CommissionFile No. 1-11712

* *

**SECURITIES AND EXCHANGE COMMISSION**

### WASHINGTON,   D.C. 20549

** **

**FORM 20-F**

**ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF**

**THE SECURITIES EXCHANGE ACT OF 1934**

## For the fiscalyear ended December 31, 2003

** **

**M-SYSTEMS FLASH DISK PIONEERS LTD.**

(Exact name of Registrant as specified in its charterand translation of Registrant`s name into English)

** **

**Israel**

(Jurisdiction of incorporation or organization)

### 7 Atir Yeda St., Kfar Saba,   Israel 44425

(Address of principal executive offices)

** **

Securities registered or to be registered pursuant to Section12(b) of the Act:
| **Title of each  class** | **Name of each  exchange on which registered** |
|--------------------------|------------------------------------------------|
| **N/A**                  | **N/A**                                        |

Securities registered or to be registered pursuant to Section12(g) of the Act:

**OrdinaryShares, nominal value 0.001 New Israeli Shekel per share**

(Title of Class)

Securities for which there is a reporting obligation pursuantto Section 15(d) of the Act:

**None**

(Title of Class)

** **

| Indicate the number of  outstanding shares of each of the issuer`s classes of capital or common stock  as of the close of the period covered by the annual report:                                                                                                                                                                                            |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                          |   | 29,082,615 |
| Indicate by  check mark whether the registrant (1) has filed all reports required to be  filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during  the preceding 12 months (or for such shorter period that the registrant was  required to file such reports), and (2) has been subject to such filing  requirements for the past 90 days: |
|                                                                                                                                                                                                                                                                                                                                                          |   | Yes | X | No |   |
| Indicate by  check mark which financial statements the registrant has elected to follow:                                                                                                                                                                                                                                                                      |
|                                                                                                                                                                                                                                                                                                                                                          |   | Item 17 |   | Item 18 | X |
|                                                                                                                                                                                                                                                                                                                                                          |   |   |   |
|                                                                                                                                                                                                                                                                                                                                                               |  |  |  |  |  |  |

 

**____ 1 ____** 

PRELIMINARY NOTE

** **

**THIS ANNUALREPORT CONTAINS HISTORICAL INFORMATION AND FORWARD-LOOKING STATEMENTS.STATEMENTS LOOKING FORWARD IN TIME ARE INCLUDED IN THIS ANNUAL REPORT PURSUANTTO THE "SAFE HARBOR" PROVISION OF THE PRIVATE SECURITIES LITIGATION REFORM ACTOF 1995. THEY INVOLVE KNOWN AND UNKNOWN RISKS AND UNCERTAINTIES THAT MAY CAUSEOUR ACTUAL RESULTS IN FUTURE PERIODS TO BE MATERIALLY DIFFERENT FROM ANY FUTUREPERFORMANCE SUGGESTED HEREIN, INCLUDING ALL OF THE RISKS AND UNCERTAINTIESDISCUSSED BELOW IN ITEM 3.D "RISK FACTORS" AND ELSEWHERE IN THIS REPORT.FURTHERMORE, WE OPERATE IN AN INDUSTRY SECTOR WHERE SECURITIES VALUES MAY BEVOLATILE AND MAY BE INFLUENCED BY ECONOMIC AND OTHER FACTORS BEYOND THECOMPANY`S CONTROL. FUTURE EVENTS AND ACTUAL RESULTS COULD DIFFER MATERIALLYFROM THOSE SET FORTH IN, CONTEMPLATED BY OR UNDERLYING THE FORWARD-LOOKINGSTATEMENTS AND THUS RELIANCE SHOULD NOT BE PLACED ON THESE FORWARD-LOOKINGSTATEMENTS, WHICH ARE APPLICABLE ONLY AS OF THE DATE HEREOF. IN THE CONTEXT OFTHE FORWARD-LOOKING INFORMATION PROVIDED IN THIS ANNUAL REPORT AND IN OTHERREPORTS, PLEASE REFER TO THE DISCUSSIONS OF RISK FACTORS DETAILED IN, AS WELLAS THE OTHER INFORMATION CONTAINED IN, THIS ANNUAL REPORT AND OUR OTHER FILINGSWITH THE SECURITIES AND EXCHANGE COMMISSION.**

** **

**WE URGE YOUTO CONSIDER THAT STATEMENTS THAT USE THE TERMS "BELIEVE," "DO NOT BELIEVE,""EXPECT," "PLAN," "INTEND," "ESTIMATE," "ANTICIPATE," "PROJECT" AND SIMILAREXPRESSIONS ARE INTENDED TO IDENTIFY FORWARD-LOOKING STATEMENTS. THESESTATEMENTS REFLECT OUR CURRENT VIEWS WITH RESPECT TO FUTURE EVENTS AND AREBASED ON ASSUMPTIONS AND ARE SUBJECT TO RISKS AND UNCERTAINTIES.**

** **

**EXCEPT ASREQUIRED BY APPLICABLE LAW, INCLUDING THE SECURITIES LAWS OF THE UNITED STATES,WE DO NOT INTEND TO UPDATE OR REVISE ANY FORWARD-LOOKING STATEMENTS, WHETHER ASA RESULT OF NEW INFORMATION, FUTURE EVENTS OR OTHERWISE AND WE DISCLAIM ANYOBLIGATION TO PUBLICLY REVISE ANY SUCH STATEMENTS TO REFLECT ANY CHANGE INEXPECTATIONS OR IN EVENTS, CONDITIONS, OR CIRCUMSTANCES ON WHICH ANY SUCHSTATEMENTS MAY BE BASED.**

**____ 2 ____** 

** **
| **INDEX**         |
|-------------------|
|              |
| **PART ONE**      |
| Item 1.           | Identity of Directors, Senior Management and Advisors -  **Not Applicable** |
| Item 2.           | Offer Statistics and Expected Timetable - **Not  Applicable** |
| Item 3.           | Key Information |
| Item 4.           | Information on the Company |
| Item 5.           | Operating and Financial Review and Prospects |
| Item 6.           | Directors, Senior Management and Employees |
| Item 7.           | Major Shareholders and Related Party Transactions |
| Item 8.           | Financial Information |
| Item 9.           | The Offer and Listing |
| Item 10.          | Additional Information |
| Item 11.          | Quantitative and Qualitative Disclosures About Market  Risk |
| Item 12.          | Description of Securities Other Than Equity Securities  - **Not Applicable** |
|              |
| **PART TWO**      |
| Item 13.          | Defaults, Dividend Arrearages and Delinquencies - **Not  Applicable** |
| Item 14.          | Material Modifications to the Rights of Security  Holders and Use of Proceeds - **Not Applicable** |
| Item 15.          | Controls and Procedures |
| Item 16.          | [Reserved] |
| Item 16A.         | Audit Committee Financial Expert |
| Item 16B.         | Code of Ethics |
| Item 16C.         | Principal Accountant Fees and  Services |
| Item 16D.         | Exemptions from the Listing  Standards for Audit Committees |
| Item 16E.         | Purchases of Equity  Securities by the Issuer and Affiliated Purchasers |
|              |   |
|              |
| **PART THREE**    |
| Item 17.          | Financial Statements - **Not Applicable** |
| Item 18.          | Financial Statements |
| Item 19.          | Exhibits |
|              |
| **EXHIBIT INDEX** |
|              |
| ** **        |
|              |
| **SIGNATURES**    |
|              |

**____ 3 ____** 

PART I

 

 

Unless thecontext otherwise requires, all references in this annual report to"M-Systems", "we", "our", "us" and the "Company" refer to M-Systems Flash DiskPioneers Ltd. and its consolidated subsidiaries. References to "dollars" or$ are to United States dollars.

Allreferences herein to "Ordinary Shares" shall refer to our Ordinary Shares,nominal value 0.001 New Israeli Shekel per share.

 

 

# ITEM1.   IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISORS 

 

**- Not applicable**

 

 

# ITEM2.   OFFER STATISTICS AND EXPECTED TIMETABLE 

 

**- Not applicable**

 

 

**____ 4 ____** 

# ITEM3.   KEY INFORMATION

 

#  A.  SELECTED FINANCIAL DATA 

#   

The followingselected summary of financial information was derived from our ConsolidatedFinancial Statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States. The selected summary datashould be read in conjunction with, and are qualified in their entirety by, ourConsolidated Financial Statements and notes thereto, which are presentedelsewhere herein and by reference to "Item 5: Operating and Financial Reviewand Prospects."

Summary Consolidated Financial Information 
|                                                                                                                                | Year ended December 31,               |
|--------------------------------------------------------------------------------------------------------------------------------|---------------------------------------|
|                                                                                                                           | 1999                                  | 2000 | 2001 | 2002 | 2003 |
|                                                                                                                           | (in thousands, except per share data) |
| Statement of Operations Data:                                                                                                  |                                  |   |   |   |   |
| Revenues..........................................                                                                             | $ 30,430                         | $ 92,589 | $ 44,678 | $ 64,817 | $ 130,054 |
| Cost of revenues...............................                                                                                | 20,735                                | 64,281 | 60,573 | 44,415 | 93,114 |
| Gross profit (loss).............................                                                                               | 9,695                                 | 28,308 | (15,895) | 20,402 | 36,940 |
| Operating expenses:                                                                                                            |                                  |   |   |   |   |
| Research and development, net..                                                                                                | 3,137                                 | 7,364 | 13,290 | 11,974 | 14,714 |
| Selling and marketing, net...........                                                                                          | 6,779                                 | 11,535 | 12,122 | 12,547 | 19,419 |
| General and administrative.........                                                                                            | 1,772                                 | 2,809 | 3,913 | 4,000 | 4,852 |
| In-process research and development write-off.................                                                                 | ---                                   | 6,215 | --- | --- | --- |
| Total operating expenses...................                                                                                    | 11,688                                | 27,923 | 29,325 | 28,521 | 38,985 |
| Operating income (loss)....................                                                                                    | (1,993)                               | 385 | (45,220) | (8,119) | (2,045) |
| Financial income, net........................                                                                                  | 217                                   | 5,875 | 4,628 | 2,619 | 2,711 |
| Other income (expenses), net............                                                                                       | ---                                   | --- | (1,193) | --- | 131 |
| Income (loss) before minority interest in losses of a Subsidiary.......                                                        | (1,776)                               | 6,260 | (41,785) | (5,500) | 797 |
| Minority interest in losses of a Subsidiary.........................................                                           | 122                                   | 19 | --- | --- | 117 |
| Net income (loss)..............................                                                                                | $ (1,654)                        | $ 6,279 | $ (41,785) | $ (5,500) | $ 914 |
| Basic net earnings (loss) per share....                                                                                        | $ (0.08)                         | $ 0.25 | $ (1.56) | $ (0.20) | $ 0.03 |
| Diluted net earnings (loss) per share.                                                                                         | $ (0.08)                         | $ 0.22 | $ (1.56) | $ (0.20) | $ 0.03 |
| Number of shares used in computing basic net earnings (loss) per share  (in thousands)........................................ | 19,881                                | 25,368 | 26,716 | 26,953 | 28,178 |
| Number of shares used in computing diluted net earnings (loss) per  share (in thousands)...................................    | 19,881                                | 28,040 | 26,716 | 26,953 | 30,513 |
|                                                                                                                           |                                  |   |   |   |   |

* *

**____ 5 ____** 

Summary Consolidated Financial Information (cont.)

 
|                                                                                                               | Year ended December 31, |
|--------------------------------------------------------------------------------------------------------------------|-------------------------|
|                                                                                                               | 1999                    | 2000 | 2001 | 2002 | 2003 |
|                                                                                                               | (in thousands)          |
| Balance Sheet Data:                                                                                                |                    |   |   |   |   |
| Cash, cash equivalents, short-term

bank deposits, short term and long term marketable securities................. | $ 6,230            | $ 120,476 | $ 97,236 | $ 94,094 | $ 79,807 |
| Working capital.................................                                                                   | 15,710                  | 155,694 | 87,264 | 70,297 | 65,827 |
| Total assets.......................................                                                                | 26,791                  | 185,251 | 145,451 | 148,202 | 180,488 |
| Shareholders` equity.........................                                                                      | 17,474                  | 172,799 | 133,051 | 128,290 | 140,625 |
| * *                                                                                                           |                    |   |   |   |   |

* *

#   

#  B.  CAPITALIZATION AND INDEBTEDNESS 

#   

 

**- Not applicable**

 

 

#  C.  REASONS FOR THE OFFER AND USE OF PROCEEDS 

#   

 

**- Not applicable**

 

 

#  D.  RISK FACTORS

#   

*You should carefully consider the risks described belowand in the documents we have incorporated by reference into this annual reportbefore making an investment decision. The risks described below and in thedocuments we have incorporated by reference into this prospectus are not theonly ones facing our company. Our business, financial condition or results ofoperations could be materially adversely affected by any of these risks. Thetrading price of our Ordinary Shares could decline due to any of these risks,and you may lose all or part of your investment.*

** **

**RISKS RELATED TOOUR BUSINESS AND PRODUCTS**

**We have a history of losses andalthough recently turned profitable we may incur additional losses in thefuture.**

We have ahistory of losses. Other than the year 2000 and the year 2003, in which we wereprofitable on an annual basis, we have incurred losses in each of our last tenyears of operation. As of March 31, 2004, we had an accumulated deficit ofapproximately $ 52.5 million. We will need to generate increased revenuesas well as manage our costs to maintain our recent profitability. We cannotassure you that we will be able to achieve or maintain profitability.

**____ 6 ____** 

**Our quarterly operating resultshave fluctuated significantly in the past and may fluctuate significantly inthe future, which may adversely impact the price of our shares.**

Our quarterlyoperating results have fluctuated significantly in the past and we expect thatthey will continue to fluctuate in the future. This fluctuation might cause ourquarterly operating results in future periods to be below the expectations ofsecurities analysts and investors. If that occurs, the market price of our OrdinaryShares could be materially and adversely affected.

**Our relative mix of product andcustomers varies quarterly, which can negatively affect our gross margins.**

Our productand customer mix varies quarterly, which affects our overall average sellingprices and gross margins, due to varying sales prices for different customersand varying margins for different products. For instance, our DiskOnKeyproducts, which currently represent the majority of our product revenues, havelower gross margins than our DiskOnChip products. Similarly, sales of ourDiskOnChip products to the market for high end cell phones and personal digitalassistants ("High-End Mobile Devices") have lower gross margins than sales ofour DiskOnChip products to the market for set-top boxes and thin clients("Embedded Devices"). Because our DiskOnKey products are ultimately sold toretail customers, these products may represent a higher proportion of ourrevenues in the fourth quarter, when there is generally greater demand forretail products in Western countries. Some of our DiskOnChip customers mayconcentrate their purchases in certain quarters, which could lead tofluctuations in the proportion of revenues represented by these products on aquarterly basis. In addition, overall market demand for any of our productscould vary on a quarterly basis, and this could result in shifts in ourrelative product mix. Depending on the relative mix of sales of our variousproducts as well as the mix of customers, our gross margins could fluctuatesignificantly from quarter to quarter and may be negatively affected in anygiven quarter. 

**We are dependent on DiskOnKey andDiskOnChip for the vast majority of our sales. As a result, our business willsuffer if demand for any of these products declines or if we cannot develop newproducts to meet the needs of our customers.**

The vastmajority of our sales are generated by our DiskOnKey and DiskOnChip products,which accounted for 76%, 87% and 91% of our sales in 2001, 2002 and 2003respectively. If other companies were to develop products with similar orbetter features, similar or better performance or wider acceptance than ourDiskOnKey or DiskOnChip products, sales of our products could decline. Ifdemand for any of these products declines, and we cannot develop new productsthat meet the needs of our customers, our sales would decline. Any significantdecrease in the sales of our DiskOnKey or DiskOnChip products would have amaterial adverse effect on our business, financial condition and results ofoperations.

**The amount of royalties payable tous from third parties varies quarterly and may decline in the future, which cannegatively affect our gross margins and results of operations**

The royaltiespayable to us from our patent cross license and other agreements are variableand fluctuate from period to period making it difficult to predict our royaltyrevenues. Our intellectual property strategy consists of licensing our patentsand technology to manufacturers of flash memory and other third parties.Under these arrangements, we earn license fees and royalties on individuallynegotiated terms. Our income from licenses and royalties can fluctuatesignificantly from quarter to quarter as a portion of this income comes fromroyalties based on actual sales by our licensees. As a result, our license androyalty revenues have fluctuated in the past and are likely to continue tofluctuate in the future. Given the relatively high gross margins associatedwith license and royalty revenues, gross margins and net income are likely tofluctuate more with changes in license and royalty revenues than with changesin product revenues. Our license and royalty revenues may decline in the futureas our existing license agreements expire or caps are reached.

**____ 7 ____** 

**Our revenues and gross marginshave been, and in the future may be, adversely affected by volatility in themarket price of flash memory components.**

For most ofour products, we rely to a significant extent on the purchase of flash memorycomponents or custom made products incorporating flash components from thirdparty manufacturers and distributors. As a result, we are exposed to the risksassociated with the volatility of the price of flash components. 

In the eventof a sharp decline in the price of flash components, the value of our inventorywill fall and we may be compelled to write-down the value of our inventory,which may result in a significant decrease in our gross margins. In addition,we may need to reduce significantly our selling prices, which may result in adecline in our revenues and gross margins. For example, during the first halfof 2001, flash component prices decreased significantly both due to theworldwide economic slowdown and the excess supply of flash components. Thisprice decrease caused our revenues to decline significantly and required us towrite-down $ 30.2 million of our inventory in the first half of 2001.

Alternatively,in the event that the market price for flash components increases (for example,as a result of increased demand for any reason or due to flash memory supplyconstraints), we may be unable to pass these price increases on to ourcustomers and, consequently, our gross margins could be adversely impacted. Forexample, in the third quarter of 2003, due to increased demand for consumerelectronic products, such as USB flash drives and flash memory cards fordigital cameras, demand for flash memory components exceeded available supply,causing flash memory component prices to rise. Due to the higher prices forflash components in the quarter, our gross margins declined to 27%, as comparedto 32% in the second quarter of 2003. Moreover, due to supply constraints, oursuppliers did not allocate to us sufficient flash memory components to enableus to meet the orders of all our customers, forcing us to decline orders orshift product orders to the following quarter.  We expect flashmemory supply constraints to continue in the coming quarters, which willcontinue to adversely impact our gross margins.  If flash componentprices increase in the future, our gross margins could suffer, or we may not beable to sell our products at a profit, resulting in a loss of revenues andmarket share or in net losses. 

**There is seasonality in ourbusiness, which may lead to fluctuations in our product sales, which couldadversely affect our sales in the first quarter of the fiscal year.**

Sales of ourDiskOnKey products to the consumer electronics market may be subject toseasonality arising from the seasonal purchasing patterns of consumerend-users. 

**High levels of inventory couldadversely affect our gross margins.**

We mayaccumulate a higher level of inventory of raw materials, including flashcomponents, and finished goods than we need due to various reasons including: 
| ●*          *  | an anticipation of a shortage  in components; |
|-----------------------------------------------------------------------------|-----------------------------------------------|
| ●*          *  | unrealized sales forecasts;                   |
| ●*          *  | long-term commitments to our  suppliers;      |
| ●*          *  | cancellation of orders from  customers; and   |
| ●*          *  | an anticipation of an increase  in prices.    |

In the eventthat we maintain large amounts of inventory, certain components or products, ifwarehoused for too long, might be rendered obsolete, which might cause us toincur an inventory write-off. 

**Our expected growth may strain ouroperations infrastructure and our supply chain.**

Over the lasttwelve months, our revenues have grown significantly in response to increasedcustomer demand. If this growth continues, it may strain our operationsinfrastructure and supply chain. To meet this growth, we will need to hire,train and manage additional employees. We also will need to identify and manageadditional third party subcontractors to accommodate the growth. In addition,our logistical infrastructure, systems, procedures and controls may not beadequate to support rapid growth, which could adversely affect our business,financial condition and results of operations. 

**____ 8 ____** 

**We depend on our key personnel,including our executive officers, the loss of whom could disrupt our business.**

Our successgreatly depends on the continued contributions of our senior management andother key research and development, sales, finance, marketing and operationspersonnel, including Mr. Dov Moran, our Chairman, President and Chief ExecutiveOfficer. We cannot assure you that we will be successful in retaining our keypersonnel. Any loss of the services of these key personnel could adverselyaffect our business, at least until a suitable replacement is identified, hiredand acclimated.

**We will not be able to sustaincontinued growth unless we are successful in attracting and retainingadditional qualified personnel.**

The successof our business depends on our ability to attract and retain highly qualifiedmanagement, technical, sales, finance and marketing personnel. In particular,we require highly qualified technical personnel who are capable of developingtechnologies and products and providing the technical support required by ourcustomers. Individuals who possess these qualifications are in high demand, andwe may not be successful in attracting, integrating and retaining them when andas needed in the various geographic regions in which we operate. In the past,we have from time to time experienced difficulty hiring the necessaryengineering, sales and marketing personnel to support our growth.

**Our revenues and gross margins maybe adversely affected by reduced activity in our customers` markets.**

As a resultof the continued worldwide economic slowdown, many of our customers may reducetheir spending, or increase their spending at slower rates than we anticipated,and may delay or cancel the development of new products. In addition, demandfor new products incorporating our products - such as High-End Mobile Devicesfor our DiskOnChip product line or for new lap-top computers and PCs for ourDiskOnKey product line may slow, resulting in reduced demand for our products.As a result, our revenues may decline, and our inventory levels may increase.To the extent our revenues decrease or our inventory levels increase in anenvironment of decreasing flash product prices or as a result of continuinglowered demand for our products, our gross margins and operating results may beadversely affected. 

**Our business depends significantlyupon sales of products in the consumer market. This market is extremelycompetitive and is highly susceptible to fluctuations in demand due to changesin general economic conditions.**

Our DiskOnKeyand Mobile DiskOnChip products are targeted for consumer electronicsapplications. The consumer market is intensely competitive and is more pricesensitive than our other target markets. Sales of consumer electronic productshave historically been dependent upon discretionary spending by consumers,which may be adversely affected by general economic conditions. The slowdown inthe U.S. and global economy may cause consumers to defer or alter purchasingdecisions, and accordingly could reduce demand for our products or products ofour customers which incorporate our products. Softening demand for theseproducts caused by worsening economic conditions has in the past caused, andmay again in the future cause, decreased revenues. As a result, there isuncertainty with respect to our expected revenues, and further delays orreductions in consumer spending on electronics and related products couldadversely affect our revenues and operating results. 

**We depend on the ability oforiginal equipment manufacturers, or OEMs, and consumer electronics companieswho purchase our products to achieve broad market acceptance for theirproducts. If these OEMs and consumer electronics companies do not succeed inselling their products, this will reduce demand for our products and ourrevenues will be adversely affected.**

Our customersare primarily OEMs and consumer electronics companies, who repackage or resellour products under private label to consumers or incorporate our products intoproducts which are then sold to consumers. We are dependent upon the success ofour customers and the broad market acceptance of their products. To the extentthat consumers choose to purchase Universal Serial Bus ("USB") flash datastorage devices and High End Mobile Devices from competitors of our customers,our revenues and operating results will be adversely affected.

**____ 9 ____** 

**Undetected hardware and softwareerrors or defects may increase our costs and impair the market acceptance ofour products.**

Our productsmay contain undetected errors or defects. These could result either from errorsor defects in components or products designed or manufactured by us that wefail to detect, or errors or defects in components supplied by third parties.Some of our customers integrate our products into their applications togetherwith products they acquire from other vendors. As a result, when problems occurin an application, it may be difficult to identify the component that causedthe problem. Regardless of the source of these errors or defects, we will needto divert the attention of engineering personnel from our product developmentefforts to address the detection of the errors or defects. These errors ordefects could cause us to incur warranty or repair costs, liability claims orlags or delays. We could be forced to recall products that were already soldinto the market by our customers. Our insurance policies may not providesufficient protection should a claim be asserted against us. Moreover, theoccurrence of errors or defects, whether caused by our products or the productsof another vendor, may significantly harm our relations with customers, orresult in the loss of customers, injure our reputation and impair marketacceptance of our products.

**We may make investments incompanies or technologies, which may distract our management and disrupt orotherwise harm our business, and if consummated, may be unsuccessful.**

One of ourstrategies is to make investments in complementary businesses, technologies orproducts if appropriate opportunities arise, including investments aimed atsecuring additional sources of supply of flash memory components. We have madeseveral investments in companies or assets of companies in the past and we mayin the future invest in additional businesses, products or technologies. Theseinvestments could disrupt our ongoing business, distract our management andemployees, increase our expenses and adversely affect our results ofoperations. We may incur indebtedness or issue equity securities to pay for anyfuture investments. The issuance of equity securities could be dilutive to ourexisting shareholders. Alternatively, investments made with cash may reduce ourcash reserves. In addition, any investment in another company will be subjectto the risks faced by that company. To the extent that any company in which weinvested in the past or any company in which we invest in the future thereafterloses value or does not succeed, we may lose part or all of our investment. Wemay also have to write-down the value of our investment in our financialstatements to the extent that the carrying value exceeds its fair market value.

**We may make acquisitions thatresult in difficulties in integrating the operations, personnel, and productsof the acquired companies or result in significant charges or otherwiseadversely affect our results of operations.**

We may growour business through acquisitions of companies, products or technologies thatallow us to expand our existing product offerings or sales channels or enhanceour technological capabilities. We cannot assure you that we will be able toidentify suitable acquisition candidates in the future, or if we do identifysuitable candidates that we will be able to make the acquisitions oncommercially acceptable terms or at all. If we acquire another company, wecould encounter difficulty integrating that company`s personnel, operations,technology and products into our own. The key personnel of the acquired companymay decide not to work for us. These difficulties could disrupt our ongoingbusiness, distract our management and employees, increase our expenses andadversely affect our results of operations. We may incur indebtedness or issueequity securities to pay for any future acquisitions, which could be dilutiveto our existing shareholders. Alternatively, acquisitions made entirely orpartially for cash may reduce our cash reserves. Furthermore, acquisitions mayrequire one-time charges and can result in increased debt or contingentliabilities, adverse tax consequences, amortization of intangible assets orimpairment of goodwill, any of which could negatively impact our results ofoperations. Any of these events could cause the price of our Ordinary Shares todecline.

**____ 10 ____** 

**Our DiskOnChip products generallyhave a long sales cycle, which increases our costs in obtaining orders andreduces the predictability of our earnings.**

OurDiskOnChip products are technologically complex and are typically intended foruse in applications that may be critical to the business of our customers.Prospective customers for DiskOnChip generally must make a significantcommitment of resources to test and evaluate our products and to integrate theminto their applications. As a result, our sales process for DiskOnChip is oftensubject to delays associated with lengthy approval processes that typicallyaccompany the design and testing of new products. The sales cycles of ourDiskOnChip products to new customers currently average approximately 12-24months from the time we make a proposal to a customer until the time the customerbegins to commercially manufacture its product. This requires us to investsignificant resources to make sales, which increases our costs in obtainingorders and reduces the predictability of our sales.

Long salescycles also subject us to risks not usually encountered by companies whoseproducts have short sales cycles, complicating our planning processes andreducing the predictability of our earnings. These risks include:

 
| ●*          *  | the potential cancellation of  orders based on customers` changing budgetary constraints;                                       |
|-----------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------|
| ●*          *  | the shift in orders expected  in one quarter to another quarter because of the timing of customers`  procurement decisions; and |
| ●*          *  | the unpredictability of  internal acceptance reviews.                                                                           |

**Sales to a small number ofcustomers represent a significant portion of our revenues. If we were to loseany of our significant customers, or if we experience a reduction in demandfrom them, our revenues and operating results would suffer.**

More thanhalf of our revenues come from a small number of customers. Specifically, salesto our top three customers accounted for approximately 19% of our revenues in2001, 34% in 2002 and 30% in 2003, and sales to our top 10 customers accountedfor approximately 47% of our revenues in 2001, 56% in 2002 and 55% in 2003. Inaddition, in 2003, sales to one of our customers represented 15.6% of revenues.If we were to lose any of our significant customers or experience any materialreduction in orders from these customers, our revenues and operating resultswould suffer. Because our sales are made by means of standard purchase ordersrather than long-term contracts, we cannot assure you that these customers willcontinue to purchase quantities of our products at current levels, or at all.In particular, due to the nature of the market for our DiskOnKey products, thefact that a customer can, with relatively little effort and investment, movefrom our product to a product of a competitor and the relative ease with whichour customers may terminate their business relationship with us, we mayencounter a severe reduction in sales of our DiskOnKey products over a veryshort period of time. In addition, the composition of our major customer basechanges from year to year as the market demand for our customers` productschange, and as we introduce new or improved products targeted at different oradditional markets. We expect our operating results for at least the nextseveral years to continue to depend on sales to a relatively small number ofcustomers.

**Increased expense levels andsignificant fixed costs will harm our business if our revenues do not grow.**

We havesignificant fixed costs and we cannot readily reduce these expenses over theshort term. We expect our operating expenses to increase due primarily toplanned increases in sales and marketing and research and developmentactivities to support our growth plan. If our revenues do not increaseproportionately to our operating expenses, or if revenues decrease or do notmeet expectations for a particular period, and we are not able to reduce ourexpenses in the short term, or at all, our business, financial condition andresults of operations will be adversely affected.

**____ 11 ____** 

**Our stock price has been, and maycontinue to be, volatile for various reasons, including the volatility anddownturn in share prices for technology companies generally and companies inour industry specifically.**

The marketprice of our stock has fluctuated significantly in the past and is likely tocontinue to fluctuate in the future. For example, between January 1st, 2001 andMay 1st, 2004, our closing stock price has fluctuated from a low of $ 3.92to a high of $ 23.15. We believe that fluctuations will continue as aresult of, among other things, the factors discussed herein and as a result ofannouncements by us, our competitors or third parties (such as industry andresearch analysts) regarding our business, the business of our competitors, ourmarkets, technological innovations, or changes in earnings estimates. Inaddition, in recent years the stock market has experienced significant priceand volume fluctuations and the market prices of the securities of hightechnology companies have been especially volatile, often for reasons outsidethe control of these companies. These fluctuations, as well as general economic,political and market conditions, including certain conditions related to theState of Israel (see in "Risks Related to Our Israeli and InternationalOperations"), may have an adverse effect on our stock price. In the past,securities class action litigation has often been brought against companiesfollowing periods of volatility in the market price of their securities. We maybe the target of similar litigation in the future. Securities litigation couldresult in substantial costs and divert our management`s attention andresources, which could cause serious harm to our business. 

**Certain provisions of our Articlesof Association and of Israeli law could delay, hinder or prevent a change inour control.**

Our Articlesof Association contain provisions that could make it more difficult for a thirdparty to acquire control of us, even if that change would be beneficial to ourshareholders. Specifically, our Articles of Association provide that any mergeror significant acquisition involving us requires the approval of 75% of thevoting power of our shareholders present at a meeting, in person or by proxy,and voting on the transaction. This provision of our Articles of Associationcan only be amended by the same supermajority shareholder vote required forapproval of a merger or acquisition transaction. In addition, certainprovisions of the Israeli Companies Law 1999, which came into effect onFebruary 1, 2000, could also delay or otherwise make more difficult a change inour control.

 

** **

**RISKS RELATED TODEVELOPMENT AND MARKETING OF NEW PRODUCTS**

** **

**We will not be able to sustain ourgrowth unless the emerging markets for our products, and for those productsthat incorporate our products, continue to grow, and unless we are able to meetthe changing needs of these emerging markets.**

Sales of ourDiskOnChip products accounted for approximately $41.0 million of our revenues in2003, an increase of 39% as compared to DiskOnChip sales in 2002. Sales of ourDiskOnChip products are directly related to the demand for High-End MobileDevices and Embedded Devices. High-End Mobile Devices and Embedded Devices arestill relatively new products, and we cannot assure you that they will achievemarket acceptance, that demand for these products will grow or that ourproducts will be included in the High-End Mobile Devices and Embedded Devicesthat achieve broad market acceptance. Most High-End Mobile Devices currently donot use or need embedded flash memory for data storage and we cannot be surethat the requirement for embedded data storage in that market will grow or thatHigh-End Mobile Device designers and OEMs will choose to use the DiskOnChip. Ifsales of High-End Mobile Devices and Embedded Devices do not grow, or ifsuccessful High-End Mobile Devices or Embedded Devices do not incorporate ourproducts, then sales of our DiskOnChip products will decrease or will not growas anticipated. This would reduce our profitability, if any, or increase ourlosses. 

**____ 12 ____** 

Sales of ourDiskOnKey products accounted for approximately $ 77.6 million of ourrevenues in 2003, an increase of 190% as compared to DiskOnKey sales in 2002. Themarket for our DiskOnKey products is a relatively new market that provides anew solution for personal and secured data storage, enabling easy transfer ofdata between different computers and other applications through the USB dataport found on the majority of computers and similar devices. We cannot be surethat the need for such new products will develop, that demand for theseproducts will grow or that our products will be accepted as the preferredsolution by OEMs, consumer electronics companies and consumer end-users. If thedemand for USB compatible personal flash data storage devices does not grow, orthe DiskOnKey is not chosen by the relevant OEMs, consumer electronic companiesand consumer end-users as their preferred solution, then sales of our DiskOnKeyproducts to this market will not develop or grow as anticipated. This wouldreduce our profitability, if any, or increase our losses. 

**Our business will be harmed if wefail to anticipate new technological changes or to introduce new products in atimely manner.**

The marketfor our products is characterized by rapidly changing technology and evolvingindustry standards. The introduction of products embodying new technology andthe emergence of new industry standards could render our existing productsobsolete and unmarketable. Although we design our products to fit and matchcertain market standard interfaces, some of these interfaces may change over arelatively short period which may cause our then existing products to becomeobsolete while possibly enabling competing products. Our ability to anticipatechanges in technology and industry standards and interfaces and to successfullydevelop and introduce new and enhanced products on a timely basis will be acritical factor in our ability to grow and to remain competitive. In addition,the anticipated development schedules for high technology companies areinherently difficult to predict and are subject to change as a result ofshifting priorities in response to customers` requirements and productintroductions from competitors. Our inability, for technological or otherreasons, to develop products and product enhancements that are technologicallycompetitive, responsive to customer needs or competitively priced wouldadversely affect our business, financial condition and results of operations.

**In transitioning to newtechnologies and processes, we face design and production risks that may causesignificant product delays that could harm our business.**

The flashmemory market continues to enjoy successively higher memory capacities at lowercosts per megabyte due to the implementation over time of more advancedtechnologies and manufacturing processes. Our success depends on our ability tocontinuously redesign our products to integrate with the latest flash memorytechnologies and manufacturing processes. The transition to new technologiesand processes is highly complex and requires new designs, components, testing andqualification processes. We cannot assure you that we will be able to timelyadapt our products to new emerging technologies or offer such new products atcompetitive prices, or that we will not suffer from design and quality issuesin connection with the transition to new technologies. We cannot assure youthat we, along with our suppliers and subcontractors, will successfully developand bring into full production with acceptable yields and reliability productsbased on these technologies and processes, or that any development orproduction ramp-up will be completed in a timely or cost-effective manner. Ifwe are not successful in adapting to new technologies or if our transition tothese new technologies is too slow or too costly, our business, financialcondition and results of operations could suffer.

** **

**____ 13 ____** 

**RISKS RELATED TOTHIRD PARTY MANUFACTURERS, SUPPLIERS AND SUBCONTRACTORS**

** **

**We depend on Toshiba Corporation("Toshiba") and Samsung Electronics Co., Ltd. ("Samsung") for flash memorycomponents and any shortage or disruption in our supply from these sources orachievement of lower yield than expected will adversely affect our results.**

Our flashmemory based products require flash memory components, which are currentlysupplied by Toshiba and Samsung. We recently secured commitments from bothToshiba and Samsung to provide us with a specified portion of their respectiveflash component manufacturing capacity. We expect that we will depend uponToshiba and Samsung for a significant portion of our anticipated flash memoryrequirements. In the past, our suppliers have, at times, been unable orunwilling to meet our supply needs, which has adversely affected our operatingresults. If either Toshiba or Samsung fails to comply with its supplycommitment to us, in terms of volumes and or pricing of flash, or closes downor downsizes its flash business, our business, financial condition andoperating results will be adversely affected. In addition, if either Toshiba orSamsung terminates its supply relationship with us at any time, our business,financial condition and operating results will be adversely affected. In theevent that we are supplied by Toshiba or Samsung with flash memory componentswith low yield, our operating results and our ability to supply products to ourcustomers will be adversely affected. Any disruption in supply from thesesources due to natural disaster, power failure, labor unrest or other causes,could significantly harm our business, financial condition and results ofoperations. In addition, if our flash suppliers do not continue to invest inthe required advancements to their flash technology and flash products, ourbusiness, financial condition and operating results may suffer. 

**Difficulty in estimating supplyrequirements may cause us to overestimate our requirements and build excessinventories, or underestimate our requirements and have a shortage of supply,either of which will harm our financial results.**

Under theterms of our agreements with Toshiba and Samsung, we are obligated to provideadvance rolling forecasts of anticipated requirements for components that weuse to manufacture some of our products. Because a significant portion of ourproducts is sold into emerging consumer markets, it is difficult to accuratelyforecast future sales. In addition, sales visibility remains limited because asubstantial majority of our quarterly sales are from orders received andfulfilled in the same quarter, which makes accurate forecasting difficult.Generally, the estimates for the first few months of each rolling forecast weprovide to Toshiba and Samsung are binding commitments and cannot be cancelledand the estimates for the remaining months of the forecast may only be changedby a certain percentage from the previous month's forecast. This limits ourability to react to fluctuations in demand for our products. If weunderestimate our needs when we place orders, we may be unable to meet ourcustomers' demands, and we could lose revenues and market share to ourcompetitors. Alternatively, if we overestimate our need for products, we couldincrease our inventory levels, which could result in reduced gross margins.Either of these situations could have a material adverse effect on ourbusiness, financial condition and operating results.

**If our flash memory suppliers areunable to provide us with sufficient quantities of flash memory in a timelymanner at competitive prices, we would have to seek alternate suppliers, whichmay not be available, and this would adversely affect our results.**

If we areunable to obtain sufficient quantities of flash memory from Toshiba and Samsungat competitive prices, or if Toshiba or Samsung are unable or unwilling totimely satisfy our requirements on competitive terms, and other flash memorysuppliers do not meet our additional capacity requirements in a timely mannerand at competitive prices, we would not be able to manufacture and deliverflash memory products to satisfy our customers` requirements. If we are unableto satisfy the requirements of our customers or supply them in the volumes theyrequest, they will likely reduce future orders or eliminate us as a supplier.Our reputation would likely also be harmed and we may not be able to replaceany lost business with new customers. Even if we are able to obtain flashmemory in sufficient volumes and on schedules that permit us to satisfy ourdelivery requirements, we cannot assure you that the prices charged by thesesuppliers will enable us to compete effectively in our market. If we are unableto obtain flash memory at competitive prices, our margins would decline unlesswe could raise the prices of our products in a commensurate manner or offsetthe cost increases elsewhere. The existing competitive conditions may notpermit us to do so, which would adversely impact our gross margins andoperating results.

**____ 14 ____** 

**We depend on Toshiba as a singlesource to manufacture our Mobile DiskOnChip, DiskOnChip Millennium andDiskOnChip Millennium Plus products, and we expect to be dependent on it as asingle source for future DiskOnChip products. Any delay or disruption in ourreceipt of these products from Toshiba will adversely affect our results.**

We developedour Mobile DiskOnChip, DiskOnChip Millennium and DiskOnChip Millennium Plusproducts as part of a strategic relationship with Toshiba. At present, Toshibais our sole manufacturer of the Mobile DiskOnChip, DiskOnChip Millennium andDiskOnChip Millennium Plus products. In addition, we are working with Toshibaon the joint development of future DiskOnChip products, for which they will bethe sole source of supply as well. Toshiba not only provides the flashcomponents but also manufactures and assembles the finished product. If Toshibawas to breach its obligations under its agreements with us, close down ordownsize its flash business, experience manufacturing problems or delays forany reason, including difficulty in obtaining sufficient raw materials, workstoppages, excessive demand for its manufacturing capacity or other causes, wemay be unable to fill our customers` orders for these product or unable tofulfill them in a timely fashion, which would result in lost sales andsignificantly lower revenues. We are seeking to develop with othermanufacturers products that will be comparable to the DiskOnChip although possessingdifferent features and capacity. This will require additional hardware andsoftware development, and we cannot assure you that we will be successful indeveloping such comparable products or that such other manufacturers willsucceed in delivering products which are of similar cost, quality andfunctionality.

**We depend on a limited number ofthird party subcontractors to manufacture and assemble our DiskOnKey products,and any delay or disruption in the supply of these products will adverselyaffect our results.**

We rely on alimited number of third party subcontractors. In particular, we have agreementswith AboCom Ltd., Global Brands Manufacturing Limited, or GBM, and CelesticaItalia S.r.l. to manufacture and assemble most of our DiskOnKey products. Anysignificant problems that occur at our subcontractors, or their failure toperform at the level we expect, could lead to product shortages or qualityassurance problems, either of which could increase the manufacturing costs ofour products and have adverse effects on our operating results. If any of oursubcontractors are unable or unwilling to continue to manufacture, assemble anddeliver products of acceptable quality, at acceptable costs and in a timelymanner, due to conditions in their respective countries or otherwise, ourfuture results might be adversely affected. In addition, we do not havelong-term contracts with our subcontractors. As a result, these subcontractorsmay terminate their relationships with us at any time, generally upon advancenotice. In either case, we would be required to qualify new subcontractors,which could take as long as six months, as well as result in unforeseenoperations problems, and our results may be adversely affected. 

**We depend on third parties for thesupply and quality of components required for the manufacture of our products,and any delay or disruption in the supply of these products will adverselyaffect our results.**

We rely onthird parties to manufacture and supply components for our products, includingthe capacitors, printed circuit boards and the application specific integratedcircuit ("ASIC") components used in our DiskOnKey and in some of our DiskOnChipproducts. For some components, we rely on a single source of supply, such asAtmel Sarl which supplies us with certain ASIC components for our DiskOnKeyproducts. Because we depend on single suppliers for certain key components, anddo not have a long-term supply contract with our suppliers, we face the risk ofinadequate component supply, price increases, late deliveries and poorcomponent quality, as any supplier may terminate their relationships with us orpursue other relationships with our competitors. If we were to lose ourrelationship with these suppliers, the lead time required to qualify newsuppliers could be as long as six months. Also, if we lose our single suppliersor these suppliers are otherwise unable to satisfy our volume and deliveryschedule requirements, it may be difficult to locate any suppliers who have theability to develop, manufacture and deliver the specialized components we needfor our products in the desired lead times and quality.

Our componentsuppliers are often operating at peak capacity. At times, the demand forcomponents used in our products has exceeded available supply, and suppliershave raised prices and/or been forced to allocate limited resources amongcompeting purchasers. On certain occasions we have been unable to obtainadequate supplies of certain components, which has resulted in delayed or lostsales of our products. In other cases, we have been required to keep unusuallylarge component inventories in order to avoid shortages. We cannot assure youthat shortages will not occur in the future. 

**____ 15 ____** 

Furthermore,if we experience quality problems from any of our component suppliers, it couldtake us a significant amount of time to identify the problem as associated witha particular component, ascertain whether this is as a result of a design or amanufacturing flaw and either correct the problem, if possible, replace thecomponents or find an alternate source of supply. Any such quality problem ordelay could, in addition to causing us lost sales, detrimentally affect ourreputation in the market and cause us to incur additional costs as a result ofthe recall and replacement of affected products. 

**Loss of or damage to inventoryheld by our subcontractors could damage our relationships with our customers.**

Some of ourinventory is held directly by our third party subcontractors and is outside ofour physical control. We may be exposed to additional risks relating to thisinventory, including loss of or damage to the inventory. In the event thatinventory held by our third party subcontractors is damaged and we are unableto timely replace that inventory, we may not be able to meet our customers'orders.

**Our business will be harmed ifoperating system vendors do not continue to support our software and includeour software with their operating systems.**

Our marketingstrategy for DiskOnChip relies on our software being included in majoroperating systems. These operating systems are constantly being updated. If weare unable to maintain or obtain the support of major operating systems for ourproducts, if the developers and distributors of major operating systems chooseto support a competing product instead of our own or support other competingsolutions together with our solution, or if other operating systems that do notinclude our software achieve market acceptance, this could adversely impactsales and accordingly have a material adverse effect on our business, financialcondition and results of operations.

** **

**RISKS RELATED TOCOMPETITION**

** **

**We sell our products in a highlycompetitive industry, often in competition with larger companies withsubstantially greater resources. Our failure to compete effectively could hurtour sales.**

The marketsin which we compete are characterized by intense competition, rapidtechnological changes, evolving industry standards, declining average sellingprices and rapid product obsolescence. Our DiskOnChip, DiskOnKey and otherflash memory products compete with other flash data storage devices, standardflash components, hard drives and alternative data storage technologies. Ourcompetitors include many large U.S. and international companies that havesubstantially greater financial, technical, marketing, logisticalinfrastructure and support and other resources, greater access to componentfabrication capacity, broader product lines and longer-standing relationshipswith customers than us, which may limit our ability to effectively compete withthem. We believe that our ability to compete successfully depends on a numberof factors, including the price, quality, features, performance, ease ofintegration and availability of our products. We expect competition to increasein the future from existing competitors and from other companies, includingflash manufacturers, that may enter our existing or future markets with similaror alternative data storage solutions that may be less costly or provideadditional and better features.

*DiskOnKey*.Our DiskOnKey product competes with other USB-compatible flash data storagedevices, removable magnetic media, removable optical media, flash cards, floppydrives and other removable storage media. Our competitors in this marketcurrently consist of numerous computer peripheral manufacturers or hardwaremanufacturers, the majority of whom are located in the Far East wheremanufacturing costs tend to be lower. Many of these competitors are vying forand attaining market share on the basis of aggressive pricing. In addition, wealso currently experience and expect to continue to experience competition fromlarge U.S. and/or international companies (including flash manufacturers) thathave substantially greater resources, greater access to component fabricationcapacity, often at substantially lower costs, broader product lines andlonger-standing relationships with customers than we do. 

**____ 16 ____** 

*DiskOnChip*.Our DiskOnChip products compete mainly with competing solutions offered byflash manufacturers. These flash manufacturers may have an advantage over us inthat they have substantially greater financial, sales, technical, marketing,logistical infrastructure and support and other resources, greater access tocomponent fabrication capacity, at substantially lower costs, broader productlines and longer-standing relationships with customers than we do. 

**We may be unable to maintainmarket share due to price competition or supply constraints, which would reduceour potential revenues and profitability.**

Duringperiods of excess supply in the market for our flash memory products, we maylose market share to competitors who aggressively lower their prices. We havein the past experienced, and may in the future experience, severe pricecompetition for our products, which adversely impacts our product gross marginsand overall profitability. Conversely, under conditions of tight flash memorysupply, we may be unable to meet customer demand and maintain our market share.The market for flash memory products is currently undergoing a period of tightsupply, but we cannot predict if this condition will continue and, if it does,for how long. Our future growth rate depends in part on our ability to obtainsufficient flash memory wafers and other components to meet demand. If we areunable to do so in a timely manner, we may lose market share to ourcompetitors. 

**We may face competition in ourtarget markets from some of our partners and their customers, due to ourlicense agreements with our partners.**

We haveentered into license agreements with several of our partners, including Toshibaand Samsung. Under these agreements, these parties and, in some circumstancestheir customers, may manufacture and sell products that incorporate technologycovered by our patents which compete with our DiskOnKey and DiskOnChipproducts. In particular, pursuant to our agreements with Toshiba, Toshiba hasbegun to market and sell the Mobile DiskOnChip, DiskOnChip Millennium and theDiskOnChip Millennium Plus to customers under Toshiba`s trademark, subject toToshiba paying us specified royalties. In addition, Toshiba may separatelymarket and sell USB flash data storage devices similar to our DiskOnKeyproducts. Toshiba also has the right to directly market products that we mayjointly develop in the future. Pursuant to our agreement with Samsung, Samsungmay market and sell products that compete with our DiskOnKey and DiskOnChipproducts. In addition, we have agreed not to pursue any action for infringementof our patents against any customer of Samsung which manufactures flash datastorage devices that incorporate both flash components and controllers providedby Samsung. Any current or future agreements to license our patents to ourpartners and competitors, may increase competition and may adversely impact ourrevenues. 

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**____ 17 ____** 

**RISKS RELATED TOOUR INTELLECTUAL PROPERTY**

** **

**Our business could suffer if thirdparties infringe upon our proprietary technology, and our patents andproprietary technology may not afford us sufficient protection frominfringement.**

Our successis dependent upon our proprietary technology. As of May 1st, 2004, we had 31 U.S. patents and several foreign patents relating to our technology and products. We alsohave as of such date 59 applications for patents pending in the U.S. with respect to new products and technologies. We currently rely on a combination ofpatent, trade secret, copyright and trademark law, together with non-disclosureagreements, to establish and protect the proprietary rights and technology usedin our products. However, these methods may not afford complete protection andwe cannot assure you that:
| ●*          *  | any of our existing 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;                                                         |
| ●*          *  | our patents will be issued in  the primary countries where our products are sold in order to protect our  rights and potential commercial advantage; |
| ●*          *  | any of our products do not  infringe on the patents of other companies; or                                                                           |
| ●*          *  | our competitors will not be  able to design their products around our patents or independently develop our  trade secrets and know-how.              |

We arecurrently involved in several opposition and/or revocation procedures where wehave opposed third party patents in various jurisdictions (China, UK and Taiwan). Oppositions to our patent applications have been filed by third parties in Taiwan and in Australia. 

**We may be involved in litigationregarding our intellectual property rights, which would be costly and woulddivert the efforts of our key technical and management personnel.**

Given thedeveloping nature of our markets and the related intellectual property, wecannot assure you that some of our competitors will not infringe ourintellectual property rights, and thereby force us to incur substantial costsif we choose to defend our rights. We recently settled one legal action inconnection with the infringement by others of our intellectual property rights(see Item 4.B below the paragraph titled "Settlement of Patent Litigation andNew License Agreement"). Litigation involving intellectual property can becomecomplex and extend for protracted time and is often very expensive.Intellectual property claims, whether or not meritorious, may result in theexpenditure of significant financial resources, injunctions against us or theimposition of damages that we must pay and would also divert the efforts andattention of some of our key management and technical personnel. If we bring anintellectual property infringement action and are not successful, ourcompetitors would be able to use similar technology to compete with us.Moreover, the defendant in such an action may successfully assert acounterclaim that our patents are invalid or unenforceable.

**Our products may infringe on theintellectual property rights of others and this could cause us to have to stopmanufacturing or selling certain of our products.**

Third partiesmay assert against us infringement claims or claims that we have violated theirpatent or infringed their copyright, trademark or other proprietary right. Wecurrently are involved in one legal action in connection with the allegation ofour infringement of the intellectual property rights of a third party (see Item8.A below the paragraph titled "Legal Proceedings"). An infringement claim,even if not meritorious, could result in the expenditure of significantfinancial and managerial resources by us. An adverse determination of anyinfringement claim could subject us to significant liabilities to thirdparties, could require us to seek licenses from third parties or expendsignificant resources to develop non-infringing technology and could prevent usfrom manufacturing, selling or using certain of our products, any of whichcould have a material adverse effect on our business, financial condition orresults of operations. 

**____ 18 ____** 

**We may be unable to licenseintellectual property to or from third parties as needed.**

We may desireor be required to obtain licenses from others in order to further develop,produce and market commercially viable products. We may also need to licensesome of our intellectual property to others in order to enable us to obtaincross-licenses to third-party patents. We cannot assure you that we will beable to obtain any required licenses on commercially reasonable terms, if atall, that the patents underlying those licenses will be valid and enforceableor that the technology underlying those licenses will remain proprietary innature. If we do obtain licenses from third parties, we may be required to paylicense fees or royalty payments. In addition, if we are unable to obtain alicense that is necessary to the manufacture of our products, we could berequired to suspend the manufacture of products. We cannot assure you that wewould be successful in redesigning our products or that the necessary licenseswill be available under reasonable terms, or that our existing licensees willrenew their licenses upon expiration, or that we will be successful in signingnew licenses in the future. 

**We may need to indemnify thirdparties for infringement claims related to our intellectual property.**

Wehistorically have agreed to indemnify distributors, partners and customers foralleged patent infringement claims in connection with our technology orproducts. The scope of this indemnity varies, but may, in some instances,include indemnification for damages and expenses, including attorney`s fees. Wemay periodically engage in litigation as a result of these indemnificationobligations. Our insurance policies exclude coverage for third-party claims forpatent infringement. Any future obligation to indemnify our distributors,partners and customers could adversely affect our business, financial conditionor results of operations. 

** **

**RISKS RELATED TOOUR ISRAELI AND INTERNATIONAL OPERATIONS**

** **

**Conditions in Israel may adverselyaffect our operations and may limit our ability to produce and sell ourproducts.**

We areincorporated under Israeli law and our principal offices and research anddevelopment facilities are located in Israel. Political, economic and militaryconditions in Israel directly affect our operations. Since the establishment ofthe State of Israel in 1948, a number of armed conflicts have taken placebetween Israel and its Arab neighbors and a state of hostility, varying indegree and intensity, has led to security and economic problems for Israel. We could be adversely affected by any major hostilities involving Israel, the interruption or curtailment of trade between Israel and its trading partners, asignificant increase in inflation, or a significant downturn in the economic orfinancial condition of Israel. Since October 2000, there has been a significantand escalating increase in violence between Israel and the Palestinians,primarily but not exclusively in the West Bank and Gaza Strip. Furtherdeterioration of hostilities into a full scale conflict might require morewidespread military reserve service by some of our employees, which could havea material adverse effect on our business. In addition, several Arab countriesstill restrict business with Israeli companies. We could be adversely affectedby restrictive laws or policies directed towards Israel or Israeli businesses.

Generally,all male adult citizens and permanent residents of Israel under the age of 45can, unless exempt, be called up and obligated to perform active militaryreserve duty for as many as 36 days annually (beyond this age, they may becalled up and obligated to take part in military training for as many as 13days annually). Additionally, all Israeli residents of this age are subject tobeing called to active duty at any time under emergency circumstances. Many ofour officers and employees are currently obligated to perform annual reserveduty. Although we have operated effectively under these requirements since webegan operations, we cannot assess the full impact of these requirements on ourworkforce or business if political and military conditions should change, andwe cannot predict the effect on us of any expansion or reduction of theseobligations. 

**Any disruptions or otherdifficulties experienced at our manufacturing facility in Israel could adversely affect our business.**

We operateone manufacturing facility at our headquarters in Kfar-Saba, Israel. We currently manufacture our FFD and DiskOnChip 2000 products at that facility. If weexperience quality problems or any significant technical or other difficultiesor interruptions in the manufacture of our products at this facility, thiscould have an adverse effect on our business, financial condition and resultsof operations.

**____ 19 ____** 

**The government programs and taxbenefits that we currently receive require us to meet several conditions andmay be terminated or reduced in the future, which would increase our costs andtaxes.**

We benefitfrom certain government programs and tax benefits, particularly as a result oftax exemptions and reductions resulting from the `approved enterprise` statusof our manufacturing facilities in Israel. To be eligible for these programsand tax benefits, we must continue to meet conditions, including makingspecified investments in property and equipment and financing a percentage ofinvestments with share capital. If we fail to meet such conditions in thefuture, the tax benefits would be canceled and we could be required to refundthe tax benefits already received. These programs and tax benefits may not becontinued in the future at their current levels or at any level. The Israeligovernment has reduced the benefits available under some of these programs inrecent years, and Israeli governmental authorities have indicated that thegovernment may further reduce or eliminate some of these benefits in thefuture. The termination or reduction of these programs and tax benefits couldincrease our expenses, thereby reducing our profits or increasing our losses.

**Our results may be negativelyimpacted by the appreciation of the NIS against the U.S. Dollar.**

The majorityof our revenues is denominated in U.S. dollars or is dollar-linked, but weincur a portion of our expenses, principally salaries and related personnelexpenses in Israel and the costs of maintaining our facilities in Israel, in NIS. As a result, we are exposed to the risk that the NIS, after adjustment for inflationin Israel, will appreciate in relation to the dollar. In that event, the dollarcost of our operations in Israel will increase and our dollar-measured resultsof operations will be adversely affected. In 2001 and 2002, the inflationadjusted NIS devalued against the dollar, which lowered the dollar cost of ourIsraeli operations. In 2003, however, the inflation adjusted NIS appreciatedagainst the dollar, which raised the dollar cost of our Israeli operations. Wecannot predict whether in the future the NIS will appreciate against the dollaror vice versa. We cannot assure you that we will not be materially adverselyaffected if the NIS appreciates against the dollar in the future.

**It may be difficult to enforce a U.S. judgment against us, our officers and directors and some of the experts named in thisprospectus or to assert U.S. securities law claims in Israel.**

We areincorporated in Israel. Substantially all of our executive officers anddirectors and certain experts named in this prospectus are nonresidents of the U.S., and a substantial portion of our assets and the assets of these persons are located outsidethe U.S. Therefore, it may be difficult to enforce a judgment obtained in the U.S. against us or any such persons. Additionally, it may be difficult for you to enforcecivil liabilities under U.S. federal securities laws in original actionsinstituted in Israel.

**Under current Israeli law, we maynot be able to enforce covenants not to compete and therefore may be unable toprevent our competitors from benefiting from the expertise of some of ourformer employees.**

We currentlyhave non-competition clauses in the employment agreements of nearly all of ouremployees. The provisions of such clauses prohibit our employees, if they ceaseworking for us, from directly competing with us or working for our competitors.Recently, Israeli courts have required employers, seeking to enforcenon-compete undertakings against former employees, to demonstrate that the competitiveactivities of the former employee will cause harm to one of a limited number ofmaterial interests of the employer recognized by the courts (for example, theconfidentiality of certain commercial information or a company`s intellectualproperty). In the event that any of our employees chooses to work for one ofour competitors, we may be unable to prevent our competitors from benefitingfrom the expertise of our former employees obtained from us, if we cannotdemonstrate to the court that we would be harmed. 

**____ 20 ____** 

**Our operations may be adverselyaffected by fluctuations in currency exchange rates.**

We price ourproducts primarily in U.S. Dollars. If the Euro, Japanese Yen, New Taiwanese(NT) dollar or other currencies in regions in which we sell our products weakenrelative to the U.S. Dollar, our products may be relatively more expensive inthese regions, which could result in a decrease in our sales. Also, in theevent that any of our customers require that our products be quoted and sold incurrencies other than the U.S. Dollar, we may receive income in such othercurrencies and as a result, our results will be impacted by fluctuations in thecurrencies relative to the U.S. Dollar.

In addition,certain of our expenses are in, or are linked to, currencies other than theU.S. Dollar, principally the NIS, the NT dollar and the Japanese Yen. Thisexposes us to potentially increased operational costs as well as increasedcosts for certain of our products as a result of currency fluctuations.

**Terrorist attacks and governmentresponses thereto and wars may have an adverse effect on all aspects of ourbusiness.**

The terroristattacks in the US, US military responses to these attacks, the ongoinghostilities in Iraq and threats of war and acts of terrorism in Europe and elsewhereand the related decline in consumer confidence and continued economic weaknesshave had a negative impact on consumer retail demand and our business. Anyescalation in these events or similar future events may disrupt our worldwideoperations or those of our customers and suppliers and may adversely affect theavailability of materials needed to manufacture our products or the means totransport those materials to manufacturing facilities and finished products tocustomers. In addition, these events have had and may continue to have anadverse impact on the US and world economy in general and consumer confidenceand spending in particular, which could harm our sales. 

**Our U.S. investors could suffersignificant adverse tax consequences if we are characterized as a passiveforeign investment company.**

We would be apassive foreign investment company ("PFIC") for US Federal Income Tax purposesif (i) 75% or more of our gross income in a taxable year including the pro ratashare of the gross income of any company, US or foreign, in which we areconsidered to own 25% of the shares by value, is passive income, or (ii) atleast 50% of our assets in a taxable year, averaged over the year andordinarily determined based on fair market value and including our pro ratashare of the assets of any company, US or foreign, in which we are consideredto own 25% or more of the shares by value, produce, or are held for theproduction of passive income. Passive income includes interest, dividends,royalties, rents and annuities. If we are or become a PFIC, or if the USInternal Revenue Service subsequently successfully asserts that we are, were orbecame a PFIC at some point, many of our shareholders will be subject topotentially substantial adverse tax consequences, including:
| ●*          *  | Taxation at the highest  ordinary income tax rates in effect during the holding period on some  distributions on our Ordinary Shares, and gain from the sale or other  disposition of our Ordinary Shares; |
|-----------------------------------------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ●*          *  | Paying interest on taxes  allocable to prior periods; and                                                                                                                                                  |
| ●*          *  | No increase in the tax basis  of our Ordinary Shares to fair market value at the date of the holder`s  death.                                                                                              |

We believethat we were not a PFIC for 2002 and will not be a PFIC for 2003. Our belief isbased, in part, on our market capitalization and, if we are to offer anysecurities or borrow funds, our plans for spending the proceeds. The tests fordetermining PFIC status are applied annually and it is difficult to make anaccurate prediction of future income and assets which are relevant to thisdetermination. Accordingly, we cannot assure you that we were not a PFIC for2002 nor that we will not be treated as a PFIC in 2003 or in future years.

 

 

**____ 21 ____** 

# ITEM4.   INFORMATION ON THE COMPANY

 

#  A.  HISTORY AND DEVELOPMENT OF THE COMPANY

#   

Our commercialand legal name is M-Systems Flash Disk Pioneers Ltd. We are a company organizedunder the laws of the State of Israel and are subject to the Companies Law. Wewere incorporated on November 10th, 1982 and began operation in 1989. Ourprincipal offices are located at 7 Atir Yeda St., Kfar Saba 44425, Israel andour telephone number is +972-9-764-5000. Our U.S. agent is our subsidiary,M-Systems, Inc., located at 8371 Central Avenue, Suite A, Newark, CA 94560, and its telephone number is (510) 494-2090.

In March2000, we completed a secondary offering of our Ordinary Shares, which providednet proceeds for the company of approximately $ 149.6 million. InSeptember 2000, we effected a 2-for-1 stock split in the form of a 100 percentstock dividend.

In September2000, we acquired the assets of Fortress U&T Ltd. ("Fortress") forapproximately $ 8 million. These assets included significant technology,patents and know-how relating to implementation of secured encryption, dataprotection, secure smart card technology and secure payment schemes. Thesetechnologies can provide security and access control to prevent accidental orintentional modification of a customer`s application code residing on a flashdisk, copy protection to prevent piracy and unauthorized cloning, and reliableauthentication of authorized users. As part of this transaction, most ofFortress` employees formed our new research and development center in Omer, Israel to develop new flash disk security features and to integrate advanced securityfeatures into our existing and future flash disk products. 

In October2000, we purchased 586,080 preferred shares of Saifun Semiconductors Ltd.("Saifun") for approximately $ 10 million. Saifun is a private,venture-backed Israeli company engaged in research, development, production andmarketing of flash memory products and technology. Boaz Eitan, who was, upuntil December 17th, 2002, a member of our Board of Directors, is the founder,chief executive officer and a director of Saifun (see Item 7.B below theparagraph titled "Related Party Transactions").

In April2001, we signed an agreement for the purchase of the building in which ourheadquarters` executive offices, research, development and manufacturingfacilities are located. As part of the agreement, we also purchased a vacantlot adjacent to our offices. The aggregate consideration for these purchaseswas approximately $ 10.5 million, which we financed ourselves. Some of theconsideration has been placed in an escrow fund pending the receipt by thesellers of these properties of various permits and third party approvals. Inaddition to the consideration paid for the building and the adjacent lot, weinvested an additional $ 3.29 million in developing and renovating thefacility.

In April 2003,we established a subsidiary in Israel named Smart Caps Ltd. ("Smart Caps") forthe purpose of developing and marketing smart applications for our line ofDiskOnKey products. The State of Israel, through the Office of the ChiefScientist ("OCS"), has committed to investing up to approximately$ 550,000 in Smart Caps. This investment by the OCS is to at least matchour investment in Smart Caps. In consideration for such investments, M-Systemsand the OCS are to be issued shares in Smart Caps pro rata to each of theirrelative investments. We have since informed the OCS of the cessation ofresearch and development in Smart Caps as from December 31st, 2003 and may windup Smart Caps in the future. 

On May 1st,2003, we entered into a Share Purchase Agreement with Dr. Hans Wagner, a memberof our Board of Directors, for the purchase of 500,000 Ordinary Shares inconsideration for $ 4.1 million, which transaction was subsequentlyconsummated (see Item 7.B below the paragraph titled "Related PartyTransactions"). 

On July 15,2003, we entered into and consummated an Ordinary Shares Purchase Agreementwith Toshiba for the purchase of 330,811 Ordinary Shares in consideration for $ 4.0million. 

In February2004, we completed a secondary offering of our Ordinary Shares, which provided net proceeds for the company of approximately$95.0 million.

 

**____ 22 ____** 

#  B.  BUSINESS OVERVIEW

#   

**Our Business**

We design,develop and market innovative flash data storage solutions for digital consumerelectronics markets. We primarily target two fast-growing digital consumerelectronics markets: the USB (universal serial bus) flash drive market with ourDiskOnKey product and the multimedia mobile handset market with our MobileDiskOnChip product.

We pioneeredthe USB flash drive concept with our DiskOnKey product, a personal, portable,thumb-sized flash disk drive for the storage and transfer of digital datafiles, including media files such as pictures and audio files. USB flash drivesare beginning to replace the current standard 3.5 inch format floppy diskdrives in personal computers (PCs) and, as a result, PC manufacturers arebeginning to bundle USB flash drives with sales of PCs. Our DiskOnKey customersinclude many of the largest PC manufacturers.

OurDiskOnChip product jointly developed with Toshiba was the first monolithicflash disk product to be introduced to the market, combining flash memory and acontroller on a single die. Mobile DiskOnChip, our next generation DiskOnChipproduct, is a high-capacity, high performance flash data storage solution forthe multimedia mobile handset market. By combining our expertise in themanagement and optimization of flash memory with Toshiba's advanced flashmemory technology, we have developed a flash memory solution for multimediamobile handsets that provides high reliability, high speed and low powerconsumption with a smaller footprint than competing solutions. We believe thatMobile DiskOnChip is the most compact embedded flash data storage solution formultimedia mobile handsets available in the market. Our Mobile DiskOnChip hasnumerous design wins and has been designed into many multimedia mobilehandsets, including handsets produced by four of the five leading handsetmanufacturers. 

To supportour anticipated growth, we recently entered into agreements with Toshiba andSamsung, our principal suppliers of flash memory components. Each supplier hascommitted to provide us with a specified portion of its flash componentsmanufacturing capacity at terms more favorable in many respects than under ourprevious arrangements. We believe that these capacity commitments will supportour expected growth by providing a substantial portion of our anticipatednear-term flash memory component needs. 

**Our Markets**

We arefocused primarily on two fast-growing digital consumer electronics markets: USBflash drives and multimedia mobile handsets. 

***USB Flash Drives***

USB flashdrives provide an innovative solution for removable data storage, allowing auser to conveniently store and carry data and to easily transfer data betweenPCs or similar devices with a USB port. USB flash drives have the followingattributes:
| ●*          *  | High  Capacity Combined with a Compact, Portable Form Factor: USB flash drives  are thumb-sized, able to fit on a key chain, and are available in capacities  ranging from 16 megabytes to 1 gigabyte (1,024 megabytes) of memory.                                                                                 |
|-----------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ●*          *  | Ease of  Use: USB flash drives are "plug-and-play" devices that are  simple to use. USB flash drives are automatically recognized when plugged  into a computer with current versions of popular operating systems, requiring  no installation of additional equipment, an adaptor or a software driver. |
| ●*          *  | Universal  Interface: USB flash drives provide users with a compelling alternative  to conventional removable storage media by leveraging the ubiquitous USB  interface, which is standard in PCs sold in recent years.                                                                                            |

 

**____ 23 ____** 

A number ofleading PC manufacturers have announced their intention to discontinueproviding floppy disk drives as standard equipment in their computers. As aresult, due to the advantages USB flash drives offer, PC manufacturers arebeginning to bundle USB flash drives with sales of PCs. In addition to being areplacement for floppy drives, we believe that USB flash drives will be used ina wide range of digital consumer electronics applications, including MP3 audioplayers, digital cameras, mobile phones and other handheld devices.

***Multimedia Mobile Handsets***

The marketfor mobile handsets with advanced multimedia capabilities is growing rapidly.An increasing number of handsets with data-centric features such as embeddeddigital cameras, color screens, e-mail capabilities and PDA (personal digitalassistant) functionality are being introduced worldwide, as manufacturerscombine mobile phones with other digital consumer electronics applications anddevices. In order to accommodate this trend, mobile handset manufacturers willneed to upgrade their existing embedded memory solutions to offer thefollowing:
| ●*          *  | Higher  Capacity: Today's multimedia handsets require increasing amounts of  memory to store more sophisticated operating systems as well as pictures,  multimedia messages, video clips and other types of data-rich content. In  many cases, new-generation handsets are required to include 4 to 16 times the  memory capacity of voice-centric handsets (16 to 64 megabytes, compared with  2 to 4 megabytes for voice-centric headsets). |
|-----------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ●*          *  | Higher  Performance: In order to accommodate the growing demand for high capacity  data storage as well as read/write functionality, mobile handset  manufacturers are increasingly seeking to provide faster read/write speed  performance with memory components that occupy less space and consume less  power.                                                                                                                            |
| ●*          *  | Lower  Cost Per Byte: Data-centric applications require higher density memory  solutions that provide high capacity with a small footprint at a lower cost  per memory byte than memory solutions currently used in voice-centric  handsets.                                                                                                                                                                                                  |

Consequently,mobile handset manufacturers are increasingly choosing to design theirmultimedia mobile handsets using embedded flash memory that can ensure highcapacity and high performance data storage functionality at a lower cost perbyte than existing memory solutions.

**Our Products**

In order toaddress the growing market opportunity for USB flash drives and flash datastorage solutions for multimedia mobile handsets and other high capacitydata-centric memory applications, we have focused primarily on the followingproduct offerings:

***DiskOnKey***

Our DiskOnKeyenables easy storage and transfer of data files, digital images and audio andvideo files between PCs, laptops and other USB-enabled devices. DiskOnKey isavailable in a range of capacities, from 16 megabytes to 1 gigabyte of memory.We believe that our DiskOnKey maintains a leading market share of the USB flashdrive market due to the following product attributes:
| ●*          *  | High  Performance: We believe that our DiskOnKey leads the USB flash drive  market in performance.                                                                                                                                                                                                                                                                                                                                                                                                                  |
|-----------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ●*          *  | Intellectual  Property Rights: We hold a number of patents relating to the use of flash  memory devices that connect using a USB interface. We believe that this  provides us with a competitive advantage and is an important factor  considered by our customers in selecting our products over products of our  competitors.                                                                                                                                                                                     |
| ●*          *  | Flash  Independent Design: Due to the flexibility of its design, DiskOnKey is  compatible with flash components from multiple suppliers, including our  current suppliers, Toshiba and Samsung, and can be adapted to be compatible  with flash components from additional suppliers that may enter the flash  memory component market in the future. This allows us to seek additional  sources of flash components for our DiskOnKey products to reduce our  dependence on any specific flash component supplier. |

 

**____ 24 ____** 

 
| ●*          *  | Embedded  Microprocessor: DiskOnKey includes an embedded processor within an  application specific integrated circuit (ASIC), instead of a conventional  controller. As a result, in addition to being a high performance data storage  device, DiskOnKey is capable of executing applications which can allow  DiskOnKey to be applied to uses other than data storage, including, for  example, functioning as a secure access device, or smart card. |
|-----------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

Our strategyis to sell our DiskOnKey through major original equipment manufacturers (OEMs)and consumer electronics companies, leveraging their market position and brandstrength to achieve wide market penetration. We have established OEMrelationships with a number of the largest PC manufacturers to sell customizedversions of our DiskOnKey under their respective brand names. We have alsoestablished relationships with leading worldwide consumer electronics companiesto sell customized or private label versions of our DiskOnKey in theirrespective geographic markets. Our DiskOnKey sales have grown from $ 26.8million in 2002 to $ 77.6 million in 2003.

***Mobile DiskOnChip***

Our MobileDiskOnChip, jointly developed with Toshiba, provides a reliable, high capacityand cost-effective embedded memory solution for data and code storage formultimedia mobile handsets. We believe our Mobile DiskOnChip product offeringprovides multimedia mobile handset manufacturers with an attractive solutiondue to the following product attributes:
| ●*          *  | High  Density: Through our relationship with Toshiba, we have access to  multi-level cell (MLC) flash memory technology which we believe allows us to  offer a higher density solution than competing solutions in the market,  practically doubling the capacity of our Mobile DiskOnChip solutions without  meaningfully increasing the size of the chip. We currently offer our Mobile  DiskOnChip in capacities from 8 megabytes to 128 megabytes.                                                                                                                                            |
|-----------------------------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ●*          *  | Cost-Effective,  Improved Performance and Optimized Reliability: By combining our patented  TrueFFS flash management software with an embedded controller, we have been  able to optimize the reliability and improve the performance of high-density  flash memory. This allows us to use high-density flash memory, traditionally  limited to data storage, for code storage as well. As a result, we are able  to provide mobile handset manufacturers with a less expensive, integrated  memory solution for both code and data storage, while maintaining high  performance and reliability. |
| ●*          *  | Compact  Size: Our monolithic, or single die, design -- which combines a  controller and flash memory within a single silicon die -- further reduces  the footprint of our Mobile DiskOnChip solution. Compact size is particularly  important to multimedia mobile handset manufacturers that increasingly are  seeking to provide increased product functionality using components that  occupy less space.                                                                                                                                                                                     |

Our strategyis to initially penetrate the mobile handset market by targeting design winsfor our Mobile DiskOnChip in multimedia and other high-end mobile handsets andPDAs. Our Mobile DiskOnChip already has numerous design wins, including designwins with four of the five leading handset manufacturers, as well as withleading PDA manufacturers. Sales of our Mobile DiskOnChip product have grownfrom $ 3.6 million in 2002 to $ 15.0 million in 2003.

***Other Products***

In additionto flash data storage products targeting the USB flash drive and multimediamobile handset markets, we also sell flash data storage products targeted atthe embedded systems and industrial applications markets. Our DiskOnChip forembedded systems provides the functionality of a mechanical hard drive on asolid-state silicon chip. DiskOnChip is a cost-effective, reliable and compactdata storage solution for embedded systems, including digital set-top boxes andthin client computers. We also sell our FFD (Fast Flash Disk) product, aruggedized solid-state flash disk product for industrial applications thatrequire reliable and high performance data storage. Sales of our DiskOnChip forembedded systems and FFD products were $ 31.7 million in 2002 and $ 30.0million in 2003.

**____ 25 ____** 

**Marketing Channels**

We market andsell the DiskOnKey to the retail consumer market through major computer vendorsand international retail chains, as well as through various distributors. Wetarget our DiskOnChip sales efforts primarily to large original equipmentmanufacturers that include our products in their applications.

We market ourproducts through a combination of our own sales managers; independent localsales representatives that sell our products on our behalf; and independentdistributors that purchase our products for resale to their customers. Oursales managers are compensated based on a salary and a bonus dependent in parton sales levels. The independent local sales representatives receivecommissions for their product sales. We continually seek to strengthen each ofour sales channels, including by engaging new representatives and distributorsand providing them with extensive training and support with respect to ourproducts and technologies. Our technical engineers are an integral part of thesales process and provide customers with technical information and supportregarding our products and their integration with the customers` applications. 

We maintainlocal sales offices in Silicon Valley, California; Boston, Massachusetts; Taipei, Taiwan; Tokyo, Japan; Shenzhen, China and Kfar Saba, Israel.

**Sources of Supply**

We purchaseour supplies from various sources. All of our products are flash memory based andrequire flash memory components, which are currently supplied by Toshiba andSamsung. We recently secured commitments from both Toshiba and Samsung toprovide us with a specified portion of their respective flash componentmanufacturing capacity. We expect that we will depend upon Toshiba and Samsungfor a significant portion of our anticipated flash memory requirements. Ourpolicy is to have more than one supplier for all of our parts whereverfeasible. However, Toshiba is currently the sole manufacturer of our DiskOnChipMillennium, DiskOnChip Millennium Plus and Mobile DiskOnChip products, andmight be the sole manufacturer of future DiskOnChip products, and Samsung iscurrently the sole supplier of the flash components for a portion of ourDiskOnKey products. We have also entered into development and supply agreementswith Atmel under which, Atmel develops, manufactures, and supplies us the ASICcomponents for certain of our DiskOnKey products. 

If Toshiba,Samsung, Atmel or any of our other suppliers fails to provide parts or servicesin a timely manner and we are unable to secure an alternate supply ofcomparable price and quality in a timely manner, our results of operationscould be adversely affected (see the discussion in Item 3.D "Risk Factors - RisksRelated to Third Party Manufacturers, Suppliers and Subcontractors").

At times, wehave experienced difficulties in securing adequate supplies of certaincomponents for our products, which has resulted in delayed or lost sales. In aneffort to mitigate supply shortages, we at times have maintained a largerinventory of certain components than we would otherwise maintain if the availabilityof adequate supplies were more certain. 

**Seasonality**

Sales of ourDiskOnKey products to the consumer electronics market may be subject toseasonality arising from the seasonal purchasing patterns of consumerend-users.

**____ 26 ____** 

**Revenue Breakdown**

Our revenuesare derived mainly from the sale of DiskOnKey, DiskOnChip, Mobile DiskOnChipand FFD products. The following table describes, for the periods indicated, thepercentage of revenues represented by each of the items on our consolidatedstatements of operations:
|              | **Year  Ended December 31,** |
|-------------------|------------------------------|
|              | 2001                         | 2002 | 2003 |
| DiskOnKey         | 15%                          | 41% | 60% |
| DiskOnChip        | 61            | 40    | 20    |
| Mobile DiskOnChip | 0             | 6    | 11    |
| FFD               | 12            | 9    | 3    |
| Others            | 12            | 4    | 6    |
| Total             | 100%                         | 100% | 100% |

 

The followingtable summarizes the revenues from our products and services by country, statedas a percentage of total revenues for the periods indicated:
|                                  | **Year  Ended December 31,** |
|---------------------------------------|------------------------------|
| Country                               | 2001                         | 2002 | 2003 |
| Israel                                | 5%                           | 3% | 2% |
| United States                         | 38            | 27    | 32    |
| Europe                                | 21            | 16    | 16    |
| Taiwan                                | 18            | 13    | 17    |
| Japan                                 | 10            | 34    | 20    |
| Far East (excluding Taiwan and Japan) | 8             | 7    | 13    |
| Total                                 | 100%                         | 100% | 100% |

**Recent Developments**

***Expanded Toshiba Relationship***

On July 29,2003, we announced a set of new agreements with Toshiba that broadened ourexisting strategic relationship. The new agreements consisted principally of:
| ●*          *  | a master purchase  agreement for the provision of flash components and Mobile DiskOnChip and  DiskOnChip products, |
|-----------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------|
| ●*          *  | a  cross-license agreement,                                                                                        |
| ●*          *  | a  development and license agreement,                                                                              |
| ●*          *  | agreements establishing  a venture relating to USB flash drives, and                                               |
| ●*          *  | a share  purchase agreement for the investment in our Ordinary Shares by Toshiba.                                  |

Under themaster purchase agreement, Toshiba has improved the overall terms under whichwe purchase from Toshiba raw flash components and Mobile DiskOnChip andDiskOnChip products. Under this agreement, we are required to make rollingforecasts that are binding on us to varying extents, and Toshiba is committedto supply us with flash components and Mobile DiskOnChip and DiskOnChipproducts in accordance with our forecasts. The agreement has a seven-year term.

Thecross-license agreement between us grants a non-exclusive, worldwide,royalty-free and fully paid license to Toshiba with respect to all of ourpatents, and to us with respect to certain of Toshiba's patents. In each case,the term of the license runs through the expiration of the last to expirelicensed patent. We expect Toshiba to utilize our intellectual property relatedto USB flash drives to develop and sell a USB flash drive that will competewith our DiskOnKey.

**____ 27 ____** 

Thedevelopment and license agreement provides for the development of new MobileDiskOnChip and DiskOnChip products and restates the provisions of our previousdevelopment and license agreements relating to earlier versions of our MobileDiskOnChip and DiskOnChip products. Under this agreement, which terminates in2018 except for certain provisions related to development which terminate in2010, we licensed certain of our intellectual property to Toshiba for theproduction and sale of the jointly developed products in exchange forroyalties.

We alsoentered into various agreements with Toshiba, under which we began to operatein November 2003, pursuant to which we established a venture designed to enableus and Toshiba to benefit from a portion of each party's respective sales ofUSB flash drives. Both Toshiba and we have obligations to conduct a portion ofour USB flash drive business through the venture. Under the agreements, Toshibahas committed to provide us with a specified portion of its flash componentmanufacturing capacity for the portion of our USB flash drive business that weconduct through the venture. In addition, Toshiba and we will each receive apercentage of the income attributable to the portion of sales of USB flashdrives generated by the other party through the venture.

Under theshare purchase agreement, Toshiba invested $ 4.0 million in our company,acquiring 330,811 Ordinary Shares. In addition, Toshiba has the option untilJuly 30, 2004 to increase its stake in our company to up to 4.99% of theaggregate shares outstanding at the time of exercise, through the purchase ofshares directly from us at a price equal to the closing price per share on thelast trading day prior to exercise of the option. Under the share purchaseagreement, if Toshiba's holdings of our Ordinary Shares exceed 7% of ouroutstanding shares, Toshiba has the right to request us to use our commerciallyreasonable efforts to have a representative of Toshiba nominated to our boardof directors as a director or observer.

***Expanded Samsung Relationship***

On December31, 2003, we entered into a Strategic Agreement with Samsung broadening ourexisting relationship. Under this agreement, Samsung agreed to provide us witha specified portion of its raw flash component manufacturing capacity availableto third parties at more favorable pricing terms compared to our previousarrangement. The agreement is effective for a period of four years. As part ofthe agreement, we granted Samsung a license to all of our patents for anyproducts produced by Samsung until the expiration of the last to expirelicensed patent. We also agreed not to pursue any action for infringement ofour patents against any customer of Samsung in connection with the manufactureof flash data storage devices, provided that the customer uses both flashcomponents and controllers sourced from Samsung. In exchange for the license,Samsung agreed to pay us a fixed stream of payments throughout the term of theagreement. Samsung may utilize its license to sell a USB flash drive thatcompetes with our DiskOnKey.

***Settlement of Patent Litigationand New License Agreement***

In September2003, we reached an agreement with JMTek regarding the patent infringementlawsuit we had filed against it on October 1, 2002. Under the terms of thisagreement, JMTek recognized our patents for the architecture of our USB flashdrive and our TrueFFS technology. As part of the settlement, JMTek entered intoa licensing agreement with us and agreed to pay us royalties on its sales ofUSB flash drive products.

 

**____ 28 ____** 

#  C.  STRUCTURE

 

The followingtable lists our subsidiaries, their country of organization and our ownershippercentage in each. 

 
| Name                                        | Country of  Organization | Ownership    |
|---------------------------------------------|--------------------------|--------------|
| M-Systems, Inc.                             | U.S.                     | 100%         |
| M-Systems Asia Ltd.                         | Taiwan                   | 100%         |
| M-Systems Flash Disk Pioneers (Japan), Inc. |  

Japan            |  

100% |
| M-Systems UK Ltd.                           | United Kingdom           | 100%         |
| M-Systems China Shenzhen Ltd.               | China                    | 100%         |
| M-Systems B.V.                              | The Netherlands          | 100%         |
| Smart Caps Ltd.*                            | Israel                   | 79.95%       |
| TwinSys Ltd. **                             | Israel                   | 50.10%       |
| TwinSys Data Storage L.P. **                | Israel                   | 50.10%       |

 
| * * | *  | See  Item 4.A above the paragraph titled "HISTORY AND DEVELOPMENT OF THE COMPANY."                                                                                                                        |
|----------|----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| * * | ** | Established  together with a partner as an Israeli corporation to serve as the General  Partner of TwinSys Data Storage L.P., which is a limited partnership  established by the Company and such partner |

 

#  D.  PROPERTY, PLANTS AND EQUIPMENT

#   

Ourheadquarters` executive offices, research, development and manufacturingfacilities are currently located in a building of approximately 75,000 squarefeet at 7 Atir Yeda St., Kfar Saba 44425, Israel, which we own. We also own anadjacent vacant plot of 117,000 square feet which we intend to utilize in orderto expand our current facilities. We own the building and the property free andclear of all encumbrances except for a mortgage taken out by the sellers fromBank Leumi. The outstanding balance of that mortgage on our building andproperty is covered in full by escrowed funds to be delivered to the sellersonly upon the receipt of various necessary permits and third party approvals,at which point the escrowed funds are to be released for the purpose of payingoff the mortgage and removing the lien. In addition, we lease office space ofapproximately 5,500 square feet for a research and development facility in Omer, Israel. 

We also leaseoffice space for our sales offices in Silicon Valley, California; North Carolina; Taipei, Taiwan; Tokyo, Japan; Shenzhen, China; and Vienna, Austria. These leases for sales offices are not material to our operations. 

 

**____ 29 ____** 

# ITEM5.   OPERATING AND FINANCIAL REVIEW AND PROSPECTS

 

*YOU SHOULDREAD THE FOLLOWING DISCUSSION AND ANALYSIS IN CONJUNCTION WITH ITEM 3 "SELECTEDFINANCIAL DATA" AND OUR CONSOLIDATED FINANCIAL STATEMENTS AND NOTES THERETOINCLUDED ELSEWHERE IN THIS ANNUAL REPORT. THIS "OPERATING AND FINANCIAL REVIEWAND PROSPECTS" SECTION CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKSAND UNCERTAINTIES. OUR ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSEANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORSINCLUDING, BUT NOT LIMITED TO, THOSE SET FORTH ELSEWHERE IN THIS REPORT.*

 

#  A.  OPERATING RESULTS

#   

**Overview**

We design,develop and market innovative flash data storage solutions for digital consumerelectronics markets. We primarily target two fast-growing digital consumerelectronics markets: the USB flash drive market with our DiskOnKey product andthe multimedia mobile handset market with our Mobile DiskOnChip product. Wealso sell flash data storage products targeted at the embedded systems andindustrial applications markets, including our DiskOnChip and Fast Flash Disk(FFD) products.

All of ourflash data storage products require flash memory components. Although we do notoperate our own fabrication facilities, we have obtained capacity commitmentsfor flash memory components as a result of our recent agreements with Samsungand Toshiba, our principal suppliers of flash memory components. We believethat these capacity commitments will support our expected growth by providing asubstantial portion of our anticipated near-term flash memory component needs.

*The following is a briefdescription of certain of the line items included in our financial statementsas well as trend information regarding those line items:*

*Revenues*.Substantially all of our revenues are generated from sales of our products. Asignificant portion of our product sales consists of sales of our DiskOnKeyproduct line, sales of our DiskOnChip product line and sales of our MobileDiskOnChip product line. For the year ended December 31, 2003, we derivedapproximately 60% of our revenues from sales of our DiskOnKey product line,approximately 20% of our revenues from sales of our DiskOnChip product line andapproximately 12% of our revenues from sales of our Mobile DiskOnChip productline.

We began togenerate revenues from our DiskOnKey product line in 2001 and from our MobileDiskOnChip product line in 2002. Although we experienced a decline inDiskOnChip revenues for embedded systems in 2001 due to the global economicslowdown, our introduction of the DiskOnKey and Mobile DiskOnChip products havesince brought us consistent revenue growth and our quarterly results have shownconsecutive growth, quarter by quarter, from the third quarter of 2001 throughthe fourth quarter of 2003.

Because ourproducts address rapidly growing markets, our revenue growth has beenaccelerating. In 2002, our revenues grew by 45% in comparison to 2001, and ourrevenues in 2003 grew by 101% in comparison to 2002. Our quarterly sequentialrevenue growth has increased from 16% in the second quarter of 2003 to 33% and42% in the last two quarters of 2003, respectively. We expect our revenues tocontinue to grow in the coming quarters, though at a slower rate. Such revenuegrowth has placed and is expected to continue to place a strain on ouroperational, logistical and managerial resources. We have expanded our workforce from 260 employees at January 1, 2002 to 352 employees at December 31,2003. While we believe we have sufficient resources to manage our anticipatedgrowth, we cannot assure you that our logistical infrastructure, systems andcontrols will be adequate to support such anticipated growth.

**____ 30 ____** 

In additionto our product sales, we generate revenues from the license of our technologyto third parties. In 2003, we increased our sources of licensing revenues,licensing our technology to flash memory manufacturers and manufacturers of USBflash drives, among others. Under our current license agreements, in exchangefor granting the licenses, we receive license fees, royalties or access toflash memory component manufacturing capacity from the licensee company, or acombination thereof. Revenues from licensing our technology represented lessthan 5% of our revenues in each of 2002 and 2003. We expect that revenues fromlicensing our technology will increase in 2004. Given the high gross marginsassociated with revenues from licensing our technology, our gross profit andnet income are more sensitive to changes in our license fees and royalties thanto changes in product sales.

In 2003, weentered into various agreements with Toshiba, under which we began to operatein November 2003, pursuant to which we established a venture designed to enableus and Toshiba to benefit from a portion of each party's respective sales ofUSB flash drives. Both Toshiba and we have obligations to conduct a portion ofour USB flash drive business through the venture. Under the agreements, Toshibahas committed to provide us with a specified portion of its flash componentmanufacturing capacity for the portion of our USB flash drive business weconduct through the venture. In addition, Toshiba and we will each receive apercentage of the income attributable to the portion of sales of USB flashdrives generated by the other party through the venture. The activities of theventure during 2003 did not have a material effect on our results ofoperations.

A majority ofour sales have been to a limited number of customers. For the years endedDecember 31, 2002 and 2003, our top 10 customers accounted for 56% and 55% ofour revenues, respectively. In 2003, one customer, I-O & YT PTE Ltd., asubsidiary of I-O Data Device, Inc., accounted for greater than 10% of ourtotal revenues. We expect that sales to a limited number of customers willcontinue to account for a substantial portion of our revenues for at least thenext several years.

Sales in Asia accounted for the majority of our revenues in 2003. For the years ended December 31,2002 and 2003, revenues in Asia represented approximately 54% and 50% of ourtotal revenues, respectively.

*Cost ofRevenues*. Our cost of revenues consists primarily of the cost of flashmemory components, ASIC components and manufacturing costs (including costs ofsubcontractors that manufacture our products), and salaries and relatedpersonnel expenses for those engaged in the manufacture of our products. Costof flash memory components accounts for the substantial majority of our cost ofrevenues.

In the eventthat the market price for flash components increases, we may be unable to passthese price increases on to our customers and, consequently, our cost ofrevenues could rise and our gross margins could be adversely impacted. Forexample, in the third and fourth quarters of 2003, due to increased demand forconsumer electronic products, such as USB flash drives and flash memory cardsfor digital cameras, demand for flash memory components exceeded availablesupply, causing flash memory component prices to rise. Due to the higher pricesfor flash components in those quarters, our gross margins declined to 27% inthe third quarter of 2003 and 25% in the fourth quarter of 2003, as compared to32% in the second quarter of 2003. 

In addition,we expect that the majority of our revenue growth in the coming quarters willcome from sales of our DiskOnKey product to the USB flash drive market andsales of our Mobile DiskOnChip product to the multimedia mobile handset market.Both of these markets are very competitive with competitors using aggressivepricing strategies to gain market share, leading to pricing pressures. Weexpect the combination of pricing pressures and continuing flash memorycomponent supply constraints to result in our DiskOnKey and Mobile DiskOnChipproducts having lower gross margins than our other products in the comingquarters. As a result, we expect that gross margins for our DiskOnKey andMobile DiskOnChip products will continue to exert downward pressure on ouroverall gross margins in the coming quarters, which may not be offset by theexpected improvement in our gross margins resulting from our recent agreementswith Toshiba and Samsung.

**____ 31 ____** 

*Researchand Development Expenses, Net*. Research and development expenses consistprimarily of salaries and related personnel expenses and subcontractor costsrelated to the design, development and testing of new products and technologiesand product enhancements. Research and development expenses are presented netof participations received or accrued from the Office of the Chief Scientist,or OCS, the Singapore-Israel Industrial Research and Development Fund, orSIIRD, and the Information Society Technology Fund, or IST. All research anddevelopment costs are expensed as incurred. We believe that continued investmentin research and development is critical to attaining our strategic objectives.During 2003, as a result of the growth in our revenues and the expected growthpotential for both the DiskOnKey and the Mobile DiskOnChip products, weexpanded our investments in research and development. We expect research anddevelopment expenses to increase in the future as we continue to enhanceexisting products and develop new products and product lines to addressexisting and potential markets, including our planned new removable memory cardform factor for the multimedia mobile handset market.

*Sellingand Marketing Expenses*. Selling and marketing expenses consist primarily ofsalaries, commissions, participation in our partners' marketing efforts andrelated personnel expenses for those engaged in the sale, marketing and supportof our products (including commissions payable to our independent salesrepresentatives), as well as related trade shows and promotional and publicrelations expenses. During 2003, as a result of the growth in our revenues andthe expected growth potential for both the DiskOnKey and the Mobile DiskOnChipproducts, we expanded our selling and marketing activities and invested inbuilding new sales channels. We expect our selling and marketing expenses toincrease in the future as we continue to expand our sales and marketingactivities.

*Generaland Administrative Expenses*. General and administrative expenses consistprimarily of salaries and related personnel expenses for executive, accounting,finance, legal and litigation, human resources, administrative and network andinformation systems personnel, facilities maintenance, professional fees andother general corporate expenses. As we add personnel and incur additionalcosts related to the growth of our business, we expect that general andadministrative expenses will also increase.

*FinancialIncome, Net*. Financial income, net consists primarily of interest earned onmarketable securities and bank deposits, gains or losses from the sale of marketablesecurities and foreign currency translation differences resulting from theconversion of monetary balance sheet items denominated in non-dollarcurrencies.

*OtherIncome*. In the fourth quarter of 2003, we recognized a capital gain of $ 131,000from the sale of a portion of the shares we held in Phison Electronics Corp., apublicly-traded Taiwanese technology company.

**Results of Operations**

The followingtable sets forth, for the periods indicated, the percentage of revenuesrepresented by certain items reflected in our consolidated statements ofoperations. 

|                                                              | Year ended December 31, |
|-------------------------------------------------------------------|-------------------------|
|                                                              | 2001                    | 2002 | 2003 |
| Revenues                                                          | 100.0%                  | 100.0% | 100.0% |
| Cost of revenues                                                  | 68.0                    | 68.5 | 71.6 |
| Inventory write-down                                              | 67.6                    | --- | --- |
| Gross profit (loss)                                               | (35.6)                  | 31.5 | 28. 4 |
| Operating expenses:                                               |                    |   |   |
| Research and development, net                                     | 29.7                    | 18.5 | 11.3 |
| Selling and marketing                                             | 27.1                    | 19.4 | 14.9 |
| General and administrative                                        | 8.8                     | 6.2 | 3.7 |
| Total operating expenses                                          | 65.6                    | 44.0 | 22.9 |
| Operating income (loss)                                           | (101.2)                 | (12.5) | (1.5) |
| Financial income, net                                             | 10.4                    | 4.0 | 2.0 |
| Other income (expenses)                                           | (2.7)                   | --- | 0.1 |
| Income (loss) before minority interest in losses of a  subsidiary | (93.5)                  | (8.5) | 0.6 |
| Minority interest in losses of a subsidiary                       | ---                     | --- | 0.1 |
| Net income (loss)                                                 | (93.5)%                 | (8.5)% | 0.7% |
|                                                              |                    |   |   |

**____ 32 ____** 

The followingtable sets forth, for the periods indicated, our revenues by product line (inthousands):

|              | Year ended December 31, |
|-------------------|-------------------------|
|              | 2001                    | 2002 | 2003 |
|              |                    |   |   |
| DiskOnKey         | $ 6,606                 | $ 26,810 | $ 77,631 |
| DiskOnChip        | 27,440                  | 25,753 | 25,960 |
| Mobile DiskOnChip | ---                     | 3,613 | 14,990 |
| FFD               | 5,389                   | 5,926 | 4,017 |
| Other             | 5,243                   | 2,715 | 7,456 |
|              |                    |   |   |
| Total             | $  44,678               | $ 64,817 | $ 130,054 |
|              |                    |   |   |

 

**Year Ended December 31st, 2003Compared to Year Ended December 31st, 2002**

*Revenues*.Revenues for the year ended December 31, 2003 increased by $ 65.2 million,or 101%, to $ 130.1 million from $ 64.8 million for the year endedDecember 31, 2002. Sales of our DiskOnKey products increased by $ 50.8million, or 190%, to $ 77.6 million and sales of our Mobile DiskOnChipproducts increased by $ 11.4 million, or 315%, to $ 15.0 million. Theincrease in revenues was attributable primarily to increased sales of ourDiskOnKey and Mobile DiskOnChip products.

*GrossProfit*. Our gross profit for the year ended December 31, 2003 increased by$ 16.5 million to $ 36.9 million, an increase of 81% from gross profitof $ 20.4 million for the year ended December 31, 2002. Our gross marginsdeclined from 31.5% for the year ended December 31, 2002 to 28.4% for the yearended December 31, 2003, due to an increase in the price of flash components asa result of a shortage in the supply of flash memory components and due topricing pressures resulting from increasing competition. This decline waspartially offset by an increase in our revenues from licensing fees androyalties.

*Researchand Development Expenses, Net*. Our gross research and development expensesfor the year ended December 31, 2003 increased by $ 3.1 million to $ 15.4million, an increase of 25.6% from gross research and development expenses of $ 12.2million for the year ended December 31, 2002. Our net research and developmentexpenses for the year ended December 31, 2003 increased by $ 2.7 millionto $ 14.7 million, an increase of 22.9% from net research and developmentexpenses of $ 12.0 million for the year ended December 31, 2002. Theincrease in our gross research and development expenses is attributable to ourdecision to increase our investments in the development of new products. As apercentage of revenues, our net research and development expenses decreased to11.3% for the year ended December 31, 2003 from 18.5% for the year endedDecember 31, 2002. During the year ended December 31, 2003, we recognized $ 84,000,$ 414,000, and $ 177,000 of research and development grants fromSIIRD, IST and OCS, respectively, compared to $ 63,000, $ 212,000 and$ 0 of research and development grants we recognized from SIIRD, IST andOCS, respectively, during the year ended December 31, 2002.

*Sellingand Marketing Expenses*. Selling and marketing expenses for the year endedDecember 31, 2003 increased by $ 6.9 million, or 55%, to $ 19.4million from $ 12.5 million for the year ended December 31, 2002. As apercentage of revenues, our selling and marketing expenses decreased to 14.9%for the year ended December 31, 2003 from 19.4% for the year ended December 31,2002.

*Generaland Administrative Expenses*. General and administrative expenses for theyear ended December 31, 2003 increased by $ 0.9 million, or 21%, to $ 4.9million from $ 4.0 million for the year ended December 31, 2002. Thisincrease is attributable mainly to expenses associated with an intellectualproperty litigation matter, which was settled in the third quarter of 2003. Asa percentage of revenues, our general and administrative expenses decreased to3.7% for the year ended December 31, 2003 from 6.2% for the year ended December31, 2002.

*FinancialIncome, Net*. Financial income, net for the year ended December 31, 2003increased slightly by $ 0.1 million to $ 2.7 million from $ 2.6million for the year ended December 31, 2002.

**____ 33 ____** 

*MinorityInterest in Losses of Subsidiary*. In July 2003, we established asubsidiary, SmartCaps Ltd., to create consumer electronics devices that use ourDiskOnKey as the device's data storage. The OCS has invested in SmartCaps, andcurrently holds 20.05% of the subsidiary's equity. During 2003, we reportedminority interest in the losses of SmartCaps of $ 117,000.

*Net Income(Loss)*. For the year ended December 31, 2003, we recognized net income of $ 0.9million compared to a net loss of $ 5.5 million for the year endedDecember 31, 2002.

**Year Ended December31st, 2002 Compared to Year Ended December 31st, 2001**

*Revenues*.Revenues in 2002 increased by $ 20.1 million or 45% to $ 64.8 millionfrom $ 44.7 million in 2001. Our DiskOnKey sales increased by $ 20.2million or 306%, Our DiskOnChip sales increased by $ 1.9 million, or 7%,and our FFD sales increased by $ 0.5 million, or 10%. The increase inrevenues was attributable primarily to the continued penetration of ourDiskOnKey product line to the PC and Laptop market.

*GrossProfit*. Our gross profit in 2002 was $ 20.4 million compared to agross loss of $ 15.9 million in 2001, which resulted from the inventorywrite-down of $ 30.2 million. Furthermore, compared to 2001, gross marginschanged from negative 35.6% to positive 31.5%.

*Researchand Development Expenses, Net*. Our gross research and development expensesin 2002 decreased by $ 1.1 million to $ 12.2 million, a decrease of8.2% from the Company`s gross research and development expenses of $ 13.3million in 2001. Our net research and development expenses decreased by $ 1.3million to $ 12.0 million, a decrease of 9.9% from the net research anddevelopment expenses of the Company`s of $ 13.3 million in 2001. Thedecrease in our gross research and development expenses is attributable to the Company`sdecision to shift focus to a more market oriented approach. As a percentage ofrevenues, our net research and development expenses decreased to 18.5% in 2002from 29.7% in 2001. In 2002, we received $ 63,000 and $ 212,000research and development grants from SIIRD and IST, respectively, in comparisonto the $ 60,000 research and development grant we received from SIIRD in2001.

*Sellingand Marketing Expenses, Net*. Gross selling and marketing expenses in 2002slightly increased by $ 0.4 million, or 3.5%, to $ 12.5 million from$ 12.1 million in 2001. As a percentage of revenues, our net selling andmarketing expenses decreased to 19.4% in 2002 from 27.1% in 2001.

*Generaland Administrative Expenses*. General and administrative expenses in 2002slightly increased by $ 0.1 million, or 2%, to $ 4.0 million from $ 3.9million in 2001. As a percentage of revenues, our general and administrativeexpenses decreased to 6.2% in 2002 from 8.8% in 2001.

*Capitalloss*. In 2001, we realized a one-time charge of $ 1.0 million due toan investment write-off, as well as a one-time write-off of $ 181,000relating to assets used in our previous facilities that could not be utilizedin our new facilities in Kfar-Saba. In 2002 we had no capital loss.

*FinancialIncome, Net*. Financial income, net, in 2002 decreased by $ 2 millionor 43.4% to $ 2.6 million from $ 4.6 million in 2001, due mainly tothe lower interest rates prevailing in the market.

*Net Income(Loss)*. For the reasons discussed above, in 2002 our net loss was $ 5.5million compared to a net loss of $ 41.8 million in 2001. 

**____ 34 ____** 

**CriticalAccounting Policies and Estimates**

Our discussion and analysis of our financial condition and results ofoperations are based upon our consolidated financial statements, which havebeen prepared in accordance with accounting principles generally accepted inthe U.S. The preparation of these financial statements requires us to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingentliabilities. On an on-going basis, we evaluate our estimates, including thoserelated to customer programs and incentives, product returns, bad debts,inventories, investments, income taxes, warranty obligations, and contingenciesand litigation. We base our estimates on historical experience and on variousother assumptions that we believe are reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources.Actual results may differ from these estimates under different assumptions orconditions.

We believethe following critical accounting policies, among others, affect oursignificant judgments and estimates used in the preparation of our consolidatedfinancial statements:

***Revenue Recognition*** - We generatemost of our revenues from selling our flash data storage products to endcustomers, distributors, retailers and OEMs.

In December 2003, the SEC issued StaffAccounting Bulletin ("SAB") No. 104 "Revenue Recognition"("SAB No. 104") which revises or rescinds certain sections of SAB No.101 "Revenue Recognition," in order to make this interpretiveguidance consistent with current authoritative accounting and auditing guidanceand SEC rules and regulations. The changes noted in SAB No. 104 did not have amaterial effect on our consolidated results of operations, consolidatedfinancial position or consolidated cash flows.

Revenues from product sales are recognizedin accordance with SAB No. 104 when delivery has occurred, persuasive evidenceof an arrangement exists, the vendor's fee is fixed or determinable, no furtherobligation exists and collectibility is probable. Because of frequent salesprice reductions and rapid technological obsolescence in the industry, salesmade to distributors and retailers under agreements allowing price protectionand/or a right of return are deferred until the retailers or distributors sellour products to the end customers, or the right expires.

Deferred revenues consist of amountsreceived from customers for which revenue has not been recognized.

We do not recognize revenues on productsales when we are uncertain of the customer's ultimate acceptance of the productdue to, for example, new product introductions, or changes to product features,manufacturing processes or component design. Revenues are not recognized onthese product sales until such time as we believe the customer's acceptance ofthe product is reasonably certain. Such product sales are included in inventoryuntil such time as the revenues are recognized.

We also do not recognize revenues onproduct sales when we are unable to determine the ability of the customer tohonor a commitment to make fixed and determinable payments. Revenues are notrecognized on these product sales until the customer proves consistency ofpayments made pursuant to agreed terms. Such product sales are included ininventory until such time as the revenues are recognized. 

Royalties from licensing the right to useour technology are recognized when the related sales are made. We determinesuch sales by receiving confirmation of sales subject to royalties fromlicensees. We recognize license fees and fixed non-refundable royalties ratablyover the term of the license.

***Inventory Valuation*** - Ourpolicy for valuation of inventory and commitments to purchase inventory,including the determination of obsolete or excess inventory, requires us toperform a detailed assessment of inventory at each balance sheet date whichincludes a review of, among other factors, an estimate of future demand forproducts within specific time horizons, valuation of existing inventory, aswell as product life-cycle and product development plans. The estimates offuture demand that we use in the valuation of inventory are the basis for therevenue forecast, which is also consistent with our short-term manufacturingplan. Inventory reserves are also provided to cover risks arising from slowmoving items. We write down our inventory for estimated obsolescence orunmarketable inventory equal to the difference between the cost of inventoryand the estimated market value based upon assumptions about future demand,market conditions, and, specifically, prices of flash components.

**____ 35 ____** 

***Warranties*** - We provide forthe estimated cost of product warranties at the time revenue is recognized. Theproducts we sell are covered by a warranty for periods ranging from one year tofive years. We accrue a warranty reserve for estimated costs to providewarranty services. Our estimate of costs to service the warranty obligations isbased on historical experience and expectation of future conditions. To theextent we experience increased warranty claim activity or increased costsassociated with servicing those claims, our warranty accrual will increase,resulting in decreased gross profits.

***Investment in PrivateCompanies*** - Investment in other companies is recorded at cost. Ourinvestments in other companies are reviewed for impairment whenever events orchanges in circumstances indicate that the carrying amount of the investmentmay not be recoverable.

***Functional Currency*** - TheU.S. dollar is the primary currency in the economic environment in which weoperate. Most of our sales are made outside of Israel and are denominated indollars. Most of our purchases of materials and components are made outside of Israel and are denominated in dollars. In addition, most marketing and service costs areincurred in dollars. As a result, our functional and reporting currency is theU.S. dollar.

#   

#  B.  LIQUIDITY AND CAPITAL RESOURCES

#   

To date, wehave funded our operations primarily through cash from operations and, to amuch lesser extent, through government grants to support our selling and marketingand research and development efforts. We completed our initial public offeringin March 1993. In March 2000, we completed a secondary offering of our OrdinaryShares, which provided net proceeds to us of approximately $ 149.6million. In February 2004, we completed a secondary offering of our OrdinaryShares, which provided net proceeds for the company of approximately $95.0 million.

As of December31, 2003, our cash, cash equivalents, bank deposits and marketable securitieswere $ 79.8 million ($ 46.1 million of this amount being comprised oflong-term marketable securities). These balances decreased in the fourthquarter of 2003 due to our having increased inventory to meet increasing marketdemand and due to accelerated payments to suppliers. We believe that our cash,cash equivalents, bank deposits and short-term marketable securities (totaling$ 33.7 million as of December 31, 2003), together with the net proceedsfrom this offering, will be sufficient to fund our working capital needs andplanned capital expenditures for the next twelve months.

We had noindebtedness as of December 31, 2003. As of December 31, 2003, we hadauthorized and available credit lines of $ 4.0 million from banks. None ofthe credit lines were drawn upon as of December 31, 2003. In connection withthe credit lines, we agreed not to place any liens on our assets without therespective banks' consent.

On May 1,2003, we entered into a share purchase agreement with Dr. Hans Wagner, a memberof our Board of Directors, for the purchase of 500,000 unregistered OrdinaryShares. The shares were issued in July 2003 for total consideration ofapproximately $ 4.1 million.

In August2003, Toshiba invested $ 4.0 million in our company ($ 3.9 millionnet of issuance expenses), receiving 330,811 unregistered Ordinary Shares at aprice per share of $ 12.0915. In addition, we issued an option to Toshibato purchase additional unregistered Ordinary Shares up to the number whichwould raise its total shareholding in our company (including all other OrdinaryShares owned by Toshiba) to 4.99% of our outstanding share capital at the timeof exercise, at an exercise price equal to the closing price of our OrdinaryShares on Nasdaq on the last trading day before the day on which Toshibaexercises its option. The option is exercisable by Toshiba through July 30,2004.

Net cash usedin operating activities for the year ended December 31, 2003 was $ 22.0million, as compared to $ 2.8 million for the year ended December 31,2002. This increase was attributable primarily to changes in our workingcapital to support a larger revenue base, in particular to an increase in ourtrade receivables and inventory. Our trade receivables increased to $ 19.7million at December 31, 2003 from $ 4.9 million at December 31, 2002. Thisincrease reflects our increased sales in 2003. We expect trade receivables tocontinue to increase as our sales grow and to represent a significant portionof our working capital for the foreseeable future.

**____ 36 ____** 

Ourinventories increased from $ 17.1 million at December 31, 2002 to $ 45.9million at December 31, 2003, in order to meet increasing market demand. Ourinventory of finished goods increased from $ 10.7 million at December 31,2002 to $ 33.1 million at December 31, 2003 due to an increase in productsales for which revenues were not recognized during the period in accordancewith our revenue recognition policy and, to a lesser extent, an increase ininventory on consignment to our customers, which collectively increased from $ 6.1million to $ 27.8 million over this same period. See also "--Critical Accounting Policies and Estimates -- Revenue Recognition." Weexpect that our inventory levels will continue to be at higher than historicallevels as our revenues continue to grow.

During 2001,as a result of a sharp reduction in the prices of flash components, and theeconomic slowdown that caused a decline in our sales, thereby causing prolongedinventory cycles, we re-evaluated the fair value of our inventories andrecorded an inventory write-down in the cost of revenues of approximately $ 30.2million.

We expectthat our uses of cash in the near future will be to fund working capital andincreases in selling and marketing expenditures and research and developmentexpenditures. In addition, we may also use cash for potential investments orexpenditures to secure additional sources of supply for flash memory componentsand potential strategic acquisitions of, or investments in, related businesses,product lines and technologies. However, we currently have no commitments forany specific acquisitions, expenditures or investments. We cannot assure youthat the uses will not be different.

For the yearended December 31, 2003, the aggregate amount of our capital expenditures was $ 2.8million. These expenditures were principally for the purchases of computerhardware and software and facilities improvements.

**Lease commitments**

Ourfacilities in Omer, Israel, our subsidiaries' facilities and our vehicles areleased under several operating lease agreements, which expire on various dates,the latest of which is in 2006.

Futureminimum lease commitments under non-cancelable operating leases, are asfollows:
| ** ** | **Year ended  December 31,**     |
|------------|----------------------------------|
|       | 2004                             | 2005 | 2006 | Total |
|       |                             |   |   |   |
| Facilities | $    267,000 | $    67,000 | $    67,000 | $    401,000 |
| Vehicles   | 1,085,000                        | 916,000 | 378,000 | 2,379,000 |
|       |                             |   |   |   |
|       |                             |   |   |   |
| Total      | $ 1,352,000                 | $ 983,000 | $ 445,000 | $ 2,780,000 |
|       |                             |   |   |   |

Facilitieslease expenses for the years ended December 31, 2002 and 2003, wereapproximately $ 456,000 and $ 386,000, respectively. Vehicle leaseexpenses for the years ended December 31, 2002 and 2003 were approximately $ 763,000and $ 1,169,000, respectively.

**Royalty Commitments**

Under ourresearch and development agreements with the OCS and SIIRD, we are required topay royalties at the rate of 1.5% to 5% of sales of products developed withfunds provided by the OCS and SIIRD, up to an amount equal to 150% of the OCSand 100% of the SIIRD research and development grants (dollar-linked) relatedto such projects. In addition, the Israeli Government, through the Fund forEncouragement of Marketing Activities ("FEMA"), awarded us and our U.S. subsidiary grants for participation in expenses for overseas marketing. We arecommitted to pay royalties to FEMA at the rate of 3% on the increase in exportsales, up to the amount of the grants received by us. As of December 31, 2003,we had outstanding obligations to pay royalties of $ 357,000 in respect ofthese various grants.

**____ 37 ____** 

**Taxation**

Israelicompanies are subject to corporate tax at the rate of 36%. However, theeffective rate of tax of a company that derives income from an approvedenterprise may be considerably lower. Most of our production facilities havebeen granted approved enterprise status under six separate programs pursuant to  Israel's Law for the Encouragement of Capital Investments, 1959. The primarytax benefits resulting from such status are described below.

During 2000,we purchased the assets of Fortress U&T Ltd., which had a facility that hadbeen granted approved enterprise status. In 2000, we initiated a research anddevelopment facility in Omer, Israel, at the site of Fortress' facilities.Income derived from our Omer facility is tax exempt for a 10-year period,commencing in the year in which we first recognize Israeli taxable income fromthat facility. However, the tax-exempt period will end no later than theearlier of 12 years from the commencement of production, or 14 years fromreceipt of the approval for the Omer approved enterprise. We came to anagreement with the Israeli tax authorities on the percentage of revenues whichare deemed attributable to the facility in Omer.

In addition,income which is not attributable to our Omer facility and which is derived fromour approved enterprises that commenced operations prior to or during 1996 istax exempt for the first four years of the 10-year tax benefit period, and issubject to a reduced tax rate during the rest of the period. Income which isnot attributable to the Omer facility and which is derived from our approvedenterprises that commenced operations after 1996 is tax exempt for the firsttwo years of the 10-year tax benefit period, and is subject to a reduced taxrate during the rest of the period. The reduced tax rate is imposed at a rateof between 10% and 25%, depending on the percentage of our Ordinary Shares heldby non-Israelis in that remaining period (the more of our Ordinary Shares heldby non-Israelis, the lower the tax rate). The tax benefit periods for eachrespective approved enterprise will commence in the year in which we firstrecognize Israeli taxable income from such approved enterprise, and will end nolater than the earlier of 12 years from the commencement of production, or 14years from receipt of the approval for such approved enterprise. Accordingly,the period relating to these approved enterprises will expire between 2005 and2012. The tax benefit periods for these approved enterprises have not yetcommenced except for the first program.

Wemanufacture part of our products outside of Israel, using foreign contractmanufacturers. This might affect the tax benefits to which we are entitled. Weare currently negotiating this matter with the Israeli tax authorities. Becausewe do not expect to report taxable income for the foreseeable future, we do notexpect the outcome of these negotiations, even if adverse, to have a materialimpact on us.

We cannot besure that approved enterprise programs will continue to be available, or thatwe will continue to qualify for benefits under such programs. In addition, thebenefits available to an approved enterprise are conditional upon thefulfillment of certain conditions stipulated in the relevant laws andregulations and the criteria set forth in the certificate of approval issued tous. In the event that we do not comply with these conditions, in whole or inpart, we may be required to refund the amount of the benefits, indexed to theIsraeli CPI, with interest.

For the yearsended December 31, 2002 and 2003, we incurred losses for tax purposes. Accordingly,we did not provide for taxes on income in the reported periods.

**Inflation**

Most of oursales are made in dollars, and most of our expenses are incurred in dollars orNew Israeli Shekels. We have not been materially affected by changes in therate of inflation in Israel. Inflation in the U.S. and our other markets hasnot had a material effect on our results of operations.

** **

**____ 38 ____** 

#  C.  RESEARCH AND DEVELOPMENT, PATENTS AND LICENSES, ETC

#   

**Government of Israel Support Programs**

***Research and DevelopmentOverview and Internal Program***

We havedevoted significant resources to research and development activities withrespect to our core flash data storage technology. We have emphasized thedevelopment of our technology, the enhancement of existing products and thedevelopment of new products, generally in response to the rapidly evolvingmarkets for High-End Mobile Devices, Embedded Devices, military systems andnetwork infrastructure equipment and other embedded systems. In addition, weemphasize the development and addition of new features to our products, such assecurity and access control. 

Our grossresearch and development expenses during 2003, 2002, and 2001 were $ 15.4million, $ 12.2 million, and $ 13.3 million, respectively. A smallportion of our revenues during those years was funded through grants from -SIIRD and IST, as discussed below. 

***Research and Development Grants***

Weparticipate in programs offered by the OCS, SIIRD and IST that support researchand development activities. We received or accrued participation from OCS,SIIRD and IST of $ 177,000, $ 84,000 and $ 414,000, respectively,in 2003, $ 0, $ 63,000 and $ 212,000 respectively in 2002, and $ 0,$ 60,000, $ 0, respectively, in 2001. Our OCS grants related to thedevelopment of a compact IDE interface flash disk, our SIIRD grants related tothe development of LPC flash disk and our IST grants related to the developmentof secure mobile payment on chip (SM-PAYSOC). For a discussion of suchprograms, including royalty obligations and limitations on manufacturing andthe transfer of technology relating to such participations, see "Item 4B:Business Overview - Research and Development."

 

#  D.  TREND INFORMATION

#   

Please seethe discussion of significant recent trends in our business, including trendsin our revenues, costs of revenues, research and development expenses, salesand marketing expenses and net income (loss), in "Item 5A: Operating Results -Overview."

 

#  E.        OFF-BALANCE SHEET ARRANGEMENTS

#   

We are notparty to any material off-balance sheet arrangements.

* *

**____ 39 ____** 

#  F.         TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS

|                                            | Payments due by  Period (US$ in thousands) |
|-------------------------------------------------|--------------------------------------------|
| Contractual Obligations as of December 31, 2003 | Total                                      | Less than 1 year | 1-3 years | 3-5 years | More than 5 years |
| Operating leases(1)                             | $   2,780                   | $   1,352 | $ 1,428 | $ --- | $ --- |
| Purchase obligations(2)                         | 46,708                                     | 46,708 | --- | --- | --- |
| Total                                           | $ 49,488                              | $ 48,060 | $ 1,428 | $ --- | $ --- |

* *
| * * | (1) | Includes leases  for facilities and vehicle leases for Israeli employees                                                                                 |
|----------|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------|
| * * | (2) | Covers material  goods and services under issued purchase orders and further includes material  purchase commitments under applicable binding forecasts. |

#  

# ITEM6.   DIRECTORS, SENIOR MANAGEMENT ANDEMPLOYEES

 

#  A.  DIRECTORS AND SENIOR MANAGEMENT

#   

The followingtable sets forth certain information regarding our directors and executiveofficers as of May 1st, 2004:

| **Name**         | **Age** | **Position**                                                               |
|------------------|---------|----------------------------------------------------------------------------|
| Dov Moran        | 48      | President, CEO and Chairman of the Board of Directors                      |
| Aryeh Mergi      | 42      | Executive Vice President of Business Development;  Director                |
| Ronit Maor       | 33      | CFO and Vice President of Finance and Administration;  Corporate Secretary |
| Dana Gross       | 37      | Chief Marketing Officer; Director                                          |
| Itsik Onfus      | 42      | Director                                                                   |
| Eli Ayalon       | 61      | Director                                                                   |
| Yair Shoham      | 50      | Director                                                                   |
| Dr. Hans Wagner  | 74      | Director                                                                   |
| Yossi Ben Shalom | 48      | Director                                                                   |

 

Thebackground of each of our directors, executive officers and key employees is asfollows:

*Dov Moran*. Mr. Moran is a founder of M-Systems and has been a director and President,Chief Executive Officer and Chairman of the Board of Directors of M-Systemssince 1989. Mr. Moran has also been a director and chairman of the board ofdirectors of our U.S. subsidiary, M-Systems Inc. ("MSU"), since 1992. From 1984to 1989, Mr. Moran was an independent consultant in the computer industry.Prior thereto, Mr. Moran served in the Israeli Navy for seven years and wasdirector of its microprocessors department. Mr. Moran received a B.Sc. inComputers and Electronic Engineering (with honors) from the Technion, IsraelInstitute of Technology, in Haifa, Israel in 1977. 

*Aryeh Mergi*. Mr. Mergi is a founder of M-Systems and has been a director of M-Systemssince 1989 and a director of MSU since 1992. Mr. Mergi has been our ExecutiveVice President of Business Development of the Company since 2000. From 1995 to2000, he served as Executive Vice President of Sales and Marketing. From 1989to 1995, he served as Vice President of Research and Development. Mr. Mergireceived a B.Sc. in Electronic Engineering (with honors) from the Technion,Israel Institute of Technology, in Haifa, Israel in 1988. 

*Ronit Maor*. Ms. Maor has been Chief Financial Officer and Vice President of Finance andAdministration since May 1997. Ms. Maor joined us as Planning and ControlManager in March 1996 and was promoted to Vice President of Planning andControl in February 1997. Prior thereto, Ms. Maor was a project manager atTefen, an industrial engineering consulting company. She received her B.Sc. inIndustrial Management Engineering (with honors) from Tel-Aviv University in 1995.

**____ 40 ____** 

*Dana Gross*. Ms. Gross has served as the Company`s Chief Marketing Officer since July,2002, and as a director of the Company since September 2000. Ms. Gross joinedthe Company in July 1992 as Vice President of Operations. She was promoted toChief Financial Officer in 1994, to President of MSU in 1995, to Executive VicePresident of Business Development in 1997, to Vice President of Worldwide Salesin 1998 and to Executive Vice President of the DiskOnChip business unit in2000. Ms. Gross received a B.Sc. in Industrial Management Engineering (withhonors) from Tel-Aviv University in 1992 and an M.B.A. degree from San Jose State University in 1997. 

*ItsikOnfus*. - Mr. Onfus has served as a director of M-Systems since August,2003. Since July, 2002, Mr. Onfus has been the Director of Finance at SapPortals Israel Ltd. From 1995 to 2002, Mr. Onfus served as the Chief FinancialOfficer of a number of start-up companies in their incubation stage, including,among others, VDOnet Corporation Ltd., TI ISRAEL (formerly Butterfly V.L.S.ILtd.), CallManage Inc., Voquette, RFWaves Ltd., Envara and IXI Mobile. From1990 to 1995, Mr. Onfus filled the positions of Controller, CorporateController and, prior to its purchase by Elbit, Chief Financial Officer ofFibronics Ltd., prior to which, from 1986 to 1990, Mr. Onfus worked as a CPAfor the accounting firm of Goren, Ben Yaakov. During his studies, Mr. Onfusworked both as an assistant professor in the Economics department of the HebrewUniversity, Jerusalem, and as a research assistant, in the Research Departmentof the Bank of Israel. Mr. Onfus received his B.A. degree in Economics andAccounting from the Hebrew University, Jerusalem in 1990.

*Eli Ayalon*.- Mr. Ayalon has served as a director of M-Systems since May, 2003. Mr. Ayalonis currently and has served since January 2000, as the Chairman of the Board& CEO of DSP Group Inc. (DSPG - NASDAQ). Mr. Ayalon also currently servesas the Chairman of the Board of ParthusCeva Inc. (PCVA - NASDAQ). From May 1996to January 2000, Mr. Ayalon served as President and CEO of DSP Group Inc. From1987 to 1996, Mr. Ayalon served as President and Chief Executive Officer ofvarious technology companies including, among others, Teledata Communication(TLDCF - NASDAQ); Mennen Medical Ltd., a supplier of advanced medical equipmentin the area of intensive care and cardiology; and Semiconductors Devices Ltd.,a technology company in the Israeli defense industry. From 1976 to 1987, Mr.Ayalon filled various positions in the Israeli electronics industry, advancingfrom R&D management, through sales & marketing management to generalmanagement. Mr. Ayalon holds a degree from the Technion, Israel Institute ofTechnology, in Haifa, Israel.

*YairShoham*. Mr. Shoham has served as a director of M-Systems since 1996. SinceJune 1999, Mr. Shoham has been general partner with Genesis Partners II L.L.C.,an Israel-based venture capital fund that is affiliated with CIBC World MarketsCorp. From 1997 to 1999, Mr. Shoham was the Vice President for BusinessDevelopment of Butterfly VLSI Ltd., and from January 1996 to December 1996 hewas the Vice President for Business Development of VDOnet Corporation Ltd. FromJanuary 1994 to December 1995, Mr. Shoham was a partner at the law firm ofGoldfarb, Levy, Eran & Co., Tel-Aviv, Israel. Mr. Shoham received his B.A.degree from Haifa University in Israel in 1982 and a J.D. degree from LoyolaUniversity of Chicago School of Law in 1985. Mr. Shoham qualifies as anindependent director under applicable Nasdaq rules and was elected to the Boardof Directors as an External Director under the applicable provisions of theCompanies Law. 

*Dr. HansWagner*. Dr. Wagner has served as a director of M-Systems since November,2002. Dr. Wagner is currently a Senior Partner of Omega Partners Ltd., atelecommunications consultancy firm, of which he was a founder in 1977. Dr.Wagner also founded and serves as a director of Ozone Ltd., a manufacturer ofrecycling devices founded in 1996, and of Pelikon Ltd., a developer andmanufacturer of electro-luminescent displays founded in 2000. From 1995 to2000, Dr. Wagner served as a strategic advisor to the management of EricssonMobile LM. From 1984 to 1992, Dr. Wagner was a founder and served as chairmanof Technophone, a mobile telephone manufacturer which was then the worldwidenumber three in sales prior to its acquisition by Nokia. From 1973 to 1977, Dr.Wagner served as the Assistant Secretary General of the UNDP. From 1969 to1973, Dr. Wagner served as the CEO of SONAB AB, Sweden`s second largestcommunication equipment manufacturer. From 1963 to 1969, Dr. Wagner served asthe COO of Incentive AB, Sweden`s largest technical conglomerate. Dr. Wagnerholds a Masters degree in Chemical Engineering, an MBA degree from theStockholm School of Economics and a Ph.D. from the Massachusetts Institute of Technology.Dr. Wagner qualifies as an independent director under applicable Nasdaq rules. 

**____ 41 ____** 

*Yossi BenShalom*. Mr. Ben Shalom has served as a director of the Company sinceJanuary, 2003. Mr. Ben Shalom is a co-founder of DBSI Investments Ltd. Beforeestablishing DBSI Investments, Mr. Ben-Shalom had been Executive Vice Presidentand Chief Financial Officer of Koor Industries Ltd. (KOR - Nasdaq) from 1998through 2000. Before that, Mr. Ben-Shalom served as Chief Financial Officer ofTadiran Ltd. Mr. Ben-Shalom serves as an active director on numerous boards,including, among others, on the boards of NICE Systems (NICE - Nasdaq) -computer telephony; Machteshim Agan - chemicals; and Bank Klali. Mr. Ben-Shalomserved as an active chairman in successful turnaround programs, such as atEurocar Israel, American Express Israel and Scopus Technologies. Mr. Ben Shalomholds a BA in Economics and an MA in Business Management from Tel Aviv University. Mr. Ben Shalom qualifies as an independent director under applicable Nasdaqrules. 

 

#  B.  COMPENSATION

#   

The aggregatecompensation paid by us and our subsidiaries to all persons who served in thecapacity of director and executive officer for the year ended December 31, 2003(10 persons of which 1 no longer serves in such capacity) was approximately$ 365,000, which includes approximately $ 35,000 set aside or accruedto provide pension, retirement or similar benefits, but does not includeamounts expended by us for automobiles made available to our officers, expenses(including business travel, professional and business association dues andexpenses) reimbursed to officers and other fringe benefits commonly reimbursedor paid by companies in Israel. The Company does not pay directors` fees to itsdirectors.

During fiscal2003, all persons who served in the capacity of director and executive officerfor the year ended December 31, 2003 (10 persons of which 1 no longer serves insuch capacity), were granted options to purchase a total of 525,000 OrdinaryShares at an average price of $ 9.44 per share, with vesting terms of 2-4years, out of which 112,000 options to purchase Ordinary Shares at an averageprice of $ 17.7 per share, are still subject to the approval andratification of our shareholders. All options were granted pursuant to our thencurrent share option and incentive plans (see in Item 6.E below the paragraphtitled "Share Option Plans and recent changes in Israeli law").

 

#  C.  BOARD PRACTICES

**Terms of Office**

Directors areelected by an ordinary resolution at the Annual General Meeting of ourshareholders. All directors of the Company, other than "External directorsunder the Companies Law (see in this Item 6.C below the paragraph titled"External Directors") who serve for a period of three years after theirelection, serve until the next Annual General Meeting, unless their offices arevacated earlier under any relevant provision of our Articles of Association.

We haveentered into employment agreements with all of our executive officers similarin form to the agreements entered into with all of our other employees. Theseagreements are subject to termination by either party, with or without cause,in most cases on either 30 or 60 days` notice, depending on the agreement.Under these agreements with our Israeli executive officers, we and the employeeeach contribute a percentage of the salary of the employee to a fund known as"Managers` Insurance." This fund provides a combination of savings plan,insurance and severance pay benefits to the employee, giving the employee alump sum of payment upon retirement and securing severance pay, if legallyentitled, upon termination of employment. Each employee who agrees toparticipate contributes an amount equal to 5% of his or her salary and wecontribute between 13.3% and 15.8% of his or her salary. Israeli law generallyrequires severance pay, which may be funded by Managers` Insurance, upon theretirement or death of an employee or termination of employment without duecause. These agreements all contain provisions standard for a company in ourindustry regarding non competition, confidentiality of information andassignment of inventions. The enforceability of covenants not to compete islimited in Israel.

**____ 42 ____** 

**Alternate Directors**

Our Articlesof Association provide that a director may appoint, by written notice to us,any individual to serve as an alternate director so long as such individualdoes not already serve as a director or an alternate director. Any alternatedirector will have all of the rights and obligations of the director appointinghim or her, except the power to appoint an alternate (unless the instrumentappointing him or her provides otherwise) and the right to remuneration. Thealternate director may not act at any meeting at which the director appointinghim or her is present. Unless the appointing director limits the time period orscope of any such appointment, the appointment will be effective for allpurposes and for an indefinite time, but will expire upon the expiration of theappointing director`s term. Currently, no alternate directors have beenappointed.

**External Directors**

Under theCompanies Law, companies incorporated under the laws of Israel whose shares have been offered to the public in or outside of Israel are required to appointat least two external directors. This law provides that a person may not beappointed as an external director if the person or the person`s relative,partner, employer or any entity under the person`s control, has, as of the dateof the person`s appointment to serve as external director, or had, during thetwo years preceding that date, any affiliation with the company or any entitycontrolling, controlled by or under common control with the company. The term"affiliation" includes:
| ●*       *  | an  employment relationship;                                            |
|-----------------------------------------------------------|-------------------------------------------------------------------------|
| ●*       *  | a business or  professional relationship maintained on a regular basis; |
| ●*       *  | control;  and                                                           |
| ●*       *  | service as  an office holder.                                           |

No person mayserve as an external director if the person`s position or other businessactivities create, or may create, a conflict of interest with the person`sresponsibilities as an external director or may otherwise interfere with theperson`s ability to serve as an out external side director.

Externaldirectors are to be elected by a majority vote at a shareholders` meeting,provided that either:

1. at least one-third of the shares ofnon-controlling shareholders voted at the meeting, vote in favor of election ofthe director; or

2. the total number of shares ofnon-controlling shareholders voted against the election of the director doesnot exceed one percent of the aggregate voting rights in the company.

The initialterm of an external director will be three years and may be extended for anadditional three years. Each committee of a company`s board of directors willbe required to include at least one external director and the audit committeeof a company`s board of directors is required to include both the externaldirectors. We have appointed Yair Shoham and Itsik Onfus as external directorspursuant to the Companies Law.

An externaldirector is entitled to compensation as provided in regulations to be adoptedunder the Companies Law and is otherwise prohibited from receiving any othercompensation, directly or indirectly, in connection with service provided as anexternal director.

**Independent Directors**

Our OrdinaryShares are listed for quotation on The Nasdaq National Market and thus we aresubject to the rules of The Nasdaq National Market applicable to quotedcompanies as well as to the applicable provisions of the Sarbanes-Oxley Act of2002 ("Sarbanes-Oxley") and the rules and regulations thereunder. Under therules, we are required to appoint a minimum of three (3) Independent Directors.The independence standard under the rules excludes any person who is a currentemployee of the Company or who has been an employee of the Company for acertain period of time as well as the immediate family members of an executiveofficer of the Company. Messrs. Ayalon, Onfus, Shoham, Ben-Shalom and Dr.Wagner serve as Independent Directors and meet the independence standard of theabove rules. 

**____ 43 ____** 

**Audit Committee**

Under theCompanies Law, the board of directors of any publicly traded company mustappoint an audit committee, comprised of at least three directors including allof the external directors but excluding: (a) the chairman of the board ofdirectors; (b) any controlling shareholder or relative of a controllingshareholder; or (c) any director employed by the company or who providesservices to the company on a regular basis. Under the Nasdaq rules, we arerequired to have at least three independent directors on the audit committee.In addition, Nasdaq requires that the members of the audit committee (a) nothave any relationship to the company that may interfere with the exercise oftheir independence, and (b) must be financially literate.

The roles ofour audit committee under the Companies Law include identifying irregularitiesin the management of the company`s business and approving related partytransactions as required by law. The responsibilities of the audit committeeunder the Nasdaq rules include, among other things, evaluating the independenceof a company`s outside auditors.

In additionto such functions as the audit committee may have under the Companies Law orunder the Nasdaq rules, the primary purpose of our audit committee is to assistthe board of directors in fulfilling its responsibility to oversee management`sconduct of the financial reporting process, the systems of internal accountingand financial controls and the annual independent audit of the company`sfinancial statements. The audit committee reviews with management and ouroutside auditors the audited financial statements included in our Annual Reporton Form 20-F and our interim quarterly financial results included on Form 6-K.

The auditcommittee must observe the independence of our outside auditors and has theauthority and responsibility to nominate for shareholder approval, evaluateand, where appropriate, replace our outside auditors. 

Indischarging its oversight role, our audit committee is empowered to investigateany matter brought to its attention with full access to all books, records,facilities and personnel of our company and the power to retain outsidecounsel, auditors or other experts for this purpose.

Our audit committeecurrently consists of Itsik Onfus, Yair Shoham and Yossi Ben Shalom. 

**Financial Expert**

UnderSarbanes-Oxley, one of the Audit Committee members must have accounting orrelated financial management expertise. Our Board of Directors has recognized Mr.Ben Shalom, based on all of the requirements set forth in the applicable rulesand regulations, as our "financial expert" and we believe that we are incompliance with this requirement.

**Internal Auditor**

Under theCompanies Law, the board of directors of a public company must appoint aninternal auditor, nominated by its audit committee. The role of the internalauditor is to examine, among other matters, whether the company`s actionscomply with the law and orderly business procedure. Under the Companies Law,the internal auditor may be an employee of the company but not an officeholder, an affiliate, or a relative of an office holder or affiliate, and hemay not be the company`s independent accountant or its representative. We haveappointed an internal auditor in accordance with the requirements of theCompanies Law. 

 

#  D.  EMPLOYEES

#   

As of May1st, 2004, we had 394 employees, including 60 employees in administration andaccounting, 120 in sales and marketing, 142 in research and development and 72 inoperations. Of these 394 employees, 321 were based in Israel, 35 in the United States and 38 in other countries. 

We aresubject to Israeli labor laws and regulations with respect to our Israeliemployees. These laws principally concern matters such as paid annual vacation,paid sick days, length of the workday and work week, minimum wages, pay forovertime, insurance for work-related accidents, severance pay and otherconditions of employment.

**____ 44 ____** 

Furthermore,by order of the Israeli Ministry of Labor and Welfare, we and our Israeliemployees are subject to provision of the collective bargaining agreementsbetween the Histadrut, the General Federation of Labor in Israel and the Coordination Bureau of Economic Organizations, including the IndustrialistsAssociations. These provisions principally concern cost of living increases,recreation pay and other conditions of employment. We believe that the benefitsand working conditions that we provide to our employees are above the requiredminimum. Our employees are not represented by a labor union. We have writtenemployment contracts with virtually all of our employees and we believe thatour relations with our employees are satisfactory. 

 

#  E.  SHARE OWNERSHIP

#   

As of May 1,2004, the aggregate number of our Ordinary Shares beneficially owned by ourdirectors and executive officers as a group was 3,806,649, and includes optionsto purchase up to 296,000 Ordinary Shares which are exercisable or will becomeexercisable within 60 days of May 1, 2004. The weighted average exercise priceof these options was $ 5.54 per share.

**Share Option Plans and RecentChanges in Israeli Law**

The Companypreviously had two incentive share option plans in place, the Incentive andRestricted Share Option Plan (the "IRSO Plan") and the Section 102 Share OptionPlan (the "102 Plan" and, together with the IRSO Plan, the "Old Plans"). Therespective term of each of the Old Plans expired on February 15th, 2003. 

Inreplacement of the Old Plans and in lieu of recent revisions (the "Tax Reform")to the Israeli Income Tax Ordinance (New Version) 1961 (the "Tax Ordinance")requiring the adoption of certain adjustments concerning the issuance of shareoptions to Israeli employees, the Company adopted, by way of a resolution ofthe Board of Directors on November 5th, 2002 and a resolution of theshareholders of the Company on December 17th, 2002, its new omnibus 2003 StockOption and Restricted Stock Incentive Plan (the "New 2003 Plan"). Following isa brief review of each of the Old Plans, of the New 2003 Plan and of the TaxReform:

***Incentive and Restricted ShareOption Plan***

Under theIRSO Plan, we were authorized to grant options for up to 3,000,000 OrdinaryShares to our employees, directors and consultants. The exercise price pershare for an incentive share option could not be less than the market value ofthe Ordinary Shares on the date the option was granted. Incentive optionsgranted under the IRSO Plan in accordance with the terms thereof were intendedto qualify as incentive stock options under Section 422 of the U.S. InternalRevenue Code of 1986, as amended (the "Code"). Any options that were cancelledor forfeited before expiration became available for future grant under the IRSOPlan. The IRSO Plan expired on February 15th, 2003.

***Section 102 Share Option Plan***

Under the 102Plan, we were authorized to grant options to purchase an aggregate of 4,000,000Ordinary Shares to our Israeli employees. The exercise prices of optionsgranted under the 102 Plan were determined by our Board of Directors at thetime of the grant, and such granted options usually expire no later than tenyears from the date of grant. Any options that were cancelled or forfeitedbefore expiration became available for future grant under the 102 Plan. The 102Plan expired on February 15th, 2003.

Prior to therevision of the Tax Ordinance, pursuant to Section 102 thereof and the rulespromulgated thereunder (including the requirement that the options and/or theresulting shares be deposited with a trustee for at least two years), the taxon the benefit arising to the employee from the grant and exercise of optionsas well as from the allotment of Ordinary Shares under these options isdeferred until the transfer of the options and/or Ordinary Shares to theemployee`s name or upon the sale of those options and/or Ordinary Shares. Wewill be allowed to claim as an expense for tax purposes the amounts credited tothe employees as a benefit upon sale of the shares allotted under the 102 Planat a price exceeding the exercise price, when the related capital gains tax ispayable by the employee.

**____ 45 ____** 

***The New 2003 Plan***

Under the New2003 Plan, the Company has reserved five million (5,000,000) Ordinary Sharesfor the granting of awards to the employees, officers, directors, serviceproviders and consultants of the Company and of any subsidiary of the Company.The New 2003 Plan is intended to enable the Company to issue awards undervarying tax regimes, including without limitation (i) pursuant and subject tothe provisions of the Tax Ordinance; (ii) incentive stock options within themeaning of Section 422 of the Code; (iii) nonqualified stock options; (iv)shares of restricted stock; and (v) other share-based awards. Apart fromissuance under the relevant tax regimes in the State of Israel and the UnitedStates of America, the New 2003 Plan contemplates issuances of awards in otherjurisdictions, with respect to which the Board of Directors is empowered tomake the requisite adjustments in the New 2003 Plan and set forth the relevantconditions in the Company`s agreement with the grantee in order to comply withthe requirements of the tax regimes in any such jurisdictions.

Awards may begranted pursuant to the New 2003 Plan from time to time within a period of ten(10) years from the date the New 2003 Plan was adopted by the Board ofDirectors. The exercise prices of options granted under the New 2003 Plan is tobe determined, subject to applicable law, by the Board of Directors at the timeof the grant, and such granted options usually expire no later than ten yearsfrom the date of grant. Any of the Ordinary Shares reserved under the New 2003Plan, which may remain unsold and which are not subject to outstanding optionsat the termination of the New 2003 Plan, shall cease to be reserved for the purposeof the New 2003 Plan. If any outstanding award under the New 2003 Plan should,for any reason, expire, be canceled or be forfeited without having beenexercised in full, the Ordinary Shares allocable to the unexercised, canceledor terminated portion of such award shall (unless the New 2003 Plan shall havebeen terminated) become available for subsequent grants of awards under the New2003 Plan. 

***Aggregate Amounts ofOutstanding Options***

As of May 1,2004, under the Old Plans and the New 2003 Plan we had, in the aggregate,outstanding options for 5,591,389 Ordinary Shares at an average exercise priceof $ 9.13 per Ordinary Share, and with expiration dates ranging from August,2003 to March, 2014 (out of which 112,000 options to purchase Ordinary Shares atan average price of $ 17.7 per share, are still subject to the approvaland ratification of our shareholders).

***Revisions to the Tax Ordinance***

The TaxReform created a new tax structure for taxing stock or stock options that theCompany grants to its Israeli employees, while the existing tax structure willcontinue to apply to the issuance of options to external service providers andto the controlling owners of the Company, who are not considered to be`employees` of the Company for the purposes of Section 102 of the TaxOrdinance. As a general rule, a company can choose to issue options or sharesthrough a trustee or without a trustee. If such company chooses the trusteetrack, it must further opt for either the `ordinary income track` or the`capital gains track` and this decision is then binding on the company and onall similarly situated office-holders for the subsequent two years. 

We havechosen to issue shares and options through a trustee, who has been authorizedby the tax authorities in accordance with and for the period set by law and, asa result, neither the issuance of shares or options to those of our eligibleemployees, nor the exercise by such employees of their options, will betaxable. The tax will be imposed only when the shares are sold by the trusteeor transferred to the employee, whichever is earlier. We have notified the taxauthorities of our opting for the `capital gains track` in accordance with therequirements of the Tax Ordinance. 

**____ 46 ____** 

As a resultof our choosing the `capital gains track,` in the event that the trustee holdsthe shares until the end of the required holding period, which is at least 2years from the end of the tax year in which the shares or options were issuedto the trustee, the value of the benefit to the employee will be considered tobe capital gain and he or she will be taxed at a rate of 25%. In addition, wewill not be able to deduct expenses for tax purposes. As our Ordinary Sharesare registered on a stock exchange, a part of the profit that reflects the valueof the benefit to the date of issuance will be considered as ordinary income bythe employee and we will be able to deduct this as a salary expense, with thebalance being deemed as capital gains and taxable at 25% which we will not beable to deduct as an expense. Had we chosen the `ordinary income (employmentincome) track`, the employee would have been considered as having receivedemployment income in an amount equal to the benefit (consideration at date ofsale, less share option exercise price and expenses from the purchase andsale). We would then have been entitled to deduct as a salary expense, the sameamount as the employee would have received in income. The required holdingperiod by the trustee under the `ordinary income (employment income) track` isone year from the end of the tax year in which the options or shares wereissued to the employee. 

**The Employee Stock Purchase Plan -Global Non-U.S. (the "Global ESPP plan"); and the Employee Stock Purchase Plan- U.S. (the "U.S. ESPP plan")**

The purposeof the ESPP plans is to enable our employees to purchase M-Systems` sharesthrough accumulated payroll deductions. The Global ESPP plan is available toall of our non-U.S. employees. The U.S. ESPP plan is available to our U.S. employees and contains certain provisions intended to qualify the U.S. ESPP plan as an"employee stock purchase plan" under Section 423 of the Code.

The terms ofour ESPP plans (both Global and U.S.) provide that any of our employees (withcertain restrictions in the U.S. ESPP Plan), if he or she so chooses, can electbefore any "Offering Period" to have any whole percentage between 1% and 10%deducted from his salary and allocated to buy M-Systems shares. An "OfferingPeriod" is a six-month period, with a new Offering Period beginning on May 15and November 15 each year (unless changed by the Board of Directors). The priceof the shares purchased by the employee - i.e., the number of shares that hewill receive in return for the amounts deducted from his salary over the six-monthOffering Period - will be determined at the end of the Offering Period and willbe equal to the lower of 85% of the closing bid for of M-Systems` shares on (1)the first day of the Offering Period; or (2) the last day of the OfferingPeriod.

Under theGlobal ESPP plan, we may sell up to 550,000 shares to our employees. Under theU.S. ESPP plan, we may sell up to 200,000 shares to our employees.

The ESPPplans expire in 2011 unless earlier terminated by our Board of Directors.

 

 

**____ 47 ____** 

# ITEM7.   MAJOR SHAREHOLDERS AND INTERESTED PARTY TRANSACTIONS

 

#  A.  MAJOR SHAREHOLDERS

#   

The followingtable sets forth the number of Ordinary Shares owned beneficially by allshareholders known to us to own beneficially more than 5% of the outstandingOrdinary Shares on May 1st, 2004.

| ** **

** **                                           | **Ordinary Shares  beneficially owned** |
|------------------------------------------------------------------|-----------------------------------------|
| Name                                                             | Number                                  | Percent |
| Dov Moran                                                        | 2,302,771                               | 6.57% |
| RS Investment Management Co. LLC (1)(2)                          | 2,201,600                               | 6.28% |
| Fidelity Investments (2)                                         | 1,923,400                               | 5.49% |
| Federated Investors, Inc. (Asset Management) (2)                 | 1,847,800                               | 5.27% |
| All directors and executive officers as a group (9  persons) (3) | 3,806,649                               | 10.86% |

 
| * * | (1) | Based  on information contained in the most recently filed Report of Form 13-G filed  by RS Investment Management Co. LLC, it is the general partner of RS  Investment Management, L.P. and the majority shareholder of RS Investment  Management, Inc. G. Randall Hecht is the chief executive officer and a  control person of RS Investment Management Co. LLC, RS Investment Management,  L.P., and RS Investment Management, Inc. RS Investment Management, L.P. is a  registered investment adviser and the investment adviser to RS Emerging  Growth Fund, a registered investment company. |
|----------|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| * * | (2) | Numbers  and percentages are based on information provided to the Company from outside  sources. We are unable to give accurate percentages of each entity`s  holdings.                                                                                                                                                                                                                                                                                                                                                                                                                            |
| * * | (3) | Also  includes options granted to such directors and executive officers of the  Company, which are exercisable within 60 days of May 1st, 2004.                                                                                                                                                                                                                                                                                                                                                                                                                                                    |

 

As of May1st, 2004, our Ordinary Shares were held by approximately 74 holders of record.Based on a review of the information provided to us by our transfer agent, 59 holdersof record, holding approximately 90.71% of our outstanding Ordinary Shares,were residents of the United States. 

Our shareholdersdo not have different voting rights.

 

#  B.  RELATED PARTY TRANSACTIONS

#   

In October,2000, we purchased 586,080 preferred shares of Saifun for approximately$ 10 million. This investment was part of a transaction in which Saifunsold 2,327,323 of its preferred shares to various venture capital and strategicinvestors for aggregate consideration of approximately $ 39.7 million.Saifun is a private, venture-backed Israeli company engaged in research,development, production and marketing of flash memory products and technology.Boaz Eitan, who was at the time of this transaction a member of our Board ofDirectors, is the founder, chief executive officer and a director of Saifun.This transaction was approved by our Audit Committee and Board of Directors, inthe absence of Dr. Eitan in both cases, in accordance with the provisions ofthe Companies Law governing approval of related party transactions. Mr. Eitan hasceased to serve as a member of the Company`s Board of Directors on December17th, 2002.

On May 1st,2003, we entered into a Share Purchase Agreement with Dr. Hans Wagner, a memberof our Board of Directors, according to which Dr. Wagner purchased 500,000 ofour Ordinary Shares, at a purchase price per share of $ 8.21, for anaggregate investment amount of $ 4,105,000. This transaction was approvedby our Audit Committee and Board of Directors, in the absence of Dr. Wagner, inaccordance with the provisions of the Companies Law governing approval ofrelated party transactions. 

**____ 48 ____** 

*Insurance*.We have obtained directors and officers liability insurance for the benefit ofour office holders and intend to continue and obtain such insurance and pay allpremiums thereunder to the fullest extent permitted by the Companies Law. Underthe Companies Law, an Israeli company may not exempt an office holder fromliability for a breach of his duty of loyalty, but may exempt in advance anoffice holder from his liability to the company, in whole or in part, for abreach of his duty of care. 

Our Articlesof Association provide that, subject to the provisions of the Companies Law, wemay enter into a contract for the insurance of the liability of any of ouroffice holders for acts which he or she performed in his or her capacity as anoffice holder in relation to: 
| ●*       *  |   | A breach of  his/her duty of care to us or to another person;                                                                                                                               |
|-----------------------------------------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ●*       *  |   | a breach of  his/her duty of loyalty to us, provided that the office holder acted in good  faith and had reasonable cause to assume that his/her act would not prejudice  our interests; or |
| ●*       *  |   | A financial  liability imposed upon him/her in favor of another person.                                                                                                                     |

*Indemnificationof Office Holders*. Our Articles of Association provide that we mayindemnify an office holder against:
| ●*       *  |   | a financial  liability imposed on him/her in favor of another person by any judgment,  including a settlement or an arbitrator`s award approved by a court  concerning an act performed in his/her capacity as an office holder;                                                                                                                                                   |
|-----------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ●*       *  |   | reasonable  litigation expenses, including attorneys` fees, expended by the office holder  or charged to him/her by a court in proceedings we institute against him/her,  instituted on our behalf, or instituted by another person, in each case  relating to an act performed in his/her capacity as an office holder; and                                                       |
| ●*       *  |   | reasonable  litigation expenses relating to an act performed in his/her capacity as an  office holder, including attorneys` fees, expended by the office holder or  charged to him/her by a court in a criminal proceeding from which he/she was  acquitted, or a criminal proceeding in which he/she was convicted for a  criminal offense that does not require proof of intent. |

Our Articlesof Association also include:
| ●*       *  |   | authorization  to undertake, in advance, to indemnify an office holder, provided that the  undertaking is limited to specified events which the board of directors  believes are anticipated and limited in amount determined by the board of  directors to be reasonable under the circumstances; and |
|-----------------------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ●*       *  |   | authorization  to indemnify retroactively an office holder.                                                                                                                                                                                                                                            |

We haveagreed to indemnify our office holders under indemnification agreements witheach office holder, to the maximum extent permitted under the Companies Law. 

# * *

#  C.  INTEREST OF EXPERT AND COUNSEL 

#   

 

**- Not applicable**

 

 

**____ 49 ____** 

# ITEM8.   FINANCIAL INFORMATION 

 

#  A.  CONSOLIDATED STATEMENTS AND OTHER FINANCIAL INFORMATION 

#   

Ourconsolidated audited financial statements are included in this annual report in"Item 18: Financial Statements." 

**Legal Proceedings**

Other thanthe litigation set forth below, we are not involved in any legal proceedingsthat we believe, individually or in the aggregate, will have a material adverseeffect on the Company other than the following:

M-Systems anda number of its distributors in Singapore are in litigation procedures withTrek Technology (Singapore) PTE Ltd. a company registered in Singapore ("Trek"). The litigation is taking place in the High Court of Singapore.

In April2002, Trek received a patent in Singapore on "Portable Data Storage Device".Trek immediately issued `Cease and Desist` letters to several companies, includingM-Systems' distributors / OEMs in Singapore alleging that M-Systems' DiskOnKeyproduct infringes its patent. M-Systems asked Trek to withdraw its letters andwas refused. Consequently, On May 17th, 2002 M-Systems filed alawsuit against Trek for groundless threats and on May 20th, 2002 Trekfiled a lawsuit against M-Systems' distributors (and later on M-Systems itself)for patent infringement. M-Systems is under a contractual obligation toindemnify the said distributors and we represent them in all litigationprocedures.

M-Systemsmain defense against Trek's infringement allegations is based on Trek's patentinvalidity. The case is still pending before the court in Singapore.

**Dividend Distribution Policy**

We have neverdeclared or paid any cash dividends on our Ordinary Shares and we do not intendto pay cash dividends on our Ordinary Shares in the foreseeable future. Wecurrently intend to retain all future earnings to finance operations and toexpand our business. 

Under theprovisions of our Articles of Association, the declaration of any final cashdividends in respect of any fiscal period requires shareholder approval, whichmay reduce but not increase such dividend from the amount proposed by our boardof directors; provided that any failure by the shareholders to approve a finaldividend will not affect any interim dividend which has been paid. Payments ofdividends may be subject to withholding and other taxes.

If we declarecash dividends, they could be taxable to the recipient. Because we havereceived benefits under the Investment Law (see item 10.E below the paragraphtitled "Law for the Encouragement of Capital Investments, 1959"), payment ofcash dividends during the exemption period granted under the Investment Lawwill subject that portion of our income derived from the `approved enterprise`status granted to us under the Investment Law, to Israeli taxes to which theincome would not otherwise be subject. We have decided to reinvest permanentlythe amount of tax-exempt income derived from our approved enterprises and notto distribute such income as dividends. In the event that we decide to pay acash dividend from income that is tax exempt, we would be liable for corporatetax on the amount distributed at the rate of 20%. Cash dividends may be paid byan Israeli company only out of retained earnings as calculated under Israelilaw.

 

#  B.  SIGNIFICANT CHANGES 

#   

 

**- Not applicable**

 

 

**____ 50 ____** 

# ITEM9.   THE OFFER AND LISTING

 

#  A. OFFER AND LISTING DETAILS

#   

4. Thefollowing table lists the high and low last reported sales prices on Nasdaq forthe periods indicated: 

 

| **Yearly  Figures**           | ** **   | ** **   |
|-------------------------------|--------------|--------------|
| ** **                    | **High**     | **Low**      |
| 1999:                         | $ 34.00 | $ 3.63  |
| 2000:*                        | $ 44.25 | $ 11.94 |
| 2001:                         | $ 16.56 | $ 3.92  |
| 2002:                         | $ 12.59 | $ 4.95  |
| 2003                          | $ 22.49 | $ 5.20  |
|                          |         |         |
| **Quarterly  Figures**        | ** **   | ** **   |
|                          |         |         |
| 2002:                         | **High**     | **Low**      |
| First Quarter                 | $ 12.59 | $ 7.15  |
| Second Quarter                | $ 9.86  | $ 7.27  |
| Third Quarter                 | $ 8.68  | $ 6.21  |
| Fourth Quarter                | $ 8.68  | $ 4.95  |
|                          |         |         |
| 2003:                         | **High**     | **Low**      |
| First  Quarter                | $ 8.25  | $ 5.20  |
| Second  Quarter               | $ 11.72 | $ 6.00  |
| Third  Quarter                | $ 17.61 | $ 11.43 |
| Fourth  Quarter               | $ 22.49 | $ 15.73 |
|                          |         |         |
| 2004:                         |         |         |
| First Quarter

 

  | $ 22.00 | $ 16.86 |
| **Monthly Figures**           |         |         |
|                          |         |         |
| 2003-2004:                    | ** **   | ** **   |
| Most Recent 6 months:         | **High**     | **Low**      |
| November 2003                 | $ 22.49 | $ 18.18 |
| December 2003                 | $ 20.15 | $ 15.78 |
| January 2004                  | $ 22.00 | $ 17.64 |
| February 2004                 | $ 19.97 | $ 16.86 |
| March 2004                    | $ 20.68 | $ 18.20 |
| April 2004                    | $ 23.15 | $ 17.45 |

 
| * * | * | We effected a two-for-one  stock split in September 2000. Accordingly, the share price information for  2000 is adjusted to reflect such stock split. The share price information for  1999 remains unadjusted and reflects the pre-split highs and lows for that  year. |
|----------|---|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

On April 30th,2004, the last reported sale price of our Ordinary Shares was $ 17.45 pershare. There is currently no trading market for our Ordinary Shares outside the  United States.

**B. - Not applicable**

**____ 51 ____** 

**C.**Our Ordinary Shares were quotedon The Nasdaq Small-Cap Market under the symbol "FLSHF" from our initial publicoffering in March 1993 through our secondary public offering in August 1996.Since August 8, 1996, our Ordinary Shares have been quoted on The NasdaqNational Market. On March 24, 1999, our ticker symbol was changed to "FLSH."

**D. - Not applicable**

**E. - Not applicable**

**F. - Not applicable**

 

 

# ITEM10.   ADDITIONAL INFORMATION

#   

#  A.  SHARE CAPITAL 

#   

**- Not applicable**

 

 

#  B.  MEMORANDUM AND ARTICLES OF ASSOCIATION

#   

**Objects and Purposes**

The objectsand purposes of our company appear in our Memorandum of Association and includetaking all actions permissible under applicable laws. 

**Approval of Specified RelatedParty Transactions**

The CompaniesLaw imposes a duty of care and a duty of loyalty on all of a company`s officeholders as defined below, including directors and executive officers. The dutyof care requires an office holder to act with the level of care that areasonable office holder in the same position would have acted under the samecircumstances. The duty of loyalty generally requires an office holder to actin good faith and for the good of the company. An "office holder" as defined inthe Companies Law is a director, a general manager, a chief executive officer,a deputy general manager, a vice general manager, other managers directlysubordinate to the general manager and any person who fills one of the abovepositions without regard to title.

The CompaniesLaw requires that an office holder of a company promptly disclose any personalinterest that he may have and all related material information known to him, inconnection with any existing or proposed transaction by the company. Once anoffice holder complies with these disclosure requirements, the board ofdirectors may approve a transaction between the company and the office holder,or a third party in which an office holder has a personal interest, unless thearticles of association provide otherwise. A transaction that is adverse to thecompany`s interest cannot be approved. If the transaction is an extraordinarytransaction under the Companies Law, then, in addition to any approvalstipulated by the articles of association, it also requires audit committeeapproval before board approval and, in specified circumstances, subsequentshareholder approval. Any transaction between a company and one of itsdirectors relating to the conditions of the director`s service, including inrelation to exculpation, insurance or indemnification, or in relation to theterms of the director`s service in any other capacity requires audit committeeapproval before board approval and subsequent shareholder approval.

**____ 52 ____** 

The CompaniesLaw also provides that a director with an interest in an extraordinarytransaction brought before the board of directors or the audit committee forits approval may not vote on the approval and may not be present for thediscussion of the issue. However, this rule would not apply if a majority ofthe directors or a majority of the members of the audit committee alsopossessed an interest in the transaction.

Under ourArticles of Association, our Board of Directors may exercise all powers andtake all actions that are not required under law or under our Articles ofAssociation to be exercised or taken by our shareholders, including the powerto borrow money for the purposes of our company.

Our directorsare not subject to any age limit requirement, nor are they disqualified fromserving on the Board of Directors because of a failure to own certain amount ofour shares.

**Rights, Preferences andRestrictions on Shares**

Our Articlesof Association authorize one class of shares, which are our Ordinary Shares. Wemay declare a dividend to be paid to the holders of our Ordinary Shares andallocated among them in proportion to the sums paid up or credited as paid upon account of the nominal value of their respective shareholdings, withouttaking into account any premium paid for the shares. Our Board of Directors maydeclare dividends only out of retained earnings, or earnings derived over thetwo most recent fiscal years, whichever is higher. Our Articles of Associationprovide that our Board of Directors may propose a final dividend in respect ofany fiscal period but that such dividend shall be payable only after approvedby our shareholders. All unclaimed dividends may be invested or otherwise usedby the Board of Directors for our benefit until those dividends are claimed. Inthe event an unclaimed dividend is claimed, only the principal amount of the dividendwill be paid to the person entitled to the dividend.

If weliquidate, after satisfying liabilities to creditors and subject to the rightsof holders of shares, if any, with any special rights upon winding up, ourassets will be distributed to the holders of Ordinary Shares in proportion totheir holdings.

Holders of OrdinaryShares have one vote for each - paid-up Ordinary Share held of record on allmatters submitted to a vote of our shareholders. These voting rights may beaffected by the grant of any special voting rights to the holders of a class ofshares with preferential rights that may be authorized in the future.

Our Articlesof Association provide that directors are elected by an ordinary resolution ofa general meeting of our shareholders. Our Ordinary Shares do not havecumulative voting rights in the election of directors. Accordingly, the holdersof Ordinary Shares representing more than 50% of the voting power in ourcompany have the power to elect all directors. 

We may,subject to the applicable provisions of the Companies Law, issue redeemableshares and subsequently redeem them. In addition, our Board of Directors maymake calls for upon shareholders in respect of any sum that has not been paidup in respect of any shares held by those shareholders.

Under theCompanies Law, the disclosure requirements that apply to an office holder alsoapply to a controlling shareholder of a public company. A controllingshareholder includes a shareholder that holds 25% or more of the voting rights ina public company if no other shareholder owns more than 50% of the votingrights in the company. Extraordinary transactions with a controllingshareholder or in which a controlling shareholder has a personal interest, andthe terms of compensation of a controlling shareholder who is an office holder,require the approval of the audit committee, the board of directors and theshareholders of the company. The shareholder approval requires that: (a) themajority of shares voted at the meeting, including at least one third of theshares of disinterested shareholders voted at the meeting, vote in favor of thetransaction; or (b) the total number of shares of disinterested shareholdersvoted against the transaction does not exceed one percent of the aggregate votingrights in the company.

**____ 53 ____** 

The CompaniesLaw also requires a shareholder to act in good faith towards a company in whichhe holds shares and towards other shareholders and to refrain from abusing hispower in the company, including in connection with voting at a shareholders`meeting on:
| ●*       *  | Any  amendment to the Articles of Association;                                    |
|-----------------------------------------------------------|-----------------------------------------------------------------------------------|
| ●*       *  | An increase  in the company`s authorized capital;                                 |
| ●*       *  | A merger;  or                                                                     |
| ●*       *  | Approval of  some of the acts and transactions that require shareholder approval. |

A shareholderhas the general duty to refrain from depriving other shareholders of theirrights. Any controlling shareholder, any shareholder that knows that itpossesses the power to determine the outcome of a shareholder vote and anyshareholder that, under the provisions of the articles of association, has thepower to appoint an office holder in the company, is under a duty to act infairness towards the company. The Companies Law does not describe the substanceof this duty.

**Modifications of Share Rights**

Under ourArticles of Association, the rights attached to any class may be varied byadoption of the necessary amendment of the Company`s Articles of Association,provided that the holders of shares of the affected class approve the change bya class meeting in which the holders of at least 75% of the shareholderspresent at the meeting, in person or by proxy, and voting on the issue approvethe change. Our Articles of Association differ from the Companies Law in thisrespect, as under the law changes in the rights of shareholders require theconsent of at least 50% of the voting power of the affected class representedat the meeting and voting on the change. Our Articles of Association requirefor quorum at a meeting of a particular class of shares the presence of twoshareholders holding at least 25% of the voting power of that class. OurArticles of Association - may be amended by majority of the voting power of ourcompany represented at a shareholders meeting and voting thereon, except thatthe provisions of our Articles of Association relating to mergers andacquisitions can only be amended by a vote of 75% of the voting power of ourcompany represented at a meeting and voting thereon. 

**Shareholders Meetings andResolutions**

We arerequired to hold an annual general meeting of our shareholders once everycalendar year, but no later than 15 months after the date of the previousannual general meeting. All meetings other than the annual general meeting ofshareholders are referred to as extraordinary general meetings. Our Board ofDirectors may call extraordinary general meetings whenever it sees fit, at suchtime and place, within or without the State of Israel, as it may be determined.In addition, the Companies Law provides that the board of directors of a publiccompany is required to convene an extraordinary meeting upon the request of (a)any two directors of the company or one quarter of the company`s board ofdirectors or (b) one or more shareholders holding, in the aggregate, (i) fivepercent of the outstanding shares of the company and one percent of the votingpower in the company or (ii) five percent of the voting power in the company.

The quorumrequired by our Articles of Association for a meeting of shareholders consistsof at least two shareholders present in person or by proxy who hold orrepresent between them at least 25% of the voting power in our company. Ameeting adjourned for lack of quorum is adjourned to the same day in thefollowing week at the same time and place or any time and place as the chairmanof the meeting decides. At such reconvened meeting, the required quorumconsists of any two shareholders present in person or by proxy.

Our Articlesof Association enable our Board of Directors to fix a record date to allow usto determine the shareholders entitled to notice of, or to vote at, any generalmeeting of our shareholders. The record date may not be more than 40 days, orany longer period permitted under the Companies Law, nor less than 4 daysbefore the date of the meeting. Each shareholder of record as of the recorddate determined by the Board of Directors may vote the shares then held by thatshareholder unless all calls and other sums then payable by the shareholder inrespect of its shares have not been paid.

**____ 54 ____** 

**Limitation on Ownership of Securities**

The ownershipand voting of our Ordinary Shares by non-residents of Israel are not restricted in any way by our Articles of Association or by the laws of theState of Israel, except for shareholders who are subjects of countries whichare enemies of the State of Israel.

**Mergers and Acquisitions;Anti-takeover Provisions**

The CompaniesLaw includes provisions allowing corporate mergers. These provisions requirethat the board of directors of each company that is party to the merger approvethe transaction. In addition, the shareholders of each company must approve themerger. Our Articles of Association require approval of a merger or acquisitionby a vote of the 75% of our company`s voting power, present and voting on theproposed merger at a shareholders` meeting. In determining whether therequisite majority has approved the merger, shares held by the other party tothe merger or by any person holding at least 25% of such other party areexcluded from the vote. The Companies Law does not require court approval of amerger other than in specified situations. However, upon the request of acreditor of either party to the proposed merger, a court may delay or preventthe merger if it concludes that there exists a reasonable concern that as aresult of the merger, the surviving company will be unable to satisfy theobligations of any of the parties of the merger to their creditors.

A merger maynot be completed unless at least 70 days have passed from the time that aMerger Proposal (as defined in the Companies Law) has been filed with theIsraeli registrar of companies.

The CompaniesLaw also provides that the acquisition of shares in a public company on theopen market (i.e., from other shareholders of the company) must be made bymeans of a tender offer if, as a result of the acquisition, the purchaser wouldbecome a 25% shareholder of the company. The rule does not apply if therealready is another 25% shareholder of the company. Similarly, the law providesthat an acquisition of shares in a public company must be made by means of atender offer if, as a result of the acquisition, the purchaser would become a45% shareholder of the company, unless there already is a 50% shareholder ofthe company.

If, followingany acquisition of shares, the purchaser would hold 90% or more of the sharesof the company that acquisition must be made by means of a tender offer for allof the target company`s shares. An acquirer who wishes to eliminate allminority shareholders must do so by means of a tender offer and acquire 95% ofall shares not held by or for the benefit of the acquirer prior to theacquisition. However, in the event that the tender offer to acquire that 95% isnot successful, the acquirer may not acquire tendered shares if by doing so theacquirer would own more than 90% of the shares of the target company.

**Changes in Capital**

Our Articlesof Association enable us to increase or reduce our share capital. Any suchchanges are subject to the provisions of the Companies Law and must be approvedby a resolution passed by a majority of the voting power of our companypresent, in person or by proxy, at a general meeting and voting on such changein the capital. In addition, certain transactions which have the effect ofreducing capital, such as the declaration and payment of dividends undercertain conditions and the issuance of shares for less than their nominalvalue, require a resolution of the Board of Directors and court approval.

**Material Contracts**

On July 29,2003, we announced a set of new agreements with Toshiba that broadened ourexisting strategic relationship (see Item 4.B above the paragraph titled"Expanded Toshiba Relationship").

On December31, 2003, we entered into a Strategic Agreement with Samsung broadening ourexisting relationship (see Item 4.B above the paragraph titled "ExpandedSamsung Relationship").

Other thanthe agreements referred to above, in the past two years we have not enteredinto any material contracts other than contracts entered into in the ordinarycourse of our business.

 

**____ 55 ____** 

#  D.  EXCHANGE CONTROLS

#   

Under Israelilaw, foreign currency transactions are generally permitted, except fortransactions that are specifically restricted. Among these restrictedtransactions are foreign currency transactions by institutional investors,including investments outside of Israel by pension funds and insurers, as wellas futures contracts by foreign residents for periods of more than one month.

Holders of OrdinaryShares are able to convert dividends and liquidation distributions into freelyrepatriable non-Israeli currencies at the rate of exchange prevailing at thetime of repatriation, pursuant to a general permit issued by the Controller ofForeign Exchange at the Bank of Israel under the Currency Control Law, 1978,provided that Israeli income tax has been withheld by us with respect to suchamounts.

Our OrdinaryShares may be freely held and traded pursuant to the General Permit and theCurrency Control Law. The ownership or voting of Ordinary Shares bynon-residents of Israel, except with respect to citizens of countries that arein a state of war with Israel, are not restricted in any way by our Memorandumof Association or Articles of Association or by the laws of the State ofIsrael.

 

**____ 56 ____** 

#  E.  TAXATION

#  

The following is a summary of thecurrent tax structure applicable to companies in Israel, with special referenceto its effect on us. The following also contains a discussion of certainIsraeli Government programs benefiting us. To the extent that the discussion isbased on new tax legislation that has not been subject to judicial oradministrative interpretation, there can be no assurance that the viewsexpressed in the discussion will be accepted by the tax authorities inquestion. The discussion is not intended, and should not be construed, as legalor professional tax advice and is not exhaustive of all possible taxconsiderations.

**General Corporate Tax Structure**

Israeli companies are subject tocorporate tax at the rate of 36%. However, the effective rate of tax of acompany that derives income from an `approved enterprise` (as referred tobelow) may be considerably lower (see in this Item 10.E below the paragraphtitled "Law for the Encouragement of Capital Investments, 1959").

**Tax Reform**

On January 1,2003, the Law for Amendment of the Income Tax Ordinance (Amendment No. 132),5762-2002, known as the `Tax Reform`, came into effect. 

The TaxReform, aimed at broadening the categories of taxable income and reducing thetax rates imposed on employment income, introduced the following, among otherthings:
| ●*       *  | Reduction of the tax rate levied on capital  gains (other than gains deriving from the sale of listed securities) derived  after January 1, 2003, to a general rate of 25% for both individuals and  corporations. Regarding assets acquired prior to January 1, 2003, the reduced tax rate  will apply to a proportionate part of the gain, in accordance with the holding periods of the asset, before or after  January 1, 2003, on a linear basis;                                                                                                                                                                                                                                                           |
|-----------------------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ●*       *  | Imposition of Israeli tax on all income of Israeli  residents, individuals and corporations, regardless of the territorial source  of income, including income derived from passive sources such as interest,  dividends and royalties;                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| ●*       *  | Introduction of controlled foreign corporation  (CFC) rules into the Israeli tax structure. Generally,  under such rules, an Israeli resident who holds, directly or indirectly, 10%  or more of the rights in a foreign corporation whose shares are not publicly  traded (or which has offered less than 30% of its shares or any rights to its shares to the public), in which more than 50% of  the rights are held directly or indirectly by Israeli residents, and a  majority of whose income in a tax year is considered passive income, will be  liable for tax on the portion of such income attributed to his holdings in such  corporation, as if such income were distributed to him as a dividend; |
| ●*       *  | Imposition of capital gains tax on capital  gains realized by Israeli individuals as of January 1, 2003, from the sale of shares of publicly traded companies on the Tel  Aviv Stock Exchange and from the sale of shares of publicly traded Israeli  companies on certain other stock exchanges (such gain was previously exempt  from capital gains tax in Israel in certain cases). For information with  respect to the applicability of Israeli capital gains taxes on the sale of  our Ordinary Shares, see "Capital Gains Taxes on Sales of our Ordinary  Shares" below;                                                                                                                                  |
| ●*       *  | Introduction of a new regime for the taxation  of shares and options issued to employees and officers (including directors); and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| ●*       *  | Introduction of tax at a rate of 25% on dividends paid by  one Israeli company to another (which are generally not subject to tax), if  the source of such dividend is income that was derived outside of Israel.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |

**Law for the Encouragement ofIndustry (Taxes), 1969**

We currently qualify as an"industrial company" under the Law for the Encouragement of Industry (Taxes),1969 (the "Industry Encouragement Law"). A company qualifies as an "industrialcompany" if it is resident in Israel and at least 90% of its income in a giventax year, determined in NIS (other than income from certain types of loans,capital gains, interest and dividends), is derived from industrial enterprisesowned by that company. An "industrial enterprise" is defined as an enterprisewhose major activity in a particular tax year is industrial manufacturingactivity. See Note 12 to our Consolidated Financial Statements.

**____ 57 ____** 

Under the Industry EncouragementLaw, an industrial company is entitled to deduct the purchase price of patentsand certain other intangible property rights (other than goodwill) over aperiod of eight years, beginning with the year in which such rights were firstused.

An industrialcompany may be eligible for special depreciation rates for machinery, equipmentand buildings. These rates differ based on various factors, including the dateof commencement of operation and the number of work shifts. An industrialcompany owning an `approved enterprise` may choose between such specialdepreciation rates and the depreciation rates available to `approvedenterprises`.

Qualificationas an industrial company under the Industry Encouragement Law is notconditioned upon the receipt of prior approval from any Israel government authority. No assurance can be given that we will continue to qualify as anindustrial company or that we will, in the future, be able to take advantage ofany tax benefits available to industrial companies.

**Law for the Encouragement ofCapital Investments, 1959**

TheInvestment Law provides that a capital investment in eligible facilities may,upon application to the Investment Center, be designated as an `approvedenterprise`. Each certificate of approval for an `approved enterprise` relatesto a specific investment program delineated both by its financial scope,including its capital resources, and by its physical characteristics, e.g., theequipment to be purchased and utilized pursuant to the program. The taxbenefits derived from any such certificate of approval relate only to taxableincome attributable to the specific `approved enterprise`. If a company hasmore than one approval, its effective tax rate is the result of a weightedcombination of the applicable rates. Income derived from activity that is notintegral to the activity of the enterprise should not be divided between thedifferent enterprises and should not enjoy tax benefits.

Most of ourcurrent production facilities have been granted the status of an `approvedenterprise` under the Investment Law, in six separate investment programs.Under the Investment Law, we have chosen the "alternative benefits" option andhave waived Government grants in return for a tax exemption. These programsprovide us with the tax benefits described below. Under the terms of our`approved enterprise` programs, our income from `approved enterprises` will betax exempt for periods of 2-4 years (except with respect to income from ourOmer facility, which will be tax-exempt for 10 years), commencing with the yearin which we first earn taxable income from the relevant `approved enterprise`,and is subject to a reduced tax rate for an additional period of up to a totalof ten years from when the tax exemption began. The reduced tax rate is imposedat a rate of between 10% and 25%, depending on the percentage of M-Systems`shares held by non-Israelis during that remaining period (the more shares heldby non-Israelis, the lower the tax rate). The tax benefits periods describedabove will end upon the earlier of (a) 12 years from the year of commencementof production, or (b) 14 years from the year of approval of `approvedenterprise` status).

A companythat has elected the alternative package of benefits, like we have, and thatsubsequently pays dividend out of income derived from the `approved enterprise`during the tax exemption period, will be subject to tax in respect of theamount distributed (including the tax thereon) at the rate that would have beenapplicable had it not elected the alternative package of benefits (generally10%-25%, depending on the extent of foreign shareholders holding our OrdinaryShares). The dividend recipient is taxed at the reduced rate applicable todividends from `approved enterprises` (15%), if the dividend is distributedduring the tax exemption period or within 12 years thereafter. 

TheInvestment Law also provides that an `approved enterprise` is entitled toaccelerated tax depreciation on property and equipment included in an approvedinvestment program.

Any futureapplications we make to the Investment Center will be reviewed separately, anddecisions as to whether or not to approve such applications will be based,among other things, on the then prevailing criteria set forth in the InvestmentLaw, on the specific objectives we set forth in such applications and oncertain financial criteria. Accordingly, there can be no assurance that anysuch applications will be approved. In addition, the benefits available to an`approved enterprise` are conditional upon our fulfilling certain conditionsstipulated in the Investment Law and its regulations and the criteria set forthin the specific certificate of approval, as described below. If we were toviolate those conditions, in whole or in part, we would be required to refundthe amount of tax benefits, with the addition of the CPI linkage adjustment andinterest. We believe that our `approved enterprises` operate in substantialcompliance with all of these conditions and criteria.

**____ 58 ____** 

As ofDecember 31, 2001, we generated a total of approximately $ 35 million ofnet operating loss carryforwards in Israel. These Israeli net operating losscarryforwards have no expiration date. The tax benefits granted to an `approvedenterprise` are not available to us with respect to the income of oursubsidiaries. The actual amount of the benefits associated with the `approvedenterprise` program will depend upon a number of factors, including whetherthese tax incentives are renewed or if the tax authorities successfullychallenge the manner in which profits are recognized among our subsidiaries orwithin specified tax jurisdictions.

**Taxation under InflationaryConditions**

The IncomeTax (Inflationary Adjustments) Law, 1985 (the "Inflationary Adjustments Law"),was designed to neutralize the erosion of capital investments in business andto prevent tax benefits resulting from deduction of inflationary expenses. Thislaw applies a supplementary set of inflationary adjustments to the normaltaxable profits computed under regular historical cost principles.

TheInflationary Adjustments Law introduced a special tax adjustment for thepreservation of equity based on changes in the Israeli CPI, whereby certaincorporate assets are classified broadly into fixed (inflation-resistant) assetsand non-fixed assets. Where a corporation`s equity exceeds the depreciated costof fixed assets, a tax deduction that takes into account the effect of theannual rate of inflation on such excess is allowed (up to a ceiling of 70% oftaxable income for companies in any single year, with the unused portioncarried forward on a linked basis, without limit). If the depreciated cost offixed assets exceeds shareholders` equity, then such excess, multiplied by theannual inflation rate, is added to taxable income.

Under theInflationary Adjustments Law, results for tax purposes are measured in realterms, in accordance with changes in the Israeli CPI. We are taxed under thislaw. The discrepancy between the change in (1) the Israeli CPI and (2) theexchange rate of Israeli currency in relation to the dollar, may in futureperiods cause significant differences between taxable income and the incomemeasured in dollars as reflected by our financial statements (which aremeasured in dollars). In addition, subject to certain limitations, depreciationof fixed assets and losses carried forward are adjusted for inflation on the basisof changes in the Israeli CPI.

**Withholding and Capital GainsTaxes Applicable to Non-Israeli Shareholders**

The State ofIsrael imposes income tax on nonresidents of Israel on income accrued orderived from sources in Israel. These sources of income include passive incomesuch as dividends, royalties and interest, as well as non-passive income fromservices rendered in Israel. We are required to withhold income tax at the rateof 25%, or 15% for dividends of income generated by an `approved enterprise`,on all distributions of dividends other than bonus shares (stock dividends),unless a different rate is provided in a treaty between Israel and theshareholder`s country of residence. Under the income tax treaty between the United States and Israel, the maximum tax on dividends paid to a holder of Ordinary Shares who is a U.S. resident (as defined in the treaty) is 25%.

**Capital Gains Taxes on Sales ofour Ordinary Shares**

Israeli lawimposes a capital gains tax on the sale of securities and other capital assets.In general, the capital gains tax rate on the sale of publicly-tradedsecurities of an Israeli company is 15% for gains accrued after December 31,2002. However, non-residents of Israel, who do not maintain a permanentestablishment within Israel, are exempt from Israeli capital gains tax on thesale of our shares.

A nonresidentof Israel who receives interest, dividend or royalty income derived from oraccrued in Israel, from which tax was withheld at the source, is generallyexempted from the duty to file tax returns in Israel with respect to suchincome, provided such income was not derived from a business conducted inIsrael by the taxpayer and the taxpayer has no other taxable sources of incomein Israel.

Israel presently has no estate or gift tax. 

**____ 59 ____** 

**United States****FederalIncome Tax Considerations**

The followingdiscussion describes the material United States federal income tax consequencesto a holder of our Ordinary Shares, referred to for purposes of this discussionas a "U.S. Holder", that is:
| ●*       *  | A citizen  or resident of the United States;                                                                                                                                                                                    |
|-----------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ●*       *  | A  corporation created or organized in or under the laws of the United States or of any state thereof;                                                                                                                          |
| ●*       *  | An estate,  the income of which is includible in gross income for United States federal  income tax purposes regardless of its source; or                                                                                       |
| ●*       *  | A trust, if  a court within the United States is able to exercise primary supervision over  the administration of the trust and one or more U.S. persons have the  authority to control all substantial decisions of the trust. |

This summarydoes not purport to be a comprehensive description of all of the taxconsiderations that may be relevant to each person`s decision to purchase OrdinaryShares. This summary considers only U.S. Holders that will own Ordinary Sharesas capital assets.

Thisdiscussion does not address all aspects of United States federal incometaxation that may be relevant to any particular shareholder based on suchshareholder`s individual circumstances. In particular, this discussion does notaddress the potential application of the alternative minimum tax or UnitedStates federal income tax consequences to U.S. Holders that are subject tospecial treatment, including:
| ●*       *  | Taxpayers  who are broker-dealers or insurance companies;                                                               |
|-----------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------|
| ●*       *  | Taxpayers  who have elected mark-to-market accounting;                                                                  |
| ●*       *  | Tax-exempt  organizations;                                                                                              |
| ●*       *  | Financial  institutions or "financial services entities";                                                               |
| ●*       *  | Taxpayers  who hold Ordinary Shares as part of a straddle, "hedge" or "conversion  transaction" with other investments; |
| ●*       *  | Taxpayers  who own directly, indirectly or by attribution at least 10% of our voting  power; and                        |
| ●*       *  | Taxpayers  whose functional currency is not the U.S. dollar.                                                            |

In addition,this discussion does not address any aspect of state, local or non-UnitedStates tax laws.

Additionally,this discussion does not consider the tax treatment of partnerships or personswho hold Ordinary Shares through a partnership or other pass-through entity orthe possible application of United States federal gift or estate tax. 

INDIVIDUALHOLDERS ARE ADVISED TO CONSULT WITH THEIR OWN TAX ADVISOR WITH RESPECT TO THESPECIFIC TAX CONSEQUENCES TO THEM OF PURCHASING, HOLDING OR DISPOSING OF OURORDINARY SHARES.

**Taxation of Ordinary Shares**

***Taxation of Dividends Paid OnOrdinary Shares***

A U.S. Holderwill be required to include in gross income as ordinary income the amount ofany distribution paid on Ordinary Shares, including the amount of foreigntaxes, if any, withheld from the amount paid, on the date the distribution isreceived to the extent the distribution is paid out of our current oraccumulated earnings and profits as determined for United States federal incometax purposes. Distributions in excess of such earnings and profits will beapplied against and will reduce the U.S. Holder`s basis in the Ordinary Shares and,to the extent in excess of such basis, will be treated as gain from the sale orexchange of a capital asset.

**____ 60 ____** 

Distributionsof current or accumulated earnings and profits paid in foreign currency to aU.S. Holder will be includible in the income of a U.S. Holder in a U.S. dollaramount calculated by reference to the exchange rate on the day thedistributions received. A U.S. Holder that receives a foreign currencydistribution and converts the foreign currency into U.S. dollars subsequent toreceipt will have foreign exchange gain or loss based on any appreciation ordepreciation in the value of the foreign currency against the U.S. dollar,which will generally be U.S. source ordinary income or loss.

U.S. Holderswill have the option of claiming the amount of any Israeli income taxeswithheld at source either as a deduction from gross income or as adollar-for-dollar credit against their United States federal income taxliability. Individuals who do not claim itemized deductions, but insteadutilize the standard deduction, may not claim a deduction for the amount of theIsraeli income taxes withheld, but such amount may be claimed as a creditagainst the individual`s United States federal income tax liability. The amountof foreign income taxes that may be claimed as a credit in any year is subjectto complex limitations and restrictions, which must be determined on anindividual basis by each shareholder. These limitations include, among others,rules that limit foreign tax credits allowable with respect to specific classesof income to the United States federal income taxes otherwise payable withrespect to each such class of income. The total amount of allowable foreign taxcredits in any year cannot exceed regular U.S. tax liability for the yearattributable to foreign source taxable income. A U.S. Holder will be denied aforeign tax credit with respect to Israeli income tax withheld from dividendsreceived on the Ordinary Shares to the extent such U.S. Holder has not held theOrdinary Shares for at least 16 days of the 30-day period beginning on the datewhich is 15 days before the ex-dividend date or to the extent such U.S. Holderis under an obligation to make related payments with respect to substantiallysimilar or related property. Any days during which a U.S. Holder hassubstantially diminished its risk of loss on the Ordinary Shares are notcounted toward meeting the 16-day holding period required by the statute. Inaddition, distributions of current or accumulated earnings and profits will beforeign source passive income for United States foreign tax credit purposes andwill not qualify for the dividends received deduction available tocorporations.

***Taxation of the Disposition ofOrdinary Shares***

Generally,upon the sale, exchange or other disposition of our Ordinary Shares, a U.S.Holder will recognize capital gain or loss in an amount equal to the differencebetween such U.S. Holder`s basis in the Ordinary Shares, which is usually thecost of such shares, and the amount realized on the disposition. If, asanticipated, the Ordinary Shares are publicly traded, a disposition of shareswill be considered to occur on the "trade date," regardless of the holder`smethod of accounting. Capital gain from the sale, exchange or other dispositionof Ordinary Shares held more than one year is long-term capital gain and iseligible for a maximum 20% rate of taxation for non-corporate holders. Gain orloss recognized by a U.S. Holder on a sale, exchange or other disposition of OrdinaryShares generally will be treated as United States source income or loss for United States foreign tax credit purposes. The deductibility of a capital loss recognizedon the sale, exchange or other disposition of Ordinary Shares is subject tolimitations.

***Information Reporting and BackupWithholding***

Dividendpayments with respect to the Ordinary Shares and proceeds from the sale,exchange or redemption of Ordinary Shares may be subject to informationreporting to the Internal Revenue Service ("IRS") and possible U.S. backup withholding. Backup withholding will not apply, however, to a U.S. Holder whofurnishes a correct taxpayer identification number and makes any other requiredcertification or who is otherwise exempt from backup withholding. Generally, aU.S. Holder will provide such certification on IRS Form W-9 (Request forTaxpayer Identification Number and Certification).

Amountswithheld under the backup withholding rules may be credited against a U.S.Holder`s tax liability, and a U.S. Holder may obtain a refund of any excess amountwithheld under the backup withholding rules by filing the appropriate claim forrefund with the IRS.

**____ 61 ____** 

***Tax Consequences of PassiveForeign Investment Company (PFIC) Status***

We will bedeemed a passive foreign investment company, or PFIC, if 75% or more of ourgross income in a taxable year, including our pro rata share of the grossincome of any company, U.S. or foreign, in which we are considered to own 25%or more of the shares by value, is passive income. Alternatively, we will bedeemed to be a PFIC if at least 50% of our assets in a taxable year, averagedover the year and ordinarily determined based on fair market value andincluding our pro rata share of the assets of any company in which we areconsidered to own 25% or more of the shares by value, are held for theproduction of, or produce, passive income. Passive income includes, among otherthings, amounts derived by reason of the temporary investment of funds raisedin offerings of our Ordinary Shares. If we were a PFIC, and a U.S. Holder didnot make an election to treat us as a "qualified electing fund" (as describedbelow):
| ●*       *  | Excess distributions by us to a  U.S. Holder would be taxed in a special way. "Excess distributions" are  amounts received by a U.S. Holder with respect to our stock in any taxable  year that exceed 125% of the average distributions received by such U.S.  Holder from us in the shorter of either the three previous years or such U.S.  Holder`s holding period for Ordinary Shares before the present taxable year.  Excess distributions must be allocated ratably to each day that a U.S Holder  has held our stock. A U.S. Holder must include amounts allocated to the  current taxable year in its gross income as ordinary income for that year. A  U.S. Holder must pay tax on amounts allocated to each prior taxable year in  which we were a PFIC at the highest rate in effect for that year on ordinary  income and the tax is subject to an interest charge at the rate applicable to  deficiencies for income tax. |
|-----------------------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ●*       *  | The entire amount of gain realized  by a U.S. Holder upon the sale or other disposition of Ordinary Shares will  also be treated as an excess distribution and will be subject to tax as  described above.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| ●*       *  | The tax basis in shares of our  stock that were acquired from a decedent who was a U.S. Holder would not  receive a step-up to fair market value as of the date of the decedent`s death  but would instead be equal to the decedent`s basis, if lower than fair market  value.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |

The special PFIC rules described above willnot apply to a U.S. Holder if the U.S. Holder makes an election to treat us asa `qualified electing fund` ("QEF") in the first taxable year in which the U.S.Holder owns Ordinary Shares and if we comply with certain reportingrequirements. Instead, a shareholder of a qualified electing fund is requiredfor each taxable year to include in income a pro rata share or the ordinaryearnings of the qualified electing fund as ordinary income and a pro rata shareor the net capital gain of the qualified electing fund as long-term capitalgain, subject to a separate election to defer payment of taxes, which deferralis subject to an interest charge. 

The QEFelection is made on a shareholder-by-shareholder basis and can be revoked onlywith the consent of the Internal Revenue Service, or IRS. A shareholder makes aQEF election by attaching a completed IRS Form 8621, including the PFIC annualinformation statement, to a timely filed United States federal income taxreturn and by filing such form with the IRS Service Center in Philadelphia, Pennsylvania. Even if a QEF election is not made, a shareholder in a PFIC who is a U.S. person must file a completed IRS Form 8621 every year.

A U.S. Holderof PFIC stock which is publicly traded could, instead of making a QEF election,elect to mark the stock to market annually, recognizing as ordinary income orloss each year an amount equal to the difference as of the close of the taxableyear between the fair market value of the PFIC stock and the U.S. Holder`sadjusted tax basis in the PFIC stock. Losses would be allowed only to theextent or net mark-to-market gain previously included by the U.S. Holder underthe election for prior taxable years. If the mark-to-market election were made,then the rules set forth above would not apply for periods covered by theelection.

We reasonably believe that wewere not a PFIC for 2003. We base our belief that we were not a PFIC in 2002 ona tax valuation made by an independent "big 4" U.S. accounting firm for thefiscal year 2001 and further calculations that we have made in comparison tosuch tax valuation and the facts set forth in such tax valuation. However, wedid not obtain any new tax valuation with respect to either 2002 of 2003. Therecan be no assurance, however, that the IRS will not determine that we are aPFIC. Furthermore, the tests for determining PFIC status are applied annuallyand it is difficult to make accurate predictions of future income and assets,which are relevant to this determination. Accordingly, we cannot assure youthat we will not be treated as a PFIC in any of 2001, 2002, 2003 or in futureyears.

**____ 62 ____** 

U.S. Holderswho hold Ordinary Shares during a period when we are a PFIC will be subject tothe foregoing rules, even if we cease to be a PFIC, subject to certainexceptions for U.S. Holders who made a QEF election. U.S. Holders are urged toconsult their tax advisors about the PFIC rules, including as to theadvisability of choosing to make a QEF election, a "protective" QEF election,or an election to mark the shares to market annually. 

 

#  F.  DIVIDENDS AND PAYING AGENTS 

#   

 

**- Not applicable**

 

 

#  G.  STATEMENT BY EXPERTS

#   

 

**- Not applicable**

 

 

#  H.  DOCUMENTS ON DISPLAY

#   

All documentsreferenced herein concerning us are archived at our principal offices locatedat:

 7 Atir Yeda St.,  Kfar Saba, Israel.

 

#  I.  SUBSIDIARY INFORMATION 

#   

 

**- Not applicable**

 

 

# ITEM11.   QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

 

We areexposed to a variety of risks, including changes in foreign currency exchangerates, changes in interest rates and weak economic conditions in foreignmarkets. However, we do not use derivative financial instruments in ourinvestment portfolio to hedge foreign currency, interest rate or other types ofmarket risks.

**Interest Rate Risk**

Our exposureto interest rate risk relates primarily to our short term deposits andinvestments. The majority of our cash is held in U.S. dollars and bearsinterest at various rates based upon the London Inter Bank Offered Rate(LIBOR). These deposits are placed with high quality U.S. and European banks.Approximately half of our cash is currently invested in bonds featuring creditratings of A or higher. The bonds possess terms of up to six (6) years.

**____ 63 ____** 

**Foreign Currency Exchange andInflation Risk**

Most of ourrevenues generated and costs incurred outside of the United States aregenerally denominated in dollar currencies. Costs not effectively denominatedin United States dollars are translated to United States dollars, whenrecorded, at the prevailing exchange rates for the purposes of our financialstatements. Consequently, fluctuations in the rates of exchange between thedollar and non-dollar currencies will affect our results of operations. Anincrease in the value of a particular currency relative to the dollar willincrease the dollar reporting value for transactions in that particularcurrency, and a decrease in the value of that currency relative to the dollarwill decrease the dollar reporting value for those transactions. This effect onthe dollar reporting value for transactions is generally only partially offsetby the impact that currency fluctuations may have on costs. We do not generallyengage in currency hedging transactions to offset the risks associated withvariations in currency exchange rates. Consequently, significant foreigncurrency fluctuations and other foreign exchange risks may have a materialadverse effect on our business, financial condition and results of operations.Since our revenues are generated in United States dollars and currencies otherthan NIS, and a substantial portion of our expenses is incurred and willcontinue to be incurred in NIS, we are exposed to risk by the amount that therate of inflation in Israel exceeds the rate of devaluation of the NIS inrelation to the dollar and other currencies or if the timing of the devaluationlags behind inflation in Israel.

 

 

# ITEM12.   DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES 

 

**- Not applicable**

 

 

 

**____ 64 ____** 

PART II

 

 

# ITEM13.   DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES 

 

**- Not applicable**

 

 

# ITEM14.   MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS ANDUSE OF PROCEEDS 

 

**- Not applicable**

 

 

# ITEM15.   CONTROLS AND PROCEDURES

 

 (a)Disclosure Controls and Procedures - The Company`s management evaluated, withthe participation of the Company`s principal executive and principal financialofficers, the effectiveness of the Company`s disclosure controls and procedures(as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Actof 1934, as amended (the "Exchange Act")), as of December 31, 2003. Based ontheir evaluation, the Company`s principal executive and principal financialofficers concluded that the Company`s disclosure controls and procedures wereeffective as of December 31, 2003. Since the evaluation, there have been nosignificant changes in our internal controls or in factors that couldsignificantly affect internal controls, including, because we have notidentified any significant deficiencies or material weaknesses in our internalcontrols, any corrective actions with regard to significant deficiencies andmaterial weaknesses. 

(b) - **Not yetapplicable**

(c) - **Not yetapplicable**

(d) Changesin Internal Control Over Financial Reporting - There has been no change in theCompany`s internal control over financial reporting (as defined in Rules13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during 2003, thathas materially affected, or is reasonably likely to materially affect, theCompany`s internal control over financial reporting.

 

# ITEM16.   [Reserved] 

 

# ITEM16A. AUDIT COMMITTEE FINANCIAL EXPERT 

 

Our Board ofDirectors has determined that we have at least one audit committee financialexpert, Mr. Yossi Ben Shalom (See in Item 6.A "Directors and Senior Management"synopsis of Mr. Ben Shalom`s biography).

 

**____ 65 ____** 

# ITEM16B. CODE OF ETHICS 

 

We have adopteda written code of ethics that applies to all of our employees, including ourprincipal executive officer, principal financial officer and principalaccounting officer. 

You mayrequest a copy of our code of ethics, at no cost, by writing to or telephoningus as follows: 

M-Systems Flash Disk Pioneers Ltd.  7 Atir Yeda St., Kfar Saba  Israel 44425

Attn. Legal DepartmentTelephone: (972)-9-764-5000

 

# ITEM16C. PRINCIPAL ACCOUNTANT FEES AND SERVICES

 

During eachof the last two fiscal years, Kost, Forer, Gabbay & Kasierer, a member ofErnst and Young Global, has acted as the Company's independent auditors. 

**Audit fees**

Ernst & Young billed the Companyapproximately $ 81,853 for audit services for 2003, including feesassociated with the annual audit and consultations on various accountingissues. Ernst & Young billed the Company approximately $ 64,354 foraudit services for fiscal 2002. 

**Audit-related fees**

Ernst &Young billed the Company approximately $ 39,611 for audit-related servicesfor fiscal 2003 and approximately $ 29,832 for audit related services forfiscal 2002. Audit-related services principally include due diligenceexaminations, reviews of the Company's quarterly financial results submitted onForm 6-K as well as assistance with certain requirements of the SECregulations.

**Tax fees**

Ernst &Young billed the Company approximately $ 75,254 for tax advice, includingfees associated with tax compliance services, tax planning services and othertax consulting services for fiscal 2003. Ernst & Young billed the Companyapproximately $ 64,403 for tax advice in fiscal 2002.

**All other fees**

We did notpay Ernst & Young for any fees other than the Audit Fees and Tax Feesdescribed above for fiscal 2003 and 2002.

**Pre-Approval Policies forNon-Audit Services**

Prior to theengagement of Ernst & Young each year, the engagement is approved by theAudit Committee of the Board of Directors and by vote of the Company'sshareholders at the Company's Annual General Meeting of Shareholders. TheCompany's Audit Committee has also adopted its own rules of procedure. TheAudit Committee's rules of procedure provide for a process with respect to theprior approval of all services, including non-audit services, to be performedby the independent auditors for the Company. In fiscal 2003, the Company'sAudit Committee approved all of the services provided by Ernst & Young. 

 

 

**____ 66 ____** 

# ITEM16D. EXEMPTION FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES 

 

**- Not applicable**

 

 

# ITEM16E. PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS

 

**- Not applicable**

 

 

 

**____ 67 ____** 

PART III

 

 

# ITEM17.   FINANCIAL STATEMENTS

 

**- Not applicable**

 

 

# ITEM18.   FINANCIAL STATEMENTS

 

SeeConsolidated Financial Statements, as previously filed on Form 6K andincorporated by reference in our Registration Statement on Form F-3, AmendmentNo. 3, File No. 333-109338, and incorporated by reference herein.

 

**____ 68 ____** 

# ITEM19.   EXHIBITS

 
| 1.1     | +      | M-Systems` Memorandum of  Association, as amended                                                                                                                                                                                             |
|---------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 1.2     | ++     | M-Systems` Articles of  Association, as amended                                                                                                                                                                                               |
| 4(a).1  | +++    | Form of Warrant for Purchase of  Ordinary Shares, dated July 23, 1999                                                                                                                                                                         |
| 4(a).2  | ++     | Purchase Agreement made as of  September 17, 2000 between Fortress U&T Ltd. and M-Systems Flash Disk  Pioneers Ltd.                                                                                                                       |
| 4(a).4  | *  !!  | Development and Supply Agreement  dated April 18, 2001 by and between Atmel Rousset, Atmel Sarl, and M-Systems  Flash Disk Pioneers Ltd.                                                                                                      |
| 4(a).5  | **  !! | Master Purchase Agreement dated  August 10, 1998 by and between Toshiba America Electronic Components, Inc.  and M-Systems, Inc.                                                                                                              |
| 4(a).6  | *      | Amendment to the Master Purchase  Agreement dated August 23, 2002 by and between Toshiba America Electronic  Components, Inc. and M-Systems, Inc., as entered into by and between Toshiba  Corporation and M-Systems Flash Disk Pioneers Ltd. |
| 4(a).7  | **  !! | Development and License Agreement  dated June 25, 2002 by and between Toshiba Corporation and M-Systems Flash  Disk Pioneers Ltd.                                                                                                             |
| 4(a).8  | !!     | Patent License Agreement dated  July 15, 2003 by and between Toshiba Corporation and M-Systems Flash Disk  Pioneers Ltd.                                                                                                                      |
| 4(a).9  | !!     | Ordinary Shares Purchase Agreement  dated July 15, 2003 by and between Toshiba Corporation and M-Systems Flash  Disk Pioneers Ltd.                                                                                                            |
| 4(a).10 | !!     | New Master Purchase Agreement  dated July 15, 2003 by and between Toshiba Corporation and M-Systems Flash  Disk Pioneers Ltd.                                                                                                                 |
| 4(a).11 | !!     | XDOC Development and License  Agreement dated July 15, 2003 by and between Toshiba Corporation and  M-Systems Flash Disk Pioneers Ltd.                                                                                                        |
| 4(a).12 | !!     | Strategic Agreement dated  December 31, 2003 by and between Samsung Electronics Co., Ltd., and M-Systems  Flash Disk Pioneers Ltd.                                                                                                            |
| 4(b)(i) | ++++   | Share Purchase Agreement dated  May 1st, 2003, by and between M-Systems Flash Disk Pioneers Ltd.  and Dr. Hans Wagner                                                                                                                         |
| 8       |   | List of M-Systems` Subsidiaries  and where they are incorporated                                                                                                                                                                              |
| 12.1    |   | Certificate of Chief Executive  Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a)                                                                                                                                                             |
| 12.2    |   | Certificate of Chief Financial  Officer pursuant to Rule 13a-14(a)/Rule 15d-14(a)                                                                                                                                                             |
| 13(a).1 |   | Certification of Chief Executive  Officer pursuant to 18 U.S.C. Section 1350                                                                                                                                                                  |
| 13(a).2 |   | Certification of Chief Financial  Officer pursuant to 18 U.S.C. Section 1350                                                                                                                                                                  |
| 15(a).1 |   | Consent of Kost Forer Gabbay  & Kasierer (formerly Kost Forer & Gabbay)                                                                                                                                                               |
| 15(a).2 |   | Consent of BDO Seidman, LLP                                                                                                                                                                                                                   |
| 15(a).3 | ***    | Consolidated Financial Statements                                                                                                                                                                                                             |

____________________

**____ 69 ____** 

** **
| +    | Previously filed as an exhibit to  our Registration Statement on Form F-1, File No. 33-55838, and incorporated  by reference herein.                                                        |
|------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ++   | Previously filed as an exhibit to  our Annual Report on Form 20-F for the fiscal year ended December 31, 2000,  and incorporated by reference herein.                                       |
| +++  | Previously filed as an exhibit to  our Registration Statement on Form F-1, File No. 333-11450, and incorporated  by reference herein.                                                       |
| ++++ | Previously filed as an exhibit to  our original Annual Report on Form 20-F for the fiscal year ended December  31, 2002, and incorporated by reference herein.                              |
| *    | Previously filed as an exhibit to  our Annual Report on Form 20-F/A Amendment No. 2 for the fiscal year ended  December 31, 2002, File No. 001-11712 and incorporated by reference herein.. |
| **   | Previously filed as an exhibit to  our Annual Report on Form 20-F/A Amendment No. 3 for the fiscal year ended  December 31, 2002, File No. 001-11712 and incorporated by reference herein.  |
| ***  | Previously filed on Form 6K and  incorporated by reference in our Registration Statement on Form F-3/A,  Amendment No. 3, File No. 333-109338, and incorporated by reference herein.        |
| !!   | Portions of the agreement and/or  exhibits have been omitted pursuant to a request for confidential treatment provided  to the SEC.                                                         |

 

 

SIGNATURES

 

Pursuant tothe requirements of Section 12 of the Securities Exchange Act of 1934,M-Systems hereby certifies that it meets all of the requirements for filing onForm 20-F, and that it has duly caused and authorized the undersigned to signthis Annual Report on its behalf on the 30th day of June, 2004.

 

**M-SYSTEMS FLASH DISK PIONEERS LTD.**

 

By: /s/ Dov Moran

Dov Moran,

President and Chief Executive Officer

**____ 70 ____**