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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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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 April 1, 2005



OR



| ̈ | 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 000-31103



LEXAR MEDIA, INC.

(Exact name of
registrant as specified in its charter)



|                                                              |  |                                     
|------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                      |  | 33-0723123                          
|(State or other jurisdiction ofincorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                              | 
|47300 Bayside ParkwayFremont, California                      |  | 94538                               
|(Address of principal executive offices)                      |  | (Zip Code)                          



(510) 413-1200

(Registrants telephone number, including area code)



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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 ̈



Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No ̈



Number of shares of common stock outstanding as of April 29, 2005: 79,731,911



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##### Table of Contents

LEXAR MEDIA, INC.



FORM 10-Q

FOR THE QUARTER ENDED APRIL 1, 2005



TABLE OF CONTENTS



|                                |  |         |  |                                                                                                                                |  |     
|------------------------------- |  | ------- |  | ------------------------------------------------------------------------------------------------------------------------------ |  | ----
|                                |  |         |  |                                                                                                                                |  | Page
|                                | 
|PART I    FINANCIAL INFORMATION |  |        
|                                |  |         | 
|                                |  | Item 1. |  | Financial Statements                                                                                                           |  | 3   
|                                |  |         | 
|                                |  |         |  | Condensed Consolidated Balance Sheets as of April 1, 2005 and December 31, 2004 (unaudited)                                    |  | 3   
|                                |  |         | 
|                                |  |         |  | Condensed Consolidated Statements of Operations for the Three-Month Periods Ended April 1, 2005 and March 31, 2004 (unaudited) |  | 4   
|                                |  |         | 
|                                |  |         |  | Condensed Consolidated Statements of Cash Flows for the Three-Month Periods Ended April 1, 2005 and March 31, 2004 (unaudited) |  | 5   
|                                |  |         | 
|                                |  |         |  | Notes to Condensed Consolidated Financial Statements (unaudited)                                                               |  | 6   
|                                |  |         | 
|                                |  | Item 2. |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                          |  | 18  
|                                |  |         | 
|                                |  | Item 3. |  | Quantitative and Qualitative Disclosures About Market Risk                                                                     |  | 54  
|                                |  |         | 
|                                |  | Item 4. |  | Controls and Procedures                                                                                                        |  | 55  
|                                | 
|PART II    OTHER INFORMATION    |  |        
|                                |  |         | 
|                                |  | Item 1. |  | Legal Proceedings                                                                                                              |  | 57  
|                                |  |         | 
|                                |  | Item 2. |  | Unregistered Sales of Equity Securities and Use of Proceeds                                                                    |  | 60  
|                                |  |         | 
|                                |  | Item 3. |  | Defaults Upon Senior Securities                                                                                                |  | 60  
|                                |  |         | 
|                                |  | Item 4. |  | Submission of Matters to a Vote of Security Holders                                                                            |  | 60  
|                                |  |         | 
|                                |  | Item 5. |  | Other Information                                                                                                              |  | 60  
|                                |  |         | 
|                                |  | Item 6. |  | Exhibits                                                                                                                       |  | 61  
|                                | 
|SIGNATURE                       |  | 62     



The Lexar Media name
and logo are trademarks that are federally registered in the United States. The titles and logos associated with our products appearing in this report, including ActiveMemory, LockTight and JumpDrive, are either federally registered trademarks or
are subject to pending applications for registration. Our trademarks may also be registered in other jurisdictions. Other trademarks or trade names appearing elsewhere in this report are the property of their respective owners.



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##### Table of Contents

PART IFINANCIAL INFORMATION



1.    Financial Statements



LEXAR MEDIA, INC. AND SUBSIDIARIES



CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share and per share data)

(unaudited)



|                                                                                                                               |  |              |          |   |                  |   |          |  
|------------------------------------------------------------------------------------------------------------------------------ |  | ------------ | -------- | - | ---------------- | - | -------- | -
|                                                                                                                               |  | April 1,2005 |          |   | December 31,2004 |  
|A S S E T S                                                                                                                    |  |              |          |   |                  |  
|Current assets:                                                                                                                |  |              |          |   |                  |   |          |  
|Cash and cash equivalents                                                                                                      |  | $            | 121,433  |   |                  | $ | 27,705   |  
|Restricted cash                                                                                                                |  |              | 5,000    |   |                  |   | 5,000    |  
|Short-term investments                                                                                                         |  |              |         |   |                  |   | 7,738    |  
|Accounts receivable, net of allowances for sales returns, discounts and doubtful accounts of $17,700 and $16,085, respectively |  |              | 70,494   |   |                  |   | 170,365  |  
|Inventories                                                                                                                    |  |              | 146,835  |   |                  |   | 177,655  |  
|Prepaid expenses and other current assets                                                                                      |  |              | 14,234   |   |                  |   | 12,799   |  
|                                                                                                                               |  |              |          |   |                  |   |          |  
|Total current assets                                                                                                           |  |              | 357,996  |   |                  |   | 401,262  |  
|Property and equipment, net                                                                                                    |  |              | 10,186   |   |                  |   | 10,305   |  
|Intangible assets, net                                                                                                         |  |              | 309      |   |                  |   | 347      |  
|Other assets                                                                                                                   |  |              | 2,613    |   |                  |   | 82       |  
|                                                                                                                               |  |              |          |   |                  |   |          |  
|Total assets                                                                                                                   |  | $            | 371,104  |   |                  | $ | 411,996  |  
|                                                                                                                               |  |              |          |   |                  |   |          |  
|L I A B I L I T I E S   A N D   S T O C K H O L D E R S   E Q U I T
Y                                                         |  |              |          |   |                  |  
|Current liabilities:                                                                                                           |  |              |          |   |                  |   |          |  
|Accounts payable                                                                                                               |  | $            | 99,640   |   |                  | $ | 163,341  |  
|Accrued liabilities                                                                                                            |  |              | 58,061   |   |                  |   | 70,029   |  
|Deferred license revenue and product margin                                                                                    |  |              | 13,650   |   |                  |   | 23,759   |  
|Notes payable to bank                                                                                                          |  |              | 33,435   |   |                  |   | 40,000   |  
|                                                                                                                               |  |              |          |   |                  |   |          |  
|Total current liabilities                                                                                                      |  |              | 204,786  |   |                  |   | 297,129  |  
|Deferred license revenue, net of current portion                                                                               |  |              | 43       |   |                  |   | 173      |  
|Senior convertible notes payable                                                                                               |  |              | 60,000   |   |                  |   |         |  
|                                                                                                                               |  |              |          |   |                  |   |          |  
|Total liabilities                                                                                                              |  |              | 264,829  |   |                  |   | 297,302  |  
|Contingencies (Note 10)                                                                                                        |  |              |          |   |                  |   |          |  
|Stockholders equity:                                                                                                          |  |              |          |   |                  |   |          |  
|Preferred stock, $0.0001 par value: 10,000,000 shares authorized; no shares issued and outstanding                             |  |              |         |   |                  |   |         |  
|Common stock, $0.0001 par value: 200,000,000 shares authorized; 79,730,651 and 79,234,651 shares issued and outstanding        |  |              | 8        |   |                  |   | 8        |  
|Additional paid-in capital                                                                                                     |  |              | 283,535  |   |                  |   | 282,501  |  
|Accumulated deficit                                                                                                            |  |              | (177,051 | ) |                  |   | (167,465 | )
|Accumulated other comprehensive loss                                                                                           |  |              | (217     | ) |                  |   | (350     | )
|                                                                                                                               |  |              |          |   |                  |   |          |  
|Total stockholders equity                                                                                                     |  |              | 106,275  |   |                  |   | 114,694  |  
|                                                                                                                               |  |              |          |   |                  |   |          |  
|Total liabilities and stockholders equity                                                                                     |  | $            | 371,104  |   |                  | $ | 411,996  |  
|                                                                                                                               |  |              |          |   |                  |   |          |  





The accompanying notes are an integral part of these condensed consolidated financial statements.



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##### Table of Contents

LEXAR MEDIA, INC. AND SUBSIDIARIES



CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)



|                                                             |  |                    |         |   |               |   |         |  
|------------------------------------------------------------ |  | ------------------ | ------- | - | ------------- | - | ------- | -
|                                                             |  | Three Months Ended |        
|                                                             |  | April 1,2005       |         |   | March 31,2004 |  
|Net revenues:                                                |  |                    |         |   |               |   |         |  
|Product revenues                                             |  | $                  | 231,633 |   |               | $ | 161,079 |  
|License and royalty revenues                                 |  |                    | 809     |   |               |   | 3,655   |  
|                                                             |  |                    |         |   |               |   |         |  
|Total net revenues                                           |  |                    | 232,442 |   |               |   | 164,734 |  
|Cost of product revenues                                     |  |                    | 203,060 |   |               |   | 135,805 |  
|                                                             |  |                    |         |   |               |   |         |  
|Gross margin                                                 |  |                    | 29,382  |   |               |   | 28,929  |  
|                                                             |  |                    |         |   |               |   |         |  
|Operating expenses:                                          |  |                    |         |   |               |   |         |  
|Research and development                                     |  |                    | 3,393   |   |               |   | 2,061   |  
|Sales and marketing                                          |  |                    | 19,934  |   |               |   | 10,752  |  
|General and administrative                                   |  |                    | 15,163  |   |               |   | 5,606   |  
|                                                             |  |                    |         |   |               |   |         |  
|Total operating expenses                                     |  |                    | 38,490  |   |               |   | 18,419  |  
|                                                             |  |                    |         |   |               |   |         |  
|Income (loss) from operations                                |  |                    | (9,108  | ) |               |   | 10,510  |  
|Other income (expense):                                      |  |                    |         |   |               |   |         |  
|Interest and other expense                                   |  |                    | (484    | ) |               |   | (48     | )
|Interest and other income                                    |  |                    | 126     |   |               |   | 143     |  
|Foreign exchange loss, net                                   |  |                    | (102    | ) |               |   | (560    | )
|                                                             |  |                    |         |   |               |   |         |  
|Total other income (expense)                                 |  |                    | (460    | ) |               |   | (465    | )
|                                                             |  |                    |         |   |               |   |         |  
|Income (loss) before income taxes                            |  |                    | (9,568  | ) |               |   | 10,045  |  
|Income taxes                                                 |  |                    | 18      |   |               |   | 619     |  
|                                                             |  |                    |         |   |               |   |         |  
|Net income (loss)                                            |  | $                  | (9,586  | ) |               | $ | 9,426   |  
|                                                             |  |                    |         |   |               |   |         |  
|Net income (loss) per common share:                          |  |                    |         |   |               |   |         |  
|Basic                                                        |  | $                  | (0.12   | ) |               | $ | 0.12    |  
|                                                             |  |                    |         |   |               |   |         |  
|Diluted                                                      |  | $                  | (0.12   | ) |               | $ | 0.11    |  
|                                                             |  |                    |         |   |               |   |         |  
|Shares used in computing net income (loss) per common share: |  |                    |         |   |               |   |         |  
|Basic                                                        |  |                    | 79,519  |   |               |   | 78,316  |  
|                                                             |  |                    |         |   |               |   |         |  
|Diluted                                                      |  |                    | 79,519  |   |               |   | 89,416  |  
|                                                             |  |                    |         |   |               |   |         |  



The accompanying notes
are an integral part of these condensed consolidated financial statements.



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LEXAR MEDIA, INC. AND SUBSIDIARIES



CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)



|                                                                                         |  |                    |         |   |               |   |         |  
|---------------------------------------------------------------------------------------- |  | ------------------ | ------- | - | ------------- | - | ------- | -
|                                                                                         |  | Three Months Ended |        
|                                                                                         |  | April 1,2005       |         |   | March 31,2004 |  
|Cash flows from operating activities:                                                    |  |                    |         |   |               |   |         |  
|Net income (loss)                                                                        |  | $                  | (9,586  | ) |               | $ | 9,426   |  
|Adjustments to reconcile net income (loss) to net cash provided by operating activities: |  |                    |         |   |               |   |         |  
|Depreciation and amortization                                                            |  |                    | 944     |   |               |   | 463     |  
|Change in operating assets and liabilities:                                              |  |                    |         |   |               |   |         |  
|Accounts receivable, net                                                                 |  |                    | 99,169  |   |               |   | 10,979  |  
|Inventories                                                                              |  |                    | 30,217  |   |               |   | (7,465  | )
|Prepaid expenses and other assets                                                        |  |                    | (405    | ) |               |   | 705     |  
|Accounts payable and accrued liabilities                                                 |  |                    | (74,102 | ) |               |   | (9,303  | )
|Deferred license revenue and product margin                                              |  |                    | (10,290 | ) |               |   | (3,329  | )
|                                                                                         |  |                    |         |   |               |   |         |  
|Net cash provided by operating activities                                                |  |                    | 35,947  |   |               |   | 1,476   |  
|                                                                                         |  |                    |         |   |               |   |         |  
|Cash flows from investing activities:                                                    |  |                    |         |   |               |   |         |  
|Purchase of property and equipment                                                       |  |                    | (801    | ) |               |   | (961    | )
|Proceeds from short-term investments                                                     |  |                    | 7,738   |   |               |   |        |  
|                                                                                         |  |                    |         |   |               |   |         |  
|Net cash provided by (used in) investing activities                                      |  |                    | 6,937   |   |               |   | (961    | )
|                                                                                         |  |                    |         |   |               |   |         |  
|Cash flows from financing activities:                                                    |  |                    |         |   |               |   |         |  
|Issuance of stock under employee stock purchase plan                                     |  |                    | 888     |   |               |   | 609     |  
|Repayment of notes receivable from stockholders                                          |  |                    |        |   |               |   | 412     |  
|Exercise of stock options                                                                |  |                    | 202     |   |               |   | 1,024   |  
|Proceeds from convertible promissory notes net of issuance costs                         |  |                    | 56,837  |   |               |   |        |  
|Proceeds from asset-based notes payable to bank net of issuance costs                    |  |                    | 32,855  |   |               |   |        |  
|Repayment of revolving credit notes payable to bank                                      |  |                    | (40,000 | ) |               |   |        |  
|                                                                                         |  |                    |         |   |               |   |         |  
|Net cash provided by financing activities                                                |  |                    | 50,782  |   |               |   | 2,045   |  
|                                                                                         |  |                    |         |   |               |   |         |  
|Effect of exchange rates on cash and cash equivalents                                    |  |                    | 62      |   |               |   | 150     |  
|                                                                                         |  |                    |         |   |               |   |         |  
|Net increase in cash and cash equivalents                                                |  |                    | 93,728  |   |               |   | 2,710   |  
|Cash and cash equivalents at beginning of period                                         |  |                    | 27,705  |   |               |   | 115,698 |  
|                                                                                         |  |                    |         |   |               |   |         |  
|Cash and cash equivalents at end of period                                               |  | $                  | 121,433 |   |               | $ | 118,408 |  
|                                                                                         |  |                    |         |   |               |   |         |  



The accompanying notes
are an integral part of these condensed consolidated financial statements.



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##### Table of Contents

LEXAR MEDIA, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS



Note 1Basis of Presentation



We have
prepared the accompanying unaudited condensed consolidated financial statements in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Regulation S-X. Accordingly,
they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In our opinion the unaudited condensed consolidated financial statements reflect all adjustments which
are necessary for a fair statement of the results for the periods presented. In addition, certain reclassifications have been made to prior year balances in order to conform to the current year presentation.



The financial statements should be read in conjunction with our audited
consolidated financial statements for the year ended December 31, 2004 included in our Annual Report on Form 10-K, as filed with the Securities and Exchange Commission on March 31, 2005. The condensed consolidated balance sheet data as of December
31, 2004 was derived from our audited financial statements.



The results of our operations for the three months ended April 1, 2005 are not necessarily indicative of results that may be expected for any future period, including the full fiscal year.



Liquidity



For the three months ended April 1, 2005, we incurred a loss from operations
of approximately $9.1 million. As of April 1, 2005, we had an accumulated deficit of approximately $177.1 million, cash and short-term investments (excluding restricted cash) of $121.4 million, bank debt of $33.4 million and convertible notes
payable of $60.0 million. We generated cash from operating activities of $35.9 million during the three months ended April 1, 2005. However, we may not generate similar levels of cash from operations in future periods and we used cash of $115.7
million to fund operating activities for the year ended December 31, 2004. We operate in an industry characterized by intense competition, supply shortages or oversupply, rapid technological change, evolving industry standards, declining average
prices and rapid product obsolescence. We intend to incur significant expenses to fund operations to develop new products and to support existing product sales. Failure to generate sufficient revenues to offset the cost of revenues and other
operating costs may require us to constrain our operations.



We
currently believe that we have sufficient cash and availability under our asset based credit facility to meet our operating, capital and debt service requirements for the next twelve months. There can be no assurance, however, that we will be
successful in executing our business plan, achieving profitability or maintaining our existing customer base. Our cash needs are also dependent on the credit terms extended to us by our suppliers, particularly Samsung which supplies the majority of
our flash memory, and if our suppliers do not provide us with credit terms that are appropriate to meet our needs, we may have to seek alternate suppliers or additional financing. To the extent that we do not generate sufficient revenues and reduce
the cost of revenues or reduce the cost of discretionary expenditures and, as a result, cash, short term investments and available credit is insufficient to satisfy liquidity requirements, additional cash may be needed to finance operating and
investing needs. However, depending on market conditions, any additional financing needed may not be available on acceptable terms, or at all.



Note 2Summary of Selected Accounting Policies



Revenue Recognition



Product Revenues



We derive our revenues primarily from sales of our digital media products, which include flash memory devices, controllers and connectivity products. We
sell products to distributors, retailers, OEMs and end users.



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LEXAR MEDIA, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



As discussed below, significant management judgments and estimates must be made and used in connection with the revenue recognized in any accounting period.



With respect to sales to OEMs and end users we generally
recognize product revenue upon delivery when persuasive evidence of an arrangement exists, the selling price is fixed or determinable and collectibility is reasonably assured.



With respect to sales to distributors and retailers we generally recognize product revenue when persuasive evidence of an
arrangement exists, delivery has occurred, the selling price is fixed or determinable and collectibility is reasonably assured. Many of our distributors and retailers (collectively referred to herein as resellers) have return rights.
Historically, for resellers where we were able to reasonably estimate the level of product returns and sales incentives, we recognized revenue upon shipment (ship-to basis) and, at the time revenue was recorded, we recorded estimated
reductions to product revenue based upon our customer sales incentive programs, the historical experience of product returns, and the impact of special pricing agreements, price protection, promotions and other volume-based incentives. In order to
make such estimates, we analyzed historical returns, current economic conditions, customer demand and other relevant specific customer information. For resellers where we were unable to reasonably estimate the level of product returns or other
revenue allowances, revenues and the costs of revenues were deferred (sell-through basis) until these resellers either sold the product to their customers or a time period that is reasonably estimated to allow these resellers to sell the
product to their end customers had elapsed. In prior public filings of our financial information, we noted that if, in the future, we were unable to reasonably estimate the level of product returns or other revenue allowances for these resellers, it
could have a significant impact on our revenue recognition, potentially requiring us to defer the recognition of additional sales and recognize such sales on the sell-through basis. Over the past several years, revenue related to all new
resellers that have return rights or other revenue allowances were accounted for on a sell-through basis.



Starting in the fourth quarter of 2004, we determined that due to the recent high volatility of prices in the retail market, we were no longer able to
reasonably estimate the level of revenue allowances and product returns, and accordingly, we became unable to determine the selling price of our products at the time the sale takes place. As a result, effective October 1, 2004, for all of our retail
customers, revenues and the cost of revenues are deferred until these customers either sell the product to their customers or a time period that is reasonably estimated to allow these customers to sell the product to their customers has elapsed. As
a result of Lexar recording revenues from all retail customers on a sell-through basis effective October 1, 2004, the first quarter of 2005 was the first quarter in which Lexar recorded significant revenue that was deferred from the prior quarter,
which had a positive impact on first quarter product revenues and gross margin. The effect of this change in estimate on the first quarter of 2005 was an increase in net revenue of approximately $25.8 million and an increase in gross profit of
approximately $5.4 million. As of April 1, 2005 and December 31, 2004, deferred product margin from sales to resellers was $13.1 million and $23.3 million, respectively.



License and Royalty Revenues



When we have a signed license agreement, the technology has been delivered, there are no remaining significant obligations
under the contract, the fee is fixed or determinable and non-refundable and collectibility is reasonably assured, we recognize license fees and fixed non-refundable royalties ratably over the term of the license or fixed royalty arrangement during
which the customer has rights to the technology. When royalties are based on the volume of products sold that incorporate our technology, revenue is recognized in the period license sales are reported. Variable royalties based on volume have been
insignificant to date.



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LEXAR MEDIA, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



We actively enforce our patented technologies and aggressively pursue third parties that are
utilizing our intellectual property without a license or who have under-reported the amount of royalties owed under license agreement with us. As a result of such activities, from time to time, we may recognize royalty revenues that relate to
infringements that occurred in prior periods. These royalty revenues may cause revenues to be higher than expected during a particular reporting period and may not occur in subsequent periods. Differences between amounts initially recognized and
amounts subsequently determined as an adjustment to those amounts are recognized in the period such adjustment is determined as a change in accounting estimate.



Deferred Taxes



Deferred income tax assets and liabilities are recorded based on the computation of differences between the financial statement and tax bases of assets
and liabilities that will result in taxable or deductible amounts in the future based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are established when
necessary to reduce deferred tax assets to an amount that we have estimated is more likely than not to be realized.



Shipping and Handling Costs



Certain shipping and handling costs are included in selling and marketing costs in the statements of operations. These costs were $6.1 million for the
three months ended April 1, 2005 and $2.4 million for the three months ended March 31, 2004. Fees charged to customers for shipping and handling are included in revenues. We defer the shipping and handling costs associated with shipments for which
revenue has not yet been recognized. Deferred shipping and handling costs of $2.8 million and $3.0 million at April 1, 2005 and December 31, 2004, respectively, are recorded in prepaid expenses and other current assets on the consolidated balance
sheet.



Accounting for Stock-based Compensation



We account for employee stock-based compensation
arrangements in accordance with the provisions of Accounting Principles Board Opinion (APB) No. 25, Accounting for Stock Issued to Employees, Financial Accounting Standards Board Interpretation (FIN) No. 44,
Accounting for Certain Transactions Involving Stock Compensation, an Interpretation of APB Opinion No. 25 and FIN No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans, and comply
with the disclosure provisions of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, and SFAS No. 148, Accounting for Stock Based CompensationTransition and
Disclosure. Under APB No. 25, compensation expense is based on the difference, if any, between the estimated fair value of our common stock on the date of grant and the exercise price. SFAS No. 123 defines a fair value based method
of accounting for an employee stock option or similar equity instrument.



We account for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force (EITF) 96-18, Accounting for Equity Instruments that are
Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services and value awards using the Black Scholes option pricing model as of the date at which the non-employees performance is complete. We recognize the
fair value of the award as a compensation expense as the non-employees interest in the instrument vests.



Pro forma information regarding net income (loss) per share, computed as if our stock options, employee stock purchase plan (ESPP) and the
restricted stock issuances had been determined based on the fair value as of the grant date consistent with the provisions of SFAS No. 123 and SFAS No. 148, are as follows for the three month periods ended April 1, 2005 and March 31, 2004 (in
thousands, except per share amounts):



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##### Table of Contents

LEXAR MEDIA, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



|                                                                                |  |                    |         |   |               |   |        |  
|------------------------------------------------------------------------------- |  | ------------------ | ------- | - | ------------- | - | ------ | -
|                                                                                |  | Three Months Ended |        
|                                                                                |  | April 1,2005       |         |   | March 31,2004 |  
|As reported:                                                                    |  |                    |         |   |               |   |        |  
|Net income (loss)                                                               |  | $                  | (9,586  | ) |               | $ | 9,426  |  
|Add: Compensation reversal included in reported net income (loss), net of tax   |  |                    | (56     | ) |               |   |       |  
|Less: Pro forma compensation expense determined based on fair value, net of tax |  |                    | (4,248  | ) |               |   | (5,114 | )
|                                                                                |  |                    |         |   |               |   |        |  
|Pro forma net (loss) income                                                     |  | $                  | (13,890 | ) |               | $ | 4,312  |  
|                                                                                |  |                    |         |   |               |   |        |  
|Net income (loss) per common sharebasic as reported                            |  | $                  | (0.12   | ) |               | $ | 0.12   |  
|                                                                                |  |                    |         |   |               |   |        |  
|Net income (loss) per common sharebasic pro forma                              |  | $                  | (0.17   | ) |               | $ | 0.06   |  
|                                                                                |  |                    |         |   |               |   |        |  
|Net income (loss) per common sharediluted as reported                          |  | $                  | (0.12   | ) |               | $ | 0.11   |  
|                                                                                |  |                    |         |   |               |   |        |  
|Net income (loss) per common sharediluted pro forma                            |  | $                  | (0.17   | ) |               | $ | 0.05   |  
|                                                                                |  |                    |         |   |               |   |        |  



In accordance with the
provisions of SFAS 123, the fair value of each option or ESPP share is estimated using the following assumptions at the date of grant for the three months ended April 1, 2005 and March 31, 2004:



|                                |  |             |      |   |          |   |      |             |  |   |          |   |  |   |      |  
|------------------------------- |  | ----------- | ---- | - | -------- | - | ---- | ----------- |  | - | -------- | - |  | - | ---- | -
|                                |  | 2005Options |      |   | 2005ESPP |   |      | 2004Options |  |   | 2004ESPP |  
|Weighted average fair value     |  | $           | 3.28 |   |          | $ | 1.49 |             |  | $ | 10.13    |   |  | $ | 5.04 |  
|                                |  |             |      |  
|Risk free interest rate         |  |             | 3.71 | % |          |   | 2.71 | %           |  |   | 2.73     | % |  |   | 1.48 | %
|Expected life (years)           |  |             | 4.08 |   |          |   | 0.5  |             |  |   | 4.08     |   |  |   | 1.19 |  
|Expected stock price volatility |  |             | 88   | % |          |   | 87   | %           |  |   | 91       | % |  |   | 84   | %
|Dividend yield                  |  |             |     |   |          |   |     |             |  |   |         |   |  |   |     |  



Note 3Restricted Cash



Restricted cash represents cash and cash equivalents used
to collateralize standby letters of credit related to purchasing agreements with our suppliers. Cash restricted under standby letters of credit amounted to $5.0 million at both April 1, 2005 and December 31, 2004.



Note 4 Balance Sheet Disclosures (in thousands):



Inventory consisted of the following:



|                      |  |              |         |                  |   |        
|--------------------- |  | ------------ | ------- | ---------------- | - | -------
|                      |  | April 1,2005 |         | December 31,2004
|Inventories:          |  |              |         |                  |   |        
|Raw materials         |  | $            | 14,137  |                  | $ | 16,981 
|Controllers           |  |              | 13,942  |                  |   | 9,848  
|Flash memory products |  |              | 116,887 |                  |   | 147,909
|Ancillary products    |  |              | 1,869   |                  |   | 2,917  
|                      |  |              |         |                  |   |        
|                      |  | $            | 146,835 |                  | $ | 177,655
|                      |  |              |         |                  |   |        



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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Note 5Net Income (Loss) Per Common Share (in thousands, except per share data):



Basic net income (loss) per common share is computed by dividing net income
(loss) available to common stockholders by the weighted average number of vested common shares outstanding for the period. Diluted net income (loss) per share is computed by giving effect to all dilutive potential common shares, including options,
warrants and convertible notes. A reconciliation of the numerator and denominator used in the calculation of historical basic and diluted net income (loss) per share follows (in thousands, except per common share amounts):



|                                                                                                                                                        |  |                    |        |   |               |   |       
|------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ------ | - | ------------- | - | ------
|                                                                                                                                                        |  | Three Months Ended
|                                                                                                                                                        |  | April 1,2005       |        |   | March 31,2004
|Numerator:                                                                                                                                              |  |                    |        |   |               |   |       
|Net income (loss)                                                                                                                                       |  | $                  | (9,586 | ) |               | $ | 9,426 
|                                                                                                                                                        |  |                    |        |   |               |   |       
|Denominator for net income (loss) per common sharebasic:                                                                                               |  |                    |        |   |               |   |       
|Weighted average common shares outstanding                                                                                                              |  |                    | 79,519 |   |               |   | 78,316
|Net income (loss) per common sharebasic                                                                                                                |  | $                  | (0.12  | ) |               | $ | 0.12  
|                                                                                                                                                        |  |                    |        |   |               |   |       
|Denominator for net income (loss) per common sharediluted:                                                                                             |  |                    |        |   |               |   |       
|Denominator for net income (loss) per common sharebasic                                                                                                |  |                    | 79,519 |   |               |   | 78,316
|Incremental common shares attributable to exercise of outstanding stock options and warrants (assuming proceeds would be used to purchase
common stock) |  |                    |       |   |               |   | 11,100
|Denominator for net income (loss) per common sharediluted                                                                                              |  |                    | 79,519 |   |               |   | 89,416
|                                                                                                                                                        |  |                    |        |   |               |   |       
|Net income (loss) per common sharediluted                                                                                                              |  | $                  | (0.12  | ) |               | $ | 0.11  
|                                                                                                                                                        |  |                    |        |   |               |   |       



Anti-dilutive
Securities



Securities listed below have not been included
in the computations of diluted net income (loss) per share for the three-month periods ended April 1, 2005 and March 31, 2004 because the inclusion of these securities would be anti-dilutive (in thousands):



|                                                        |  |                    |  |              
|------------------------------------------------------- |  | ------------------ |  | -------------
|                                                        |  | Three Months Ended
|                                                        |  | April 1,2005       |  | March 31,2004
|Weighted average shares under warrants for common stock |  | 41                 |  |             
|Weighted average shares under options for common stock  |  | 19,461             |  | 463          
|Weighted average shares under senior convertible note   |  | 197                |  |             



Note 6Notes Payable:



In April 2004, we entered into a credit agreement with
Wells Fargo Bank. Our credit agreement with Wells Fargo Bank enabled us to borrow up to $40.0 million under a revolving line of credit note. All advances under this revolving line of credit note were secured by our accounts receivable and other
rights to payment, general intangibles, inventory, equipment and proceeds of the foregoing. We were required to comply with certain financial covenants over the term of the credit facility, which had an expiration date of April 3, 2006. At December
31, 2004, we were in technical default on four of these covenants: the ratio of total liabilities to tangible net worth, quick ratio and two net income after tax covenants. However, we obtained from Wells Fargo Bank a waiver of our compliance with
these financial covenants and any corresponding events of default. Interest was payable on borrowings under this facility at either an annual rate equal to LIBOR plus 1.5 percent, or at an



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annual rate equal to the banks prime rate minus 0.5 percent, with the determination of the applicable interest rate to have been made by us for each
borrowing under the note. At December 31, 2004, we had $40 million outstanding under this credit facility. The interest rate was 4.75% at December 31, 2004. We used the proceeds from this loan to fund working capital requirements. This note was
subsequently repaid with proceeds from a new three-year asset based revolving credit facility discussed below.



On February 28, 2005, we entered into a three-year asset based revolving credit facility arranged and agented by Wells Fargo Foothill, a subsidiary of
Wells Fargo & Company, with a maximum loan commitment of $80.0 million. The actual amount available for borrowing depends upon the value of our North American accounts receivable base. On April 1, 2005, the balance outstanding was approximately
$33.4 million under the Wells Fargo Foothill facility. The maximum amount available to us under this facility on April 1, 2005 was $40.1 million. Borrowings under this facility bear interest at our choice of one of two floating rates: either an
annual rate equal to LIBOR plus 1.75 to 2.25 percentage points, depending on availability under the facility and the amount of our unrestricted cash, or an annual rate equal to the banks prime rate plus 0.25 to 0.75 percentage points,
depending on availability under the facility and the amount of our unrestricted cash. At April 1, 2005, the annual interest rate for borrowings under the facility was 6.25% determined using the banks prime rate. As a condition of our asset
based facility with Wells Fargo Foothill, we terminated our credit agreement with Wells Fargo Bank.



The asset based credit facility with Wells Fargo Foothill is secured by substantially all of our property and assets (other than leased real property),
including, but not limited to, inventory, accounts, equipment, chattel paper, documents, instruments, deposit accounts, cash and cash equivalents, investment property, commercial tort claims and all proceeds and products thereof. We did not,
however, grant a security interest in our intellectual property rights, including, but not limited to, copyrights, trademarks, patents and related rights, although we did grant a negative pledge on all such intellectual property rights. In addition,
we pledged 65% of the common stock of each of our foreign subsidiaries as collateral to secure the asset-based facility.



Pursuant to the credit agreement with Wells Fargo Foothill, we must comply with certain affirmative and negative covenants. The affirmative covenants
include a restriction on capital expenditures of up to $3.5 million in any fiscal year and a requirement that we report losses before interest, tax and amortization, commonly referred to as EBITDA, of not more than a loss of $20.1
million for the three months ending March 31, 2005, a loss of $22.5 million for the six months ending June 30, 2005, a loss of $18.2 million for the nine months ending September 30, 2005, a loss of $4 million for the year ending December 31, 2005
and a loss of not more than the loss in the immediately preceding period for any trailing twelve month period thereafter. The negative covenants include, among others, limitations on indebtedness; liens; distribution or disposal of assets; changes
in the nature of our business; investments; mergers or consolidations with or into third parties; transactions with affiliates; and modifications to material agreements.



Upon the occurrence of an event of default, our obligations under the credit facility may become immediately due and
payable. Events of default include, among others, our failure to pay our obligations under the credit facility when due; our failure to perform any covenant set forth in the credit agreement; the attachment or seizure of a material portion of our
assets; an insolvency proceeding is commenced by or against us; we are restrained from conducting any material part of our business; any judgment in excess of $250,000 is filed against us and not released, discharged, bonded against or stayed
pending an appeal within 30 days; breach of any material warranty in the credit agreement; breach or termination of a material contract; or the acceleration of, or default in connection with, any indebtedness involving an aggregate amount of
$250,000 or more.



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Note 7Senior Convertible Notes Payable



On March 30, 2005, we issued $60 million in aggregate principal amount of 5.625% senior convertible notes due April 1, 2010
in a private offering (the Notes). We have granted the purchasers of the Notes a 60 day option to acquire an additional $10 million aggregate principal amount of Notes. The Notes are unsecured senior obligations, ranking equally in right
of payment with all of our existing and future unsecured senior indebtedness, and senior in right of payment to any future indebtedness that is expressly subordinated to the Notes.



The Notes are convertible into shares of our common stock any time at the option of the holders of the Notes at a price
equal to approximately $6.68 per share, subject to adjustment in certain circumstances, which represents a 30% premium over our closing price of $5.14 on March 29, 2005. The indenture governing the Notes (the Indenture) provides that no
holder of the Notes has the right to convert any portion of the Notes to the extent that, after giving effect to such conversion, such holder (together with such holders affiliates) would beneficially own in excess of 4.99% of our common stock
outstanding immediately after giving effect to such conversion. Interest on the Notes will be payable on March 31 and September 30 of each year, beginning on September 30, 2005.



The Notes are redeemable, in whole or in part, for cash at our option beginning on April 1, 2008 at a redemption price equal
to the principal amount of the Notes being redeemed plus accrued but unpaid interest, if any, up to but excluding the redemption date; provided, however, that Lexar may only exercise such redemption right if its common stock has exceeded 175% of the
conversion price of the Notes for at least 20 trading days in the 30 consecutive trading days ending on the trading day prior to the date upon which we deliver the notice of redemption. Upon redemption, we will be required to make a payment equal to
the net present value of the remaining scheduled interest payments through April 1, 2010.



Upon the occurrence of a fundamental change, as defined in the Indenture, the holders of the Notes will have:



| | · |  | the option to receive, if and only to the extent the holders convert their Notes into our common stock, a make-whole premium of additional shares of common stock equal to the
approximate lost option time value, if any, plus accrued but unpaid interest, if any, up to but excluding the conversion date; or
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | the right to require us to purchase for cash any or all of its Notes at a repurchase price equal to the principal amount of the Notes being repurchased plus accrued but unpaid
interest, if any, up to but excluding the repurchase date.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The conversion rate of the Notes will be subject to adjustment upon the occurrence of certain events, including the following:



| | · |  | We declare certain dividends or distributions;
| | - |  | ----------------------------------------------



| | · |  | We effect a stock split or combination;
| | - |  | ---------------------------------------



| | · |  | We offer certain rights or warrants to all or substantially all our stockholders; and
| | - |  | -------------------------------------------------------------------------------------



| | · |  | We purchase shares of our common stock pursuant to a tender or exchange offer under certain circumstances.
| | - |  | ----------------------------------------------------------------------------------------------------------



Upon the occurrence of an event of default, as defined in the
Indenture, the holders of at least 25% in aggregate principal amount of the Notes or the trustee for the Notes under the Indenture shall have the right to cause the principal amount of the Notes to become due and payable immediately (except in
certain events of bankruptcy, insolvency or reorganization of Lexar, in which case the principal amount of the Notes shall automatically become due and payable immediately).



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We have agreed to register the common stock issuable upon conversion of the Notes under the
Securities Act within 180 days from the closing date at our expense or we will be required to pay additional interest on the Notes of 0.50% per annum until the sooner of registration effectiveness or the maturity date of the Notes.



Cash proceeds from the issuance of the convertible notes were $56.8 million,
net of issuance costs of $3.2 million. The issuance costs are being amortized over the term of the convertible debt to April 1, 2010.



Note 8Comprehensive Loss:



The following are the components of comprehensive income (loss) (in thousands)



|                                  |  |                    |        |   |               |   |       |  
|--------------------------------- |  | ------------------ | ------ | - | ------------- | - | ----- | -
|                                  |  | Three Months Ended |       
|                                  |  | April 1,2005       |        |   | March 31,2004 |  
|Net income (loss)                 |  | $                  | (9,586 | ) |               | $ | 9,426 |  
|Other comprehensive income (loss) |  |                    | 120    |   |               |   | (26   | )
|                                  |  |                    |        |   |               |   |       |  
|Comprehensive income (loss)       |  | $                  | (9,466 | ) |               | $ | 9,400 |  
|                                  |  |                    |        |   |               |   |       |  



Other comprehensive
income for the three months ended April 1, 2005 was attributable to the effects of foreign currency translation. Other comprehensive loss for the three months ended March 31, 2004 was attributable to the effects of foreign currency translation.
Accumulated other comprehensive loss at April 1, 2005 was $217,000 and was attributable to the effects of foreign currency translation. Accumulated other comprehensive loss at December 31, 2004 was $350,000, of which $337,000 was attributable to the
effects of foreign currency translation and $13,000 was attributable to unrealized losses on available for sale securities.



Note 9Hedging:



We have foreign subsidiaries that operate and sell our products in various global markets. As a result, we are exposed to risks associated with changes in
foreign currency exchange rates between the functional currencies of our subsidiaries and other currencies. At any point in time, we might use various hedging instruments, primarily forward contracts, to mitigate the exposures associated with
fluctuations in foreign currency exchange rates. We do not enter into derivative financial instruments for speculative or trading purposes.



We record our hedges of foreign currency denominated assets and liabilities at fair value, with the related gains or losses recorded in foreign exchange
gain (loss) in the Condensed Consolidated Statements of Operations. The foreign exchange gains and losses on these contracts were substantially offset by transaction losses and gains on the underlying balances being hedged. In addition, at April 1,
2005, we had foreign currency denominated assets and liabilities that were not hedged. Our net foreign exchange losses for the three-month periods ended April 1, 2005 and March 31, 2004 were approximately $0.1 million and $0.6 million, respectively.
As of April 1, 2005 and December 31, 2004, we held forward contracts for yen and pound sterling with aggregate notional values of $42.5 million and $59.5 million, respectively.



Note 10Contingencies:



Indemnifications



We are a party to a variety of agreements pursuant to which we may be obligated to indemnify the other party with respect to certain matters. Typically
these obligations arise in connection with sales contracts and license agreements under which we customarily agree to hold the other party harmless against any losses incurred as a result of a claim by any third party with respect to our products.
We also typically agree to pay any



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costs incurred in defense of any such claim. The terms of the indemnification obligations are generally perpetual from the effective date of the agreement.
In certain cases, there are limits and exceptions to our potential liability for indemnification relating to intellectual property infringement claims. We cannot estimate the amount of potential future payments, if any, that we might be required to
make as a result of these agreements. To date, the amounts required to defend indemnification claims have been insignificant. Accordingly, we did not accrue any amounts for these indemnification obligations as of April 1, 2005 or December 31, 2004.



We have agreements whereby our directors and officers are
indemnified for certain events or occurrences while the officer or director is serving at our request in such capacity. The maximum amount of future payments we could be required to make under these indemnification agreements is unlimited; however,
we have a directors and officers insurance policy that reduces our exposure and enables us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these
indemnification agreements is minimal. Accordingly, we did not record any liabilities for these agreements as of April 1, 2005 or December 31, 2004.



Litigation with Toshiba



We are involved in three separate lawsuits with Toshiba Corporation as follows:



Lexar Media, Inc. v. Toshiba Corporation, Toshiba America, Inc. and Toshiba America



On November 4, 2002, we filed a lawsuit in Santa Clara County Superior Court
against Toshiba Corporation, Toshiba America, Inc. and Toshiba America alleging theft of trade secrets and breach of fiduciary duty. We later filed an amended complaint to add violation of California Business and Professions Code Section 17200 and
to drop without prejudice claims against Toshiba America, Inc. The basis of the allegations is that since our inception in 1996, and including the period from 1997 through 1999 when Toshiba was represented on our Board of Directors, Toshiba had
access to and was presented with details of our strategy as well as our methods of achieving high performance flash devices that Toshiba has now incorporated into its flash chips and flash systems.



Trial began on February 7, 2005, and after a six-week trial, on March 23,
2005 the jury found that Toshiba Corporation and Toshiba America Electronic Components, Inc. misappropriated Lexars trade secrets and breached their fiduciary duty to us. The jury awarded Lexar $255.4 million in damages for Toshibas
misappropriation of trade secrets. The jury also awarded Lexar $58.7 million in damages for Toshibas breach of fiduciary duty, $58.7 million in damages for TAECs breach of fiduciary duty and $8.2 million in prejudgment interest for
breach of fiduciary duty. The jury also found Toshiba and TAECs breach of fiduciary duty was oppressive, fraudulent or malicious which supported an award of punitive damages. On March 25, 2005, the jury awarded an additional $84.0 million in
punitive damages.



We are also seeking an injunction to prevent
the importation of chips or cards manufactured by Toshiba or its Flash Vision affiliate that incorporate our technology. Our claim for unfair competition, based on California Business and Professions Code Section 17200, was not given to the jury and
will be decided by the Court. We expect that the Court will rule on that claim and our motion for an injunction, as well as on anticipated post-trial motions, shortly after a hearing we expect to be held no earlier than late June 2005. This hearing
was previously scheduled for May 16, 2005 but was recently delayed by the court.



Toshiba Corporation v. Lexar Media, Inc.; Lexar Media, Inc. v. Toshiba Corporation



On November 1, 2002, Toshiba Corporation filed a lawsuit seeking declaratory judgment that Toshiba does not infringe our U.S. Patent Nos. 5,479,638;
5,818,781; 5,907,856; 5,930,815; 6,034,897; 6,040,997; 6,134,151;



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6,141,249; 6,145,051; 6,172,906; 6,202,138; 6,262,918; 6,374,337; and 6,397,314 or that these patents are invalid. This suit was filed in the United States
District Court for the Northern District of California. We believe that Toshibas claims are without merit and are contesting this lawsuit vigorously.



On November 21, 2002, we filed an answer and counterclaim in which we alleged that Toshiba infringes our U.S. Patent Nos. 5,818,781; 5,907,856; 5,930,815;
6,034,897; 6,040,997; 6,134,151; 6,172,906; 6,202,138; and 6,374,337. We sought an injunction and damages against Toshiba.



On December 20, 2002, Toshiba filed its first amended complaint in which Toshiba dropped its allegations that our patents are unenforceable.



On February 28, 2003, we filed an answer and our first amended
counterclaim against Toshiba for infringement of our U.S. Patent Nos. 5,479,638; 5,818,781; 5,907,856; 5,930,815; 6,034,897; 6,040,997; 6,134,151; 6,141,249; 6,145,051; 6,172,906; 6,202,138; 6,262,918; 6,374,337; and 6,397,314. We are seeking
damages as well as an injunction against Toshiba for its products that we allege infringe our patents, including its flash memory chips, flash cards and digital cameras. Discovery has commenced. The parties have now mutually dismissed with prejudice
all claims regarding U.S. Patent No. 6,172,906.



This case has
been coordinated for discovery purposes with our litigation against Pretec, PNY, Memtek and C-One. On September 17, 2003 and October 1, 2003, the Court held two scheduling hearings for all of these matters. As a result of these hearings, the court
determined that our patent claims against Toshiba will be heard in an initial phase.



Claim construction in our litigation against Toshiba was held in August 2004. The Court issued a claim construction ruling on January 24, 2005. We believe that the claim construction ruling favorably construes the
claims of our patents.



Discovery has now commenced and we
expect that a trial will take place in late 2006. The patents at issue in this first phase will be Lexars U.S. Patent No.s 5,479,638 entitled Flash Memory Mass Storage Architecture Incorporation Wear Leveling Technique;
6,145,051 entitled Moving Sectors Within Block of Information in a Flash Memory Mass Storage Architecture; 6,397,314 entitled Increasing The Memory Performance Of Flash Memory Devices By Writing Sectors Simultaneously To Multiple
Flash Memory Device; 6,202,138 entitled Increasing The Memory Performance Of Flash Memory Devices By Writing Sectors Simultaneously To Multiple Flash; 6,262,918 entitled Space Management For Managing High Capacity Nonvolatile
Memory; and 6,040,997 entitled Flash Memory Leveling Architecture Having No External Latch.



Our litigation against Fuji, Memtek and PNY will be stayed until after claim construction with Toshiba has been completed.



Toshiba Corporation v. Lexar Media, Inc.



On January 13, 2003, Toshiba Corporation filed a lawsuit against us in the
United States District Court for the Northern District of California, alleging that we infringe Toshibas U.S. Patent Nos. 5,546,351; 5,724,300; 5,793,696; 5,946,231; 5,986,933; 6,145,023; 6,292,850; and 6,338,104. On February 7, 2003, Toshiba
Corporation filed an amended complaint and now alleges that we infringe U.S. Patent Nos. 5,546,351; 5,724,300; 5,793,696; 5,946,231; 5,986,933; 6,094,697; 6,292,850; 6,338,104; and 5,611,067. In this action, Toshiba Corporation seeks injunctive
relief and damages. Toshibas patents appear to primarily relate to flash components that we purchase from vendors who provide us with indemnification. On March 5, 2003, we filed an



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answer in which we are seeking a judgment that we do not infringe these patents or that they are invalid or unenforceable. We believe that Toshibas
claims are without merit and intend to contest this lawsuit vigorously.



Litigation Against Fuji, Memtek and PNY



On July 11, 2002, we filed a lawsuit in the United States District Court for the Eastern District of Texas against Fuji Photo Film USA, Memtek Products, Inc. and PNY Technologies Inc. for patent infringement. We alleged that the defendants
infringe our U.S. Patent Nos. 5,479,638; 5,907,856; 5,930,815; 6,034,897; 6,134,151; 6,141,249; 6,145,051; and 6,262,918. We sought injunctive relief and damages against all defendants.



On November 4, 2002, we filed an amended complaint against Fuji Photo Film USA. In the amended complaint, we allege that
Fuji Photo Film USA infringes U.S. Patent Nos. 5,479,638; 6,141,249; 6,145,051; 6,262,918; and 6,397,314 through the sale of its flash memory products and digital cameras. We are seeking injunctive relief and damages against Fuji. Memtek Products,
Inc. and PNY Technologies, Inc. are no longer parties to this particular action. On December 9, 2002, Fuji filed an answer in which they sought declaratory relief that they do not infringe the five patents named in the suit as well as our U.S.
Patent Nos. 5,907,856; 5,930,815; 6,034,897; and 6,134,151.



On
January 8, 2003, the United States District Court for the Eastern District of Texas ordered this case transferred to the United States District Court for the Northern District of California where it is now pending.



In a second amended complaint, we added counterclaims for infringement on the
additional patents for which Fuji has sought declaratory relief, U.S. Patent Nos. 5,907,856; 5,930,815; 6,034,897; and 6,134,151. Discovery has commenced.



This case has been coordinated for discovery purposes with our litigation against Toshiba, Pretec, PNY, Memtek and C-One, which is discussed below. On
September 17, 2003 and October 1, 2003, the court held two scheduling hearings for all of these matters. As a result of these hearings, the court has determined that the various actions pending before it will be sequenced beginning with the Toshiba
matter. Our litigation against Fuji, Memtek and PNY will be stayed until after the claim construction with Toshiba has been completed.



On October 1, 2003, we reached a settlement agreement with Ritek Corporation, which supplied Fuji with CompactFlash cards between 2001 and 2002. Under the
terms of the agreement, Ritek made a one-time payment for past damages. We have not given Ritek a license to any of our patents going forward.



Litigation Against Pretec, PNY, Memtek and C-One



On December 22, 2000, we sued Pretec Electronics Corporation and PNY for patent infringement. We sued Pretec and PNY on the basis of four patents: U.S.
Patent Nos. 5,818,781; 5,907,856; 5,930,815; and 6,145,051. The suit is pending in the United States District Court for the Northern District of California. We are seeking injunctive relief and damages against all defendants.



On April 13, 2001, we filed an amended complaint in our litigation with
Pretec, naming Memtek as an additional defendant. On June 26, 2001, the Court allowed us to file our second amended complaint in our litigation with Pretec, naming C-One as an additional defendant and adding our U.S. Patent No. 5,479,638 against all
of the defendants. In this action we allege that Memtek and the other defendants infringe our U.S. Patent Nos. 5,479,638, 5,818,781, 5,907,856, 5,930,815 and 6,145,051. This suit is pending in the United States District Court for the Northern
District of California. We are seeking injunctive relief and damages against all of the defendants.



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LEXAR MEDIA, INC. AND SUBSIDIARIES



NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)



This case has been coordinated for discovery purposes with our litigation against Toshiba. On
September 17, 2003 and October 1, 2003, the court held two scheduling hearings for all of these matters. As a result of these hearings, the court determined that the litigation will be sequenced beginning with the Toshiba matter. Claim construction
in our litigation against Toshiba was held in August 2004. Our litigation against Pretec, Memtek and C-One will be stayed until after the claim construction with Toshiba has been completed.



Litigation With Willem Vroegh



On February 20, 2004, an individual, Willem Vroegh, sued us, along with
DaneElec Memory, Fuji Photo Film USA, Eastman Kodak Company, Kingston Technology Company, Inc., Memorex Products, Inc.; PNY Technologies Inc., SanDisk Corporation, Verbatim Corporation, and Viking InterWorks, alleging that our description of
the capacity of our flash memory cards is false and misleading under California Business and Professions Code Sections 17200 and 17500. The plaintiff has also asserted allegations for breach of contract, common law claims of fraud, deceit and
misrepresentation; as well as a violation of the Consumers Legal Remedies Act, California Civil Code Sec. 175, all arising out of the same set of facts. Plaintiff seeks restitution, disgorgement, compensatory damages and injunctive relief and
attorneys fees. Discovery has commenced. We believe the plaintiffs claims are without merit and intend to contest them vigorously.



Shareholder Litigation



On May 21, 2004, we, along with our Chief Executive Officer and Chief Financial Officer, were named as defendants in a federal class action in the United
States District Court for the Northern District of California. That action was brought allegedly on behalf of a class of plaintiffs who purchased our common stock, and asserted claims under Sections 10(b) and 20(a) of the Exchange Act, as well as
Rule 10b-5 promulgated thereunder, based principally on allegations that we made misrepresentations regarding our business. Six similar class actions have since been filed in the Northern District of California. The Court has appointed a lead
plaintiff and ordered that those actions be consolidated. In October 2004, plaintiffs filed a consolidated amended complaint, on behalf of those who purchased our stock between October 16, 2003 and April 16, 2004. In January 2005, we filed a motion
to dismiss the consolidated amended complaint that is currently scheduled to be heard in late May 2005. We believe the plaintiffs claims are without merit and intend to contest them vigorously.



On June 4, 2004, a shareholder derivative lawsuit was filed in the Superior
Court of the State of California, Alameda County, in which we are a nominal defendant and certain of our officers and directors are defendants. A substantially identical derivative action was filed thereafter in the same court. The derivative
actions are based on allegations substantially similar to those in the federal class actions. On November 29, 2004, the Court sustained defendants demurrer to the complaint but granted plaintiffs leave to amend. On December 21, 2004, plaintiff
filed an amended complaint. On March 21, 2005, the Court sustained defendants demurrer to the amended complaint without leave to amend, on the grounds that plaintiffs failed to show that pre-suit demand on our board of directors should be
excused.



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ITEM 2.    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.



The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial
statements and related notes included elsewhere in this report. In addition to historical information, this discussion contains forward-looking statements that involve risks and uncertainties. These forward-looking statements include statements
about trends and uncertainties in our business, such as our expectations about our liquidity, flash memory supply, pricing strategy, expected growth, plans to manufacture new flash memory products, and expected future trends in component costs and
operating expense levels. Our actual results could differ materially from those anticipated by these forward-looking statements due to factors, including, but not limited to, those set forth under Risks That Could Affect Future Results
and elsewhere in this report. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. We undertake no obligation to update these forward-looking statements to reflect events or
circumstances occurring after the date hereof.



Overview



We design, develop, manufacture and market high-performance digital media as
well as other flash based storage products for consumer markets that utilize digital media for the capture and retrieval of digital content for the digital photography, consumer electronics, computer, industrial and communications markets. Our
digital media products include a variety of flash memory cards with a range of speeds, capacities and special features to satisfy the various demands of different users of flash cards. To address the growing market for compact digital data and media
storage solutions, our digital media products also include our JumpDrive products, which are high-speed, portable USB flash drives for consumer applications that serve a variety of uses, including floppy disk replacement, as well as our line of
digital music players, which are both portable MP3 players and storage devices. In addition, we market a variety of connectivity products that link our media products to PCs and other electronic host devices. We also license our proprietary
controller technology and sell controllers, digital media accessories and other components to other manufacturers of flash storage media.



The average gross selling price per megabyte of our digital media products declined approximately 60% from the first quarter of 2004 to the first quarter
of 2005. During the first quarter of 2005 we reduced promotional programs and, despite declining industry selling prices, increased our selling prices on certain products to most of our customers to better align our selling prices with our cost
structure. Product gross margins improved from the fourth quarter of 2004 to the first quarter of 2005 primarily as a result of our improved selling price management Our competitors are continuing to reduce selling prices in the second quarter of
2005 despite expectations that industry demand for flash memory during the second quarter of 2005 will continue to be greater than available supply. We are adjusting our selling price strategy with the intention of focusing on profitability while
balancing the need to maintain the significant majority of our retail market share. In addition, we are planning to emphasize more of our premium products, which have higher gross margins. Our resellers may not accept our price increases from the
first quarter of 2005 or in the future, if any, and, if we do not lower our selling prices to be consistent with our competitors selling prices, our resellers may decide to reduce their orders, purchase from other vendors or return unsold
product to us. In the past several months, we have lost product placements to our competitors at Wal-Mart and Sams Club, Comp USA and other resellers in part because of our selling price strategy. In particular, CompUSA has terminated their
relationship with us. In addition, at Wal-Mart and Sams Club, which accounted for approximately 17% of our gross revenue in the first quarter of 2005, we may experience a significant decline in sales due to their addition of other vendors
products into their stores.



In order to meet the expected
demand for our products, we are also focused on efforts to ensure that our costs for flash memory and components will enable us to sell our products at competitive prices, that we have sufficient cash to fund our operations, that our supply of flash
memory and flash card components is sufficient to meet our anticipated supply needs, that our supply chain can support the rates of growth we expect and that we have sufficient engineering resources to design the products demanded by our customers.
In the second quarter of 2004, our component costs did not decrease as quickly as market pricing, which resulted in our reporting a net



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loss for the second quarter. During the third quarter of 2004 supply and demand came into better balance, and as new flash memory suppliers entered the
market, our costs came into line with market pricing resulting in improved margins. During the fourth quarter of 2004, we experienced rapid decreases in market pricing for our products, which resulted in our reporting a substantial net loss for the
fourth quarter of 2004. Starting in the fourth quarter of 2004, we determined that due to the recent high volatility of prices in the retail market, we were no longer able to reasonably estimate the level of revenue allowances and product returns,
and accordingly, we became unable to determine the selling price of our products at the time the sale takes place. As a result, effective October 1, 2004, for all of our retail customers, revenues and the cost of revenues are deferred until these
customers either sell the product to their customers or a time period that is reasonably estimated to allow these customers to sell the product to their customers has elapsed. As a result of recording revenues from all retail customers on a
sell-through basis effective October 1, 2004, the first quarter of 2005 was the first quarter in which we recorded significant revenue that was deferred from the prior quarter, which had a positive impact on first quarter product revenues and gross
margin. The effect of this change in estimate on the first quarter of 2005 was an increase in net revenue of approximately $25.8 million and an increase in gross margin of approximately $5.4 million. As of December 31, 2004 and April 1, 2005,
deferred product margin from sales to resellers was $23.3 million and $13.1 million, respectively.



During the second quarter of 2004, we began to diversify our suppliers of flash memory. However, to date, most of the flash supply from new suppliers has
been lower density chips, which are only cost effective for use in manufacturing lower capacity cards. We expect that Samsung and Toshiba will dominate the market for high density flash chips for at least the next twelve months as new flash memory
suppliers generally expect to begin their production with lower density products and transition to producing higher density chips over a period of time.



The rapid price declines during 2004 strained our operations and financial resources. During periods of rapid price declines, we must manage our internal,
consignment and channel inventory carefully while balancing the need to meet the demands of our customers quickly. Any reduction in prices by us will hurt our gross margin unless we can manage our internal, consignment and channel inventories and
our cost structure to minimize the impact of such price declines and reduce our costs. As a result, we are actively focusing our planning efforts to optimize our supply chain and reduce our inventories. This includes adjusting our business model to
build products to a buffer inventory based on when our customers order those products rather than build products to forecast and in advance of receiving orders from our customers. Our build to buffer based on orders model will still include certain
inventory to enable us to adequately support our customers. In addition, we are working with our suppliers to reduce our cycle times and reduce the component and assembly cost of our products. We are also expecting to rationalize the number of
products we offer to the market in order to make our internal and channel inventory management more effective. We are also focused on expanding our distribution channels, particularly internationally, and trying to ensure that our products are
available at outlets where consumers look to purchase these products and expanding our sales to markets other than retail, particularly to OEM customers.



We face other challenges as well. Flash card formats continue to change and to miniaturize. We are focused on trying to ensure that we have the rights to
manufacture and sell all flash card formats, that we have the engineering resources to design controllers for all media formats and design advanced features into our products and that we have partners with manufacturing capabilities that allow us to
produce the newest and most advanced flash card formats and high capacity cards. We also believe that a number of companies are selling flash products that infringe our intellectual property, and we are focused on protecting our intellectual
property through litigation or negotiations. We believe that meeting such challenges will be necessary to remain competitive in our markets.



Revenues.    We generate revenues primarily from the sale of digital media and connectivity products to end-users through mass
market, photo and OEM channels. Since the beginning of 2002, we have significantly increased our presence in the mass-market channel by increasing the number of retail storefronts in which our customers sell our products. Our products were sold in
more than 67,000 retail stores worldwide at the end of



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first quarter of 2005, which represents an increase of approximately 2,000 storefronts from the end of 2004. As is common practice in the mass-market
channel, we offer our customers various programs and incentive offerings, including price protection, market development funds and cooperative marketing programs, rebates and other discounts. Digital media sales comprised 88.8% and 95.2% of our
gross revenues for the first quarters of 2005 and 2004, respectively.



We also generate revenues from the sales of flash memory controllers, digital media accessories and other components and from license and royalty revenues under license agreements, which revenues have primarily been from Samsung. In April
2001, we entered into a license agreement with Samsung Electronics Co., Ltd. Payments under the license agreement from Samsung were fixed through March 31, 2004. After March 31, 2004, under the agreement, any license payments from Samsung became
variable-based. Variable-based royalties from Samsung depend on factors such as which flash products Samsung manufactures and sells and in what volumes, as well as our relative market share and our aggregate purchases from Samsung. Since March 31,
2004, variable-based royalties from Samsung under this agreement have been minimal, and we expect that trend to continue for the foreseeable future. License and royalty revenues from all licensees were approximately $0.8 million during the first
quarter of 2005. We are actively working to license our technology to other companies, including companies that we believe infringe our patents.



A significant portion of our sales have been to a limited number of customers. Our top 10 customers accounted for 46.7% of our gross revenues in the first
quarter of 2005, and 47.0% of our gross revenues in the first quarter of 2004. We expect that sales to a limited number of customers will continue to account for a substantial portion of our revenues for at least the next several years.



Product sales in North America have historically accounted for the
majority of our total net product revenues. Net product revenues in North America represented approximately 62.4%, and 56.9% of our total net product revenues for the three months ended April 1, 2005 and March 31, 2004, respectively. Over the long
term, we expect our sales outside of North America will increase as a percentage of our total net product revenues. Such revenue growth, however, may not be consistent between periods; for example, our product sales outside of North America as a
percentage of our total net product revenues were approximately 37.6% in the first quarter of 2005 and 43.1% in the first quarter of 2004. Net product revenues in Europe represented 16.7%, and 28.6% of our total net product revenues for the three
months ended April 1, 2005 and March 1, 2004, respectively. Net product revenues in Japan and the rest of the world represented 20.9%, and 14.5% of our total net product revenues for the three months ended April 1, 2005 and March 1, 2004,
respectively.



The markets we serve with our digital film,
JumpDrive and MP3 products have been expanding rapidly. This has increased the pressure on our ability to ensure an adequate supply of components and the scalability of our operations to meet surges in product demand such as we experienced in the
fiscal fourth quarter of 2004 when product revenues grew 14.2% sequentially over the third quarter of 2004. On a continuing basis, we must forecast our customers product mix and volume accurately to ensure that we can meet their demands. If we
are unable to forecast our customers product mix and volume accurately it may affect our ability to grow our revenues as projected and could result in product obsolescence or inventory write-downs, which would harm our operating results.



In the second quarter of 2004, we entered into an exclusive,
multi-year agreement with Eastman Kodak whereby we offer digital media for sale to customers under the Kodak brand name on a worldwide basis. We began introducing such products in the third quarter of 2004. Kodak branded products increased as a
percentage of our revenues during the third and fourth quarters of 2004 and during the first quarter of 2005. Kodak branded products were less than 10% of our sales in the first quarter of 2005. We expect Kodak branded products to continue to
increase as a percentage of revenues during 2005.



Cost of
Product Revenues.    Our cost of product revenues consists primarily of materials costs, with flash memory accounting for a majority of the costs for both the products we manufacture and the products we purchase. We maintain
relationships with key suppliers and, in particular, we have supply agreements with both



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Samsung and UMC. In April 2001, we entered into a supply agreement with Samsung. Under the supply agreement, we purchase the majority of our flash memory
from Samsung, which is priced based upon an agreed methodology. Samsung has guaranteed a certain allocation of flash memory production capacity to us. In addition, Samsung also has the right to purchase our flash memory controllers. Under the
agreement, Samsung provides us with intellectual property indemnification for the products we purchase from Samsung, as well as industry standard warranties. The supply agreement runs through March 29, 2006 unless the agreement is extended. Under
our supply agreement with UMC we purchase controllers at pricing based upon the timing and volume of purchases. The purchase commitment for such controllers is generally restricted to a forecasted time horizon based on a rolling forecast of our
anticipated purchase orders, and such forecasts may only be changed by a certain percentage each month. The agreement expires on December 31, 2005 unless the agreement is extended.



Prior to 2004, our industry has historically experienced average annual price reductions of flash memory per megabyte in the
range of 30% to 40%. The cost of flash memory declined moderately in 2002 and in the first half of 2003. In the second half of 2003 and the first quarter of 2004, prices of flash memory remained stable or increased as industry wide demand for flash
memory outpaced the supply of flash memory, which resulted in a general industry wide shortage. In the latter half of 2004, prices of flash memory declined as supply exceeded demand in certain densities and in anticipation of additional supply of
flash memory. We expect supply to remain tight in at least the first half of 2005. Despite the general industry over-demand condition, we expect prices of flash memory components to decline further in the second quarter of 2005. Price reductions of
flash memory from the first quarter of 2004 to the first quarter of 2005 on a cost per megabyte basis were approximately 60%. A number of companies, including Hynix, Infineon, Micron and ST Micro, have either entered the market in 2004 or have
announced that they plan to do so in the first half of 2005. In addition, other companies, including Renesas, Samsung and Toshiba, have announced that they plan to expand their production of flash memory during 2005. If these companies successfully
introduce new products and/or expand output of flash memory, it could create an over-supply situation in the second half of 2005, driving product prices down and lowering our cost of flash. However, most of the new flash supply is lower density
chips that can only be used cost effectively to manufacture lower capacity cards. We expect that Samsung and Toshiba will dominate the market for high density flash chips for at least the next twelve months as new flash memory suppliers generally
expect to begin their production with lower density products or do not bring significant supply of larger capacity flash to market over the period. Also, because of irregular component shipments from certain of our suppliers, we have had to carry a
higher level of inventory as a buffer against delivery delays.



From time to time we enforce our rights under our supply agreements to ensure that the pricing terms are correctly applied with respect to our purchases from these suppliers. As a result of such activities, we may recognize adjustments to
amounts paid to such suppliers for products purchased in prior periods. Differences between amounts determined as an adjustment to those amounts are recognized in cost of product revenues as a change in accounting estimate in the period that such a
determination is made. Cost of product revenues also includes expenses related to materials procurement, inventory management, other overhead expenses and adjustments.



Research and Development.    Our research and development expenses include salaries and related
expenses for research and development personnel, fees for outside consultants, patent development and registration costs and prototype development and materials costs. The technology in our industry is evolving as flash cards, USB flash drives and
MP3 players become smaller in size, perform at faster speeds, have increased storage capacity and require development of new hardware and software applications to meet the demands of the target markets we serve. In addition, as new suppliers of
flash memory enter the market, we will continue to evaluate their flash memory and make modifications to our controller technology as necessary to be able to utilize different types of flash memory technology in our products. The number of digital
media formats continues to increase, and we need to develop and manufacture controllers for each significant digital media format. As a result of these and other developments, we believe that continued investment in research and development is
important to enable us



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to attain our strategic objectives and we therefore expect research and development expenses to increase during the next twelve months.



Sales and Marketing.    Our sales and marketing
expenses include freight and fulfillment, market development expenses, salaries and related expenses for sales and marketing personnel, advertising, customer service, technical support, distribution and travel and trade shows, and allowances for bad
debt. We expect sales and marketing expenses to vary during the next twelve months primarily in conjunction with changes in sales volumes throughout the year. In addition, although we expect our sales and marketing expenses to decline as a
percentage of revenues during 2005, we expect to increase our expenses related to the sales of Kodak branded memory cards worldwide.



General and Administrative.    Our general and administrative expenses include salaries and related expenses for executive,
administrative and operational personnel, fees for professional services and other corporate expenses. We are involved in several intellectual property litigation matters, as we have focused our efforts to protect our intellectual property rights
and license our technology to those companies that we believe infringe our intellectual property. We are also involved in additional litigation, including securities and product class action litigation. In addition to our current litigation, a
number of companies have brought products to market that we believe may infringe our intellectual property. Our legal expenses increased substantially in the first quarter of 2005 due to the trial against Toshiba. While we anticipate a significant
reduction in the level of legal costs as a result of the first Toshiba trial being completed, we anticipate legal expenses will continue at a moderate rate as legal activities related to the Toshiba matters are expected to be heard in June 2005. In
addition, we expect that we will continue to incur legal expenses as discovery continues in connection with our other legal case against Toshiba. If another of our legal actions were to proceed to trial, or if we become involved in additional
litigation, our legal expenses could significantly increase beyond anticipated levels. In addition to increased costs associated with our litigation, we also believe that our general and administrative expenses will likely continue to remain
significant in 2005 primarily as a result of costs associated with regulatory requirements related to compliance with Section 404 of the Sarbanes-Oxley Act of 2002.



Critical Accounting Policies and Estimates



Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to price protection, customer programs and incentives, product returns, doubtful
accounts, inventory valuation reserves, investments, intangible assets, income taxes and related valuation allowances, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to
be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and reported amounts of revenue and expenses that are not readily apparent from other sources. Actual
results may differ materially from these estimates under different assumptions or conditions.



Estimates and assumptions about future events and their effects cannot be determined with certainty. These estimates and assumptions may change as new events occur, as additional information is obtained and as our
operating environment changes. These changes have been included in the consolidated financial statements as soon as they became known. In addition, we are periodically faced with uncertainties, the outcomes of which are not within our control and
will not be known for prolonged periods of time. These uncertainties are discussed in this report in the section entitled Risks That Could Affect Future Results.



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We believe the following critical accounting policies reflect our most significant judgments and
estimates used in the preparation of our consolidated financial statements:



| | · |  | Revenue recognition, including price protection, rebates and other customer programs; and
| | - |  | -----------------------------------------------------------------------------------------



| | · |  | Valuation allowances and accrued liabilities, including sales returns and other allowances, inventory valuation reserves, the allowance for doubtful accounts and deferred tax asset
valuation allowances.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Revenue Recognition



Product Revenues



We derive our revenues primarily from sales of our digital media products,
which include flash memory devices, controllers and connectivity products. We sell our products to OEMs, end users, distributors and retailers. As discussed below, significant management judgments and estimates must be made and used in connection
with the revenue recognized in any accounting period.



With
respect to sales to OEMs and end users we generally recognize product revenue upon delivery when persuasive evidence of an arrangement exists, the selling price is fixed or determinable and collectibility is reasonably assured.



With respect to sales to distributors and retailers we generally recognize
product revenue when persuasive evidence of an arrangement exists, delivery has occurred, the selling price is fixed or determinable and collectibility is reasonably assured. Many of our distributors and retailers (collectively referred to herein as
resellers) have return rights. Historically, for resellers where we were able to reasonably estimate the level of product returns and sales incentives, we recognized revenue upon shipment (ship-to basis) and, at the time
revenue is recorded, we recorded estimated reductions to product revenue based upon our customer sales incentive programs and the historical experience of product returns, and the impact of special pricing agreements, price protection, promotions
and other volume-based incentives. In order to make such estimates, we analyzed historical returns, current economic conditions, customer demand and other relevant specific customer information. For resellers where we were unable to reasonably
estimate the level of product returns or other revenue allowances, revenues and the costs of revenues were deferred (sell-through basis) until these resellers either sold the product to their customers or a time period that is reasonably
estimated to allow these resellers to sell the product to their end customers had elapsed. In prior public filings of our financial information, we noted that if, in the future, we were unable to reasonably estimate the level of product returns or
other revenue allowances for these resellers, it could have a significant impact on our revenue recognition, potentially requiring us to defer the recognition of additional sales and recognize such sales on the sell-through basis. Over
the past several years, revenue related to all new resellers that have return rights or other revenue allowances were accounted for on a sell-through basis.



Starting in the fourth quarter of 2004, we determined that due to the recent high volatility of prices in the retail market, we were no longer able to
reasonably estimate the level of revenue allowances and product returns, and accordingly, we became unable to determine the selling price of our products at the time the sale took place. As a result, effective October 1, 2004, for all of our
resellers, revenues and the cost of revenues are deferred until these resellers have either sold the product to their customers or a time period that is reasonably estimated to allow these resellers to sell the product to their customers has
elapsed. The change in the timing of recognizing revenue related to all resellers now on a sell-through basis, some of which were previously recognized on a sell-to basis, had the effect of increasing net revenues recorded in the first quarter of
2005 by $25.8 million, increasing gross margin by $5.4 million and decreasing net loss by $5.8 million. As of December 31, 2004 and April 1, 2005, deferred product margin from sales to resellers was $23.3 million and $13.1 million, respectively.



We record estimated reductions to revenue for customer and
distributor incentive programs and offerings, including price protection, promotions, co-op advertising, and other volume-based incentives and expected returns. Additionally, we have incentive programs or rebates that require us to estimate, based
on historical



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experience, the number of customers who will actually redeem the incentive. Marketing development programs are either recorded as a reduction to revenue or
as an addition to marketing expense in compliance with the consensus reached by the Emerging Issues Task Force, or EITF, of the Financial Standards Accounting Board, or FASB, on issue 01-09.



License and Royalty Revenues



When we have a signed license agreement, the technology has been delivered,
there are no remaining significant obligations under the contract, the fee is fixed or determinable and non-refundable and collectibility is reasonably assured, we recognize license fees and fixed non-refundable royalties ratably over the term of
the license or fixed royalty arrangement during which the customer has rights to the technology. When royalties are based on the volume of products sold that incorporate our technology, revenue is recognized in the period licensed sales are reported
to us.



We actively enforce our patented technologies and
aggressively pursue third parties that are utilizing our intellectual property without a license or who have under-reported the amount of royalties owed under license agreement with us. As a result of such activities, from time to time, we may
recognize royalty revenues that relate to infringements that occurred in prior periods. These royalty revenues may cause revenues to be higher than expected during a particular reporting period and may not occur in subsequent periods. Differences
between amounts initially recognized and amounts subsequently determined as an adjustment to those amounts are recognized in the period such adjustment is determined as a change in accounting estimate.



Valuation Allowances and Accrued Liabilities



Valuation of Inventory



Our inventories are stated in the lower of cost or market value. Cost
includes materials, labor and other overhead costs. Determining market value of inventories involves numerous judgments, including average selling prices and sales volumes for future periods. We primarily utilize estimated selling prices for
measuring any potential declines in market value below cost. Any adjustment for market value provision is charged to cost of revenues.



We evaluate our ending inventories for excess quantities and obsolescence on a quarterly basis. This evaluation includes analysis of historical and
forecasted sales levels by product. Inventories on hand in excess of forecasted demand are provided for. In addition, we write-off inventories that are considered obsolete based on several factors including competitiveness of product offerings,
market conditions and product life cycles when determining obsolescence.



Changes to increase the inventory valuation reserve for lower of cost or market provision or excess and obsolete inventory provision are charged to cost of revenues. At the point of this loss recognition, a new,
lower-cost basis for that inventory is established and subsequent changes in facts and circumstances do not result in the restoration or increase in that newly established cost basis. If this lower-costed inventory is subsequently sold, the related
allowance is matched to the movement of related product inventory, resulting in lower costs and higher gross margins for those products.



We operate in an industry that is characterized by intense competition, supply shortages or oversupply, rapid technological change, evolving industry
standards, declining average selling prices and rapid product obsolescence. If actual product demand or selling prices are less favorable than we estimate, we may be required to take additional inventory write-downs.



Deferred Tax Valuation Allowance



As part of the process of preparing our consolidated financial statements,
we are required to estimate our income taxes, which involves estimating our actual current tax liabilities together with assessing temporary



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differences resulting from differing treatment of items for tax and accounting purposes, such as deferred revenue. These differences have resulted in a net
deferred tax asset. Our judgment is required to assess the likelihood that the net deferred tax asset will be recovered from future taxable income. We have determined that it is more likely than not that the net deferred tax asset will not be
realizable. Accordingly, a full valuation allowance has been recorded against the net deferred tax asset. In the event management determines that it has become more likely than not that the net deferred tax asset will be realizable in the future, an
adjustment to the deferred tax asset valuation allowance would be made, which would increase income and additional paid-in-capital in the period such determination is made.



Other Valuation Allowances and Accrued Liabilities



We also maintain accruals and allowances for price protection, market development funds and cooperative marketing programs,
rebates and other discounts. We incurred sales related discounts of $22.9 million, and $12.9 million during the three months end April 1, 2005 and March 31, 2004, respectively. At April 1, 2005 and December 31, 2004, we had related accruals and
allowances of $51.7 million and $55.2 million, respectively. Price protection, market development funds and cooperative marketing programs, rebates and other discounts are provided for at the time the associated revenue is recognized. If market
conditions were to change adversely, we may take actions to increase our customer incentive offerings, which could result in increased accruals and allowances for these programs. Historically, warranty expenses have not been material. In the event
that a problem is identified that would result in the need to replace a product or products on a large scale, such an event would result in changes that would be recorded in the determination of net income (loss) in the period in which the
additional cost is identified and may have a material adverse effect on our operating results and financial position.



Allowance for Doubtful Accounts



We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. At April 1,
2005 and December 31, 2004, we had an allowance for doubtful accounts of $1.3 million and $1.2 million, respectively. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, an
increase in the allowance may be required.



Results of Operations



In view of the rapidly changing nature of our market and
our operating history, we believe that period-to-period comparisons of our revenues and other operating results are not necessarily meaningful, and should not be relied upon as indications of future performance. Our historic revenue growth rates are
not necessarily indicative of our future growth.



Revenues,
Cost of Product Revenues and Gross Margin



The following
table sets forth revenues, cost of product revenues and gross margin amounts from our Condensed Consolidated Statements of Operations:



|                         |  |                            |         |                             |   |                      |  |       |   
|------------------------ |  | -------------------------- | ------- | --------------------------- | - | -------------------- |  | ----- | --
|                         |  | Quarter endedApril 1, 2005 |         | Quarter endedMarch 31, 2004 |   | % Change2004 to 2005 | 
|Product revenues         |  | $                          | 231,633 |                             | $ | 161,079              |  | 43.8  | % 
|License and royalty      |  |                            | 809     |                             |   | 3,655                |  | (77.9 | )%
|                         |  |                            |         |                             |   |                      |  |       |   
|Total net revenues       |  |                            | 232,442 |                             |   | 164,734              |  | 41.1  | % 
|Cost of product revenues |  |                            | 203,060 |                             |   | 135,805              |  | 49.5  | % 
|                         |  |                            |         |                             |   |                      |  |       |   
|Gross margin             |  | $                          | 29,382  |                             | $ | 28,929               |  | 1.6   | % 
|                         |  |                            |         |                             |   |                      |  |       |   
|Product gross margin     |  | $                          | 28,573  |                             | $ | 25,274               |  | 13.1  | % 
|                         |  |                            |         |                             |   |                      |  |       |   



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The following table sets forth revenues, cost of product revenues and gross margin amounts from our
Condensed Consolidated Statements of Operations expressed as a percentage of total net revenues:



|                         |  |                            |   |  |                             |  
|------------------------ |  | -------------------------- | - |  | --------------------------- | -
|                         |  | Quarter endedApril 1, 2005 |   |  | Quarter endedMarch 31, 2004 |  
|Product revenues         |  | 99.7                       | % |  | 97.8                        | %
|License and royalty      |  | 0.3                        | % |  | 2.2                         | %
|                         |  |                            |   |  |                             |  
|Total net revenues       |  | 100.0                      | % |  | 100.0                       | %
|Cost of product revenues |  | 87.4                       | % |  | 82.4                        | %
|                         |  |                            |   |  |                             |  
|Gross margin             |  | 12.6                       | % |  | 17.6                        | %
|                         |  |                            |   |  |                             |  



The following table
sets forth cost of product revenues and product gross margin amounts from our Condensed Consolidated Statements of Operations expressed as a percentage of product revenues:



|                         |  |                            |   |  |                             |  
|------------------------ |  | -------------------------- | - |  | --------------------------- | -
|                         |  | Quarter endedApril 1, 2005 |   |  | Quarter endedMarch 31, 2004 |  
|Product revenues         |  | 100.0                      | % |  | 100.0                       | %
|Cost of product revenues |  | 87.7                       | % |  | 84.3                        | %
|                         |  |                            |   |  |                             |  
|Gross product margin     |  | 12.3                       | % |  | 15.7                        | %
|                         |  |                            |   |  |                             |  



Revenues



During the first quarter of 2005, we experienced a 230.5% increase in
megabytes sold compared with the first quarter of 2004. The increase in megabytes sold was due to increased demand in the retail and OEM channels. The positive impact of this change was partially offset by a 60.0% decline in our average gross
selling price per megabyte of digital media. In addition, our revenues from controllers, digital media accessories and other components increased to $27.2 million in the first quarter of 2005 compared to $4.7 million in the first quarter of 2004. We
expect our component and controller revenues to increase in the second quarter of 2005 from the first quarter of 2005. Additionally, as a result of recording revenues from all retail customers on a sell-through basis effective October 1, 2004, the
first quarter of 2005 was the first quarter in which we recorded significant revenue that was deferred from the prior quarter. The effect of this change in estimate resulted in an increase of the first quarter of 2005 product revenues by
approximately $25.8 million. During the first quarter of 2005, we experienced a 63.2% increase in digital media units sold and a 102.6% increase in the average capacity per digital media unit sold compared with the first quarter of 2004. We expect
that the number of units and average capacity of digital media sold will continue to increase in 2005 and that the average gross selling price per megabyte of digital media will continue to decline at the historical averages of between 30 percent
and 40 percent per year. We also anticipate that our product mix will continue to change with CompactFlash representing a declining percentage of our revenues and Secure Digital and Jump Drive products increasing as a percentage of revenues.



In the first quarter of 2005, we derived 58.3%, 16.7%, 4.5%
and 20.5% of our product revenues from sales to customers in the United States, Europe, Japan and the rest of the world, respectively. In the first quarter of 2004, we derived 53.3%, 28.6%, 3.9% and 14.2% of our product revenues from sales to
customers in the United States, Europe, Japan and the rest of the world, respectively.



We generate license and royalty revenues from various agreements with licensees who use of our intellectual property Our license and royalty revenues decreased to $0.8 million in the first quarter of 2005 from $3.7
million in the first quarter of 2004, which was primarily a result of license and royalty revenues from Samsung becoming variable in April 2004. We have generated minimal variable-based royalties under this agreement to date. We will continue to
seek new licensing opportunities in 2005. However, to the extent that we are unsuccessful in licensing our intellectual property or recovering license and royalty revenues from third



26



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parties who are infringing our patents or under-reporting royalty revenues, our total license and royalty revenues will decline in 2005. We expect license
and royalty revenue in the second quarter of 2005 to be approximately $1.0 million.



Cost of Product Revenues



The increase in cost
of product revenues for the first quarter of 2005 compared to the first quarter of 2004 was primarily the result of a 230.5% increase in megabytes sold due to increased demand. This factor was partially offset by a 59.9% decline in the cost per
megabyte of digital media sold in the first quarter of 2005 compared to the first quarter of 2004. In addition, our cost of revenues from controllers, digital media accessories and other components were $23.5 million in the first quarter of 2005
compared to $2.5 million in the first quarter of 2004. We expect our controller, digital media accessories and other component cost of revenues to increase in the second quarter of 2005 from the first quarter of 2005. Additionally, the effect of the
change in recording revenues from all retail customers on a sell-through basis on the first quarter of 2005 was an increase in cost of product revenues of approximately $20.4 million.



Gross Margin



The decrease in gross margin to 12.6% for the first quarter of 2005 compared to 17.6% for the first quarter of 2004 was due, in part, to a change in
revenue mix, as our license and royalty revenues were $0.8 million, or 0.3% of our total net revenue, in the first quarter of 2005 compared to $3.7 million, or 2.2% of our total net revenue, in the first quarter of 2004. Product margin declined to
12.3% in the first quarter of 2005 compared to 15.7% in the first quarter of 2004. The decline in gross product margin was primarily the result of lower margins on digital media revenues due primarily to product mix as well as a slight decrease in
our gross margins from revenues of controllers, digital media accessories and other components. Additionally, the change in recording revenues from all retail customers on a sell-through basis on the first quarter of 2005 was an increase in gross
margin of approximately $5.4 million.



Operating Expenses



The following table sets forth operating expense data from our Condensed
Consolidated Statements of Operations:



|                           |  |                            |        |                             |   |                      |  |       |  
|-------------------------- |  | -------------------------- | ------ | --------------------------- | - | -------------------- |  | ----- | -
|                           |  | Quarter endedApril 1, 2005 |        | Quarter endedMarch 31, 2004 |   | % Change2004 to 2005 | 
|Research and development   |  | $                          | 3,393  |                             | $ | 2,061                |  | 64.6  | %
|Sales and marketing        |  |                            | 19,934 |                             |   | 10,752               |  | 85.4  | %
|General and administrative |  |                            | 15,163 |                             |   | 5,606                |  | 170.5 | %
|                           |  |                            |        |                             |   |                      |  |       |  
|Total operating expenses   |  | $                          | 38,490 |                             | $ | 18,419               |  | 109.0 | %
|                           |  |                            |        |                             |   |                      |  |       |  



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The following table sets forth operating expenses from our Condensed Consolidated Statements of
Operations expressed as a percentage of total net revenues:



|                           |  |                             |   |  |                             |  
|-------------------------- |  | --------------------------- | - |  | --------------------------- | -
|                           |  | Quarter endedMarch 31, 2005 |   |  | Quarter endedMarch 31, 2004 |  
|Research and development   |  | 1.5                         | % |  | 1.3                         | %
|Sales and marketing        |  | 8.6                         | % |  | 6.5                         | %
|General and administrative |  | 6.5                         | % |  | 3.4                         | %
|                           |  |                             |   |  |                             |  
|Total operating expenses   |  | 16.6                        | % |  | 11.2                        | %
|                           |  |                             |   |  |                             |  



Research and
Development



The increase in research and development
expenses for the first quarter of 2005 compared to the first quarter of 2004 was primarily due to a $0.8 million increase in design costs, project materials and non-recurring engineering to support existing products and new product development
initiatives including controllers for new flash memory types and form factors as well as new flash products. The increase was also due to a $0.3 million increase in compensation expenses as a result of hiring additional personnel.



Sales and Marketing



The increase in sales and marketing expenses for the first quarter of 2005
compared to the first quarter of 2004 was primarily due to costs associated with increased product revenues, which resulted in increases of $3.7 million in freight and fulfillment expenses, $3.4 million in market development, advertising, tradeshow
and other promotional expenses, $1.3 million in compensation expenses and $0.3 million in travel expenses. The increase in compensation expenses was primarily due to increased headcount.



General and Administrative



The increase in general and administrative expenses in the first quarter of 2005 compared to the first quarter of 2004 was primarily due to an increase
of $7.4 million in legal expenses in connection with our ongoing litigation, $1.1 million in compensation expenses as a result of hiring additional personnel and a $0.6 million increase in costs associated with regulatory requirements related in
part to compliance with Section 404 of the Sarbanes-Oxley Act of 2002



Income Taxes



The following table sets forth
income tax data from our Condensed Consolidated Statements of Operations expressed as a percentage of total net revenues and as a percentage of income before income taxes:



|                                                   |  |                            |     |   |                             |   |     |                      |  |       |   
|-------------------------------------------------- |  | -------------------------- | --- | - | --------------------------- | - | --- | -------------------- |  | ----- | --
|                                                   |  | Quarter endedApril 1, 2005 |     |   | Quarter endedMarch 31, 2004 |   |     | % Change2004 to 2005 | 
|Income taxes                                       |  | $                          | 18  |   |                             | $ | 619 |                      |  | (97.1 | )%
|                                                   |  |                            |     |   |                             |   |     |                      |  |       |   
|Income taxes as a percentage of total net revenues |  |                            | 0.0 | % |                             |   | 0.4 | %                    |  | *     | % 
|                                                   |  |                            |     |   |                             |   |     |                      |  |       |   
|Effective tax rate                                 |  |                            | *   | % |                             |   | 6.2 | %                    |  | *     | % 
|                                                   |  |                            |     |   |                             |   |     |                      |  |       |   

---

|* | percentage is not meaningful
|- | ----------------------------



Income tax expense for the first quarter of 2005 was comprised primarily of state taxes. We expect our second quarter 2005 income tax expense will be
nominal due to the expected loss for the quarter.





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Other Income and Expense



Foreign exchange loss, net, decreased $0.5 million to $0.1 million in the first quarter of 2005 compared to $0.6 million in the first quarter of 2004.
These losses were primarily attributable to our sales activity into European and Japanese markets, which exposed us to fluctuations in foreign currencies including the British pound, Euro and Japanese yen. During both the first quarter of 2005 and
the first quarter of 2004 we entered into designated foreign currency exchange forward contracts to mitigate these exposures.



Interest and other expense for the first quarter of 2005 decreased slightly compared to the first quarter of 2004. In the first quarter of 2005, interest
and other expense consisted primarily of miscellaneous taxes. Interest and other expense for the first quarter of 2004 consisted primarily of interest on short-term borrowings and miscellaneous taxes. Interest and other income decreased slightly in
the first quarter of 2005 compared to the first quarter of 2004 due to lower interest rates. Interest and other income for both the first quarter of 2005 and the first quarter of 2004 consisted primarily of interest earned on our cash balances.



Liquidity and Capital Resources



Liquidity and Capital Resources



The following table is a summary of our cash flows from operating, investing
and financing activities:



|                                                    |  |                            |        |                             |   |       |  
|--------------------------------------------------- |  | -------------------------- | ------ | --------------------------- | - | ----- | -
|                                                    |  | Quarter endedApril 1, 2005 |        | Quarter endedMarch 31, 2004 |  
|Net cash provided by operating activities           |  | $                          | 35,947 |                             | $ | 1,476 |  
|Net cash provided by (used in) investing activities |  |                            | 6,937  |                             |   | (961  | )
|Net cash provided by financing activities           |  |                            | 50,782 |                             |   | 2,045 |  



The following table
sets forth our accounts receivable days sales outstanding and inventory turns per year:



|                                                           |  |                            |  |                            
|---------------------------------------------------------- |  | -------------------------- |  | ---------------------------
|                                                           |  | Quarter endedApril 1, 2005 |  | Quarter endedMarch 31, 2004
|Days sales outstanding (net of change in deferred revenue) |  | 35                         |  | 48                         
|Inventory turns per year (net of change in deferred cost)  |  | 4                          |  | 5                          



Net cash provided by
operating activities for the quarter ended April 1, 2005 included net decreases in working capital of $44.6 million and non-cash charges of $0.9 million comprised primarily of depreciation and amortization. Changes in working capital for the period
included a $30.2 million decrease in inventory and a $99.2 million decrease in accounts receivable. The decrease in our inventory was primarily due to reduced purchasing during the first quarter of 2005 compared to the fourth quarter of 2004 as a
result of reduced requirements subsequent to the seasonally high business levels surrounding the holiday period and improved asset management. The decrease in accounts receivable was primarily due to the decrease in our days sales outstanding from
49 days for the fourth quarter of 2004 to 35 days for the first quarter of 2005 due to focused efforts to collect against the receivable balances built during the seasonally high fourth quarter holiday period. We anticipate that days sales
outstanding in future quarters will be in the range of between 45 to 55 days. These changes in working capital were offset by a $74.1 million decrease in accounts payable and accrued liabilities, a $10.3 million decrease in deferred license revenue
and product margin and a $0.4 million increase in prepaid expenses and other assets. The decrease in accounts payable and accrued liabilities was due primarily to reduced inventory purchases due to the lower shipment volumes during the first quarter
of 2005 compared with the seasonally high shipping volumes of the fourth quarter of 2004 and the decrease in freight and fulfillment accruals of $4.3 million, rebates of $4.2 million and market development funds of $2.2 million which was due to the
timing of payments and credits taken during the first quarter of 2005 related to seasonally high business levels during the fourth quarter of 2004. The decrease in deferred license revenue and product margin was primarily the result of the first
quarter of 2005 sell-through of products by our customers of the seasonally high levels of inventory they had purchased from us during the fourth quarter of 2004.



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Net cash provided by operating activities for the quarter ended March 31, 2004 included net decreases in
working capital of $8.4 million, which were partially offset by non-cash benefits of $0.5 million. Changes in working capital for the period included a $9.3 million decrease in accounts payable and accrued liabilities, a $7.5 million increase in
inventories and a $3.3 million decrease in deferred license revenue and product margin. These changes were partially offset by an $11.0 million decrease in accounts receivable and a $0.7 million decrease in prepaid expenses and other assets. The
decrease in accounts receivable was due to the seasonal decline in billings in the first quarter of 2004 compared to the fourth quarter of 2003 and was partially offset by an increase in days sales outstanding from 40 days for the fourth quarter of
2003 to 48 days in the first quarter of 2004. The decrease in accounts payable and accrued liabilities was primarily related to the timing of inventory receipts during the quarter and lower levels of operating expenses in the first quarter of 2004
compared to the fourth quarter of 2003. The decrease in deferred license revenue and product margin resulted primarily from the amortization of license revenue.



Net cash provided by investing activities for the quarter ended April 1, 2005 was the result of selling $7.7 million of short-term investments to fund
operations, which was partially offset by $0.8 million of purchases of property and equipment. Net cash used in investing activities for the quarter ended March 31, 2004 was the result of purchases of $1.0 million property and equipment.



Net cash provided by financing activities for the quarter ended April 1,
2005 was the result of receiving $56.8 million of net proceeds from the issuance of convertible promissory notes and $1.1 million from purchases under our employee stock purchase plan and the exercise of stock options, which was partially offset by
the net repayment of $6.5 million related to borrowings under our credit facilities with Wells Fargo Bank and Wells Fargo Foothill described below and $0.6 million of financing costs related to our bank credit facility with Wells Fargo Foothill. Net
cash provided by financing activities for the quarter ended March 31, 2004 was primarily the result of receiving $2.0 million related to the exercise of stock options, purchases under our employee stock purchase plan and repayment of notes
receivable from stockholders.



On February 28, 2005, we entered
into a three-year asset based revolving credit facility arranged and agented by Wells Fargo Foothill, with a maximum loan commitment of $80.0 million. The actual amount available for borrowing depends upon the value of our North American accounts
receivable base. On February 28, 2005, we borrowed approximately $40.2 million under the Wells Fargo Foothill facility. The maximum amount available to us under this facility on March 1, 2005 was $43.9 million. We used proceeds to repay, in full,
our credit agreement with Wells Fargo Bank. As a condition of our asset based facility with Wells Fargo Foothill, we terminated our then outstanding credit agreement with Wells Fargo Bank. At April 1, 2005 the amount available to us under this
facility was $40.1 million of which we had borrowed $33.4 million. At April 1, 2005, the annual interest rate for borrowings under the facility was 6.25% determined using the banks prime rate.



Pursuant to the credit agreement with Wells Fargo Foothill, we must comply
with certain affirmative and negative covenants. The affirmative covenants include a restriction on capital expenditures of up to $3.5 million in any fiscal year and a requirement that we report losses before interest, tax and amortization, commonly
referred to as EBITDA, of a loss of not more than $20.1 million for the three months ending March 31, 2004, a loss of not more than $22.5 million for the six months ending June 30, 2005, a loss of not more than $18.2 million for the nine
months ending December 31, 2005, a loss of not more than $4 million for the year ending December 31, 2005 and a loss of not more than the loss in the immediately preceding period for any trailing twelve month period thereafter. The negative
covenants include, among others: limitations on indebtedness; liens; distribution or disposal of assets; changes in the nature of our business; investments; mergers or consolidations with or into third parties; transactions with affiliates; and
modifications to material agreements.



Upon the occurrence of
an event of default, our obligations under the credit facility may become immediately due and payable. Events of default include, among others: our failure to pay our obligations under the credit facility when due; our failure to comply with any
covenant set forth in the credit agreement; the attachment or seizure of a material portion of our assets; an insolvency proceeding is commenced by or against



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us; we are restrained from conducting any material part of our business; any judgment in excess of $250,000 is filed against us and not released, discharged,
bonded against or stayed pending an appeal within 30 days; breach of any material warranty in the credit agreement; breach or termination of a material contract; or the acceleration of, or default in connection with, any indebtedness involving an
aggregate amount of $250,000 or more.



On March 30, 2005, we
issued $60 million in aggregate principal amount of 5.625% senior convertible notes due April 1, 2010 (the Notes) in a private offering. As a result of this issuance, we received net proceeds of $56.8 million.



The Notes are convertible into shares of our common stock any time at the
option of the holders of the Notes at a price equal to approximately $6.68 per share, subject to adjustment in certain circumstances, which represents a 30% premium over our closing price of $5.14 on March 29, 2005. The indenture governing the Notes
(the Indenture) provides that no holder of the Notes has the right to convert any portion of the Notes to the extent that, after giving effect to such conversion, such holder (together with such holders affiliates) would
beneficially own in excess of 4.99% of our common stock outstanding immediately after giving effect to conversion. Interest on the Notes will be payable on March 31 and September 30 of each year, beginning on September 30, 2005.



The Notes will be redeemable, in whole or in part, for cash at our option
beginning on April 1, 2008 at a redemption price equal to the principal amount of the Notes being redeemed plus accrued but unpaid interest, if any, up to but excluding the redemption date; provided, however, that we may only exercise such
redemption right if our common stock has exceeded 175% of the conversion price of the Notes for at least 20 trading days in the 30 consecutive trading days ending on the trading day prior to the date upon which we deliver the notice of redemption.
Upon redemption, we will be required to make a payment equal to the net present value of the remaining scheduled interest payments through April 1, 2010.



Upon the occurrence of a fundamental change, as defined in the Indenture, the holders of the Notes will have:



| | · |  | the option to receive, if and only to the extent the holders convert their Notes into our common stock, a make-whole premium equal to the approximate lost option time value, if any,
plus accrued but unpaid interest, if any, up to but excluding the conversion date; or
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | the right to require us to purchase for cash any or all of its Notes at a repurchase price equal to the principal amount of the Notes being repurchased plus accrued but unpaid
interest, if any, up to but excluding the repurchase date.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The conversion rate of the Notes will be subject to adjustment upon the occurrence of certain events, including the following:



| | · |  | We declare certain dividends or distributions;
| | - |  | ----------------------------------------------



| | · |  | We effect a stock split or combination;
| | - |  | ---------------------------------------



| | · |  | We offer certain rights or warrants to all or substantially all of our stockholders; and
| | - |  | ----------------------------------------------------------------------------------------



| | · |  | We purchase shares of our common stock pursuant to a tender or exchange offer under certain circumstances.
| | - |  | ----------------------------------------------------------------------------------------------------------



Upon the occurrence of an event of default, as defined in the
Indenture, the holders of at least 25% in aggregate principal amount of the Notes or the trustee for the Notes under the Indenture shall have the right to cause the principal amount of the Notes to become due and payable immediately (except in
certain events of bankruptcy, insolvency or reorganization of Lexar, in which case the principal amount of the Notes shall automatically become due and payable immediately).



We have agreed to register the common stock issuable upon conversion of the Notes under the Securities Act within 180 days
from the closing date or we will be required to pay additional interest on the Notes of 0.50% per annum until the sooner of registration effectiveness or the maturity date of the Notes.



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We currently believe that we have sufficient cash and availability under our asset based credit facility
to meet our operating, capital and debt service requirements for at least the next twelve months. There can be no assurance, however, that we will be successful in executing our business plan, achieving profitability or maintaining our existing
customer base. Our cash needs are also dependent on the credit terms extended to us by our suppliers, particularly Samsung, which supplies the majority of flash memory, and if our suppliers do not provide us with credit terms that are appropriate to
meet our needs, we may have to seek alternate suppliers or additional financing. To the extent that we do not generate sufficient revenues and reduce the cost of revenues or reduce the cost of discretionary expenditures and, as a result, cash, short
term investments and available credit is insufficient to satisfy liquidity requirements, additional cash may be needed to finance operating and investing needs. However, depending on market conditions, any additional financing needed may not be
available on acceptable terms, or at all.



Commitments



We purchase the majority of our flash memory from Samsung pursuant to a
supply agreement that expires on March 29, 2006, unless the agreement is extended. Samsung has guaranteed a certain allocation of its flash memory production capacity to us. Under the supply agreement, our purchases are priced based on an agreed
upon methodology and Samsung provides us with intellectual property indemnification for the products we purchase from them. Either party can terminate the supply agreement in the event of the other partys breach of the agreement or bankruptcy.
We are not obligated to purchase minimum volumes of flash memory from Samsung.



We also have a supply agreement with UMC under which we purchase controllers. The purchase commitment for such controllers is generally restricted to a forecasted time horizon based on a rolling forecast of our
anticipated purchase orders. This agreement expires on December 31, 2005 unless the agreement is extended. If we do not extend the agreement, we intend to continue to purchase controllers from UMC on a purchase order basis.



We depend on third party subcontractors for assembly and testing of our
digital media products. We do not have long-term agreements with these subcontractors. Instead, we procure services from these subcontractors on a per-order basis.



The following table summarizes our contractual obligations and commercial commitments that are both on our balance sheet and
off balance sheet at April 1, 2005:



|                                                         |  |                                       |         |                  |   |           |  |           |        |              |   |        |  |   |      
|-------------------------------------------------------- |  | ------------------------------------- | ------- | ---------------- | - | --------- |  | --------- | ------ | ------------ | - | ------ |  | - | -----
|                                                         |  | Payments due by period (in thousands)
|                                                         |  | Totalamount committed                 |         | Less than 1 year |   | 13 years |  | 35 years |        | After5 years
|Contractual obligations and commercial commitments:      |  |                                       |         |                  |   |           |  |           |        |              |   |        |  |   |      
|Senior convertible notes payable:                        |  |                                       |         |                  |   |           |  |           |        |              |   |        |  |   |      
|Principal                                                |  | $                                     | 60,000  |                  | $ |          |  | $         |       |              | $ | 60,000 |  | $ |     
|Interest                                                 |  |                                       | 16,875  |                  |   | 3,375     |  |           | 10,125 |              |   | 3,375  |  |   |     
|Open purchase orders with vendors and suppliers*         |  |                                       | 53,999  |                  |   | 53,999    |  |           |       |              |   |       |  |   |     
|Operating leases                                         |  |                                       | 6,040   |                  |   | 1,094     |  |           | 2,169  |              |   | 1,362  |  |   | 1,415
|Standby letters of credit                                |  |                                       | 5,000   |                  |   | 5,000     |  |           |       |              |   |       |  |   |     
|                                                         |  |                                       |         |                  |   |           |  |           |        |              |   |        |  |   |      
|Total contractual obligations and commercial commitments |  | $                                     | 141,914 |                  | $ | 63,468    |  | $         | 12,294 |              | $ | 64,737 |  | $ | 1,415
|                                                         |  |                                       |         |                  |   |           |  |           |        |              |   |        |  |   |      

---

|* | At any given point in time, in the normal course of business, we have both cancelable and non-cancelable purchase orders open with our vendors and suppliers.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------



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Off Balance Sheet Arrangements



We have no off-balance sheet arrangements other than operating leases and unconditional purchase obligations as described
above.



Indemnifications



We are a party to a variety of agreements pursuant to which we may be
obligated to indemnify the other party with respect to certain matters. Typically these obligations arise in connection with sales contracts and license agreements under which we customarily agree to hold the other party harmless against any losses
incurred as a result of a claim by any third party with respect to our products. We also typically agree to pay any costs incurred in defense of any such claim. The terms of the indemnification obligations are generally perpetual from the effective
date of the agreement. In certain cases, there are limits and exceptions to our potential liability for indemnification relating to intellectual property infringement claims. We cannot estimate the amount of potential future payments, if any, that
we might be required to make as a result of these agreements. To date, the amounts required to defend indemnification claims have been insignificant. Accordingly, we have not accrued any amounts for these indemnification obligations as of April 1,
2005.



We have agreements whereby our directors and officers
are indemnified for certain events or occurrences while the officer or director is serving at our request in such capacity. The maximum amount of future payments we could be required to make under these indemnification agreements is unlimited;
however, we have a directors and officers insurance policy that reduces our exposure and enables us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of
these indemnification agreements is minimal. Accordingly, we did not record any liabilities for these agreements as of April 1, 2005.



Warranties



We provide warranties that range from one year for digital music players and the xD Picture Card to lifetime warranties for our professional products.
Warranty costs are the costs to rework or scrap returned inventories. Our warranty costs have historically been minimal.



Recent Accounting Developments



In November 2004, the FASB issued Financial Accounting Standard No. 151, Inventory Costsan Amendment of ARB No. 43, Chapter 4 (SFAS
151). SFAS 151 amends ARB 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges. In addition, this statement requires that
allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this statement are effective for inventory costs incurred during fiscal years beginning after June
15, 2005. The adoption of the provisions of SFAS 151 is not expected to have a material impact on our consolidated financial statements.



In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment. SFAS No. 123R requires employee stock options and rights to purchase
shares under stock participation plans to be accounted for under the fair value method, and eliminates the ability to account for these instruments under the intrinsic value method prescribed by APB Opinion No. 25, and allowed under the original
provisions of SFAS No. 123. SFAS No. 123R requires the use of an option pricing model for estimating fair value, which is amortized to expense over the service periods. On April 14, 2005, the U.S. Securities and Exchange Commission adopted a rule
amending the compliance dates for FAS 123R. As a result, the accounting provisions of FAS 123R will be effective for us in 2006. SFAS No. 123R allows for either prospective recognition of compensation expense or retrospective recognition, which may
be back to the original issuance of SFAS No. 123 or only to interim periods in the year of adoption. Management is currently evaluating the impact of adopting SFAS 123R; however, it believes the adoption of SFAS No. 123R will have a significant
impact on net income (loss) and net income (loss) per share. The impact on our financial statements will be dependent on the transition method, the option-pricing model used



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to compute fair value and the inputs to that model such as volatility and expected life. The pro-forma disclosures of the impact of SFAS 123 provided in Note
2 to the Condensed Consolidated Financial Statements may not be representative of the impact of adopting SFAS 123R.



In December 2004, the FASB issued SFAS No. 153, Exchange of Nonmonetary Assets, an amendment of APB No. 29, Accounting for Nonmonetary
Transactions (SFAS 153). SFAS 153 amends APB No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have
commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. We are required to adopt SFAS 153, on a prospective basis, for nonmonetary
exchanges beginning after June 15, 2005. The adoption of SFAS No. 153 is not expected to have an impact on our consolidated results of operations.



On March 29, 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (SAB 107). This staff accounting bulletin
expresses views of the staff regarding the interaction between Statement of Financial Accounting Standards statement No. 123 (revised 2004), Share-Based Payment (Statement 123R or the Statement) and certain Securities and
Exchange Commission (SEC) rules and regulations and provides the staffs views regarding the valuation of share-based payment arrangements for public companies. We do not expect the adoption of SAB 107 to have a material impact on
our consolidated financial position, results of operations or cash flows.



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 this Annual Report on Form 10-K.



Risks Related to Our Business



We expect that Toshiba and Toshiba America Electronics Company, Inc. will
appeal a jurys award to us of over $465 million in damages, and an unfavorable outcome could lead to a decline in our stock price and have a negative impact on our ability to increase our licensing revenues.



In March 2005, a jury found Toshiba Corporation and Toshiba America
Electronic Components, Inc. liable to us for breach of fiduciary duty and theft of trade secrets and awarded us over $465 million in damages, including a punitive damage award for conduct by Toshiba that the jury found to be oppressive, fraudulent
or malicious. Toshiba has indicated that it intends to pursue vigorously an appeal of these rulings. The outcome of any post trial motions or an appeal is inherently uncertain and could result in the damage award being reduced or eliminated or the
case being remanded to the trial court for further proceedings. An appeal could take a significant amount of time during which we would not be able to collect on the verdict. During the time the case remains pending, we expect to incur substantial
additional legal costs. If Toshiba prevailed on having the verdict set aside either by the trial court or through an appeal of this verdict, the damages awarded to us could be reduced or eliminated. This could adversely affect our ability to secure
additional licensing revenue either from Toshiba or other potential licensees, which would likely have a negative impact on the value of our stock.



We have a history of losses and may not be able to return to or sustain profitability.



We incurred net losses in each of the second, third and fourth quarters of
2004 and a net loss of $9.6 million in the first quarter of 2005. As of April 1, 2005, we had an accumulated deficit of approximately $177.1 million. We cannot assure you that we will be able to return to or sustain profitability in future periods,
and we will likely use cash for operations. Our ability to return to or sustain profitability depends on the rate of price decreases for our products, the cost of our components, particularly flash memory, the growth of the markets for digital
cameras or other host devices that use digital storage media, the extent to which our products, particularly our higher margin products, are accepted by these markets, our ability to charge a premium for our higher



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performance products, the success of our products and our ability to control our operating expenses, particularly our litigation costs, and adequately manage
our inventory and the challenges associated with the breadth and diversity of our product offerings. We also must continue to reduce the costs of producing and selling our flash media products by controlling our internal and channel inventory,
securing the best available pricing for flash memory and components used in our digital media products and reducing our manufacturing costs. If we are unsuccessful in increasing revenues from our higher margin products and controlling our operating
expenses, we may not be able to return to or sustain profitability on a quarterly or an annual basis.



Our operating results and gross margins have fluctuated in the past, may fluctuate significantly in the future and are difficult to predict. If our
future results are below the financial guidance provided by us or the expectations of investors or securities analysts, the market price of our common stock could decline significantly.



Our operating results and gross margins have fluctuated in the past and may
vary significantly in the future based on a number of factors related to our industry and the markets for our products. We will have little or no control over many of these factors and any of these factors could cause our operating results and gross
margins, and consequently the price of our common stock, to fluctuate significantly. These factors include, among others:



| | · |  | increases in the price of flash memory that we buy or the failure of cost decreases to keep up with price decreases for our products;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------



| | · |  | the decision of our customers to return products or rotate their stock;
| | - |  | -----------------------------------------------------------------------



| | · |  | the amount of price protection, volume incentive rebates, discounts, market development funds, cooperative advertising payments and other concessions and discounts that we may need
to provide to some of our customers due to competitive pricing pressures;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | fluctuation in demand for our products, including seasonal demand for our products and the volume and timing of potential retail customer and distributor orders;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | competitive pricing pressures for the products we sell;
| | - |  | -------------------------------------------------------



| | · |  | the rate of growth of the market for digital cameras, digital media, cell phones with card slots, USB flash drives and MP3 players;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------



| | · |  | the timely availability of flash memory, particularly flash memory that meets our technological requirements;
| | - |  | -------------------------------------------------------------------------------------------------------------



| | · |  | the availability of sufficient silicon wafer foundry capacity and product components to meet customer demand;
| | - |  | -------------------------------------------------------------------------------------------------------------



| | · |  | the difficulty of forecasting sell-through rates of our products and their impact on inventory levels at our resellers if sell-through data is not timely reported to us, which may
result in additional orders being delayed or reduced and inventory being returned;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | the timing and amount of expenses related to obsolescence and disposal of excess inventory and the difficulty of forecasting and managing our inventory levels, including inventories
on consignment and at contract manufacturers;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | the timing and amount of any reductions in the average selling prices of our products and services;
| | - |  | ---------------------------------------------------------------------------------------------------



| | · |  | the mix of business between retail, OEM and licensing;
| | - |  | ------------------------------------------------------



| | · |  | price reductions in key components, such as flash memory, could result in reduced margins when selling products that include previously purchased components held in inventory;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | increases in costs charged by our component or card suppliers or the failure of our suppliers to decrease the prices they charge to us when industry prices decline;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | the timing and amount of orders, cancellations from existing and new customers and penalties imposed by customers for failure to meet their requirements;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | the commencement of, involvement in or the expansion, appeal or settlement of our litigation;
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| | · |  | any changes in the trend of declining average selling prices per unit sold of digital storage media;
| | - |  | ----------------------------------------------------------------------------------------------------



| | · |  | competing flash card standards, which displace the standards used in our products;
| | - |  | ----------------------------------------------------------------------------------



| | · |  | shortages of components such as capacitors and printed circuit boards required for the manufacturing of our products;
| | - |  | ---------------------------------------------------------------------------------------------------------------------



| | · |  | exchange rate fluctuations, particularly the U.S. dollar to British pound and Japanese yen and the British pound to Euro exchange rates;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------



| | · |  | the announcement or introduction of products and technologies by competitors;
| | - |  | -----------------------------------------------------------------------------



| | · |  | the inability of new NAND flash memory suppliers to fully indemnify us should we be subjected to litigation;
| | - |  | ------------------------------------------------------------------------------------------------------------



| | · |  | potential product quality problems which could raise return or rework costs; and
| | - |  | --------------------------------------------------------------------------------



| | · |  | whether we can sell controllers, digital media accessories and other components in the volumes and at the prices we anticipate.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------



In addition, as a result of the emerging nature of our market, we may be
unable to accurately forecast our revenues and gross margins. We incur expenses based predominantly on operating plans and estimates of future revenues. Our expenses are to a large extent fixed in the short term and we may not be able to adjust them
quickly to meet a shortfall in revenues during any particular quarter. We also plan inventory levels based on anticipated demand for our products and on anticipated product mix. As we anticipate increased demand for certain products we increase our
level of inventory, which results in increased risk if we inaccurately estimate anticipated demand. Also, because of irregular component shipments from certain of our suppliers, we have had to carry a higher level of inventory as a buffer against
delivery delays. Any significant shortfall in revenues in relation to our expenses and planned inventories would decrease our net income or increase our operating losses and harm our financial condition. Declines in our operating results or gross
margins may cause us to fail to meet the expectations of investors or securities analysts, which would be likely to cause the market price of our common stock to decline.



We are substantially leveraged, which could adversely affect our ability to adjust our business, to develop or enhance
our products, expand our operations, respond to competitive pressures or obtain additional financing.



We have significant indebtedness. On February 28, 2005, we borrowed approximately $40.2 million under our asset based credit facility with Wells Fargo
Foothill. On March 30, 2005, we issued $60 million aggregate principal amount of 5.625% senior convertible notes due April 1, 2010. As of April 1, 2005, the amount available to us under the Wells Fargo Foothill facility was $40.1 million of which we
had borrowed $33.4 million. Subsequent to April 1, 2005, we repaid all outstanding amounts under this facility.



The degree to which we are leveraged could have important consequences, including, but not limited to, the following:



| | · |  | our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions, general corporate or other purposes may be limited;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | a substantial portion of our cash flow from operations will be dedicated to the payment of the principal and interest of our indebtedness;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | if we elect to pay any premium on the senior convertible notes with shares of our common stock or we are required to pay a make-whole premium with our shares of common
stock, our existing stockholders interest in us would be diluted; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | we may be more vulnerable to economic downturns, less able to withstand competitive pressures and less flexible in responding to changing business and economic conditions.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Our ability to pay interest and principal on our asset based credit facility and debt securities, to
satisfy other debt obligations which may arise and to make planned expenditures will be dependent on our future operating performance, which could be affected by changes in economic conditions and other factors, some of which are beyond our control.
A failure to comply with the covenants and other provisions of our debt instruments could result in events of default under such instruments, which could permit acceleration of the debt under such instruments and in some cases acceleration of debt
under other instruments that may contain cross-default or cross-acceleration provisions. If we are at any time unable to generate sufficient cash flow from operations to service our indebtedness, we may be required to attempt to renegotiate the
terms of the instruments relating to the indebtedness, seek to refinance all or a portion of the indebtedness or obtain additional financing. There can be no assurance that we will be able to successfully renegotiate such terms, that any such
refinancing would be possible or that any additional financing could be obtained on terms that are favorable or acceptable to us.



If we cannot raise needed funds on acceptable terms, or at all, we may not be able to maintain our product development schedule, respond to competitive
pressures or grow our business. Failure to obtain additional funds when required could also result in inadequate capital to operate our business in accordance with our plans and require us to cut back operations, which could result in a further
decline in revenues, or to cease our operations. Historically, cash generated from operations have not been sufficient to fund our capital requirements. If we need to raise additional funds during the next twelve months to fund potential growth or
our operations, it could be difficult to obtain additional financing on favorable terms, or at all. We may try to obtain additional financing by issuing shares of common stock, preferred stock, convertible debt securities, or warrants or otherwise,
which could dilute our existing stockholders.



A lack of
effective internal control over financial reporting could result in an inability to accurately report our financial results that could lead to a loss of investor confidence in our financial reports and have an adverse effect on our stock price.



Effective internal control over financial reporting is
essential for us to produce reliable financial reports. If we cannot provide reliable financial information or prevent fraud, our business and operating results could be harmed. We have in the past discovered, and may in the future discover,
deficiencies in our internal control over financial reporting. In connection with our managements evaluation of our internal control over financial reporting as of December 31, 2004, management identified two control deficiencies that
constitute material weaknesses. As more fully described in Item 9A of our annual report for the year ended December 31, 2004 and Item 4 of this report, as of December 31, 2004 and April 1, 2005, our management determined that we did not maintain
effective internal control over:



| | · |  | revenue recognition with respect to certain customers (primarily our resellers), including adequate consideration of our estimates regarding offsets to or discounts from revenue
such as price protection and promotional activities; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | the accounting for inventory valuation reserves.
| | - |  | ------------------------------------------------



These deficiencies resulted in audit adjustments that were recorded in our consolidated financial statements for the fourth quarter of 2004. As a result
of the material weaknesses identified, we concluded that our internal control over financial reporting was not effective as of December 31, 2004, and PricewaterhouseCoopers LLP, our independent registered public accounting firm, issued an adverse
opinion on the effectiveness of our internal control over financial reporting as of December 31, 2004. Although we have taken steps to remediate deficiencies in our internal control over financial reporting, a failure to successfully implement and
maintain effective internal control over financial reporting, including any ineffectiveness of the corrective actions we have subsequently implemented to address the control deficiencies identified above, could result in a material misstatement of
our financial statements or otherwise cause us to fail to meet our financial reporting obligations. This, in turn, could result in a loss of investor confidence in the accuracy and completeness of our financial reports, which could have an adverse
effect on our stock price.



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We primarily depend upon Samsung for our flash memory. If Samsung is unable to provide us with
sufficient quantities of flash memory when we need it at prices and sales terms that allow us to be competitive in the marketplace, if Samsung is unable to remain technologically competitive, or if Samsung were to reduce or eliminate our credit
terms, we would not be able to manufacture and deliver digital media to our customers in accordance with their volume, price and schedule requirements which would have a serious negative impact on our revenues and margins.



As a result of the supply agreement we entered into with Samsung in April
2001, it is our primary supplier of flash memory, which is the primary cost of our digital media. During much of 2004, the demand for flash memory was substantially greater than the supply of flash memory due to the continuing demand for digital
cameras, increased use of flash memory in cellular phones and other digital consumer products, and increasing demand for USB flash drives. Shortages of flash memory now continue and we expect that the demand for flash memory during 2005 will
continue to be greater than the available supply. If we are unable to obtain sufficient quantities of flash memory from Samsung or from another flash memory supplier in a timely manner and at competitive prices, we will not be able to manufacture
and deliver flash memory products to satisfy our customers requirements.



Although a number of semiconductor companies have begun to manufacture flash memory that would meet some of our needs, Samsung and Toshiba continue to control virtually all of the market for flash memory for our
products. The new flash suppliers have been delayed in their efforts to enter the flash chip market and their technical roadmaps may now be substantially behind the products manufactured and sold by Samsung and Toshiba. Even as additional flash
memory capacity becomes available from new suppliers, these suppliers may not be able to supply our flash memory needs at competitive prices if we cannot obtain adequate supplies from Samsung. Even if we are able to obtain flash memory in sufficient
volumes and on schedules that permit us to satisfy our delivery requirements, we cannot assure you that the prices charged by Samsung or other suppliers will enable us to compete effectively in our market. If we are unable to satisfy the
requirements of our customers or supply digital media to them in the volumes and at the pricing they request, they will likely reduce future orders, impose penalties on us for failure to meet their requirements or eliminate us as a supplier. Our
reputation would likely also be harmed and we may not be able to replace any lost business with new customers. If we are unable to obtain flash memory at economical prices, our gross margins would decline unless we could raise the prices of our
products in a commensurate manner or offset the cost increases elsewhere. The existing competitive conditions in our industry may not permit us to do so, which would adversely impact our revenues and gross margins.



In addition, if Samsung does not offer us prices, sales terms and credit
terms that are appropriate to meet our growing needs, we might have to seek alternate suppliers or additional financing. Samsung and other current and potential suppliers of flash memory are located in Asia, a region that has been, and in the future
may be, affected by economic and political instability that could adversely affect the price and supply of flash memory. Furthermore, if Samsung is unable to increase its output of flash memory in a manner commensurate with our needs, or to
manufacture flash memory that is technologically and price competitive, or if it has any interruptions in shipment for any reason, we would be unable to satisfy our customers requirements. For example, Samsung has previously emphasized smaller
flash geometries over multi-level cell technology. In contrast, Toshiba and SanDisk appear to be manufacturing multi-level cell technology in volume at high yields, which appears to give them significant cost advantages over single-level cell
technologies.



In addition, Samsung has from time to time
considered directly entering the retail market for flash media, which would make it a direct competitor to us. Because flash memory represents a significant portion of the cost of flash media, flash manufacturers like Samsung may have a competitive
advantage.



Our agreements with Samsung terminate in March 2006
unless extended. Either party can terminate the agreement in the event of the other partys breach of the agreement or bankruptcy. In addition, if our license agreement with Samsung were to terminate in the event of Samsungs breach,
Samsung may, in turn, breach our



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supply agreement with them. The expiration or termination of our supply agreement with Samsung could negatively impact our ability to deliver flash memory
products to satisfy our customers requirements in the event we were unable to secure a sufficient volume of flash memory from other suppliers.



The solid-state storage market is evolving and we may not have rights to manufacture and sell certain types of flash card formats or we may be forced
to pay a royalty to sell digital media in these formats. Future digital media formats may not use our core technology.



Many new digital cameras and other consumer devices now use digital media formats such as the Secure Digital Card or xD Picture Card formats, which we do
not have the rights to manufacture. Our cost structure on these products is higher than our cost structure for other products. The Secure Digital Card was introduced by a consortium consisting of SanDisk, Matsushita and Toshiba. The consortium
charges significant license fees to other companies that want to manufacture SD Cards. The Secure Digital Card and the xD Picture Card have rapidly gained broad consumer acceptance. This has resulted, and will likely continue to result in a decline
in demand, on a relative basis, for products that we have the rights to manufacture without the payment of a royalty.



In 2004 and the first quarter of 2005, products we purchase and resell significantly increased as a percentage of our total net revenues. We believe that
one of our advantages is our ability to offer retailers all major flash card formats, and if we were unable to supply all flash card formats at competitive prices or if we were to have product shortages, our margins would be adversely impacted and
our customers would likely cancel orders or seek other suppliers to replace us.



Our products are characterized by average selling prices that have historically declined over relatively short time periods. If we are unable to effectively manage our inventories, reduce our costs, introduce new
products with higher average selling prices or increase our sales volumes, our revenues and gross margins will be negatively impacted.



Our competitors and customers impose significant pricing pressures on us. At times, these pricing pressures have been possible as a result of lower flash
memory costs. At other times, such as in the fourth quarter of 2004, our prices have fallen faster than our costs which has resulted in additional margin pressure. In addition, because a large percentage of our sales are to a small number of
customers that are primarily retail consumer chains, distributors and large OEMs, these customers have exerted, and we expect they will continue to exert, pressure on us to make price concessions. In the past, we have significantly reduced the
prices of many of our flash products from time to time, and we expect we will need to continue to do so to remain competitive even though we asked many of our customers to accept price increases in the first quarter of 2005. During the second
quarter of 2005, our competitors, particularly SanDisk and Toshiba, are continuing to reduce selling prices despite expectations that industry demand for flash memory during the quarter will continue to be greater than available supply. We are
adjusting our selling price strategy with the intention of focusing on profitability while balancing the need to maintain the significant majority of our retail market share. Any reduction in prices by us in response to pricing pressures will hurt
our gross margins unless we can manage our internal and channel inventories and our cost structure to minimize the impact of such price declines and reduce our costs. We also sell our products to certain customers on a consignment basis, which has
resulted in us carrying higher inventory levels.



If we are
unable to reduce our costs to offset declines in average selling prices or increase the sales volume of our existing products, our revenues and gross margins will be adversely affected. We anticipate that our average selling prices will continue to
decline in 2005. This may negatively impact our anticipated growth in product revenues as well as our gross margins, particularly if the decline in our average selling prices is not matched by price declines in our component costs, primarily the
cost of flash memory. Furthermore, even if we experience price declines in our component costs, such price reductions could result in reduced margins when we sell products that include components in inventory which were previously purchased at a
higher price.



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Our strategic partnership with Kodak and our ongoing relationships with OEM customers pose significant
challenges for us, and if we are unable to manage these relationships, our business and operating results will be adversely affected.



We have entered into an exclusive multi-year agreement with Kodak under which we will manufacture and distribute a full range of KODAK branded memory
cards. The management of the Kodak business could adversely affect our revenues and gross margins if we are, among other things, unable to:



| | · |  | properly manage the distribution and use of the KODAK brand;
| | - |  | ------------------------------------------------------------



| | · |  | control the sales and marketing expenses associated with launching the brand in new channels;
| | - |  | ---------------------------------------------------------------------------------------------



| | · |  | plan for anticipated changes in demand;
| | - |  | ---------------------------------------



| | · |  | effectively leverage the KODAK brand to achieve premium pricing and grow market share;
| | - |  | --------------------------------------------------------------------------------------



| | · |  | maintain the market share position of the Lexar brand; and
| | - |  | ----------------------------------------------------------



| | · |  | appropriately allocate resources to support a dual branding strategy.
| | - |  | ---------------------------------------------------------------------



In the future, a significant portion of our revenue may be derived from sales of digital media under the Kodak brand. We have a number of obligations that
we must fulfill under our agreement with Kodak to keep the license exclusive and to keep it in effect. These obligations include compliance with Kodak guidelines and trademark usage, customer satisfaction, and a number of market share goals and
target minimum royalty payments. If we were to lose the rights to sell products under the Kodak brand, our financial results could be significantly negatively impacted.



In addition, our business may also be negatively impacted if we are unable to manage our existing relationships with our OEM
customers. Our OEM customers include many large domestic and international companies that have greater financial resources and bargaining power than we do. As a result, our agreements with some of these customers include restrictions and commitments
that could adversely affect our revenues and gross margins. These contractual provisions include, among others: guaranteed pricing and price protection; commitments to supply product at the customers requested volumes; penalties for late
shipment, delivery cancellation or failure to meet certain quality assurances; agreements not to sue, or assert our intellectual property rights against, such customers; and limitations on our ability to terminate such agreements.



We have recently modified our pricing strategy and have significantly
reduced promotional programs and increased prices on certain products to most of our customers to better align our selling prices with our cost structure. Many of our retail customers and distributors have rights of return, and we may be required to
take back large quantities of unsold customer inventory if as a result of our recent actions, or otherwise, they decide to terminate their relationship with us and purchase from other vendors.



Substantially all of our sales of our digital media products to end-users
are made through distributors and retailers. Our sales through these channels often include rights to return unsold customer inventory still in the customers inventory for credit. During the first quarter of 2005, we modified our pricing
strategy and significantly reduced our promotional programs and increased prices on certain products to most of our customers to better align our selling prices with our cost structure. Our resellers or their customers may not accept these price
increases and may decide to reduce their orders, purchase from other vendors or return unsold product to us. In the past several months, we have lost product placements to our competitors at Wal-Mart and Sams Club, CompUSA and other resellers
in part because of our pricing strategy. In particular, CompUSA has terminated their relationship with us. In addition, at Wal-Mart and Sams Club, which accounted for approximately 17% of our gross revenue in the first quarter of 2005, we have
experienced a significant decline in sales due to the addition of other vendors.



If our resellers reduce or cancel their orders, they may also decide to exercise their rights of return and require that we take back large quantities of unsold customer inventory. Our customers generally place orders
on



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the expectation of certain promotional support from us, and as we reduce our promotional activities, those customers may decide to return significant amounts
of products to us. If there are significant inventories of old products in our distribution channel when a new product is released, or if these distributors and retailers are unsuccessful in selling our products, there could be substantial product
returns. If our reserves are insufficient to account for these or future returns or if we are unable to resell these products on a timely basis at similar prices, our revenues may be reduced. Because the market for our products is rapidly evolving,
we may not be able to resell returned products at attractive prices or at all.



If we are unable to generate increased revenue from licensing our intellectual property, our gross margins and results of operations would be negatively impacted.



We have historically derived the substantial majority of our licensing
revenue from a limited number of sources. If we fail to generate significant licensing revenues or increase the revenues we derive from our higher margin controller sales, we may not grow our revenues and margins as planned. In March 2002, we
executed a license agreement with Samsung that provided for fixed license payments through March 31, 2004 and variable based royalties thereafter. Whether we will be paid any royalties under the variable based royalty obligations depends on many
factors, including which flash products Samsung manufactures and sells and in what volumes, as well as our relative market share and our aggregate purchases from Samsung. Since March 31, 2004, variable-based royalties from Samsung under this
agreement have been minimal and we expect that trend to continue for the foreseeable future. We cannot assure you that we will be successful in our efforts to secure new license or royalty revenues, and our failure to do so could negatively impact
our operating results.



Our unit volume has increased
substantially in recent periods and has strained our operations infrastructure and our supply chain.



The number of units we manufacture on a weekly basis has increased significantly and has strained our supply chain and operational capabilities. Our
contract manufacturers may not be able to manufacture product at levels necessary to sustain our increased growth. Our component suppliers may not be able to keep up with the growth in our need for parts. Our other vendors, such as those that
package our products, also may have trouble meeting our additional demands on them. If we are not able to continue to accommodate this increased unit demand from our customers, we may have product shortages. If we were to have product shortages, our
customers would likely cancel orders, impose penalties for late shipment or delivery cancellations, require that we use faster shipping methods which would increase our freight and fulfillment expenses or seek other suppliers to replace us.



If our component suppliers are not able to meet our demand in
a timely manner, we may not be able to manufacture and package products quickly enough to meet customer demand. If this were to occur, customers would likely cancel orders or switch suppliers. In addition if we are unable to manufacture products at
rates sufficient to keep up with our component purchases, we may have too much inventory that would later need to be written down if component prices decrease. This challenge can be, and has in the past been, particularly acute during the fourth
quarter when demand for components is high and retail customers require the delivery of large volumes of products during a narrow window of time. In addition, because the first quarter typically experiences lower demand than the fourth quarter,
inventory planning becomes particularly important. If we are not able to manage our component purchases and inventory appropriately, our financial results will be negatively impacted.



In addition, we must continue to make significant investments in our existing internal information management systems to
support increased manufacturing, as well as accounting and other management related functions. Our systems, procedures and controls may not be adequate to support rapid growth, and as described in further detail in Item 9A of our annual report for
the year ended December 31, 2004 and Item 4 of this report, as of December 31, 2004, we identified two deficiencies in our internal control over financial reporting that were determined to be material weaknesses. We cannot assure you that we will
not have internal control deficiencies in the future, including deficiencies that may be deemed to be material weaknesses, which could in turn harm our business, financial condition and results of operations. In addition, the improvement in economic
conditions will



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likely extend the lead-time for procuring components. If we do not plan properly or if the demand rises too quickly, we will face material shortages.



We market our digital media primarily on the basis of its
superior technology. If we are unable to achieve or maintain technological leadership or gain commercial acceptance of the performance and technology advantages of our products, our revenues and gross margins would likely decline significantly.



We market our digital media primarily on the basis of its
performance and technology advantage over our competitors products. In doing so, we have emphasized our speed and other advantages over our competitors products and have tried to establish ourselves as the brand of choice among
professional photographers. We label our CompactFlash and some of our JumpDrive and Secure Digital Card products as capable of sustained write speed performance in which 1x is equal to a write speed of 150 kilobytes per second, nomenclature similar
to that used in the CD-ROM industry. For example, our 4x CompactFlash digital film is capable of sustained write speeds of at least 600 kilobytes per second. Currently, we offer CompactFlash, Secure Digital and JumpDrive flash drives capable of
minimum sustained write speeds up to 80x, 32x and 120x, respectively. Our highest capacity card is currently eight gigabytes. In addition to offering flash memory cards in a variety of speeds and capacities, we are also offering more advanced
features in some of our flash media card products, such as Write Acceleration technology, the ActiveMemoryTMSystem
and LockTightTMCompactFlash. We also market our JumpDrive products in a range of functionality to target specific
consumer needs.



From time to time our competitors have
introduced products for which they have claimed large storage capacities, high, sustained write speeds, including write speeds faster than that of some of our own competing products, and similar functionality to that of our own products. If we are
unable to design and manufacture products that are technologically superior to those of our competitors, if we lose our status as a brand preferred by professional photographers or if we are unable to gain commercial acceptance of the performance
and technology advantages of our products, we will be unable to achieve a premium price for our products. If this were to occur, our revenues and gross margins would likely decline significantly.



Increased competition in the digital media market may lead to a decrease
in our revenues and market share.



Our industry is
characterized by intense competition, supply shortages or oversupply, rapid technological change, evolving industry standards, declining average selling prices and rapid product obsolescence. Our existing competitors include many large domestic and
international companies that have longer operating histories and have or may have greater brand name recognition, greater access to flash memory, substantially greater financial, technical, marketing and other resources, broader product lines and
longer standing relationships with retailers, OEMs and end users. As a result, these competitors may be able to better absorb price declines, ensure more stable supply, adapt more quickly to new or emerging technologies or devote greater resources
to the promotion and sale of their products than we may. Ultimately, this may lead to a decrease in our sales and market share.



We compete with semiconductor companies that manufacture and sell flash memory chips or flash memory cards. These include Hynix, Infineon, Micron,
Renesas, Samsung, SanDisk, ST Micro and Toshiba. SanDisk and Toshiba jointly develop and manufacture both low-cost and high-performance flash memory through their Flash Vision joint venture. Because flash memory represents a significant portion of
the cost of flash media, SanDisk and other flash manufacturers may have a competitive advantage and may have access to flash memory at prices substantially below the prices that our suppliers charge to us. SanDisk has other competitive advantages in
that it also collects substantial royalties pursuant to license agreements with Samsung and others. SanDisk also collects royalties on the manufacture and sale of SD Cards. In conjunction with the SanDisk/Samsung license agreement, SanDisk has
announced that Samsung sells flash to SanDisk at very favorable pricing.



We also face significant competition from manufacturers or card assemblers and resellers that either resell flash cards purchased from others or assemble cards from controllers and flash memory chips purchased from
companies such as Renesas, Samsung or Toshiba, into flash cards. These companies include Crucial, Dane-Elec,



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Delkin Devices, Kodak, Feiya, Fuji, Hagiwara, Hewlett Packard, Data I/O, Infineon, Kingston, M-Systems, Matsushita, Memorex, Memory Plus, Micron, PNY, PQI,
Pretec, Ritek, Samsung, SanDisk, Silicon Storage Technology, SimpleTech, SMART Modular Technologies, Sony, TDK, Transcend, Viking InterWorks and many others.



In addition, an increasing number of companies are manufacturing their own controllers, including Genesys, Hyperstone, Prolific, SanDisk, Sigmatel,
Silicon Storage Technology, SMI, Solid State System, Sony and Zoran. Such companies either combine their controller with flash memory from third parties to manufacture their own flash cards or sell their controllers to third parties who use them to
assemble flash cards. Additionally, major semiconductor companies such as Infineon, Micron, Renesas, Samsung and Toshiba have also developed or are currently developing their own controllers that will likely compete with our controller and/or card
sales.



Furthermore, many companies have introduced USB flash
drives that compete directly with our JumpDrive line of products. These include Apacer, Belkin, Fuji, Iomega, JMTek, KTI Networks, M-Systems, Netac, PNY, Samsung, SanDisk, SimpleTech, Sony, Trek and many others.



Many of our competitors are larger than we are and, because they manufacture
their own controllers and flash memory, do not depend to the extent we do on third parties to supply them with those products. Flash memory has been in short supply for a number of quarters which has resulted in our flash costs decreasing at a
slower rate than product pricing in the market. Companies that manufacture their own flash memory will have a significant advantage so long as this allocation situation continues.



Our competitors have also introduced certain flash card formats. For example, a consortium consisting of SanDisk, Matsushita
and Toshiba have developed the Secure Digital Card, a media format used in digital cameras as well as in other electronic applications, and Fuji and Olympus introduced the xD Picture Card. Although we currently sell these flash memory products,
which we source from third parties, we must pay significant royalties or higher costs to do so and may not be able to do so in the future at a reasonable rate or at all. In addition, SanDisk has introduced TransFlash which is designed to be used in
cell phone applications. If we are unable to obtain the rights to manufacture these products, our business will be adversely affected.



We also face competition from some manufacturers of traditional film products. Kodak and Fuji are the largest and best-known manufacturers of traditional
film products. Fuji has entered the flash card market, but does not yet manufacture its own flash cards. Last year, we entered into an agreement with Kodak to sell flash cards under the Kodak brand on a worldwide basis. With their resources and
worldwide brand recognition, Fuji and Kodak, if we were to lose the rights to sell products under that brand, would be formidable competitors for our core business.



Several companies, such as Cornice, IBM, and Matrix Semiconductor have introduced competing technologies for use in digital
cameras. These include products such as Digital Capture Technology and the MicroDrive. Although the cost per megabyte of rotating media such as Digital Capture Technology and the MicroDrive is lower than that of flash cards, rotating media has
historically had higher power consumption and lower reliability than flash cards. Compact discs can also be used as a storage medium for digital cameras and other devices, and, while inexpensive, are quite bulky. We expect to continue to face
competition from existing or future competitors that design and market similar or alternative data storage solutions that may be less costly or provide additional features. If a manufacturer of digital cameras or other consumer electronic devices
designs one of these alternative competing standards into its products, the digital media we manufacture, as currently configured, will not be compatible with that product and our revenues may decline.



If we are unable to continue to develop, competitively market and sell our
JumpDrive portable flash storage product line or maintain or continue to increase our sales of controllers, digital media accessories or other components, our revenues, gross margins and results of operations would be negatively impacted.



We derive a significant portion of our revenues and gross
margin from sales of our JumpDrive flash storage products. The market for USB drives has become increasingly competitive. We believe that design has become



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an important selling feature for these products unlike other flash cards which have fixed dimensions and specifications. If we cannot continue to develop,
market and sell these products, particularly with designs that appeal to a broad group of customers, and successfully educate consumers regarding the products selling features in order to gain commercial acceptance and premium pricing, our
revenues, gross margins and profits may decline.



In addition,
in the first quarter of 2005, our revenues from controllers, digital media accessories and other components increased to $27.2 million and we expect our controller and other component revenues to increase further in the second quarter of 2005. If we
cannot continue to successfully sell these component products to our customers or maintain the rights to do so, our revenues and results of operations would be negatively impacted.



If we are unable to develop and introduce, on a timely basis, new products or services that are accepted by our customers
and consumers, we will not be able to compete effectively in our market.



We operate in an industry that is subject to evolving industry standards, rapid technological changes, rapid changes in consumer demands and the rapid introduction of new, higher performance products that shorten
product life cycles and tend to decrease average selling prices. To remain competitive in this demanding market, we must continually design, develop and introduce new products and services that meet the performance and price requirements of our
customers and consumers. For example, as the number of flash card formats proliferates, it puts significant additional strain on our engineering group to design controllers for each format. Any significant delay or failure in releasing new products
or services would harm our reputation, provide a competitor a first-to-market opportunity or allow a competitor to achieve greater market share. Also, we cannot assure you that any products or services we do introduce will gain market acceptance.
The introduction of new products is inherently risky because it is difficult to foresee advances in technology and the adoption of new standards, to coordinate our technical personnel and strategic relationships, to identify and eliminate design and
product flaws and successfully develop product features and designs that will appeal to a wide range of consumers. We may not be able to recoup research and development expenditures if our new products or services are not widely accepted.



Because we protect many of our retail customers and
distributors against the effects of price decreases on their inventories of our products, we have in the past and may in the future incur large price protection charges if we reduce our prices when there are large quantities of our products in our
distribution channel.



Nearly all of our retail product
sales in 2002, 2003, 2004 and the first quarter of 2005 were made through our resellers to which we have provided price protection. Price protection allows customers to receive a price adjustment on existing inventory when its published price is
reduced. In an environment of slower demand and abundant supply of products, price declines and channel promotions expenses are more likely to occur and, should they occur, are more likely to have a significant impact on our operating results.
Further, in this environment, high channel inventory may result in substantial price protection charges. These price protection charges have the effect of reducing gross sales and gross margin. Price protection in our retail channel during 2003 was
approximately $13.3 million, or 3.4% of product revenues, and in 2004, we incurred price protection of approximately $52.6 million, or 7.8% of product revenues, and in the first quarter of 2005 we incurred price protection of approximately $1.6
million, or 0.7% of product revenues. We anticipate that we will continue to incur price protection charges for the foreseeable future due to competitive pricing pressures. If our price protection reserves are insufficient or we continue to have
difficulties estimating future charges, our revenues and gross margins would be adversely affected in future periods.



We may need to write-down our inventory if our sales levels do not match our expectations or if pricing declines more than we anticipate, which could
adversely impact our revenues and gross margins.



We
operate in an industry that is characterized by intense competition, supply shortages or oversupply, rapid technological change, evolving industry standards, declining average selling prices and rapid product obsolescence, all of which make it more
challenging to effectively manage our inventory. Our inventories are



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stated in the lower of cost or market value. Determining market value of inventories involves numerous judgments, including judgments regarding average
selling prices and sales volumes for future periods. We primarily utilize estimated selling prices for measuring any potential declines in market value below cost. When market value is determined to be below cost, we make appropriate allowances to
reduce the value of inventories to net realizable value. This may occur where we determine that inventories are slow moving, obsolete or excess or where the selling price of the product is insufficient to cover product costs and selling expenses. If
actual product demand or selling prices are less favorable than we estimate, we may be required to take additional inventory write-downs and our revenues and gross margins will be negatively impacted.



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



Historically, a small
number of our customers have accounted for a significant portion of our revenues. During the first three months of 2005, sales to the ten customers from which we received the greatest revenues accounted for approximately 46.7% of our gross revenues.
Sales to one customer, Wal-Mart (including Sams Club), represented approximately 17% of our gross revenues. We have lost product placements to our competitors at Wal-Mart and Sams Club and expect that these accounts will be a smaller
portion of our business in 2005. Our revenues could decline if one or more of these customers were to significantly reduce, delay or cancel their orders; decide to purchase digital media manufactured by one of our competitors; terminate their
relationship with us, as CompUSA did in the first quarter of 2005; develop and manufacture their own digital media; or cease operations due to the downturn in the global economy or otherwise. In addition, we do not carry credit insurance on our
accounts receivables and any difficulty in collecting outstanding amounts due from our customers, particularly customers that place larger orders or experience financial difficulties, could adversely affect our revenues and our net income. Because
our sales are made by means of standard purchase orders rather than long-term contracts, we cannot assure you that these customers will continue to purchase quantities of our products at current levels, or at all.



Furthermore, our revenues include sales to OEMs, some of which have elected,
or may in the future decide, to compete against us in the digital media market. We expect our operating results for at least the next several years to continue to depend on sales to a relatively small number of customers.



If we are unable to develop or maintain the strategic relationships
necessary to develop, sell and market products that are commercially viable and widely accepted, the growth and success of our business may be limited.



We may not be able to develop and sell products that are commercially viable and widely accepted if we are unable to anticipate market trends and the
price, performance and functionality requirements of digital camera and flash memory manufacturers and customers. We must continue to collaborate closely with our customers, digital camera manufacturers, flash memory manufacturers and other
suppliers to ensure that critical development, marketing and distribution projects proceed in a coordinated manner. This collaboration is also important because our ability to anticipate trends and plan our development activities depends to a
significant degree upon our continued access to information derived from strategic relationships we currently have with digital camera and flash memory manufacturers. This collaboration can be difficult because many of these companies are located in
Europe or Asia. If any of our current relationships terminate or otherwise deteriorate, or if we are unable to enter into future alliances that provide us with comparable insight into market trends, we will be hindered in our product development
efforts.



We rely to a significant degree on retailers to
sell our digital media products and our inability to control the activities of such retailers could cause our operating results and gross margins to fluctuate significantly.



We sell a significant percentage of our digital media products through retailers, most notably in the first quarter of 2005,
Best Buy, Office Max, Ritz Camera Centers, Target and Wal-Mart and Sams Club, rather than through OEMs. Sales to retailers subject us to many special risks, including the following:



| | · |  | continued downward pricing pressure in the retail channel has, and we expect will continue to, necessitate price protection of the inventories of our products that many of our
customers carry;
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| | · |  | retailers may emphasize our competitors products over our products, or decline to carry our products;
| | - |  | ------------------------------------------------------------------------------------------------------



| | · |  | loss of market share if the retailers that carry our products do not grow as quickly and sell as many digital media products as the retailers that carry the digital media products
of our competitors;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | loss of business or monetary penalties if we are unable to satisfy the product needs of these customers or fulfill their orders on a timely basis;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | increased sales and marketing expenses if we are unable to accurately forecast our customers orders, including, among other items, increased freight and fulfillment costs if
faster shipping methods are required to meet customer demand;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | product returns could increase as a result of our strategic interest in assisting retailers in balancing their inventories;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



| | · |  | reduced ability to forecast sales; and
| | - |  | --------------------------------------



| | · |  | reduced gross margins, delays in collecting receivables and increased inventory levels due to the increasing tendency for some retailers to require products on a consignment basis.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Availability of reliable sell-through data
varies throughout the retail channel, which makes it difficult for us to determine actual retail product revenues until after the end of each of our fiscal quarters. Unreliable sell-through data may result in either an overstatement or
understatement of our reported revenues and results of operations. Our arrangements with our customers also provide them price protection against declines in our recommended selling prices. Except in limited circumstances, we do not have exclusive
relationships with our retailers or distributors and therefore must rely on them to effectively sell our products over those of our competitors. Our reliance on the activities of retailers over which we have little or no control could cause our
operating results and gross margins, and consequently the price of our common stock, to fluctuate significantly.



Because we depend on single suppliers for some key components and products and do not have long-term supply contracts with those suppliers, we are
exposed to the risks, including price increases, late deliveries, poor component quality and a potential inability to obtain an adequate supply of components In addition, not all of these suppliers provide us with indemnification for their products,
so we also face the risk that our margins and operating results would be severely negatively impacted if such products infringe the intellectual property rights of a third party or if we are found to owe license fees or royalties relating to these
products.



We have a sole source of supply for certain
components in our digital media. Because we depend on single suppliers for certain key components, and do not have a long-term supply contract with any of these suppliers, we face the risk of inadequate component supply, price increases, late
deliveries and poor component quality. Any supplier may terminate their relationships with us or pursue other relationships with our competitors, and if we were to lose our relationship with these single suppliers, the lead time required to qualify
new suppliers could be as long as three months. Also, if we lose our single suppliers or these suppliers are otherwise unable to satisfy our volume and delivery schedule requirements, it may be difficult to locate any suppliers who have the ability
to develop, manufacture and deliver the specialized components we need for our products. If we are unable to accurately predict our supply needs, or if our supply of components is disrupted, our reputation may be harmed and we may lose existing
customers, incur penalties imposed by existing customers or be unable to attract new customers.



We also do not currently manufacture certain digital media formats, such as the Memory Stick Duo, xD Picture Card, Secure Digital Card or mini
Secure Digital, with our own controllers. Until we are able to develop our own flash memory controller for these and other products, we must purchase such cards from third parties for resale. We do not have long-term supply contracts with all
of these suppliers, and therefore face the risks of inadequate supply, price increases, late delivery or unavailability and the need to maintain buffer inventory. If our supply of such products is disrupted, we will lose existing customers and may
be unable to replace them or to attract new ones. Furthermore, not all of our suppliers provide us with indemnification regarding such sales. Other suppliers impose limits on their indemnification obligations. If such products infringe the
intellectual property rights of a third party or if we are found to owe license fees or royalties relating to these products, our margins and operating results would be severely negatively impacted.



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We depend primarily on United Microelectronics Corporation, or UMC, to manufacture our controllers,
and if we are unable to obtain from UMC sufficient quantities of controllers at acceptable quality, yields and prices, and in a timely manner, we may not be able to meet customer demand for our products, which could limit the growth and success of
our business.



We do not own or operate a semiconductor
fabrication facility, or fab. Instead, we rely primarily on a foundry, UMC, to produce the majority of our controller products. Our reliance on an independent foundry involves a number of significant risks, including



| | · |  | reduced control over delivery schedules, quality assurance, manufacturing yields and production costs; and
| | - |  | ----------------------------------------------------------------------------------------------------------



| | · |  | unavailability of, or delayed access to, next-generation or key process technologies.
| | - |  | -------------------------------------------------------------------------------------



We have entered into a supply agreement with UMC under which we are obligated to provide UMC with a rolling forecast of our
anticipated purchase orders. Such forecasts may only be changed by a certain percentage each month. This limits our ability to react to significant fluctuations in demand for our products. If UMC were to become unable or unwilling to continue
manufacturing our controllers in the required volumes, at acceptable quality, yields and prices, and in a timely manner, we might not be able to meet customer demand for our products, which could limit the growth and success of our business. We have
qualified other fabs, but we cannot assure you that they will have sufficient capacity to accommodate our demand at any particular time. Our contract with UMC terminates in December 2005.



In addition, if competition for foundry capacity increases, we may incur significant expenses to secure access to
manufacturing services, which in turn may cause our product costs to increase substantially. We expect that the demand for capacity at these facilities will change in the near future due to fluctuating demand for consumer electronic and industrial
products that depend on semiconductors manufactured at these facilities. All of these foundries are located in an area of the world that may be subject to political and economic instability, the SARS epidemic and natural disasters, particularly
earthquakes. While the last major earthquake in Taiwan did not have a significant impact on deliveries to us from UMC, a similar event in the future at one of their foundries could have a significant impact.



We depend solely on third-party subcontractors for assembly and testing of
our digital media products, which could result in product shortages or delays or increase our costs of manufacturing, assembling or testing our products.



Our flash cards are primarily assembled and tested by PC Partner in China; Power Digital Card in Taiwan; Venture Manufacturing Services in Singapore
and Indonesia; and Venture Manufacturing, Vitron, Macrotron and PC Partner in the United States. We do not have a long-term agreement with Vitron, Venture Manufacturing or PC Partner and typically obtain services from them on a per order basis.
Additionally, our controllers are assembled, tested and packaged primarily by Advanced Semiconductor Engineering in Taiwan and Advanced Interconnection Technologies in Indonesia and in the United States. Our reliance on these subcontractors involves
risks such as reduced control over delivery schedules, quality assurance, inventory levels and costs. These risks could result in product shortages or increase our costs of manufacturing, assembling or testing our products. If these subcontractors
are unable or unwilling to continue to provide assembly and test services and deliver products of acceptable quality, at acceptable costs and in a timely manner, we would have to identify and qualify other subcontractors. This could be
time-consuming and difficult and result in unforeseen operations problems.



If our efforts to optimize our supply chain are unsuccessful and we are unable to meet our customers requirements, our business could be negatively impacted.



In order to improve our ability to operate within an increasingly
competitive environment, we are taking a variety of measures designed to improve operational efficiency, including, among other items, streamlining our



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logistics to improve inventory management and reducing manufacturing costs and operating expenses. One impact of these changes will be that we will carry
less inventory as a buffer against irregular deliveries from our suppliers. If we are unsuccessful in our efforts to achieve the foregoing, or, if the third-party subcontractors and suppliers on whom we depend fail to deliver or manufacture products
in a timely manner or are unable or unwilling to provide the products and services we obtain from them at the cost and quality we require, our supply of components may be adversely affected. If this were to occur, we would not be able to deliver
products to our customers in a timely manner necessary to meet their requirements. As a result, our business could be harmed, we may lose customers, and we may be unable to achieve our goal of returning to profitability.



Our failure to successfully promote our brand and achieve strong brand
recognition in target markets could limit or reduce the demand for our products and services.



We believe that brand recognition will be important to our ability to succeed as the digital photography and the digital media markets continue to
develop. We plan to continue to invest in marketing programs to create and maintain prominent brand awareness. If we fail to promote our brand successfully, or if the expenses associated with doing so become increasingly high, our business may not
grow as we anticipate. Other companies, who may have significantly more resources to promote their own brands than we do, may not be aggressively promoting their flash card brands. If they begin to more aggressively promote their brand or if our
products exhibit poor performance or other defects, our brand may be adversely affected, which would inhibit our ability to attract or retain customers.



If we encounter difficulties in attracting and retaining qualified personnel, we may not be able to successfully execute our business strategy, we may
need to grant large stock-based incentives that could be dilutive to our stockholders and we may be required to pay significant salaries which would increase our general and administrative costs.



Our future success will depend to a significant extent on the continued
services of our key employees, including Eric B. Stang, our Chairman of the Board of Directors, President and Chief Executive Officer, and Petro Estakhri, our Chief Technology Officer and Executive Vice President of Engineering. Our success will
also depend on our ability to attract and retain qualified technical, sales, marketing, finance and managerial personnel. If we are unable to find, hire and retain qualified individuals, we may have difficulty implementing portions of our business
strategy in a timely manner, or at all.



We may experience
difficulty in hiring and retaining candidates with appropriate qualifications. To attract and retain qualified personnel, we may be required to grant large option or other stock-based incentive awards, which may be highly dilutive to existing
stockholders and, as a result of a recent accounting pronouncement issued by the FASB, would require us to record compensation expense related to such grants, which would result in lower reported earnings. We may also be required to pay significant
base salaries and cash bonuses to attract and retain these individuals, which could harm our operating results. If we do not succeed in hiring and retaining candidates with appropriate qualifications, we will not be able to grow our business.



We are currently involved in stockholder litigation, and
could be involved in additional litigation in the future, which could have a negative impact on our business, operating results, financial position and liquidity.



In the past, securities class action litigation has often been brought against a company following a period of volatility in
the market price of its securities. Following just such a period of volatility in the market price of our securities, we were named (along with our Chief Executive Officer and Chief Financial Officer) as a defendant in federal class action
litigation, based principally on allegations that we made misrepresentations regarding our business. In addition, derivative litigation against certain of our officers and directors (in which we were a nominal defendant), based on allegations
substantially similar to those in the class action litigation, was commenced in California state court. The Court granted our motion to dismiss the plaintiffs complaint in the derivative action, but the federal class action continues to
proceed. Although we are unable to predict the scope



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or outcome of that litigation, it and similar litigation in the future, if any, could result in substantial costs and divert managements attention and
resources, which could harm our operating results and our business. In addition, the conduct of these proceedings could negatively impact our stock price, and an unfavorable outcome could have a material adverse impact on our financial position and
liquidity.



If our products contain defects, we may incur
unexpected and significant operating expenses to correct the defects, we may be required to pay damages to third parties and our reputation may suffer serious harm.



Although the digital media products that we manufacture are tested after they are assembled, these products are extremely
complex and may contain defects. These defects are particularly likely when new versions or enhancements are released. The sale of products with defects or reliability, quality or compatibility problems may damage our reputation and our ability to
retain existing customers and attract new customers. For example, if there are defects in our products that cause loss of data, customers may lose their digital images stored on our digital media. In addition, product defects and errors could result
in additional development costs, diversion of technical and management resources, delayed product shipments, increased product returns, and product liability claims against us which may not be fully covered by insurance. Products we source from
others may have defects that we cannot quickly fix and that will require us to return them to the manufacturer, which could result in delayed product shipments and damage to our reputation.



Our significant sales outside the United States subject us to increasing
foreign political and economic risks, including foreign currency fluctuations, and it may be difficult for us to anticipate demand and pricing in those regions or effectively manage the distributor channels and relationships in those regions.



Total net revenues outside of the United States accounted
for approximately 41.9% of our total net revenues for the fiscal quarter ended April 1, 2005. We generated a majority of our international revenues from product sales in Europe and from product sales and licensing agreements in Asia. The European
and Asian markets are intensely competitive. One of our principal growth strategies is to expand our presence in this and other international markets both through increased international sales and strategic relationships. For example, we are
expanding distribution of our products into Latin America, China, India, Malaysia, Indonesia, the Middle East, Russia and Eastern Europe. Consequently, we anticipate that sales outside of the United States will continue to account for a significant
portion of our net revenues in future periods. Accordingly, we are subject to international risks, including:



| | · |  | foreign currency exchange fluctuations;
| | - |  | ---------------------------------------



| | · |  | political and economic instability;
| | - |  | -----------------------------------



| | · |  | delays in meeting customer commitments due to difficulties associated with managing an international distribution system;
| | - |  | -------------------------------------------------------------------------------------------------------------------------



| | · |  | increased time to collect receivables caused by slower payment practices that are common in many international markets;
| | - |  | -----------------------------------------------------------------------------------------------------------------------



| | · |  | difficulties associated with managing export licenses, tariffs and other regulatory issues pertaining to international trade;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------



| | · |  | increased effort and costs associated with the protection of our intellectual property in foreign countries;
| | - |  | ------------------------------------------------------------------------------------------------------------



| | · |  | natural disasters, political uncertainties and changing regulatory environments in foreign countries; and
| | - |  | ---------------------------------------------------------------------------------------------------------



| | · |  | difficulties in hiring and managing employees in foreign countries.
| | - |  | -------------------------------------------------------------------



In addition, if we are unable to accurately anticipate demand and pricing of products in international markets, or if we cannot work effectively with our
distribution partners to create demand, develop effective marketing programs, manage inventory levels and collect receivables in a timely fashion, our operating results will be harmed and our stock price will likely decline.



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Increases in the value of the United States dollar relative to foreign currencies could cause our
products to become less competitive in international markets and could adversely affect our operating results. Although the sales of our products are denominated primarily in United States dollars, we also have product sales denominated in British
pounds, Euros and other European currencies, as well as the Japanese yen. To the extent our prices are denominated in foreign currencies, particularly the British pound, the Euro and Japanese yen, we will be exposed to increased risks of currency
fluctuations.



We have foreign subsidiaries in Australia, Great
Britain, Japan, Hong Kong and Shanghai that operate and sell our products in various global markets. As a result, we are exposed to risks associated with changes in foreign currency exchange rates for our sales as well as our costs denominated in
those currencies. We use forward contracts, to manage the exposures associated with our net asset or liability positions. However, we cannot assure you that any policies or techniques that we have implemented will be successful or that our business
and financial condition will not be harmed by exchange rate fluctuations.



If our suppliers or customers elect to compete with us in the digital media market, our revenues and gross margins would likely decline.



We sell our controllers to companies that use our controllers to manufacture flash card products. Many of these customers
are large companies that have longer operating histories and greater brand recognition, greater access to flash memory, substantially greater financial, technical, marketing and other resources and longer standing relationships with customers. If
these companies elected to compete directly with us in the digital media market or in our retail channels, our revenues and gross margins would likely decline.



Our financial results may be affected by mandated changes in accounting and financial reporting.



We prepare our financial statements in conformity with accounting principles
generally accepted in the United States of America. These principles are subject to interpretation by the Securities and Exchange Commission and various bodies formed to interpret and create appropriate accounting policies. A change in these
policies can have a significant effect on our reported results and may even retroactively affect previously reported transactions.



In particular, changes to FASB guidelines relating to accounting for stock-based compensation will likely increase our compensation expense, could make
our operating results less predictable in any given reporting period and could change the way we compensate our employees or cause other changes in the way we conduct our business.



Changes in securities laws and regulations have increased our costs; further, in the event we are unable to satisfy
regulatory requirements relating to internal control over financial reporting, or if our internal control over financial reporting is not effective, our business could suffer.



The Sarbanes-Oxley Act of 2002 that became law in July 2002 required changes in our corporate governance, public disclosure
and compliance practices. The number of rules and regulations applicable to us have increased, and will continue to increase, our legal and financial compliance costs and have made some activities more difficult, such as stockholder approval of new
option plans. In addition, we have incurred and expect to continue to incur significant costs in connection with compliance with Section 404 of that law regarding internal control over financial reporting. These laws and regulations and perceived
increased risk of liability could make it more difficult for us to attract and retain qualified members of our board of directors, particularly to serve on our audit committee, and qualified executive officers. We cannot estimate the timing or
magnitude of additional costs we may incur as a result.



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Our stock price and those of other technology companies have experienced extreme price and volume
fluctuations, and, accordingly, our stock price may continue to be volatile.



The trading price of our common stock has fluctuated significantly since our initial public offering in August 2000. Many factors could cause the market price of our common stock to fluctuate, including:



| | · |  | variations in our quarterly operating results;
| | - |  | ----------------------------------------------



| | · |  | announcements of technological innovations by us or by our competitors;
| | - |  | -----------------------------------------------------------------------



| | · |  | introductions of new products or new pricing policies by us or by our competitors;
| | - |  | ----------------------------------------------------------------------------------



| | · |  | departure of key personnel;
| | - |  | ---------------------------



| | · |  | the gain or loss of significant orders or customers;
| | - |  | ----------------------------------------------------



| | · |  | sales of common stock by our officers and directors;
| | - |  | ----------------------------------------------------



| | · |  | changes in the estimates of our operating performance or changes in recommendations by securities analysts;
| | - |  | -----------------------------------------------------------------------------------------------------------



| | · |  | announcements related to our outstanding litigation; and
| | - |  | --------------------------------------------------------



| | · |  | market conditions in our industry and the economy as a whole.
| | - |  | -------------------------------------------------------------



In addition, stocks of technology companies have experienced extreme price and volume fluctuations that often have been unrelated or disproportionate to
these companies operating performance. Public announcements by companies in our industry concerning, among other things, their performance, accounting practices or legal problems could cause fluctuations in the market for stocks of these
companies. These fluctuations could lower the market price of our common stock regardless of our actual operating performance.



Risks Related to Our Industry



Our business will not succeed unless the digital photography market and other markets that use flash media continue to grow and are accepted by
consumers.



We currently depend on sales of digital media
and connectivity products to digital camera owners for a substantial portion of our revenues, which exposes us to substantial risk in the event the digital photography market does not continue to grow rapidly. The digital photography market has
grown very rapidly over the last several years and may now be reaching maturity and lower growth rates. The success of this market depends on many factors, including:



| | · |  | the availability of digital cameras at prices and with performance characteristics comparable to traditional cameras;
| | - |  | ---------------------------------------------------------------------------------------------------------------------



| | · |  | the availability of digital media that meet users requirements with respect to price, speed, connectivity, capacity and compatibility;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------



| | · |  | the speed at which digital cameras are able to take successive photographs;
| | - |  | ---------------------------------------------------------------------------



| | · |  | the ease with which digital files can be transferred to a personal computer or printer;
| | - |  | ---------------------------------------------------------------------------------------



| | · |  | the availability of digital image prints comparable in quality and price to traditional photographs; and
| | - |  | --------------------------------------------------------------------------------------------------------



| | · |  | market conditions in the industry and the economy as a whole.
| | - |  | -------------------------------------------------------------



In addition to the above factors related to the digital photography market as a whole, we believe the following additional factors will affect the
successful adoption of digital photography by consumers:



| | · |  | marketing campaigns that increase brand awareness in end-user markets, both domestically and internationally;
| | - |  | -------------------------------------------------------------------------------------------------------------



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| | · |  | increased association between brand names and attractive price and performance characteristics; and
| | - |  | ---------------------------------------------------------------------------------------------------



| | · |  | heightened consumer confidence in digital photography technology.
| | - |  | -----------------------------------------------------------------



Over the last several years, we have derived the majority of our revenue from the digital camera market. Although other applications such as USB storage
devices, cell phones, personal digital assistants and MP3 players may consume large volumes of flash cards in the near future, today the digital photography market still remains the primary driver of demand for flash cards. As this market begins to
experience slower growth rates, our growth will be increasingly dependent on the development of new markets and new products for NAND flash memory. However, if these new applications do not develop or if we are unable to successfully expand our
product offerings into these markets, demand for our products may not increase at the same rates as they have in the past. At the present time, the extent to which these new applications will use or continue to use removable digital media is
unclear. Cell phones, for example, could use embedded rather than removable storage. In addition, USB storage devices, cell phones or MP3s could use miniature hard disk technologies rather than flash based digital media. Such developments would
likely result in a reduction of anticipated future demand for flash media sales thereby negatively impacting our revenues, revenue growth and gross margins.



There can be no assurance that new markets and products will develop and grow fast enough, or that new markets will adopt NAND flash technologies or our
products, to enable us to continue our growth. If the digital photography market does not continue to grow and be accepted by professional, commercial and consumer users, or if any reduction in demand in digital photography is not absorbed by other
new applications, we will not continue to grow at the rates that we have in prior years.



General economic conditions, political and military conditions associated with current worldwide conflicts and similar events may prevent consumers from purchasing our products, and reduced demand for digital media
and related products may prevent us from achieving targeted revenues and profitability.



Our revenues and our ability to return to profitability depend significantly on the overall demand for flash cards and related products. Sales of consumer electronic goods, including our products, have historically
been dependent upon discretionary spending by consumers, which may be adversely affected by general economic conditions. Changes in the U.S. and the global economy, such as a decline in consumer confidence or a slowdown in the United States economy,
may cause consumers to defer or alter purchasing decisions, including decisions to purchase our products. If the economy declines as a result of recent economic, political and social turmoil, consumers may reduce discretionary spending and may not
purchase our products, which would harm our revenues as softening demand caused by worsening economic conditions has done in the past.



If digital camera manufacturers do not develop and promote products that are able to take advantage of our fastest digital media products, the growth
and success of our business may be limited.



We depend on
the research and development, marketing and sales efforts of digital camera manufacturers in developing, marketing and selling digital cameras that can use our more advanced existing and future products. Most of the digital cameras currently
available on the market do not incorporate technologies that can take advantage of the speed available in our fastest digital film products or the advanced features available in some of our products, such as LockTight CompactFlash. If digital camera
manufacturers do not successfully develop, market and sell digital cameras that take full advantage of our most advanced products, from which we realize higher gross margins, the growth and success of our business may be negatively impacted.



The manufacturing of our products is complex and subject to
yield problems, which could decrease available supply and increase costs.



The manufacture of flash memory and controllers is a complex process, and it is often difficult for companies to achieve acceptable product yields. Reduced flash memory yields could decrease available supply and
increase costs. Controller yields depend on both our product design and the manufacturing process



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technology unique to the semiconductor foundry. Because low yields may result from either design defects or process difficulties, we may not identify yield
problems until well into the production cycle, when an actual product exists and can be analyzed and tested. In addition, many of these yield problems are difficult to diagnose and time consuming or expensive to remedy.



Risks Related to Our Intellectual Property



If we are unable to adequately protect our intellectual property, our
competitors may gain access to our technology, which could harm our ability to successfully compete in our market.



We regard our intellectual property as critical to our success. If we are unable to protect our intellectual property rights, we may be unable to
successfully compete in our market.



We rely on a combination
of patent, copyright, trademark and trade secret laws, as well as confidentiality agreements and other methods to protect our proprietary technologies. As of April 1, 2005, we had been granted or allowed 84 patents in the United States and other
countries and had 95 pending United States and foreign patent applications. We cannot assure you, however, that:



| | · |  | any of our existing or future patents will not be invalidated;
| | - |  | --------------------------------------------------------------



| | · |  | patents will be issued for any of our pending applications;
| | - |  | -----------------------------------------------------------



| | · |  | any claims allowed from existing or pending patents will have sufficient scope or strength; or
| | - |  | ----------------------------------------------------------------------------------------------



| | · |  | our patents will be issued in the primary countries where our products are sold in order to protect our rights and potential commercial advantage.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------



It may also be possible for a third party to copy or otherwise obtain and use
our products or technology without authorization, develop similar technology independently or design around our patents.



We are involved in intellectual property litigation, and expect to become involved in additional litigation that could divert managements time
and attention, be time-consuming and expensive to defend and limit our access to important technology.



We are a party to litigation with third parties to protect our intellectual property or as a result of an alleged infringement of others
intellectual property. We expect to be involved in additional patent litigation in the future. These lawsuits could subject us to significant liability for damages. These lawsuits could also lead to the invalidation of our patent rights. Patent
lawsuits are extremely expensive and time-consuming and can divert managements time and attention. When we sue other companies for patent infringement, it may prompt them to respond by suing us for infringement of their patents. We are also
negotiating license agreements with third parties, which could result in litigation if these negotiations are unsuccessful. Additional patent litigation would significantly increase our legal expenses, which would result in higher operational
expenses and lower operating margins. We are currently in patent litigation with Toshiba. In this litigation, we have asserted that Toshiba infringes thirteen of our patents through their sale of flash memory chips, cards and cameras. In a separate
action, Toshiba has asserted that we infringe eight of Toshibas patents through our sale of flash devices that we manufacture and readers. Such products comprise a substantial portion of our revenues. If we were found to infringe
Toshibas patents or if we were involved in other intellectual property litigation, we could be forced to do one or more of the following:



| | · |  | pay damages on products that were found to infringe the other partys intellectual property;
| | - |  | --------------------------------------------------------------------------------------------



| | · |  | stop selling products or using technology that contain the allegedly infringing intellectual property;
| | - |  | ------------------------------------------------------------------------------------------------------



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



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



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If we are forced to take any of the foregoing actions, we may incur additional costs or be unable to
manufacture and sell our products. We also do not currently manufacture certain digital media formats and currently purchase such cards from third parties for resale. Not all of our suppliers provide us with indemnification regarding such sales.
Other suppliers impose limits on their indemnification obligations. If such products infringe the intellectual property rights of a third party or if we are found to owe license fees or royalties relating to these products, our margins and operating
results would be severely negatively impacted.



ITEM 3.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



Foreign Currency Risk. We sell our products primarily to customers in the U.S. and, to a lesser extent, Europe, Japan and Canada. Most of our sales
are currently denominated in U.S. dollars; however, we anticipate an increasing amount of our sales will be denominated in British pounds, the Japanese yen, the Euro and the Canadian dollar. Foreign currency denominated revenues were approximately
22.6%, and 29.2% of our total product revenues for the quarters ended April 1, 2005 and March 31, 2004, respectively. We purchase our products and the materials and services to build our products primarily from vendors in Korea, Taiwan, Indonesia,
China, the United States, the United Kingdom, Germany and Japan. Most of these costs are currently denominated in U.S. dollars; however, we anticipate an increasing amount of our costs will be denominated in the Euro, Japanese yen, pound sterling
and possibly other currencies. Foreign currency denominated costs were approximately 3.3%, and 2.2% of our cost of product revenues for the quarters ended April 1, 2005 and March 31, 2004, respectively. As a result, it is possible that our future
financial results could be directly affected by changes in foreign currency exchange rates, and the prices of our products would become more expensive in a particular foreign market if the value of the U.S. dollar rises in comparison to the local
currency, which may make it more difficult to sell our products in that market. Conversely, the prices of our products would become less expensive in a particular foreign market if the value of the U.S. dollar falls in comparison to the local
currency, which may make it easier to sell our products in that market. We will continue to face foreign currency exchange risk in the future. Therefore, our financial results could be directly affected by weak economic conditions in foreign
markets. These risks could become more significant as we expand business outside the U.S. or if we increase sales in non-U.S. dollar denominated currencies.



We have adopted and implemented a hedging policy to mitigate these potential risks. We use forward contracts to mitigate the exposures associated with
certain net foreign currency asset or liability positions. However, we cannot assure you that any policies or techniques that we have implemented, or may implement in the future, will be successful or that our business and financial condition will
not be harmed by exchange rate fluctuations. We do not enter into derivative financial instruments for speculative or trading purposes. During the quarter ended April 1, 2005, we entered into hedges on intercompany payables denominated in the
British pound and Japanese yen. During the quarter ended April 1, 2005, the foreign currency exposures on our net asset and liability positions were not fully hedged. For the quarter ended March 31, 2004, gains on our foreign currency net asset and
liability positions were $0.2 million and were offset by losses on hedging transactions of $0.8 million. For the quarter ended April 1, 2005, losses on our foreign currency net asset and liability positions were $1.6 million and were offset by gains
on hedging transactions of $1.5 million. As of April 1, 2005, we held forward contracts with an aggregate notional value of $42.5 million to hedge the risks associated with forecast British pound and Japanese yen denominated assets and liabilities.
At April 1, 2005, our aggregate exposure to non-U.S. dollar currencies, net of currency hedge contracts, was approximately $13.7 million. If, at April 1, 2005, we applied an immediate 10% adverse move in the levels of foreign currency exchange rates
relative to these exposures, we would incur a foreign exchange loss of approximately $1.4 million.



Interest Rate Risk.    Our exposure to market risk for changes in interest rates relates primarily to the increase or decrease
in the amount of interest income we earn on our investments and the amount of interest expense we pay on borrowings under our line of credit. The risk associated with fluctuating interest rates impacts all of our investments because of the short
duration of the investments and our borrowings under our line of credit. Accordingly, since we had no short-term investments at April 1, 2005. our interest rate risk is related only to our $33.4 million of borrowings under our line of credit
facility with Wells Fargo Foothill at April 1, 2005.



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We do not plan to use derivative financial instruments in our investment portfolio. We plan to ensure the safety and preservation of our invested principal
funds by limiting default risk and market risk. We plan to mitigate default risk by investing in investment-grade securities. We have historically invested in investment-grade, short-term securities that we have held until maturity to limit our
market risk.



All of the potential changes noted above are
based on sensitivity analysis performed on our financial position at April 1, 2005. Actual results may differ materially.



ITEM 4.    CONTROLS AND PROCEDURES



Evaluation of Disclosure Controls and Procedures.



Regulations under the Securities Exchange Act of 1934 require public companies to maintain disclosure controls and procedures, which are defined to mean a companys controls and other procedures that
are designed to ensure that information required to be disclosed in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the
Commissions rules and forms. Our President and Chief Executive Officer and our Chief Financial Officer, based on their evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the
period covered by this report as well as our Annual Report on Form 10-K, concluded that, our internal control over financial reporting was not effective to provide reasonable assurance that the foregoing objectives are achieved as of December 31,
2004 and April 1, 2005, based upon their findings of two control deficiencies that constituted material weaknesses in connection with: (i) revenue recognition with respect to certain customers (primarily our resellers), including adequate
consideration of our estimates regarding offsets to or discounts from revenue such as price protection and promotional activities; and (ii) the accounting for inventory valuation reserves.



Changes in Internal Control Over Financial Reporting.



| | · |  | Revenue recognition.    During the first quarter of 2005, we began taking steps toward remediation of the material weakness described above with respect
to revenue recognition by taking the following actions:
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | Hiring additional personnel to review the effects of each price movement on our customers inventory;
| | - |  | -----------------------------------------------------------------------------------------------------



| | · |  | Instituting more rigorous policies and procedures regarding the approvals that must be obtained from management personnel before reducing prices to either a specific customer or on
a national level;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | Recording revenue from all of our retail customers on a sell-through basis to ensure that at the time revenue is recognized for financial reporting purposes the effects of offsets
or discounts to revenue, including the impact of price moves we implemented in response to price moves by competitors, are accurately reflected in our statement of operations;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | Increasing training and awareness to sales and marketing representatives on our processes and procedures; and
| | - |  | -------------------------------------------------------------------------------------------------------------



| | · |  | Instituting more rigorous procedures regarding the approvals that must be obtained from management personnel before promotional activities can be accepted.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | Inventory valuation reserves.    During the first quarter of 2005, we took the following remediation actions to improve our internal control over
accounting for inventory valuation reserves
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | Performing a more detailed review of our inventory to identify all excess and slow moving products;
| | - |  | ---------------------------------------------------------------------------------------------------



| | · |  | Increased management oversight on the analysis or review of inventory valuation reserves and their changes from period to period;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



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| | · |  | Enhancing review of inventory valuation reserves to ensure that all price reductions are considered to identify write-downs to net realizable value; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------



| | · |  | Evaluating responsibilities within our finance organization to improve our controls and increase the level of management oversight of the process.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------



We believe that these corrective actions, taken as a whole, have mitigated
the control deficiencies identified above but we still need to test the effectiveness of these actions. We plan to continue an on-going review and evaluation of our internal control over financial reporting, and we may make other changes as we deem
desirable based on managements reviews and evaluations. For example, we continue to enhance our controls by hiring additional qualified personnel in key financial areas and by automating a number of procedures.



In addition, while we believe our disclosure controls and procedures and our
internal control over financial reporting are improving, no system of controls can prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control
systems objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in
all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected. These inherent limitations include the realities that judgments in
decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls.
The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.
Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with its policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to
error or fraud may occur and not be detected.



Except as
described above, during the first quarter ended April 1, 2005, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial
reporting.



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PART IIOTHER INFORMATION



Item 1.    Legal Proceedings.



Litigation with Toshiba



We are involved in three separate lawsuits with Toshiba Corporation as follows:



Lexar Media, Inc. v. Toshiba Corporation, Toshiba America, Inc. and Toshiba America



On November 4, 2002, we filed a lawsuit in Santa Clara County Superior Court against Toshiba Corporation, Toshiba America, Inc. and Toshiba America
alleging theft of trade secrets and breach of fiduciary duty. We later filed an amended complaint to add violation of California Business and Professions Code Section 17200 and to drop without prejudice claims against Toshiba America, Inc. The basis
of the allegations is that since our inception in 1996, and including the period from 1997 through 1999 when Toshiba was represented on our Board of Directors, Toshiba had access to and was presented with details of our strategy as well as our
methods of achieving high performance flash devices that Toshiba has now incorporated into its flash chips and flash systems.



Trial began on February 7, 2005, and after a six-week trial, on March 23, 2005 the jury found that Toshiba Corporation and Toshiba America Electronic
Components, Inc. misappropriated Lexars trade secrets and breached their fiduciary duty to us. The jury awarded Lexar $255.4 million in damages for Toshibas misappropriation of trade secrets. The jury also awarded Lexar $58.7 million in
damages for Toshibas breach of fiduciary duty, $58.7 million in damages for TAECs breach of fiduciary duty and $8.2 million in prejudgment interest for breach of fiduciary duty. The jury also found Toshiba and TAECs breach of
fiduciary duty was oppressive, fraudulent or malicious which supported an award of punitive damages. On March 25, 2005, the jury awarded an additional $84.0 million in punitive damages.



We are also seeking an injunction to prevent the importation of chips or cards manufactured by Toshiba or its Flash Vision
affiliate that incorporate our technology. Our claim for unfair competition, based on California Business and Professions Code Section 17200, was not given to the jury and will be decided by the Court. We expect that the Court will rule on that
claim and our motion for an injunction, as well as on anticipated post-trial motions, shortly after a hearing we expect to be held no earlier than late June 2005. This hearing was previously scheduled for May 16, 2005 but was recently delayed by the
Court.



Toshiba Corporation v. Lexar Media, Inc.; Lexar
Media, Inc. v. Toshiba Corporation



On November 1, 2002,
Toshiba Corporation filed a lawsuit seeking declaratory judgment that Toshiba does not infringe our U.S. Patent Nos. 5,479,638; 5,818,781; 5,907,856; 5,930,815; 6,034,897; 6,040,997; 6,134,151; 6,141,249; 6,145,051; 6,172,906; 6,202,138; 6,262,918;
6,374,337; and 6,397,314 or that these patents are invalid. This suit was filed in the United States District Court for the Northern District of California. We believe that Toshibas claims are without merit and are contesting this lawsuit
vigorously.



On November 21, 2002, we filed an answer and
counterclaim in which we alleged that Toshiba infringes our U.S. Patent Nos. 5,818,781; 5,907,856; 5,930,815; 6,034,897; 6,040,997; 6,134,151; 6,172,906; 6,202,138; and 6,374,337. We sought an injunction and damages against Toshiba.



On December 20, 2002, Toshiba filed its first amended complaint in which
Toshiba dropped its allegations that our patents are unenforceable.



On February 28, 2003, we filed an answer and our first amended counterclaim against Toshiba for infringement of our U.S. Patent Nos. 5,479,638; 5,818,781; 5,907,856; 5,930,815; 6,034,897; 6,040,997; 6,134,151; 6,141,249; 6,145,051;
6,172,906; 6,202,138; 6,262,918; 6,374,337; and 6,397,314. We are seeking damages as well as an injunction against Toshiba for its products that we allege infringe our patents, including its



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flash memory chips, flash cards and digital cameras. Discovery has commenced. The parties have now mutually dismissed with prejudice all claims regarding
U.S. Patent No. 6,172,906.



This case has been coordinated for
discovery purposes with our litigation against Pretec, PNY, Memtek and C-One. On September 17, 2003 and October 1, 2003, the Court held two scheduling hearings for all of these matters. As a result of these hearings, the court determined that our
patent claims against Toshiba will be heard in an initial phase.



Claim construction in our litigation against Toshiba was held in August 2004. The Court issued a claim construction ruling on January 24, 2005. We believe that the claim construction ruling favorably construes the claims of our patents.



Discovery has now commenced and we expect that a trial will
take place in late 2006. The patents at issue in this first phase will be Lexars U.S. Patent No.s 5,479,638 entitled Flash Memory Mass Storage Architecture Incorporation Wear Leveling Technique; 6,145,051 entitled
Moving Sectors Within Block of Information in a Flash Memory Mass Storage Architecture; 6,397,314 entitled Increasing The Memory Performance Of Flash Memory Devices By Writing Sectors Simultaneously To Multiple Flash Memory
Device; 6,202,138 entitled Increasing The Memory Performance Of Flash Memory Devices By Writing Sectors Simultaneously To Multiple Flash; 6,262,918 entitled Space Management For Managing High Capacity Nonvolatile
Memory; and 6,040,997 entitled Flash Memory Leveling Architecture Having No External Latch.



Our litigation against Fuji, Memtek and PNY will be stayed until after claim construction with Toshiba has been completed.



Toshiba Corporation v. Lexar Media, Inc.



On January 13, 2003, Toshiba Corporation filed a lawsuit against us in the
United States District Court for the Northern District of California, alleging that we infringe Toshibas U.S. Patent Nos. 5,546,351; 5,724,300; 5,793,696; 5,946,231; 5,986,933; 6,145,023; 6,292,850; and 6,338,104. On February 7, 2003, Toshiba
Corporation filed an amended complaint and now alleges that we infringe U.S. Patent Nos. 5,546,351; 5,724,300; 5,793,696; 5,946,231; 5,986,933; 6,094,697; 6,292,850; 6,338,104; and 5,611,067. In this action, Toshiba Corporation seeks injunctive
relief and damages. Toshibas patents appear to primarily relate to flash components that we purchase from vendors who provide us with indemnification. On March 5, 2003, we filed an answer in which we are seeking a judgment that we do not
infringe these patents or that they are invalid or unenforceable. We believe that Toshibas claims are without merit and intend to contest this lawsuit vigorously.



Litigation Against Fuji, Memtek and PNY



On July 11, 2002, we filed a lawsuit in the United States District Court for the Eastern District of Texas against Fuji
Photo Film USA, Memtek Products, Inc. and PNY Technologies Inc. for patent infringement. We alleged that the defendants infringe our U.S. Patent Nos. 5,479,638; 5,907,856; 5,930,815; 6,034,897; 6,134,151; 6,141,249; 6,145,051; and 6,262,918. We
sought injunctive relief and damages against all defendants.



On November 4, 2002, we filed an amended complaint against Fuji Photo Film USA. In the amended complaint, we allege that Fuji Photo Film USA infringes U.S. Patent Nos. 5,479,638; 6,141,249; 6,145,051; 6,262,918; and 6,397,314 through the
sale of its flash memory products and digital cameras. We are seeking injunctive relief and damages against Fuji. Memtek Products, Inc. and PNY Technologies, Inc. are no longer parties to this particular action. On December 9, 2002, Fuji filed an
answer in which they sought declaratory relief that they do not infringe the five patents named in the suit as well as our U.S. Patent Nos. 5,907,856; 5,930,815; 6,034,897; and 6,134,151.



On January 8, 2003, the United States District Court for the Eastern District of Texas ordered this case transferred to the
United States District Court for the Northern District of California where it is now pending.



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In a second amended complaint, we added counterclaims for infringement on the additional patents for
which Fuji has sought declaratory relief, U.S. Patent Nos. 5,907,856; 5,930,815; 6,034,897; and 6,134,151. Discovery has commenced.



This case has been coordinated for discovery purposes with our litigation against Toshiba, Pretec, PNY, Memtek and C-One, which is discussed below. On
September 17, 2003 and October 1, 2003, the court held two scheduling hearings for all of these matters. As a result of these hearings, the court has determined that the various actions pending before it will be sequenced beginning with the Toshiba
matter. Our litigation against Fuji, Memtek and PNY will be stayed until after the claim construction with Toshiba has been completed.



On October 1, 2003, we reached a settlement agreement with Ritek Corporation, which supplied Fuji with CompactFlash cards between 2001 and 2002. Under the
terms of the agreement, Ritek made a one-time payment for past damages. We have not given Ritek a license to any of our patents going forward.



Litigation Against Pretec, PNY, Memtek and C-One



On December 22, 2000, we sued Pretec Electronics Corporation and PNY for patent infringement. We sued Pretec and PNY on the basis of four patents: U.S.
Patent Nos. 5,818,781; 5,907,856; 5,930,815; and 6,145,051. The suit is pending in the United States District Court for the Northern District of California. We are seeking injunctive relief and damages against all defendants.



On April 13, 2001, we filed an amended complaint in our litigation with
Pretec, naming Memtek as an additional defendant. On June 26, 2001, the Court allowed us to file our second amended complaint in our litigation with Pretec, naming C-One as an additional defendant and adding our U.S. Patent No. 5,479,638 against all
of the defendants. In this action we allege that Memtek and the other defendants infringe our U.S. Patent Nos. 5,479,638, 5,818,781, 5,907,856, 5,930,815 and 6,145,051. This suit is pending in the United States District Court for the Northern
District of California. We are seeking injunctive relief and damages against all of the defendants.



This case has been coordinated for discovery purposes with our litigation against Toshiba. On September 17, 2003 and October 1, 2003, the court held two
scheduling hearings for all of these matters. As a result of these hearings, the court determined that the litigation will be sequenced beginning with the Toshiba matter. Claim construction in our litigation against Toshiba was held in August 2004.
Our litigation against Pretec, Memtek and C-One will be stayed until after the claim construction with Toshiba has been completed.



Litigation With Willem Vroegh



On February 20, 2004, an individual, Willem Vroegh, sued us, along with DaneElec Memory, Fuji Photo Film USA, Eastman Kodak Company, Kingston
Technology Company, Inc., Memorex Products, Inc.; PNY Technologies Inc., SanDisk Corporation, Verbatim Corporation, and Viking InterWorks, alleging that our description of the capacity of our flash memory cards is false and misleading under
California Business and Professions Code Sections 17200 and 17500. The plaintiff has also asserted allegations for breach of contract, common law claims of fraud, deceit and misrepresentation; as well as a violation of the Consumers Legal Remedies
Act, California Civil Code Sec. 175, all arising out of the same set of facts. Plaintiff seeks restitution, disgorgement, compensatory damages and injunctive relief and attorneys fees. Discovery has commenced. We believe the plaintiffs
claims are without merit and intend to contest them vigorously.



Shareholder Litigation



On May 21,
2004, we, along with our Chief Executive Officer and Chief Financial Officer, were named as defendants in a federal class action in the United States District Court for the Northern District of California. That action was brought allegedly on behalf
of a class of plaintiffs who purchased our common stock, and



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asserted claims under Sections 10(b) and 20(a) of the Exchange Act, as well as Rule 10b-5 promulgated thereunder, based principally on allegations that we
made misrepresentations regarding our business. Six similar class actions have since been filed in the Northern District of California. The Court has appointed a lead plaintiff and ordered that those actions be consolidated. In October 2004,
plaintiffs filed a consolidated amended complaint, on behalf of those who purchased our stock between October 16, 2003 and April 16, 2004. In January 2005, we filed a motion to dismiss the consolidated amended complaint that is currently scheduled
to be heard in late May 2005. We believe the plaintiffs claims are without merit and intend to contest them vigorously.



On June 4, 2004, a shareholder derivative lawsuit was filed in the Superior Court of the State of California, Alameda County, in which we are a nominal
defendant and certain of our officers and directors are defendants. A substantially identical derivative action was filed thereafter in the same court. The derivative actions are based on allegations substantially similar to those in the federal
class actions. On November 29, 2004, the Court sustained defendants demurrer to the complaint but granted plaintiffs leave to amend. On December 21, 2004, plaintiff filed an amended complaint. On March 21, 2005, the Court sustained
defendants demurrer to the amended complaint without leave to amend, on the grounds that plaintiffs failed to show that pre-suit demand on our board of directors should be excused.



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



Pursuant to the terms of a Purchase Agreement, dated March 30, 2005, we sold an aggregate of $60 million in aggregate principal amount of our 5.625%
Senior Convertible Notes due 2010 (the Notes) to two institutional investors. The Notes are currently convertible into shares of our common stock at a conversion price of $6.68 per share. However, this conversion price is
subject to adjustment under certain circumstances, including stock splits, stock dividends or distributions and other anti-dilution adjustments. If all outstanding Notes were converted at the current conversion price, this would result in the
issuance of approximately 8,979,348 shares of our common stock. However, the indenture governing the Notes provides that no holder of the Notes has the right to convert any portion of the Notes to the extent that, after giving effect to such
conversion, such holder (together with such holders affiliates) would beneficially own in excess of 4.99% of our common stock outstanding immediately after giving effect to such conversion. Due to this conversion limitation, as of April 14,
2005, the investors were permitted to convert the $60 million in aggregate principal amount of notes into no more than 7,957,150 shares of our common stock, based on the current conversion price of $6.68 per share. The issuance and sale of the notes
was exempt from the registration provisions of the Securities Act of 1933 pursuant to Section 4(2) of the Securities Act and Rule 144A promulgated thereunder. We did not utilize any underwriters in the sale of the Notes, but J.P. Morgan Securities
Inc. acted as our exclusive placement agent in connection with the sale of the Notes. We paid J.P. Morgan Securities Inc. for their services as our exclusive placement agent.



Item 3.    Defaults Upon Senior Securities.



None.



Item 4.    Submission of Matters to a Vote of Security Holders.



None.



Item 5.    Other Information.



None.



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Item 6.    Exhibits.



|               |  |                                                                                                                                                                                
|-------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Exhibit                                                                                                                                                                        
|               | 
|31.1           |  | Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                            
|               | 
|31.2           |  | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                            
|               | 
|32.1           |  | Certifications of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.



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SIGNATURE



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



LEXAR MEDIA, INC./s/    BRIAN T. MCGEEBrian T. McGee Vice President, Finance and Chief Financial Officer (Principal Financial Officer and Duly Authorized Officer)




Date: May 10, 2005



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INDEX TO EXHIBITS



|              |  |                                                                                                                                                                               
|------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Exhibit                                                                                                                                                                       
|              | 
|31.1          |  | Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                           
|              | 
|31.2          |  | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                           
|              | 
|32.1          |  | Certifications of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.



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