##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D. C. 20549
 FORM 10-Q (Mark One) x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934
 For the Quarterly Period Ended September 30, 2004 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 000-31803 TRANSMETA CORPORATION (Exact name of registrant as specified in its charter)
 Delaware
(State or other jurisdiction of
incorporation or organization)
    
    77-0402448
(I.R.S. employer
identification no.)
 3990 Freedom Circle, Santa Clara, CA 95054
(Address of principal executive offices, including zip code) (408) 919-3000
(Registrants telephone number, including area code)   Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes x No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes x No o There were 176,468,261 shares of the Companys common stock, par value
$0.00001 per share, outstanding on October 22, 2004.




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TRANSMETA CORPORATION FORM 10-Q
Quarterly Period Ended September 30, 2004 TABLE OF CONTENTS PagePART I. FINANCIAL INFORMATIONItem 1. Unaudited Condensed Consolidated Financial Statements
    
    
    3Unaudited Condensed Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003
    
    
    3Unaudited Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2004 and September 30, 2003
    
    
    4Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2004 and September 30, 2003
    
    
    5Notes to Unaudited Condensed Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    11Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    32Item 4. Controls and Procedures
    
    
    32PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    34Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    34Item 3. Defaults Upon Senior Securities
    
    
    34Item 4. Submission of Matters to a Vote of Security Holders
    
    
    34Item 5. Other Information
    
    
    34Item 6. Exhibits
    
    
    34Signatures
    
    
    36EXHIBIT 31.01EXHIBIT 31.02EXHIBIT 32.01EXHIBIT 32.02
  2




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##### Table of Contents



PART I. FINANCIAL INFORMATION 
 Item 1.Condensed Consolidated Financial Statements TRANSMETA CORPORATION 
 CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share amounts)
 September 30,
    
    December 31,2004
    
    2003(1)(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    18,401
    
    
    $
    83,765Short-term investments
    
    
    46,725
    
    
    
    37,000Accounts receivable, net
    
    
    2,509
    
    
    
    1,719Inventories
    
    
    7,541
    
    
    
    8,796Prepaid expenses and other current assets
    
    
    3,298
    
    
    
    3,671Total current assets
    
    
    78,474
    
    
    
    134,951Property and equipment, net
    
    
    4,551
    
    
    
    5,305Patents and patent rights, net
    
    
    24,637
    
    
    
    29,771Other assets
    
    
    2,205
    
    
    
    1,563Total assets
    
    $
    109,867
    
    
    $
    171,590LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    3,130
    
    
    $
    1,900Accrued
inventory-related charges
    
    
    5,076
    
    
    
    Other accrued liabilities
    
    
    5,534
    
    
    
    5,360Current portion of accrued restructuring costs
    
    
    1,602
    
    
    
    1,916Obligation to former development partner
    
    
    15,478
    
    
    
    21,129Current portion of long-term debt and capital lease obligations
    
    
    350
    
    
    
    370Total current liabilities
    
    
    35,359
    
    
    
    35,661Long-term accrued restructuring costs, net of current portion
    
    
    4,059
    
    
    
    4,155Long-term debt and capital lease obligations, net of current portion
    
    
    91
    
    
    
    356Commitments and contingenciesStockholders Equity:Preferred stock, $0.00001 par value Authorized shares - 5,000,000. None issued
    
    
    
    
    
    
    Common stock, $0.00001 par value, at amounts paid in; Authorized shares -
1,000,000,000. Issued and outstanding shares - 176,379,470 at September 30,
2004 and 167,528,493 at December 31, 2003
    
    
    694,139
    
    
    
    677,093Treasury stock
    
    
    (2,439
    )
    
    
    (2,439
    )Deferred stock compensation
    
    
    (12
    )
    
    
    (696
    )Accumulated other comprehensive income (loss)
    
    
    (83
    )
    
    
    24Accumulated deficit
    
    
    (621,247
    )
    
    
    (542,564
    )Total stockholders equity
    
    
    70,358
    
    
    
    131,418Total liabilities and stockholders equity
    
    $
    109,867
    
    
    $
    171,590
   (1)
    
    Derived from the Companys audited financial statements as of December
31, 2003, included in the Companys Form 10-K filed with the Securities
and Exchange Commission. (See accompanying notes) 3




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##### Table of Contents



TRANSMETA CORPORATION 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts)
(Unaudited)
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenue:Product
    
    $
    3,297
    
    
    $
    2,365
    
    
    $
    13,977
    
    
    $
    12,909License and service
    
    
    3,698
    
    
    
    323
    
    
    
    4,220
    
    
    
    850Total revenue
    
    
    6,995
    
    
    
    2,688
    
    
    
    18,197
    
    
    
    13,759Cost of revenue:Product
    
    
    11,147
    
    
    
    3,073
    
    
    
    25,681
    
    
    
    12,523License and service
    
    
    197
    
    
    
    
    
    
    
    541
    
    
    
    Total cost of revenue
    
    
    11,344
    
    
    
    3,073
    
    
    
    26,222
    
    
    
    12,523Gross profit (loss)
    
    
    (4,349
    )
    
    
    (385
    )
    
    
    (8,025
    )
    
    
    1,236Operating expenses:Research and development(1)(2)
    
    
    13,751
    
    
    
    12,452
    
    
    
    40,187
    
    
    
    37,121Selling, general and administrative(3)(4)
    
    
    7,424
    
    
    
    5,978
    
    
    
    21,563
    
    
    
    18,959Restructuring charges
    
    
    904
    
    
    
    
    
    
    
    904
    
    
    
    Amortization of deferred charges, patents and patent rights
    
    
    2,233
    
    
    
    2,628
    
    
    
    6,984
    
    
    
    7,902Stock compensation
    
    
    56
    
    
    
    2,302
    
    
    
    1,636
    
    
    
    3,833Total operating expenses
    
    
    24,368
    
    
    
    23,360
    
    
    
    71,274
    
    
    
    67,815Operating loss
    
    
    (28,717
    )
    
    
    (23,745
    )
    
    
    (79,299
    )
    
    
    (66,579
    )Interest income and other, net
    
    
    188
    
    
    
    203
    
    
    
    677
    
    
    
    1,222Interest expense
    
    
    (26
    )
    
    
    (116
    )
    
    
    (61
    )
    
    
    (363
    )Net loss
    
    $
    (28,555
    )
    
    $
    (23,658
    )
    
    $
    (78,683
    )
    
    $
    (65,720
    )Net loss per share  basic and diluted
    
    $
    (0.16
    )
    
    $
    (0.17
    )
    
    $
    (0.45
    )
    
    $
    (0.47
    )Weighted average shares outstanding  basic and diluted
    
    
    175,487
    
    
    
    139,844
    
    
    
    173,794
    
    
    
    138,674
   (1)
    
    Excludes $79 and $190 in amortization of deferred stock compensation for
the three months ended September 30, 2004 and September 30, 2003,
respectively, and $434 and $924 for the nine months ended September 30,
2004 and September 30, 2003, respectively.(2)
    
    Excludes $(49) and $135 in variable stock compensation for the three
months ended September 30, 2004 and September 30, 2003, respectively, and
$313 and $170 for the nine months ended September 30, 2004 and September
30, 2003, respectively.(3)
    
    Excludes $26 and $115 in amortization of deferred stock compensation for
the three months ended September 30, 2004 and September 30, 2003,
respectively, and $231 and $621 for the nine months ended September 30,
2004 and September 30, 2003, respectively.(4)
    
    Excludes $0 and $1,862 in variable stock compensation for the three
months ended September 30, 2004 and September 30, 2003, respectively, and
$658 and $2,118 for the nine months ended September 30, 2004 and September
30, 2003, respectively. (See accompanying notes) 4




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TRANSMETA CORPORATION 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)
(Unaudited)
 Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003Cash flows from operating activities:Net loss
    
    $
    (78,683
    )
    
    $
    (65,720
    )Adjustments to reconcile net loss to net cash used in operating activities:Stock compensation
    
    
    1,636
    
    
    
    3,833Depreciation
    
    
    2,778
    
    
    
    4,470Amortization of other assets
    
    
    
    
    
    
    370Amortization of deferred charges, patents and patent rights
    
    
    6,984
    
    
    
    7,902Non cash restructuring charges
    
    
    904
    
    
    
    Changes in operating assets and liabilities:Accounts receivable
    
    
    (790
    )
    
    
    2,654Inventories
    
    
    1,255
    
    
    
    3,536Prepaid expenses and other current assets
    
    
    (269
    )
    
    
    357Accounts payable and accrued liabilities
    
    
    5,680
    
    
    
    (3,800
    )Accrued restructuring charges
    
    
    (1,314
    )
    
    
    (1,851
    )Net cash used in operating activities
    
    
    (61,819
    )
    
    
    (48,249
    )Cash flows from investing activities:Purchase of available-for-sale investments
    
    
    (69,994
    )
    
    
    (83,775
    )Proceeds from sale or maturity of available-for-sale investments
    
    
    60,162
    
    
    
    157,634Purchase of property and equipment
    
    
    (2,024
    )
    
    
    (834
    )Payment for previously acquired patents and patent rights
    
    
    (7,500
    )
    
    
    (9,000
    )Other assets
    
    
    
    
    
    
    (59
    )Net cash provided by / (used in) investing activities
    
    
    (19,356
    )
    
    
    63,966Cash flows from financing activities:Net proceeds from public offering of common stock
    
    
    10,289
    
    
    
    Proceeds from sales of common stock under ESPP and stock option plans
    
    
    4,948
    
    
    
    3,854Repayment of notes from stockholders
    
    
    857
    
    
    
    Repayment of debt and capital lease obligations
    
    
    (283
    )
    
    
    (584
    )Net cash provided by financing activities
    
    
    15,811
    
    
    
    3,270Change in cash and cash equivalents
    
    
    (65,364
    )
    
    
    18,987Cash and cash equivalents at beginning of period
    
    
    83,765
    
    
    
    16,613Cash and cash equivalents at end of period
    
    $
    18,401
    
    
    $
    35,600
 (See accompanying notes) 5




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TRANSMETA CORPORATION 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
 1. Basis of Presentation The accompanying unaudited condensed consolidated financial statements
have been prepared pursuant to the rules and regulations of the Securities and
Exchange Commission and accounting principles generally accepted in the United
States for interim financial information. However, certain information or
footnote disclosures normally included in financial statements prepared in
accordance with accounting principles generally accepted in the United States
have been condensed, or omitted, pursuant to such rules and regulations. The
preparation of financial statements in accordance with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the amounts reported in the financial statements.
Actual results could differ from those estimates. Significant estimates made in
preparing the financial statements include license revenue recognition,
inventory valuations, long-lived and intangible asset valuations, restructuring
charges and loss contingencies. In the opinion of management, the statements
include all adjustments (which are of a normal and recurring nature) necessary
for the fair presentation of the results of the interim periods presented.
These financial statements should be read in conjunction with our audited
consolidated financial statements and the notes thereto included in the
Companys Form 10-K for the year ended December 31, 2003. The results of
operations for the three months and nine months ended September 30, 2004 are
not necessarily indicative of the operating results for the full fiscal year or
any future period. The financial statements of the Company have been presented based on the
assumption that the Company will continue as a going concern. The Company,
however, has a history of substantial losses, and expects to incur future
losses. The Company has
historically reported negative cash flows from operations because the gross
profit, if any, generated from its product and licensing revenues has not been
sufficient to cover its operating cash requirements. The Company believes that
its existing cash and cash equivalents and short-term investment balances and
cash from operations will be insufficient to fund its operations, planned
capital and R&D expenditures for the next 12 months on its current business
model. Accordingly, the Company intends to raise during that time period
additional funds through public or private equity or debt financing or by any
other means available to the Company at that time. Additional funds may not be
available on terms favorable to the Company or at all. In the event that the
Company is unable to raise additional funds, it is positioned to modify its
current business model, for example, by leveraging its intellectual property
assets and by focusing on its strategy of licensing its advanced power
management and other technologies to other companies and, in doing so, to
substantially limit its operations and reduce costs related to aspects of the
business other than intellectual property and technology licensing to permit it
to continue to operate on a modified business model for a period that extends
at least through September 30, 2005. The Companys fiscal year ends on the last Friday in December, and each
fiscal quarter ends on the last Friday of each calendar quarter. For ease of
presentation, the accompanying financial information has been shown as of
December 31 and calendar quarter ends for all annual and quarterly financial
statement captions. The three-month periods ended September 24, 2004 and
September 26, 2003 each consisted of 13 weeks. The first nine months of fiscal
2004 and 2003 each consisted of 39 weeks. 2. Net Loss per Share Basic and diluted net loss per share is presented in conformity with the
Financial Accounting Standards Boards (FASB) Statement of Financial Accounting
Standards (SFAS) No. 128, Earnings Per Share, for all periods presented.
Basic and diluted net loss per share has been computed using the
weighted-average number of shares of common stock outstanding during each
period, less weighted-average shares subject to repurchase. 6




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The following table presents the computation of basic and diluted net loss
per share: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(in thousands, except for per share amounts)Basic and diluted:Net loss, as reported
    
    $
    (28,555
    )
    
    $
    (23,658
    )
    
    $
    (78,683
    )
    
    $
    (65,720
    )Basic and diluted:Weighted average shares outstanding
    
    
    175,487
    
    
    
    139,844
    
    
    
    173,794
    
    
    
    138,682Less: Weighted average shares subject to repurchase
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (8
    )Weighted average shares used in computing basic
and diluted net loss per share
    
    
    175,487
    
    
    
    139,844
    
    
    
    173,794
    
    
    
    138,674Net loss per share  basic and diluted
    
    $
    (0.16
    )
    
    $
    (0.17
    )
    
    $
    (0.45
    )
    
    $
    (0.47
    )
 The Company has excluded all outstanding stock options and shares subject
to repurchase from the calculation of basic and diluted net loss per share
because these securities are antidilutive for all periods presented. Options
and warrants to purchase 41,923,626 and 35,532,096 shares of common stock at
September 30, 2004 and 2003, respectively, determined using the treasury stock
method, were not included in the computation of diluted net loss per share
because the effect would be antidilutive. These securities, had they been
dilutive, would have been included in the computation of diluted net loss per
share using the treasury stock method. 3. Revenue Recognition The Company recognizes revenue from products sold when persuasive evidence
of an arrangement exists, the price is fixed or determinable, title of goods is
transferred and collectibility is reasonably assured. The Company accrues for
estimated sales returns, and other allowances at the time of shipment. Certain
of the Companys product sales are made to distributors under agreements
allowing for price protection and/or right of return on unsold products. The
Company defers recognition of revenue on these sales until the distributors
sell the products. The Company may also sell certain products with End of
Life status to its distributors under special arrangements without price
protection or return privileges for which revenue is recognized upon transfer
of title, typically upon shipment. The Company enters into license agreements, some of which may contain
multiple elements, including technology license and support services, or
non-standard terms and conditions. As a result, in accordance with Emerging
Issues Task Force (EITF) Issue No. 00-21, Revenue Arrangements with Multiple
Deliverables and the Securities and Exchange Commissions Staff Accounting
Bulletin No. 104, Revenue Recognition, significant
interpretation on these agreements is sometimes required to determine the
appropriate accounting, including whether deliverables specified in a multiple
element arrangement should be treated as separate units of accounting for
revenue recognition purposes, and if so, how the price should be allocated
among the deliverable elements and when to recognize revenue for each element.
The Company recognizes revenue from license agreements when earned, which
generally occurs when agreed-upon deliverables are provided, or milestones are
met and confirmed by licensees and relative fair values of multiple elements
can be determined. Additionally, license revenues and maintenance and
service revenues are recognized only if
payments received are non-refundable and not subject to any future performance
obligation by the Company. The Company recognizes revenue from
maintenance agreements based on the fair value of such agreements
ratably over the period in which such services are rendered. License and service revenue for the three and nine months ended September
30, 2004 were $3.7 million and $4.2 million, respectively. Through September
30, 2004, the Company has collected a total of $3.5 million for
technology transfer fees and
maintenance service fees related to an agreement with its initial LongRun2 licensing
partner. The Company has recognized revenue in respect of this
agreement upon receipt of payments which are non-refundable and not
subject to any future performance obligation by the Company. 4. Stock Based Compensation The Company accounts for its stock options and equity awards in accordance
with the provisions of Accounting Principles Board Opinion No. 25, Accounting
for Stock Issued to Employees, and related interpretations and has elected to
follow the disclosure only alternative prescribed by SFAS 123, Accounting
for Stock-Based Compensation. Expense associated with stock-based compensation
is amortized on an accelerated basis over the vesting period of the individual
award consistent with the method 7




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##### Table of Contents



described in FASB Interpretation 28, Accounting for Stock Appreciation
Rights and Other Variable Stock Option or Award Plan. Accordingly,
approximately 59% of the unearned deferred compensation is amortized in the
first year, 25% in the second year, 12% in the third year, and 4% in the fourth
year following the date of grant. Pursuant to SFAS 123, Transmeta discloses the
pro forma effect of using the fair value method of accounting for its
stock-based compensation arrangements. In December 2002, the FASB issued, and
the Company adopted, SFAS 148, Accounting for Stock-Based Compensation -
Transition and Disclosure  an Amendment of FASB Statement No. 123. SFAS 148
amends the disclosure requirements of FASBs SFAS 123, Accounting for
Stock-Based Compensation, to require more prominent disclosures in both annual
and interim financial statements regarding the method of accounting for
stock-based employee compensation and the effect of the method used on reported
results. For purposes of pro forma disclosures, the estimated fair value of options
is amortized to pro forma expense over the options vesting period using an
accelerated graded method. Pro forma information follows: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(in thousands, except for per share amounts)Net loss, as reported
    
    $
    (28,555
    )
    
    $
    (23,658
    )
    
    $
    (78,683
    )
    
    $
    (65,720
    )Add: Stock-based employee compensation expense
included in reported net loss, net of related tax
effects
    
    
    56
    
    
    
    2,302
    
    
    
    1,636
    
    
    
    3,833Less: Total stock-based employee compensation
expense under fair value based method for all
awards, net of related tax effects
    
    
    (7,538
    )
    
    
    (13,621
    )
    
    
    (27,652
    )
    
    
    (36,690
    )Pro forma net loss
    
    $
    (36,037
    )
    
    $
    (34,977
    )
    
    $
    (104,699
    )
    
    $
    (98,577
    )Basic and diluted net loss per share  as reported
    
    $
    (0.16
    )
    
    $
    (0.17
    )
    
    $
    (0.45
    )
    
    $
    (0.47
    )Basic and diluted net loss per share  pro forma
    
    $
    (0.21
    )
    
    $
    (0.25
    )
    
    $
    (0.60
    )
    
    $
    (0.71
    )
 The fair value for the Companys stock-based awards is estimated at the
date of grant using a Black-Scholes option-pricing model. The Black-Scholes
option-pricing model was developed for use in estimating the fair value of
traded options that have no vesting restrictions and are fully transferable. In
addition, the Black-Scholes option-pricing model requires the input of highly
subjective assumptions, including expected stock price volatility. Because the
Companys stock-based awards have characteristics significantly different from
those of traded options and because changes in the subjective input assumptions
can materially affect the fair value estimate, in managements opinion, the
existing models do not necessarily provide a reliable single measure of the
fair value of its stock-based awards. The fair value of options granted was
determined based on estimated stock price volatility. The weighted average
assumptions used to determine fair value were as follows: Options
    
    ESPPThree Months
    
    Nine Months
    
    Three Months
    
    Nine MonthsEnded September 30,
    
    Ended September 30,
    
    Ended September 30,
    
    Ended September 30,2004
    
    2003
    
    2004
    
    2003
    
    2004
    
    2003
    
    2004
    
    2003Expected volatility
    
    
    0.91
    
    
    
    0.92
    
    
    
    0.91
    
    
    
    0.86
    
    
    
    0.91
    
    
    
    1.03
    
    
    
    0.91
    
    
    
    1.03Expected life in years.
    
    
    3.4
    
    
    
    4.0
    
    
    
    3.4
    
    
    
    4.0
    
    
    
    0.5
    
    
    
    0.5
    
    
    
    0.5
    
    
    
    0.5Risk-free interest rate
    
    
    2.9
    %
    
    
    2.7
    %
    
    
    2.7
    %
    
    
    2.3
    %
    
    
    1.8
    %
    
    
    1.2
    %
    
    
    1.4
    %
    
    
    1.3
    %Expected dividend yield
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0
 5. Net Comprehensive Loss Net comprehensive loss includes the Companys net loss, as well as
accumulated other comprehensive income/(loss) on available-for-sale investments
and foreign currency translation adjustments. Net comprehensive loss for the
three and nine month periods ended September 30, 2004 and 2003, respectively,
is as follows (in thousands): Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net loss
    
    $
    (28,555
    )
    
    $
    (23,658
    )
    
    $
    (78,683
    )
    
    $
    (65,720
    )Net change in unrealized loss on investments
    
    
    132
    
    
    
    (22
    )
    
    
    (108
    )
    
    
    (139
    )Net change in foreign currency translation adjustments
    
    
    13
    
    
    
    (14
    )
    
    
    1
    
    
    
    (6
    )Net comprehensive loss
    
    $
    (28,410
    )
    
    $
    (23,694
    )
    
    $
    (78,790
    )
    
    $
    (65,865
    )
 8




---



##### Table of Contents



The components of accumulated other comprehensive income/(loss), net of
taxes as of September 30, 2004 and December 31, 2003, respectively, is as
follows (in thousands): September 30,
    
    December 31,2004
    
    2003Net unrealized loss on investments
    
    $
    (109
    )
    
    $
    (1
    )Cumulative foreign currency translation adjustments
    
    
    26
    
    
    
    25Accumulated other comprehensive income/(loss)
    
    $
    (83
    )
    
    $
    24
 6. Inventories Inventories are stated at the lower of cost (first-in, first-out) or
market. The components of inventories consist of the following (in thousands): September 30,
    
    December 31,2004
    
    2003Work in progress
    
    $
    4,930
    
    
    $
    6,136Finished goods
    
    
    2,611
    
    
    
    2,660$
    7,541
    
    
    $
    8,796
 In the third quarter of fiscal 2004, the Company recorded a $3.2 million
charge related to inventory on hand, which resulted in a reduction of the
carrying value of that inventory. The Company additionally recorded a $3.6
million charge during the period related to non-cancelable commitments for
substrates and wafers on order with our third-party suppliers, as
such contractual commitments were in excess of that inventorys net realizable value. The charge for inventory on hand
as well as the charge for inventory on order primarily related to the cost to
manufacture our 130 nanometer and 90 nanometer Efficeon products exceeding the
price at which we expect to be able to sell these products. Of the $7.5
million and $8.8 million of net inventory on hand at September 30, 2004 and
December 31, 2003, respectively, $2.3 million and $2.6 million of net inventory,
respectively, were stated at net realizable value. Accordingly, gross margin
may be impacted from future sales of these parts to the extent that the
associated revenue exceeds or fails to achieve their currently adjusted values.
Benefits to gross margin as a result of products being sold at ASPs in excess
of their previously written down values were $0.1 million and $0.3 million for
the three and nine months ended September 30, 2004, respectively, compared to
$0.2 million and $0.6 million for the same periods last year. 7. Restructuring Charges In the second quarter of fiscal 2002, Transmeta recorded a $10.6 million
restructuring charge as a result of the Companys decision to cease development
and productization of the TM6000 microprocessor. The restructuring charge
consisted primarily of lease costs, equipment write-offs and other costs as the
Company identified a number of leased facilities as well as leased and owned
equipment that were no longer required. During the fourth quarter of fiscal 2003, Transmeta reassessed the
adequacy of the remaining accrual and adjusted the accrued restructuring costs as a result of an update in certain underlying assumptions. During the third quarter of fiscal 2004, Transmeta reassessed the adequacy
of the remaining accrual and adjusted the accrued restructuring costs as a
result of an update in certain underlying assumptions. In view of current
market conditions, the Company has no assumptions of subleasing previously
vacated space that remains unused as of September 30, 2004. As a result of
this update in assumptions, the Company adjusted the accrued restructuring
costs and recorded a charge of $0.9 million in restructuring charges. Accrued restructuring charges consist of the following at September 30,
2004 (in thousands): ProvisionBalance atDecember 31,
    
    Drawdowns
    
    ProvisionBalance atMarch 31,
    
    Drawdowns
    
    ProvisionBalance atJune 30,
    
    Restructuring
    
    Drawdowns
    
    ProvisionBalance atSeptember 30,2003
    
    Cash
    
    Non-Cash
    
    2004
    
    Cash
    
    Non-Cash
    
    2004
    
    Charges
    
    Cash
    
    Non-Cash
    
    2004Building leasehold
costs
    
    $
    6,071
    
    
    $
    408
    
    
    
    
    
    
    $
    5,663
    
    
    $
    499
    
    
    
    
    
    
    $
    5,164
    
    
    $
    904
    
    
    $
    407
    
    
    
    
    
    
    $
    5,661
 9




---



##### Table of Contents



8. Related Party Transaction Transmeta entered into a trademark and technology licensing agreement
during fiscal 2003 with Chinese 2 Linux (Holdings) Limited. In relation to
this agreement, the Company became a 16.6% beneficial owner of the party with
which the agreement was entered. In relation to this agreement, the Company
recognized license revenue of $198,000 and $720,000 for the three and nine
months ended September 30, 2004, respectively. 9. Recent Accounting Pronouncements In March 2004, the FASB issued a proposed Statement, Share-Based Payment,
an amendment of FASB Statements Nos. 123 and 95, that addresses the accounting
for share-based payment transactions in which a Company receives employee
services in exchange for either equity instruments of the Company or
liabilities that are based on the fair value of the Companys equity
instruments or that may be settled by the issuance of such equity instruments.
The proposed statement would require all companies to measure compensation cost
for all share-based payments at fair value. The effective date of the proposed
standard is for periods beginning after June 15, 2005. The Company is
currently evaluating the effect that the adoption of the proposed statement
will have on its financial position and results of operations. 10. Legal Proceedings The Company is a party in one consolidated lawsuit. Beginning in June
2001, the Company, certain of its directors and officers, and certain of the
underwriters for its initial public offering were named as defendants in three
putative shareholder class actions that were consolidated in and by the United
States District Court for the Southern District of New York in In re Transmeta
Corporation Initial Public Offering Securities Litigation, Case No. 01 CV 6492.
The complaints allege that the prospectus issued in connection with the
Companys initial public offering on November 7, 2000 failed to disclose
certain alleged actions by the underwriters for that offering, and alleges
claims against the Company and several of its officers and directors under
Sections 11 and 15 of the Securities Act of 1933, as amended, and under
Sections 10(b) and Section 20(a) of the Securities Exchange Act of 1934, as
amended. Similar actions have been filed against more than 300 other companies
that issued stock in connection with other initial public offerings during
1999-2000. Those cases have been coordinated for pretrial purposes as In re
Initial Public Offering Securities Litigation, Master File No. 21 MC 92 (SAS).
In July 2002, the Company joined in a coordinated motion to dismiss filed on
behalf of multiple issuers and other defendants. In February 2003, the Court
granted in part and denied in part the coordinated motion to dismiss, and
issued an order regarding the pleading of amended complaints. Plaintiffs
subsequently proposed a settlement offer to all issuer defendants, which
settlement would provide for payments by issuers insurance carriers if
plaintiffs fail to recover a certain amount from underwriter defendants.
Although the Company and the individual defendants believe that the complaints
are without merit and deny any liability, but because they also wish to avoid
the continuing waste of management time and expense of litigation, they
accepted plaintiffs proposal to settle all claims that might have been brought
in this action. The Company and the individual Transmeta defendants expect that
their share of the global settlement will be fully funded by their director and
officer liability insurance. Although the Company and the Transmeta defendants
have approved the settlement in principle, it remains subject to several
procedural conditions, as well as formal approval by the Court. It is possible
that the parties may not reach a final written settlement agreement or that the
Court may decline to approve the settlement in whole or part. In the event that
the parties do not reach agreement on the final settlement, the Company and the
Transmeta defendants believe that they have meritorious defenses and intend to
defend any remaining action vigorously. 11. Subsequent Events On October 19, 2004, the Company entered into an agreement with
International Business Machines, or IBM, to add a second amendment to the
Companys amended technology license agreement with IBM, which second amendment
relates solely to the terms of the Companys final $16 million cash commitment
payable to IBM in December 2004 pursuant to the amended technology license
agreement. Specifically, the second amendment reschedules and amortizes over
the next four fiscal quarters the Companys final $16 million payment to IBM.
Under the second amendment, the Company is now obligated, and currently
expects, to pay $4.0 million cash to IBM in December 2004, and to pay the
remaining $12.0 million of its cash commitment to IBM, with an imputed interest rate of 7.5%, during
the first three quarters of fiscal 2005. 10




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##### Table of Contents



On October 26, 2004, the Company received from NEC Electronics, or NEC, a
cash payment of $3.0 million, which payment constitutes a portion of
the Companys deliverable-based license fee for licensing to NEC the Companys
proprietary LongRun2 technologies for power management and transistor leakage
control pursuant to the Companys March 2004 licensing agreement with NEC.
This $3.0 million payment was received during the fourth quarter
of fiscal 2004 and will be recognized as revenue in that period. 
 Item 2.Managements Discussion and Analysis of Financial Condition and Results
of Operations Caution Regarding Forward-Looking Statements The following discussion and analysis should be read in conjunction with
the condensed consolidated financial statements and the related notes contained
in this report and with the information included in the Companys Annual Report
on Form 10-K for the year ended December 31, 2003 and subsequent reports filed
with the Securities and Exchange Commission (SEC). The information contained in
this report is not a complete description of our business or the risks
associated with an investment in our common stock. We urge you to carefully
review and consider the various disclosures made by us in this report and in
our other reports filed regularly with the SEC, some of which reports discuss
our business in greater detail. This report contains forward-looking statements that are based upon our
current expectations, estimates and projections about our industry, and that
reflect our beliefs and certain assumptions based upon information made
available to us at the time of this report. Words such as anticipates,
expects, intends, plans, believes, seeks, estimates, may,
could, will and variations of these words or similar expressions are
intended to identify forward-looking statements. Such statements include, but
are not limited to, statements concerning anticipated trends or developments in
our business and the markets in which we operate, the competitive nature and
anticipated growth of those markets, our expectations for our future
performance and the market acceptance of our products, our ability to migrate
our products to smaller process geometries, and our future gross margins,
operating expenses and need for additional capital. Investors are cautioned that such forward-looking statements are only
predictions, which may differ materially from actual results or future events.
These statements are not guarantees of future performance and are subject to
risks, uncertainties and assumptions that are difficult to predict. Some of the
important risk factors that may affect our business, results of operations and
financial condition are set out and discussed below in the section entitled
Risks That Could Affect Future Results. You should carefully consider those
risks, in addition to the other information in this report and in our other
filings with the SEC, before deciding to invest in our company or to maintain
or change your investment. Investors are cautioned not to place reliance on
these forward-looking statements, which reflect managements analysis only as
of the date of this report. We undertake no obligation to revise or update any

forward-looking statement for any reason. Overview We design, develop and sell highly efficient x86-compatible software-based
microprocessors. Since the introduction of our first family of microprocessors,
the Crusoe series, in January 2000, we have derived the majority of our revenue
from the sale of these products. In October 2003, we introduced the Efficeon
TM8000 family of microprocessors, which is our next family of x86-compatible
processors. In September 2004, we began limited production of our Efficeon
TM8800 processor on an advanced 90 nanometer manufacturing process. In fiscal
2003, and through the first nine months of fiscal 2004, we additionally have
recognized revenue from technology and intellectual property license
agreements. During the first quarter of fiscal 2004, we entered into a
licensing agreement with NEC Electronics, or NEC, wherein NEC licensed our
LongRun2 technologies for power management and transistor leakage control. The
agreement with NEC includes deliverable-based license fees, maintenance service
fees, and subsequent royalties payable to us once NEC begins production of
products incorporating our technologies, which NEC currently expects to begin
in late 2005. Through September 30, 2004, we have collected a total of $3.5
million in license fees and maintenance service fees related to our NEC
agreement. These funds were recognized as revenue as certain predetermined
milestones have been met and customer acceptance has been received. We expect
in the near term that technology and intellectual property license revenues
will contribute to our total revenue, and we will continue to explore
additional opportunities for licensing our advanced power management and other
technologies to other companies. Our total revenue, including product revenue and license and service
revenue, for the three and nine months ended September 30, 2004, was $7.0
million and $18.2 million, respectively, compared to $2.7 million and $13.8
million for the corresponding periods last 11




---



##### Table of Contents



year. These increases were primarily due to increased license and service
revenue, which totaled $3.7 million and $4.2 million for the three and nine
months ended September 30, 2004, compared to $0.3 million and $0.9 million for
the corresponding periods last year. Product revenue also increased 39% and
8%, respectively, for the three and nine months ended September 30, 2004,
compared to the corresponding periods last year, primarily due to respective
increases of 144% and 36% in net units shipped, consisting largely of our
Crusoe products. Our average selling prices, or ASPs, for Crusoe product sales
decreased, but we also reduced our Crusoe manufacturing costs for the three and
nine months ended September 30, 2004 compared to the same periods last year. Our
gross margin was negative 62.2% for the three months ended September
30, 2004, compared to negative 14.3% for the same period last year. We have
historically reported negative cash flows from operations because the gross
profit, if any, generated from our product and licensing revenues has not been
sufficient to cover our operational cash requirements. We had total operating
expenses of $24.4 million and $71.3 million for the three and nine months ended
September 30, 2004, respectively, compared to $23.4 million and $67.8 million
for the corresponding periods last year. Net loss was $28.6 million and $78.7
million for the three and nine months ended September 30, 2004, respectively,
compared to $23.7 million and $65.7 million for the corresponding periods last
year. Historically we have incurred significant losses, and as of September 30,
2004, we had an accumulated deficit of $621.2 million. We believe that our existing cash and cash equivalents and short-term
investment balances and cash from operations will be insufficient to fund our
operations, planned capital and R&D expenditures for the next twelve months on
our current business model. Accordingly, we intend to raise during that time
period additional funds through public or private equity or debt financing. If
we are unable to do so, we are positioned to modify our current business model,
for example, by leveraging our intellectual property assets and by focusing on
our strategy of licensing our advanced power management and other technologies
to other companies and, in doing so, to substantially limit our operations and
reduce costs related to aspects of the business other than intellectual
property and technology licensing to permit us to continue to operate on a
modified business model for a period that extends at least through September
30, 2005. The majority of our sales have been to a limited number of customers.
Additionally, we derive a significant portion of our revenue from customers
located in Asia. The following table represents our sales to customers, each of
which is located in Asia, that accounted for more than 10% of total revenue for
the three and nine months ended September 30, 2004 and 2003: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Customer A (1)
    
    
    50
    %
    
    
    *
    %
    
    
    20
    %
    
    
    *
    %Customer B
    
    
    17
    %
    
    
    *
    %
    
    
    35
    %
    
    
    *
    %Customer C
    
    
    *
    %
    
    
    32
    %
    
    
    15
    %
    
    
    23
    %Customer D
    
    
    *
    %
    
    
    24
    %
    
    
    *
    %
    
    
    23
    %Customer E
    
    
    *
    %
    
    
    14
    %
    
    
    *
    %
    
    
    18
    %Customer F
    
    
    *
    %
    
    
    12
    %
    
    
    *
    %
    
    
    *
    %
   *
    
    represents less than 10% of total revenue(1)
    
    includes revenue from our first LongRun2 licensing partner The following table represents balances from our customers that accounted
for more than 10% of our accounts receivable balance at September 30, 2004 and
December 31, 2003: September 30,
    
    December 31,2004
    
    2003Customer B
    
    
    26
    %
    
    
    66
    %Customer C
    
    
    24
    %
    
    
    13
    %Customer G
    
    
    21
    %
    
    
    *
    %Customer H
    
    
    10
    %
    
    
    *
    %
 12




---



##### Table of Contents



We began shipments in the fourth quarter of 2003 of our initial Efficeon
TM8000 microprocessor, manufactured using a 130 nanometer complementary metal
oxide semiconductor, or CMOS, process. We believe that we must successfully
complete the transition of the manufacturing of our Efficeon TM8000
microprocessors to a 90 nanometer CMOS process in order to be able to achieve
broad market acceptance of our Efficeon TM8000 microprocessors. We sampled our
90 nanometer Efficeon TM8800 processors in early April 2004 and we began
limited production of these products in the third quarter of fiscal 2004. In the third quarter of fiscal 2004 we recorded a $6.8 million
inventory-related charge. Of the $6.8 million charge, $3.2 million was for
inventory on hand, the majority of which was for our Crusoe and 130 nanometer
Efficeon processors. The remaining $3.6 million of the inventory charge was
for substrates and wafers on order, the majority of which relates to both our
130 and 90 nanometer Efficeon processors, and which resulted in our recording
an accrued liability for an equal amount. As of September 30, 2004, our
expected costs to produce 130 and 90 nanometer Efficeon processors on hand and
on order exceeded the average selling prices that we anticipated to be able to
sell the related product. As a result, we have had to take charges related to
this difference between cost and expected average selling prices, and
accordingly anticipate that we will not see contributions to our gross profits
as these products are sold. Our goal is to improve gross margins once unit
sales of the 90 nanometer Efficeon product are substantial enough to drive down
production costs as the product moves into a stage of substantial volume
production. Critical Accounting Policies The process of preparing financial statements requires the use of
estimates on the part of our management. The estimates used by management are
based on our historical experiences combined with managements understanding of
current facts and circumstances. Certain of our accounting policies are
considered critical as they are both important to the portrayal of our
financial condition and results and require significant or complex judgment on
the part of management. For a description of what we believe to be our most
critical accounting policies and estimates, refer to our Annual Report on Form
10-K for the year ended December 31, 2003 filed with the Securities and
Exchange Commission on March 9, 2004. There have been no changes in any of our
critical accounting policies since December 31, 2003. Results of Operations Changes to Previously Announced Financial Results for the Third Quarter of
Fiscal 2004 On October 20, 2004, we issued a press release and filed a current report
on Form 8-K to announce our financial results for the third quarter of fiscal
2004. In conjunction with the filing of this quarterly report, we are required
to reassess all significant estimates and judgments made in the financial
statements for the period, as well as consider any relevant additional
information that is available as of the filing date. This updated analysis
includes information that had not been previously identified at the time we
announced our financial results for the third quarter of fiscal 2004. In light
of this information, as well as correcting for an error in calculations that
was detected following October 20, 2004, we concluded that decreasing our
inventory valuation by $1.1 million and recording related additional product
cost of revenue of $1.1 million in the third quarter of fiscal 2004 was
appropriate. Additionally, we concluded that reclassifying a $0.9
million charge related to non-cancelable commitments for goods and
services from research and development expenses to cost of product
revenue was appropriate. As a result of the $1.1 million adjustment, our fiscal third quarter 2004
net loss was $28.6 million, or a loss of $0.16 per share, compared to $27.5
million, or a loss of $0.16 per share, as previously announced. Total Revenue We derive revenue from two sources: product revenue, and license and
service revenue. Total revenue for each period presented is summarized in the
following table: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(in thousands)Product
    
    $
    3,297
    
    
    $
    2,365
    
    
    $
    13,977
    
    
    $
    12,909License and service
    
    
    3,698
    
    
    
    323
    
    
    
    4,220
    
    
    
    850Total revenue
    
    $
    6,995
    
    
    $
    2,688
    
    
    $
    18,197
    
    
    $
    13,759
 13




---



##### Table of Contents



Our products are targeted at a broad range of computing platforms,
particularly battery-operated mobile devices and applications that need high
performance, low power consumption and low heat generation. Such platforms
include thin clients, notebook computers, embedded computers and blade servers,
ultra-personal computers, or UPCs, and tablet PCs. Product revenue derived from
each computing market segment as well as license and service revenue is
presented as a percentage of total revenue in the following table: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Product revenue:Thin client desktop
    
    
    17
    %
    
    
    9
    %
    
    
    38
    %
    
    
    8
    %Notebook computers
    
    
    15
    %
    
    
    47
    %
    
    
    21
    %
    
    
    47
    %Embedded/servers
    
    
    5
    %
    
    
    6
    %
    
    
    8
    %
    
    
    7
    %UPCs
    
    
    3
    %
    
    
    1
    %
    
    
    4
    %
    
    
    1
    %Tablet PCs
    
    
    7
    %
    
    
    25
    %
    
    
    6
    %
    
    
    31
    %License and service
revenue:
    
    
    53
    %
    
    
    12
    %
    
    
    23
    %
    
    
    6
    %
 Total product revenue for the three and nine months ended September 30,
2004 was $3.3 million and $14.0 million, respectively, compared to $2.4 million
and $12.9 million for the corresponding periods last year. The increase in
product revenue is primarily due to an overall increase in net product shipped
of 144% and 36%, respectively, for the three and nine months ended September
30, 2004 compared to the same periods last year. Contributing to this increase
were the shipments of our Efficeon product, which began in the fourth quarter
of 2003 and represented 13% and 20%, respectively, of total revenue for the
three and nine months ended September 30, 2004. Partially offsetting this
increase was the decrease of ASPs for our Crusoe processors. Pricing pressure on the TM5800 has increased and may continue to increase
as the product has matured and continues to sell into market segments and
geographies, such as China and Taiwan, that traditionally demand lower ASPs. We
expect to continue to manufacture the TM5800 as that processor continues to
sell into market segments such as the embedded and thin client markets,
from which we expect the processor to derive the majority of its future
revenue. The Efficeon TM8000 product is targeted at higher-volume notebook and
other markets that demand low power consumption and low heat generation
characteristics, such as the UPC and thin and light notebook markets. For the three and nine months ended September 30, 2004, we recognized
license and service revenue of $3.7 million and $4.2 million, respectively.
This revenue related to a license and service agreement that we entered into
during fiscal 2003 and a licensing agreement with NEC Electronics for power
management and transistor leakage control. We will continue to explore
additional opportunities for licensing our advanced power management
technologies to other companies. For
example, we believe our proprietary LongRun2 leakage control technology could
be valuable to the semiconductor industry and could generate significant future
licensing revenues for us without impairing our microprocessor product
business. Gross Margin Our gross margin is comprised of the components displayed in the following
table, shown as a percentage of total revenue: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenue:Product
    
    
    47.1
    %
    
    
    88.0
    %
    
    
    76.8
    %
    
    
    93.8
    %License and service
    
    
    52.9
    %
    
    
    12.0
    %
    
    
    23.2
    %
    
    
    6.2
    %Total revenue
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Cost of revenue:Product
    
    
    43.9
    %
    
    
    72.5
    %
    
    
    73.4
    %
    
    
    73.6
    %Underabsorbed overhead
    
    
    5.7
    %
    
    
    17.3
    %
    
    
    5.2
    %
    
    
    11.4
    %Charges for inventory adjustments
    
    
    111.0
    %
    
    
    32.3
    %
    
    
    64.2
    %
    
    
    10.1
    %Cost of product revenue
    
    
    160.6
    %
    
    
    122.1
    %
    
    
    142.8
    %
    
    
    95.1
    %Cost of
license and service revenue
    
    
    2.8
    %
    
    
    
    %
    
    
    3.0
    %
    
    
    
    %
 14




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##### Table of Contents



Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Total cost of revenue
    
    
    163.4
    %
    
    
    122.1
    %
    
    
    145.8
    %
    
    
    95.1
    %Benefits to gross margin from
the sale of previously written down
inventory
    
    
    1.2
    %
    
    
    7.8
    %
    
    
    1.7
    %
    
    
    4.1
    %Gross margin
    
    
    (62.2
    )%
    
    
    (14.3
    )%
    
    
    (44.1
    )%
    
    
    9.0
    %
 Gross
margin was negative 62.2% the third quarter of fiscal 2004 compared
to negative 14.3% for the same period last year. In the third quarter of fiscal
2004, we recorded a $6.8 million inventory-related charge. Of the $6.8 million
charge, $3.2 million was for inventory on hand, the majority of which was for
our Crusoe and 130 nanometer Efficeon processors. The remaining $3.6 million
of the inventory charge was for non-cancelable orders for substrates and
wafers, the majority of which relates to both our 130 and 90 nanometer Efficeon
processors. The majority of the Efficeon-related charges for inventory on hand
and on order primarily related to the cost to manufacture our 130 nanometer and
90 nanometer Efficeon products exceeding the price at which we expect to be
able to sell these products. Our 130 and 90 nanometer products have incurred
higher than anticipated initial costs of production. Further, we believe that
the initial availability of our first limited production 90 nanometer Efficeon processors in
September 2004 had a greater than expected adverse effect on demand for our
130 nanometer Efficeon microprocessors, and, as a result, we have
to take inventory-related charges for 130 nanometer product on hand and on
order that are in excess of our anticipated demand for that product. We often
must place our orders with third party suppliers in advance of expected
purchase orders form our customers, and, as a result, we may have too much
material for a particular product on hand or on order. Gross margin from our
130 and 90 nanometer parts on hand and on order may benefit from future sales
only to the extent that the associated revenue exceeds their currently adjusted
values. Similarly, our gross margins could be adversely affected if the
products are sold at a price lower than our currently estimated market value.
For the nine months ended September 30, 2004, we have taken a charge of $5.0
million for inventory on order. There were no similar charges related to
purchase commitments in any other periods. We expect that we may incur similar
charges in future periods related to our 90 nanometer Efficeon products until
we are able to align product costs below expected ASPs, which should be
achieved once unit sales of the product are substantial enough to drive down
production costs as the product moves into a stage of substantial volume
production. Gross margin was negative 44.1% for the first nine months of fiscal 2004
compared to 9.0% for the same period last year. As a percent of total revenue,
our product costs decreased 0.2 percentage points, from 73.6% to
73.4%, which was the result of a decrease in average selling prices
as well as a slight increase in the average
dollar cost of products sold in the first nine months of fiscal 2004 compared
to the same period last year. The initial product cost for our 130 nanometer and 90 nanometer
Efficeon TM8000 processors is significantly higher than the product cost of a
more mature product, as the first quarter of fiscal 2004 was our first full
quarter of producing the 130 nanometer product while the third quarter of
fiscal 2004 was the first quarter of producing the 90 nanometer product. Gross
margin was additionally adversely affected in the third quarter of fiscal 2004
as a result of the $6.8 million inventory-related charge noted
above, as well as from a $0.9 million charge related to non-cancelable obligations
that we had made to third party suppliers for goods and services for which we
currently do not anticipate seeing any economic benefits. Gross margin was adversely affected during both periods by unabsorbed
overhead costs as our production-related infrastructure exceeded our needs. For
the third quarter of fiscal 2004, these unabsorbed costs were $0.4 million, or
5.7% of total revenue, compared to $0.5 million, or 17.3% of total revenue, for
the same period in the prior year. For the first nine months of fiscal 2004,
these unabsorbed costs were $0.9 million, or 5.2% of total revenue, compared to
$1.6 million, or 11.4% of total revenue, for the same period in the prior year.
We expect to increase the utilization of our manufacturing overhead in coming
periods as the volume of shipments of our Efficeon TM8000 products increase. Of
the $7.5 million and $8.8 million net inventory on hand at September 30,
2004 and December 31, 2003, respectively, $2.3 million and $2.6 million of
net inventory, respectively, were stated at net realizable value. Accordingly,
gross margin may be impacted from future sales of these parts to the extent
that the associated revenue exceeds or fails to achieve their currently
adjusted values. Benefits to gross margin as a result of products being sold
at ASPs in excess of their previously written down values were $0.1 million and
$0.3 million for the three and nine months ended September 30, 2004,
respectively, compared to $0.2 million and $0.6 million for the same periods
last year. Research and Development Research and development (R&D) expenses were
$13.8 million and $40.2 million for the three and nine months ended September 30, 2004, respectively,
compared to $12.5 million and $37.1 million for the corresponding periods last
year. The increase in R&D expenses for the third quarter of fiscal 2004
compared to the same period last year was due to increases in non-recurring
engineering charges of $1.0 million, headcount-related expenses of $0.7
million and other expenses of $0.4 million, partially offset by a decrease in
consultant expenses of 15




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$0.4 million and depreciation expenses of $0.4 million. The increase in
R&D expenses for the first nine months of fiscal 2004 compared to the same
period last year was due to increases in non-recurring engineering charges of
$1.8 million, headcount-related expenses of $2.0 million and other expenses of
$0.4 million, partially offset by a decrease in depreciation expenses of $1.0
million. The increased engineering and headcount-related expenses through the
first nine months of fiscal 2004 were primarily the result of our increased
efforts devoted to the development of the 90 nanometer and 130 nanometer
manufacturing technology for our Efficeon TM8000 family of microprocessors, as
well as our LongRun2 power management technologies. Partially attributing to
the increase in other expenses was a one time sales tax refund received in
fiscal 2003. The decreases in depreciation expenses were primarily due to
certain property and equipment being fully depreciated throughout the last
fiscal year. Selling, General and Administrative Selling, general and administrative (SG&A) expenses were $7.4 million and
$21.6 million for the three and nine months ended September 30, 2004,
respectively, compared to $6.0 million and $19.0 million for the corresponding
periods last year. The increase in SG&A expenses for the third quarter of
fiscal 2004 compared to the same period last year was due to increases in legal
and accounting expenses of $0.5 million, headcount-related expenses of $0.4
million and consultant expenses of $0.4 million. The increase in SG&A expenses
for the first nine months of fiscal 2004 compared to the same period last year
was due to increases in headcount-related expenses of $1.1 million, building
and facilities expenses of $0.9 million, travel and tradeshow expenses of $0.5
million and advertising expenses of $0.3 million, offset by decreases in
depreciation expenses of $0.7 million and insurance expenses of $0.4 million.
The increased headcount-related expenses, travel and tradeshow expenses and
advertising expenses through the first nine months of fiscal 2004 were
primarily the result of our continued efforts to hire additional personnel, to
expand our presence in the Asia-Pacific market with new offices and to promote
awareness of our Efficeon TM8000 processor. The increased building and
facilities expenses were primarily the result of our increased building
occupancy at our offices in Santa Clara. The increased legal expenses were
primarily the result of higher expenditures for patent protection of our
inventions. The increased accounting expenses were primarily due to costs
incurred for compliance with Section 404 Managements Internal Controls and
Procedures for Financial Reporting of the Sarbanes Oxley Act of 2002. Restructuring Charges As part of our quarterly reassessment of restructuring accruals, during
the third quarter of fiscal 2004, we adjusted our accrued restructuring costs
as a result of an update to certain underlying assumptions. We had previously anticipated subleasing our
vacant facilities in future periods. In view of current market conditions,
this assumption has been revised such that we no longer assume that we will be able to sublease our previously vacated
space that remains unused as of September 30, 2004. As a result of this update
in assumptions, we adjusted the accrued restructuring costs and recorded a
charge of $0.9 million in restructuring charges. Amortization of Deferred Charges, Patents and Patent Rights Amortization of deferred charges, patents and patent rights were $2.2
million and $7.0 million for the three and nine months ended September 30,
2004, respectively, compared to $2.6 million and $7.9 million for the
corresponding periods last year. Amortization charges relate to various patents
and patent rights acquired from Seiko Epson and others during fiscal 2001. Also
included in the amortization charges are accretion expenses associated with the
liability recorded from the acquisition of these patent and patent rights. The
decreases can be attributed to a decrease in accretion expenses as a result of
a reduction in payments due under our patent and patent rights and our
technology license agreement with IBM, as amended. Amounts due under the
agreements decreased from $30.5 million at September 30, 2003 to $16.0 million
at September 30, 2004. Stock Compensation Stock compensation was $0.1 million for the three months ended September
30, 2004 compared to $2.3 million for the same period last year, representing a
decrease of $2.2 million. Stock compensation was $1.6 million for the nine
months ended September 30, 2004 compared to $3.8 million for the same period
last year, representing a decrease of $2.2 million. The two components of stock
compensation were the amortization of deferred stock compensation and variable
stock compensation. Net amortization of deferred stock compensation for the third quarter of
fiscal 2004 was $0.1 million, compared to $0.3 million for the same period last
year. For the first nine months of fiscal 2004, net amortization was $0.7
million, compared to $1.5 million for the same period last year. The decrease
was primarily a result of amortizing the deferred charge on an accelerated
method in accordance with our accounting policy, as well as a decrease in the
number of outstanding options affecting the compensation charge as a result of
cancellations. The amortization of the remaining $12,000 of deferred stock
compensation will continue through the end of fiscal 2004. 16




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Variable stock compensation is based on the excess, if any, of the current
market price of our stock as of the period-end over the purchase price of the
stock award, adjusted for vesting and prior stock compensation expense
recognized on the stock award. Variable stock compensation for the third
quarter of fiscal 2004 was a credit of $49,000, compared to a charge of $2.0
million for the same period last year. This decrease was the result of certain
notes receivable from stockholders being fully paid toward the end of fiscal
2003. For the first nine months of fiscal 2004, variable stock compensation was
$1.0 million, compared to $2.3 million for the same period last year. This
decrease was the result of a lower market price of our stock as of September
30, 2004, compared to the same period in the prior year. Interest Income and Other, Net and Interest Expense Interest income and other, net was $0.2 million and $0.7 million for the
three and nine months ended September 30, 2004, respectively, compared to $0.2
million and $1.2 million for the corresponding periods last year. The decreases
were due to lower average invested cash balances as we continued to use cash to
fund operations, as well as a decrease in interest rates earned on investments
during the period. The decrease in interest expense was primarily the result of
lower average debt balances due to several lease-financing arrangements
expiring during 2003, as well as decreases in certain accretion expenses
related to our facilities lease commitments. Liquidity and Capital Resources Cash and Cash Flows We have historically reported negative cash flows from operations because
the gross profit, if any, generated from our product and licensing revenues has
not been sufficient to cover our operating cash requirements. We
intend to rely on funds that we have received from financing activities until we are able to generate sufficient revenue and
gross profit to cover operational expenses as well as anticipated increases in
our working capital requirements. We believe that our existing cash and cash
equivalents and short-term investment balances and cash from operations will be
insufficient to fund our operations, planned capital and R&D expenditures for
the next twelve months on our current business model because of significant
risks and uncertainties as noted below. Accordingly, we intend to raise during
that time period additional funds through public or private equity or debt
financing. Additional funds may not be available on terms favorable to us or
at all. In the event that we are unable to raise additional funds, we are
positioned to modify our current business model, for example, by leveraging our
intellectual property assets and by focusing on our strategy of licensing our
advanced power management and other technologies to other companies and, in
doing so, to substantially limit our operations and reduce costs related to
aspects of the business other than intellectual property and technology
licensing to permit us to continue to operate on a modified business model for
a period that extends at least through September 30, 2005. For the period through September 30, 2005 and over the longer term, our
capital requirements for our current business model will depend on many
factors, including but not limited to general economic conditions, the rate of
sales growth, market acceptance of our products, costs of securing access to
adequate manufacturing capacity, the timing and extent of research and
development projects and increases in our operating expenses. As we shift our
product mix to our new 90 nanometer Efficeon TM8000 microprocessors, and as we
continue to develop new or enhance existing products or services in line with
our current business model, we expect that, as a result of an increased level
of operations, we will need to increase our non-cash working capital, and
accordingly, the net cash which we will use in our operating activities will
increase. Our ability to increase sales of our Crusoe TM5800 products into
additional market segments, to decrease manufacturing costs for our Crusoe
TM5800 and Efficeon TM8000 products, to achieve market acceptance of our
initial Efficeon TM8000 microprocessor manufactured using a 130 nanometer
process and to transition successfully our Efficeon TM8000 microprocessor to a
90 nanometer process will be particularly critical in determining our cash
needs. All of these factors are subject to significant risks and uncertainties. Although we are currently not a party to any agreement or letter of intent
for a potential acquisition or business combination, we may enter into
acquisitions or business combinations in the future, which also could require
us to seek additional equity or debt financing. If adequate funds were not
available or were not available on acceptable terms, our ability to fund our
operations, take advantage of unanticipated opportunities, develop or enhance
our products or otherwise respond to competitive pressures would be
significantly limited. 17




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As of September 30, 2004 we had $65.1 million in cash, cash equivalents
and short-term investments compared to $120.8 million at December 31, 2003. The following comparison table summarizes our usage of cash and cash
equivalents for the nine months ended September 30, 2004 and the nine months
ended September 30, 2003: Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003(in thousands)Net cash used in operating activities
    
    $
    (61,819
    )
    
    $
    (48,249
    )Net cash provided by/(used in) investing activities
    
    
    (19,356
    )
    
    
    63,966Net cash provided by financing activities
    
    
    15,811
    
    
    
    3,270Increase/(decrease) in cash and cash equivalents
    
    $
    (65,364
    )
    
    $
    18,987
 Net cash used in operating activities was $61.8 million for the nine
months ended September 30, 2004, compared to $48.2 million for the
corresponding period in fiscal 2003. Net cash used during the first nine months
of fiscal 2004 was primarily the result of a net loss of $78.7 million, cash
drawdowns in restructuring charges of $1.3 million and an increase in accounts
receivable of $0.8 million. The net loss and changes in operating assets and
liabilities were partially offset by non-cash charges related to amortization
of patents and patent rights of $7.0 million, increases in accounts payable and
accrued liabilities of $5.7 million, depreciation of $2.8 million, decrease in
inventory of $1.3 million, stock compensation of $1.6 million and non cash
change in restructuring charges of $0.9 million. Net cash used in investing activities was $19.4 million for the nine
months ended September 30, 2004, compared to net cash provided by investing
activities of $64.0 million for the corresponding period in fiscal 2003. This
change was primarily due to $9.8 million in net purchases of available-for-sale
investments for the first nine months of fiscal 2004, compared to net proceeds
of $73.9 million from the maturity of available-for-sale investments for the
same period last year. Additionally, we made scheduled payments for previously
acquired patent and patent rights totaling $7.5 million during the first nine
months of fiscal 2004, compared to $9.0 million in the same period last year.
We have remaining payments to a development partner totaling $16.0 million that
is due in four quarterly installments starting in December 2004. Additional
cash used in investing activities included the purchase of property and
equipment, which amounted to $2.0 million and $0.9 million for the first nine
months in fiscals 2004 and 2003, respectively. Net cash provided by financing activities was $15.8 million for the nine
months ended September 30, 2004, compared to $3.3 million for the corresponding
period in fiscal 2003. This increase was primarily the result of our receipt of
$10.2 million when our underwriters exercised their over-allotment option to
purchase an additional 3.75 million shares of our common stock in relation to
our December 2003 common stock offering. We also received $4.9 million in net
proceeds from sales of common stock under our employee stock purchase and stock
option plans for the first nine months of fiscal 2004, compared to $3.9 million
for the same period last year. Additionally, we received $0.9 million for the
repayment of notes from our stockholders in the first nine months of fiscal
2004. Since our inception, we have financed our operations primarily through
sales of equity securities and, to a lesser extent, from lease financing. It is
reasonably possible that we may continue to seek financing through these
sources of capital as well as other types of financing, including, but not
limited to, debt financing. Additional financing might not be available on
terms favorable to us, or at all. At September 30, 2004, we had $18.4 million in cash and cash equivalents
and $46.7 million in short-term investments. We lease our facilities under
non-cancelable operating leases expiring in 2008, and we lease equipment and
software under non-cancelable leases with terms ranging from 12 to 36 months. Contractual Obligations At September 30, 2004, we had the following contractual obligations: 18




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Payments Due by PeriodLess Than
    
    1-3
    
    AfterContractual Obligations
    
    Total
    
    1 Year
    
    Years
    
    4 Years(In thousands)Capital Lease Obligations
    
    $
    464
    
    
    $
    371
    
    
    $
    93
    
    
    
    Operating Leases(1)
    
    $
    17,438
    
    
    $
    4,559
    
    
    $
    12,879
    
    
    
    Unconditional Purchase Obligations(2)
    
    $
    9,954
    
    
    $
    8,300
    
    
    $
    1,654
    
    
    
    Other Obligation(3)
    
    $
    16,000
    
    
    $
    16,000
    
    
    
    
    
    
    
    Total
    
    $
    43,856
    
    
    $
    29,230
    
    
    $
    14,626
    
    
    $
    
   (1)
    
    Operating leases include agreements for building facilities.(2)
    
    Purchase obligations include agreements to purchase goods or services
that are enforceable and legally binding on Transmeta and that specify all
significant terms, including: fixed or minimum quantities to be purchased;
fixed, minimum or variable price provisions; and the approximate timing of
the transaction. Purchase obligations also include agreements for design
tools and software for use in product development.(3)
    
    Other obligation represents payments to our development partner. Recent Accounting Pronouncements In March 2004, the FASB issued a proposed Statement, Share-Based Payment,
an amendment of FASB Statements Nos. 123 and 95, that addresses the accounting
for share-based payment transactions in which a Company receives employee
services in exchange for either equity instruments of the Company or
liabilities that are based on the fair value of the Companys equity
instruments or that may be settled by the issuance of such equity instruments.
The proposed statement would require all companies to measure compensation cost
for all share-based payments at fair value. The effective date of the proposed
standard is for periods beginning after June 15, 2005. The Company is
currently evaluating the effect that the adoption of the proposed statement
will have on its financial position and results of operations. Risks that Could Affect Future Results The factors discussed below are cautionary statements that identify
important factors that could cause actual results to differ materially from
those anticipated in the forward-looking statements in thisForm 10-K. If any
of the following risks actually occurs, our business, financial condition and
results of operations would suffer. In this case, the trading price of our
common stock could decline and investors might lose all or part of their
investment in our common stock. We have a history of losses, expect to incur further significant losses and may
never achieve or maintain profitability. We have historically reported negative cash flows from operations because
the gross profit, if any, generated from our product and licensing revenues has
not been sufficient to cover our operating cash requirements. Since our
inception, we have incurred cumulative losses aggregating $621.2 million,
including net losses of $78.7 million for the first nine months of fiscal 2004,
$87.6 million in fiscal 2003 and $110.0 million in fiscal 2002, which have
reduced stockholders equity to $70.4 million at September 30, 2004. We
currently expect to continue to incur losses under our current business plan
until at least September 30, 2005. We have financed our operations primarily through sales of equity
securities and, to a lesser extent, from product and license revenue and lease
financing. We believe that our existing cash and cash equivalents and
short-term investment balances and cash from operations will be insufficient to
fund our operations, planned capital and R&D expenditures for the next twelve
months on our current business model. Accordingly, we intend to raise during
that time period significant additional funds through public or private equity
or debt financing. See Managements Discussion and Analysis of Financial
Condition and Results of Operations  Liquidity and Capital Resources.
However, even if we are able to raise additional funds, our ability to continue
to operate under our current business model until we achieve profitability may
be affected by a variety of factors, which may include our ability to achieve
market acceptance for our Efficeon TM8000 products, significant unexpected
technical or manufacturing problems we may experience in transitioning our
Efficeon TM8000 microprocessor to a 90 nanometer manufacturing process or any
significant problems we may face in selling our TM5800 microprocessors in
additional market segments. All of these factors are subject to significant
risks and uncertainties. We may not be able to raise further financing or it may only be available on
terms unfavorable to us or our stockholders. 19




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We intend to raise significant additional funds through public or private
equity or debt financing in order to continue to operate under our current
business model. Further, as we shift our product mix to our next family of
microprocessors, the Efficeon TM8000, and as we continue to develop new or
enhance existing products or services in line with our business model, we
expect that, as a result of an increased level of operations, our cash
expenditures will increase. In addition, we may begin to generate positive cash
flow from operations later than anticipated or we may never generate positive
cash flow from operations. A variety of other business contingencies could
contribute to our need for funds in the future, including the need to:  
    
    fund expansion;
    
    fund marketing expenditures;
    
    develop new products or enhance existing products;
    
    enhance our operating infrastructure;
    
    hire additional personnel;
    
    respond to customer concerns about our viability;
    
    respond to competitive pressures; or
    
    acquire complementary businesses or technologies. If we were to raise additional funds through the issuance of equity or
convertible debt securities, the percentage ownership of our stockholders would
be reduced, and these newly issued securities might have rights, preferences or
privileges senior to those of our then-existing stockholders. Additional
financing might not be available on terms favorable to us, or at all. For
example, in order to raise equity financing, we may decide to sell our stock at
a discount of our then current trading price, which may have an adverse effect
on our future trading price. If adequate funds were not available on acceptable
terms or at all, we are positioned to modify our current business model, for
example, by leveraging our intellectual property assets and by focusing on our
strategy of licensing our advanced power management and other technologies to
other companies and, in doing so, to substantially limit our operations and
reduce costs related to aspects of the business other than intellectual
property and technology licensing to permit us to continue to operate on a
modified business model for a period that extends at least through September
30, 2005. If we are unable to raise significant additional funds or
appropriately modify our business model, then we expect that our independent
auditors will issue a going concern opinion that would raise substantial doubt
about our ability to continue as a going concern. The uncertainty raised by a
going concern opinion may cause our stock price to fall and impair our ability
to raise additional capital. This uncertainty may create a concern among our
current and future customers and vendors as to whether we will be able to
fulfill our obligations or, in the case of customers, fulfill their future
product or service needs. As a result, current and future customers may
determine not to do business with us, or only do so on less favorable terms,
which would cause our revenues to decline. Employee concern about the future
of the business and their continued prospects for employment may cause them to
seek employment elsewhere, depriving us of the human capital we need to be
successful. Our future operating results under our current business model will depend
significantly on sales of our new Efficeon TM8000 products. Our future revenue and gross margins under our current business model will
be influenced in large part by the level of sales of our new Efficeon TM8000
products. Therefore, our future operating results will depend on the demand for
these products from future customers. We began shipment in the fourth quarter
of 2003 of our initial Efficeon TM8000 microprocessor manufactured using a 130
nanometer complementary metal oxide semiconductor, or CMOS, process. In
September 2004, we began limited production of our TM8800 Efficeon processor on
an advanced 90 nanometer CMOS manufacturing process. If we experience delays
in manufacturing sufficient quantities of microprocessors, our target customers
could design a competitors microprocessor into their product, which would lead
to lost sales and impede our ability to generate market interest in our new
microprocessor. If these products are not widely accepted by the market due to
performance, price, compatibility or any other reason, significant demand for
our new products may fail to materialize. We are transitioning the manufacturing of our Efficeon TM8000
microprocessors to a 90 nanometer CMOS process, and we have achieved limited production on the new 90 nanometer process. We believe that
successfully completing this transition will be 20




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important to our ability to achieve broad market acceptance of our
Efficeon TM8000 microprocessors and to our ability to compete, particularly in
market segments in which performance is a key competitive factor such as the
notebook personal computer and blade server markets. The availability of our 90
nanometer Efficeon TM8000 appears to have reduced, and may continue to reduce,
demand for our 130 nanometer Efficeon TM8000 microprocessor. We cannot be sure
that we will successfully achieve volume production of the Efficeon TM8000
microprocessor using the 90 nanometer process. We could encounter a variety of technical and manufacturing problems that could
delay or prevent volume shipments of Efficeon TM8000 microprocessors
manufactured using a 90 nanometer process. Transitioning our TM8000 microprocessors to a 90 nanometer manufacturing
process involves a variety of technical and manufacturing challenges. We are
using Fujitsu Microelectronics to manufacture our initial 90 nanometer Efficeon
TM8000 microprocessors. Fujitsu Microelectronics has limited experience with
the 90 nanometer CMOS process and, although we have achieved limited production
of our Efficeon TM8800 product on the Fujitsu Microelectronics 90 nanometer
CMOS process, we cannot be sure that Fujitsu Microelectronics 90 nanometer
foundry will achieve production shipments on our planned schedule or that other
manufacturing challenges might later arise. For example, during 2001 we
experienced yield problems as we migrated our products to smaller geometries,
which caused increases in our product costs, delays in product availability and
diversion of engineering personnel. If we encounter problems with the
manufacture of the Efficeon TM8000 microprocessors using the 90 nanometer
process that are more significant or take longer to resolve than we anticipate,
our ability to increase our revenue would suffer and we could incur significant
expenses. If those problems prove to be more serious than expected and cannot
be remedied on a timely basis and at a reasonable cost, our stock price would
likely be very substantially reduced. Our Crusoe TM5800 microprocessors are experiencing decreasing demand from
notebook computer manufacturers and are experiencing declining average selling
prices. If we are unable to sell the TM5800 microprocessors into additional
market segments or reduce our costs of production, our operating results will
suffer. As our Crusoe TM5800 microprocessors have matured, demand for the TM5800
microprocessors from notebook computer manufacturers has declined in that
market segment. We have begun to sell the TM5800 microprocessors into
additional market segments such as the thin client, ultra-personal computer, or
UPC, and embedded computer market segments, many of which are only beginning to
be developed. We cannot be sure that we will be successful in selling the
TM5800 microprocessors into these markets or that these markets will experience
significant growth. In addition, the average selling price of the TM5800
microprocessors has decreased, and we expect that pricing pressure on the
TM5800 microprocessors will continue to increase as sales of these
microprocessors increasingly derive from geographies and market segments that
traditionally demand lower average selling prices. If we are unable to achieve
sufficient reductions in our costs of products sold, this decline in prices
will adversely affect our gross margins. The growth of our business depends in part upon the development of emerging
markets and our ability to meet the needs of these markets. The growth of our business depends in part on acceptance and use of our
products in new classes of devices such as UPCs, high density
servers and new embedded processor applications. We depend on the ability of
our target customers to develop new products and enhance existing products for
these markets that incorporate our products and to introduce and promote their
products successfully. These new markets often rely on newly developed
technologies, which will require extensive development and marketing before
widespread acceptance is achieved, so the new markets may grow slowly, if at
all. If the new markets do not grow as we anticipate, our target customers do
not incorporate our products into theirs, or our products are not widely
accepted by end users, our ability to increase our revenues would suffer. In
addition, manufacturers within emerging markets may have widely varying
requirements. To meet the requirements of different manufacturers and markets,
we may be required to change our product design or features, sales methods or
pricing policies. The costs of addressing these requirements could be
substantial and could delay or prevent any improvement in our operating
results. Our future revenue depends in part upon our ability to penetrate additional
segments of the notebook computer market. Historically, our sales in the notebook computer market have primarily
been in the market segment consisting of thin and light notebook computers for
which low heat generation and power consumption are particularly critical. Our
ability to increase our revenues in the future will depend in significant part
on our ability to market our new Efficeon TM8000 microprocessors in additional
segments of the notebook computer market in which microprocessor performance is
a more significant factor. These notebook market segments are intensely
competitive and dominated by Intel. We have not succeeded in deriving
significant revenues from sales of our 21




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microprocessors in these market segments in the past and cannot be sure
that we will successfully market and sell our microprocessor products in these
market segments in the future. Due to our software-based approach to microprocessor design, we have been
required, and expect to continue to be required, to devote substantial
resources to educate prospective customers in the notebook computer market
about the benefits of our products and to assist potential customers with their
designs. In addition, since computer products generally are designed to
incorporate a specific microprocessor, original equipment manufacturers, or
OEMs, must design new products to utilize different microprocessors such as our
products. Given the complexity of these computer products and their many
components, designing new products requires significant investments. For
instance, OEMs may need to design new computer casings, basic input/output
system, or BIOS, software and motherboards. Our target customers may not choose
our products for technical, performance, packaging, novelty, design cost or
other reasons. If our products fail to achieve widespread acceptance in the
notebook computer market, our ability to increase our revenue would likely be
seriously harmed. We might not succeed if we choose to transition to a modified business model. In the event that we are unable to raise additional funds to cover
operational expenses, planned capital and R&D expenditures, as well as
anticipated increases in our working capital requirements, we are positioned to
modify our current business model, for example, by leveraging our intellectual
property assets and by focusing on our strategy of licensing our advanced power
management and other technologies to other companies. There would be
significant risks and costs inherent in any efforts that we may undertake under
a modified business model. These include the risks that we may not be able to
develop viable products or services, achieve market acceptance for our products
or services, earn adequate revenues from the sale of our products or services,
or achieve profitability. Employee concern about the future of the business
and their continued prospects for employment might cause them to seek
employment elsewhere, depriving us of the human capital we would need to be
succeed. Since limited operating and financial information would be available
relating to a modified business model, it would be difficult for us, as well as
investors, to evaluate our performance and future prospects. Our prospects
would need to be considered in light of the uncertainties and difficulties
frequently encountered by companies in their early stages of development. The
uncertainty raised by modifying our business model might cause our stock price
to fall and impair our ability to raise additional capital. We might not experience growth in our licensing revenues. Licensing revenue was $4.2 million for the first nine months of fiscal
year 2004 and $1.1 million for fiscal year 2003. However, we may not recognize
significant licensing revenue in the future. License transactions often have a
long sales cycle and can result in additional liability, such as
indemnification obligations. A portion of the revenue to which we might be
entitled under some of our license transactions depends upon our provision of
future deliverables to licensees. If we do not provide those deliverables in a
timely and satisfactory manner, then we may not receive that portion of the
revenue and we may strain our relationship with the licensee. In addition, the
amount of revenue we recognize under some of our license transactions can
depend significantly upon product sales by the licensees, over which we will
have no control. While we anticipate that we will continue to license our
technology to licensees, we cannot predict the timing or the extent of any
future licensing revenue, and recent levels of license revenues may not be
indicative of future periods. We face intense competition in the x86-compatible microprocessor market. Many
of our competitors are much larger than we are and have significantly greater
resources. We may not be able to compete effectively. The market for microprocessors is intensely competitive. We may not be
able to compete effectively against current and potential competitors,
especially those with significantly greater resources and market leverage.
Competition may cause price reductions, reduced gross margins and loss of
market share, any one of which could significantly reduce our future revenue
and increase our losses. For example, we may determine to lower the prices of
our products in order to increase or maintain market share, which would likely
increase our losses. Significant competitors in the x86-compatible microprocessor product
market include Intel, Advanced Micro Devices and VIA Technologies. Our current
and potential competitors have longer operating histories, significantly
greater financial, technical, product development and marketing resources,
greater name recognition and significantly larger customer bases than we do.
Our competitors may be able to develop products comparable or superior to those
we offer, adapt more quickly than we do to new technologies, evolving industry
trends and customer requirements, and devote greater resources to the
development, promotion and sale of their products than we can. Many of our
competitors also have well-established relationships with our existing and
prospective customers and suppliers. As a result of these factors, many of our
competitors, either alone or with other companies, have significant influence
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our target markets that could outweigh any advantage that we may possess.
For example, negotiating and maintaining favorable customer and strategic
relationships are and will continue to be critical to our business. If our
competitors use their influence to negotiate strategic relationships on more
favorable terms than we are able to negotiate, or if they structure
relationships that impair our ability to form strategic relationships, our
competitive position and our business would be substantially damaged. In particular, Intel has dominated the market for x86-compatible
microprocessors for many years. We may be adversely affected by Intels pricing
decisions, product mix and introduction schedules, marketing strategies and
influence over industry standards and other market participants and the loyalty
of consumers to the Intel brand. We cannot be sure that we can compete
effectively against Intel even in the market segments that we intend to target. In 2003, Intel introduced a new microprocessor that is focused on the
notebook computer market segment and designed to consume less power than its
prior microprocessors. We expect that Intel, and potentially other
microprocessor companies, will increasingly seek to offer microprocessors
specifically targeted at many of the same market segments that we intend to
serve, which could adversely affect our ability to compete successfully. Furthermore, our competitors may merge or form strategic relationships
that might enable them to offer, or bring to market earlier, products that are
superior to ours in terms of features, quality, pricing or other factors. We
expect additional competition from other established and emerging companies and
technologies. We may experience manufacturing difficulties that could increase the cost and
reduce the supply of our products. The fabrication of wafers for our microprocessors is a highly complex and
precise process that requires production in a tightly controlled, clean room
environment. Minute impurities, difficulties in the fabrication process,
defects in the masks used to print circuits on a wafer or other factors can
cause numerous die on each wafer to be nonfunctional. The proportion of
functional die expressed as a percentage of total die on a wafer is referred to
as product yield. Semiconductor companies frequently encounter difficulties
in achieving expected product yields, particularly when introducing new
products. Yield problems may not be identified and resolved until a product has
been manufactured and can be analyzed and tested, if ever. As a result, yield
problems are often difficult, time-consuming and expensive to correct. We have
experienced yield problems in the past, and we may experience yield problems in
the future that impair our ability to deliver our products to our customers,
increase our costs, adversely affect our margins and divert the efforts of our
engineering personnel. Difficulties in achieving the desired yields often occur
in the early stages of production of a new product or in the migration of
manufacturing processes to smaller geometries. We could experience difficulties
in achieving desired yields or other manufacturing problems in the production
of our Efficeon TM8000 products that could delay our ability to further
introduce Efficeon TM8000 products in volume, adversely affect our costs and
gross margins and harm our reputation. In addition, we could also experience
these difficulties as we migrate the Efficeon TM8000 products to a 90 nanometer
process technology, which poses significant technical challenges and in which
neither we nor Fujitsu Microelectronics, which we intend to use to manufacture
these products, has significant experience. Even with functional die, normal
variations in wafer fabrication can cause some die to run faster than others.
Variations in speed yield could lead to excess inventory of the slower, less
valuable die, a resulting unfavorable impact on gross margins and an
insufficient inventory of faster products, depending upon customer demand. Our lengthy and variable sales cycles make it difficult for us to predict when
and if a design win will result in volume shipments. We depend upon other companies designing our microprocessors into their
products, which we refer to as design wins. Many of our targeted customers
consider the choice of a microprocessor to be a strategic decision. Thus our
targeted customers may take a long time to evaluate our products, and many
individuals may be involved in the evaluation process. We anticipate that the
length of time between our initial contact with a customer and the time when we
recognize revenue from that customer will vary. We expect our sales cycles to
range typically from six to 12 months, or more, from the time we achieve a
design win to the time the customer begins volume production of products that
incorporate our microprocessors. We do not have historical experience selling
our products that is sufficient for us to determine accurately how our sales
cycles will affect the timing of our revenue. Variations in the length of our
sales cycles could cause our revenue to fluctuate widely from period to period.
While potential customers are evaluating our products and before they place an
order with us, we may incur sales and marketing expenses and expend significant
management and engineering resources without any assurance of success. The
value of any design win depends upon the commercial success of our customers
products. If our customers cancel projects or change product plans, we could
lose anticipated sales. We can offer no assurance that we will achieve further
design wins or that the products for which we achieve design wins will
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If we fail to forecast demand for our products accurately, we could lose sales
and incur inventory losses. The demand for our products depends upon many factors and is difficult to
forecast. Many shipments of our products may be made near the end of the fiscal
quarter, which makes it difficult to estimate demand for our products. We
expect that it will become more difficult to forecast demand as we introduce
new products and as competition in the markets for our products intensifies.
Significant unanticipated fluctuations in demand have caused, and in the future
could cause, problems in our operations. The lead-time required to fabricate
large volumes of wafers is often longer than the lead-time our customers
provide to us for delivery of their product requirements. Therefore, we often
must place our orders in advance of expected purchase orders from our
customers. As a result, we have only a limited ability to react to fluctuations
in demand for our products, which could cause us to have either too much or too

little inventory of a particular product. If demand does not develop as we
expect, we could have excess production. Excess production would result in
excess inventories of product, which would use cash and could result in
inventory write-downs and write-offs. For example, we recorded a $6.8 million
inventory-related charge for the third quarter of fiscal 2004. We have limited
capability to reduce ongoing production once wafer fabrication has commenced.
Further, as we introduce product enhancements and new products, and improve our
manufacturing processes, demand for our existing products decreases.
Conversely, if demand exceeds our expectations, Taiwan Semiconductor
Manufacturing Company, or TSMC, or Fujitsu Microelectronics might not be able
to fabricate wafers as quickly as we need them. Also, Advanced Semiconductor
Engineering, or ASE, might not be able to increase assembly functions in a
timely manner. In that event, we would need to increase production and assembly
rapidly or find, qualify and begin production and assembly at additional
manufacturers or providers of assembly and test services, which may not be
possible within a time frame acceptable to our customers. The inability of our
product manufacturer or ASE to increase production rapidly enough could cause
us to fail to meet customer demand. In addition, rapid increases in production
levels to meet unanticipated demand could result in higher costs for
manufacturing and other expenses. These higher costs could lower our gross
margins. We currently derive a substantial portion of our revenue from a small number of
customers, and our revenue would decline significantly if any major customer
were to cancel, reduce or delay a purchase of our products. Sales to three customers in the aggregate accounted for 70% of total
revenue in the first nine months of fiscal 2004. These customers are located in
Asia, which subjects us to economic cycles in that area as well as the
geographic areas in which they sell their products containing our
microprocessors. We expect that a small number of customers and distributors
will continue to account for a significant portion of our revenue. Our future
success will depend upon the timing and size of future purchase orders, if any,
from these customers and new customers and, in particular:  
    
    the success of our customers in marketing products that incorporate our products;
    
    the product requirements of our customers; and
    
    the financial and operational success of our customers. We expect that our sales to OEM customers will continue to be made on the
basis of purchase orders rather than long-term commitments. In addition,
customers can delay, modify or cancel orders without penalty. Many of our
customers and potential customers are significantly larger than we are and have
sufficient bargaining power to demand reduced prices and favorable nonstandard
terms. The loss of any major customer, or the delay of significant orders from
these customers, could reduce or delay our recognition of revenue. We have entered into distributor agreements and rely in part on
distributors and stocking representatives for sales of our products in large
territories, including Japan, Taiwan, Hong Kong, Europe, China, Korea and North
America. These agreements do not contain minimum purchase commitments. Additionally, we have entered into agreements with manufacturers
representatives in North America and Europe. Any distributor, stocking
representative or manufacturers representative that fails to emphasize sales
of our products, chooses to emphasize alternative products or devices or to
promote products of our competitors might not sell a significant amount or any
of our products. If our customers are not able to obtain the other components necessary to build
their systems, sales of our products could be delayed or cancelled. 24




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Suppliers of other components incorporated into our customers systems may
experience shortages, which could reduce the demand for our products. For
example, from time to time, the computer and semiconductor industries have
experienced shortages of some materials and devices, such as memory components,
displays, and storage devices. Our customers could defer or cancel purchases of
our products if they are not able to obtain the other components necessary to
build their systems. We rely on an independent foundry that has no obligation to provide us with
fixed pricing or production capacity for the fabrication of our wafers, and our
business will suffer if we are unable to obtain sufficient production capacity
on favorable terms. We do not have our own manufacturing facilities and, therefore, must rely
on third parties to manufacture our products. We currently rely on TSMC in
Taiwan to fabricate the wafers for our current 130 nanometer products, and we
rely on Fujitsu Microelectronics in Japan to manufacture our initial 90
nanometer Efficeon TM8000 products. As is common in the industry, we do not
have a manufacturing contract with TSMC that guarantees any particular
production capacity or any particular price, and although we have not yet
entered into a definitive manufacturing agreement with Fujitsu
Microelectronics, we cannot be assured that we will have any guaranteed
production capacity with Fujitsu Microelectronics. The Fujitsu Microelectronics
90 nanometer foundry has relatively limited capacity and we cannot be sure that
sufficient capacity will be available at that foundry to enable us to
manufacture our initial 90 nanometer Efficeon TM8000 products in the quantities
that we would desire if these products were to achieve rapid market acceptance. These foundries may allocate capacity to other companies products while
reducing the capacity available to us on short notice. Foundry customers that
are larger than we and have greater economic resources, that have long-term
agreements with these foundries or that purchase in significantly larger
volumes than we may cause these foundries to reallocate capacity to them,
decreasing the capacity available to us. In addition, these foundries could,
with little or no notice, refuse to continue to fabricate all or some of the
wafers that we require. If these foundries were to stop manufacturing for us,
we would likely be unable to replace the lost capacity in a timely manner.
Transferring to another manufacturer would require a significant amount of time
and money. As a result, we could lose potential sales and fail to meet existing
obligations to our customers. These foundries could also, with little or no
notice, change the terms under which they manufacture for us, which could cause
our manufacturing costs to increase substantially. Our reliance on TSMC and Fujitsu Microelectronics to fabricate our wafers
limits our ability to control the production, supply and delivery of our
products. Our reliance on third-party manufacturers exposes us to a number of risks
outside our control, including the following:  
    
    unpredictability of manufacturing yields and production costs;
    
    interruptions in shipments;
    
    inability to control quality of finished products;
    
    inability to control product delivery schedules;
    
    potential lack of access to key fabrication process technologies; and
    
    potentially greater exposure to misappropriation of our intellectual property. We depend on ASE to provide assembly and test services. If ASE were to cease
providing services to us in a timely manner and on acceptable terms, our
business would suffer. We rely on ASE, which is located in Taiwan, for the majority of our
assembly and test services. We do not have a contract with ASE for test and
assembly services, and we typically procure these services from ASE on a per
order basis. ASE could cease to perform all of the services that we require, or
could change the terms upon which it performs services for us. If we were
required to find and qualify alternative assembly or testing services, we could
experience delays in product shipments, increased product costs or a decline in
product quality. In addition, as a result of our reliance on ASE, we do not
directly control our product delivery schedules. If ASE were not to provide
high quality services in a timely manner, our costs could increase, we could
experience delays in the delivery of our products and our product quality could
suffer. 25




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If our products are not compatible with industry standards, hardware that our
customers design into their systems or that is used by end-users or software
applications or operating systems for x86-compatible microprocessors, market
acceptance of our products and our ability to maintain or increase our revenues
would suffer. Our products are designed to function as components of a system. If our
customers experience system-level incompatibilities between our products and
the other components in their systems, we could be required to modify our
products to overcome the incompatibilities or delay shipment of our products
until the manufacturers of other components modify their products or until our
customers select other components. These events would delay purchases of our
products, cause orders for our products to be cancelled or result in product
returns. In addition, to gain and maintain market acceptance, our microprocessors
must not have significant incompatibilities with software for x86-compatible
microprocessors, and in particular, the Windows operating systems, or hardware
used by end-users. Software applications, games or operating systems with
machine-specific routines programmed into them can result in specific
incompatibilities. If a particular software application, game or operating
system is programmed in a manner that makes it unable to respond correctly to
our microprocessor, it will appear to users of that software that our
microprocessor is not compatible with that software. Software or hardware

incompatibilities that are significant or are perceived to be significant could
hinder our products from achieving or maintaining market acceptance and impair
our ability to increase our revenues. In an effort to test and ensure the compatibility of our products with
hardware and software for x86-compatible microprocessors, we rely on the
cooperation of third-party hardware and software companies, including
manufacturers of graphics chips, motherboards, BIOS software and other
components. All of these third-party designers and manufacturers produce
chipsets, motherboards, BIOS software and other components to support each new
generation of Intels microprocessors, and Intel has significant leverage over
their business opportunities. If these third parties were to cease supporting
our microprocessor products, our business would suffer. Our products may have defects that could damage our reputation, decrease market
acceptance of our products, cause us to lose customers and revenue and result
in liability to us. Highly complex products such as our microprocessors may contain hardware
or software defects or bugs for many reasons, including design issues or
defective materials or manufacturing processes. Often, these defects and bugs
are not detected until after the products have been shipped. If any of our
products contains defects, or has reliability, quality or compatibility
problems, our reputation might be damaged significantly and customers might be
reluctant to buy our products, which could result in the loss of or failure to
attract customers. In addition, these defects could interrupt or delay sales.
We may have to invest significant capital and other resources to correct these
problems. If any of these problems is not found until after we have commenced
commercial production of a new product, we might incur substantial additional
development costs. If we fail to provide solutions to the problems, such as
software patches, we could also incur product recall, repair or replacement
costs. These problems might also result in claims against us by our customers
or others. In addition, these problems might divert our technical and other
resources from other development efforts. Moreover, we would likely lose, or
experience a delay in, market acceptance of the affected product or products,
and we could lose credibility with our current and prospective customers. This
is particularly significant as we are a new entrant to a market dominated by
large well-established companies. We are subject to general economic and market conditions. Our business is subject to the effects of general economic conditions in
the United States and worldwide and, in particular, market conditions in the
semiconductor and computer industries. In 2001, 2002 and through parts of 2003,
our operating results were adversely affected by unfavorable global economic
conditions and reduced information technology spending, particularly in Japan,
where we currently generate a substantial portion of our revenue. These adverse
conditions resulted in decreased demand for notebook computers and, as a
result, our products, which are components of notebook computers. Further,
demand for our products decreases as computer manufacturers seek to manage
their component and finished product inventory levels. If the economic
conditions in Japan and worldwide do not improve, or worsen, we may continue to
experience material adverse effects on our business, operating results and
financial condition. The cyclical nature of the semiconductor industry could create fluctuations in
our operating results. The semiconductor industry has historically been cyclical and
characterized by wide fluctuations in product supply and demand. From time to
time, the industry has also experienced significant downturns, often in
connection with, or in anticipation of, maturing product cycles and declines in
general economic conditions. Industry downturns have been characterized by
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demand, production overcapacity and accelerated decline in average selling
prices, and in some cases have lasted for more than a year. The industry
experienced a downturn of this type in 1997 and 1998, and began experiencing a
downturn again in 2001. Our revenue has decreased, in part due to industry-wide
downturns, and could decrease further. In addition, we may determine to lower
our prices of our products to increase or maintain market share, which would
likely harm our operating results. If we do not keep pace with technological change, our products may not be
competitive and our revenue and operating results may suffer. The semiconductor industry is characterized by rapid technological change,
frequent new product introductions and enhancements, and ongoing customer
demands for greater performance. In addition, the average selling price of any
particular microprocessor product has historically decreased substantially over
its life, and we expect that trend to continue. As a result, our products may
not be competitive if we fail to introduce new products or product enhancements
that meet evolving customer demands. It may be difficult or costly for us, or
we may not be able, to enhance existing products to fully meet customer
demands. For instance, in order to meet the demands of our customers for
enhancement of our existing products, we may incur manufacturing or other costs
that would harm our operating margins and financial condition. Further, we may
not achieve further design wins with current customers unless we continue to
meet their evolving needs by developing new products. The development of new
products is complex, and we may not be able to complete development in a timely
manner, or at all. To introduce and improve products on a timely basis, we
must:  
    
    accurately define and design new products to meet market needs;
    
    design features that continue to differentiate our products from those of our competitors;
    
    transition our products to new manufacturing process technologies;
    
    identify emerging technological trends in our target markets;
    
    anticipate changes in end-user preferences with respect to our customers products;
    
    bring products to market on a timely basis at competitive prices; and
    
    respond effectively to technological changes or product announcements by others. We believe that we will need to continue to enhance our products and
develop new products to keep pace with competitive and technological
developments and to achieve market acceptance for our products. We may incur
significant research and development, manufacturing or other costs that would
harm our operating margins and financial conditions, in our development
efforts. These efforts may not result in enhanced products, or in additional
product sales. Accordingly, these investments may not provide us with an
acceptable return, or any return at all. Advances in battery design, cooling systems and power management systems could
adversely affect our ability to achieve widespread market acceptance for our
products. We believe that our ability to achieve widespread market acceptance for
our products will depend in large part on whether potential purchasers of our
products believe that the low power usage of our products is a substantial
benefit. Advances in battery technology, or energy technologies such as fuel
cell technologies, that offer increased battery life and enhanced power
capacity, as well as the development and introduction of more advanced cooling
systems, may make microprocessor power consumption a less important factor to
our customers and potential customers. These developments, or developments in
power management systems by third parties, may adversely affect our ability to
market and sell our products and increase our revenues. Our products may infringe the intellectual property rights of others, which may
cause us to become subject to expensive litigation, cause us to incur
substantial damages, require us to pay significant license fees or prevent us
from selling our products. Our industry is characterized by the existence of a large number of
patents and frequent claims and related litigation regarding patent and other
intellectual property rights. We cannot be certain that our products do not and
will not infringe issued patents, patents that may be issued in the future, or
other intellectual property rights of others. In addition, leading companies in
the semiconductor industry have extensive intellectual property portfolios with
respect to semiconductor technology. From time to time, third parties, 27




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including these leading companies, may assert exclusive patent, copyright,
trademark and other intellectual property rights to technologies and related
methods that are important to us. We expect that we may become subject to
infringement claims as the number of products and competitors in our target
markets grows and the functionality of products overlaps. We have received, and
may in the future receive, communications from third parties asserting patent
or other intellectual property rights covering our products. Litigation may be
necessary in the future to defend against claims of infringement or invalidity,
to determine the validity and scope of the proprietary rights of others, to
enforce our intellectual property rights, or to protect our trade secrets. We
may also be subject to claims from customers for indemnification. Any resulting
litigation, regardless of its resolution, could result in substantial costs and
diversion of resources. If it were determined that our products infringe the intellectual property
rights of others, we would need to obtain licenses from these parties or
substantially reengineer our products in order to avoid infringement. We might
not be able to obtain the necessary licenses on acceptable terms, or at all, or
to reengineer our products successfully. Moreover, if we are sued for
infringement and lose the suit, we could be required to pay substantial damages
or be enjoined from licensing or using the infringing products or technology.
Any of the foregoing could cause us to incur significant costs and prevent us
from selling our products. If we are unable to protect our proprietary rights adequately, our competitors
might gain access to our technology and we might not compete successfully in
our markets. We believe that our success will depend in part upon our proprietary
technology. We rely on a combination of patents, copyrights, trademarks, trade
secret laws and contractual obligations with employees and third parties to
protect our proprietary rights. These legal protections provide only limited
protection and may be time consuming and expensive to obtain and enforce. If we
fail to protect our proprietary rights adequately, our competitors might gain
access to our technology. As a result, our competitors might offer similar
products and we might not be able to compete successfully in our market.
Moreover, despite our efforts to protect our proprietary rights, unauthorized
parties may copy aspects of our products and obtain and use information that we
regard as proprietary. Also, our competitors may independently develop similar,
but not infringing, technology, duplicate our products, or design around our
patents or our other intellectual property. In addition, other parties may
breach confidentiality agreements or other protective contracts with us, and we
may not be able to enforce our rights in the event of these breaches.
Furthermore, we expect that we will increase our international operations in
the future, and the laws of many foreign countries do not protect our
intellectual property rights to the same extent as the laws of the United
States. We may be required to spend significant resources to monitor and
protect our intellectual property rights. Our pending patent and trademark applications may not be approved. Our
patents, including any patents that may result from our patent applications,
may not provide us with any competitive advantage or may be challenged by third
parties. If challenged, our patents might not be upheld or their claims could
be narrowed. We may initiate claims or litigation against third parties based
on our proprietary rights. Any litigation surrounding our rights could force us
to divert important financial and other resources from our business operations. We might not be able to execute on our business plan if we lose key management
or technical personnel, on whose knowledge, leadership and technical expertise
we rely. Our success depends heavily upon the contributions of our key management
and technical personnel, whose knowledge, leadership and technical expertise
would be difficult to replace. Many of these individuals have been with us for
several years and have developed specialized knowledge and skills relating to
our technology and business. For instance, Svend-Olav Carlsen, who had joined
Transmeta in October 2000 and was promoted to be our Chief Financial Officer in
June 2002, resigned in June 2004. Others have joined us in senior management
roles only recently. In September 2004, Mark R. Kent joined us as our Chief
Financial Officer. All of our executive officers and key personnel are
employees at will. We have no employment contracts and do not maintain key
person insurance on any of our personnel. We might not be able to execute on
our business plan if we were to lose the services of any of our key personnel.
If any of these individuals were to leave our company unexpectedly, we could
face substantial difficulty in hiring qualified successors and could experience
a loss in productivity while any such successor develops the necessary training
and experience. We will not be able to grow our business if we are unable to hire, train and
retain sales, marketing, operations, engineering and finance personnel. To grow our business successfully and maintain a high level of quality, we
will need to recruit, train, retain and motivate highly skilled sales,
marketing, operations, engineering and finance personnel. We will need to
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organizations in order to increase market awareness of our products and to
increase revenue. In addition, as a company focused on the development of
complex products, we will need to hire skilled engineering staff of various
experience levels in order to meet our product roadmap. We may not be able to
hire on a timely basis a sufficient number of skilled employees, which could
lead to delays in product deliveries or the development of new products.
Competition for skilled employees, particularly in the San Francisco Bay Area,
is intense. We may have difficulty recruiting potential employees and retaining
our key personnel if prospective or current employees perceive the equity
component of our compensation package to be less valuable than that of other
employers. The evolution of our business could place significant strain on our management
systems, infrastructure and other resources, and our business may not succeed
if we fail to manage it effectively. Our ability to implement our business plan in a rapidly evolving market
requires effective planning and management process. Changes in our business
plans could place significant strain on our management systems, infrastructure
and other resources. In addition, we expect that we will continue to improve
our financial and managerial controls and procedures. We will also need to
expand, train and manage our workforce worldwide. Furthermore, we expect that
we will be required to manage an increasing number of relationships with
suppliers, manufacturers, customers and other third parties. If we fail to
manage change effectively, our employee-related costs and employee turnover
could increase and our business may not succeed. We have significant international operations and plan to expand our
international operations, which exposes us to risk and uncertainties. We believe that we must expand our international sales and distribution
operations to be successful. We have sold, and in the future we expect to sell,
most of our products to customers in Asia. In addition, TSMC and ASE are
located in Taiwan, and the Fujitsu Microelectronics foundry we use for our
initial 90 nanometer product is located in Japan. As part of our international
expansion, we have personnel in Japan, Taiwan, China, Korea and Europe who
provide sales and customer support. We have appointed distributors, stocking
representatives and manufacturers representatives to sell products in Japan,
Taiwan, Hong Kong, Europe, China, Korea and North America. In addition, we
generally ship our products from a third-party warehouse facility located in
Hong Kong. In attempting to conduct and expand business internationally, we are
exposed to various risks that could adversely affect our international
operations and, consequently, our operating results, including:  
    
    difficulties and costs of staffing and managing international operations;
    
    fluctuations in currency exchange rates;
    
    unexpected changes in regulatory requirements, including imposition of currency exchange controls;
    
    longer accounts receivable collection cycles;
    
    import or export licensing requirements;
    
    problems in the timeliness or quality of product deliveries;
    
    potentially adverse tax consequences;
    
    major health concerns, such as SARS;
    
    political and economic instability, for example as a result of tensions
between Taiwan and the Peoples Republic of China; and
    
    potentially reduced protection for intellectual property rights. Our operating results are difficult to predict and fluctuate significantly. A
failure to meet the expectations of securities analysts or investors could
result in a substantial decline in our stock price. Our operating results fluctuate significantly from quarter to quarter, and
we expect that our operating results will fluctuate significantly in the future
as a result of one or more of the risks described in this section or as a
result of numerous other factors. You should not rely on quarter-to-quarter
comparisons of our results of operations as an indication of our future
performance. Our stock 29




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price has declined substantially since our stock began trading publicly.
If our future operating results fail to meet or exceed the expectations of
securities analysts or investors, our stock price would likely decline from
current levels. A large portion of our expenses, including rent and salaries, is fixed and
difficult to reduce. Our expenses are based in part on expectations for our
revenue. If our revenue does not meet our expectations, the adverse effect of
the revenue shortfall upon our operating results may be acute in light of the
fixed nature of our expenses. We often make many shipments of our products at
or near the end of the fiscal quarter, which makes it difficult to estimate or
adjust our operating activities quickly in response to a shortfall in expected
revenue. The price of our common stock has been volatile and is subject to wide
fluctuations. The market price of our common stock has been volatile and is likely to
remain subject to wide fluctuations in the future. Many factors could cause the
market price of our common stock to fluctuate, including:  
    
    variations in our quarterly results;
    
    market conditions in our industry, the industries of our customers and the economy as a whole;
    
    announcements of technological innovations by us or by our competitors;
    
    introductions of new products or new pricing policies by us or by our competitors;
    
    acquisitions or strategic alliances by us or by our competitors;
    
    recruitment or departure of key personnel;
    
    the gain or loss of significant orders;
    
    the gain or loss of significant customers; and
    
    changes in the estimates of our operating performance or changes in recommendations by securities analysts. In addition, the stock market generally and the market for semiconductor
and other technology-related stocks in particular experienced a decline during
2000, 2001 and through 2002, and could decline from current levels, which could
cause the market price of our common stock to fall for reasons not necessarily
related to our business, results of operations or financial condition. The
market price of our stock also might decline in reaction to events that affect
other companies in our industry even if these events do not directly affect us.
Accordingly, you may not be able to resell your shares of common stock at or
above the price you paid. Securities litigation is often brought against a
company following a period of volatility in the market price of its securities,
and we have been subject to such litigation in the past. Any such lawsuits in
the future will divert managements attention and resources from other matters,
which could also adversely affect our business and the price of our stock. Our California facilities and the facilities of third parties upon which we
rely to provide us critical services are located in regions that are subject to
earthquakes and other natural disasters. Our California facilities, including our principal executive offices, are
located near major earthquake fault lines. If there is a major earthquake or
any other natural disaster in a region where one of our facilities is located,
our business could be materially and adversely affected. In addition, TSMC,
upon which we currently rely to fabricate our wafers, and ASE, upon which we
currently rely for the majority of our assembly and test services, are located
in Taiwan. Fujitsu Microelectronics, which we expect will fabricate a
significant amount of our wafers in the future, is located in Japan. Taiwan and
Japan have experienced significant earthquakes and could be subject to
additional earthquakes in the future. Any earthquake or other natural disaster
in these areas could materially disrupt our manufacturers production
capabilities and ASEs assembly and test capabilities and could result in our
experiencing a significant delay in delivery, or substantial shortage, of
wafers and possibly in higher wafer prices. Our certificate of incorporation and bylaws, stockholder rights plan and
Delaware law contain provisions that could discourage or prevent a takeover,
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Provisions of our certificate of incorporation and bylaws, as well as
provisions of Delaware law, could make it more difficult for a third party to
acquire us, even if doing so would be beneficial to our stockholders. These
provisions include:  
    
    establishing a classified board of directors so that not all members of our board may be elected at one time;
    
    providing that directors may be removed only for cause and only with the vote of 66 2/3% of our outstanding shares;
    
    requiring super-majority voting to amend some provisions in our certificate of incorporation and bylaws;
    
    authorizing the issuance of blank check preferred stock that
our board could issue to increase the number of outstanding shares and
to discourage a takeover attempt;
    
    limiting the ability of our stockholders to call special meetings of
stockholders;
    
    prohibiting stockholder action by written consent, which requires
all stockholder actions to be taken at a meeting of our stockholders;
and
    
    establishing advance notice requirements for nominations for
election to our board or for proposing matters that can be acted upon
by stockholders at stockholder meetings. In addition, the stockholder rights plan, which we implemented in 2002,
and Section 203 of the Delaware General Corporation Law may discourage, delay
or prevent a change in control. Our reported financial results may be adversely affected by changes in
accounting principles generally accepted in the United States. Generally accepted accounting principles in the United States are subject
to interpretation by the Financial Accounting Standards Board (FASB), the
American Institute of Certified Public Accountants, the Securities and Exchange
Commission (SEC) and various bodies formed to promulgate and interpret
appropriate accounting principles. A change in these principles or
interpretations could have a significant effect on our reported financial
results, and could affect the reporting of transactions completed before the
announcement of a change. For example, we currently are not required to record
stock-based compensation charges if an employees stock option exercise price
is equal to or exceeds the deemed fair value of our common stock at the date of
grant. However, several companies have recently elected to change their
accounting policies and begun to record the fair value of stock options as an
expense. The FASB published in March 2004 an exposure draft that would require
us to record expense for the fair value of stock options granted. The effective
date of the proposed standard is for periods beginning after June 15, 2005.
Our reported earnings and/or loss would be harmed if we were required to change
our current accounting policy. We have identified material weaknesses in our internal control over financial
reporting, which contributed to our need to amend our financial statements for
the second quarter of fiscal 2004. Further, we may be unable to assess on a
timely basis the effectiveness of our internal control over financial reporting
as required by Section 404 of the Sarbanes-Oxley Act of 2002. In the course of preparing our financial statements for the third quarter
of fiscal 2004, material weaknesses, as defined in Public Company Accounting
Oversight Board Standard No. 2, were identified in our internal control over
financial reporting. Specifically, material weaknesses were identified
with respect to our financial statement close process and our contract
administration. These material weaknesses contributed to post-closing adjustments and the
resulting need to amend our financial statements for the second quarter of
fiscal 2004. By amending our previously released financial statements, we
could suffer a loss of public confidence in the reliability of our financial
statements, which could harm our business and our publicly traded stock price.
In addition, we cannot assure you that we will not in the future identify
further material weaknesses or significant deficiencies in our internal control
over financial reporting that we have not discovered to date. In order to comply with the Sarbanes-Oxley Act of 2002, we are currently
performing the system and process evaluation and testing (and any necessary
remediation) required in an effort to allow our management to assess the
effectiveness of our system of internal control as of December 31, 2004, the
end of our current fiscal year. Our independent auditors must then attest to
and report on that assessment by our management. We have been notified by our
independent auditors that we may not be able to complete, on a timely basis,
our assessment in compliance with Section 404. If we fail to timely complete
our evaluation and testing in order to 31




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allow for this assessment by our management, or if our independent
auditors cannot timely attest to our managements assessment, we could be
subject to regulatory scrutiny and a loss of public confidence in our internal
controls, which could harm our business and our publicly traded stock price.
Further, if our independent auditors are not satisfied with our internal
control over financial reporting or with the level at which it is documented,
designed, operated or reviewed, they may decline to attest to managements
assessment or may issue a qualified report identifying a material weakness in
our internal controls. This could result in significant additional
expenditures responding to the Section 404 internal control audit, a diversion
of management attention and potentially an adverse reaction to our publicly
traded stock price. Changes in securities laws and regulations have increased our costs. The Sarbanes-Oxley Act of 2002 has required and will require changes in
some of our corporate governance, public disclosure and compliance practices.
The Act also requires the SEC to promulgate new rules on a variety of subjects.
In addition to final rules and rule proposals already made by the SEC, the
National Association of Securities Dealers has adopted revisions to its
requirements for companies, such as us, that are listed on the Nasdaq National
Market. These developments have increased our legal and financial compliance
costs and have made some activities, such as SEC reporting requirements, more
difficult. Additionally, we expect these developments to make it more difficult
and more expensive for us to obtain director and officer liability insurance,
and we may be required to accept reduced coverage or incur substantially higher
costs to obtain coverage. These developments could make it more difficult for
us to attract qualified executive officers and attract and retain qualified
members of our board of directors, particularly to serve on our audit
committee. We are presently evaluating and monitoring regulatory developments
and cannot estimate the timing or magnitude of additional costs we may incur as
a result. 
 Item 3.Quantitative and Qualitative Disclosures about Market Risk Interest Rate Risk.Our cash equivalents and available-for-sale
investments are exposed to financial market risk due to fluctuations in
interest rates, which may affect our interest income. Over the past few years,
we have experienced significant reductions in our interest income due in part
to declines in interest rates. These declines have led to interest rates that
are low by historical standards and we do not believe that further decreases in
interest rates will have a material impact on the interest income earned on our
cash equivalents and short-term investments held at September 30, 2004. Foreign Currency Exchange Risk.All of our sales and substantially all of
our expenses are denominated in U.S. dollars. As a result, we have relatively
little exposure to foreign currency exchange risk. We do not currently enter
into forward exchange contracts to hedge exposures denominated in foreign
currencies or any other derivative financial instruments for trading or
speculative purposes. However, in the event our exposure to foreign currency
risk increases, we may choose to hedge those exposures. 
 Item 4.Controls and Procedures We maintain a set of disclosure controls and procedures designed to ensure
that information required to be disclosed by us in the reports filed under the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the time periods specified by the rules and forms of the Securities and
Exchange Commission. Disclosure controls and procedures are also designed with
the objective of ensuring that this information is accumulated and communicated
to our management, including our chief executive officer and chief financial
officer, as appropriate to allow timely decisions regarding required
disclosure. In the course of preparing our financial statements for the third quarter
of fiscal 2004, material weaknesses, as defined in Public Company Accounting
Oversight Board, or PCAOB, Standard No. 2, were identified in our internal
control over financial reporting. As used by the PCAOB, a material weakness is
a significant deficiency, or a combination of significant deficiencies, that
results in more than a remote likelihood that a material misstatement of the
annual or interim financial statements will not be prevented or detected.
Specifically, material weaknesses with were identified with respect to our financial
statement close process and our contract administration. The
material weakness with respect to our financial statement close process
affected our inventory for the second and third quarters of fiscal 2004 and
accrued restructuring costs for the third quarter of fiscal 2004. In respect
of our financial statements for the second quarter of fiscal 2004, we did not
properly record an inventory charge because we had not identified our
contractual obligation to purchase materials from a third-party supplier. We
identified that contractual obligation after we filed on August 4, 2004 our
quarterly report on Form 10-Q for the quarterly period ended June 30, 2004, and
a charge for those materials in excess of our anticipated needs as of June 30,
2004 is now reflected in our amended financial statements included in the
amendment of that quarterly report which we filed on November 8, 2004. In
respect of our financial statements for the third quarter of fiscal 2004, we
initially made inappropriate 32




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and inconsistent assumptions
with respect to certain inventory valuations and
accrued restructuring costs and initially misapplied accounting principles
with respect to the impairment of certain manufacturing related equipment.
Management and Ernst & Young LLP, our independent auditors, identified these
inaccuracies, and the correct charges are reflected in the financial
statements included in this quarterly report. The
material weakness with respect to our contract administration contributed
to our failure to identify our contractual obligation to purchase materials
from a third-party supplier described above. We also recently experienced transitions in the oversight of our finance
and accounting personnel. In June 2004, Svend-Olav Carlsen, who had served as
our chief financial officer since June 2002, resigned. In September 2004, we
hired Mark R. Kent as our new chief financial officer. During a portion of the
interim period, our general counsel served as our chief financial officer. Our management evaluated, with the participation of our chief executive
officer and our chief financial officer, the effectiveness of our disclosure
controls and procedures as of September 30, 2004, the end of the period covered
by this report. As a consequence of the material weaknesses described above
that existed at September 30, 2004, our chief executive officer and chief
financial officer concluded that our disclosure controls and procedures were
not effective as of September 30, 2004. Our management and audit committee have assigned a high priority to the
short-term and long-term improvement of our internal control over financial
reporting. Specific initiatives with respect to our disclosure controls and
procedures and actions to address the material weaknesses described above that
we have undertaken through the end of the fiscal year ended December 31, 2004
include the revision and implementation of our policies regarding:  
    
    who at the company is authorized to sign contracts;
    
    confirmation that only authorized company employees have signed contracts;
    
    provision of appropriate signed contracts to our finance group; and
    
    determination of our assumptions used to calculate inventory
valuation by
the finance group integrating in a more comprehensive manner the sales
and inventory forecasting processes. Our management and audit committee intend to closely monitor the
implementation of our remediation plan. Although we have undertaken the
foregoing initiatives, the existence of a material weakness is an indication
that there is more than a remote likelihood that a material misstatement of our
financial statements will not be prevented or detected in a future period. In
addition, we cannot assure you that we will not in the future identify further
material weaknesses or significant deficiencies in our internal control over
financial reporting that we have not discovered to date. We are taking steps to
address the material weaknesses that have been identified and to refine our
internal controls and procedures to meet the internal control reporting
requirements of Section 404 of the Sarbanes-Oxley Act and the rules adopted
thereunder although these initiatives may not be concluded by December 31, 2004. The effectiveness of the
steps we have taken to date and the steps we are still in the process of
completing is subject to continued management review, as well as audit
committee oversight, and we may make additional changes to our internal control
over financial reporting. Other
than the foregoing initiatives, during the third quarter of
fiscal 2004, there have been no changes in our internal control over financial
reporting that have materially affected, or are reasonably likely to materially
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PART II. OTHER INFORMATION 
 Item 1.Legal Proceedings The Company is a party in one consolidated lawsuit. Beginning in June
2001, the Company, certain of its directors and officers, and certain of the
underwriters for its initial public offering were named as defendants in three
putative shareholder class actions that were consolidated in and by the United
States District Court for the Southern District of New York in In re Transmeta
Corporation Initial Public Offering Securities Litigation, Case No. 01 CV 6492.
The complaints allege that the prospectus issued in connection with the
Companys initial public offering on November 7, 2000 failed to disclose
certain alleged actions by the underwriters for that offering, and alleges
claims against the Company and several of its officers and directors under
Sections 11 and 15 of the Securities Act of 1933, as amended, and under
Sections 10(b) and Section 20(a) of the Securities Exchange Act of 1934, as
amended. Similar actions have been filed against more than 300 other companies
that issued stock in connection with other initial public offerings during
1999-2000. Those cases have been coordinated for pretrial purposes as In re
Initial Public Offering Securities Litigation, Master File No. 21 MC 92 (SAS).
In July 2002, the Company joined in a coordinated motion to dismiss filed on
behalf of multiple issuers and other defendants. In February 2003, the Court
granted in part and denied in part the coordinated motion to dismiss, and
issued an order regarding the pleading of amended complaints. Plaintiffs
subsequently proposed a settlement offer to all issuer defendants, which
settlement would provide for payments by issuers insurance carriers if
plaintiffs fail to recover a certain amount from underwriter defendants.
Although the Company and the individual defendants believe that the complaints
are without merit and deny any liability, but because they also wish to avoid
the continuing waste of management time and expense of litigation, they
accepted plaintiffs proposal to settle all claims that might have been brought
in this action. The Company and the individual Transmeta defendants expect that
their share of the global settlement will be fully funded by their director and
officer liability insurance. Although the Company and the Transmeta defendants
have approved the settlement in principle, it remains subject to several
procedural conditions, as well as formal approval by the Court. It is possible
that the parties may not reach a final written settlement agreement or that the
Court may decline to approve the settlement in whole or part. In the event that
the parties do not reach agreement on the final settlement, the Company and the
Transmeta defendants believe that they have meritorious defenses and intend to
defend any remaining action vigorously. 
 Item 2.Unregistered Sales of Equity Securities and Use of Proceeds Not Applicable. 
 Item 3.Defaults upon Senior Securities Not Applicable. 
 Item 4.Submission of Matters to a Vote of Security Holders Not Applicable. 
 Item 5.Other Information Not Applicable. 
 Item 6.Exhibits (a) Exhibits. The following exhibits are filed herewith: Exhibit Number
    
    Exhibit Title31.01
    
    Certification by Matthew R. Perry pursuant to Rule 13a-14(a)
promulgated under the Securities Exchange Act of 1934.31.02
    
    Certification by Mark R. Kent pursuant to Rule 13a-14(a)
promulgated under the Securities Exchange Act of 1934.
 34




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Exhibit Number
    
    Exhibit Title32.01*
    
    Certification by Matthew R. Perry pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.32.02*
    
    Certification by Mark R. Kent pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
 * As contemplated by SEC Release No. 33-8212, these exhibits are furnished
with this quarterly report on Form 10-Q and are not deemed filed with the
Securities and Exchange Commission and are not incorporated by reference in any
filing of Transmeta Corporation under the Securities Act of 1933 or the
Securities Exchange Act of 1934, including this quarterly report, whether made
before or after the date hereof and irrespective of any general incorporation
language in any filings. 35




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized. TRANSMETA CORPORATIONBy:
    /s/ MARK R. KENTMark R. KentChief Financial Office
(Principal Financial Officer and
Duly Authorized Officer) Date: November 8, 2004 36




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EXHIBIT INDEX Exhibit Number
    
    Exhibit Title31.01
    
    Certification by Matthew R. Perry pursuant to Rule 13a-14(a) promulgated
under the Securities Exchange Act of 1934.31.02
    
    Certification by Mark R. Kent pursuant to Rule 13a-14(a) promulgated under
the Securities Exchange Act of 1934.32.01*
    
    Certification by Matthew R. Perry pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.02*
    
    Certification by Mark R. Kent pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 * As contemplated by SEC Release No. 33-8212, these exhibits are furnished
with this quarterly report on Form 10-Q and are not deemed filed with the
Securities and Exchange Commission and are not incorporated by reference in any
filing of Transmeta Corporation under the Securities Act of 1933 or the
Securities Exchange Act of 1934, including this quarterly report, whether made
before or after the date hereof and irrespective of any general incorporation
language in any filings.