths as collateral for indemnity obligations of the principal TransWarpstockholders.****** We also assumed TransWarp’s  2002 Stock Option / Stock Issuance Plan,under which a reserve of approximately 116,461 shares of our common stockremained available for future issuance as of April 7, 2003. This transactionwill be recorded during the quarter ended June 30, 2003 using the purchasemethod of accounting. The operating results of TransWarp will be combined withour results from the date of acquisition.

 

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**Outlook**

 

We expect 2003 revenue to increase from the levelachieved in 2002, and believe our revenue in the second quarter of 2003 willincrease 3% - 8% from the first quarter of 2003. We expect to generate positivecash flow for the year 2003.

 

Our expectation of overall revenue growth and positivecash flows in 2003 is based on four assumptions. First, we believe the DVIadoption rate will increase in the PC market as the quality, cost and contentcapabilities of all-digital solutions become more attractive than those offeredby analog solutions and as prices of digital displays become lower. DisplaySearch forecasts the adoption rate to increase from approximately 12% in thefourth quarter of 2002 to approximately 17% by the end of 2003. Second, weachieved numerous design wins in the CE market for DVI with HDCP and HDMIproducts, and expect these designs to go into production during 2003. Althoughit is difficult to predict exactly when and how aggressively revenue from theseproducts will ramp during 2003, our expectation is that we will generate significantrevenue from these designs in the second quarter and that revenue will growquarter-over-quarter throughout the remainder of 2003. Third, we believe thatthe storage market will continue its transitions to 2 Gb fibre channel switchesand serial ATA technology, which should result in increasing revenue from ourfibre channel and SATALink products. We expect the availability of serialATA-enabled hard drives and other peripherals to improve, which should enableacceleration of the transition to serial ATA technology. Fourth, we expectlicensing and royalty revenue to exceed $15.0 million during 2003 as wecontinue to implement our strategy of licensing our technology to companiesthat address market segments in which we have chosen not to directly participate,and expect to begin receiving royalties from licenses entered into during 2001and 2002.

 

Among the factors that may cause our actual results todiffer materially from those anticipated by our assumptions include the rate atwhich the PC market adopts DVI, acceptance of all digital solutions in the PCmarket, CE market acceptance of our DVI with HDCP and HDMI products, the rateat which the storage market transitions to 2 Gb fibre channel switches andserial ATA technology, consumer demand in the PC and CE markets, theavailability of serial ATA-enabled hard drives and other peripherals, whetherand how quickly OEMs are able to integrate transmitters in their graphics chipsand serial ATA functionality into their chip sets, our ability to leverage ourintellectual property into licensing revenue and the ability of oursemiconductor foundries to manufacture our products in commercial volumes at anacceptable cost and in a timely manner. In addition, our revenue remainssubject to competition and general economic and market conditions, none ofwhich can be accurately predicted.

 

Since the amount of stock compensation expense werecord in any period is dependent on changes in our stock price, we are notable to reasonably estimate the amount of stock compensation we will record infuture periods.  Additionally, we havenot yet completed the purchase price allocation for our most recentacquisition, and therefore cannot reasonably estimate stock compensation expensein future periods resulting from this acquisition.  Therefore, our discussion of gross margin percentage, R&Dexpense and SG&A expense expectations will be done on a non-GAAP basis.

 

Excluding non-cash charges for stock compensationexpense, we expect our gross margin percentage in the second quarter of 2003 toincrease 2% - 3% from the first quarter of 2003 as a result of a shift inproduct mix to products with higher gross margins and improved yields andproduct quality, offset somewhat by declines in average selling prices andlower licensing revenue, for which there is no associated cost of sales.  .

 

Excluding non-cash charges for stock compensationexpense, we expect the dollar amount of our R&D expense to increase in thesecond quarter of 2003 by approximately 5% - 7% from the first quarter of 2003.R&D expense will be incurred for enhancements to existing products and forfurther development of technology related to consumer electronics and storageapplications. Excluding non-cash charges for stock compensation expense, weexpect SG&A expense to increase in the second quarter of 2003 byapproximately 5% from the first quarter of 2003, primarily as a result of ourscheduled implementation of a new enterprise resource planning software system

 

We expect to incur substantial non-cash stock compensationexpense in 2003 and future periods as a result of previous stock optionrepricings, stock options assumed in connection with acquisitions, the issuanceof stock options to consultants, and modifications to stock options. We mayalso incur non-cash stock compensation expense in connection with recent orfuture acquisitions. The amount of stock compensation expense in each periodwill fluctuate with changes in our stock price and volatility.  Since the amount of stock compensationexpense or benefit is highly dependent on fluctuations in our stock price, itis not possible for us to reasonably estimate the amount of

 

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expense we will incur for a particular period.  Additionally, we recently completed anacquisition that will affect the amount of our stock compensation for thesecond quarter of 2003.  Since we are inthe early stages of allocating the purchase price to the various assets andliabilities acquired, including unearned stock compensation, it is not possibleto reasonably estimate the effect of the acquisition on the amount of stockcompensation expense we will incur for the second quarter of 2003.

 

Because of our recent acquisition of TransWarp, wewill also incur expenses in the second quarter of 2003 for in-process researchand development and amortization of intangible assets.  These expenses are also not reasonablyestimable at this time due to the fact that we are still in the early stages ofallocating the purchase price to these items. During 2003 and future periods, we may also incur non-cash expenses forthe impairment of intangible assets, which is something we cannot reasonablypredict or estimate at this time.

 

We will also incur legal fees in the second quarter of2003 in conjunction with our patent infringement lawsuit against GenesisMicrochip (Genesis). The amount of legal fees incurred will depend on thenature and extent of the litigation activities. We are not able to accuratelyestimate the amount of legal fees we will incur with respect to this matter;however, we do expect to incur substantial legal expenses through at least thesecond quarter of 2003.

 

During the first quarter of 2003, we reorganized ourcompany into lines of business and incurred $1.0 million of restructuringexpense.  We may incur additionalrestructuring expenses in the second quarter of 2003 associated with thisreorganization or with changes in estimates relative to our leased facilityspace available for sublease.  We cannotreasonably predict the amount of these expenses at this time.

 

**Commitments, Contingencies and Concentrations**

 

In September 1998, we entered into an agreement withIntel to develop and promote the adoption of a digital display interfacespecification. In connection with this agreement, we granted Intel a warrant topurchase 285,714 shares of our common stock at $1.75 per share. Under the sameagreement, we granted Intel a warrant to purchase 285,714 shares of our commonstock at $0.18 per share upon achievement of a specified milestone that wasreached during the first quarter of 1999. Both of these warrants were exercisedin May 2001. Additionally, if a second specified milestone is achieved, whichwe do not believe is likely, we would be required to grant Intel a third warrantto purchase 285,714 shares of our common stock at $0.18 per share. Theestimated fair value of the warrant at March 31, 2003 was $1.1 million.

 

Historically, a relatively small number of customersand distributors have generated a significant portion of our revenue. Forinstance, our top five customers, including distributors, generated 40% of ourrevenue in the first quarter of 2003 and 41% of our revenue in 2002.  Additionally, the percentage of revenuegenerated through distributors tends to be significant, since many OEM’s relyupon third party manufacturers or distributors to provide purchasing andinventory management functions. In the first quarter of 2003, 36% of ourrevenue was generated through distributors, compared to 42% in 2002. Ourlicensing revenue is not generated through distributors, and to the extentlicensing revenue increases faster than product revenues, we would expect adecrease in the percentage of our revenue generated through distributors.

 

A significant portion of our revenue is generated fromproducts sold overseas. Sales to customers in Asia, including distributors,generated 71% of our revenue in the first quarter of 2003 and 64% of ourrevenue in 2002. The reason for our geographical concentration in Asia is thatmost of our products are part of flat panel displays, graphic cards andmotherboards, the majority of which are manufactured in Asia. The percentage ofour revenue derived from any country is dependent upon where our end customerschoose to manufacture their products. Accordingly, variability in ourgeographic revenue is not necessarily indicative of any geographic trends, butrather is the combined effect of new design wins and changes in customermanufacturing locations. All revenue to date has been denominated in U.S.dollars.

 

**RecentAccounting Pronouncements**

 

In June 2002, the Financial Accounting Standards Board(“FASB”) issued Statement of Financial Accounting Standards No. 146 (SFAS No.146), Accounting for Costs Associated with Exit or Disposal Activities. SFAS No.146 addresses issues regarding the recognition, measurement and reporting ofcosts associated with exit and disposal

 

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activities, including restructuring activities, costs related toterminating a contract that is not a capital lease and termination benefitsprovided under a one-time benefit arrangement to involuntarily terminatedemployees. SFAS No. 146 requires that an expense associated with an exit ordisposal activity be recognized when a liability is incurred, and that fairvalue be used for the initial measurement of the liability. SFAS No. 146 iseffective for all exit or disposal activities that are initiated after December31, 2002. The restructuring charge we recorded in the first quarter of 2003 wasrecognized in accordance with SFAS No. 146. The adoption of SFAS No. 146 didnot have a significant effect on our results of operations or financialcondition.

 

In November 2002, the FASB issued Interpretation No.45 (Interpretation 45), “Guarantor’s Accounting and Disclosure Requirements forGuarantees, Including Guarantees of Indebtedness of Others. Interpretation 45clarifies disclosure, recognition and measurement requirements related tocertain guarantees. The disclosure requirements are effective for financialstatements issued after December 15, 2002 and the recognition and measurementrequirements are effective for guarantees issued or modified after December 31,2002. The adoption of Interpretation 45 did not have a significant effect on ourresults of operations or financial condition. Refer to Note 4 for the requiredwarranty disclosure.

 

In December 2002, the FASB issued Statement ofFinancial Accounting Standards No. 148 (SFAS No. 148), “Accounting forStock-Based Compensation—Transition and Disclosure”. SFAS No. 148 amends SFASNo. 123, “Accounting for Stock-Based Compensation”, to provide alternativemethods of transition for a voluntary change to the fair value based method ofaccounting for stock-based employee compensation. In addition, SFAS No. 148amends the disclosure requirements of SFAS No. 123 to require prominentdisclosures in both annual and interim financial statements about the method ofaccounting for stock-based employee compensation and the effect of the methodused on reported results. The transition guidance and annual disclosureprovisions of SFAS No. 148 are effective for fiscal years ending after December15, 2002. The interim disclosure provisions of SFAS No. 148 are effective forinterim periods beginning after December 15, 2002. We adopted the disclosurerequirements of SFAS No. 148 on December 31, 2002.

 

**Results of Operations for the ThreeMonths Ended March 31, 2003 Compared to Results of Operations for the ThreeMonths Ended March 31, 2002**

 

*Revenue*.  Revenue was $24.7 million for the firstquarter of 2003, an increase of 44% from the year ago quarter.  Of this increase, $4.5 million can beattributed to licensing of our intellectual property, which first became partof our business strategy in late 2001 when we decided to license our technologyin order to complement our product strategy and to enable markets for newstandards we were developing.  Theremainder of the increase is primarily attributable to our new product offeringsin consumer electronics and storage, as well as overall growth in thesemarkets. The effect of these increases was partially offset by a decrease indemand for our PC products, which can be attributed to a weak PC market,competition and some level of integration of our technology by our customerswhich eliminates the need for our discrete devices.

 

*Costof revenue*.  Cost ofrevenue consists primarily of costs incurred to manufacture, assemble and testour products, as well as related overhead costs and provisions for excess andobsolete inventories. Cost of revenue excludes non-cash stock compensationexpense (benefit) of $(135,000) and $923,000 for the first quarter of 2003 and2002, respectively.  Including stockcompensation and warrant expense, our cost of revenue and gross margin (revenueminus cost of revenue, as a percentage of revenue) would have been $11.1million or 55.2%, and $9.4 million or 44.9%, for the first quarters of 2003 and2002, respectively.  Gross margin,excluding non-cash stock compensation expense, increased to 54.7% for the firstquarter of 2003, from 50.3% for the first quarter of 2002. The increase ingross margin was primarily due to the shift in our overall product revenue,whereby license revenue, which has no associated cost of sales, was 20% of ourrevenue in the first quarter of 2003, compared to only 3% of our revenue in thefirst quarter of 2002.  This was offsetby an increase in sales of our storage products in the first quarter of 2003,which are lower margin products, and higher manufacturing costs of $1.0million, including a $600,000 provision against inventories, in the firstquarter of 2003 associated with lower than expected yields and lack ofautomated testing for recently-introduced products.  We expect to resolve some of the manufacturing yield and testissues during the second quarter of 2003, and to reduce our manufacturing costsby approximately $0.5 million in the second quarter of 2003 as a result.

 

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*Researchand Development*. R&D consists primarily of compensation and related costs foremployees, fees for independent contractors and prototypes. R&D excludesnon-cash stock compensation expense of $127,000 and $5.9 million for the firstquarters of 2003 and 2002, respectively. Including stock compensation expense,R&D would have been $9.0 million and $13.3 million, or 36% and 78%, ofrevenue for the first quarters of 2003 and 2002, respectively.  R&D, excluding non-cash stockcompensation expense, was $8.8 million, or 36% of revenue, for the firstquarter of 2003, and $7.4 million, or 43% of revenue, for the first quarter of2002. The increase in absolute dollars was primarily due to an increase in thenumber of R&D projects to support the multiple markets in which we operate,as well as to additional personnel, as headcount increased from 102 at March31, 2002 to 128 for the three months ended March 31, 2003.

 

*Selling,General and Administrative*. SG&A consists primarily of employee compensation and benefits, salescommissions, and marketing and promotional expenses.  SG&A excludes non-cash stock compensation expense (benefit)of ($354,000) for the first quarter of 2003 and $3.6 million for the firstquarter of 2002. Including stock compensation and warrant expense, SG&Aexpense would have been $4.0 million and $8.5 million, or 16% and 50% ofrevenue, for the first quarters of 2003 and 2002, respectively. Excludingnon-cash stock compensation expense, SG&A was $4.3 million, or 17% ofrevenue, for the first quarter of 2003, and $4.9 million, or 29% of revenue,for the first quarter of 2002.  Thedecrease in absolute dollars was primarily due to reduced headcount, asheadcount decreased from 99 at March 31, 2002 to 77 at March 31, 2003.

 

*StockCompensation Expense*. Stock compensation expense (benefit) was ($362,000), or 1% of revenue,for the first quarter of 2003, and $10.5 million, or 61% of revenue, for thefirst quarter of 2002. The decrease in expense can be attributed primarily to adecline in our stock price as of March 31, 2003, versus our stock price atMarch 31, 2002.  The amount of stockcompensation expense we recognize in connection with repriced stock options isdependent on changes in our stock price. The following table summarizes the components of our stock compensationand warrant expense for the first quarters of 2003 and 2002 (in thousands).

 
|                                                 |   | **Three Months Ended  March 31,** |   |
|------------------------------------------------------|--------|-----------------------------------|--------|
|                                                 |   | **2003**                          |   | **2002** |   |
|                                                 |   |                              |   |   |   |
| Options granted prior to our initial public offering |   | $                                 | 222    |   | $ | 437 |   |
| Options granted to non-employees                     |   | 359                               |   | 601 |   |
| Option repricings                                    |   | (1,358                            | )      | 7,932 |   |
| Options assumed in connection with acquisitions      |   | 415                               |   | 1,481 |   |
|                                                 |   | $                                 | (362   | ) | $ | 10,451 |   |

 

We will incur substantial non-cash stock compensationexpense in future periods as a result of (1) the issuance of, or modificationsto, restricted stock awards and stock option grants to employees andnon-employees, (2) the option repricing programs we implemented in 2000 and2001, and (3) amortization of our existing unearned compensation balance.  Since the expense associated with our optionrepricing and grants to non-employees is dependent on our stock price andvolatility, it will fluctuate from period to period and may increasesignificantly.

 

*Amortizationof Intangible Assets*. We did not record any expense in the first quarter of 2003 for amortizationof intangible assets.  This is due tothe fact that our intangible assets subject to amortization were fullyamortized as of December 31, 2002.  Forthe first quarter of 2002, we recorded $909,000 of expense for the amortizationof intangible assets recorded in connection with our acquisitions.

 

*Restructuring.*During the first quarter of 2002, we implemented a secondworkforce reduction in connection with the program we began in the thirdquarter of 2001, eliminating 35 positions or 13% of our workforce.  Positions were eliminated from allfunctional areas – operations, R&D and SG&A.  This reduction resulted from the continued integration ofrecently acquired companies, as well as continued execution of our product andtechnology strategy, whereby we decided to phase out the legacy storagesubsystem board products we acquired from CMD and to develop new board productsonly if we believed it would facilitate or accelerate the use of our storagesemiconductor products.  In connectionwith this workforce reduction, we recorded restructuring expense in the firstquarter of 2002 of $2.2 million, consisting of cash severance-related costs of$198,000, non-cash

 

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severance-related costs of $318,000 representing the intrinsic value ofmodified stock options, an expected loss on leased facilities of $1.2 millionand fixed asset write-downs of $500,000 for assets to be disposed of. Inaddition, we reversed $76,000 of unearned compensation, a component of stockholders’equity, for unvested stock options that were cancelled in connection withemployee terminations.  Since some ofthe affected employees had termination dates in the second quarter of 2002, werecorded additional expense at that time for the modification of their stockoptions.

 

In March 2003, we reorganized the company into linesof business for PC, CE and Storage products to enable us to better manage ourlong-term growth potential.  Inconnection with this reorganization, we reduced our workforce by 27 people, orapproximately 10%.  These reductionswere primarily in R&D and operations functions.  Because of this workforce reduction, we recorded a restructuringexpense of $1.0 million 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.

 

Severance-related costs were determined based on theamount of pay people received that was not for services performed and bymeasuring the intrinsic value of stock options that were modified to thebenefit of terminated employees.  Theexpected loss on leased facilities resulted from our plan to consolidate ourremaining workforce to the extent practicable and sublease any excessspace.  To determine the expected loss,we compared our lease and operating costs for the space to our estimate of thenet amount we would be able to recover by subleasing the space.  This estimate was based on a number ofassumptions, including the length of time it will take to secure a tenant, thesublease rate per square foot, the cost of necessary improvements ormodifications and real estate broker commissions.  The fixed asset write-down was determined based on the estimatedfair value of assets, primarily computer hardware and software that would nolonger be utilized after the employees’ termination date.

 

We expect severance and benefits payments to becompleted by the second quarter of 2003. Lease payments will be made in theform of cash through the end of the related lease terms of July 2003 andNovember 2005. The following table presents restructuring activity for 2001though March 31, 2003 (in thousands).

 
|                             |   | **Severance  and Benefits** |   | **Leased  Facilities** |   | **Fixed  Assets** |   | **Total** |   |
|----------------------------------|--------|-----------------------------|--------|------------------------|--------|-------------------|--------|-----------|--------|
| 2001  provision                  |   | $                           | 902    |                   | $      | 500               |   | $         | 50     |   | $ | 1,452 |   |
| Cash  payments                   |   | (191                        | )      | —                 |   | —            |   | (191      | )      |
| Non-cash  activity               |   | (303                        | )      | (115                   | )      | —            |   | (418      | )      |
| Balance  as of December 31, 2001 |   | 408                         |   | 385                    |   | 50                |   | 843       |   |
| 2002  provision                  |   | 2,547                       |   | 2,633                  |   | 2,013             |   | 7,193     |   |
| Cash  payments                   |   | (865                        | )      | (420                   | )      | —            |   | (1,285    | )      |
| Non-cash  activity               |   | (1,952                      | )      | —                 |   | (2,063            | )      | (4,015    | )      |
| Balance  as of December 31, 2002 |   | 138                         |   | 2,598                  |   | —            |   | 2,736     |   |
| 2003  provision                  |   | 986                         |   | —                 |   | —            |   | 986       |   |
| Cash  payments                   |   | (24                         | )      | (170                   | )      | —            |   | (194      | )      |
| Non-cash  activity               |   | (646                        | )      | —                 |   | —            |   | (646      | )      |
| Balance  as of March 31, 2003    |   | $                           | 454    |                   | $      | 2,428             |   | $         | — |   | $ | 2,882 |   |

 

As of March 31, 2003 and December 31, 2002, 31 and 4terminated employees, respectively, had not yet received their severancepayments.

 

*Patentdefense and acquisition integration costs*.  Patent defense and acquisition integrationcosts were $1.2 million for the first quarter of 2003, compared to $706,000 forthe first quarter of 2002.  Patentdefense costs are related to the lawsuit we filed against Genesis Microchip inApril 2001, and acquisition integration costs represent costs incurred tointegrate CMD and SCL.  The increase canbe attributed to increased activity relative to the Genesis lawsuit in thefirst quarter of 2003.

 

*InterestIncome and other, net*. Interest income and other, net decreased to $109,000 for the firstquarter of 2003, from $270,000 for the first quarter of 2002. The decrease isdue to lower interest rates and a $7.4 million decrease in our cash andinvestment balances.

 

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*Provisionfor Income Taxes*. We generated book income in the firstquarter of 2003; however, the gain on escrow settlement is a non-taxable eventand therefore we did not generate taxable income in the first quarter of2003.  We did not record a provision forincome tax in the first quarter of 2002 due to our taxable loss in thatquarter.

 

At March 31, 2003, we had a net operating losscarryforward for federal income tax purposes of approximately $64.0 millionthat expires in various years through 2022. These future tax benefits have not been recognized as an asset on ourbalance sheet due to uncertainties surrounding our ability to generatesufficient taxable income in future periods to realize the benefits.  Under the Tax Reform Act of 1986, theamounts of, and benefits from, net operating loss carryforwards may berestricted or limited in certain circumstances. We do not expect to be subjectto these restrictions or limitations.

 

*Gain onescrow settlement, net. *Werecorded a net gain of $4.6 million, net of legal expenses, in the firstquarter of 2003 in connection with the settlement of the CMD escrow claim, asdiscussed in Note 8 to the accompanying unaudited condensed consolidatedfinancial statements.

 

**Liquidity and Capital Resources**

 

At March 31, 2003, we had $28.7 million of workingcapital and $31.5 million of cash, cash equivalents and short-term investments.

 

Operating activities used $5.2 million of cash duringthe first quarter of 2003 and $4.1 million of cash during the first quarter of2002.  During the first quarter of 2003,our net loss excluding depreciation, stock compensation expense, a non-cashgain on escrow settlement and the non-cash portion of our restructuring chargeswas $230,000, which accounts for some of the cash used in operating activities.  Other uses of cash for operating activitiesconsisted of decreases in accounts payable and accrued liabilities of $4.1million, and an increase in accounts receivable of $2.0 million.  These uses of cash were somewhat offset by a$409,000 decrease in prepaid expenses and other assets.  During the first quarter of 2002, net lossexcluding depreciation, stock compensation expense, amortization of intangibleassets and the non-cash portion of restructuring charges was $4.5 million,which accounted for most of the cash used in operating activities.  Decreases in accounts payable and accruedexpenses used $677,000 of cash and an increase in inventories used $377,000 ofcash.  These uses were somewhat offsetby an increase in deferred margin of $906,000 and a decrease in prepaidexpenses and other assets of $570,000.

 

We generated $1.8 million of cash from investingactivities during the first quarter of 2003 and $2.8 million during the firstquarter of 2002.  The source of cash inboth periods was net proceeds from sales of short-term investments, partiallyoffset by capital expenditures.

 

Financing activities provided $2.1 million of cash inthe first quarter of 2003 and $2.4 million in the first quarter of 2002. Cashprovided by financing activities in both periods was primarily from stockoption exercises and proceeds from sales of shares under our employee stockpurchase plan, partially offset by repayments of our capital leases and otherobligations.

 

Our contractual obligations at March 31, 2003, and theeffect such obligations are expected to have on our liquidity and cash flow infuture periods, have not changed materially since December 31, 2002, asdescribed in our Form 10-K for the year ended December 31, 2002. As of March31, 2003, we were in compliance with all of our financial covenants. However,since we were not in compliance at December 31, 2002, and cannot be assured wewill be in compliance in the future, we have classified all amounts outstandingunder the credit agreement as current liabilities as of March 31, 2003.

 

We believe our existing cash balance is sufficient tomeet our capital and operating requirements for at least the next12 months based on our business plan. Operating and capital requirementsdepend on many factors, including the levels at which we generate revenue andmaintain margins, inventory and accounts receivable, the cost of securingaccess to adequate manufacturing capacity and our operating expenses. To theextent existing resources and cash from operations are insufficient to supportour activities, we may need to raise additional funds through public or privateequity or debt financing. These funds may not be available, or if available, wemay not be able to obtain them on terms favorable to our stockholders or us.

 

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**Factors Affecting Future Results**

 

*Youshould carefully consider the following risk factors, together with all otherinformation contained or incorporated by reference in this filing, before youdecide to purchase shares of our common stock. These factors could cause ourfuture results to differ materially from those expressed in or implied byforward-looking statements made by us. Additional risks and uncertainties notpresently known to us or that we currently deem immaterial may also harm ourbusiness. The trading price of our common stock could decline due to any ofthese risks, and you may lose all or part of your investment.*

 

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

 

The revenue and income potential of our business andthe markets we serve is unproven. We began volume shipments of our firstdisplay products in the third quarter of 1997. The Digital Visual Interface(DVI) specification, which is based on technology developed by us and used inmany of our products, was first published in April 1999. The DVI specificationdefines a high-speed data communication link between computers and digitaldisplays, such as flat panel displays, projectors and cathode ray tubes. 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 Multimedia Interface(HDMI) specification was first released in December 2002. Accordingly, we facerisks and difficulties frequently encountered by early-stage companies in newand rapidly evolving markets. If we do not successfully address these risks anddifficulties, our results of operations could be negatively affected.

 

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

 

We have incurred net losses in each fiscal year sinceour inception, including losses of $40.1 million and $76.1 million for theyears ended December 31, 2002 and 2001, respectively. We expect to continue toincur net losses for the foreseeable future. Accordingly, we may not achieveand sustain profitability.

 

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

 

Our quarterly operating results are likely to varysignificantly in the future based on a number of factors over which we havelittle 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;

 

•                  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;

 

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

 

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

 

•                  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;

 

•                  thefact that our licensing revenue is heavily dependent on a few key deals beingcompleted, the timing of which is not always predictable and is especiallysusceptible to delay beyond the period in which they are expected, and ourconcentrated dependence on a few licensees for substantial portions of ourexpected licensing revenue;

 

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•                  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; and

 

•                  thenature and extent of litigation activities, particularly our patentinfringement suit against Genesis.

 

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

 

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

 

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

 

•                  ourability to manage product introductions and transitions;

 

•                  ourability to successfully manage our entry into new markets such as storage andconsumer electronics;

 

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

 

•                  ourability to close licensing deals and make deliverables and milestones on whichrecognition of revenue often depends;

 

•                  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 our business, thiscould adversely affect our results of operations.

 

**The licensing component of our business strategy may not besuccessful.**

 

Part of our business strategy is to license certain ofour technology to companies that address markets in which we do not want todirectly participate. We have limited experience marketing and selling ourtechnology on a licensing basis. In conjunction with the business strategy weadopted in late 2001, we signed our first license contract in December 2001,and have signed numerous more since then; however, there can be no assurancethat additional companies will be interested in licensing our technology oncommercially favorable terms or at all. We also cannot ensure that companieswho license our technology will introduce and sell products incorporating ourtechnology, will accurately report royalties owed to us, will pay agreed uponroyalties, will not infringe upon or misappropriate our intellectual propertyand will maintain the confidentiality of our proprietary information. Licensingrevenue is heavily dependent on a few key deals being completed, the timing ofwhich is not always predictable and is especially susceptible to delay beyondthe period in which they are expected. Also, generating revenue from licensingarrangements is a lengthy and complex process that may last beyond the periodin which efforts begin, and once an agreement is in place, the timing of revenuerecognition may be dependent on customer acceptance of deliverables,achievement of milestones, and other factors. In addition, in any period, ourexpectation of licensing revenue is or may be dependent on one or a fewlicenses being completed. Due to these factors, the amount of license revenuerecognized in any period may differ significantly from our expectations.

 

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**Our strategic restructuring program may not be successful.**

 

During the third quarter of 2001, we began a programto focus our business on products and technology, including those obtainedthrough acquisitions, in which we have, or believe we can achieve, a leadershipposition. As part of this program, we decided to cancel numerous products underdevelopment, to remove certain projects from our development plan, to phase outor de-emphasize certain existing products, to license our technology tocompanies that participate in markets we do not address and to integrate theoperations of our two recently acquired companies, CMD and SCL. In particular,we intend to concentrate on our discrete transmitter and receiver products forPCs and displays, and on developing products and promoting adoption of the HDMIand serial ATA standards for the consumer electronics and storage markets,respectively. Additionally, in the second quarter of 2002, we transitioned to alicensing model for our storage systems business and are therefore phasing outour board level products through the middle of 2003. We expect that we willcontinue to generate revenue from sales of products being phased out orde-emphasized for a limited period of time and that costs for selling andmarketing these products will be minimal due to the limited resources allocatedfor this purpose. However, if demand for these products is not sufficient touse our existing inventory, we may incur charges for excess and obsoleteinventory. Products to be phased out or de-emphasized represented approximately25% of our revenue in 2001 and 10% of our revenue for the year ended December31, 2002. In connection with this program, we have implemented three workforcereductions eliminating 109 positions, or 36% of our third quarter 2001workforce, and have recorded restructuring expense of $8.6 million.  In addition, we reduced our workforce by 27people, or approximately 10%, in the first quarter of 2003 in connection with arealignment of our company into lines of business.  In connection with this workforce reduction, we recorded $1.0million of restructuring expense in the first quarter of 2003.

 

There is no guarantee that our strategic restructuringprogram or reorganization will be successful. The markets in which we arepromoting new technologies and standards are still developing and evolving, andthere can be no assurance as to the rate or extent of adoption of these newtechnologies and standards.

 

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

 

The PC, CE and storage markets in which we operate areintensely competitive. These markets are characterized by rapid technologicalchange, evolving standards, short product life cycles and declining sellingprices. Our display products face competition from a number of sources, includinganalog solutions, DVI-based solutions, dual (analog and DVI based) solutionsand other digital interface solutions. We expect competition in the displaymarket to increase. For example, Analog Devices, ATI, Broadcom, Chrontel,Genesis Microchip, Matrox, National Semiconductor, nVidia, Phillips,Pixelworks, SIS, Smart ASIC, ST Microelectronics, Texas Instruments and Thinehave all begun shipping products or announced intentions to introduce productsthat we expect will compete with our PanelLink products. Other companies haveannounced DVI-based solutions and we expect that additional companies arelikely to enter the market. In the future, our current or potential customersmay also develop their own proprietary solutions that would likely be the integrationof a DVI transmitter into a graphics processing unit or integration of a DVIreceiver into a monitor controller.

 

In the CE market, our digital interface products areused to connect cable set-top boxes, satellite set-top boxes and DVD players todigital televisions. These products incorporate DVI and HDCP, or HDMI with orwithout HDCP support. Companies that have announced or are shipping DVI-HDCPsolutions include TI, Thine, Broadcom and Genesis. In addition, our videoprocessing products face competition from products sold by AV Science,Broadcom, Focus Enhancements, Genesis, Mediamatics, Micronas Semiconductor,Oplus, Philips, Pixelworks and Trident. We also compete, in some instances,against in-house processing solutions designed by large original equipmentmanufacturers. We expect competition for HDMI products from the other HDMIfounders and adopters, including Hitachi, Matsushita, Philips, Sony, Thomsonand Toshiba.

 

In the storage market, our Fibre Channel product facescompetition from companies selling similar discrete products, includingAgilent, PMC Sierra and Vitesse, from other Fibre Channel SerDes providers wholicense their core technology, such as LSI Logic, and from companies that sellHBA controllers with integrated SerDes, such as QLogic and Agilent. In thefuture, our current or potential customers may also develop their ownproprietary solutions that may include integration of SerDes.

 

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Our serial ATA products compete with similar productsfrom Marvell and Promise. In addition, other companies such as Adaptec, APT,Intel, LSI Logic, ServerWorks and Vitesse, have developed or announcedintentions to develop serial ATA controllers. We also may compete against Inteland other motherboard chip-set makers that may integrate serial ATAfunctionality into their chipsets; in fact, Intel has announced its intentionto integrate this functionality into one of its upcoming chip sets.

 

Our parallel ATA products compete with IC vendorsincluding Promise and Highpoint. Our RAID controller board products facecompetition from Mylex, Infortrend, and Chaparral.

 

Some of these competitors have already establishedsupplier or joint development relationships with current or potential customersand may be able to leverage their existing relationships to discourage thesecustomers from purchasing products from us or persuade them to replace ourstorage products with theirs. Many of our competitors have longer operatinghistories, greater presence in key markets, better name recognition, access tolarger customer bases and significantly greater financial, sales and marketing,manufacturing, distribution, technical and other resources than we do. Inaddition, some of our competitors could merge which may enhance their marketpresence. As a result, they may be able to adapt more quickly to new oremerging technologies and customer requirements, or devote more resources tothe promotion and sale of their products. We cannot assure you that we cancompete successfully against current or potential competitors, or thatcompetition will not reduce our revenue and increase our losses.

 

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

 

Our success is largely dependent upon the rapid andwidespread adoption of the DVI specification, which defines a high-speed datacommunication link between computers and digital displays. We cannot predictthe rate at which manufacturers of computers and digital displays will adoptthe DVI specification. To date, relatively few systems implementing all of theelectrical and mechanical aspects of the DVI specification have been shipped.The DVI adoption rate in the PC market increased to 12% in 2002, from 7% in2001. Adoption of the DVI specification may be affected by the availability ofcomputer components able to communicate DVI-compliant signals, such astransmitters, receivers, connectors and cables necessary to implement thespecification. Other specifications may also emerge that could adversely affectthe acceptance of the DVI specification. For example, a number of companieshave promoted alternatives to the DVI specification using other interfacetechnologies, such as low voltage differential signaling, or LVDS. Furtherdelays in the widespread adoption of the DVI specification could reduceacceptance of our products, limit or reduce our revenue growth and increase ourlosses.

 

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

 

Our success in the consumer electronics market islargely dependent upon the rapid and widespread adoption of the HDMI 1.0specification, which combines high-definition video and multi-channel audio inone digital interface and uses our patented underlying TMDS technology, andoptionally Intel’s HDCP technology, as the basis for the interface. Version 1.0of the specification was published for adoption on December 9, 2002. We cannotpredict the rate at which manufacturers will adopt the HDMI specification or ifthe specification will be adopted at all. Adoption of the HDMI specificationmay be affected by the availability of consumer products, such as DVD playersand televisions, and of computer components that implement this new interface.Other competing specifications may also emerge that could adversely affect theacceptance of the HDMI specification. Delays in the widespread adoption of theHDMI specification could reduce acceptance of our products, limit or reduce ourrevenue growth and increase our losses.

 

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

 

Our success depends on increasing sales of ourreceiver products to display manufacturers. To increase sales of our receiverproducts, we need computer manufacturers to incorporate DVI-complianttransmitters in their systems, making these systems digital-ready. During 2002,we introduced a low-cost add-in card that can be used in conjunction withIntel’s 845G chip set to provide an all-digital connection to flat panels.Intel’s 845G chip set is

 

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intended to provide an all-digital path on the motherboard bus, andshould make it easier to provide digital video out. Use of Intel’s 845G chipset, or any digital path chip set, is not universal and may not gain marketacceptance. If computers are not digital-ready, they will not operate withtheir digital displays, which will limit and may reduce the demand for ourdigital host and receiver products.

 

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

 

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

 

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

 

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

 

•                  Webelieve that Intel has the power to drive adoption of DVI, serial ATA and HDMI,by making them widely available in its chip sets and motherboards, which couldnegatively affect demand for 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 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 topositive benefits if managed effectively. If our relationship with Intel is notmanaged effectively, it could seriously harm our business, negatively affectour revenue, and increase our operating expenses.

 

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

 

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

 

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

 

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•                  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 must be widely available and affordable to consumers. In thepast, the supply of digital displays, such as flat panels, has been cyclicaland consumers have been very price sensitive. Also, some manufacturers have implementedDVI interfaces that are not fully DVI-compliant. These interfaces ofteninterfere with 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 fully DVI-compliant interfaces.

 

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

 

Our product development efforts in the storage marketare focused on the development of products using new interface technologiessuch as fibre channel and serial ATA. The markets for these new interfacetechnologies are at an early stage of development, and there can be noassurance that they will replace other storage interfaces that are now widelyused, such as parallel ATA and SCSI. The potential size and rate of developmentof these markets are uncertain 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;

 

•                  whetherIntel or other motherboard manufacturers integrate the functionality of ourproducts, such as serial ATA, into their chips and chip sets; 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.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Because our products are based on new technology andstandards, a lengthy sales process, typically requiring several months or more,is often required before potential customers begin the technical evaluation ofour products. This technical evaluation can exceed nine months, and it can thenbe an additional nine months before a customer commences volume shipments ofsystems incorporating our products, if at all. Given our lengthy sales cycle,we may experience a delay between the time we incur expenditures and the timewe generate revenue, if any. As a result, our operating results could beseriously harmed if a significant customer reduces or delays orders, or choosesnot to release products incorporating our products.

 

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

 

Historically, a relatively small number of customersand distributors have generated a significant portion of our revenue. For thefirst quarter of 2003, shipments to World Peace International, an Asiandistributor, generated 12% of our revenue and shipments to Weikeng, an Asiandistributor, and Sunplus, a licensee, each generated 10% of our revenue.  For the year ended December 31, 2002,shipments to World Peace International generated 15% of our

 

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revenue and shipments to Weikeng generated 11% of our revenue.  In addition, an end-customer may buy throughmultiple distributors, contract manufacturers, and / or directly, which couldcreate an even greater concentration. We cannot be certain that customers andkey distributors that have accounted for significant revenue in past periods,individually or as a group, will continue to sell our products and generaterevenue. As a result of this concentration of our customers, our results ofoperations could be negatively affected if any of the following occurs:

 

•                  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 select products manufactured by one of ourcompetitors for inclusion in their future product generations.

 

Due to our entrance into new markets, our customerbase has broadened significantly and we therefore anticipate being lessdependent on a relatively small number of customers to generate revenue.However, as product mix may fluctuate from quarter to quarter, we may becomemore dependent on a small number of customers or a single customer for asignificant portion of our revenue in a particular quarter, the loss of whichcould adversely affect our operating results.

 

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

 

Many original equipment manufacturers rely onthird-party manufacturers or distributors to provide inventory management andpurchasing functions. Distributors generated 36% of our revenue in the firstquarter of 2003 and 42% of our revenue for the year ended December 31, 2002.The decrease is as expected as our licensing revenue, which is direct, was ahigher percentage of our revenue in the first quarter of 2003 than it was in2002. 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 disruptor reduce sales of our products.

 

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

 

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

 

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

 

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

 

•                  timelycompletion and introduction of new product designs;

 

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

 

•                  marketacceptance of new products.

 

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

 

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

 

Our growth depends upon market growth and our abilityto enhance our existing products and introduce new products on a timely basis.One of the ways we develop new products and enter new markets is through acquisitionsof other companies. In 2000, we completed the acquisitions of Zillion and DVDO,and in 2001, we completed the acquisitions of CMD and SCL. In April 2003, weacquired TransWarp Networks.  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; and

 

•                  inabilityto commercialize acquired technology.

 

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

 

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

 

In the past, the semiconductor industry has beencharacterized by significant downturns and wide fluctuations in supply anddemand. For example, demand in the semiconductor industry rose to record levelsin 1999, but is currently in a downward cycle. 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 semiconductors fabricated using 0.18 microtechnology could be subject to allocation, whereby not all of our productionrequirements would be met. This may impact our ability to meet demand and couldalso increase our production costs. Cyclicality has also accelerated decreasesin average selling prices per unit. We may experience fluctuations in ourfuture financial results because of changes in industry-wide conditions.

 

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

 

We do not own or operate a semiconductor fabricationfacility. We rely almost entirely on Taiwan Semiconductor Manufacturing Company(TSMC), an outside foundry, to produce all of our display-related semiconductorproducts. We also rely on Kawasaki, UMC and Atmel, who are also outsidefoundries, to produce our storage semiconductor products and we rely on Amkorand ASE to test certain of our semiconductor products. Our reliance onindependent foundries, assembly and test facilities involves a number ofsignificant 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 processtechnologies; and

 

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

 

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

 

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

 

The manufacture of semiconductors is a complexprocess, and it is often difficult for semiconductor foundries to achieveacceptable product yields. Product yields depend on both our product design andthe

 

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manufacturing process technology unique to the semiconductor foundry.Since low yields may result from either design or process difficulties,identifying yield problems can only occur well into the production cycle, whenan actual product exists that can be analyzed and tested.

 

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

 

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

 

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

 

A substantial portion of our business is conductedoutside of the United States, and as a result, we are subject to foreignbusiness, political and economic risks. Nearly all of our products aremanufactured in Taiwan or elsewhere in Asia, and for the three months endedMarch 31, 2003 and year ended December 31, 2002, 73% and 72%, respectively, ofour revenue was generated from customers and distributors located outside ofthe United States, primarily in Asia. We anticipate that sales outside of theUnited States will continue to account for a substantial portion of our revenuein future periods. Accordingly, we are subject to international risks,including, but not limited to:

 

•                  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 Iraq), the SARS epidemic (particularly affecting theAsian markets we serve), and the financial instability and bankruptcy of majorair 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

 

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

 

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

 

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

 

We rely on a combination of patent, copyright,trademark, mask work and trade secret laws, as well as nondisclosure agreementsand other methods, to protect our proprietary technologies. We have been issuedpatents and have a number of pending patent applications. However, we cannotassure you that any patents will be issued as a result of any applications or,if issued, that any claims allowed will protect our technology. In addition, wedo not file patent applications on a worldwide basis, meaning we do not havepatent protection in some jurisdictions. It is possible that existing or futurepatents may be challenged, invalidated or circumvented and effective patent,copyright, trademark and trade secret protection may be unavailable or limitedin foreign countries. It may be possible for a third party to copy or otherwiseobtain and use our products or technology without authorization, developsimilar technology independently or design around our patents in the UnitedStates and in other jurisdictions. It is also possible that some of ourexisting or new licensing relationships will enable other parties to use ourintellectual property to compete against us. Legal actions to enforceintellectual property rights tend to be lengthy and expensive, and the outcomeoften is not predictable. As a result, despite our efforts and expenses, we maybe unable to prevent others from infringing upon or misappropriating ourintellectual property, which could harm our business.

 

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

 

We are a promoter of the Digital Display WorkingGroup, which published and promotes the DVI specification. Our strategyincludes establishing the DVI specification as the industry standard, promotingand enhancing this specification and developing and marketing products based onthis specification and future enhancements. As a result:

 

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

 

•                  wemay license additional intellectual property for free as the Digital DisplayWorking Group promotes enhancements to the DVI specification.

 

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

 

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

 

In April 2002, together with Sony, Philips, Thomson,Toshiba, Matsushita and Hitachi, we announced the formation of a working groupto define the next-generation digital interface specification for consumerelectronics products. Version 1.0 of the specification was published foradoption on December 9, 2002. The HDMI specification combines high-definitionvideo and multi-channel audio in one digital interface and uses Silicon Image’spatented underlying TMDS technology along with Intel’s HDCP as the basis forthe interface. The founders of the working group have signed a founder’sagreement in which each commits to license certain intellectual property toeach other, and to adopters of the specification.

 

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

 

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

 

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

 

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

 

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

 

Securities class action suits are often brought againstcompanies, particularly technology companies, following periods of volatilityin the market 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 the prospectus relatedto our initial public offering was misleading because it failed to disclosethat the underwriters of our initial public offering had solicited and receivedexcessive commissions from certain investors in exchange for agreements byinvestors to buy our shares in the aftermarket for predetermined prices. Due toinherent uncertainties in litigation, we cannot accurately predict the outcomeof this litigation. We believe that these claims are without merit and we intendto defend vigorously against them.  Weand certain of our officers, together with certain investment banks and theircurrent or former employees have been named as defendants in a securities classaction suit filed against us on behalf of a putative class of shareholders whopurchased stock from some or all of approximately 50 issuers whose publicofferings were underwritten by Credit Suisse First Boston. The lawsuit allegesthat Silicon Image and certain officers were part of a scheme by Credit SuisseFirst Boston to artificially inflate the price of Silicon Image’s stock throughthe dissemination of allegedly false analysts’ reports. We believe that theseclaims are without merit and we intend to defend vigorously against them.However, these claims and any other that may be brought, even if meritless,could require us to incur expenses and could divert our management’s attentionand resources. In addition, any unfavorable outcome of either of theselitigations could adversely impact our business, financial condition andresults of operations.

 

**We are currently engaged in intellectual property litigationthat is time-consuming and expensive to prosecute. We may become engaged inadditional intellectual property litigation that could be time-consuming,**

 

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**maybe be expensive to prosecute or defend, and couldadversely affect our ability to sell our product.**

 

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

 

In April 2001, we filed suit against Genesis Microchipfor infringement of one of our U.S. patents. At that time, we also filed acomplaint against Genesis for unlawful trade practices related to theimportation of articles infringing our patent. In February 2002, our motion todismiss the unlawful trade practices complaint was granted and we filed anamended complaint against Genesis alleging infringement of two of our U.S.patents. These patents relate to our DVI receiver products, which generate asignificant portion of our revenue. The amended complaint seeks a declarationthat Genesis has infringed our patents, that Genesis’s behavior is notlicensed, an injunction to halt the importation, sale, manufacture and use ofGenesis DVI receiver chips that infringe our patents, and monetary damages. InApril 2002, Genesis answered and made counterclaims against us fornon-infringement, license, patent invalidity, fraud, antitrust, unfaircompetition and patent misuse. We filed a motion to dismiss certain ofGenesis’s counterclaims. In addition, we filed a motion to bifurcate trial ofthe counterclaims to the extent the court does not dismiss them. In May 2002,the Court granted our motion to dismiss certain of the counterclaims, withleave to amend. Genesis re-filed counterclaims against us for fraud and patentmisuse. We filed another motion to dismiss these counterclaims. In August 2002,the Court granted our motion and dismissed Genesis’s re-filed counterclaimswith prejudice. In September 2002, we filed a motion for summary judgment, uponwhich the Court has yet to rule. In October 2002, both parties filed severalmore motions for summary judgment, upon which the Court has yet to rule.Several dispositive motions have subsequently been filed under seal and wereheard by the Court in March 2003; the Court has yet to rule on these motions.Depending on the outcome of such motions, a trial date may be set, the case maybe dismissed, or other orders may be entered. We intend to prosecute ourposition vigorously until this matter is resolved.

 

There can be no assurance that we will prevail in thislitigation. While this litigation is pending, Genesis can use the technologycovered by these patents to develop products that might compete with ours. Ifwe are unsuccessful in this litigation, we could be unable to prevent Genesisor others from using the technology covered by this patent. Even if we doprevail in this litigation, uncertainties regarding the outcome prior to thattime may reduce demand for our products. In addition, disputes may occurregarding whether any intellectual property licenses were granted and the scopeof any such licenses, based on our interactions in various standards bodies,including the Digital Display Working Group and for HDMI. These disputes mayresult in additional costly and time-consuming litigation or the license ofadditional elements of our intellectual property for free.

 

Any potential intellectual property litigation againstus could also force 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

 

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•                  attemptto redesign products that contain the allegedly infringing intellectualproperty.

 

If we are forced to take any of these actions, we maybe unable to manufacture and sell our products. We may be exposed to liabilityfor monetary damages, the extent of which would be very difficult to accuratelypredict. In addition, we may be exposed to customer claims, for potentialindemnity obligations, and to customer dissatisfaction and a discontinuance ofpurchases of our products while the litigation is pending. Any of theseconsequences could substantially harm our business and results of operations.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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In the last two fiscal years and in the first quarterof 2003, we implemented mandatory company-wide shutdowns. Although theseshutdown periods represent a cost savings to us, they may be perceivednegatively by our customers, vendors and employees. We currently intend toimplement a company-wide shutdown during the second half of 2003. In addition,we may continue to implement company-wide shutdowns in future periods, whichmay negatively impact employee morale or the perception of our company by ourcustomers and vendors. If we elect not to implement these shutdowns, ouroperating expenses will increase.

 

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

 

In connection with the restructuring program we beganin the third quarter of 2001 to focus our business on products and technologyin which we have, or believe we can achieve, a leadership position, and thereorganization of the company in the first quarter of 2003 into lines ofbusiness, we have implemented four workforce reductions, eliminating a total of136 positions. As a result of the elimination of these positions, ourmarketing, sales and customer support capabilities could be reduced, ourability to respond to unexpected challenges may be impaired, and we may beunable to take advantage of new opportunities. These workforce reductions, orfuture workforce reductions, if any, may reduce employee morale and createconcern among existing employees about job security, which could lead toincreased turnover. Workforce reductions may also raise concerns amongcustomers, suppliers and other corporate partners regarding our continuedviability. Further, these workforce reductions may subject us to the risk oflitigation, which could be costly to defend, divert the attention of managementand subject us to possible liability for damages.

 

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

 

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

 

•                  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 cannot manage industry cycles effectively, ourbusiness could be seriously harmed.

 

**Our operations and the operations of our significant customers,third-party wafer foundries and third-party assembly and test subcontractorsare located in areas susceptible to natural disasters.**

 

Our operations are headquartered in the San FranciscoBay Area, which is susceptible to earthquakes, and the operations of CMD, whichwe acquired, are based in the Los Angeles area, which is also susceptible toearthquakes. TSMC and UMC, the outside foundries that produce the majority ofour semiconductor 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 quarter ended March31, 2003, customers and distributors located in Taiwan generated 40% of ourrevenue and customers and distributors located in Japan generated 11% of ourrevenue. For the quarter ended March 31, 2002, customers and distributorslocated in Taiwan generated 36% of our revenue and customers and distributorslocated in Japan generated 13% of our revenue. Both Taiwan and Japan aresusceptible to earthquakes, typhoons and other natural disasters.

 

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

 

•                  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;

 

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

 

•                  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

 

•                  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.

 

**Our implementation of a new ERP system may negatively affectour business.**

 

In order to respond to the growth we anticipate in ourbusiness, we have decided implement a new enterprise resource planning (ERP)system to replace the multiple, sometimes non-interoperable systems currentlyused in various aspects of our business. We have entered into commitments to purchasesoftware licenses and services, many of which we expect to be expensed andintroduced during future periods, particularly our second fiscal quarter of2003. The ERP system will affect numerous operational and financial systems,reporting and processes. Even after introduction of the new system, it willneed to be tested further. In the event that the ERP system is delayed, lacksnecessary features, or has runtime errors, or we are unable to train ourpersonnel to use the ERP system in an efficient and timely manner, our businesscould be adversely affected. Moreover, there can be no assurance that the ERPsystem will be able to support the anticipated growth of our business.Additionally, systems conversions can be disruptive to a company’s business.

 

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

 

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

 

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

 

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

 

•                  authorizingthe issuance of preferred stock without stockholder approval;

 

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

 

•                  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

 

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•                  prohibitingstockholder actions by written consent.

 

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

 

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

 

The stock market has experienced extreme price andvolume fluctuations that have affected the market valuation of many technologycompanies, including Silicon Image. These factors, as well as general economicand political conditions, may materially and adversely affect the market priceof our common stock 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.

 

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

 

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

 

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

 

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

 

**Interest Rate Risk**

 

Our cash equivalents and short-term investmentsconsist primarily of fixed-income securities that are subject to interest raterisk and will decline in value if interest rates increase. Due to the shortduration of our cash equivalents and short-term investments, an immediate 10%change in interest rates would not be expected to have a material effect on ournear-term results of operations or financial condition. Our long-term capitallease obligations bear interest at fixed rates; therefore, our results ofoperations would not be affected by immediate changes in

 

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interest rates.  Also,components of our stock compensation expense are tied to our stock price.  Changes in our stock price can have asignificant affect on the amount recorded as stock compensation expense.

 

**Foreign Currency Exchange Risk**

 

All of our sales are denominated in U.S. dollars, andsubstantially all of our expenses are incurred in U.S. dollars, thus limitingour exposure to foreign currency exchange risk. We currently do not enter intoforward exchange contracts to hedge exposures denominated in foreign currenciesand do not use derivative financial instruments for trading or speculativepurposes. The effect of an immediate 10% change in foreign currency exchangerates should not have a material effect on our future operating results or cashflows; however, a long term change in foreign currency rates would likelyresult in increased wafer, packaging, assembly or testing costs.

 

**Item 4.  Controls and Procedures**

 

(a)          Within the 90 days priorto the date of this report, we carried out an evaluation, under the supervisionand with the participation of our management, including our Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of the design andoperation of our disclosure controls and procedures pursuant to Exchange ActRule 13a-14.  Based upon thatevaluation, our Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures are effective in timely alertingthem to material information relating to the Company (including itsconsolidated subsidiaries) required to be included in our periodic SEC filings.

 

(b)         There have been nosignificant changes in our internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date we carried outthis evaluation.

 

## **Part II.  Other Information**

 

## **Item 1.  Legal Proceedings**

 

On April 24, 2001, wefiled suit in the U.S. District Court for the Eastern District of Virginiaagainst Genesis Microchip Corp. and Genesis Microchip, Inc. (collectively,Genesis) for infringement of our U.S. patent number 5,905,769 (USDC E.D.Virginia Civil Action No.: CA-01-266-R) (the Federal Suit). On April 24, 2001,we also filed a complaint against Genesis with the International TradeCommission of the United States government (ITC) for unlawful trade practicesrelated to the importation of articles infringing our patent (the ITCinvestigation). The actions sought injunctions to halt the importation, sale,manufacture and use of Genesis DVI receiver chips that infringe our patent, andmonetary damages. We voluntarily moved to dismiss the ITC investigation, withnotice that we would proceed directly in the Federal Suit. Our motion todismiss was granted on February 7, 2002. We filed an amended complaint for theFederal Suit as of February 28, 2002. In April 2002, Genesis answered and madecounterclaims against us for non-infringement, license, patent invalidity,fraud, antitrust, unfair competition and patent misuse. Also in April 2002, wefiled a motion to dismiss certain of Genesis’ 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 to dismisscertain of the counterclaims, with leave to amend. Genesis re-filedcounterclaims against us for fraud and patent misuse. We filed another motionto dismiss these counterclaims. In August 2002, the Court granted our motionand dismissed Genesis’ counterclaims without leave to amend. In September 2002,we filed a motion for summary judgment, upon which the Court has yet to rule.In October 2002, both parties filed several more motions for summary judgment,upon which the Court has yet to rule. Several dispositive motions havesubsequently been filed under seal and were heard by the Court in March 2003;the Court has yet to rule on these motions. Depending on the outcome of suchmotions, a trial date may be set, the case may be dismissed, or other ordersmay be entered. Management intends to prosecute our position vigorously untilthis matter is resolved. Through March 31, 2003, we have spent approximately$9.4 million on this matter and expect to continue to incur significant coststhrough at least the second quarter of 2003.

 

Silicon Image, certain officers and directors, andSilicon Image’s underwriters have been named as defendants in a securitiesclass action lawsuit captioned Gonzales v. Silicon Image, et al., No. 01 CV10903 (SDNY 2001) pending in Federal District Court for the Southern District ofNew York. The lawsuit alleges that all defendants were part of a scheme tomanipulate the price of Silicon Image’s stock in the aftermarket following

 

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Silicon Image’s initial public offering in October 1999. Response tothe complaint and discovery in this action on behalf of Silicon Image andindividual defendants has been stayed by order of the court. The lawsuit isproceeding as part of a coordinated action of over 300 such cases brought byplaintiffs in the Southern District of New York. Pursuant to a tollingagreement, individual defendants have been dropped from the suit for the timebeing. In February 2003, the Court denied underwriters’ motion to dismiss andordered that the case may proceed against issuers including against SiliconImage. At this time, we cannot predict the outcome of this lawsuit; however, weintend to defend this matter vigorously.

 

Silicon Image, certain officers and directors, andSilicon Image’s underwriters have been named as defendants in a securitiesclass action lawsuit captioned Liu v. Credit Suisse First Boston Corp., et al.,No. 03-20459 (S.D. Fla. 2003) pending in Federal District Court for theSouthern District of Florida. Plaintiff filed an action on behalf of a putativeclass of shareholders who purchased stock from some or all of approximately 50issuers whose public offerings were underwritten by Credit Suisse First Boston.The lawsuit alleges that Silicon Image and certain officers were part of ascheme by Credit Suisse First Boston to artificially inflate the price ofSilicon Image’s stock through the dissemination of allegedly false analysts’reports. Silicon Image has not been served with a copy of the complaint. Atthis time, we cannot predict the outcome of this lawsuit; however, we intend todefend this matter vigorously.

 

On August 7, 2002, we filed a demand for arbitrationwith the American Arbitration Association, file #74 Y 117 01399 02 GAP, againstthe principal shareholders of CMD Technology (CMD) relating to shares held inescrow in connection with our acquisition of CMD. Pursuant to agreements bywhich we acquired CMD, a portion of the Silicon Image common stock issued tothe principal 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 settlementagreement and mutual release, pursuant to which our indemnification claims wereresolved. As a result of the settlement, we received 949,780 of the escrowedshares, valued at approximately $4.8 million.

 

In addition, we are involved in a number of judicialand administrative proceedings incidental to our business. We intend toprosecute or defend, as appropriate, such matters vigorously, and although adversedecisions or settlements may occur in one or more of such cases, the finalresolution of these matters, individually or in the aggregate, is not expectedto have a material adverse effect on our results of operations or financialposition.

 

The amount of legal fees we incur with respect to thelitigation matters described above will depend on the duration of ourlitigation matters, as well as the nature and extent of the litigationactivities. We are not able to accurately estimate the amount of legal fees wewill incur in 2003 with respect to the litigation matters described above,however, we do expect to incur substantial amounts through at least the firsthalf of 2003.

## ** **

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

 

In connection with our acquisition of ZillionTechnologies, LLC, we are obligated under an exchange agreement to periodicallyissue to the two founders of Zillion shares of our common stock asconsideration for their membership interests in Zillion which we acquired andservices provided pursuant to their employment agreements with us.  The Zillion founders were grantedregistration rights with respect to the shares to be issued under this exchangeagreement.  These issuances of shareswere made in reliance on an exemption from registration under Section 4(2) ofthe Securities Act.  On March 31, 2003,we issued 18,750 shares of our common stock to the Zillion founders pursuant tothe exchange agreement.  The issuancesof shares were made without general solicitation or advertising and were onlymade to two individuals.

 

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

 

Not applicable.

 

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

 

Not applicable.

 

**Item5.  Other Information**

 

Not applicable.

 

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

 

(a)          Exhibits

 

10.50       Separation Agreement for Badar Baqai datedApril 9, 2003

 

(b)         Reports on Form 8-K

 

On February 20, 2003, we filed a current report onForm 8-K to report under Item 5 that Robert G. Gargus, Vice President Financeand Administration and Chief Financial Officer, entered into a Rule 10b5-1sales plan with Deutsche Bank Alex. Brown.

 

On March 3, 2003, wefiled a current report on Form 8-K to report under Item 5 that Steve Tirado, Presidentand Chief Operating Officer, entered into a Rule 10b5-1 sales plan withFinancial West Group/Correspondent Services Corp.

 

On April 21, 2003, wefiled a current report on Form 8-K to report under Item 2 that we havecompleted our acquisition of TransWarp Networks, Inc.

 

On April 23, 2003, wefurnished a current report on Form 8-K to furnish under Item 12 our earningsrelease and conference call script and transcript for the first quarter of2003.

 

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**Signatures**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
| Dated:  May 8, 2003 | 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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### **Certifications**

 

I, David D. Lee, certifythat:

 

1.               I have reviewedthis quarterly report on Form 10-Q of Silicon Image, Inc.;

 

2.               Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3.               Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.               The registrant’sother certifying officers and I are responsible for establishing andmaintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)              designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisquarterly report is being prepared;

 

b)             evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)              presented in thisquarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.               The registrant’sother certifying officers and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a)              all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)             any fraud, whether ornot material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6.               The registrant’sother certifying officers and I have indicated in this quarterly report whetheror not there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 
| Date:  May 8, 2003                            |
|----------------------------------------------------|
|                                               |
| */s/  David D. Lee*                           |   |
| David D. Lee                                       |
| Chief Executive Officer  and Chairman of the Board |
| (Principal Executive  Officer)                     |

 

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I, Robert G. Gargus,certify that:

 

1.               I have reviewedthis quarterly report on Form 10-Q of Silicon Image, Inc.;

 

2.               Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3.               Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.               The registrant’sother certifying officers and I are responsible for establishing andmaintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

a)              designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisquarterly report is being prepared;

 

b)             evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

c)              presented in thisquarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.               The registrant’sother certifying officers and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

a)              all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)             any fraud, whether ornot material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6.               The registrant’sother certifying officers and I have indicated in this quarterly report whetheror not there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 
| Date:  May 8, 2003                                                  |
|--------------------------------------------------------------------------|
|                                                                     |
| */s/  Robert G. Gargus*                                             |   |
| Robert G. Gargus                                                         |
| Vice President, Finance  and Administration  and Chief Financial Officer |
| (Principal Financial  Officer)                                           |

 

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