##### Table of Contents




---




SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





---




FORM 10-Q





(Mark One)





| | x |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
| | - |  | -------------------------------------------------------

| |  |  | SECURITIES EXCHANGE ACT OF 1934
| |  |  | -------------------------------




| |  |  | For the quarterly period ended September 30, 2002
| |  |  | -------------------------------------------------




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 of incorporation or organization)

(I.R.S. Employer Identification No.)47421 Bayside Parkway Fremont,
California

94538(Address of principal executive offices)

(Zip Code)





(510) 413-1200


(Registrants telephone number, including area code)





---




Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past
90 days.    Yes  x    No  ̈





Number of shares of common stock outstanding as of November 6, 2002:  60,557,740





---



---

##### Table of Contents




LEXAR MEDIA, INC.





FORM 10-Q


FOR THE QUARTER ENDED SEPTEMBER 30, 2002





TABLE OF CONTENTS





PagePART I    FINANCIAL INFORMATIONItem 1.

Financial Statements

3Condensed Consolidated Balance Sheets as of September 30, 2002 and December 31, 2001

3Condensed Consolidated Statements of Operations for the Three-Month and Nine-Month Periods Ended September 30, 2002 and 2001

4Condensed Consolidated Statements of Cash Flows for the Nine-Months Ended September 30, 2002 and 2001

5Notes to Unaudited Condensed Consolidated Financial Statements

6Item 2.

Managements Discussion and Analysis of Financial Condition and Results of Operations

12Item 3.

Quantitative and Qualitative Disclosures Regarding Market Risk

35Item 4.

Controls and Procedures

36PART II    OTHER INFORMATIONItem 1.

Legal Proceedings

37Item 2.

Changes in Securities and Use of Proceeds

38Item 3.

Defaults Upon Senior Securities

38Item 4.

Submission of Matters to a Vote of Security Holders

38Item 5.

Other Information

38Item 6.

Exhibits and Reports on Form 8-K

38SIGNATURES

39




---

##### 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)





September 30, 2002


December 31, 2001ASSETSCurrent assets:Cash and cash equivalents

$
26,220


$
8,656Restricted cash


5,000



2,333Accounts receivable, net


31,255



14,188Inventories


21,247



6,827Prepaid expenses and other current assets


2,244



1,074Total current assets


85,966



33,078Property and equipment, net


2,995



2,341Intangible and other assets, net


1,054



1,033Total assets

$
90,015


$
36,452LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable

$
27,528


$
12,245Accrued liabilities


10,451



7,813Deferred revenue


21,896



6,033Notes payable to stockholders






168Notes payable


13,980



2,237Total current liabilities


73,855



28,496Deferred revenue


9,020



1,748Notes payable, net


120



Total liabilities


82,995



30,244Stockholders equity:Common stock, $0.0001 par value:200,000,000 shares authorized; 60,427,279 and 59,759,518 shares issued and outstanding


6



6Additional paid-in capital


146,383



147,609Unearned stock-based compensation


(738
)


(1,969
)Notes receivable from stockholders


(1,001
)


(3,453
)Accumulated deficit


(137,421
)


(135,856
)Accumulated other comprehensive loss


(209
)


(129
)Total stockholders equity


7,020



6,208Total liabilities and stockholders equity

$
90,015


$
36,452





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




3




---

##### Table of Contents




LEXAR MEDIA, INC. AND SUBSIDIARIES





CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(in thousands, except per share amounts)


(unaudited)





Three Months Ended


Nine Months EndedSeptember 30, 2002


September 30, 2001


September 30, 2002


September 30, 2001Net revenues:Product revenues

$
41,329


$
14,319


$
95,571


$
43,870License and royalty revenues


4,400



3,829



12,927



7,838Total net revenues


45,729



18,148



108,498



51,708Cost of product revenues (excludes stock-based compensation of $6, $(16), $28, and $35)


34,295



12,942



80,163



53,061Gross margin


11,434



5,206



28,335



(1,353
)Operating expenses:Research and development (excludes stock-based compensation of $152, $322, $554 and $1,028)


1,306



1,215



3,784



4,421Sales and marketing (excludes stock-based compensation of $99, $87, $131 and $232)


4,564



4,167



12,008



16,151General and administrative (excludes stock-based compensation of $170, $(459), $628 and $554)


2,259



2,500



6,635



10,171Goodwill impairment














2,854Restructuring charge














2,086Stock-based compensation


427



(66
)


1,341



1,849Total operating expenses


8,556



7,816



23,768



37,532Income (loss) from operations


2,878



(2,610
)


4,567



(38,885
)Other income (expense):Interest and other expense


(115
)


(545
)


(571
)


(3,911
)Interest and other income


123



144



319



868Foreign exchange gain (loss)


10



194



224



(198
)Total other income (expense)


18



(207
)


(28
)


(3,241
)Income (loss) before income taxes


2,896



(2,817
)


4,539



(42,126
)Income taxes


853



676



6,104



2,276Net income (loss)

$
2,043


$
(3,493
)

$
(1,565
)

$
(44,402
)Net income (loss) per common share:Basic

$
0.03


$
(0.06
)

$
(0.03
)

$
(0.77
)Diluted

$
0.03


$
(0.06
)

$
(0.03
)

$
(0.77
)Shares used in net income (loss) per common share calculation:Basic


59,654



58,547



59,356



57,912Diluted


68,517



58,547



59,356



57,912





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




4




---

##### Table of Contents




LEXAR MEDIA, INC. AND SUBSIDIARIES





CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(in thousands)


(unaudited)





Nine Months Ended September 30,2002


2001Cash flows from operating activities:Net loss

$
(1,565
)

$
(44,402
)Adjustments to reconcile net loss to net cash provided by (used in) operating activities:Depreciation and amortization


933



1,461Goodwill impairment






2,854Issuance of warrants and stock to non-employees






51Restructuring charge






1,590Loss on disposition of fixed assets






6Amortization of stock-based compensation


1,341



1,849Imputed and other non-cash interest


4



2,991Change in operating assets and liabilities:Accounts receivable, net


(18,319
)


(819
)Inventory


(13,592
)


20,991Prepaid expenses and other assets


(1,232
)


264Accounts payable and accrued liabilities


17,921



(2,684
)Deferred revenue


23,529



6,834Net cash provided by (used in) operating activities


9,020



(9,014
)Cash flows from investing activities:Purchase of property and equipment


(1,542
)


(856
)Purchase of intangible assets


(75
)


Proceeds from sale of short-term investments






19,987Net cash (used in) provided by investing activities


(1,617
)


19,131Cash flows from financing activities:Issuance of stock under employee stock purchase plan


365



392Exercise of stock options and warrants


458



45Increase in restricted cash


(2,667
)


(1,333
)Repayment of notes payable


(25,862
)


(6,445
)Proceeds from notes payable


37,553



2,000Repayment of notes receivable from stockholders


394



220Repurchase of stock






(20
)Net cash provided by (used in) financing activities


10,241



(5,141
)Effect of exchange rates on cash and cash equivalents


(80
)


(84
)Net increase in cash and cash equivalents


17,564



4,892Cash and cash equivalents at beginning of period


8,656



7,755Cash and cash equivalents at end of period

$
26,220


$
12,647





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




5




---

##### Table of Contents




LEXAR MEDIA, INC. AND SUBSIDIARIES





NOTES TO UNAUDITED 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, all
normally recurring adjustments considered necessary for a fair presentation have been included. 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, 2001 included in our Annual Report on Form 10-K, as filed with the Securities and Exchange Commission on April 1, 2002. The condensed consolidated balance sheet data as of December 31, 2001 was derived from our audited financial
statements.





The results of our operations for the three and nine months ended September 30, 2002 are not
necessarily indicative of results that may be expected for any other future period, including the full fiscal year.





Note
2Summary of Selected Accounting Policies





Revenue recognition





Our customers include distributors, retailers, original equipment manufacturers and end users. Certain customers have return and price
protection rights. We recognize revenue where there is a contract or purchase order, upon shipment or delivery depending on the terms of sale, and where collectibility of the resulting receivable is reasonably assured. We provide for estimated
future returns and price protection based on historical experience at the time revenue is recognized. At the time of sale, we also provide for the estimated costs of meeting product warranty obligations. For certain customers where we are unable to
reasonably estimate the level of returns or where the customers do not take title to the product on delivery, revenues and the costs of revenues are deferred until these customers have sold the product to their customers. We recognize royalty and
license revenues ratably over the term of the agreement when the amounts are fixed and future obligations are insignificant. When amounts are based on volume of products sold that incorporate our technology, revenue is recognized when earned.





Deferred taxes





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 exposure together with
assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences have resulted in net deferred tax assets. Significant management judgment is required to assess
the likelihood that our deferred tax assets will be recovered from future taxable income and we currently provide a full valuation allowance against our deferred tax assets. In the event we were to determine it is more likely than not that we will
be able to realize our deferred tax assets in the future, an adjustment to the deferred tax asset would increase income in the period such determination was made.





Recent accounting developments





In November 2001, the Emerging Issues Task Force (EITF) reached a consensus on EITF No. 01-09, Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendors Products. EITF No.
01-09 addresses the accounting for consideration given by a vendor to a customer and is a codification of




6




---

##### Table of Contents



LEXAR MEDIA, INC. AND SUBSIDIARIES





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)




EITF No. 00-14, Accounting for Certain Sales Incentives, EITF No. 00-22, Accounting for Points and Certain Other Time-Based or Volume-Based Sales Incentive Offers
and Offers for Free Products or Services to be Delivered in the Future, and EITF No. 00-25, Vendor Income Statement Characterization of Consideration Paid to a Reseller of the Vendors Products. Our gross margins for the three
and nine months ended September 30, 2002 reflect the implementation of EITF 01-09 and EITF 00-25. The effect of these changes was a reduction in our product gross margins in the third quarter of 2002 from 19% to 17%. The effect of these changes
was a reduction in our product gross margins for the nine months ended September 30, 2002 from 19% to 16%. There was no impact on our income before income taxes or our net income (loss) for the periods. We determined that it was impracticable to
gather the data required to restate the impact of these consensuses on the third quarter and first nine months of 2001, had they been in place at that time.





We adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (SFAS 142), on January 1, 2002. The application of this pronouncement
modified the accounting for goodwill and intangibles, which included the cessation of amortizing capitalized goodwill and certain intangible assets.





The following table reflects the unaudited loss and net loss per share information reported for the three-month and nine- month periods ended September 30, 2001, prior to the adoption of SFAS 142:





Three months ended September 30, 2001


Nine months ended September 30, 2001(in thousands, except per
share data)Net loss

$
(3,493
)

$
(44,402
)Net loss per common sharebasic and diluted

$
(0.06
)

$
(0.77
)





The following table reflects the unaudited loss and net loss per
share information reported for the three month and nine month periods ended September 30, 2001 excluding the amortization of capitalized goodwill:





Add: amortization expense

$
64


$
387Net loss

$
(3,429
)

$
(44,015
)Net loss per common sharebasic and diluted

$
(0.06
)

$
(0.76
)





In June 2002, the Financial Accounting Standards Board
FASB issued SFAS No. 146, Accounting for Exit or Disposal Activities (SFAS 146). SFAS 146 addresses significant issues regarding the recognition, measurement, and reporting of costs that are associated with
exit and disposal activities, including restructuring activities that are currently accounted for under EITF No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs
Incurred in a Restructuring). The scope of SFAS 146 also includes costs related to terminating a contract that is not a capital lease and termination benefits that employees who are involuntarily terminated receive under the terms of a
one-time benefit arrangement that is not an ongoing benefit arrangement or an individual deferred-compensation contract. SFAS 146 will be effective for exit or disposal activities that are initiated after December 31, 2002 and early application is
encouraged. The provisions of EITF No. 94-3 shall continue to apply for an exit activity initiated under an exit plan that met the criteria of EITF No. 94-3 prior to the adoption of SFAS 146. The effect on adoption of SFAS 146 will change, on a
prospective basis, the timing of when restructuring charges are recorded from a commitment date approach to when the liability is incurred.




7




---

##### Table of Contents



LEXAR MEDIA, INC. AND SUBSIDIARIES





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)







Shipping and handling costs





Shipping and handling costs associated with our product revenues are included in sales and marketing expenses in our condensed
consolidated statements of operations. These costs were $0.7 million and $0.5 million for the three months ended September 30, 2002 and September 30, 2001, respectively, and $2.0 million and $1.4 million for the nine months ended September 30,
2002 and September 30, 2001, respectively.





Note 3Restricted Cash





Restricted cash supports a stand-by letter of credit, which in turn is used to collateralize certain trade payable balances.





Note 4Balance Sheet Detail (in thousands)





September 30, 2002

December 31, 2001Inventories:Raw materials

$
5,071

$
1,305Controllers


1,857


510Flash memory products


13,596


4,129Ancillary products


723


883$
21,247

$
6,827





Note 5Deferred Revenue and Income Taxes





In March 2002, we entered into a new licensing relationship with Samsung Electronics Co., Ltd. that renewed and extended the prior
license. Under this new agreement, Samsung prepaid the remaining fixed royalties owed under the prior agreement and paid additional licensing fees for expanded rights to license our proprietary technology. The entire prepayment of licensing fees was
subject to foreign income tax that was withheld at the time of the prepayment. This tax, in the amount of $5.2 million, is recoverable only as credit against federal income taxes. Due to the uncertainty of the recoverability, the entire amount has
been reflected as income tax expense in the first quarter of 2002. Accordingly, as these deferred license fees are being amortized into revenues over the next two years, there will be no related foreign income tax expense. License and royalty fees
recognized in the three months ended September 30, 2002 includes $4.0 million for which the related foreign income tax expense of approximately $0.7 million for foreign taxes withheld was recognized in the first quarter of 2002. License and royalty
fees recognized in the nine months ended September 30, 2002 include $4.4 million for which the related foreign income tax expense of $0.7 million for foreign taxes withheld was recognized in 2001.





In the third quarter of 2002, the State of California retroactively suspended the state income tax net operating loss carryforward
provisions for a two-year period for income years beginning on or after January 1, 2002. As a result of this suspension, in the third quarter of 2002, we provided approximately $800,000 for California state income taxes. The taxes arose principally
from the receipt of royalties and licensing fees that were taxable in the period received rather than when recognized for financial reporting purposes. The remainder of the tax expense for the third quarter related primarily to foreign income taxes.





Income tax expense of $0.7 million and $2.3 million for the three- and nine-month periods ended
September 30, 2001 represents foreign tax withholdings related to license and royalty fees received during those




8




---

##### Table of Contents



LEXAR MEDIA, INC. AND SUBSIDIARIES





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)




periods. Of the $2.3 million, approximately $1.0 million related to license and royalty revenue that was deferred at September 30, 2001.





Note 6Net Income (Loss) Per Common Share (in thousands, except per share data)





Three Months Ended


Nine Months EndedSeptember 30, 2002


September 30, 2001


September 30, 2002


September 30, 2001Numerator for basic and diluted net income (loss) per share:Net income (loss)

$
2,043


$
(3,493
)

$
(1,565
)

$
(44,402
)Denominator for basic net income (loss) per common share:Weighted average common shares outstanding


60,128



60,420



59,942



60,290Weighted average common shares subject to repurchase


(474
)


(1,873
)


(586
)


(2,378
)Denominator for basic net income (loss) per share


59,654



58,547



59,356



57,912Basic net income (loss) per common share

$
0.03


$
(0.06
)

$
(0.03
)

$
(0.77
)Denominator for diluted net income (loss) per common share:Denominator for basic net income (loss) per common share


59,654



58,547



59,356



57,912Dilutive effect of exercise of outstanding stock options and warrants (assuming proceeds would be used to repurchase
common stock)


8,389











Dilutive effect of common shares attributable to common shares subject to repurchase


474











Denominator for diluted net income (loss) per common share


68,517



58,547



59,356



57,912Diluted net income (loss) per common share

$
0.03


$
(0.06
)

$
(0.03
)

$
(0.77
)





The securities listed below have not been included in the
computations of diluted net income (loss) per common share for the three and nine-month periods ended September 30, 2002 and 2001 because the inclusion of these securities would be anti-dilutive (in thousands):





Three Months Ended September 30,

Nine Months Ended September 30,2002

2001

2002

2001Common stock issuable upon exercise of outstanding warrants

324

2,603

1,791

2,603Common stock issuable upon exercise of outstanding options

2,316

12,714

16,317

12,714Common stock subject to repurchase



911

438

911




9




---

##### Table of Contents



LEXAR MEDIA, INC. AND SUBSIDIARIES





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)







Note 7Related Party Transactions





During the second quarter of 2002, four individuals, including three Section 16 officers, our President and Chief Executive Officer, our
Executive Vice President, Engineering and Chief Technology Officer and our Chairman of the Board of Directors, repaid an aggregate of $2.5 million in outstanding principal and interest due under promissory notes held by us related to stock options
and other receivables from stockholders by tendering to us an aggregate of 825,116 shares of our common stock. The stock was valued at the fair market value on the date each individual tendered his shares, which ranged from $3.00 to $3.11 per share.
The weighted average value was $3.08 per share.





Note 8Restructuring





At the end of the second quarter of fiscal 2001, we decided to implement a 27% reduction in our work force and to discontinue our Printroom.com operations. We
recognized a $2.1 million restructuring charge related to this restructuring. The restructuring was effected in the third quarter of fiscal 2001 to achieve substantial reductions in overhead costs and is substantially complete. The disposition of
Printroom.com was implemented through a sale of the Printroom.com assets to a company owned by the management of Printroom.com. We recorded a note receivable of $0.1 million in connection with the transaction and have fully reserved it.





A summary of the restructuring costs is outlined as follows (in thousands):





Accrued Balance
at December 31, 2001

Cash Payments


Non-cash Charges (Credits)

Accrued Balance at September 30, 2002Reduction in workforce

$
415

$
(270
)

$


$
145Excess facilities and related costs


298


(36
)





262Asset write-offs and other


63


(37
)





26$
776

$
(343
)

$


$
433





Final adjustments relating to workforce reductions and termination
agreements will be made in the last quarter of 2002. We expect to pay amounts related to excess facilities and related costs over the terms of the related leases through 2004. Accrued restructuring costs are included with accrued liabilities on the
condensed consolidated balance sheet.





Note 9Comprehensive Loss





Other comprehensive loss for the three-month and nine-month periods ended September 30, 2002 was $41,000 and $80,000, respectively. Other comprehensive loss for the
three-month and nine-month periods ended September 30, 2001 was $82,000 and $84,000, respectively. These amounts were attributable to the effects of foreign currency translation. There was no other comprehensive income or loss during these periods.





Note 10Notes Payable





In September 2001, we established an asset based credit facility with Greater Bay Bank. At September 30, 2002, the balance outstanding under this facility was $8.2 million. Our agreement with Greater
Bay Bank provides for interest at an annual rate of the banks prime rate plus 4.5% of the gross amount financed, has a term of one year, and is renewable from year to year thereafter. Either party can terminate the facility, at any time, upon
30 days notice. At December 31, 2001 the balance outstanding under this facility was $2.2 million.




10




---

##### Table of Contents



LEXAR MEDIA, INC. AND SUBSIDIARIES





NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)







During the second quarter of 2002, we commenced selling certain
receivables denominated in Japanese yen, to a financial institution. The receivables are sold based upon a 1.375% discounted annual rate. We have included the $5.6 million balance outstanding at September 30, 2002 in accounts receivable and in notes
payable on the condensed consolidated balance sheet at September 30, 2002.





Note 11Supplemental Cash Flow Information (in
thousands, except share and per share data)





Nine Months Ended September 30,2002

2001Supplemental cash flow disclosure:Interest paid

$
398

$
863Income taxes paid

$
5,258

$
2,276Supplemental disclosure of non-cash financing and investing activities:Issuance of 565,154 shares of common stock in 2002 upon net exercise of warrants to purchase 812,500 shares of common
stock at prices ranging from $0.80-$1.26 per share (weighted average exercise price of $1.14 per share)

$


$
Settlement of interest and notes receivable from stockholders with 825,116 shares of common stock

$
2,543

$
Issuance of 104,607 shares of common stock at $3.65 per share for purchase of patents

$
382

$
Re-pricing of warrants in connection with amended credit facility agreement

$


$
792Repurchase of common stock by cancellation of notes receivable

$


$
1,479Issuance of warrants in connection with license and royalty agreement

$


$
206





Note 12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. At any point in time, we might use various hedging instruments, primarily forward contracts, to manage the exposures associated with our net asset or liability positions. 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 or (loss). During the third quarter of 2002, we recorded hedges on intercompany payables denominated in the British pound and Japanese yen. The gains and losses on these
contracts were substantially offset by transaction losses and gains on the underlying balances being hedged. In addition, during the third quarter of 2002, we had foreign currency denominated assets and liabilities that were not hedged. Our net
foreign exchange gains (losses) on hedging transactions were $0.1 million for both the three-month and nine-month periods ended September 30, 2002. As of September 30, 2002, we held forward contracts with an aggregate notional value of $8.0 million
to hedge the risks associated with British pound and Japanese yen denominated assets and liabilities. We did not enter into any hedging transactions during 2001.




11




---

##### Table of Contents




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 condensed consolidated financial statements and related notes included
elsewhere in this report. In addition to historical information, this discussion contains certain forward-looking statements that involve risks and uncertainties. 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 and market high-performance flash memory cards that we market as digital film and other flash-based storage products for consumer markets that utilize portable media for the capture and retrieval of digital content. In addition, we
market a variety of connectivity products that link our media products to PCs and other electronic devices. Our digital photography products enable customers to capture digital images and download them quickly to a personal computer for editing,
distributing and printing. We also license our proprietary controller technology and sell controllers to other manufactures of flash storage media to address markets adjacent to digital photography.





Our digital film combines flash memory from leading suppliers with our patented technology to address the needs of professional,
commercial and consumer photographers. Digital film and storage media sales comprised 84.0% of our gross revenues for the first nine months of 2002. Our high-performance digital film can record images faster than other digital film. This performance
advantage is particularly noticeable when used in advanced digital cameras that take advantage of our write speed, or the rate at which our film can capture a digital image. Our digital film is compatible with substantially all digital cameras,
including those manufactured by Agfa, Canon, Casio, Epson, Fuji, Hewlett-Packard, Kodak, Konica, Minolta, Nikon, Olympus, Polaroid, Ricoh, Sony and Yashica. We offer digital film in the five primary media formats currently used by digital cameras
and other electronic devices: CompactFlash, Memory Stick, SmartMedia, Secure Digital Card and MultiMedia Card. We also recently began selling the xD Picture Card which is currently marketed and sold only as digital film although it may in the future
be marketed for use in other electronic devices as well.





Our digital film reader/writers are products that
facilitate the transfer of digital images to personal computers and other devices without a direct connection to the digital camera. Our JumpShot cable connects the universal serial bus, or USB, port to our USB-enabled CompactFlash digital film to
quickly and easily transfer images. In addition, to address the growing market for compact digital data and media storage solutions, we recently began selling our JumpDrive  , a new, high-speed portable USB flash drive for consumer applications that serves a variety of uses including floppy disk
replacement.





Our flash memory controller technology can be applied to a variety of consumer electronic
applications such as digital music players, laptop computers, personal digital assistants, telecommunication and network devices and digital video recorders. In order to extend our technology into these markets we have selectively licensed our
products and technology to third parties. For example, during 2001, we entered into supply and/or license agreements with Smart Modular and more recently with InterWorks, a business unit of the Sanmina-SCI Modular Solutions Division. We agreed to
supply ATA flash controllers for InterWorks flash-based storage products. InterWorks and Sanmina-SCI have recently begun to integrate our high-performance controller into their business sectors such as data communications, telecommunications,
industrial, computing and embedded markets. Also, in 2000, we entered into an agreement with Sony to combine our proprietary controller technology with their Memory Stick media format and include the Memory Stick as one of our digital film products.
The Memory Stick is used in a wide variety of consumer electronic products, including camcorders, personal computers, portable music players, cameras and video recorders.




12




---

##### Table of Contents




In March 2002, we terminated our prior license agreement with Samsung and
executed a new license agreement that renewed and extended the prior license. Under this new agreement, Samsung prepaid fixed royalties due under the prior license agreement at a 5% discount rate. Samsung also paid additional licensing fees for
expanded rights to license our technology. We also have an agreement with Samsung under which it is our primary supplier of flash memory.





Revenues.    We generate revenues primarily from the sale of digital film and connectivity products to end-users through mass market, photo and original equipment manufacturer channels. In 2000, we
began generating revenues from the licensing of our technology to Sony. In 2001, we began generating licensing revenues under license agreements with Samsung and Olympus. During the third quarter of 2002, we significantly increased our presence in
the mass market channel by adding approximately 4,000 retail storefronts, for a total of approximately 29,000 worldwide. We also generate revenues from the sales of our controllers to flash storage manufacturers.





We sell products to distributors, retailers, original equipment manufacturers and end users. Certain customers have return rights. 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. At the time revenue is recorded, we record estimated
reductions to product revenue based upon our historical experience, customer price protection programs and incentive offerings, including special pricing agreements, price protection, promotions and other volume-based incentives. In order to make
such estimates we analyze historical returns, current economic conditions, customer demand and any relevant specific customer information. For certain customers where we are unable to reasonably estimate the level of returns or where the customers
do not take title to the product on delivery, revenues and the costs of revenues are deferred until these customers have sold the product to their customers. Should our ability to estimate, based on these various factors, change, this could have a
significant impact on our revenue recognition, potentially reducing revenue in the period of such change.





We sell
our products to certain customers on a consignment basis. As a result, our inventory balance at the end of the third quarter included amounts for consigned inventory. Carrying higher levels of consigned inventory may result in additional operational
costs. To date, additional operating costs associated with our consigned inventories have not been significant.





We recognize royalty and license revenues ratably over the term of the agreement when the amounts are fixed and future obligations are insignificant. When amounts are based on the volume of products sold that incorporate our
technology, revenue is recognized when earned.





A majority of our sales have been to a limited number of
customers. Our top 10 customers accounted for 65.2% of our gross revenues for the nine months ended September 30, 2002 and 62.0% of our gross revenues for the nine months ended September 30, 2001. 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.





Domestic product sales account for the majority of our total net revenues. Net product revenues in the United States represented 66.5% of our total net revenues for the nine months ended September 30, 2002 and 63.2% of our total net
revenues for the nine months ended September 30, 2001.





Cost of Revenues.    Our cost
of revenues consists primarily of materials costs, with flash memory accounting for a majority of those costs. We maintain relationships with key suppliers, which we believe will be able to provide us with sufficient quantities of flash memory for
at least the next 12 months. We have an agreement with Samsung Electronics, Co., Ltd. under which it has become our primary supplier of flash memory and has guaranteed that we will have access to a portion of its available production capacity. The
price we have historically paid for flash memory has fluctuated considerably. For example, the price of flash memory decreased significantly in 2001 and decreased more moderately in the first nine months of 2002. We expect that there may




13




---

##### Table of Contents

be additional price declines during the remainder of 2002 as additional flash memory capacity becomes available. In addition, cost of revenues includes expenses related to materials procurement,
inventory management, adjustments and manufacturing. As a result of our agreement with SanDisk, in the second quarter of 2001, we began incurring royalty expenses related to domestic sales of our CompactFlash digital film that utilizes our previous
generation controller technology. We do not owe royalties on end user sales made outside of the United States or on digital film that includes our latest generation controller technology.





Research and Development.    Our research and development expenses include salaries and related expenses for research and development personnel,
fees for outside consultants, patent costs and prototype development and materials costs. Research and development activities are primarily focused on developing the technology for new products and product enhancements, as well as supporting
existing products. We believe that continued investment in research and development is important to attain our strategic objectives. In the fourth quarter of 2002, we expect research and development expenses to moderately increase compared with our
research and development expenses in the third quarter of 2002.





Sales and
Marketing.    Our sales and marketing expenses include salaries and related expenses for sales and marketing personnel, advertising, customer service, technical support, distribution and travel and trade show expenses. In the
fourth quarter of 2002, we expect sales and marketing expenses to be consistent with the third quarter of 2002, except for certain selling and marketing costs, such as advertising, order fulfillment and commission costs, that generally fluctuate
with the level of sales.





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. In the fourth quarter of 2002, we expect general and administrative expenses to
increase significantly as a result of increased litigation expenses that we expect to incur in our expanded efforts to protect our intellectual property. If additional litigation were filed against us, we expect that our general and administrative
expenses could increase significantly beyond our current expectations.





Restructuring.    At the end of the second quarter of fiscal 2001, we decided to implement an approximately 27% reduction in our work force and to discontinue our Printroom.com operations. These actions
were taken to allow us to focus on our core competitive strengths and position us for future revenue growth and near-term profitability. The restructuring was effected in the third quarter of 2001 and is substantially complete.





Stock-based Compensation.    Stock-based compensation related to options granted to employees
represents the aggregate difference, at the date of grant, between the deemed fair market value of the stock underlying options and the exercise prices of these options. Stock-based compensation related to options granted to consultants is revalued
as it vests using the Black-Scholes option-pricing model. Stock-based compensation is amortized over the vesting period of the underlying options based on an accelerated vesting method.





Critical Accounting Policies And Estimates





Our
discussion and analysis of our financial condition and results of operations are 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, bad debts, inventories, investments, intangible assets, income taxes, warranty obligations, restructuring,
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 that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.




14




---

##### Table of Contents




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





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




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




Revenue Recognition





Product revenues





We derive our revenues primarily from product revenues, which include flash memory products, controllers and connectivity products. As discussed below, significant management judgments and estimates must be made and used in
connection with the revenue recognized in any accounting period.





We sell products to distributors, retailers,
original equipment manufacturers and end users. Certain customers have return rights. 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. At the time revenue is recorded, we record estimated reductions to product revenue based upon our historical experience, customer price protection programs and incentive offerings, including special pricing
agreements, price protection, promotions and other volume-based incentives. In order to make such estimates we analyze historical returns, current economic conditions, customer demand and any relevant specific customer information. For certain
customers where we are unable to reasonably estimate the level of returns or where the customers do not take title to the product on delivery, revenues and the costs of revenues are deferred until these customers have sold the product to their
customers. Should our ability to estimate, based on these various factors, change, this could have a significant impact on our revenue recognition, potentially reducing revenue in the period of such change.





License and royalty revenues





We recognize license and royalty revenues ratably over the term of the agreement when the amounts are fixed and future obligations are insignificant. When amounts are based on the volume of products
sold that incorporate our technology, revenue is recognized when earned.





Valuation allowances and accrued liabilities





Inventory write-downs





We write-down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based
upon assumptions about future demand and market conditions. If actual market conditions are less favorable than we anticipate, for example, if product sales and prices decline more substantially than projected by management, additional inventory
write-downs may be required.





Allowance for doubtful accounts





We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments.
If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.




15




---

##### Table of Contents




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 exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences have resulted in net deferred tax
assets. Significant management judgment is required to assess the likelihood that our deferred tax assets will be recovered from future taxable income and we currently provide a full valuation allowance against our deferred tax assets. In the event
we were to determine it is more likely than not that we are able to realize our deferred tax assets in the future, an adjustment to the deferred tax asset would increase income in the period such determination was made.





Other valuation allowances and accrued liabilities





We also maintain accruals and allowances for all cooperative marketing and other programs. 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 unlikely event that a problem is identified that would result in the need to
replace product on a large scale, such an event may have a material adverse effect on our operating results and financial position.





Our History of Losses





The three months ended September 30, 2002 yielded the second
profitable quarter in our history. However, we have incurred significant losses to date. As of September 30, 2002, we had an accumulated deficit of approximately $137.4 million. We intend to continue to expend significant financial and management
resources on developing additional products and services, improving our technologies, protecting our intellectual property and meeting increased working capital needs. As a result, we may not be able to sustain profitability and we expect to incur
negative operating cash flows during the remainder of 2002. In view of the rapidly changing nature of our market and our limited 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.




16




---

##### Table of Contents




Results of Operations





The following table sets forth our statement of operations data expressed as a percentage of net sales for the periods indicated:





Three months ended


Nine months endedSeptember 30, 2002


September 30, 2001


September 30, 2002


September 30, 2001Net revenues:Product revenues

90.4
%

78.9
%

88.1
%

84.8
%License and royalty revenues

9.6
%

21.1
%

11.9
%

15.2
%Total net revenues

100.0
%

100.0
%

100.0
%

100.0
%Cost of product revenues

75.0
%

71.3
%

73.9
%

102.6
%Gross margin

25.0
%

28.7
%

26.1
%

(2.6
)%Operating expenses:Research and development

2.9
%

6.7
%

3.5
%

8.6
%Sales and marketing

10.0
%

23.0
%

11.1
%

31.2
%General and administrative

4.9
%

13.8
%

6.1
%

19.7
%Goodwill impairment










5.5
%Restructuring charge










4.0
%Stock-based compensation

0.9
%

(0.4
)%

1.2
%

3.6
%Total operating expenses

18.7
%

43.1
%

21.9
%

72.6
%Income (loss) from operations

6.3
%

(14.4
)%

4.2
%

(75.2
)%Other income and expense:Interest and other expense

(0.3
)%

(3.0
)%

(0.5
)%

(7.6
)%Interest and other income

0.3
%

0.8
%

0.3
%

1.7
%Foreign exchange gain (loss)

0.0
%

1.1
%

0.2
%

(0.4
)%Total other income and expense

0.0
%

(1.1
)%

0.0
%

(6.3
)%Income (loss) before income taxes

6.3
%

(15.5
)%

4.2
%

(81.5
)%Income taxes

1.9
%

3.7
%

5.6
%

4.4
%Net income (loss)

4.4
%

(19.2
)%

(1.4
)%

(85.9
)%





Revenues





Total net revenues for the third quarter of 2002 increased approximately $27.6 million, or 152.0%, to $45.7 million from $18.1 million for the third quarter of 2001.
Total net revenues for the nine months ended September 30, 2002 increased approximately $56.8 million, or 109.8%, to $108.5 million from $51.7 million for the nine months ended September 30, 2001.





Product revenues comprised 90.4% and 78.9% of total revenues for the third quarters of 2002 and 2001, respectively. Product revenues for
the third quarter of 2002 increased approximately $27.0 million, or 188.6%, to $41.3 million from $14.3 million in the third quarter of 2001. Product revenues comprised 88.1% and 84.8% of total net revenues for the first nine months of 2002 and
2001, respectively. Product revenues for the first nine months of 2002 increased approximately $51.7 million, or 117.9%, to $95.6 million from $43.9 million for the first nine months of 2001. The increase in product revenues for the comparative
three-month and nine-month periods was primarily the result of significantly increased demand in the retail and OEM channels that was partially offset by declining average selling prices. During the third quarter of 2002, we continued to see
moderation in the rate of decline of average selling prices compared to the declines experienced during 2001. In the third quarter of 2002, we derived 70.1%, 13.1% and 16.4% of our product revenues from sales to customers in the United States,
Europe and Japan, respectively. In the third quarter of 2001, we derived 74.8%, 17.2% and




17




---

##### Table of Contents

5.8% of our product revenues from sales to customers in the United States, Europe and Japan, respectively. One customer accounted for 13.4% of our gross product revenues in the third quarter of
2002. Two customers accounted for 13.6% and 13.4% of our gross product revenues in the third quarter of 2001. In the first nine months of 2002, we derived product revenues of 75.5%, 12.3% and 11.8% from customers in the United States, Europe
and Japan, respectively. In the first nine months of 2001, we derived product revenues of 74.5%, 18.0% and 5.9% from customers in the United States, Europe and Japan, respectively. Two customers accounted for 14.5% and 14.1% of our gross product
revenues in the first nine months of 2002. One customer accounted for 11.1% of our gross product revenues in the first nine months of 2001.





License and royalty revenues comprised 9.6% and 21.1% of our total net revenues for the three months ended September 30, 2002 and 2001, respectively. License and royalty revenues for the third quarter
of 2002 increased $0.6 million, or 14.9%, to $4.4 million from $3.8 million in the third quarter of 2001. The increase in license and royalty revenues was primarily the result of the license and royalty agreements that we entered into during the
first quarter of 2002. License and royalty revenues comprised 11.9% and 15.2% of total net revenues for the nine months ended September 30, 2002 and 2001, respectively. License and royalty revenues for the first nine months of 2002 increased $5.1
million, or 64.9%, to $12.9 million from $7.8 million in the first nine months of 2001. The increase in license and royalty revenues was primarily the result of the license and royalty agreements that we entered into during the second half of 2001
and the first quarter of 2002.





Cost of product revenues





Cost of product revenues increased 165.0% to $34.3 million for the third quarter of 2002 from $12.9 million for the third quarter of 2001. Cost of product revenues
increased 51.1% to $80.2 million for the first nine months of 2002 from $53.1 million for the first nine months of 2001. The increase in cost of product revenues for each of these periods was primarily the result of the increase in both the number
of units and the average capacity of products manufactured and sold. These factors were partially offset by the decreases in the cost of flash memory compared to the cost in the comparable periods of 2001, and the benefits of improved inventory
control and turnover compared to the comparable periods of 2001.





Gross margin





Gross margins for product revenues in the third quarter of 2002 increased to 17.0%, as compared to 9.6% in the third quarter of 2001.
Gross margins for product revenues in the first nine months of 2002 increased to 16.1%, as compared to a negative margin of (20.9)% in the first nine months of 2001. These increases were primarily the result of decreases in product costs, moderation
in the rate of decline of average selling prices, reductions in price protection charges, and improved inventory control and turnover. Implementation of EITF 00-25 and EITF 01-09 resulted in classification of certain revenue reductions that
negatively impacted product margins in the third quarter and in the first nine months of 2002 by approximately 2 percentage points.





Operating expenses





Research and Development.    For the third
quarter of 2002, research and development expenses increased to $1.3 million, or 2.9% of total net revenues, from $1.2 million, or 6.7% of total net revenues, for the third quarter of 2001. For the first nine months of 2002, research and development
expenses decreased to $3.8 million, or 3.5% of total net revenues, from $4.4 million, or 8.6% of total net revenues, for the first nine months of 2001. The decrease in research and development expenses for the first nine months of 2002 compared to
the first nine months of 2001 was primarily due to the disposition of Printroom.com. The increase in our total net revenues accounted for approximately 76% of the reduction in research and development expenses as a percentage of net revenues for the
first nine months of 2002 as compared to the first nine months of 2001 and the decrease in expenditures related to Printroom.com accounted for the remainder of the reduction.




18




---

##### Table of Contents




Sales and Marketing.    Sales and marketing expenses
for the third quarter of 2002 increased to $4.6 million, or 10.0% of total net revenues, as compared to $4.2 million, or 23.0% of total net revenues, for the third quarter of 2001. Sales and marketing expenses for the first nine months of 2002
decreased to $12.0 million, or 11.1% of net revenues, as compared to $16.2 million, or 31.2% of net revenues, for the first nine months of 2001. The increase in sales and marketing expenses for the third quarter of 2002 compared to the third quarter
of 2001 was primarily due to increases in expenses that vary directly with sales, such as advertising, order fulfillment and sales commissions, which was partially offset by lower inclusion of market development costs. The increase in revenues
accounted for the reduction in sales and marketing expenses as a percentage of total net revenues in the third quarter of 2002 as compared to the third quarter of 2001. The decrease in sales and marketing expenses for the first nine months of 2002
compared to the first nine months of 2001, was primarily due to reductions in employee compensation costs related to the restructuring we implemented in the second quarter of 2001, lower advertising costs and lower inclusion of market development
costs, which were partially offset by increases in expenses which vary with directly with sales, such as order fulfillment and sales commissions. The decrease in actual expenditures accounted for approximately 40% of the reduction in sales and
marketing expenses as a percentage of total net revenues for the first nine months of 2002 as compared to the first nine months of 2001, and the increase in revenues accounted for the remainder of the reduction.





General and Administrative.    General and administrative expenses for the third quarter of 2002 decreased to
$2.3 million, or 4.9% of total net revenues, as compared to $2.5 million, or 13.8% of total net revenues, for the third quarter of 2001. General and administrative expenses for the first nine months of 2002 decreased to $6.6 million, or 6.1% of
total net revenues, as compared to $10.2 million, or 19.7% of total net revenues for the first nine months of 2001. The decrease in general and administrative expenses in the first nine months of 2002 compared to the first nine months of 2001
periods was primarily due to lower employee compensation related costs due to the restructuring that we implemented in the second quarter of 2001 and lower legal expenses. The decrease in actual expenditures accounted for approximately 15% of the
reduction in general and administrative expenses as a percentage of total net revenues for the third quarter of 2002 as compared to the third quarter of 2001 and the increase in our total net revenues accounted for the remainder of the reduction.
The decrease in actual expenditures accounted for approximately 50% of the reduction in general and administrative expenses as a percentage of total net revenues for the first nine months of 2002 as compared to the first nine months of 2001 and the
increase in revenues accounted for the remainder of the reduction. As we incur increased litigation expenses as part of our expanded efforts to protect our intellectual property, we expect that general and administrative expenses will increase
significantly. If additional litigation were filed against us, we expect that our general and administrative expenses could increase significantly beyond our current expectations.





Goodwill impairment.    During the first nine months of 2001, a charge of $2.9 million was recognized as an impairment charge against
Printroom.com goodwill. There were no such charges during the first nine months of 2002.





Restructuring.    At the end of the second quarter of fiscal 2001, we decided to implement an approximately 27% reduction in our work force and to discontinue our Printroom.com operations. These actions
were taken to allow us to focus on our core competitive strengths and position us for future revenue growth and near-term profitability. In connection with these decisions, we recognized a $2.1 million restructuring charge in the second quarter of
fiscal 2001 for estimated severance costs related to organizational changes and the planned reduction in work force, to reduce property and equipment to its estimated realizable value and to provide for consolidation of excess facilities and other
charges related to the discontinuance of our operation of Printroom.com. At September 30, 2002, the balance of the restructuring reserve was approximately $0.4 million, which primarily represents facilities costs.





Stock-based compensation.    Stock-based compensation expense was $0.4 million in the third quarter of 2002 and
$(0.1) million in the third quarter of 2001. Stock-based compensation for the nine months ended September 30, 2002 decreased to $1.3 million, as compared to $1.8 million for the nine months ended September 30, 2001. The decrease resulted from
the declining amortization rate under FIN No. 28, as well as from the reduction of employees as a result of the restructuring effected in 2001.




19




---

##### Table of Contents




Other Income and Expense





Interest and other expense for the third quarter of 2002 decreased to $0.1 million as compared to $0.5 million for the third quarter of 2001. Interest and other
expense for the third quarter of 2002 consisted primarily of interest on short-term borrowings. Interest and other expense for the third quarter of 2001 included imputed interest of $0.3 million, associated primarily with the amortization of the
value of the warrants issued and fees paid in connection with The Chase Manhattan Bank and Access Technology Partners credit facilities, the write-off of the remaining balances related to fees on the Chase loan that was repaid and the costs
associated with the warrants issued to Chase. Interest and other expense for the first nine months of 2002 decreased to $0.6 million as compared to $3.9 million for the first nine months of 2001. Interest and other expense for the first nine
months of 2002 consisted primarily of interest on short-term borrowings. The imputed interest and other non-cash interest for the first nine months of 2001 was $3.0 million and included a $0.7 million forbearance charge.





Interest and other income for the third quarter of 2002 was $0.1 million and is consistent with the third quarter of 2001. For the first
nine months of 2002, interest and other income decreased to $0.3 million as compared to $0.9 million in the first nine months of 2001. The decrease was primarily due to lower interest rates in 2002.





The net foreign exchange gain reported in the third quarter of 2002 was nominal, compared to the net gain of $0.2 million reported in the
third quarter of 2001. The net foreign exchange gain for the nine months ended September 30, 2002 was $0.2 million, compared to a net foreign exchange loss of $0.2 million for the nine months ended September 30, 2001. These amounts were
primarily attributable to European and Japanese sales activities and fluctuations in the British pound and the Japanese yen against the U.S. dollar, in each of the periods. Our net foreign exchange gains on hedging transactions were $0.1 million for
both the three-month and nine-month period ended September 30, 2002. We did not enter into any hedging transactions in 2001.





Income
Taxes





Income tax expense for the third quarter of 2002 was $0.9 million, or 1.9% of total net revenues,
compared to income tax expense for the third quarter of 2001 of $0.7 million, or 3.7% of total net revenues. Income tax expense in the third quarter of 2002 resulted primarily from the State of Californias decision during the third quarter to
retroactively suspend the state income tax net operating loss deduction for a two-year period for income years beginning on or after January 1, 2002. Income tax expense in the third quarter of 2001 represented foreign taxes withheld on payments from
foreign licensees. Income tax expense for the first nine months of 2002 was $6.1 million, or 5.6% of total net revenues, of which $5.2 million represented foreign taxes withheld from a license prepayment received from Samsung. For the first nine
months of 2001, income tax expense of $2.3 million, or 4.4% of total net revenues, represented foreign taxes withheld on license revenues. Withholding taxes are recoverable only as a credit against federal income taxes. Due to the uncertainty
of the recoverability, the withholding taxes have been reflected as income tax expense. There will be no future foreign income tax expense associated with these license fees.





Liquidity and Capital Resources





Net cash provided by
operating activities was $9.0 million for the nine months ended September 30, 2002 as compared to net cash used in operating activities of $9.0 million for the nine months ended September 30, 2001. For the first nine months of 2002, our net loss of
$1.6 million, when adjusted for non-cash charges of approximately $2.3 million, resulted in operating cash provided of $0.7 million before changes in operating assets and liabilities. During the first nine months of 2002, our cash position from
operations was favorably impacted by the receipt of the Samsung license payment which, along with the increase in deferred product revenues, resulted in the net increase in deferred revenue of $23.5 million, and by an increase of $17.9 million in
accounts payable and accrued liabilities. This favorable impact was offset by increases in accounts receivable of $18.3 million and increases in inventory and other assets of $14.8 million. The $18.3 million increase in accounts receivable was
primarily due to the increases in our total net revenues and deferred product revenues. In the first




20




---

##### Table of Contents

nine months of 2001, our net cash used in operating activities was primarily attributable to our net loss, adjusted for non-cash items, decreases in inventory, accounts payable and accrued
liabilities and other assets, and increases in deferred revenue and accounts receivable.





Net cash used in
investing activities was $1.6 million for the nine months ended September 30, 2002, which was the result of purchases of property and equipment and patents. Net cash provided by investing activities was $19.1 million for the nine months ended
September 30, 2001, which was primarily proceeds from the sale of short-term investments.





Net cash provided by
financing activities was $10.2 million for the nine months ended September 30, 2002, which was primarily the result of debt proceeds of $37.6 million which were primarily from our asset based credit facility with Greater Bay Bank, and net proceeds
from equity transactions of $1.2 million, offset by debt repayments of $25.9 million primarily against our asset based credit facility with Greater Bay Bank and the $2.7 million increase in restricted cash. Net cash used in financing activities
was $5.1 million for the nine months ended September 30, 2001, which was primarily the result of $6.4 million in repayment of notes and the $1.3 million increase in restricted cash, and $0.6 million in net proceeds from equity transactions.





In September 2001, we established an asset based credit facility with Greater Bay Bank. During the fourth quarter
of 2002, Greater Bay Bank committed to increase the availability under the facility from $15.0 million to $20.0 million subject to our acceptance of the terms and conditions associated with the commitment. The amount that we can draw under this
facility is limited to a portion of our eligible receivables. At September 30, 2002, the balance outstanding under this facility was approximately $8.2 million. Under an agreement with a financial institution, we also have the ability to factor
certain Yen denominated receivables and the balance factored at September 30, 2002 was approximately $5.6 million.





From our inception until the completion of our initial public offering in August 2000, we financed our operations primarily through private sales of our common stock and preferred stock and, to a lesser degree, through debt
financings. At September 30, 2002, we had approximately $31.2 million in cash and cash equivalents and restricted cash. We currently anticipate that this amount, together with funds available under our bank and vendor credit facilities, will be
sufficient to meet our anticipated needs for working capital and capital expenditures through the next 12 months at our current operating levels. However, it is likely that we would need to raise additional funds prior to the expiration of this
period to fund additional growth or if we do not realize our expectation of continued operating income and incur operating losses that deplete our working capital, or if we are unable to maintain our existing credit facilities. If we were required
to raise additional funds, it could be difficult to obtain additional financing on favorable terms, if at all. We may try to obtain additional financing by issuing shares of common stock, preferred stock, debt securities, or warrants pursuant to our
effective shelf registration statement or otherwise, which could dilute our existing stockholders. 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.





Following is a table outlining our contractual obligations and
commercial commitments at September 30, 2002:





Payments due by period (in thousands)Total amount committed

Less than 1 year

1-3 years

4-5 years

After 5 yearsContractual obligations:Operating leases

$
2,018

$
824

$
1,129

$
65

$
Other commercial commitments:Standby letters of credit


5,000


5,000








Borrowings


14,100


13,980


120





Total

$
19,100

$
18,980

$
120

$


$
Total contractual obligations and commercial commitments

$
21,118

$
19,804

$
1,249

$
65

$





21




---

##### Table of Contents




Recent accounting developments





In June 2002, the Financial Accounting Standards Board (FASB) issued SFAS No. 146, Accounting for Exit or Disposal Activities (SFAS
146). SFAS 146 addresses significant issues regarding the recognition, measurement, and reporting of costs that are associated with exit and disposal activities, including restructuring activities that are currently accounted for under EITF
No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). The scope of SFAS 146 also includes costs related to terminating a
contract that is not a capital lease and termination benefits that employees who are involuntarily terminated receive under the terms of a one-time benefit arrangement that is not an ongoing benefit arrangement or an individual deferred-compensation
contract. SFAS 146 will be effective for exit or disposal activities that are initiated after December 31, 2002 and early application is encouraged. The provisions of EITF No. 94-3 shall continue to apply for an exit activity initiated under an exit
plan that met the criteria of EITF No. 94-3 prior to the adoption of SFAS 146. The effect on adoption of SFAS 146 will change on a prospective basis the timing of when restructuring charges are recorded from a commitment date approach to when the
liability is incurred.





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 Quarterly Report on Form 10-Q.





Risks Related to Our Business





Our quarterly operating results and gross margins declined significantly in the first quarter of 2001, may
fluctuate significantly in the future and are difficult to predict. If our future results are below the expectations of investors or securities analysts, the market price of our common stock could decline significantly.





Our quarterly operating results and gross margins declined significantly in the first quarter of 2001, and while they have subsequently
improved, they 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:





| | · |  | competitive pricing pressures;
| | - |  | ------------------------------




| | · |  | the rate of growth of the market for digital cameras and digital film;
| | - |  | ----------------------------------------------------------------------




| | · |  | fluctuation in demand for our products;
| | - |  | ---------------------------------------




| | · |  | 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;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | · |  | our ability to estimate revenue reserves for product sales to certain customers;
| | - |  | --------------------------------------------------------------------------------




| | · |  | the timing and amount of expenses related to obsolescence and disposal of excess inventory;
| | - |  | -------------------------------------------------------------------------------------------




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




| | · |  | the difficulty of forecasting and managing our inventory levels;
| | - |  | ----------------------------------------------------------------




| | · |  | the difficulty of forecasting sell-through rates of our products and their impact on inventory levels at our distributors and customers, which may result in
additional orders being delayed or reduced and inventory being returned;
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



22




---

##### Table of Contents




| | · |  | 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 suppliers, particularly our flash memory suppliers;
| | - |  | -----------------------------------------------------------------------------------------------




| | · |  | the availability and pricing of flash memory, particularly high-performance flash memory with increased memory capacity;
| | - |  | ------------------------------------------------------------------------------------------------------------------------




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




| | · |  | the timing and amount of orders and cancellations from existing and new customers;
| | - |  | ----------------------------------------------------------------------------------




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




| | · |  | the timing and manner of revenue recognition for any given customer, including the deferral of revenue from new customers until the product is sold to their
customers or changes in our ability to estimate appropriate reductions in product revenue based upon historical experience which may lead to the deferral of revenue until product is sold to their customers;
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | · |  | any lessening or decline in the trend of sequential increases of the capacity per unit sold of digital storage media;
| | - |  | ---------------------------------------------------------------------------------------------------------------------




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




| | · |  | availability of sufficient silicon wafer foundry capacity to meet customer demand;
| | - |  | ----------------------------------------------------------------------------------




| | · |  | 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 Japanese yen exchange rate;
| | - |  | ---------------------------------------------------------------------------------------




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




| | · |  | commencement of or involvement in litigation;
| | - |  | ---------------------------------------------




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




| | · |  | whether we can sell controllers 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 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 revenues. Any significant shortfall in revenues in relation to our expenses and planned inventories would decrease our net income or increase our operating losses and would also 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. If this were to happen, the market price for our common stock would likely decline significantly.





If we are unable to obtain additional financing for our future capital needs, we may be unable to develop or enhance our products,
expand our operations or respond to competitive pressures.





We had approximately $31.2 million in cash and
cash equivalents and restricted cash as of September 30, 2002. We currently anticipate that this amount, together with funds available under our bank and vendor credit facilities, will be sufficient to meet our anticipated needs for working capital
and capital expenditures through the next 12 months at our current operating levels. However, it is likely that we would need to raise additional funds prior to the expiration of this period to fund additional growth or if we do not realize our
expectation of continued operating income and incur operating losses that deplete our working capital, or if we are unable to maintain our existing credit facilities. If we were required to raise additional funds, it could be difficult to obtain
additional financing on favorable terms, if at all. We may try to obtain additional financing by issuing shares of




23




---

##### Table of Contents

common stock, preferred stock, debt securities, or warrants pursuant to our effective shelf registration statement or otherwise, which could dilute our existing stockholders. 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.





We primarily depend upon Samsung for our flash memory, and if Samsung is unable to provide us with sufficient quantities of flash memory in a timely manner and remain
technologically competitive and competitive on its price and sales terms, or if Samsung were to reduce or eliminate our credit terms, we would not be able to manufacture and deliver digital film to our customers in accordance with their volume,
price and schedule requirements, or we would have to seek alternate suppliers or additional financing.





As a
result of the supply agreement we entered into with Samsung in April 2001, it has become our primary supplier of flash memory, which is a significant component of our digital film. We expect that the demand for flash memory over the next several
years will be substantially greater than in past periods due to the increasing acceptance of digital cameras and other digital consumer products. If we are unable to obtain sufficient quantities of flash memory from Samsung or, if necessary, from
another flash memory supplier in a timely manner we would not be able to manufacture and deliver flash memory products to satisfy our customers requirements. In addition, if Samsung does not offer us sales terms and credit that are sufficient
to meet our growing needs, we might have to seek alternate suppliers or additional financing. Furthermore, if Samsung is unable to ensure that its flash memory is technologically and price competitive or has any interruptions in shipment for any
reason, we may also be unable to satisfy our customers requirements. For example, Samsung is emphasizing smaller flash geometries over multi-level cell technology. If multi-level cell technology can be manufactured in volume at high yields, it
could offer significant cost advantages over single-level cell technologies. If we are unable to satisfy the requirements of our customers, they may reduce any future orders 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. Because we will likely obtain most of our flash memory from Samsung for the foreseeable future, our relationships with other flash suppliers may not be as strong as they had
been in the past. Other flash suppliers may not be able to supply our flash memory needs if we cannot obtain adequate supplies from Samsung. Even if we are able to obtain flash memory in sufficient volume and on schedules that permit us to satisfy
our delivery requirements, we cannot assure you that the prices charged by these suppliers will enable us to compete effectively in our market. Samsung and many other 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. If we are unable to obtain flash memory at economical prices, our margins would decline unless we could raise
the prices of our products in a commensurate manner. The existing competitive conditions may not permit us to do so, in which case we may suffer increased losses or reduced profits.





The solid-state storage market is evolving and future digital film formats may not use our core technology or we may be forced to pay a royalty to sell digital film in
these formats.





Our products may become less useful to our customers if we are unable to respond to
technological advances in our industry or as innovative products become available to our customers. Although the majority of digital cameras currently use Compact Flash, Memory Stick or Smart Media Cards, future digital cameras may use other digital
film formats such as the Secure Digital Card or the recently announced xD Picture Card, formats which we do not currently manufacture. We may have to obtain a license before we are able to manufacture such digital film formats. For example, a
consortium led by SanDisk, Matsushita and Toshiba introduced the Secure Digital Card format and charges license fees to other companies that want to manufacture this product. We currently source such products from third parties. We may be unable to
secure licensing arrangements that give us the right to manufacture these or other future digital film formats at reasonable rates or at all. If we are not able to supply all digital film formats or if we were to have product shortages, our
customers would likely cancel orders or seek other suppliers to replace us. Matrix Semiconductor has announced that it soon plans to introduce a one time programmable memory with significant cost savings over the types of memory that are currently
commercially available. If we are unable to obtain such technology at competitive prices, our business may be




24




---

##### Table of Contents

adversely affected. Further, future digital cameras may use other digital film formats, such as compact discs, rotating media, micro-optical storage or magneto-optical storage, which may not use
our controller technology. For example, DataPlay has introduced a low cost micro-optical device. If these other digital film formats were to gain broad consumer acceptance, demand for our controller technology would decline, which would negatively
impact our gross margins and operating results.





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





We currently compete in an industry characterized by intense
competition, 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 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, 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.





Our primary competitors are companies that sell digital film into the consumer and
original equipment manufacturer digital film markets. These companies are primarily manufacturers with both controller and flash memory capabilities, such as Hitachi, SanDisk and Toshiba. Samsung has recently begun to sell flash memory cards in
larger volumes to third parties, including to our competitors. Hitachi has recently made several announcements that suggest that it has increased its commitment to flash memory. SanDisk and Toshiba now jointly develop and manufacture
high-performance flash memory. Because flash memory represents a significant portion of the cost of digital film, SanDisk may have a competitive advantage in that it will have access to high-capacity flash memory at prices that may be substantially
below the prices that Samsung will charge.





We also compete with manufacturers, package or card assemblers and
resellers that combine controllers and flash memory developed by others, such as Hitachi, Toshiba or SanDisk, into flash memory cards, including Dane-Elec Manufacturing, Delkin Devices, Inc., Fuji, Kingston Technology, M-Systems, PNY, Pretec, Ritek,
Simple Technology, Smart Modular Technologies, Sony Corporation, TDK Corporation, Viking and many others. Additionally, Hitachi and Samsung, as well as flash controller developers such as Solid State System Co. Ltd. (3-S), compete with our
controller and card sales.





Kodak and Fuji are the largest and best-known manufacturers of traditional film
products. Kodak and Fuji have entered the U.S. digital film market, but do not yet manufacture their own digital film. Kodak has also announced that it plans to build on its digital strategy with investments and purchases as it aims to be the number
one player in digital photography. It further stated that it would fund its digital plans from $6 billion in free cash flow between 2001 and 2005. With their resources and worldwide brand recognition, either Kodak or Fuji would be formidable
competitors for our core business. We also expect 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, our digital film, as currently configured, will not be compatible with that product and our revenues may decline.





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





We incurred net losses of approximately $1.6 million for the nine months ended September 30, 2002, and as of September 30, 2002, we had an
accumulated deficit of approximately $137.4 million. Although we sustained profitability in the third quarter of 2002, we cannot assure you that we will be able to sustain profitability in future periods, and we expect to incur negative operating
cash flows during the remainder of 2002. Our ability to sustain profitability depends on the rate of growth of the markets for digital cameras, digital film and digital storage media, the extent to which our products, particularly our higher margin
products, are accepted by these




25




---

##### Table of Contents

markets, our ability to charge a premium for our higher performance products and our ability to adequately control our operating expenses.We also must continue to reduce the costs of
producing and selling our digital film products by controlling our internal and channel inventory, securing the best available pricing for flash cards and components used in our digital film 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 sustain or increase profitability on a quarterly or an annual basis.





We market our digital film primarily on the basis of its superior technology. If we are unable to achieve or maintain technology
leadership, our gross margins and revenues would likely decline significantly.





We market our digital film
primarily on the basis of its performance and technology advantage over our competitors products. In doing so, we have emphasized our speed advantage over our competitors products and have tried to establish ourselves as the brand of
choice among professional photographers. We label our CompactFlash products for 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 with write speeds ranging from 4x to 24x. Our highest capacity card is currently 1 gigabyte. From time to time our
competitors have introduced products for which they have claimed high, sustained write speeds. If we are unable to design and manufacture products that are technologically superior to those of our competitors or if we lose our status as a brand
preferred by professional photographers, 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. 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 gross
margins will be negatively impacted.





Although consumers have recently begun to purchase digital cameras in
volume, they still exert pressure on digital camera manufacturers and on us to lower prices of digital photography products, like our digital film, to prices comparable to those of traditional photography products. Our competitors also impose
pricing pressures on us. 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 original equipment manufacturers, these customers have exerted, and we
expect they will continue to exert, pressure on us to make price concessions. In 2000, 2001 and in the first nine months of 2002, we significantly reduced the prices of many of our digital photography products, and may need to do so in the future to
remain competitive. Any reduction in prices by us will negatively impact our gross margins unless we can manage our internal and channel inventories to minimize such price declines and reduce our costs. We also sell our products to certain customers
on a consignment basis. As a result, our inventory balance at the end of the third quarter included amounts for consigned inventory. Carrying higher levels of consigned inventory may result in additional operational costs. To date, additional
operating costs associated with our consigned inventories have not been significant.





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 gross margins will be adversely affected. We anticipate that our average selling prices will decline as additional flash memory
capacity becomes available in late 2002.





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.





More than half of our product sales in 2001 and in the first three quarters of 2002 were made
through distributors and retailers to which we have provided price protection. In the third quarter of 2002, we incurred approximately $1.9 million in price protection charges, and 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 are not able to estimate future charges, our revenues and gross margins would be adversely affected in future periods.




26




---

##### Table of Contents




Because many of our retail customers and distributors have rights of return,
we may be required to take back large quantities of unsold inventory, which could reduce our revenues.





Substantially all of our sales of our digital film products to end-users are made through distributors and retailers. Our sales through these channels often include rights to return unsold inventory. For sales of some of our
products, we recognize revenue upon shipment of our products, although we establish reserves for estimated returns. Additionally, we permit some of our customers to return products in their inventory for credit or in exchange for new products. 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 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 our customers elect to compete with us in the
digital film market, our revenues and gross margins would likely decline.





We sell our CompactFlash
controllers to companies that could use our controllers to manufacture CompactFlash 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 were to choose to compete directly with us in the digital film market, our revenues and gross margins
would likely decline.





If we are unable to generate increased revenue from licensing our controller technology
for application in other products and selling our controllers on a stand-alone basis to third parties, our gross margins may be negatively impacted and we will have difficulty sustaining profitability.





We have historically derived the substantial majority of our revenues from the sale of our digital film and connectivity products. We
believe, however, that our future growth and ability to sustain profitability may depend on our ability to license our proprietary controller technology for use in new digital photography applications or applications in other markets, such as music,
video and cell phones, and to generate increased revenues from the sales of our controllers. If we fail to generate significant licensing revenues from these activities or increase the revenues we derive from our controller sales, we may not grow
our revenues and margins as planned and we may have difficulty sustaining profitability.





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 third quarter of 2002, sales to the ten customers from which we received the greatest revenues accounted for approximately 66.5% of our total gross
revenues. Our revenues could decline if one or more of these customers were to significantly reduce, delay or cancel their orders, decide to purchase digital film manufactured by one of our competitors, develop and manufacture their own digital film
or cease operations due to the downturn in the global economy or otherwise. In addition, any difficulty in collecting outstanding amounts due from our customers, particularly customers that place larger orders or experience financial difficulties,
would also reduce our revenues. 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 may in the future decide to compete against
us in the digital film 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.




27




---

##### Table of Contents




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.
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 and to identify and eliminate design and product flaws. We may not be able to recoup research and development expenditures if our new products or services are not widely accepted.





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. 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 film products.





We sell a significant percentage of our digital film products to retailers, most notably CompUSA, Ritz, Target, and Wal-mart rather than through original equipment manufacturers. As such, we are subject to many risks,
including the following:





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




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




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




| | · |  | reduction of 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;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| | · |  | retailers may emphasize our competitors products over our products, or decline to carry our products; and
| | - |  | ----------------------------------------------------------------------------------------------------------




| | · |  | continued downward pricing pressure in the retail channel has and could continue to necessitate price protection of the inventories of our products that many of
our customers carry.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



28




---

##### Table of Contents




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 of a potential inability to obtain an adequate supply of components, price increases, late deliveries and poor component quality.





ZETEX Semiconductors is the sole manufacturer of transistors for our CompactFlash and connectivity products, NEC is the sole manufacturer
of connectors for our JumpDrive product and Japan Aviation Electronics Industry, Ltd. (JAE) is the sole manufacturer of the interface circuit for our JumpDrive product. We rely on additional vendors for other critical components. Because we depend
on single suppliers for certain key components, and do not have a long-term supply contract with 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 or be unable to attract new customers.





We also do not manufacture certain flash memory cards such as the SD Card, SmartMedia Card, xD Picture Card or
Multi-Media Card. Until we develop our own flash memory controller for these and other products, we purchase such cards from third parties for resale. We do not have a long-term supply contract with these suppliers, and therefore face the risks of
inadequate supply, price increases, late delivery or unavailability. If our supply of such products is disrupted, our reputation may be harmed and we may lose existing customers or be unable to attract new customers.





We depend on United Microelectronics Corporation, or UMC, to manufacture all of 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. Instead, we rely on a single outside foundry, UMC of Taiwan, to
produce all 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;
| | - |  | ------------------------------------------------------------------------------------------------------




| | · |  | lack of guaranteed production capacity or product supply; and
| | - |  | -------------------------------------------------------------




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




We do not have a long-term supply agreement with UMC and instead obtain manufacturing services on a purchase order basis. UMC has no obligation to supply products to
us for any specific period, in any specific quantity or at any specific price, except as set forth in a particular purchase order. Our requirements represent a small portion of the total production capacity of UMC, and UMC may reallocate capacity to
other customers on short notice, even during periods of high 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. Although we have attempted to diversify our sources of controllers by qualifying other fabs, we cannot assure you
that they will have sufficient capacity to accommodate our demand at any particular time.





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




29




---

##### Table of Contents

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 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 film products, which could result in product shortages or delays or increase our costs of manufacturing, assembling or testing our products.





Our CompactFlash digital film is currently assembled and tested by Venture Manufacturing in the United States and Singapore and also by PC Partner in China. We do not have a long-term agreement with
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, Inc. in Taiwan and Multitech Design
& Test, Inc. in Sunnyvale, California. 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.





Our unit volume has increased substantially over the last year and has strained our operations infrastructure and our supply chain.





Over the last year, the number of units we manufacture on a weekly basis has increased significantly. This significant increase in growth has strained our supply chain and
operations capabilities. 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 or seek other
suppliers to replace us. 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, which could in turn harm our business, financial condition and results of operations.





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 be successful as the digital
photography market continues 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 the expenses associated with doing so become increasingly
high, our business may not grow as we anticipate. In addition, 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 and we may need to grant large stock-based incentives that could be dilutive to our stockholders and 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
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




30




---

##### Table of Contents

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. 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.





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 our digital film products 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 film. 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.





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.





Sales outside of the United States accounted for
36.7% of our total net revenues for the quarter ended September 30, 2002. We generated a majority of our international revenues from licensing agreements in Asia and product sales in Europe and 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. We have begun conducting transactions in the euro, and are
expanding distribution of our products into Latin America. 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 regulator 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




31




---

##### Table of Contents

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.





The sales of our products are denominated primarily in United States dollars. As a result, 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 result in a reduction in sales and profitability. We have product sales denominated in British pounds, Euros and other
European currencies, as well as the Japanese yen. In addition, we anticipate having some sales in Latin American currencies in 2002. To the extent our prices are denominated in foreign currencies, particularly the British pound and Japanese yen, we
will be exposed to increased risks of currency fluctuations.





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. At any point in time, we might use various hedging instruments, primarily 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.





Risks Related to Our Industry





Our business will not succeed unless the digital photography market continues to grow and is accepted by professional, commercial and consumer users.





We currently depend on sales of digital film and connectivity products for a substantial portion of our revenues, which exposes
us to substantial risk in the event the digital photography market does not grow rapidly. The digital photography market is in an early stage of development and is rapidly evolving. The success of this market depends on many factors, including:





| | · |  | the ability of digital cameras to take high-quality photographs;
| | - |  | ----------------------------------------------------------------




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




| | · |  | the availability of digital film 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;
| | - |  | -------------------------------------------------------------------------------------------------------------




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




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




If the digital photography market does not continue to grow and be accepted by professional, commercial and consumer users, our business will not succeed.




32




---

##### Table of Contents




General economic conditions and reduced demand for digital film and related
products may prevent us from achieving targeted revenues and profitability.





Our revenues and our ability to
sustain profitability depends significantly on the overall demand for digital film and related products. Our customers decisions to purchase our products are largely discretionary. The slowdown in the U.S. and global economy may cause
customers to defer or alter purchasing decisions, and accordingly could reduce demand for our products. Softening demand for these products caused by worsening economic conditions has resulted in the past, and may again in the future result, in
decreased revenues. As a result, there is uncertainty with respect to our expected revenues for the balance of 2002, and further delays or reductions in spending on digital film and related products could have a material adverse effect on our
revenues and operating results.





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 which could negatively affect your investment.





The trading price of our common stock has fluctuated significantly since our initial public offering in August 2000 and is significantly below the original offering price of $8 per share. An active
public market for our common stock may not be sustained in the future. 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; 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.





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. We may in the future be the target of similar litigation. Securities
litigation could result in substantial costs and divert managements attention and resources, which could harm our operating results and our business.





If digital camera manufacturers do not develop and promote products that are able to take advantage of our fastest digital film 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. If digital camera manufacturers do not




33




---

##### Table of Contents

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 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. We have been granted patents in the United States and other countries and have a number of 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 near 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. Any potential intellectual property litigation also could force us to do one or more of the following:





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



34




---

##### Table of Contents




| | · |  | 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.
| | - |  | -----------------------------------------------------------------------------------------------




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.





Item 3.    Quantitative and Qualitative Disclosures Regarding Market Risk.





Foreign currency risk.    We sell our products primarily to customers in the U.S. and, to a lesser extent, Japan, Europe 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 and possibly the Euro and Latin American currencies. 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. We will continue to face foreign currency exchange risk in the future. Approximately 24.5% of our product revenues for the nine months ended September 30, 2002 were derived from countries other than the United States.
Therefore, our financial results could be directly affected by weak economic conditions in foreign markets. In addition, a strengthening of the U.S. dollar could make our products less competitive in foreign markets. These risks could become more
significant if 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. At any point in time, we might use various hedge instruments, primarily 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, 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.





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 or (loss). During the third quarter of 2002, we entered into hedges on intercompany payables
denominated in the British pound and Japanese yen. The gains and losses on these contracts were substantially offset by transaction losses and gains on the underlying balances being hedged. In addition, during the third quarter of 2002, we had
foreign currency denominated assets and liabilities that were not hedged. Our net foreign exchange gains (losses) on hedging transactions were $0.1 million for both the three-month and nine-month periods ended September 30, 2002. As of
September 30, 2002, we held forward contracts with an aggregate notional value of $8.0 million to hedge the risks associated with British pound and Japanese yen denominated assets and liabilities. We did not enter into any hedging transactions
during 2001.





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 expense we must pay on our outstanding debt instruments. The risk associated with fluctuating interest expense is limited to the exposure related to those debt
instruments and credit facilities that are tied to market rates. Accordingly, our interest rate risk is comprised of our credit facility with Greater Bay Bank. At September 30, 2002, we had $8.2 million outstanding under this facility. At September
30, 2002, our agreement with Greater Bay Bank provides for interest at an annual rate of the banks prime rate plus 4.5% of the gross amount financed. 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.




35




---

##### Table of Contents




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 chief executive officer and our chief financial officer, based on their evaluation of the effectiveness of our disclosure controls and procedures within 90 days before the filing date of this
report, concluded that our disclosure controls and procedures were effective for this purpose.





Changes in
Internal Controls.    There were no significant changes in our internal controls or, to our knowledge, in other factors that could significantly affect our disclosure controls and procedures subsequent to the date of the
evaluation referenced above.




36




---

##### Table of Contents




PART IIOTHER INFORMATION





Item 1.    Legal Proceedings.





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: 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.





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, 6,145,051, 6,262,918; 6,141,249; and 6,397,314 through the sale of its flash memory products and digital cameras. We are seeking injunctive relief and damages against Fuji.





Litigation with Toshiba





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 intend to contest this lawsuit vigorously.





On November 4, 2002, we filed a lawsuit against
Toshiba Corporation, Toshiba America, Inc. and Toshiba America alleging theft of trade secrets and breach of fiduciary duty. 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 methods of achieving high performance flash devices that Toshiba has now incorporated into its flash chips and flash systems. This lawsuit
is pending in Santa Clara County Superior Court.





Litigation with Simple Technologies





On October 1, 2002, Simple Technologies, Inc. filed a lawsuit against us in Orange County Superior Court
alleging trade libel, libel per se, interference with business opportunities, violation of the California Unfair Competition Act, and violation of the California Unfair Trade Practices Act. SimpleTech is seeking treble and punitive damages. On
October 30, 2002, we removed this case to federal court. It is now pending in the United States District Court for the Central District of the Southern Division of California.





On November 6, 2002, we filed a motion to dismiss SimpleTechs complaint. We believe that SimpleTechs lawsuit is without merit and intend to vigorously defend
ourselves in this matter.





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 on the basis of four patents:
U.S. Patent Nos. 5,818,781; 5,907,856; 5,930,815; and 6,145,051. The Pretec 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, 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




37




---

##### Table of Contents

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.





Item 2.    Changes in Securities and Use of Proceeds.





None.





Item 3.    Defaults Upon Senior Securities.





None.





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





None.





Item 5.    Other Information.





None.





Item 6.    Exhibits and Reports on Form 8-K.





A.    Exhibits





None.





B.    Reports on Form 8-K





We filed a Current Report on Form 8-K on August 14, 2002 reporting under Item 9 that we had submitted to the SEC the certifications of our Chief Executive Officer and Chief
Financial Officer made pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.




38




---

##### Table of Contents




SIGNATURES





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





LEXAR MEDIA, INC./s/    MICHAEL J.
PEREZMichael J. Perez Chief
Financial Officer (Principal Financial Officer and Principal Accounting
Officer)





Date:  November 13, 2002




39




---

##### Table of Contents




CERTIFICATIONS





I, Michael J. Perez, certify that:





1.    I
have reviewed this quarterly report on Form 10-Q of Lexar Media, Inc.;





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





3.    Based on my knowledge, the
financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in
this quarterly report;





4.    The registrants other certifying officer and I are
responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:





a)    designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;





b)    evaluated the effectiveness of the registrants disclosure controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the Evaluation Date); and





c)    presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;





5.    The registrants other certifying officers and I have disclosed, based on our most recent evaluation, to
the registrants auditors and the audit committee of registrants board of directors (or persons performing the equivalent function):





a)    all significant deficiencies in the design or operation of internal controls which could adversely affect the registrants ability to record, process, summarize and
report financial data and have identified for the registrants auditors any material weaknesses in internal controls; and





b)    any fraud, whether or not material, that involves management or other employees who have a significant role in the registrants internal controls; and





6.    The registrants other certifying officers and I have indicated in this quarterly report whether
or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant
deficiencies and material weaknesses.





Date:  November 13, 2002





/s/    MICHAEL J.
PEREZMichael J. Perez Chief
Financial Officer (Principal Financial Officer and Principal Accounting
Officer)




40




---

##### Table of Contents




I, Eric B. Stang, certify that:





1.    I have reviewed this quarterly report on Form 10-Q of Lexar Media, Inc.;





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





3.    Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;





4.    The registrants other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules
13a-14 and 15d-14) for the registrant and we have:





a)    designed such
disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly
report is being prepared;





b)    evaluated the effectiveness of the
registrants disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the Evaluation Date); and





c)    presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;





5.    The registrants other certifying officers
and I have disclosed, based on our most recent evaluation, to the registrants auditors and the audit committee of registrants board of directors (or persons performing the equivalent function):





a)    all significant deficiencies in the design or operation of internal controls which could
adversely affect the registrants ability to record, process, summarize and report financial data and have identified for the registrants auditors any material weaknesses in internal controls; and





b)    any fraud, whether or not material, that involves management or other employees who have a
significant role in the registrants internal controls; and





6.    The registrants
other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most
recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.





Date:  November 12, 2002





/s/    ERIC B.
STANGEric B. Stang President, Chief
Executive Officer and Director




41