CommissionFile No. 1-11712

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**SECURITIES AND EXCHANGE COMMISSION**

### WASHINGTON,D.C. 20549

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**FORM 20-F/A**

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

**THE SECURITIES EXCHANGE ACT OF 1934**

## For the fiscalyear ended December 31, 2002

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

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

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**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:                                                                                                                                                                                            |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                                                                                          |   | 27,485,361 |
| 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 |
|                                                                                                                                                                                                                                                                                                                                                          |   |   |   |
|                                                                                                                                                                                                                                                                                                                                                               |  |  |  |  |  |  |

 

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**EXPLANATORYNOTE**

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**ThisAmendment No. 5 on Form 20-F/A (the "Amended 20-F") speaks as of thefiling date of our Form 20-F for the fiscal year ended December 31, 2002, filedon June 30, 2003 (the "Original 20-F"), except for the certifications whichspeak as of their respective dates and the filing date of the Amended 20-F.Except as specifically indicated, the Amended 20-F has not been updated toreflect events occurring subsequent to the filing of the Original 20-F.  Thefiling of this Amended 20-F shall not be deemed an admission that the Original20-F, when filed, included any untruestatement of a material fact or omitted to state a material fact necessary tomake a statement not misleading.  **

 

**PRELIMINARYNOTE**

** **

**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.**

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** **
| **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 interested 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 16A.                 | [Reserved] |
| Item 16B.                 | [Reserved] |
| Item 16C.                 | [Reserved] |
|                      |
| **PART THREE**            |
| Item 17.                  | Financial statements - not applicable |
| Item 18.                  | Financial statements |
| Item 19.                  | Exhibits |
|                      |
| **EXHIBIT INDEX**         |
|                      |
| **FINANCIAL  STATEMENTS** |
|                      |
| **SIGNATURES**            |
|                      |
| **CERTIFICATIONS**        |

** **

**** 

PART I

 

Unless the context otherwise requires, all references inthis annual report to "M-Systems", "we", "our", "us" and the "Company" refer toM-Systems Flash Disk Pioneers Ltd. and its consolidated subsidiaries.References to "dollars" or $ are to United States dollars.

All references herein to "ordinary shares" shall refer toour ordinary shares, nominal value 0.001 New Israeli Shekel per share.

 

 

# ITEM 1.  IDENTITY OFDIRECTORS, SENIOR MANAGEMENT AND ADVISORS 

** **

**- Not applicable**

 

 

# ITEM 2.  OFFER STATISTICS ANDEXPECTED TIMETABLE 

** **

**- Not applicable**

 

**___1___** 

# item 3.  KEY INFORMATION

 

#  A.  SELECTED FINANCIAL DATA 

 

The following selected summary of financial informationwas derived from our Consolidated Financial Statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States. The selected summary data should be read in conjunction with,and are qualified in their entirety by, our Consolidated Financial Statementsand notes thereto, which are presented elsewhere herein and by reference to"Item 5: Operations and Financial Review and Prospects."

Summary Consolidated Financial Information 
|                                                                                                                                    | Year ended December 31,               |
|------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------|
|                                                                                                                               | 1998                                  | 1999 | 2000 | 2001 | 2002 |
|                                                                                                                               | (in thousands, except per share data) |
| Statement of Operations Data:                                                                                                      |                                  |   |   |   |   |
| Revenues...........................................                                                                                | $ 16,351                         | $ 30,430 | $ 92,589 | $ 44,678 | $ 64,817 |
| Cost of revenues................................                                                                                   | 9,834                                 | 20,735 | 64,281 | 60,573 | 44,415 |
| Gross profit (loss)...............................                                                                                 | 6,517                                 | 9,695 | 28,308 | (15,895) | 20,402 |
| Operating expenses:                                                                                                                |                                  |   |   |   |   |
| Research and development, net.....                                                                                                 | 2,237                                 | 3,137 | 7,364 | 13,290 | 11,974 |
| Selling and marketing, net..............                                                                                           | 4,310                                 | 6,779 | 11,535 | 12,122 | 12,547 |
| General and administrative............                                                                                             | 1,264                                 | 1,772 | 2,809 | 3,913 | 4,000 |
| In-process research and development write-off...................                                                                   | ---                                   | --- | 6,215 | --- | --- |
| Total operating expenses...............                                                                                            | 7,811                                 | 11,688 | 27,923 | 29,325 | 28,521 |
| Operating income (loss)......................                                                                                      | (1,294)                               | (1,993) | 385 | (45,220) | (8,119) |
| Other income (expenses), net..............                                                                                         | 785                                   | --- | --- | (1,193) | --- |
| Financial income, net...........................                                                                                   | 202                                   | 217 | 5,875 | 4,628 | 2,619 |
| Income (loss) before minority interest in losses of a Subsidiary..........................                                         | $ (307)                          | $ (1,776) | $ 6,260 | $ (41,785) | $ (5,500) |
| Minority interest in losses of a Subsidiary..........................................                                              | 37                                    | 122 | 19 | --- | --- |
| Net income (loss)...............................                                                                                   | $ (270)                          | $ (1,654) | $ 6,279 | $ (41,785) | $ (5,500) |
| Basic net earnings (loss) per share.......                                                                                         | $ (0.01)                         | $ (0.08) | $ 0.25 | $ (1.56) | $ (0.20) |
| Diluted net earnings (loss) per share....                                                                                          | $ (0.01)                         | $ (0.08) | $ 0.22 | $ (1.56) | $ (0.20) |
| Number of shares used in computing basic net earnings (loss) per  share (in thousands)..........................................   | 19,245                                | 19,881 | 25,368 | 26,716 | 26,953 |
| Number of shares used in computing diluted net earnings (loss) per  share (in thousands).......................................... | 19,245                                | 19,881 | 28,040 | 26,716 | 26,953 |
|                                                                                                                               |                                  |   |   |   |   |

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**___2___** 

Summary Consolidated Financial Information (cont.)

 
|                                                                                                                        | Year ended December 31, |
|-----------------------------------------------------------------------------------------------------------------------------|-------------------------|
|                                                                                                                        | 1998                    | 1999 | 2000 | 2001 | 2002 |
|                                                                                                                        | (in thousands)          |
| Balance Sheet Data:                                                                                                         |                    |   |   |   |   |
| Cash, cash equivalents, short-term

Bank deposits, short term and long term marketable securities.......................... | $ 7,990            | $ 6,230 | $ 120,476 | $97,236 | $94,094 |
| Working capital..................................                                                                           | 12,242                  | 15,710 | 155,694 | 87,264 | 70,297 |
| Total assets........................................                                                                        | 17,882                  | 26,791 | 185,251 | 145,451 | 148,202   |
| Shareholders` equity...........................                                                                             | 13,832                  | 17,474 | 172,799 | 133,051 | 128,290 |
| * *                                                                                                                    |                    |   |   |   |   |

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#   

#  B.  CAPITALIZATION AND INDEBTEDNESS 

 

**- Not applicable**

 

 

#  C.  REASONS FOR THE OFFER AND USE OF PROCEEDS 

 

**- Not applicable**

 

 

#  D.  RISK FACTORS 

 

Our business, operating results and financial condition couldbe seriously harmed due to any of the following risks. In addition, the tradingprice of our ordinary shares could decline due to any of these risks, and youcould lose all or part of your investment.

 

 

**We have incurred losses in thepast, are currently incurring losses, and may incur losses in the future.**

We have a history of losses. Other than the year 2000, inwhich we were profitable, we have incurred losses in our past ten years ofoperation. In recent years, we incurred net losses of $ 1.7 million in1999, $ 41.8 million in 2001 ($ 30.2 million of them were due to aninventory write-down, and $ 1.0 million of them were due to an investmentwrite-off) and $ 5.5 million in 2002. We will need to generate increasedrevenues to return to and maintain profitability. We cannot be sure that wewill be successful in increasing our revenues or that we will be able toachieve profitability or maintain profitability, if achieved, on a consistentbasis.

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**___3___** 

**Our quarterly operatingresults have fluctuated significantly in the past and may fluctuatesignificantly in the future, which may harm the price of our shares.**

Our quarterly operating results have fluctuatedsignificantly in the past and we expect that they will continue to fluctuate inthe future. This fluctuation could cause the market price of our ordinaryshares to decline. This fluctuation may result from a variety of factors,including, without limitation, the following:
| ●*       *  | Changes in global economic conditions in general, and  conditions in our industry and target markets in particular;                                                                                             |
|-----------------------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ●*       *  | Changes in business and economic conditions or growth  rates in any of the geographic regions in which we do business, particularly  in the United States, the European Union and the Far East;                 |
| ●*       *  | Availability of components, including flash components, in  sufficient quantities, at competitive prices and delivered in a timely manner  to allow us to meet customer demand;                                 |
| ●*       *  | Accessibility of third party manufacturing and assembly  services for certain of our products;                                                                                                                  |
| ●*       *  | Changes in the price of components, including flash  components, used in our products;                                                                                                                          |
| ●*       *  | Decline in the average selling prices of our products due  to competitive pricing pressures;                                                                                                                    |
| ●*       *  | Expenses related to obsolescence or devaluation of unsold  inventory, or reserves necessary to protect us against future write-downs of  unsold inventory;                                                      |
| ●*       *  | Lengthening in manufacturing cycle times or increases in  manufacturing costs due to disruptions in the manufacturing process or  reductions in yield;                                                          |
| ●*       *  | Manufacturing flaws affecting the reliability,  functionality or performance of our products which could increase our product  costs, reduce demand for our products or require product recalls;                |
| ●*       *  | Quality problems or any other significant technical  difficulties or interruptions in the manufacture or supply of our products,  which could cause shipment delays and require product recalls;                |
| ●*       *  | Difficulty of forecasting sales and managing inventory  levels;                                                                                                                                                 |
| ●*       *  | Competition in general and the timing of new product  introductions by us and our competitors;                                                                                                                  |
| ●*       *  | Lower than anticipated market acceptance of our new or  enhanced products;                                                                                                                                      |
| ●*       *  | Slower than anticipated market acceptance of the products  that incorporate our solutions, resulting in delays or cancellation of such  product introductions;                                                  |
| ●*       *  | Changes in our distribution channels;                                                                                                                                                                           |
| ●*       *  | Competitive pricing pressures, which affect both the  selling prices of our products and the value of our inventory;                                                                                            |
| ●*       *  | Increases in our research and development and marketing  expenses;                                                                                                                                              |
| ●*       *  | Decreases in our financial income based on interest rate  reductions;                                                                                                                                           |
| ●*       *  | The business impact of unrest or political instability in  locales in which we conduct our business, such as the current unrest in  Israel;                                                                     |
| ●*       *  | Difficulties in conducting business with subcontractors,  customers, partners and others in Asia and other areas of the world that have  been or may be affected by contagious diseases such as the SARS virus; |
| ●*       *  | Exchange rate fluctuations; and                                                                                                                                                                                 |
| ●*       *  | Adverse economic conditions and currency fluctuations, and  especially the new conditions associated with the September 11, 2001  terrorist attacks in the U.S.                                                 |

**___4___** 

Sales and profitability, if any, in any particular quartermay be lower (or losses may be greater) than those of preceding quarters,including comparable quarters. Moreover, our product and customer mix variesquarterly, which affects our overall average selling prices and gross margins.Our DiskOnChip and DiskOnKey products, which currently represent the majorityof our product revenues, have lower average selling prices and gross marginsthan our Fast Flash Disk ("FFD") products. Depending on the relative mixbetween sales of these products (and any other products we may offer), ourgross margins could fluctuate significantly. In addition, a significant portionof our research and development, marketing, and general and administrativeexpenses are relatively fixed. Accordingly, our operating results have been andmay in the future be, adversely affected when our revenues do not meet ourexpectations in any given quarter. Our operating results in future periods maybe below the expectations of securities analysts and investors. If that occurs,the market price of our ordinary shares could be materially and adverselyaffected.

** **

**Our revenues and gross marginsmay be, and have been, adversely affected by volatility in, and various factorsaffecting, the market price of flash memory components.**

For most of its products, the Company relies to asignificant extent on the purchase of flash memory components or custom madeproducts incorporating flash components from third party manufacturers anddistributors. As a result, the Company is exposed to the risks associated withany increase or decrease in the price of flash components and to the volatilityof such price range.  

In the event of a sharp decline in the price of flashcomponents, the value of our inventory will fall and the Company may becompelled to write-down its inventory's value, which may result in asignificant decrease in our gross margins. In addition, we may need tosignificantly reduce our selling prices, which may result in a decline in ourrevenues and gross profits. An example of this vulnerability occurred duringthe first half of 2001, when the flash prices decreased significantly both dueto the worldwide economic slowdown and the excess of supply of flashcomponents. This caused our revenues to decline significantly and caused us towrite-down $ 30.2 million against the valuation of our inventory in thefirst half of 2001.  

Alternatively, in the event that the market price forflash components goes up (e.g. as a result of inflationary pressures on flashcomponent suppliers or increased demand for any reason), we may be unable topass these price increases on to our customers and, consequently, our grossmargins could suffer, or, in the extreme, we may not be able to sell theCompany` products at a profit at all, resulting in loss of revenues and marketshare and/or in net losses. 

To the extent that the market price for flash componentseither increases or declines dramatically and this situation continues orworsens, our revenues may decline or may fail to grow. If we cannot reduce ourproduct manufacturing costs to offset either a reduction or an increase inprices, as the case may be, our gross margins and net results will be adverselyaffected.  

** **

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

As a result of the continued worldwide economic slowdown,many of our customers may continue refraining from increased spending atpreviously estimated rates or decide to decrease spending and may hold back orcease the development of new products. In addition, public demand for newproducts incorporating our technology - such as high end cell phones andPersonal Digital Assistants ("High-End Mobile Devices") for our DiskOnChipproduct line or for new lap-top computers and PCs and their accessories for ourDiskOnKey product line (see in Item 4.D below the paragraph titled "Our TargetMarkets") - might languish resulting in reduced demand for our products. As aresult, our revenues may decline, and our inventory levels may increase. To theextent our inventory levels increase in an environment of decreasing flashproduct prices or as a result of continuing lowered demand for our products,our gross margins may be negatively impacted. 

** **

**___5___** 

**Our stock price has been, andmay continue to be, volatile for various reasons, including the volatility anddownturn in share prices for technology companies generally as well as forcompanies in our industry.**

The market price of our stock has fluctuated significantlyin the past and is likely to continue to fluctuate in the future. For example,between January 1, 2002 and May 1, 2003, our closing stock price has fluctuatedfrom a low of $ 4.95 to a high of $ 12.59. We believe thatfluctuations will continue as a result of, among other things, the factorsdiscussed above (see in this Item 3.D above the paragraph titled "Our quarterlyoperating results may have fluctuated significantly in the past and mayfluctuate significantly in the future, which may harm the price of our shares")and as a result of announcements by us, our competitors or third parties (suchas industry and research analysts) regarding our business, the business of ourcompetitors, our markets, technological innovations, or changes in earningsestimates. In addition, in recent years the stock market has experiencedsignificant price and volume fluctuations and the market prices of thesecurities of high technology companies have been especially volatile, oftenfor reasons outside the control of these companies. These fluctuations, as wellas general economic, political and market conditions, including certainconditions related to the State of Israel (also see in this Item 3.D below theparagraph titled "Conditions in Israel affect our operations and may limit ourability to produce and sell our products"), may have an adverse effect on ourstock price. In the past, securities class action litigation has often beenbrought against companies following periods of volatility in the market priceof their securities. We may be the target of similar litigation in the future.Securities litigation could result in substantial costs and divert ourmanagement`s attention and resources, which could cause serious harm to ourbusiness.

** **

**The success of our businessdepends on emerging markets and new products and on our ability to maintain acompetitive edge as these markets grow.**

Sales of our DiskOnChip products are directly related tothe demand for High-End Mobile Devices and for such products as set-top boxesand thin clients ("Embedded Devices"). High-End Mobile Devices and EmbeddedDevices are still relatively new types of products, and we cannot be sure thatthey will achieve market acceptance, that demand for these products will growor that our products will be included in the High-End Mobile Devices andEmbedded Devices that achieve market acceptance. If sales of High-End MobileDevices and Embedded Devices do not grow, or if successful High-End MobileDevices or Embedded Devices do not incorporate our products, then sales of ourDiskOnChip products will decrease or will not grow as anticipated. Most High-EndMobile Devices currently do not use or need flash for data storage and wecannot be sure that the requirement for data storage in that market will growor that High-End Mobile Device designers and Original Equipment Manufacturers("OEMs") will choose to use the DiskOnChip. If the demand for Flash datastorage does not grow in the High-End Mobile Devices market, or the DiskOnChipis not chosen by the relevant manufacturers as their preferred solution, thensales of our products to this market will not develop or grow as anticipated.This would reduce our revenues and our profitability, if any, or increase ourlosses.

The market for our DiskOnKey products is relatively newmarket that comes to answer a new need - secured and easy transfer of databetween different computers and other applications. We cannot be sure that theneed for such new products will develop, that demand for these products willgrow or that our products will be accepted as the preferred solution bymanufacturers, OEMs and consumer end-users. If the demand for Universal SerialBus ("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 revenues and our profitability, if any, or increase our losses. 

As certain of our markets are in their initial stages ofdevelopment, our competition in these markets may be comparatively limited.However, should the potential of these markets increase, we expect majorcorporations to enter into competition for these markets, which may result inour losing current design wins and/or customers. This would reduce our revenuesand our profitability, if any, or increase our losses. 

** **

**We may be unable to achievebroad market acceptance for our products.**

Our business strategy depends on our achieving broadmarket acceptance for our products. We may, however, be unsuccessful indeveloping products that meet the needs of our target markets, in effectivelymarketing our products and in convincing potential customers to adopt ourproducts and solutions. In addition, in order to attain a high market share, wemay have to increase our production volumes at a rapid rate. If our productsare not accepted in the market or if we are unable to increase our productionvolumes in a timely manner, we may lose market share to our competitors.****___6___** **

**We depend on operating system vendors to support oursoftware and include our software with their operating systems.**

Our marketing strategy for DiskOnChip relies on oursoftware being included in major operating systems. These operating systems areconstantly being updated. As a result, we should continue to promote oursoftware to ensure that it remains supported by these operating systems. If weare unable to maintain the support of major operating systems for our products,if the developers and distributors of major operating systems choose to supporta competing product instead of our own or support other competing solutionstogether with our solution, or if other operating systems that do not includeour software achieve market acceptance, this could adversely impact sales andaccordingly have a material adverse effect on our business, financial conditionand results of operations.

** **

**We depend on Toshiba as asingle source for our Mobile DiskOnChip and our DiskOnChip Millennium Plusproducts, and we expect to be dependant on them as a single source for futureDiskOnChip products.**

We developed our Mobile DiskOnChip, DiskOnChip Millenniumand DiskOnChip Millennium Plus products as part of a strategic relationshipwith Toshiba Corporation ("Toshiba"). At present, Toshiba is our sole manufacturerof the Mobile DiskOnChip and DiskOnChip Millennium Plus products. In addition,we are working with Toshiba on the joint development of future DiskOnChipproducts, for which they will be the sole source of supply as well. Toshiba notonly provides the flash components but also manufactures and assembles thefinished product. We are seeking to develop, with other manufacturers, productsthat will be comparable to the DiskOnChip although possessing differentfeatures and capacity. This will require additional hardware and softwaredevelopment, and we cannot assure you that we will be successful in developingsuch comparable products or that such other manufacturers will succeed indelivering products which are of similar cost, quality and functionality. IfToshiba were to close down or downsize its flash business, experiencemanufacturing problems or delays for any reason, including difficulty inobtaining sufficient raw materials, work stoppages, excessive demand for itsmanufacturing capacity or other causes, we may be unable to fill our customers`orders for this product or unable to fulfill it in a timely fashion, whichwould result in lost sales and significantly lower revenues. 

Pursuant to our agreement with them, Toshiba has begun tomarket and expects to begin selling the Mobile DiskOnChip, the DiskOnChipMillennium Plus and presumably future jointly-developed products as well, tocustomers under Toshiba`s trademark without obtaining our prior consent,subject to Toshiba paying us specified royalties. If Toshiba markets and sellsthe Mobile DiskOnChip, DiskOnChip Millennium Plus or future jointly-developedproducts to customers, they may compete in the same markets as we do, whichcould result in lost sales and lower revenues. 

** **

**We depend on third partysubcontractors and certain strategic partners to manufacture, assemble andsupply almost all of our products, and to jointly develop certain of ourproducts.**

We rely on third party subcontractors and certainstrategic partners to manufacture, assemble and supply most of our products,and to jointly develop certain of our products. For some products, we rely on asingle source of supply (e.g., see in this Item 3.D above the paragraph titled"We depend on Toshiba as a single source for our Mobile DiskOnChip, DiskOnChipMillennium and DiskOnChip Millennium Plus products etc."). The prices chargedfor the products we need manufactured, and the availability of qualifiedsubcontractors for a particular product or products, may vary from time totime. Our product suppliers are often operating at peak capacity. At times, wehave been unable to obtain adequate supplies of certain products within thetime frame we need, which has resulted in delayed or lost sales of ourproducts. In other cases, we have been required to keep unusually large productinventories in order to avoid shortages. We cannot assure you that shortageswill not occur in the future. Moreover, an increase in prices by any of oursuppliers could reduce our gross margins. In addition, should any of oursuppliers or strategic partners become unable or unwilling to continuesupplying us with their components or services, this would have a materialadverse effect on the Company. As a majority of our third party subcontractorsand strategic partners are located in the Far East, in the event that the SARSvirus causes any of their manufacturing facilities to experience a shut-down orslow-down of manufacturing capacity and/or shipping ability, this may have amaterial adverse effect on the Company.

**___7___** 

Some of our manufacturers and suppliers require that wegive them lead times of three months or more when we place orders. 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, in turn, increase our workingcapital needs and increase our exposure to a later devaluation of the inventoryin stock if prices in the market go down. Either of these situations could havea material adverse effect on our business, financial condition and results ofoperations.

Should any of our strategic partners refrain fromdeveloping future products with us, our future results may be adverselyaffected.

If we experience quality problems or any significanttechnical or other difficulties or interruptions in the manufacture of ourproducts, or supply delays from any of our product manufacturers or suppliers,it could take us a significant amount of time to correct the problem or to finda replacement source of supply. 

** **

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

We operate one manufacturing facility at our headquartersin Kfar-Saba, Israel. We currently manufacture our FFD and DiskOnChip 2000products at that facility. If we experience quality problems or any significanttechnical or other difficulties or interruptions in the manufacture of ourproducts at our facility, this could have an adverse effect on our business,financial condition and results of operations (also see in this Item 3.D belowthe paragraph titled "Conditions in Israel affect our operations and may limitour ability to produce and sell our products."). 

** **

**We depend on third parties forthe supply and quality of components required for the manufacture of ourproducts, including flash components.**

We rely on third parties to manufacture and supplycomponents for our products, including the basic flash components used in allour products and the application specific integrated circuit ("ASIC")components used in our DiskOnKey and in some of our DiskOnChip products. Forsome components, we rely on a single source of supply. The availability andprices in the market of the components we need may vary from time to time. Ourcomponent suppliers are often operating at peak capacity. At times, the demandfor components 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. Moreover, an increase in prices byour suppliers could reduce our gross margins. In addition, should any of oursuppliers become unable or unwilling to continue supplying us with theircomponents, this would have a material adverse effect on the Company.  

Some of our suppliers require that we give them lead timesof three months or more when we place orders. If we underestimate our needswhen we place orders, we may be unable to meet our customers` demands, and wecould lose revenues and market share to our competitors. Alternatively, if weoverestimate our need for products, we could increase our inventory levels,which could, in turn, increase our working capital needs. Either of thesesituations could have a material adverse effect on our business, financialcondition and results of operations.

If we experience supply delays from any of our componentsuppliers, it could take us a significant amount of time to find a replacementsource of supply. Any such delay in supply could cause us to lose sales. 

Furthermore, if we experience quality problems from any ofour component suppliers, it could take us a significant amount of time toidentify the problem as associated with a particular component, ascertainwhether this is as a result of a design or a manufacturing flaw and eithercorrect the problem, if possible, replace the components or find an alternatesource of supply. Any such quality problem or delay could, in addition tocausing us lost sales, detrimentally affect our reputation in the market andcause us to incur additional costs as a result of the recall and replacement ofaffected products. 

** **

**___8___** 

**We depend on third partyfoundries for silicon wafers and any shortage or disruption in our supply fromthese sources will reduce our revenues, earnings and gross margins.**

Our flash memory based products require silicon wafers,which are currently supplied by Toshiba and Samsung Electronics Co., Ltd.("Samsung"). If Toshiba or Samsung are uncompetitive, or are unable orunwilling to satisfy our requirements, our business, financial condition andoperating results may suffer. In addition, in the event that we are suppliedwith silicon wafers with low yield, our operating results and our ability tosupply products to our costumers may suffer. Any disruption in supply fromthese sources due to natural disaster, power failure, labor unrest or othercauses, could significantly harm our business, financial condition and resultsof operations. Our obligation to provide a rolling forecast of anticipatedpurchase orders, limits our ability to react to fluctuations in demand for ourproducts which may lead to excess wafer inventories and could result in higheroperating expenses and reduced gross margins. In addition, if our flashsuppliers do not continue to invest in the required advancements to****theirflash technology and flash products, our business, financial condition andoperating results may suffer.

** **

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

Due to various reasons (e.g. an anticipation of a shortagein components, a high sales forecasts which is not realized, cancellation oforders from customers, anticipation of an increase in prices), the Company mayfind itself with a higher level of inventory than its then current needs. As aresult of this high level of inventory, the Company may be exposed to the riskof a decrease in the value of the inventory should the price of such componentsdrop, and our gross margins will be adversely affected. Furthermore, in theevent that the Company maintains large amounts of inventory, certain componentsor products, if warehoused for too long, might be rendered obsolete due to themodification and improvement of the Company`s products which might cause theCompany to incur an inventory write-off. In addition, the Company may lose outon any financial income which it might have earned from cash assets convertedinto inventory. 

** **

**Undetected hardware andsoftware errors or defects may increase our costs and impair the marketacceptance of our products.**

Our products may contain undetected errors or defects.These could result either from errors or defects in components or productsdesigned or manufactured by us that we fail to detect, or errors or defects incomponents supplied by third parties. In the past we have at times found theseerrors or defects in new or enhanced products after the commencement ofcommercial shipments. Our customers integrate our products into theirapplications together with products they acquire from other vendors. As aresult, when problems occur in an application, it may be difficult to identifythe product that has caused the problem. Regardless of the source of theseerrors or defects, we will need to divert the attention of engineeringpersonnel from our product development efforts to address the detection of theerrors or defects. These errors or defects could cause us to incur warranty orrepair costs, liability claims or lags or delays. We could be forced to recallproducts that were already sold into the market and installed by our customers.Our insurance policies may not provide sufficient protection should a claim beasserted. Moreover, the occurrence of errors or defects, whether caused by ourproducts or the products of another vendor, may significantly harm ourrelations with, or result in the loss of, customers, injure our reputation andimpair market acceptance of our products.

 

**We sell our products in ahighly competitive industry. As a result, we may lose market share and beunable to achieve or maintain profitability.**

The markets in which we compete are characterized byintense competition. Our DiskOnChip, DiskOnKey and FFD products compete withother flash disks, standard flash components, hard drives and alternative datastorage technologies. Our competitors include many large U.S. and internationalcompanies that have substantially greater financial, technical, marketing,logistical infrastructure and support and other resources, greater access tocomponent fabrication capacity, broader product lines and longer-standingrelationships with customers than us, which may limit our ability toeffectively compete with them. We believe that our ability to competesuccessfully depends on a number of factors, including the price, quality,features, performance, ease of integration and availability of our products.

**___9___** 

Our DiskOnKey product competes with other USB-compatibleflash disks, removable magnetic media, removable optical media, flash cards,floppy drives and other removable storage media. Our competitors in this marketcurrently consist of numerous third tier computer peripheral manufacturers orhardware manufacturers, the majority of whom are located in Asia 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 this trend to continue) competition fromlarge U.S. and/or international companies (including flash manufacturers) thathave substantially greater financial, sales, technical, marketing, logisticalinfrastructure and support and other resources, greater access to componentfabrication capacity, sometimes at substantially lower costs, broader productlines and longer-standing relationships with customers than we do. 

The competition for our DiskOnChip products comes mainlyfrom flash manufacturers offering competing solutions to our own. These flashmanufacturers may have an advantage over us in that they have substantiallygreater financial, sales, technical, marketing, logistical infrastructure andsupport and other resources, greater access to component fabrication capacity,sometimes at substantially lower costs, broader product lines andlonger-standing relationships with customers than we do. In addition, customerswho desire to purchase our DiskOnChip products, may need to make engineeringchanges in the architecture of their current NOR based solution (for which mostcell phones today are designed) to our NAND based solution, changes which arenot required of certain of our competitors. 

We expect competition to increase in the future fromexisting competitors and from other companies, including flash manufacturers,that may enter our existing or future markets with similar or alternative datastorage solutions that may be less costly or provide additional and betterfeatures. In addition, given the developing nature of our markets and therelated intellectual property, we cannot assure you that some of ourcompetitors will not infringe our intellectual property rights, and therebymight force us to incur substantial or even prohibitive costs if we choose to defendour rights. In fact, we believe that some of our competitors to the DiskOnKeyinfringe our patent covering USB flash drives and we have initiated legalaction in two separate instances (see Item 4.B below the paragraph titled"Intellectual Property Rights and Current Litigation"). Furthermore, increasedcompetition may force us to reduce the prices for our products, therebyreducing our revenues and margins, and could otherwise have a material adverseeffect on our business, financial condition and results of operations. Therecan be no assurance that we will be able to compete successfully againstcurrent and future competitors or that competitive pressures faced by us willnot materially adversely affect our business, financial condition or results ofoperations. 

** **

**We have limited productofferings. As a result, our business may suffer if demand for any of theseproducts declines or if we cannot develop new products to meet the needs of ourcustomers.**

We offer three major product lines, with our DiskOnChipproducts accounting for approximately 45% of our sales in 2002, and ourDiskOnKey products accounting for approximately 41% of our sales in 2002. Ifother companies were to develop products with similar or more features, similaror better performance or wider acceptance than our products, sales of ourproducts could decline. Any significant decrease in the sales of our productscould have a material adverse effect on our business, financial condition andresults of operations

Adversely, focusing on three different major product linesrequires that the Company allocate sufficient resources to each, and theCompany might not have the infrastructure to be able to fully support the needsof each product line and of additional product lines. As a result of not beingable to adequately focus our efforts and resources on all of the Company`sproduct lines, we may loose our positioning in already existing markets.

** **

**___10___** 

**Our success depends on ourability to anticipate new technological changes and to introduce new productsin a timely manner.**

The market for our products is characterized by rapidlychanging technology and evolving industry standards. The introduction ofproducts embodying new technology and the emergence of new industry standardscould render our existing products obsolete and unmarketable. Although wedesign our products to fit and match certain market standard interfaces, someof these interfaces may change over a relatively short period which may causeour then existing products to become obsolete while possibly enabling competingproducts. Our ability to anticipate changes in technology and industrystandards and interfaces and to successfully develop and introduce new andenhanced products on a timely basis will be a critical factor in our ability togrow and to remain competitive. In addition, the anticipated developmentschedules for high technology companies are inherently difficult to predict andare subject to change as a result of shifting priorities in response tocustomers` requirements and product introductions from competitors. Ourinability, for technological or other reasons, to develop products and productenhancements that are technologically competitive, responsive to customer needsor competitively priced would have a material adverse effect on our business,financial condition and results of operations.

** **

**Our non-retail productsgenerally have a long sales cycle, which increases our costs in obtainingorders and reduces the predictability of our earnings.**

Our DiskOnChip and FFD products are technologicallycomplex and are typically intended for use in applications that may be criticalto the business of our customers. Non-retail prospective customers generallymust make a significant commitment of resources to test and evaluate our productsand to integrate them into their applications. As a result, our non-retailsales process is often subject to delays associated with lengthy approvalprocesses that typically accompany the design and testing of new computer andtelecommunications equipment. The sales cycles of our non-retail products tonew customers currently average approximately 18 months from the time we make aproposal to a customer until the time the customer begins to commerciallymanufacture its product. This requires us to invest significant resources tomake sales, and reduces the predictability of our sales.

Long sales cycles also subject us to risks not usuallyencountered by companies whose products have short sales cycles. These risksinclude the potential cancellation of orders based on customers` changingbudgetary constraints, and the unpredictability of internal acceptance reviews.In addition, orders expected in one quarter could shift to another because ofthe timing of customers` procurement decisions. This complicates our planningprocesses and reduces the predictability of our earnings.

** **

**Sales to a small number ofcustomers represent a significant portion of our revenues.**

More than half of our revenues come from a small number ofcustomers. Specifically, sales to our top 3 customers accounted forapproximately 34.5% of our revenues in 2000, 18.8% in 2001 and 33.8% in 2002and sales to our top 10 customers accounted for approximately 55% of ourrevenues in 2000, 47% in 2001 and 56% in 2002. If we were to lose any of oursignificant customers or experience any material reduction in orders from thesecustomers, our revenues and operating results would suffer. In particular, dueto the business nature of the market for our DiskOnKey products (the fact thata customer can, with little effort and investment, move from our solution to asolution of a competitor), and the relative ease with which our customers mayterminate their business relationship with us, we may encounter a severereduction in sales of our DiskOnKey products over a very short period of time.Furthermore, due to the high level of fluctuation in the amount of unitsordered by significant customers, our overall revenues may fluctuate fromquarter to quarter. 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.

** **

**___11___** 

**We expect our expenses toincrease, which could adversely affect our financial condition and results ofoperation.**

We expect our quarterly operating expenses to increase in2003 beyond the figures for the fourth quarter of 2002 due primarily to plannedsales & marketing and research & development activities. In addition,subject to market conditions at the time, our operating expenses might increaseas a result of a need to hire additional personnel to support possible futuregrowth in sales unit volumes, and sales and marketing efforts. Furthermore, wehave significant fixed costs, and we cannot readily reduce these expenses overthe short term. If revenues do not increase as our operating expenses increase,or if revenues decrease or do not meet expectations for a particular period, wewill experience growing losses.  

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

Our success is dependent upon our proprietary technology.We currently rely on a combination of patent, trade secret, copyright andtrademark law, together with non-disclosure agreements, to establish andprotect the proprietary rights and technology used in our products.

As of May 1st, 2003, we hold twenty two (22)U.S. patents and several foreign patents relating to our technology andproducts. We also have forty three (43) applications for patents pending in theU.S. with respect to new products and technologies. However, we cannot assureyou that the pending patent applications will be granted or that our existingpatents or any other patents that may be granted will be enforceable or provideus with meaningful protection from competitors. Patents that may be granted tous in some foreign countries may not afford the same protection to us as isprovided under the patent laws of the U.S. If a competitor were to infringe ourpatents, the costs of enforcing patent rights might be substantial or evenprohibitive. In seeking to protect our trademarks, copyrights and otherproprietary rights, or defending ourselves against claims of infringementbrought by others, with or without merit, we could face costly litigation andthe diversion of our management`s attention and resources. This could have amaterial adverse effect on our business, financial condition and results ofoperations (see Item 4.B below the paragraph titled "Intellectual PropertyRights and Current Litigation"). 

We also may desire or be required to obtain licenses fromothers in order to further develop, produce and market commercially viableproducts. We cannot assure you that we will be able to obtain any requiredlicenses on commercially reasonable terms, if at all, that the patentsunderlying those licenses will be valid and enforceable or that the technologyunderlying those licenses will remain proprietary in nature.

We also rely on unpatented proprietary know-how,copyrights and trade secrets, and employ various methods, includingconfidentiality agreements with employees, consultants and marketing partners,to protect our trade secrets and know-how. However, these methods may notafford complete protection and we cannot assure you that others will notindependently develop our trade secrets and know-how or obtain access thereto.

** **

**Our products may infringe onthe intellectual property rights of others and this could cause us to have tostop manufacturing or selling certain of our products.**

Third parties may assert against us infringement claims orclaims that we have violated a patent or infringed a copyright, trademark orother proprietary right belonging to them. An infringement claim, even if notmeritorious, could result in the expenditure of significant financial andmanagerial resources by us. An adverse determination of any infringement claimcould subject us to significant liabilities to third parties, could require usto seek licenses from third parties and could prevent us from manufacturing,selling or using certain of our products, any of which could have a materialadverse effect on our business, financial condition or results of operations. 

** **

**Our success depends on keypersonnel, including our executive officers, the loss of whom could disrupt ourbusiness.**

Our success greatly depends on the continued contributionsof our senior management and other key research and development, sales,finance, marketing and operations personnel, including, without limitation, Mr.Dov Moran, our Chairman, President and Chief Executive Officer. We cannotassure you that we will be successful in retaining our key personnel. 

**___12___** 

**Our success depends onattracting and retaining additional qualified personnel.**

The success of our business depends on our ability toattract and retain highly qualified management, technical, sales, finance andmarketing personnel. In particular, we require highly qualified technicalpersonnel who are capable of developing technologies and products and providingthe technical support required by our customers. Individuals who possess thesequalifications are in high demand, and we may not be successful in attracting,integrating and retaining them when and as needed.

** **

**Investments in or acquisitionsof companies or technologies may distract our management and disrupt orotherwise harm our business.**

One of our strategies is to acquire or make investments incomplementary businesses, technologies, services or products if appropriateopportunities arise. We have made several investments in or acquisitions ofcompanies or assets of companies in the past. We may in the future engage indiscussions and negotiations with companies about our acquiring or investing inthose companies` businesses, products, services or technologies. We cannot makeassurances that we will be able to identify future suitable acquisition orinvestment candidates, or if we do identify suitable candidates that we will beable to make the acquisitions or investments on commercially acceptable termsor at all. If we acquire or invest in another company, we could have difficultyassimilating that company`s personnel, operations, technology or products andservice offerings into our own. The key personnel of the acquired company maydecide 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. The issuance of equitysecurities could be dilutive to our existing shareholders. In addition, anyinvestment in another company will be subject to the risks faced by thatcompany. To the extent that any company in which we invested in the past or anycompany in which we invest in the future, thereafter loses value or does notsucceed, we may lose part or all of our investment. We do not now have anyagreement to enter into any material investment or acquisition transaction.

** **

**Our United States investorscould suffer significant adverse tax consequences if we are characterized as apassive foreign investment company.**

Although we do not believe that we were a passive foreigninvestment company for U.S. federal income tax purposes during 2002, we cannotassure you that we will not be treated as a passive foreign investment companyin any of 2002, 2003 or in future years. We would be deemed to be a passiveforeign investment company if (i) 75% or more of our gross income in a taxableyear including the pro rata share of the gross income of any company, U.S. orforeign, in which we are considered to own 25% of the shares by value, ispassive income, or (ii) 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, U.S. or foreign, inwhich we are considered to own 25% or more of the shares by value, produce, orare held for the production of passive income. Passive income includesinterest, dividends, royalties, rents and annuities. If we are or become apassive foreign investment company, or if the U.S. Internal Revenue Service subsequentlysuccessfully asserts that we are, were or became a passive foreign investmentcompany at some point, many of our shareholders will be subject to potentiallysubstantial 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.                                                                                              |

** **

**Our costs may be impacted byfluctuations in currency exchange rates.**

Certain of our expenses are in, or are linked to,currencies other than the U.S. Dollar, principally the New Israeli Shekel(NIS), the New Taiwanese Dollar and the Japanese Yen. This exposes us topotentially increased operational costs as well as increased costs for certainof our products as a result of currency fluctuations. In the event that any ofour customers demand that certain of the Company`s products be quoted and soldin currencies other than the U.S. Dollar, we may receive income in the futurein such other currencies. As a result, our revenues may be adversely affected.

**___13___** 

 

**Conditions in Israel affect ouroperations and may limit our ability to produce and sell our products.**

We are incorporated under Israeli law and our principaloffices and research and development facilities are located in Israel.Political, economic and military conditions in Israel directly affect ouroperations. Since the establishment of the State of Israel in 1948, a number ofarmed conflicts have taken place between Israel and its Arab neighbors and astate of hostility, varying in degree and intensity, has led to security and economicproblems for Israel. We could be adversely affected by any major hostilitiesinvolving Israel, the interruption or curtailment of trade between Israel andits trading partners, a significant increase in inflation, or a significantdownturn in the economic or financial condition of Israel. Since October 2000,there has been a significant and escalating increase in violence between Israeland the Palestinians, primarily but not exclusively in the West Bank and GazaStrip. Further deterioration of hostilities into a full scale conflict mightrequire more widespread military reserve service by some of our employees,which could have a material adverse effect on our business. In addition,several Arab countries still restrict business with Israeli companies. We couldbe adversely affected by restrictive laws or policies directed towards Israelor Israeli businesses. In addition, the current conflict in Iraq may haveadverse implications on business in Israel.

Generally, all male adult citizens and permanent residentsof Israel under the age of 54 are, unless exempt, obligated to perform up to 43days of military reserve duty annually. Additionally, all Israeli residents ofthis age are subject to being called to active duty at any time under emergencycircumstances. Many of our officers and employees are currently obligated toperform annual reserve duty. Although we have operated effectively under theserequirements since we began operations, we cannot assess the full impact ofthese requirements on our workforce or business if political and militaryconditions should change, and we cannot predict the effect on us of anyexpansion or reduction of these obligations. 

** **

**The government programs andtax benefits that we currently receive require us to meet several conditionsand may be terminated or reduced in the future, which would increase our costsand taxes.**

We benefit from certain government programs and taxbenefits, particularly as a result of tax exemptions and reductions resultingfrom the `approved enterprise` status of our manufacturing facilities in Israel(see Item 10.E below the paragraph titled "Law for the Encouragement of CapitalInvestments, 1959"). To be eligible for these programs and tax benefits, wemust continue to meet conditions, including making specified investments inproperty and equipment and financing a percentage of investments with sharecapital. If we fail to meet such conditions in the future, the tax benefitswould be canceled and we could be required to refund the tax benefits alreadyreceived. These programs and tax benefits may not be continued in the future attheir current levels or at any level. The Israeli government has reduced thebenefits available under some of these programs in recent years, and Israeligovernmental authorities have indicated that the government may further reduceor eliminate some of these benefits in the future. The termination or reductionof these programs and tax benefits could increase our expenses, therebyreducing our profits and increasing our losses.

** **

**The rate of inflation inIsrael may negatively impact our costs if it exceeds the rate of devaluation ofthe New Israeli Shekel against the U.S. Dollar.**

The majority of our revenues is denominated in U.S.dollars or is dollar-linked, but we incur a portion of our expenses,principally salaries and related personnel expenses in Israel and the costs ofmaintaining our facilities in Israel, in NIS. As a result, we are exposed tothe risk that the rate of inflation in Israel will exceed the rate of devaluationof the NIS in relation to the dollar or that the timing of this devaluationlags behind inflation in Israel. In that event, the dollar cost of ouroperations in Israel will increase and our dollar-measured results ofoperations will be adversely affected. In 1997, 1998, 2001 and 2002, the rateof devaluation of the NIS against the dollar exceeded the rate of inflation inIsrael, a reversal from prior years, which benefited us. In 1999 and 2000however, the rate of inflation in Israel exceeded the rate of devaluation ofthe NIS against the dollar. We cannot predict whether in the future the rate ofdevaluation of the NIS against the dollar will exceed the rate of inflation inIsrael or vice versa. We cannot assure you that we will not be materially adverselyaffected if the rate of inflation in Israel exceeds the devaluation of the NISagainst the dollar, or if the timing of this devaluation lags behind increasesin inflation in Israel.

** **

**___14___** 

**It may be difficult to enforcea U.S. judgment against us, our officers and directors and some of the expertsnamed in this report or to assert U.S. securities law claims in Israel.**

We are incorporated in Israel. Substantially all of ourexecutive officers and directors and certain experts named in this report arenonresidents of the U.S., and a substantial portion of our assets and theassets of these persons are located outside the U.S. Therefore, it may bedifficult to enforce a judgment obtained in the U.S. against us or any suchpersons. Additionally, it may be difficult for you to enforce civil liabilitiesunder U.S. federal securities laws in original actions instituted in Israel.

** **

**Under current Israeli law, wemay not be able to enforce covenants not to compete and therefore may be unableto prevent our competitors from benefiting from the expertise of some of ourformer employees.**

We currently have non-competition clauses in theemployment agreements of nearly all of our employees. The provisions of suchclauses prohibit our employees, if they cease working for us, from directlycompeting with the Company or working for our competitors. Recently, Israelicourts have required employers, seeking to enforce non-compete undertakingsagainst former employees, to demonstrate that the competitive activities of theformer employee will cause harm to one of a limited number of materialinterests of the employer recognized by the courts (e.g. the confidentiality ofcertain commercial information or a company`s intellectual property). In theevent that any of the Company`s employees chooses to go and work for one of ourcompetitors, we may be unable to prevent our competitors from benefiting fromthe expertise of our former employees obtained from us, if we cannotdemonstrate to the court that harm would be caused to the Company. 

** **

**Certain provisions of ourArticles of Association and of Israeli law could delay, hinder or prevent achange in our control.**

Our Articles of Association contain provisions that couldmake it more difficult for a third party to acquire control of us, even if thatchange would be beneficial to our shareholders. Specifically, our Articles ofAssociation provide that any merger or significant acquisition involving usrequires the approval of 75% of the voting power of our shareholders present ata meeting, in person or by proxy, and voting on the transaction. This provisionof our Articles of Association can only be amended by the same supermajorityshareholder vote required for approval of a merger or acquisition transaction.In addition, certain provisions of the Israeli Companies Law 1999 (the"Companies Law"), which came into effect in February 2000, could also delay orotherwise make more difficult a change in our control. The provision of theCompanies Law relating to mergers and acquisitions are discussed in greaterdetail in "Item 10: Additional Information."

 

 

**___15___** 

# ITEM 4.  INFORMATIONON THE COMPANY

 

#  A.  HISTORY AND DEVELOPMENT OF THE COMPANY

 

Our commercial and 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. 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, andits telephone number is (510) 494-2090.

In March 2000, we completed a secondary offering of ourordinary shares, which provided net proceeds for the company of approximately$ 149.6 million. In September 2000, we effected a 2-for-1 stock split inthe form of a 100 percent stock dividend.

In September 2000, we acquired the assets of FortressU&T Ltd. ("Fortress") for approximately $ 8 million. These assetsincluded significant technology, patents and know-how relating toimplementation of secured encryption, data protection, secure smart cardtechnology and secure payment schemes. These technologies can provide securityand access control to prevent accidental or intentional modification of acustomer`s application code residing on a flash disk, copy protection toprevent piracy and unauthorized cloning, and reliable authentication ofauthorized users. As part of this transaction, most of Fortress` employeesformed our new research and development center in Omer, Israel to develop newflash disk security features and to integrate advanced security features intoour existing and future flash disk products. 

In October 2000, we purchased 586,080 preferred shares ofSaifun Semiconductors Ltd. ("Saifun") for approximately $ 10 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, up until the last Annual General Meeting of theshareholders of the Company, a member of our Board of Directors, is thefounder, chief executive officer and a director of Saifun (see Item 7.B belowthe paragraph titled "Related Party Transactions").

In April 2001, we signed an agreement for the purchase ofthe building in which our headquarters` executive offices, research,development and manufacturing facilities are located. As part of the agreement,we also purchased a vacant lot adjacent to our offices. The aggregateconsideration for these purchases was approximately $ 10.5 million, whichwe financed ourselves. Some of the consideration has been placed in an escrowfund pending the receipt by the sellers of these properties of various permitsand third party approvals. In addition to the consideration paid for the buildingand the adjacent lot, we invested an additional $ 3.29 million indeveloping and renovating the facility.

In April, 2003 we established a subsidiary in Israel namedSmart Caps Ltd. ("Smart Caps") for the purpose of developing and marketingsmart applications for our line of DiskOnKey products. The State of Israel,through the Office of the Chief Scientist ("OCS"), has committed to investingup to approximately $ 550,000 in Smart Caps. This investment by the OCS isto at least match our investment in Smart Caps. In consideration for suchinvestments, M-Systems and the OCS are to be issued shares in Smart Caps prorata to each of their relative investments.

On May 1st, 2003, we entered into a SharePurchase Agreement with Dr. Hans Wagner, a member of our Board of Directors,for the purchase of 500,000 ordinary shares, which transaction was subsequentlyconsummated (see Item 7.B below the paragraph titled "Related PartyTransactions"). 

 

**___16___** 

B.  BUSINESS OVERVIEW

 

**Our Company**

We  develop, manufacture and market innovativedata storage products based on flash memory, known as flash disks. Our flashdisks provide the functionality of a mechanical hard drive on a solid-statesilicon chip. We achieve this through the combination of our patented flashmanagement technology, known as TrueFFS (True Flash File System), with standardflash memory components and miniaturization technologies that we havedeveloped. Flash components are silicon chips on which data can be recorded andfrom which data can be retrieved and which require no power to retain data. OurTrueFFS software enables us to transform standard flash components into highlyreliable, easy to integrate and efficient flash disks which meet the uniquedata storage needs of our target markets. 

Our products are based on our TrueFFS technology andinclude both removable and non-removable data storage media in a wide range ofcapacities, interfaces, and form factors. We have three primary product lines:the DiskOnChip, DiskOnKey and FFD product families.

Our DiskOnChip and FFD product lines provide non-removable(sometimes referred to as `local`) data storage. In this way, they areanalogous to a hard disk, which is embedded within a computer system, incontrast to removable storage such as a floppy disk.  

Our DiskOnKey product line provides removable andpocketable thumb-sized data storage which plugs directly into the USB port ofPC`s, laptops, and other computer-based consumer products, allowing the user tostore and carry his data with him and to quickly, easily and reliably transferdata between any computer or any computerized system which has a USB port.  

Typically, our flash disks are used to store operatingsystems, applications software, and data such as voice, video, documents,e-mail and pictures, in the many applications where the use of traditional datastorage devices, such as mechanical hard drives or floppy drives, is unsuitableor is less suitable. As we discuss in further detail below (see in this Item4.B below the paragraphs titled "Industry Background" and "The M-SystemsSolution"), the benefits of flash disks over traditional data storage devicesinclude lower power consumption; much higher reliability, durability andruggedness; greater cost-effectiveness in many applications, much greatercapacity when comparing the DiskOnKey to a floppy drive, and (except for theFFD products, which are designed to serve as drop-in replacements for harddrives) much smaller and more lightweight. 

In very broad terms, the difference between the DiskOnChipand FFD product lines can be summarized as follows: Our DiskOnChip family iscomprised of various compact and light-weight flash disk products (at a formfactor of either a chip or module) which are optimized for applications whichare relatively small and/or need relatively small data storage capacities. OurFFD product line is available in much higher data storage capacities, comes instandard hard-drive sizes and interfaces, and is designed to provide extremelyhigh reliability, ruggedness and durability under the harshest environmentaland other conditions. 

Our DiskOnChip product family is well-suited for andprimarily targeted at the High-End Mobile Devices and Embedded Devices markets.

Our DiskOnKey product family is targeted at the PC andlaptop markets. It currently provides 8, 16, 32, 64, 128, 256, 512 megabytesand 1 gigabyte of portable, reliable data storage in a thumb-sized andpocketable device that plugs directly into the USB port of PCs, laptops andvarious consumer appliances. This product is designed to replace other portabledata storage devices, such as conventional floppy disks, which lack theconvenience, reliability and/or the storage capacity of the DiskOnKey.

Our FFD product line is well-suited for and primarilytargeted at military systems and network infrastructure equipment.

See in this Item 4.B below the paragraph titled "Products"for more details on our product lines and our specific products.

** **

**___17___** 

**Industry Background**

The memory and data storage markets have traditionallyincluded data storage devices such as hard drives and floppy drives, andtraditional memory components such as ROM (Read Only Memory), RAM (RandomAccess Memory) devices, or standard flash memory components.

These traditional solutions are not suitable, or are notefficient, in meeting the data storage needs of many existing and emergingproducts. Our target markets for our DiskOnChip, DiskOnKey and FFD productlines are comprised of such products (see in this Item 4.B below the paragraphtitled "Our Target Markets.")

Following is a brief review of the aforementionedtraditional solutions:
| ●*       *  | A hard drive is a high capacity,  low cost-per-megabyte data storage device that consists of one or more flat,  mechanically spinning circular disks coated with magnetizable material, over  which an arm with a read/write head is positioned to magnetically record and  retrieve data to and from the disk. Traditional hard drives are not a  suitable solution for the data storage requirements of High-End Mobile  Devices and Embedded Devices (products which are based on a computer platform  but are not generally thought of as computers). Hard drives are unsuitable  for these products because, among other things, they are too big and heavy,  too noisy, consume too much power, and are not cost-effective in relatively  low capacities. In addition, hard drives are susceptible to mechanical  failures, and wear, strong shocks, vibrations or extremes in temperature and  humidity adversely affect their performance. As a result, they are not  sufficiently reliable either for High-End Mobile Devices or the many portable  Embedded Devices that are subject to shocks, falls and other stresses.  Furthermore, they are certainly a problematic solution for the data storage  requirements of military systems and network infrastructure equipment  applications and other applications where data reliability and extended life  expectancy is critical. |
|-----------------------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ●*       *  | A floppy drive is a very low  capacity (1.44 megabyte) mechanical data storage device that, similar to a  hard drive, includes a flat, mechanically spinning circular disk coated with  magnetizable material, over which an arm with one or two read/write heads are  positioned to magnetically record and retrieve data to and from the disk.  Unlike a hard drive, it has no accurate feedback mechanism from the disk,  which makes the floppy disk a much less reliable solution than a hard disk.  Furthermore, writing to and reading from a floppy disk are much slower than  on a hard drive. In addition to reliability and speed concerns, a floppy disk  lacks the storage capacity required by many of today`s files and  applications, is less convenient to carry around than a DiskOnKey that can  clip in one`s pocket, and requires one to carry an external floppy drive  around for use with the many laptops which do not integrate a floppy drive.  The current 3.5 inch format of the floppy disk and drive was introduced in  1980, using the same basic technology used in the 8 inch floppy drives  introduced in 1973. In light of all of the above, the floppy drive and floppy  disk are clearly much less suitable for storing, transporting and  transferring data than the much more reliable, convenient, high-speed and  high capacity DiskOnKey.           |
| ●*       *  | Traditional memory components, such  as ROM or RAM devices and standard flash memory components, are not suitable  solutions for the data storage requirements of High-End Mobile Devices,  Embedded Devices, military systems and network infrastructure equipment  applications, and key-chain storage devices. ROM devices are unable to record  new data or update previously recorded data. RAM devices are able to record  new data but are volatile, meaning that they are unable to retain stored data  when the power supply is cut off. Standard flash memory components are able  to record new data and are non-volatile. However, standard flash memory  components alone are not an optimal data storage solution because they are  unable to rewrite to locations that have already been written to without  first erasing large blocks of data and they have a limited number of write  cycles. Among other things, they are less reliable than our flash disks  because they lack our error detection and correction feature. Moreover, they  do not organize stored data in a way that is efficiently recognized by the  operating systems commonly used in computers and computer-based systems.                                                                                                                                                                            |

** **

**___18___** 

**The M-Systems Solution**

We have capitalized on our patented TrueFFS flashmanagement technology to provide a broad range of both non-removable andremovable flash disks that resolve many of the drawbacks and limitations of thetraditional data storage solutions discussed above. 

Our DiskOnChip products provide the combination of ease ofintegration, compact size, cost-effectiveness, reliability, durability, speedand low power consumption required by High-End Mobile Devices and EmbeddedDevices. The Mobile DiskOnChip family was designed for and optimized to thespecific needs of advanced High-End Mobile Devices.

Our DiskOnKey products, introduced at the end of 2000, areremovable, reliable, lightweight, high-speed and high capacity thumb-sized andpocketable data storage devices that are based both on our TrueFFS technologyand on our new and patented DiskOnKey technology. The DiskOnKey plugs directlyinto the USB port of PC`s, laptops, and other computer-based consumer products,allowing the user to conveniently store and carry his data with him and toquickly and reliably transfer data between any computer-based system which hasa USB port. Since the DiskOnKey has its own central processing unit ("CPU"), it can also support and run multiple software applicationsdirectly from the product itself. For example, in November 2001, we introducedour KeySafe(TM) security application that ensures theconfidentiality of private data by means of a user-defined password andinternally secured access verification and is supported by the latest Windowsoperating systems.

Our FFD products offer much higher maximum data storagecapacities than our DiskOnChip and DiskOnKey products families, and provide thecombination of speed and extremely high reliability, durability, and ruggednessunder the harshest environmental conditions that are required by militarysystems and network infrastructure equipment.

In general, although not all of the following advantagesare relevant to all of our products or to some of our products when competingin specific markets, the benefits that our products provide include thefollowing: 

*Ease of Integration.*Our TrueFFS software supportsnearly all major operating systems used in High-End Mobile Devices and EmbeddedDevices. As a result, our customers can easily integrate our DiskOnChipproducts into their products with minimal integration efforts. This enables ourDiskOnChip products to provide a convenient solution for the data storagerequirements of our customers` products and reduces the time and cost requiredfor our customers to bring a product to market. In addition, several hundreddifferent types of commercially available embedded motherboards currentlyinclude a socket specifically designed for our DiskOnChip 2000 products. As aresult, our customers can easily integrate the DiskOnChip into their designs.Our FFD products have a standard hard drive interface and can therefore easilyreplace a hard drive. Our products are available in modular form, which enablesour customers to easily upgrade from one of our flash disks to another withgreater capacity, if and when required. 

*Compact Size.* Our technology enables our DiskOnChipproducts to emulate a hard drive without the need for a microprocessor, unlikecompeting products. As a result, our DiskOnChip products are small. We believethat our Mobile DiskOnChip is the smallest flash disk in the world, with theDiskOnChip Millennium and DiskOnChip Millennium Plus being smaller than anyflash disk other than the Mobile DiskOnChip. Compact size is particularlyimportant to manufacturers of High-End Mobile Devices and Embedded Devices thatincreasingly are seeking to provide more product functionality with componentsoccupying less space.

*Low Power Consumption; Non-Volatility.* All of ourproducts require relatively little power to operate. This feature isparticularly important to manufacturers of battery-powered and other portableor small appliances. All our products are also non-volatile, meaning theyretain stored data even while the power supply is cut off, and our TrueFFSsoftware ensures data integrity if for any reason the power supply is cut offwhile data is being read or written.

*Cost-Effectiveness.* The DiskOnChip Millennium andthe Mobile DiskOnChip families provide particularly cost-effective solutionsfor the data storage needs of our customers` products because all of the logiccircuitry and related hardware of the flash disk have been integrated with theflash memory component onto a single chip. In addition, our FFD products arehighly reliable and durable. As a result, they represent a cost-effectivesolution for products such as military systems and network infrastructureequipment, where the cost of repairing or replacing the data storage device ishigh or where the potential costs of losing data or the failure of the relatedsystem are great. 

**___19___** 

*High Reliability, Durability and Ruggedness.* Unlikemany traditional data storage devices that use rotating media such as harddrives, or floppy disks, our products are solid-state, meaning that they haveno moving parts and therefore are not susceptible to mechanical failure. Inaddition, because our products are solid-state, they can withstand shocks,vibrations and temperature and humidity extremes better than data storagedevices that use rotating media. Our products also contain effective errordetection and correction algorithms that further enhance reliability. Moreover,our TrueFFS software performs wear leveling, which spreads the writing of dataover the entire flash storage device, thereby increasing the durability of theproduct. 

*High Performance.* Our products have a higher writespeed than standard flash components alone. In addition, our FFD productsprovide faster access times than hard drives and read and write speedscomparable to high-performance hard drives.

*Compatibility; Capacity.*Our DiskOnKey is alightweight, thumb-sized and pocketable device that plugs directly into the USBport of PCs, laptops and other consumer appliances. The DiskOnKey does notrequire drivers with the latest operating systems and isoperating-system-independent, thus allowing users with both a Mac and Windowsmachine to easily transfer data between the two systems. In addition, incontrast to floppy disks whose maximum capacity is 1.44 megabytes, theDiskOnKey is currently available in capacities of 8, 16, 32, 64, 128, 256 and512 megabytes and 1 gigabyte.

** **

**Our Target Markets**

As discussed above, our primary target markets for ourthree principal product lines, the DiskOnChip, the DiskOnKey, and the FFDfamilies, are as follows:

***- Target Markets for theDiskOnChip Product Line***

The primary target markets for our DiskOnChip productsare: (i) the High-End Mobile Devices market; and (ii) the Embedded Devicesmarket.  

**The High-End Mobile Devices Market:**

High-End Mobile Devices are portable handsets of allkinds. The High-End Mobile Devices market is comprised primarily of cellularphones and PDAs. 

Cellular phones were originally just that; telephones thatyou could carry around with you to make and receive phone calls, with noadditional features (i.e. voice-centric cellular hand-sets). The first handheldcomputers were dubbed Personal Digital Assistants, or PDAs, because they wereprimarily used to store phone numbers, addresses and appointments. Many werebasically just expensive electronic organizers.

The market for 2.5G-3G feature-rich handsets is growingrapidly. More and more handsets with features such as digital cameras, colorscreens, MMS (Multimedia Messaging Services) & Email capabilities, PIM(Personal Information Management) and gaming, as well as graphical applications& operating systems (i.e. data-centric cellular devices) are introduced andsold world wide. These data-centric devices require (among others), much more memorythan their predecessors. For example, a simple voice-centric 2G cellular phoneusually featured 2 megabytes of flash memory, while 2.5G and 3G data-centricdevices feature 16-64 megabytes. This increase in memory must also take intoaccount the unique characteristics of data-centric mobile handsets that must bephysically small yet feature improved performance and lower power consumptionfor a longer battery life. 

Most of today`sdata-centric mobile handsets suffer from slow writeperformance, low reliability, limited capacity and high power consumption. Thislimits the ability of designers of mobile applications to provide advancedapplications and to allow the customer to store more than a minimal amount ofdata. The Mobile DiskOnChip offers both the storage capacity and the featuresneeded to overcome these limitations. 

We believe that our MobileDiskOnChip delivers an ideal combination of high capacity & small size,with the high performance and reliability needed for multimedia enabledhandsets and PDAs. Based on the latest NAND technology, integrated with afeature rich ultra thin controller, Mobile DiskOnChip also features an idealcost structure.

**___20___** 

**The Embedded Devices Market:**

Our DiskOnChip product line was designed and developedover the years with the needs of embedded systems in mind. Embedded systems areproducts that are based on a computer platform but that are nevertheless notgenerally thought of as computers. Among the numerous examples of theseproducts are point-of-sale terminals, bar-code readers, video conferencingequipment and manufacturing robots and control systems. 

With the advent and increasing popularity of the Internet,the ever-growing demand for access to the Internet anytime and anywhere fueleddramatic growth in the year 2000 in the Connected Devices market and we shiftedour focus to this then-emerging market for internet connected devices("Connected Devices").****Connected Devices (many of which are EmbeddedDevices themselves) are digital devices of all kinds that are used to accessthe Internet and process, store and respond to information. These appliancesenable low-cost and convenient access to Internet content, services andapplications and are revolutionizing the way people access and use information.Examples of Connected Devices are digital set-top boxes and thin clients whichare relatively inexpensive devices (also known as "network computers") designedprimarily for business use which are configured with only essential equipment(usually without hard disk drives) and connected to a local area network orother server via the Internet or other communications lines. Our DiskOnChipproducts provide the combination of ease of integration, compact size,cost-effectiveness, reliability, durability, speed and low power consumptionrequired by Connected Devices and other embedded systems. However, in light ofthe sharp decrease in the worldwide demand for Connected Devices whichnegatively affected our revenues in 2001, together with the growing andanticipated demand for the next-generation of data-centric mobile handsets, wedecided to widen our target markets and focus on more than just the ConnectedDevices Market. Embedded systems which we are targeting include, for example,residential gateways (i.e. devices which allow to easily and securely share ahigh-speed broadband Internet connection with all of the computers throughoutthe home or small office), point of sales devices and wireless terminals (i.e.small hand held computers, ruggedized to withstand the rigors of everyday useand abuse).  

***- Target Markets for theDiskOnKey Product Line***

The DiskOnKey product family is targeted at the PC andlaptop markets. It is designed to replace other portable data storage devices,such as conventional megabyte floppy disks, which lack the convenience,reliability and/or the storage capacity of the DiskOnKey. The DiskOnKey,currently available in capacities of 8, 16, 32, 64, 128, 256 or 512 megabyteand 1 gigabyte, provides the user with the ability to save and transfer data suchas Word documents, songs (MP3s), pictures (JPEGs), PowerPoint presentations,digital video and anything else that can be saved within the boundaries of thestorage capacity of the model purchased. It provides portable, secure andreliable data storage in a thumb-sized and pocketable device that plugsdirectly into the USB port of PCs and laptops, and so enables the easy storage,back-up and transfer of data between any PC, laptop or other computer appliancewith a USB port. 

We sell our DiskOnKey products through PC and laptopvendors, distributors, Consumer Electronic Companies, and our other marketingchannels. DiskOnKey is re-sold by our customers mainly under their own privatename and label. 

***- Target Markets for theFFD Product Line***

Our FFD product line is primarily targeted to providesolutions for the military and aerospace, telecommunication networkinfrastructure, public safety and automation markets. These mission-critical systems, where the risk and/or cost ofdata loss based on technical failure or down-time is unacceptably high, require products which may be subject to rough handling, extreme shocks, vibrations and/or to avariety of temperature, humidity or altitude extremes; or which otherwise needto store data reliably under harsh environmental conditions. 

**___21___** 

Our FFD product line was designed specifically to meet theneeds of the markets for mission critical systems. The FFD products provideextremely high reliability, measured by impressive MTBF (Mean Time BetweenFailures), durability, ruggedness, enabling compliance with various US militaryand telecom standards, and extended life expectancy under the harshestenvironmental conditions. The FFD line offer high performance and high capacityin standard hard-drive sizes and interfaces, serving as drop-in replacementsfor standard rotating hard drives. In contrast to rotating/mechanical harddrives, which are susceptible to mechanical failure and whose performance isadversely affected by shocks, vibrations or extremes in temperature, high altitudeand humidity, the FFD product line is a solid-state flash disk with no movingparts. As with all of our products, this feature, combined with the errordetection and correction capabilities of our TrueFFS technology, makes our FFDproducts significantly more rugged, reliable and long-lived than hard drives.The markets for our FFD products include the military and aerospace markets(e.g. data recorders, moving maps, sonar, radar, fire control systems, blackboxes, airborne reconnaissance systems, rugged laptops, tactical computers andservers), the telecommunication network infrastructure market (e.g. datastorage in optical switches, ATM (Asynchronous Transfer Mode) switches, IPgateways and wireless base stations), the public safety-computing systems market(in police vehicles, public buses and in trains) and the market for missioncritical automated applications (e.g. production line manufacturing machines,point of sales systems and automatic teller machines).

** **

**Products**

***DiskOnChip***

**Our DiskOnChip product line includes, inhistorical order of their introduction to the market, the DiskOnChip 2000, theDiskOnChip Millennium, the DiskOnChip Millennium Plus, Mobile DiskOnChip,DiskOnChip based MCP (Multi-Chip Packaging)and the Mobile DiskOnChip G3. DiskOnChip is based on cost effective, highcapacity NAND flash technology, optimized to meet the unique requirements ofMobile devices and embedded systems 

DiskOnChip provides an easy and reliable high capacity nonvolatile memory ("NVM") solution. It utilizes standard NAND flashcomponents, while overcoming the technological limitations of NAND flash.DiskOnChip supports virtually all major operating systems in its target markets(such as Symbian OS, all Microsoft OSs, Linux, Palm, VxWorks, QNX, Nucleus). Asa result, our customers can integrate the DiskOnChip into their products withrelatively minimal integration efforts, reducing their integration risk andtime to market. Thanks to built-in error detection and correction features,enabled by our TrueFFS technology, DiskOnChip provides extremely reliable datastorage to the market. 

●*       ****DiskOnChip 2000.***

DiskOnChip 2000 is a module that contains NAND flashcomponents and a thin controller, forming a flash disk. Its capacities rangefrom 16 megabytes to 1 gigabyte, all using the exact same pinout, making itideal as an easy drop-in storage solution for embedded application. It featuresa standard memory interface (similar to that of NOR flash or EEPROM), and builtin error detection / correction capabilities, based on TrueFFS technology.DiskOnChip 2000 is available in a standard DIP (Dual In-line Package) formfactor, which enables it to be easily incorporated into our customers`products. 

●*       ****DiskOnChip Millennium.***

DiskOnChip Millennium is the industry`s first monolithicflash disk (both the flash and the controller are placed on the same silicondie). It is also the first NAND device with XIP (eXecution In Place) bootcapabilities. DiskOnChip Millennium was jointly developed by M-Systems andToshiba as part of a strategic relationship. We believe that, when introduced,the DiskOnChip Millennium was the smallest flash disk in the world; 

The main advantages of DiskOnChip Millennium`s monolithicstructure are its reduced cost and size and its boot capabilities. DiskOnChipMillennium is available with 8 megabytes of storage capacity, in form factorsof TSOP (Thin Small Outline Package) and DIP (compatible with DiskOnChip 2000).

**___22___** 

●*       ****DiskOnChip Millennium Plus.***

DiskOnChip Millennium Plus is the world`s first 32megabyte monolithic (single die) flash disk. This product is the second jointdevelopment with Toshiba. In addition to the larger storage capacity that itprovides, the DiskOnChip Millennium Plus offers data protection features toprevent customers` software, proprietary data and products from beingduplicated or modified. It also features an improved XIP boot capabilitydesigned to efficiently replace boot ROM in any hardware environment. 

●*       ****Mobile DiskOnChip.***

The Mobile DiskOnChip product line is the most recentaddition to the DiskOnChip family of products. It is the first NAND-baseddevice optimized for the unique requirements of mobile handsets, including alow 1.8V I/O interface, a deep power-down mode, and a small BGA (Ball GridArray) form factor (as small as 7x10mm, the smallest in the world). MobileDiskOnChip offers capacities of 16 megabytes to 64 megabytes. The 16 megabytesand 32 megabytes are monolithic (single die) products, and the 64 megabytes isa single chip product comprised of two dies of Mobile DiskOnChip 32 megabytes(using MCP technology). Mobile DiskOnChip also provides mobile applicationswith increased write performance.

We have recently announced (along with Toshiba) the newMobile DiskOnChip G3 which is the first device to implement Multi Level Cell(MLC) NAND technology. We believe that the Mobile DiskOnChip G3 is the smallestflash disk in the world. It features a complete NVM solution in approximately60 percent of the die size of a standard NAND flash of the same capacity.Mobile DiskOnChip G3 is based on M-Systems` x2 technology, designed to overcomethe limitations of MLC NAND technology and enables it as a reliable,high-performance, low-cost local storage device - mainly intended for 2.5G and3G mobile handsets.

●*       ****DiskOnChip-based MCP.***

DiskOnChip-based MCP packs Mobile DiskOnChip along with aselected combination from NOR flash, PSRAM (PseudoStatic Random Access Memory), SDRAM (SynchronousDynamic Random Access Memory) or SRAM (StaticRandom Access Memory), delivering all system memory needs in a single,compact FBGA package. This is extremely useful for Mobile applications, facingshrinking printed circuit boards ("PCBs") and increasing memoryrequirement. M-Systems offers DiskOnChip-based MCP combinations as well ascombinations tailored to specific customer needs. To provide the service,M-Systems partnered with both Toshiba and Advanced Micro Devices Inc. ("AMD"),thus has access to best of breed flash technologies (NAND and MLC NAND fromToshiba and MirrorBit from AMD) to provide ideal MCP solutions.

***DiskOnKey***

In November 2000, we announced the introduction of ourDiskOnKey product. The DiskOnKey is a lightweight, thumb-sized and pocketabledevice that plugs directly into the USB port of PCs, laptops and other consumerappliances. The DiskOnKey provides removable, secured data storage based onflash memory and our patented technology. It can be used as an alternative tobulky storage devices and floppy disks for reliable and personal data storage,and enables users to quickly, easily and reliably transfer data between theircomputers at home or work, in their pocket, or briefcase or on their keychain.The DiskOnKey does not require drivers with the latest operating systems andallows users with both a Mac and Windows machine to easily transfer databetween the two systems. The DiskOnKey is currently available in capacities of8, 16, 32, 64, 128, 256 and 512 megabytes, and 1 gigabyte. In addition toproviding data storage, since the DiskOnKey has its own CPU, it can also support and run multiple software applicationsdirectly from the product itself. For example, in November 2001, we introducedour KeySafe security application (available in six languages), which ensures the confidentiality of private data by meansof a user-defined password and internally-secured access verification and issupported by the latest Windows operating systems. In June of 2002, weintroduced our MyKey(TM) application, which allows users easy access,synchronization, and personalization of their DiskOnKey, and is supported onall the latest Windows operating systems.

Throughout 2002, the DiskOnKey product family grew to meetthe various market demands. The DiskOnKey Pro was introduced in August of 2002to meet the market's demand for a smaller form factor. DiskOnKey USB 2.0,allowing faster performance (speeds) was introduced in October of 2002. Inaddition, during the second half of 2002, certain partners of M-Systems begandeveloping their own unique form factors (different shape of exterior plasticcasing) to differentiate themselves in the marketplace, while continuing toincorporate our technology and components inside.

**___23___** 

 The DiskOnKey has been tested under extreme conditionsfor reliability and durability, securing both USB-compliance and certificationby Microsoft`s Windows Hardware Quality Testing Lab (WHQL). The DiskOnKey hasbeen granted industry awards and write-ups, such as CNET`s Top 100 Products of2002, numerous gift and tech buying guides mentions, such as Business Week, CNNHeadline News, Newsweek, and mentioned as the industry leader in Wall StreetJournal, just to name a few. 

***FFD***

 Our FFD, or Fast Flash Disk, product line is designed tomeet the data storage requirements of the military and aerospace,telecommunication network infrastructure, public safety and automation markets.Our FFD products consist of a printed circuit board that contains a number offlash components, a microprocessor that runs our TrueFFS software and otherproprietary algorithms, and the logic circuitry and related hardware of a flashdisk, all encased in a rugged metal package. Our FFD products provide anattractive alternative to traditional hard drive technologies for applicationsthat require extremely reliable, rugged, high-performance and high capacityflash data storage. Unlike rotating hard drives, our flash disk products aresolid-state devices that have no moving parts and canwithstand rough handling, extreme shocks, vibrations, or a variety oftemperature, humidity and altitude extremes. This characteristic,together with the error detection and correction capabilities of our TrueFFStechnology, makes our flash disks significantly more rugged and reliable thanhard drives. The FFD product line is available in capacities ranging from 32megabytes to 35 gigabytes. Our newest FFD product provides a data rate of 30megabytes per second for sustained read, 20 megabytes per second for sustainedwrite. Our FFD products are available with standard hard drive form factors andinterfaces, including IDE/ATA (Integrated Drive Electronics/AT Attachment),Narrow SCSI (Small Computer Systems Interface) and Ultra Wide SCSI interfacesin standard 2.5" and 3.5" casing can, and can therefore be used as a "drop inreplacement" for hard drives. 

  

**Technology**

Our proprietary TrueFFS (True Flash File System) software,which consists of patented data organization algorithms, procedures andmethodologies, is the core of our flash disk technology. We designed TrueFFS toenable our flash disks to emulate a hard drive and overcome the inherentlimitations of flash memory technology. We work with major operating systemvendors to make TrueFFS universally available, free of charge, in the form ofsoftware modules incorporated in their operating systems, or supporting theiroperating systems.

TrueFFS enables our flash disks to overcome critical flashmemory limitations, including: 
| ●*       *  | Standard flash memory  components are unable to rewrite to locations that have already been written  to without erasing large blocks of data. TrueFFS overcomes this limitation by  virtual mapping and allocation of "sector size" flash areas. Sector size is  the standard size of an information block written to a data storage device  such as a hard drive.                                                                                                                                                  |
|-----------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ●*       *  | Standard flash memory  components have a limited number of write cycles. TrueFFS overcomes this  limitation by wear leveling, a process which spreads the writing of data over  the available media even if the application is continuously rewriting the  same file or to the same sector.                                                                                                                                                                                                                         |
| ●*       *  | Standard flash memory  components often include imperfections in the silicon, which make certain  areas unusable for read/write functions. TrueFFS addresses this limitation by  incorporating sophisticated error detection and correction algorithms, which  are supported by the internal logic of our DiskOnChip products, to ensure  reliable operation while maintaining high performance. In addition, TrueFFS  performs on-line block mapping out mechanism to isolate imperfect areas of  the flash media. |
| ●*       *  | Standard flash memory  components may lose large portions of data if power is lost while "writing"  data. TrueFFS addresses this limitation by incorporating algorithms that  ensure data integrity in the event that power is cut off in the middle of a  write operation.                                                                                                                                                                                                                                         |

 

We achieve hard disk emulation for our DiskOnChip productsthrough our TrueFFS software, rather than through a hardware-based solution,such as the addition of a microprocessor. By doing so, we are able to produceour DiskOnChip products with the addition of only minimal logic circuitry. Inour DiskOnChip Millennium and DiskOnChip Millennium Plus and Mobile DiskOnChipthis architecture enables us to integrate all the required logic circuitry ontothe flash component itself. As a result, our products are able to providecompact and cost-effective solutions for our customers` data storagerequirements. 

** **

**___24___** 

**Marketing and Sales**

We market our products through a variety of methods,including participation in industry trade shows, conferences, publications,media promotion, through our website and increasingly, through strategicpartners. 

We target our DiskOnChip sales efforts primarily to largeoriginal equipment manufacturers that include our products in theirapplications. Our DiskOnKey is a retail product. Accordingly, we market andsell the DiskOnKey to the retail consumer market through major computer vendorsand international retail chains, as well as through various distributors. 

We market our products through a combination of our ownsales managers; independent local sales representatives that sell our productson our behalf; and independent distributors that purchase our products forresale to their customers. Our sales managers are compensated based on a salaryand a bonus dependent in part on sales levels. The independent local salesrepresentatives receive commissions for their product sales. We continuallyseek to strengthen each of our sales channels, including by engaging newrepresentatives and distributors and providing them with extensive training andsupport with respect to our products and technologies. Our technical engineersare an integral part of the sales process and provide customers with technicalinformation and support regarding our products and their integration with thecustomers` applications. 

In addition, we have entered into a strategic partnershipwith Toshiba in order to position the DiskOnChip as the market standard. Aspart of this  arrangement, Toshiba provides us with raw flashcomponents and fabrication services for some of our DiskOnChip products. Inaddition, we have, from time to time, entered into agreements with Toshiba forthe joint development of some of our DiskOnChip products using Toshiba`s flashcomponent technology and our flash data storage technology. These developmentagreements also grant Toshiba an 8-year license to manufacture and distributespecific DiskOnChip products as a second source******for which wereceive royalty payments. 

We maintain local sales offices in Silicon Valley,California; Boston, Massachusetts; Taipei, Taiwan; Tokyo, Japan; Shenzhen,China and Kfar Saba, Israel. As of May 1st, 2003, we had 112employees dedicated to marketing, sales and technical support functions.******

See Note 14 to our Consolidated Financial Statementsincluded elsewhere in this report for a breakdown by geographical market of ourrevenues for 2000, 2001 and 2002.

**Manufacturing and Sources ofSupply**

***Manufacturing***

We manufacture most of our products through qualifiedsubcontractors. Toshiba manufactures our DiskOnChip Millennium, DiskOnChipMillennium Plus and Mobile DiskOnChip products. We have entered into amanufacturing agreement******with Toshiba, pursuant to which Toshibahas agreed to provide us with specified manufacturing capacity through 2005,and we negotiate and place purchase orders with Toshiba from time to time forthe manufacture of products.******Subcontractors located in China andTaiwan manufacture our DiskOnKey products for us. We manufacture our DiskOnChip2000 and FFD products at our facility in Kfar Saba. 

Our products are European Union CE (Communaute Europenne)approved and our manufacturing process meets the ISO-9001 quality standards.The Company`s Quality System is ISO-9001, certified for the design anddevelopment, manufacturing and service processes. The Company`s contractmanufacturers are all ISO-9002 certified as well as ISO-14001 certified. 

The Company`s DiskOnKey products comply with worldwideregulatory standards such as UL, TUV, CB and FCC.

**___25___** 

***Sources of Supply***

We purchase our supplies from various sources, includingflash components that we purchase principally from Toshiba and Samsung. Samsungcurrently supplies the majority of our flash components. Although our agreementwith Samsung expired in March 2003, we continue to purchase flash componentsfrom them. Our policy is to have more than one supplier for all of our partswherever feasible. However, Toshiba is currently the sole manufacturer of ourDiskOnChip Millennium, DiskOnChip Millennium Plus and Mobile DiskOnChipproducts, and might be the sole manufacturer of future DiskOnChip products.Samsung is currently the sole supplier of the flash components for a portion ofour DiskOnKey products. In addition, we currently rely on Atmel Sarl as asingle source for supply of ASIC components for our DiskOnKey products. InApril 2001 we entered into a development and supply agreement with Atmel Sarl.Under this agreement, Atmel is to layout, develop, manufacture, test and supplythe ASIC components for our DiskOnKey products. We paid Atmel Sarl an initialfee for engineering work in developing these components, and we continue to paythem for each component purchased. The purchase price for the components willbe reduced if we exceed certain quantity levels. We provide Atmel with anon-binding 12-month rolling forecast for future demand, and generally placepurchase orders on the basis of 12 weeks of lead time. We have the right tocancel purchase orders previously delivered, subject to cancellation fees basedon the date of cancellation. Product prices are based on our forecastedpurchase quantities, subject, under specified conditions, to adjustment if thequantity we purchase differs from our forecast. These prices are reviewed everythree months to determine if cost reductions can be made. The agreement isterminable by Atmel at will, subject to six-months` prior notice, or by eitherparty for breach, subject to thirty days` prior notice. 

If Toshiba, Samsung, Atmel or any of our other suppliersfails to provide parts or services in a timely manner and we are unable tosecure an alternate supply of comparable price and quality in a timely manner,our results of operations could be adversely affected.  See thediscussion in Item 3.D "Risk Factors - We depend on Toshiba as a single sourcefor our Mobile DiskOnChip and our DiskOnChip Millennium Plus products, and weexpect to be dependant on them as a single source for future DiskOnChipproducts," " - We depend on third parties for the supply and quality ofcomponents required for the manufacture of our products, including flashcomponents" and " - We depend on third party foundries for silicon wafers andany shortage or disruption in our supply from these sources will reduce ourrevenues, earnings and gross margins."

At times, we have experienced difficulties in securingadequate supplies of certain components for our products, which has resulted indelayed or lost sales. In an effort to mitigate supply shortages, we at timeshave maintained a larger inventory of certain components than we wouldotherwise maintain if the availability of adequate supplies were more certain. 

**Seasonality**

We do not believe that seasonality has a material affecton our business at this time. However, we anticipate that we may experienceseasonality in sales of our DiskOnKey product in the future. This is due toDiskOnKey being a retail product that may experience higher sales duringholiday shopping seasons.

**Research and Development**

We have devoted significant resources to research anddevelopment activities with respect to our core flash data storage technology.We have emphasized the development of our technology, the enhancement ofexisting products and the development of new products, generally in response tothe rapidly evolving markets for PCs and laptops, High-End Mobile Devices andEmbedded Devices and the demanding markets for military systems and networkinfrastructure equipment applications. In addition, we emphasize thedevelopment and addition of new features to our products, such as dataprotection, security and access control, and the development of newapplications for our DiskOnKey products. Our expertise and in depth know how inthe usage of advanced flash technologies is utilized to good effect in ourresearch and development activities. We believe that our success will continueto depend upon our ability to enhance our existing products and to introducenew products in response to changes in market demands in a timely manner.Accordingly, we intend to continue to make substantial investments in productand technology development. As of March 15, 2003, we had 91 employees dedicatedto research and development activities.

**___26___** 

 

Our gross research and development expenses during 2000,2001 and 2002 were $ 7.4 million, $ 13.3 million and 12.2 million,respectively. A small portion of our operating expenses during 2001 was fundedby the Singapore - Israel industrial research and development ("SIIRD"). In2002 a small portion of our operating expenses was funded by the SIIRD and theInformation Society Technology ("IST") funds, in the amounts of $ 63,000and $ 212,000, respectively. Net research and development expensesrepresented, 8%, 29.7% and 18.5%, of our revenues during, 2000, 2001 and 2002respectively. In connection with the grants received from the OCS and SIIRD, weare required to pay the OCS and SIIRD royalties at the rate of 1.5%-5.0% on allrevenues derived from the sale of products developed as a result of theresearch projects funded by these grants, up to a maximum of 150% of thedollar-linked amount of the grant. The IST fund does not require any royalties.The manufacture of products developed using OCS funding must remain in Israel,and any technology developed using OCS funding may not be transferred to anyother entity without the prior consent of the OCS. These restrictions do notaffect sales of our products outside Israel.

**Intellectual Property Rightsand Current Litigation**

Our success is dependent upon our proprietary technology.We currently rely on a combination of patent, trade secret, copyright andtrademark law, together with non-disclosure agreements, to establish andprotect the proprietary rights and technology used in our products.

As of May 1st, 2003, we hold twenty two (22)U.S. patents and several foreign patents relating to our technology andproducts. We also have forty three (43) applications for patents pending in theU.S. with respect to new products and technologies. However, we cannot be surethat the pending patent applications will be granted or that our existingpatents or any other patents that may be granted will be enforceable or provideus with meaningful protection from competitors. Patents that may be granted tous in some foreign countries may not afford the same protection to us as isprovided under the patent laws of the U.S. If a competitor were to infringe ourpatents, the costs of enforcing patent rights might be substantial and, in somecases, even prohibitive.

We also may desire or be required to obtain licenses fromothers in order to further develop, produce and market commercially viableproducts effectively. We cannot be sure that these licenses will be obtainableon commercially reasonable terms, if at all, that the patents underlying theselicenses will be valid and enforceable or that the technology underlying theselicenses will remain proprietary in nature.

We also rely on unpatented proprietary know-how,copyrights and trade secrets, and employ various methods, includingconfidentiality agreements with employees, consultants and marketing partners,to protect our trade secrets and know-how. However, these methods may notafford complete protection and we cannot be sure that others will notindependently develop our trade secrets and know-how or obtain access thereto.

We have registered U.S. trademarks with respect to"M-Systems," "TrueFFS," "DiskOnChip," "DiskOnChip Millennium," "DiskOnKey" andour stylized kangaroo symbol for our DiskOnKey products and have filed U.S.trademark applications in connection with certain of our other products,including "DiskOnKey MyKey" and "Mobile DiskOnChip".

The Company is currently involved in two separate lawsuitsrelating to its intellectual property. Following is a short summary of thestatus of these lawsuits:  

(1)  JMTek LLC ("JMTek") - On October 1st,2002, we filed suit in U.S. Federal Court against JMTek, a corporation based inWashington State, for infringement of one of our patents. As of May 1st,2003, the suit is still in pre-trial stages. Although we are confident in ourassertions, it is not possible, at this stage, to predict the outcome orestimate the financial consequences of this action.

**___27___** 

 

(2)  Trek Technology (Singapore) PTE Ltd.("Trek") - During 2002, Trek, a Singaporean company, issued what we believed tobe threatening letters to some of the our distributors in Singapore, allegingthat our DiskOnKey products infringe their Singaporean patent. Our request fromTrek to retract its allegations went unanswered and in May, 2002, we filed suitagainst Trek in the High Court of Singapore for making groundless threatsalleging that our products infringe Trek`s patent. Concurrently, Trek sued certainof our distributors in Singapore, for infringement of Trek`s patent. Treksubsequently added us and another distributor as co-defendants. In accordancewith indemnification agreements entered into between M-Systems and itsco-defendants, we have been managing the litigation for all of theco-defendants. A trial date was set for June 28th, 2003. Under ourindemnification obligations, we have undertaken to indemnify its co-defendantsin the event that Trek prevails in its action and our co-defendants sufferlosses as a result. Although we are confident in our assertions, it is notpossible, at this stage, to predict the outcome or estimate the financialconsequences of this action.

**Competition**

Our products compete with flash data storage products,including flash components and other flash disks, and alternative data storagetechnologies, including hard drives. The markets in which we compete arecharacterized by intense competition, rapid technological change, evolvingindustry standards, unstable average selling prices and rapid productobsolescence. Our competitors include many large U.S. and internationalcompanies that have substantially greater financial, technical, marketing,logistical infrastructure and support and other resources, greater access tocomponent fabrication capacity, broader product lines and longer-standingrelationships with customers than we have, which may limit our ability toeffectively compete with them. In addition, we have also experiencedcompetition from a number of relatively small companies (mainly from the fareast) who have taken advantage of low assembly costs and have accepted lowerthan average gross margins resulting in such competitors setting very lowprices for their products.

We believe that our various products possess many, if not all, of the following competitivestrengths: reliability, ease of integration, ease of use, high-performance,cost-effectiveness, features and capabilities.

We believe that our non-retailproducts, such as the DiskOnChip and FFD product lines also benefit from theextensive and pre-sale technical support we provide to our customers. Inaddition, we believe that our DiskOnChip product line benefits from long-term strategic relationships that we have with Toshiba,and we expect it to benefit from our strategic relationship with AMD.

The advantages of our DiskOnKeyproduct over older technologies, such as floppy disks that require floppydrives, include much higher capacity, reliability, and greater convenience andportability. In competing against rival USB-compatible `keychain storage` products, we believe that our DiskOnKey products benefitfrom the fact that we are considered by many to be the leader and innovator ofthe USB-compatible `keychain storage` market, having first introduced theconcept and product. We believe that we also benefit, among other things, fromthe combination of the following factors: our long-standing reputation andexpertise in the flash disk storage field relative to newer and smallerthird-tier competitors; the fact that DiskOnKey products do not need driverswith the latest operating systems and their ability to transfer data betweenWindows and Mac machines; our advanced technology and the incorporatedCPU which enables the DiskOnKey to directly supportand run multiple, advanced software applications directly from theproduct itself; and the DiskOnKey`s reliability and performance and itsexisting and planned features.

Specifically, our DiskOnChip products compete primarilyagainst standard flash components, with or without added software, and otherflash disks. The DiskOnChip competes against these products based on a numberof factors, including functionality, cost-effectiveness, ease of integration,size, reliability, performance, capacity, modularity and the effectiveness ofthe related disk emulation software. Flash components are manufactured byvarious companies, including Intel Corporation, Samsung, Toshiba and AMD.However, customers relying on standard flash components currently have todevelop or purchase, test and integrate additional hardware and/or softwareinto their products in order for the flash components to be able to emulate ahard drive in the way a flash disk does. Our DiskOnChip products also facecompetition from other flash disk products, principally those manufactured bySanDisk. The DiskOnChip product in the DIP package faces competition in theembedded systems market from a product called DiskOnModule manufactured by aTaiwanese company, Power Quotient International Co., Ltd. (PQI) and fromothers.

**___28___** 

** **

Our DiskOnChip products are specifically designed forapplications where removability of the flash disk is not required. For theseapplications, the DiskOnChip is generally more cost-effective, faster andconsumes less power than removable flash disks and it requires a simplerinterface. 

Our DiskOnKey product competes with other flash USBdrives, removable magnetic media, removable optical media, flash cards, floppydrives and other removable storage media. Our primary competitors in this marketcurrently consist of numerous third tier computer peripheral manufacturers ornew hardware manufacturers, the majority of whom are located in Asia wheremanufacturing costs tend to be lower. These companiesinclude, among others, Trek 2000, J.M. Tech, Netac and LGN. Many of these competitors are vying for andattaining market share on the basis of aggressive pricing. We have also begunto experience competition from large U.S. and international companies (e.g.SanDisk and Lexar) that have more experience in the retail market,substantially greater financial, sales, technical, marketing and otherresources, greater access to component fabrication capacity, broader productlines and longer-standing relationships with customers than we do. 

We believe the DiskOnKey will compete in this market onthe basis of its patented and advanced technology and features (including theability to directly run security and other software applications that we havedeveloped and are developing), its user-friendly size, reliability andperformance. 

Our FFD products facecompetition primarily from traditional hard drives, which are available frommany sources, including Seagate Technology,Inc., Maxtor Corporation and International Business Machines Corp. ("IBM"), anddrives based on flash or other solid-state memory offered by a number ofcompetitors, including SanDisk, Silicon Storage Technology, Inc., Memtech, andBiTMICRO Networks. The FFD competes against these products based on a number offactors, including performance, reliability, durability, ruggedness, availablecapacities, price (in some instances) and other features, including the abilityto customize the product to a customer`s needs.

In general, we expect competition to increase in thefuture from existing competitors and from other companies that may have a moreefficient cost structure and/or direct access to distribution channels and/orstronger relations with the OEMs we currently sell to or intend to sell to.Such companies may enter our existing or future markets with similar oralternative data storage solutions that may be less costly and/or provideadditional features and/or sell directly to computer manufacturers that willprovide such device with their computers. In addition, computer manufacturersthemselves may choose to manufacture competing devices. Increased competitionmay force us to reduce the prices for our products, thereby reducing ourrevenues and margins, and could otherwise have a material adverse effect on ourbusiness, financial condition and results of operations. We cannot be sure thatwe will be able to compete successfully against current and future competitorsor that competitive pressures faced by us will not materially adversely affectour business, financial condition or results of operations.

**___29___** 

 

# C.*    *STRUCTURE 

 

The following table lists our subsidiaries, their countryof organization and our ownership percentage 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 B.V.                                                                                                      | The Netherlands          | 100%         |
| Smart Caps Ltd.                                                                                                     | Israel                   | 100%*        |

 

* As of May 1st, 2003, Smart Caps Ltd. is awholly owned subsidiary of M-Systems. As and when the OCS invests in SmartCaps, our ownership percentage will decrease (see Item 4.A above the paragraphtitled "HISTORY AND DEVELOPMENT OF THE COMPANY").

 

#  D.  PROPERTY, PLANTS AND EQUIPMENT

 

Our headquarters` executive offices, research, developmentand manufacturing facilities are currently located in a building ofapproximately 75,000 square feet at 7 Atir Yeda St., Kfar Saba 44425, Israel,which we own. We also own an adjacent vacant plot of 117,000 square feet. Weown the building and the property free and clear of all encumbrances except fora mortgage taken out by the sellers from Bank Leumi. The outstanding balance ofthat mortgage on our building and property is covered in full by escrowed fundsto be delivered to the sellers only upon the receipt of various necessarypermits and third party approvals, at which point the escrowed funds are to bereleased for the purpose of paying off the mortgage and removing the lien. Inaddition, we lease office space of approximately 5,000 square feet for aresearch and development facility in Omer, Israel. 

We also lease office space for our sales offices inSilicon Valley, California; Massachusetts; Taipei, Taiwan; Tokyo, Japan;Shenzhen, China; and Vienna, Austria. These leases for sales offices are notmaterial to our operations. 

 

 

**___30___** 

# ITEM 5.  OPERATING ANDFINANCIAL REV IEW AND PROSPECTS

 

This "Operating and FinancialReview and Prospects" section contains forward-looking statements that involverisks and 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 develop, manufacture and market innovative data storageproducts, known as flash disks. Our products are based on our patented TrueFFStechnology and include the DiskOnChip, DiskOnKey and Fast Flash Disk (FFD)product families. DiskOnChip is primarily targeted at the Mobile Devices andEmbedded Devices markets, while the FFD product line is used in militarysystems and network infrastructure equipment. The DiskOnKey product familytargets the PC and laptop markets.  

During 2000, our efforts were primarily targeted at the Connected Devices market andas a result, our revenues increased significantly in 2000 as compared to 1999.During 2000, we began investing both time and resources in the development of anew product line, the DiskOnKey. In early 2001, due primarily to the worldwideeconomic slowdown, we experienced a significantdecrease in our revenues, mainly from the Connected Devices market. As a resultof this slowdown, we decided to shift our focus to the Mobile Devices marketand the PC and Laptop market. Due to this shift in focus, we succeeded inshowing a significant growth in our revenues in 2002, in comparison to 2001. Ona quarterly basis, our revenues decreased significantly in the first and secondquarters of 2001. Since then, from the third quarter of 2001, throughout theend of 2002 and continuing on through the first quarter of 2003, our revenueshave steadily increased on a quarter by quarter basis. 

The worldwide economic slowdownwas the primary cause of both the decrease in our revenues during the firsthalf of 2001 and the concurrent industry-wide decrease in the price of flashcomponents. This decrease in our revenues and the significant decrease in theprice of flash components necessitated a re-evaluation of our inventory, whichresulted in our accepting a significantinventory write-down and, in turn, resulted in negative gross profits for 2001.

During 2000 and the firstquarter of 2001, our operating expenses increased on a quarterly basis, as theCompany invested additional resources in the development and marketing of bothits DiskOnChip and DiskOnKey product lines. Following the sharp decrease in theCompany`s revenues and as the existence of a continuing global economicslowdown became evident, we decreased our quarterly expenses, from the secondquarter of 2001 until the first quarter of 2002 (inclusive), by sharpening ourfocus only on those products and activities deemed to be crucial to our futuregrowth and cutting or eliminating expenses in other areas. As we identified thegreat potential of both the Mobile Devices market and the market for Laptops and PCs for the sale of our products, we beganinvesting in the development of new products and new sales & marketingchannels, which resulted in an increase of our quarterly expenses from thesecond quarter of 2002, throughout the end of 2002 and continuing on throughthe first quarter of 2003. On a yearly basis, our operating expenses increasedfrom 2000 to 2001, and slightly decreased from 2001 to 2002.

The preparation of financialstatements requires management to make estimates, assumptions, and judgmentsthat affect both (1) the reported amounts ofassets and liabilities and the disclosure of contingent liabilities as of thedate of the financial statements, and (2) the reported amounts of revenues andexpenses during the reporting period. On an ongoing basis, management evaluatesits estimates, assumptions, and judgments. Management bases its estimates,assumptions, and judgments on historical experience and on various otherfactors that it believes to be reasonable under the circumstances, some ofwhich may not be readily apparent from other sources. Under differentestimates, assumptions, judgments, factors or circumstances, actual resultsmight differ from the results that were reported. 

**___31___** 

Management believes thefollowing critical accounting policies, among others, affect its significantjudgments and estimates used in the preparationof the Company`s Consolidated Financial Statements: 

***Revenue Recognition***-The Company and its subsidiaries generate most of their revenues from sellingtheir data storage products to end customers, resellers and to OEMs. Revenuesfrom product sales are recognized in accordance with Staff Accounting BulletinNo. 101 "Revenue Recognition in Financial Statements" ("SAB101") when delivery has occurred, persuasive evidence of an arrangementexists, the vendor's fee is fixed or determinable, no further obligation existsand collectibility is reasonably assured. Because of frequent sales pricereductions and rapid technology obsolescences in the industry, sales made todistributors or retailers under agreements allowing price protection and/orright of return are deferred until the retailers or distributors sell themerchandise to the end customer, or the right of return expires. 

***Inventory Valuation***-Our policy 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.

***Warranties***-We provide for the estimated cost of product warranties at the time revenue isrecognized. Our products sold are covered by a warranty for periods rangingfrom one (1) year to five (5) years. We accrue a warranty reserve for estimatedcosts to provide warranty services. Our estimate of costs to service thewarranty obligations is based on historical experience and expectation offuture conditions. To the extent we experience increased warranty claimactivity or increased costs associated with servicing those claims, ourwarranty accrual will increase, resulting in decreased gross profits. 

***Investment in privatecompanies***- Investment in a privately-held company is recorded at thelower of cost or estimated fair value. Any decrease in the value ofinvestments, other than a temporary decrease, is recorded when it becomes knownto us. 

*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 aregenerated from the sale of our products. A significant portion of our productsales consists of sales of our DiskOnChip, DiskOnKey and FFD product lines. In2002, we derived approximately 45% of our revenues from sales of our DiskOnChipproduct line and 41% from sales of our DiskOnKey product line.

Due to the global economic slowdown which began during thefirst half of 2001, our 2001 revenues went down as compared to our revenues for2000. Our resulting shift in focus to the PC andLaptop market and to the Mobile Devices markethas since brought us consistent growth and our quarterly results haveshown consecutive growth, quarter by quarter, from the third quarter of 2001through the first quarter of 2003. On an annual basis, in 2002 we have shown agrowth in revenues of 45% in comparison to 2001.

*Cost of Revenues.* Our cost of revenues consistsprimarily of the cost of components and manufacturing costs (including costs ofsubcontractors that manufacture our products), salaries and related personnelexpenses for those engaged in the manufacture of our products, maintenancecosts and other overhead costs.  

The market price for flash memory components decreasedsignificantly during 2001, mainly in the first half of 2001, due to the excesssupply of flash memory components caused by the significant increases in 2000in worldwide flash memory supply and the significant decrease in customerdemand sparked by the worldwide economic slowdown in 2001. In response to thisdecline in the market price for flash memory components, we reduced the valueof our inventory during the first half of 2001 by approximately $ 30.2million. Our inventory decreased from $ 37.5 millions at December 31, 2000to $ 13.4 millions at June 30, 2001, mainly due to the inventory write-down.Any further decline in the market price of such components could have a furthernegative effect on the value of inventory of flash memory components and,therefore, increase our costs of revenues. 

**___32___** 

*Gross Profit.* Our gross profit increasedsignificantly in 2002 compared to 2001, moving from a gross loss to a grossprofit. Our gross loss in 2001 is attributable mainly to the inventorywrite-down and the sharp decrease of our revenues. Furthermore, compared to2001, gross margins shifted significantly from negative gross margins (due tothe inventory write-down done in 2001) to positive gross margins. 

*Research and Development Expenses, Net.*Researchand development expenses consist primarily of salaries and related personnelexpenses and subcontractor costs related to the design, development and testingof new products and technologies and product enhancements. Research anddevelopment expenses are presented net of participations received or accruedfrom the OCS, the Binational Industrial Research and Development ("BIRD") Foundation,SIIRD and IST. All research and development costs are expensed as incurred. Webelieve that continued investment in research and development is critical toattaining our strategic objectives. As a result ofthe decrease in the revenues in 2001 compared to 2000, and the company`sdecision to sharpen its focus only on those products and activities deemed tobe crucial to our future growth and cutting or eliminating expenses in otherareas, the research and development expenses went down from the first quarterof 2001 till the first quarter of 2002. During 2002, as a result of thecontinued growth in our revenues compared to those of 2001 and the highpotential for revenues growth both in the DiskOnKey and the Mobile DiskOnChipproducts, we decided to expand our investments in the development of newproducts. In addition, during 2002 we decided to change the company's focus tobe more markets oriented, and as a result some of our employees and theirrelated activities moved from R&D to sales and marketing. We consequentlyshifted $ 2.2 million from R&D expenses to sales and marketingexpenses during 2002. We expect the R&D expenses to increase in the futureas we continue to develop new products and product lines and enhance existingproducts 

*Selling and Marketing Expenses, Net.*Selling andmarketing expenses consist primarily of salaries, commissions and relatedpersonnel expenses for those engaged in the sale, marketing and support of ourproducts (including commissions payable to our independent salesrepresentatives), as well as related trade shows, promotional and publicrelations expenses. As a result of the decrease inthe Company`s revenues in 2001 compared to 2000, and the Company`s decision tosharpen our focus only on those activities deemed to be crucial to our futuregrowth and cutting or eliminating expenses in other areas, the selling andmarketing expenses went down from the first to the fourth quarter of 2001.During 2002, as a result of the continued growth in our revenues compared to thoseof 2001 and the high potential for the growth of our revenues from both in theDiskOnKey and the Mobile DiskOnChip products, we have decided to expand oursales and marketing activities. In addition, during 2002 we have decided tochange the company's focus to be more markets oriented, and as a result some ofour employees and their related activities moved from R&D to sales andmarketing. As a result, during 2002 we shifted $ 2.2 million from R&Dexpenses to selling and marketing expenses. We intend to pursue sales andmarketing campaigns aggressively and expect selling and marketing expenses toincrease in the future 

*General and Administrative Expenses.*General andadministrative expenses consist primarily of salaries and related personnelexpenses for executive, accounting, finance, legal and litigation, humanresources, administrative and network and information systems personnel,facilities maintenance, professional fees and other general corporate expenses.As we add personnel and incur additional costs related to the growth of ourbusiness, we expect that general and administrative expenses will alsoincrease. 

*Financial Income, Net.*Financial income, netconsists primarily of interest earned on bank deposits, bonds and gains orlosses from selling marketable securities and from the translation of monetarybalance sheet items denominated in non-dollar currencies. Our financial income,net, decreased during both 2001 and 2002 as a result of the both of thedecrease of interest rates in the market and of our reduced cash balance. 

*Taxes.*Israeli companies are generally subject toincome tax at the corporate rate of 36%. However, as an `approved enterprise`we are eligible for certain tax benefits. These benefits should result in ourincome being tax exempt or taxed at a lower rate after we begin to reporttaxable income for a number of years (see in Item 5.B below the paragraphtitled "Taxation").

*Net Income (Loss)*. In 2001 our net loss was$ 41.8 million, $ 30.2 million of which was due to the inventorywrite-down, and $ 1 million was an investment write-off. In 2002 our netloss was $ 5.5 million dollars.

**___33___** 

**Results of Operations**

The following table sets forth, for the periods indicated,the percentage of revenues represented by certain items reflected in ourconsolidated statements of operations. 

|                                                                   | Year ended December 31, |
|-------------------------------------------------------------------|-------------------------|
|                                                              | 2000                    | 2001 | 2002 |
| Revenues                                                          | 100.0%                  | 100.0% | 100.0% |
| Cost of revenues                                                  | 69.4                    | 68.0 | 68.5 |
| Inventory write-down                                              | ---                     | 67.6 | --- |
| Gross profit (loss)                                               | 30.6                    | (35.6) | 31.5 |
| Operating expenses:                                               |                    |   |   |
| Research and development, net                                     | (8.0)                   | (29.7) | (18.5) |
| Selling and marketing, net                                        | (12.5)                  | (27.1) | (19.4) |
| General and administrative                                        | (3.0)                   | (8.8) | (6.2) |
| In-process research and development write-off                     | 6.7                     | --- | --- |
| Total operating expenses                                          | 30.2                    | 65.6 | 44.0 |
| Operating income (loss)                                           | 0.4                     | (101.2) | (12.5) |
| Capital loss                                                      | ---                     | (2.7) | --- |
| Financial income, net                                             | 6.3                     | 10.4 | 4.0 |
| Income (loss) before minority interest in losses of a  subsidiary | 6.8                     | (93.5) | (8.5) |
| Minority interest in losses of a subsidiary                       | 0.0                     | --- | --- |
| Net income (loss)                                                 | 6.8%                    | (93.5)% | (8.5)% |
|                                                              |                    |   |   |

 

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

*Revenues*. Revenues in 2002 increased by $ 20.1million or 45% to $ 64.8 million from $ 44.7 million in 2001. OurDiskOnKey sales increased by *$ *20.2 million or 306%. Our DiskOnChipsales increased by $ 1.9 million, or 7%, and our FFD sales increased by$ 0.5 million, or 10%. The increase in revenues was attributable primarilyto the continued penetration of our DiskOnKey product line to the PC and Laptopmarket, which resulted in a significant increase in unit sales in 2002 ascompared to 2001.  Average selling prices for our DiskOnKey productsremained relatively constant during 2001 and 2002.

*Gross Profit*. Our gross profit in 2002 was$ 20.4 million compared to a gross loss of $ 15.9 million in 2001,which resulted from the inventory write-down of $ 30.2 million.Furthermore, compared to 2001, gross margins changed from negative 35.6%,reflecting the 2001 inventory write-down, to positive 31.5%.  

*Research and Development Expenses, Net*. Our grossresearch and development expenses in 2002 decreased by $ 1.1 million to$ 12.2 million, a decrease of 8.2% from the Company`s gross research anddevelopment expenses of $ 13.3 million in 2001. Our net research and developmentexpenses decreased by $ 1.3 million to $ 12.0 million, a decrease of9.9% from the net research and development expenses of the Company`s of$ 13.3 million in 2001. The decrease in our gross research and developmentexpenses is attributable to the Company`s decision to shift focus to a moremarket oriented approach. This, in turn, caused us during 2002 to reallocateemployees and the related expenses in the amount of $ 0.7 million fromresearch and development to selling and marketing. As a percentage of revenues,our net research and development expenses decreased to 18.5% in 2002 from 29.7%in 2001. In 2002, we received $ 63,000 and $ 212,000 research anddevelopment grants from SIIRD and IST, respectively, in comparison to the$ 60,000 research and development grant we received from SIIRD in 2001.

*Selling and Marketing Expenses, Net*. Gross sellingand marketing expenses in 2002 slightly increased by $ 0.4 million, or3.5%, to $ 12.5 million from $ 12.1 million in 2001. As a result ofthe Company`s decision to shift focus to a more market oriented approach,during 2002 we reallocated employees and the related expenses in the amount of$ 0.7 million from research and development to selling and marketing. As apercentage of revenues, our net selling and marketing expenses decreased to19.4% in 2002 from 27.1% in 2001.

**___34___** 

*General and Administrative Expenses*. General andadministrative expenses in 2002 slightly increased by $ 0.1 million, or2%, to $ 4.0 million from $ 3.9 million in 2001, as we increased ouradministrative staff to support our expanding operations. As a percentage ofrevenues, our general and administrative expenses decreased to 6.2% in 2002from 8.8% in 2001.

*Capital loss*. In 2001, we realized a one-timecharge of $ 1.0 million due to an investment write-off, as well as aone-time write-off of $ 181,000 relating to assets used in our previousfacilities that could not be utilized in our new facilities in Kfar-Saba. In2002 we had no capital loss.

*Financial Income, Net*. Financial income, net, in2002 decreased by $ 2 million or 43.4% to $ 2.6 million from$ 4.6 million in 2001, due mainly to the lower interest rates prevailingin the market.

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

 

Year Ended December 31st,2001 Compared to Year Ended December 31st, 2000 

 

*Revenues*. Revenues in 2001 decreased by $ 47.9million or 52% to $ 44.7 million from $ 92.6 million in 2000. OurDiskOnChip sales decreased by $ 45.5 million, or 62%, and our FFD salesdecreased by $ 2.6 million, or 33%. The decrease in revenues wasattributable primarily to the economic slowdown that negatively affected theConnected Devices and the telecom infrastructure markets, and by extensionsales of our DiskOnChip products which are incorporated into these devices. In2001, we commenced sales of our DiskOnKey products, and derived revenues of$ 6.6 million from such sales by the end of that year. 

*Gross Loss.* Our gross loss in 2001 was $ 15.9million and was attributable mainly to the inventory write-down accepted by theCompany in 2001 and to the sharp decrease in our revenues compared to 2000. Ourgross loss in 2001 was $ 15.9 million compared to a gross profit of$ 28.3 million in 2000. Furthermore, compared to 2000, gross margins wentdown significantly due to the inventory write-down.

*Research and Development Expenses, Net*. Grossresearch and development expenses in 2001 increased by $ 6.0 million, or81.3%, to $ 13.3 million from $ 7.4 million in 2000. The increase inour research and development expenses was attributable primarily to a highlevel of activity in connection with the development of new products in theDiskOnChip family, mainly the Mobile DiskOnChip, the development of theDiskOnKey and the addition of the activity of the new development center basedon the personnel and technology of Fortress, acquired by us in September 2000,the expenses of which were only consolidated to our results in 2000 in thefourth quarter. As a percentage of revenues, our net research and developmentexpenses increased to 29.7% in 2001 from 8.0% in 2000. In 2001, we received$ 60,000 in research and development grants from SIIRD while we did notreceive research and development grants in 2000 from any of SIIRD, OCS or BIRD.

*Selling and Marketing Expenses, Net*. Gross sellingand marketing expenses in 2001 increased by $ 0.6 million, or 5.1%, to$ 12.1 million from $ 11.5 million in 2000. We increased the sellingand marketing expenses in connection with our introduction and promotion of theMobile DiskOnChip and the DiskOnKey. At the same time, we minimized other salesand marketing activities to the level we believed was crucial for the companyto allow for future growth. As a percentage of revenues, our net selling andmarketing expenses increased to 27.1% in 2001 from 12.5% in 2000.

*General and Administrative Expenses*. General andadministrative expenses in 2001 increased by $ 1.1 million, or 39.3%, to$ 3.9 million from $ 2.8 million in 2000. In 2000 and the beginningof 2001, we built an administrative and finance infrastructure which would beable to cope with the sales growth that we had experienced in 2000, and that wethen expected would continue. As a percentage of revenues, our general andadministrative expenses increased to 8.8% in 2001 from 3.0% in 2000.

*In Process R&D Write-Off*. In 2000, we realizeda one-time charge of $ 6.2 million due to a write-off of in-processresearch and development in connection with our acquisition of the business andassets of Fortress.  

*Capital loss*. In 2000 we had no capital loss. In2001, we realized a one-time charge of $ 1.0 million due to an investmentwrite-off, as well as a one-time write-off of $ 181,000 relating to assetsused in our previous facilities that could not be utilized in our newfacilities in Kfar-Saba.

**___35___** 

*Financial Income, Net*. Financial income, net, in2001 decreased by $ 1.2 million or 21.2% to $ 4.6 million from$ 5.9 million in 2000, due both to the lower interest rates prevailing inthe market and to a decrease in our cash balance.

*Minority Interest in Losses of Subsidiary*. In June1998, we established a subsidiary in Japan, M-Systems Flash Disk Pioneers(Japan), Inc., to further the sales and marketing of our products in Japan. Thesubsidiary was established together with a Japanese partner, Dempa Shinbun Inc.("Dempa"), which owned 33% of the company through June 2001, at whichtime we purchased Dempa`s share in the subsidiary. In 2001, no minorityinterest in losses of this subsidiary was recorded, compared to $ 19,000in 2000. 

*Net Income (Loss)*. For the reasons discussed above,in 2001 our net loss was $ 41.8 million as opposed to our income of$ 6.3 million in 2000. 

**In-Process Research andDevelopment**

 

In September 2000, we acquired the business and assets ofFortress U&T Ltd. ("Fortress"), in exchange for $ 8,456,000 in cash,out of which $ 6,215,000 was allocated to in-process research anddevelopment and written-off. 

The project under development at the time of theacquisition was for the development of a Smart Card. As of the date of theacquisition, the Smart Card technology had not demonstrated its technologicalor commercial feasibility. Significant risks of technical completion, costs andtiming were associated with the development of this project, as there weresignificant new features being developed at the time of the acquisition. Inaddition, there were also high levels of market risks as there was very strongcompetition in the market for Smart Card technology. In the event that theproject failed to become viable, it was unlikely that Fortress would be able torealize any value from the sale of the technology to another party.

As the in-process research and development had noalternative use in the event that the proposed project did not prove to befeasible, these development efforts are within the definition of In-ProcessResearch and Development (IPR&D) contained in Statement of FinancialAccounting Standards (SFAS) No. 2 "Accounting for Research and Development Costs".

Sales of Smart Card based on this project were expected tocontinue through 2005. We have assessed a percentage of completion for theSmart Card in order to allocate only the value of research and developmentperformed as of the acquisition date.  The percentage of completionwas primarily based on our estimates as to the costs incurred on the projectprior to the date of the acquisition out of the total estimated budget. As ofthe date of the acquisition, approximately $ 2,900,000 had been spentwhile an additional approximately $ 1,000,000 was thereafter estimated tobe incurred to complete the project. Thus, the technical development wasestimated to be approximately 74% complete. Actual total expenses incurredunder this project were in compliance with the original estimates.

We used an income approach in valuing the acquiredIPR&D. Under this approach, the fair value reflects the present value ofthe projected free cash flows that will be generated by the IPR&D projectsand that would be attributable to the acquired technology, if successfullycompleted. The projected revenues used in the income approach were based uponour estimate of the revenues to be generated upon completion of the projectsand the beginning of commercial sales.  The projections assumed thatthe products will be successful and that the product's development andcommercialization would meet our management's time schedule.

In determining applicable discount rates to be used in thevaluation of the in-process technology, we analyzed the risks of an investmentin Fortress. In arriving at appropriate discount rates, we considered theweighted average cost of capital. The weighted average cost of capital wascalculated to be 15%. The discount rate applicable to in-process project reflectsthe risks inherent in such project, as described above. An overall after-taxdiscount rate of 45% was applied to the in-process projects' cash flows.

Although we had expected revenues from this project tocommence in 2001 and to continue through 2005, we suffered a significantdeterioration in our results of operations in 2001, due to a sharp decline inrevenues. As a result, we decided to reduce expenses by focusing only on thoseproducts and activities that are directly related to our core business and thatwe deemed to be crucial to our future growth, and therefore we did not completethe development of this technology. We did not, therefore, ever achieverevenues from this project.

**___36___** 

#  B.  LIQUIDITY AND CAPITAL RESOURCES

 

To date, we have funded our operations primarily throughcash from operations and the sale of securities and, to a much lesser extent,through government grants to support our marketing and research and developmentefforts. We completed our initial public offering in March, 1993, which providednet proceeds of $ 4.6 million. In July, 1993, we called for redemption ofcertain of the warrants we had issued in connection with the IPO, whichresulted in the exercise of most of these warrants and provided net proceeds of$ 4.7 million. In January, 1995, we completed a private placement ofordinary shares and warrants, which provided net proceeds of $ 3.7 million(and thereafter, an additional $ 480,000 upon exercise by certaininvestors of some of the warrants issued). In August, 1996, we completed asecondary offering of our ordinary shares, which provided net proceeds of$ 12.6 million. In March, 1998, we received net proceeds of $ 72,000from the exercise of warrants that had been granted to the underwriters`representative in connection with our IPO. In March, 2000, we completed asecondary offering of our ordinary shares, which provided net proceeds to us ofapproximately $ 149.6 million.

In July, 1999, we raised approximately $ 5.0 millionin a private placement of 1,818,182 ordinary shares, reflecting a price pershare of $ 2.75, and 1,038,962 warrants. Each warrant entitled the holderto purchase one ordinary share at a price of $ 2.875 until December 31st,2002, subject to certain anti-dilution and other adjustment protections. Theholders of the ordinary shares issued in the private placement and upon theexercise of the warrants have registration rights, including the right todemand registration of their shares in an underwritten public offering at anytime after January, 2002. As of December 31st, 2002 all of saidwarrants have been exercised and none remain outstanding. 

On May 1st, 2003, we entered into a SharePurchase Agreement with Dr. Hans Wagner, a member of our Board of Directors,for the purchase of 500,000 ordinary shares (see Item 7.B below the paragraphtitled "Related Party Transactions"). 

We had no indebtedness as of May 1st, 2003,December 31, 2001 and as of December 31, 2000.

Our cash, cash equivalents, short-term deposits and shortterm marketable securities were $ 64.0 million at December 31st,2002, compared to $ 80.1 million at December 31st, 2001. Ourlong term marketable securities were $ 30.1 million at December 31st,2002, compared to $ 17.2 million at December 31st, 2001.

Net cash used in operating activities in 2002, 2001 and2000 was $ 2.75 million, $ 9.8 million and $ 15.4 million,respectively. This was attributable primarily to changes in our workingcapital. We expect that our principal uses of cash in the near future will beto fund increases in sales and marketing expenditures and research anddevelopment expenditures. We cannot assure you that the uses will not bedifferent. In addition, we may also use cash to finance strategic acquisitionsof, or investments in, related businesses, product lines and technologies.

During the years ended December 31st, 2002,2001 and 2000, the aggregate amount of our capital expenditures was $ 19.2million. These expenditures were principally for the purchase of our buildingand the adjacent vacant lot, improvement of our building, investment in ourmanufacturing facilities, purchases of computer equipment and leaseholdimprovement.  As of December 31, 2002, we had no commitment formaterial capital expenditures.

 

**___37___** 

**Lease****commitments**:

The Company's facilities in Omer, its subsidiaries`facilities and its vehicles are leased under several operating leaseagreements, which expire on various dates, the latest of which is in 2005.

Future minimum lease commitments under non-cancelableoperating leases, are as follows:
| ** ** | **Year ended December  31,** | ** ** |
|------------|------------------------------|------------|
|       | 2003                         | 2004       | 2005 | Total |
|       |                         |       |   |   |
| Facilities | $ 363,000               | 369,000    | 305,000 | $ 1,037,000 |
| Vehicles   | $ 666,000               | 375,000    | 122,000 | $ 1,163,000 |
|       |                         |       |   |   |
|       |                         |       |   |   |
| Total      | $ 1,029,000             | 744,000    | 427,000 | $ 2,200,000 |
|       |                         |       |   |   |

 

Facilities lease expenses for the years ended December 31,2000, 2001 and 2002, were approximately $ 798,000, $ 384,000 and$ 456,000, respectively.  Vehicles lease expenses for the yearsended December 31, 2000, 2001 and 2002 were approximately $ 234,000,$ 606,000 and $ 763,000, respectively.

As of December 31, 2002, the Company has authorized andavailable credit lines of $ 4.0 million from banks.  None of thecredit lines were drawn as of December 31, 2002.  In connection withthe credit lines, the Company agreed not to place any liens on its assets withoutthe respective bank's consent.

 

**Royalty Commitments**

Under the Company's research and development agreementswith the OCS, BIRD and SIIRD, the Company is required to pay royalties at therate of 1.5%-5% of sales of products developed with funds provided by the OCS,BIRD and SIIRD, up to an amount equal to 150% of the OCS and BIRD and 100% ofthe SIIRD research and development grants (dollar-linked) related to suchprojects.  In addition, the Israeli Government, through the Fund forEncouragement of Marketing Activities ("FEMA"), and BIRD awarded the Companyand its U.S. subsidiary grants for participation in expenses for overseasmarketing. The Company is committed to pay royalties to FEMA at the rate of 3%on the increase in export sales, up to the amount of the grants received by theCompany.  As of December 31, 2002, the Company had outstandingobligations to pay royalties of $ 447,000 in respect of these variousgrants.

**OtherCommitments**

Under our master purchase agreement with Toshiba, we haveagreed to purchase from Toshiba a minimum aggregate amount of flash memorycomponents and flash based products.  As of December 31, 2002, weagreed to purchase an aggregate $13 million, $19.5 million and $27.5 millionfor 2002, 2003 and 2004, respectively.  Our agreement is conditionedupon Toshiba guaranteeing competitive pricing, reasonable lead time andsufficient capacity (assuming reasonable prior demand forecast by us) for ourproducts.

**Taxation**

Israeli companies are subject to corporate tax at the rateof 36%. However, the effective rate of tax of a company that derives incomefrom an `approved enterprise` (as referred to below) may be considerably lower(see Item 10.E below the paragraph titled "Law for the Encouragement of CapitalInvestments, 1959").

Most of our production facilities have been granted`approved enterprise` status under six separate programs pursuant to Israel`sLaw for the Encouragement of Capital Investments, 1959 (the "Investment Law").The primary tax benefits resulting from such status are described below.

**___38___** 

** **

During 2001, we purchased the assets of Fortress, whichhad a facility that had been granted `approved enterprise` status. In 2001, we initiated a research and development facilityin Omer, Israel, at the site of Fortress` facilities. Income derived from ourOmer facility is tax-exempt for a 10-year period, commencing in the year inwhich we first recognize Israeli taxable income from that facility, and willend no later than the earlier of 12 years from the commencement of production, or 14 years from receipt of the approvalfor the Omer `approved enterprise`. The Company came to an agreement with theIsraeli tax authorities on the percentage of revenues which are deemedattributable to the facility in Omer.  

In addition, income which is notattributable to our Omer facility and which is derived from our `approvedenterprises` that commenced operations prior to or during 1996 is tax exemptfor the first four years of the 10-year tax benefit period, and is subject to areduced tax rate during the rest of the period. Income which is notattributable 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 arate of between 10% and 25%, depending on the percentage of M-Systems` sharesheld by non-Israelis in that remaining period (themore shares held by non-Israelis, the lower the tax rate). The tax benefitperiods for each respective `approved enterprise` will commence in the year inwhich we first recognize Israeli taxable income from such `approvedenterprise`, and will end no later than the earlier of 12 years from thecommencement of production, or 14 years from receipt of the approval for such`approved enterprise`. Accordingly, the period relating to these `approvedenterprises` will expire between 2005 and 2012. The tax benefit periods forthese `approved enterprises` have not yet commenced except for the first plan.

We cannot be sure that `approved enterprise` programs willcontinue to be available, or that we will continue to qualify for benefitsunder such programs. In addition, the benefits available to an `approvedenterprise` are conditional upon the fulfillment of certain conditionsstipulated in the relevant laws and regulations and the criteria set forth inthe certificate of approval issued to us. In the event that we do not complywith these conditions, in whole or in part, we may be required to refund theamount of the benefits, indexed to the Israeli CPI, with interest.

In the years ended December 31st, 2002, 2001and 2000, we incurred losses for tax purposes. Accordingly, we did not providefor taxes on income in any of the reported periods.

 

**___39___** 

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

 

**Governmentof Israel Support Programs**

***Research and Development Overview and InternalProgram***

We have devoted significant resources to research anddevelopment activities with respect to our core flash data storage technology.We have emphasized the development of our technology, the enhancement ofexisting products and the development of new products, generally in response tothe rapidly evolving markets for Mobile Devices, Embedded Devices, militarysystems and network infrastructure equipment and other embedded systems. Inaddition, we emphasize the development and addition of new features to ourproducts, such as security and access control. 

Our gross research and development expenses during 2002,2001 and 2000 were $ 12.2 million, $ 13.3 million and $ 7.4million, respectively. A small portion of our revenues during those years wasfunded through grants from - SIIRD and IST, as discussed below. 

***Research and Development Grants***

We participate in programs offered by the OCS, SIIRD andIST that support research and development activities. We received or accruedparticipation from OCS, SIIRD and IST of $ 0, $ 63,000 and$ 212,000 respectively in 2002, $ 0, $ 60,000, $ 0 in 2001,and $ 0, $ 0 and $ 0, respectively, in 2000. Our OCS grantsrelated to the development of a compact IDE interface flash disk, our SIIRDgrants related to the development of LPC flash disk and our IST grants relatedto the development of secure mobile payment on chip (SM-PAYSOC). For adiscussion of such programs, including royalty obligations and limitations onmanufacturing and the transfer of technology relating to such participations,see "Item 4B: Business Overview - Research and Development."

**Inflation**

Most of our sales traditionally have been made in dollars,and most of our expenses have been incurred in dollars or denominated in NIS.We have not been materially affected by changes in the rate of inflation inIsrael. Inflation in the U.S. and our other markets has not had a materialeffect on our results of operations.

**FunctionalCurrency**

The U.S. dollar is the primary currency in the economicenvironment in which we operate. Most of our sales are made outside of Israeland are denominated in dollars. Most of our purchases of materials andcomponents are made outside of Israel and are denominated in dollars. Inaddition, most marketing and service costs are incurred in dollars. As aresult, our functional and reporting currency is the U.S. dollar.

 

#  D.  TREND INFORMATION

 

Please see the discussion of significant recent trends inour business, including trends in our revenues, costs of revenues, research anddevelopment expenses, sales and marketing expenses and net income (loss), in"Item 5A: Operating Results - Overview."

 

 

**___40___** 

# ITEM 6.  DIRECTORS,SENIOR MANAGEMENT AND EMPLOYEES

 

#  A.  DIRECTORS AND SENIOR MANAGEMENT

 

The following table sets forth certain informationregarding our directors and executive officers as of May 1st, 2003:

| **Name**         | **Age** | **Position**                                                |
|------------------|---------|-------------------------------------------------------------|
| Dov Moran        | 47      | President, CEO and Chairman of the Board of Directors       |
| Aryeh Mergi      | 41      | Executive Vice President of Business Development;  Director |
| Ronit Maor       | 32      | CFO and Vice President of Finance and Administration        |
| Dana Gross       | 36      | Chief Marketing Officer; Director                           |
| Amir Friedman    | 41      | Director                                                    |
| Yair Shoham      | 49      | Director                                                    |
| Dr. Hans Wagner  | 73      | Director                                                    |
| Yossi Ben Shalom | 47      | Director                                                    |

 

The background of each of our directors, executiveofficers and key employees is as follows:

*Dov Moran.*Mr. Moran is a founder of M-Systems andhas been a director and President, Chief Executive Officer and Chairman of theBoard of Directors of M-Systems since 1989. Mr. Moran has also been a directorand chairman of the board of directors of our U.S. subsidiary, M-Systems Inc.("MSU"), since 1992. From 1984 to 1989, Mr. Moran was an independent consultantin the computer industry. Prior thereto, Mr. Moran served in the Israeli Navyfor seven years and was director of its microprocessors department. Mr. Moranreceived a B.Sc. in Computers and Electronic Engineering (with honors) from theTechnion, Israel Institute of Technology, in Haifa, Israel in 1977. 

*Aryeh Mergi.*Mr. Mergi is a founder of M-Systemsand has been a director of M-Systems since 1989 and a director of MSU since1992. Mr. Mergi has been our Executive Vice President of Business Developmentof the Company since 2000. From 1995 to 2000, he served as Executive VicePresident of Sales and Marketing. From 1989 to 1995, he served as VicePresident of Research and Development. Mr. Mergi received a B.Sc. in ElectronicEngineering (with honors) from the Technion, Israel Institute of Technology, inHaifa, Israel in 1988. 

*Ronit Maor.*Ms. Maor has been Chief FinancialOfficer and Vice President of Finance and Administration since May 1997. Ms.Maor joined us as Planning and Control Manager in March 1996 and was promotedto Vice President of Planning and Control in February 1997. Prior thereto, Ms.Maor was a project manager at Tefen, an industrial engineering consulting company.She received her B.Sc. in Industrial Management Engineering (with honors) fromTel-Aviv University in 1995.

*Dana Gross.*Ms. Gross has served as the Company`sChief Marketing Officer since July, 2002, and as a director of the Companysince September 2000. Ms. Gross joined the Company in July 1992 as VicePresident of Operations. She was promoted to Chief Financial Officer in 1994,to President of MSU in 1995, to Executive Vice President of BusinessDevelopment in 1997, to Vice President of Worldwide Sales in 1998 and toExecutive Vice President of the DiskOnChip business unit in 2000. Ms. Grossreceived a B.Sc. in Industrial Management Engineering (with honors) fromTel-Aviv University in 1992 and an M.B.A. degree from San Jose State Universityin 1997. 

*Amir Friedman.*Mr. Friedman is a founder ofM-Systems and has served us as a director since 1991. Mr. Friedman served asour Vice President for U.S. operations from 1991 to 1994 and as the Presidentof MSU from 1989 to 1994. Mr. Friedman is also a founder and director ofConnect-ONE Ltd., and has served as its President since 1995. Mr. Friedmanreceived a B.Sc. in Electronic Engineering from the University of Wisconsin in1981 and an M.B.A. from Tel-Aviv University in 1989. Mr. Friedman 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.

**___41___** 

*Yair Shoham.*Mr. Shoham has served as a director ofM-Systems since 1996. Since June 1999, Mr. Shoham has been general partner withGenesis Partners II L.L.C., an Israel-based venture capital fund that isaffiliated with CIBC World Markets Corp. From 1997 to 1999, Mr. Shoham was theVice President for Business Development of Butterfly VLSI Ltd., and fromJanuary 1996 to December 1996 he was the Vice President for BusinessDevelopment of VDOnet Corporation Ltd. From January 1994 to December 1995, Mr.Shoham was a partner at the law firm of Goldfarb, Levy, Eran & Co.,Tel-Aviv, Israel. Mr. Shoham received his B.A. degree from Haifa University inIsrael in 1982 and a J.D. degree from Loyola University of Chicago School ofLaw in 1985. Mr. Shoham qualifies as an independent director under applicableNasdaq rules and was elected to the Board of Directors as an External Directorunder the applicable provisions of the Companies Law. 

*Dr. Hans Wagner.*Dr. Wagner has served as adirector of M-Systems since November, 2002. Dr. Wagner is currently a SeniorPartner of Omega Partners Ltd., a telecommunications consultancy firm, of whichhe was a founder in 1977. Dr. Wagner also founded and serves as a director ofOzone Ltd., a manufacturer of recycling devices founded in 1996, and of PelikonLtd., a developer and manufacturer of electro-luminescent displays founded in2000. From 1995 to 2000, Dr. Wagner served as a strategic advisor to themanagement of Ericsson Mobile LM. From 1984 to 1992, Dr. Wagner was a founderand served as chairman of Technophone, a mobile telephone manufacturer whichwas then the worldwide number three in sales prior to its acquisition by Nokia.From 1973 to 1977, Dr. Wagner served as the Assistant Secretary General of theUNDP. From 1969 to 1973, Dr. Wagner served as the CEO of SONAB AB, Sweden`ssecond largest communication equipment manufacturer. From 1963 to 1969, Dr.Wagner served as the COO of Incentive AB, Sweden`s largest technicalconglomerate. Dr. Wagner holds a Masters degree in Chemical Engineering, an MBAdegree from the Stockholm School of Economics and a Ph.D. from theMassachusetts Institute of Technology. Dr. Wagner qualifies as an independentdirector under applicable Nasdaq rules. 

*Yossi Ben Shalom* Mr. Ben Shalom has served as adirector of the Company since January, 2003. Mr. Ben Shalom is a co-founder ofDBSI Investments Ltd. Before establishing DBSI Investments, Mr. Ben-Shalom hadbeen Executive Vice President and Chief Financial Officer of Koor IndustriesLtd. (KOR - Nasdaq) from 1998 through 2000. Before that, Mr. Ben-Shalom servedas Chief Financial Officer of Tadiran Ltd. Mr. Ben-Shalom serves as an activedirector on numerous boards, including, among others, on the boards of NICESystems (NICE - Nasdaq) - computer telephony; Machteshim Agan - chemicals; andBank Klali. Mr. Ben-Shalom served as an active chairman in successfulturnaround programs, such as at Eurocar Israel, American Express Israel andScopus Technologies. Mr. Ben Shalom holds a BA in Economics and an MA inBusiness Management from Tel Aviv University. Mr. Ben Shalom qualifies as anindependent director under applicable Nasdaq rules. 

 

#  B.  COMPENSATION

 

The aggregate compensation paid by us and our subsidiariesto all persons who served in the capacity of director and executive officer forthe year ended December 31, 2002 (11 persons of which 4 no longer serve in suchcapacity) was approximately $ 636,800, which includes approximately$ 37,300 set aside or accrued to provide pension, retirement or similarbenefits, but does not include amounts expended by us for automobiles madeavailable to our officers, expenses (including business travel, professionaland business association dues and expenses) reimbursed to officers and otherfringe benefits commonly reimbursed or paid by companies in Israel. The Companydoes not pay directors` fees to its directors.  

During fiscal 2002, all persons who served in the capacityof director and executive officer for the year ended December 31, 2002, weregranted options to purchase a total of 289,600 ordinary shares at an averageprice of $ 7.18 per share, with vesting terms of 2-4 years. All optionswere granted pursuant to our then current share option and incentive plans (seein Item 6.E below the paragraph titled "Share Option Plans and recent changesin Israeli law").

 

**___42___** 

#  C.  BOARD PRACTICES

 

**Terms of Office**

Directors are elected by an ordinary resolution at theAnnual General Meeting of our shareholders. All directors of the Company, otherthan "External directors under the Companies Law (see in this Item 6.C belowthe paragraph titled "External Directors") who serve for a period of threeyears after their election, serve until the next Annual General Meeting, unlesstheir offices are vacated earlier under any relevant provision of our Articlesof Association.

We have entered into employment agreements with all of ourexecutive officers similar in form to the agreements entered into with all ofour other employees. These agreements are subject to termination by eitherparty, with or without cause, in most cases on either 30 or 60 days` notice,depending on the agreement. Under these agreements with our Israeli executiveofficers, we and the employee each contribute a percentage of the salary of theemployee to a fund known as "Managers` Insurance." This fund provides acombination of savings plan, insurance and severance pay benefits to theemployee, giving the employee a lump sum of payment upon retirement andsecuring severance pay, if legally entitled, upon termination of employment.Each employee who agrees to participate contributes an amount equal to 5% of hisor her salary and we contribute between 13.3% and 15.8% of his or her salary.Israeli law generally requires severance pay, which may be funded by Managers`Insurance, upon the retirement or death of an employee or termination ofemployment without due cause. These agreements all contain provisions standardfor a company in our industry regarding non competition, confidentiality ofinformation and assignment of inventions. The enforceability of covenants notto compete is limited in Israel.

** **

**Alternate Directors**

Our Articles of Association provide that a director mayappoint, by written notice to us, any individual to serve as an alternatedirector so long as such individual does not already serve as a director or analternate director. Any alternate director will have all of the rights andobligations of the director appointing him or her, except the power to appointan alternate (unless the instrument appointing him or her provides otherwise)and the right to remuneration. The alternate director may not act at anymeeting at which the director appointing him or her is present. Unless theappointing director limits the time period or scope of any such appointment,the appointment will be effective for all purposes and for an indefinite time,but will expire upon the expiration of the appointing director`s term.Currently, no alternate directors have been appointed.

** **

**External Directors**

Under the Companies Law, companies incorporated under thelaws of Israel whose shares have been offered to the public in or outside ofIsrael are required to appoint at least two external directors. This lawprovides that a person may not be appointed as an external director if theperson or the person`s relative, partner, employer or any entity under theperson`s control, has, as of the date of the person`s appointment to serve asexternal director, or had, during the two years preceding that date, anyaffiliation with the company or any entity controlling, controlled by or undercommon 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 may serve as an external director if theperson`s position or other business activities create, or may create, aconflict of interest with the person`s responsibilities as an external directoror may otherwise interfere with the person`s ability to serve as an outexternal side director.

External directors are to be elected by a majority vote ata shareholders` meeting, provided that either:

1. at least one-third of the sharesof non-controlling shareholders voted at the meeting, vote in favor of electionof the 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.

**___43___** 

The initial term of an external director will be threeyears and may be extended for an additional three years. Each committee of acompany`s board of directors will be required to include at least one externaldirector and the audit committee of a company`s board of directors is requiredto include both the external directors. We have appointed Yair Shoham and AmirFriedman as external directors pursuant to the Companies Law.

An external director is entitled to compensation asprovided in regulations to be adopted under the Companies Law and is otherwiseprohibited from receiving any other compensation, directly or indirectly, inconnection with service provided as an external director.

** **

**Independent Directors**

Our ordinary shares are listed for quotation on the NasdaqNational Market and thus we are subject to the rules of the Nasdaq NationalMarket applicable to quoted companies as well as to the applicable provisionsof the Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley") and the rules andregulations thereunder. Under the rules, we are required to appoint a minimumof three (3) Independent Directors. The independence standard under the rulesexcludes any person who is a current employee of the Company or who has been anemployee of the Company for a certain period of time as well as the immediatefamily members of an executive officer of the Company. Messrs. Friedman, Shohamand Ben-Shalom and Dr. Wagner serve as Independent Directors and meet theindependence standard of the above rules. 

** **

**Audit Committee**

Under the Companies Law, the board of directors of anypublicly traded company must appoint an audit committee, comprised of at leastthree directors including all of the external directors but excluding: (a) thechairman of the board of directors; (b) any controlling shareholder or relativeof a controlling shareholder; or (c) any director employed by the company orwho provides services to the company on a regular basis. Under the Nasdaqrules, we are required to have at least three independent directors on theaudit committee. In addition, Nasdaq requires that the members of the auditcommittee (a) not have any relationship to the company that may interfere withthe exercise of their independence, and (b) must be financially literate.  

The roles of our audit committee under the Companies Lawinclude identifying irregularities in the management of the company`s businessand approving related party transactions as required by law. Theresponsibilities of the audit committee under the Nasdaq rules include, amongother things, evaluating the independence of a company`s outside auditors.

In addition to such functions as the audit committee may haveunder the Companies Law or under the Nasdaq rules, the primary purpose of ouraudit committee is to assist the board of directors in fulfilling itsresponsibility to oversee management`s conduct of the financial reportingprocess, the systems of internal accounting and financial controls and theannual independent audit of the company`s financial statements. The auditcommittee reviews with management and our outside auditors the auditedfinancial statements included in our Annual Report on Form 20-F and our interim quarterly financial results included on Form 6-K.

The audit committee mustobserve the independence of our outside auditors and has the authority andresponsibility to nominate for shareholder approval, evaluate and, whereappropriate, replace our outside auditors. 

In discharging its oversight role, our audit committee isempowered to investigate any matter brought to its attention with full accessto all books, records, facilities and personnel of our company and the power toretain outside counsel, auditors or other experts for this purpose.

Our audit committee currently consists of Amir Friedman,Yair Shoham and Yossi Ben Shalom. 

** **

**Financial Expert**

Under Sarbanes-Oxley, one of the Audit Committee membersmust have accounting or related financial management expertise. Our Board ofDirectors has recognized Mr. Ben Shalom, based on all of the requirements setforth in the applicable rules and regulations, as our "financial expert" and webelieve that we are in compliance with this requirement.

** **

**___44___** 

**Internal Auditor**

Under the Companies Law, the board of directors of apublic company must appoint an internal auditor, nominated by its auditcommittee. The role of the internal auditor is to examine, among other matters,whether the company`s actions comply with the law and orderly businessprocedure. Under the Companies Law, the internal auditor may be an employee ofthe company but not an office holder, an affiliate, or a relative of an officeholder or affiliate, and he may not be the company`s independent accountant orits representative. We have appointed an internal auditor in accordance withthe requirements of the Companies Law. 

 

#  D.  EMPLOYEES  

 

As of May 1st, 2003, we had 311 employees,including 42 employees in administration and accounting, 112 in sales andmarketing, 95 in research and development and 62 in operations. Of these 311employees, 243 were based in Israel, 27 in the United States and 41 in othercountries. 

We are subject to Israeli labor laws and regulations withrespect to our Israeli employees. These laws principally concern matters suchas paid annual vacation, paid sick days, length of the workday and work week,minimum wages, pay for overtime, insurance for work-related accidents,severance pay and other conditions of employment.

Furthermore, by order of the Israeli Ministry of Labor andWelfare, we and our Israeli employees are subject to provision of thecollective bargaining agreements between the Histadrut, the General Federationof Labor in Israel and the Coordination Bureau of Economic Organizations,including the Industrialists Associations. These provisions principally concerncost of living increases, recreation pay and other conditions of employment. Webelieve that the benefits and working conditions that we provide to ouremployees are above the required minimum. Our employees are not represented bya labor union. We have written employment contracts with virtually all of ouremployees and we believe that our relations with our employees aresatisfactory. 

 

# E.  SHARE OWNERSHIP 

 

As of May 1st, 2003, the aggregate number ofour ordinary shares beneficially owned by each of our directors and executiveofficers as of such date is set forth in the following table. For the purposeshereof, beneficial ownership by a person, as of a particular date, assumes theexercise of all options and warrants held by such person that are currentlyexercisable or are exercisable within 60 days of such date. 

| ** **

** **             | **Ordinary Shares  beneficially owned** |
|------------------------------------|-----------------------------------------|
| Name of director/executive officer | Number                                  | Percent |
|                               |                                    |   |
| Dov Moran                          | 2,362,771                               | 8.58% |
| Aryeh Mergi                        | 822,256                                 | 2.99% |
| Amir Friedman                      | *                                       | * |
| Yair Shoham                        | *                                       | * |
| Hans Wagner                        | *                                       | * |
| Dana Gross                         | *                                       | * |
| Ronit Maor                         | *                                       | * |
| Yossi Ben-Shalom                   | *                                       | * |

 

* beneficially owned lessthan 1% of the Company`s issued and outstanding ordinary shares as of May 1st,2003.

** **

**___45___** 

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

The Company previously had two incentive share optionplans in place, the Incentive and Restricted Share Option Plan (the "IRSOPlan") and the Section 102 Share Option Plan (the "102 Plan" and, together withthe IRSO Plan, the "Old Plans"). The respective term of each of the Old Plansexpired on February 15th, 2003. 

In replacement of the Old Plans and in lieu of recentrevisions (the "Tax Reform") to the Israeli Income Tax Ordinance (New Version)1961 (the "Tax Ordinance") requiring the adoption of certain adjustmentsconcerning the issuance of share options to Israeli employees, the Companyadopted, by way of a resolution of the Board of Directors on November 5th,2002 and a resolution of the shareholders of the Company on December 17th,2002, its new omnibus 2003 Stock Option and Restricted Stock Incentive Plan(the "New 2003 Plan"). Following is a brief review of each of the Old Plans, ofthe New 2003 Plan and of the Tax Reform:

***Incentive and RestrictedShare Option Plan  ***

Under the IRSO Plan, we were authorized to grant optionsfor up to 3,000,000 ordinary shares to our employees, directors andconsultants. The exercise price per share for an incentive share option could notbe less than the market value of the ordinary shares on the date the option wasgranted. Incentive options granted under the IRSO Plan in accordance with theterms thereof were intended to qualify as incentive stock options under Section422 of the U.S. Internal Revenue Code of 1986, as amended (the "Code"). Anyoptions that were cancelled or forfeited before expiration became available forfuture grant under the IRSO Plan. The IRSO Plan expired on February 15th,2003.

As of December 31, 2002, we had outstanding options for1,108,116 ordinary shares under the IRSO Plan, at an average exercise price of$ 6.46 per ordinary share, and with expiration dates ranging fromFebruary, 2005 to December, 2012.

***Section 102 Share OptionPlan***

Under the 102 Plan, we were authorized to grant options topurchase an aggregate of 4,000,000 ordinary shares to our Israeli employees.The exercise prices of options granted under the 102 Plan were determined byour Board of Directors at the time of the grant, and such granted optionsusually expire no later than ten years from the date of grant. Any options thatwere cancelled or forfeited before expiration became available for future grantunder the 102 Plan. The 102 Plan expired on February 15th, 2003.

Prior to the revision of the Tax Ordinance, pursuant toSection 102 thereof and the rules promulgated thereunder (including therequirement that the options and/or the resulting shares be deposited with atrustee for at least two years), the tax on the benefit arising to the employeefrom the grant and exercise of options as well as from the allotment ofordinary shares under these options is deferred until the transfer of theoptions and/or ordinary shares to the employee`s name or upon the sale of thoseoptions and/or ordinary shares. We will be allowed to claim as an expense fortax purposes the amounts credited to the employees as a benefit upon sale ofthe shares allotted under the 102 Plan at a price exceeding the exercise price,when the related capital gains tax is payable by the employee.

As of December 31, 2002, we had outstanding options for2,705,538 ordinary shares under the 102 Plan, at an average exercise price of$ 6.24 per ordinary share, and with expiration dates ranging from August,2003 to December, 2012.

**___46___** 

***The New 2003 Plan***

Under the New 2003 Plan, the Company has reserved fivemillion (5,000,000) ordinary shares for the granting of awards to theemployees, officers, directors, service providers and consultants of theCompany and of any subsidiary of the Company. The New 2003 Plan is intended toenable the Company to issue awards under varying tax regimes, including withoutlimitation (i) pursuant and subject to the provisions of the Tax Ordinance;(ii) incentive stock options within the meaning of Section 422 of the Code;(iii) nonqualified stock options; (iv) shares of restricted stock; and (v)other share-based awards. Apart from issuance under the relevant tax regimes inthe State of Israel and the United States of America, the New 2003 Plancontemplates issuances of awards in other jurisdictions, with respect to whichthe Board of Directors is empowered to make the requisite adjustments in theNew 2003 Plan and set forth the relevant conditions in the Company`s agreementwith the grantee in order to comply with the requirements of the tax regimes inany such jurisdictions.

Awards may be granted pursuant to the New 2003 Plan fromtime to time within a period of ten (10) years from the date the New 2003 Planwas adopted by the Board of Directors. The exercise prices of options grantedunder the New 2003 Plan is to be determined, subject to applicable law, by theBoard of Directors at the time of the grant, and such granted options usuallyexpire no later than ten years from the date of grant. Any of the ordinary sharesreserved under the New 2003 Plan, which may remain unsold and which are notsubject to outstanding options at the termination of the New 2003 Plan, shallcease to be reserved for the purpose of the New 2003 Plan. If any outstandingaward under the New 2003 Plan should, for any reason, expire, be canceled or beforfeited without having been exercised in full, the ordinary shares allocableto the unexercised, canceled or terminated portion of such award shall (unlessthe New 2003 Plan shall have been terminated) become available for subsequentgrants of awards under the New 2003 Plan. 

***Revisions to the TaxOrdinance***

The Tax Reform created a new tax structure for taxingstock or stock options that the Company grants to its Israeli employees, whilethe existing tax structure will continue to apply to the issuance of options toexternal service providers and to the controlling owners of the Company, whoare not considered to be `employees` of the Company for the purposes of Section102 of the Tax Ordinance. As a general rule, a company can choose to issueoptions or shares through a trustee or without a trustee. If such companychooses the trustee track, it must further opt for either the `ordinary incometrack` or the `capital gains track` and this decision is then binding on thecompany and on all similarly situated office-holders for the subsequent twoyears. 

We have chosen to issue shares and options through atrustee, who has been authorized by the tax authorities in accordance with andfor the period set by law and, as a result, neither the issuance of shares oroptions to those of our eligible employees, nor the exercise by such employeesof their options, will be taxable. The tax will be imposed only when the sharesare sold by the trustee or transferred to the employee, whichever is earlier.We have notified the tax authorities of our opting for the `capital gainstrack` in accordance with the requirements of the Tax Ordinance. 

As a result of our choosing the `capital gains track,` inthe event that the trustee holds the shares until the end of the requiredholding period, which is at least 2 years from the end of the tax year in whichthe shares or options were issued to the trustee, the value of the benefit tothe employee will be considered to be capital gain and he or she will be taxedat a rate of 25%. In addition, we will not be able to deduct expenses for taxpurposes. As our ordinary shares are registered on a stock exchange, a part ofthe profit that reflects the value of the benefit to the date of issuance willbe considered as ordinary income by the employee and we will be able to deductthis as a salary expense, with the balance being deemed as capital gains andtaxable at 25% which we will not be able to deduct as an expense. Had we chosenthe `ordinary income (employment income) track`, the employee would have beenconsidered as having received employment income in an amount equal to thebenefit (consideration at date of sale, less share option exercise price andexpenses from the purchase and sale). We would then have been entitled todeduct as a salary expense, the same amount as the employee would have receivedin income. The required holding period by the trustee under the `ordinaryincome (employment income) track` is one year from the end of the tax year inwhich the options or shares were issued to the employee. 

**___47___** 

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

The purpose of the ESPP plans is to enable our employeesto purchase M-Systems` shares through accumulated payroll deductions. TheGlobal ESPP plan is available to all of our non-U.S. employees. The U.S. ESPPplan is available to our U.S. employees and contains certain provisions intendedto qualify the U.S. ESPP plan as an "employee stock purchase plan" underSection 423 of the Code.

The terms of our ESPP plans (both Global and U.S.) providethat any of our employees (with certain restrictions in the U.S. ESPP Plan), ifhe or she so chooses, can elect before any "Offering Period" to have any wholepercentage between 1% and 10% deducted from his salary and allocated to buyM-Systems shares. An "Offering Period" is a six-month period, with a newOffering Period beginning on May 15 and November 15 each year (unless changedby the Board of Directors). The price of the shares purchased by the employee -i.e., the number of shares that he will receive in return for the amountsdeducted from his salary over the six-month Offering Period - will bedetermined at the end of the Offering Period and will be equal to the lower of85% of the closing bid for of M-Systems` shares on (1) the first day of theOffering Period; or (2) the last day of the Offering Period.

Under the Global ESPP plan, we may sell up to 550,000shares to our employees. Under the U.S. ESPP plan, we may sell up to 200,000shares to our employees.

The ESPP plans expire in 2011 unless earlier terminated byour Board of Directors.

 

**___48___** 

# ITEM 7.  MAJOR SHAREHOLDERSAND INTERESTED PARTY TRANSACTIONS

#  A.  MAJOR SHAREHOLDERS

 

The following table sets forth the number of ordinaryshares owned beneficially by all shareholders known to us to own beneficiallymore than 5% of the outstanding ordinary shares on May 1st, 2003 . 

| ** **

** **                                           | **Ordinary Shares  beneficially owned** |
|------------------------------------------------------------------|-----------------------------------------|
| Name                                                             | Number                                  | Percent |
| RS Investment Management Co. LLC (1)                             | 2,874,000                               | 10.44% |
| Dov Moran                                                        | 2,362,771                               | 8.58% |
| All directors and executive officers as a group (8  persons) (2) | 3,578,740                               | 13.00% |

 

(1) Based oninformation contained in the Report of Form 13-G filed by RS InvestmentManagement 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 InvestmentManagement Co. LLC, RS Investment Management, L.P., and RS InvestmentManagement, Inc.

(2)  Also includes options granted to such directors andexecutive officers of the Company, which are exercisable within 60 days of May1st, 2003.

As of May 1st, 2003, our ordinary shares wereheld by approximately 74 holders of record. Based on a review of theinformation provided to us by our transfer agent, 54 holders of record, holdingapproximately 85.56% of our outstanding ordinary shares, were residents of theUnited States. 

 

#  B.  RELATED PARTY TRANSACTIONS

 

In October, 2000, we purchased 586,080 preferred shares ofSaifun for approximately $ 10 million.This investment was part of a transaction in which Saifun sold 2,327,323 of itspreferred shares to various venture capital and strategic investors foraggregate consideration of approximately $ 39.7 million. Saifun is aprivate, 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 of Directors, isthe founder, chief executive officer and a director of Saifun. This transactionwas approved by our Audit Committee and Board of Directors, in the absence ofDr. Eitan in both cases, in accordance with the provisions of the Companies Lawgoverning approval of related party transactions. As of the date hereof, Mr.Eitan is no longer a member of the Company`s Board of Directors.

On May 1st, 2003, we entered into a SharePurchase Agreement (the "PPM") with Dr. Hans Wagner, a member of our Board ofDirectors, according to which Dr. Wagner is to purchase 500,000 of our ordinaryshares, at a purchase price per share of $ 8.21, for an aggregateinvestment amount of $ 4,105,000 (a copy of the PPM is attached to thisAnnual Report as Exhibit 4(b)(i)). The closing of this transaction occurredprior to the filing of this Annual Report. This transaction was approved by ourAudit Committee and Board of Directors, in the absence of Dr. Wagner, inaccordance with the provisions of the Companies Law governing approval ofrelated party transactions. 

**___49___** 

**Insurance**. We have obtained directors and officersliability insurance for the benefit of our office holders and intend tocontinue and obtain such insurance and pay all premiums thereunder to thefullest extent permitted by the Companies Law. Under the Companies Law, anIsraeli company may not exempt an office holder from liability for a breach ofhis duty of loyalty, but may exempt in advance an office holder from hisliability to the company, in whole or in part, for a breach of his duty ofcare. 

Our Articles of Association provide that, subject to theprovisions of the Companies Law, we may enter into a contract for the insuranceof the liability of any of our office holders for acts which he or sheperformed in his or her capacity as an office 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.                                                                                                                     |

 

#  C.  INTEREST OF EXPERT AND COUNSEL 

 

**- Not applicable**

 

 

# ITEM 8.  FINANCIALINFORMATION 

 

#  A.  CONSOLIDATED STATEMENTS AND OTHER FINANCIAL INFORMATION 

 

Our consolidated audited financial statements are includedin this annual report in "Item 18: Financial Statements." 

**Legal Proceedings**

Other than the litigation set forth in Item 4.B above inthe paragraph titled "Intellectual Property Rights and Current Litigation," weare not involved in any legal proceedings that we believe, individually or inthe aggregate, will have a material adverse effect on the Company. 

**Dividend Distribution Policy**

We have never declared or paid any cash dividends on ourordinary shares and we do not intend to pay cash dividends on our shares in theforeseeable future. We currently intend to retain any future earnings tofinance operations and to expand our business. If we declare cash dividends,they could be taxable to the recipient. Because we have received benefits underthe Investment Law (see item 10.E below the paragraph titled "Law for theEncouragement of Capital Investments, 1959"), payment of cash dividends duringthe exemption period granted under the Investment Law will subject that portionof our income derived from the `approved enterprise` status granted to us underthe Investment Law, to Israeli taxes to which the income would not otherwise besubject. We intend to reinvest the amount of the tax-exempt income derived fromour "approved enterprises" status permanently and not to distribute such incomeas dividends.  

Under the provisions of our Articles of Association, thedeclaration of any final cash dividends in respect of any fiscal periodrequires shareholder approval, which may reduce but not increase such dividendfrom the amount proposed by our Board of Directors; provided that any failureby our shareholders to approve a final dividend will not affect any interimdividend which has been paid.

 

#  B.  SIGNIFICANT CHANGES 

** **

**- Not applicable**

 

 

**___50___** 

# ITEM 9.  THEOFFER AND LISTING

 

A. 4.  The following table lists the high and low lastreported sales prices on Nasdaq for the periods indicated: 

 

| **Yearly  Figures**    | ** **   | ** **   |
|------------------------|--------------|--------------|
| ** **             | **High**     | **Low**      |
| 1998:                  | $ 8.09  | $ 2.75  |
| 1999:                  | $ 34.00 | $ 3.63  |
| 2000:*                 | $ 44.25 | $ 11.94 |
| 2001:                  | $ 16.56 | $ 3.92  |
| 2002:                  | $ 12.59 | $ 4.95  |
|                   |         |         |
| **Quarterly  Figures** | ** **   | ** **   |
|                   |         |         |
| 2001:                  | **High**     | **Low**      |
| First  Quarter         | $ 16.56 | $ 5.78  |
| Second  Quarter        | $ 11.96 | $ 6.02  |
| Third  Quarter         | $ 8.13  | $ 3.92  |
| Fourth  Quarter        | $ 11.69 | $ 4.13  |
|                   |         |         |
| 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  |
|                   |         |         |
| **Monthly Figures**    |         |         |
|                   |         |         |
| 2002-2003:             | ** **   | ** **   |
| Most Recent 6 months:  | **High**     | **Low**      |
| November 2002          | $ 8.68  | $ 6.15  |
| December 2002          | $ 8.68  | $ 6.89  |
| January 2003           | $ 8.25  | $ 5.82  |
| February 2003          | $ 6.50  | $ 5.63  |
| March 2003             | $ 6.40  | $ 5.20  |
| April 2003             | $ 8.84  | $ 6.00  |

 

* We effected a two-for-one stock split in September 2000.Accordingly, the share price information for 2000 is adjusted to reflect suchstock split. The share price information for the years 1999 and 1998 remainunadjusted and reflect the pre-split highs and lows for said years.

On May 1st, 2003, the last reported sale priceof our ordinary shares was $ 8.34 per share. There is currently no tradingmarket for our ordinary shares outside the United States.

**___51___** 

**B. - Not applicable**

**C.  **Our ordinary shareswere quoted on the Nasdaq Small-Cap Market under the symbol "FLSHF" from ourinitial public offering in March 1993 through our secondary public offering inAugust 1996. Since August 8, 1996, our ordinary shares have been quoted on theNasdaq National Market. On March 24, 1999, our ticker symbol was changed to"FLSH."

**D. - Not applicable**

**E. - Not applicable**

**F. - Not applicable**

 

 

# ITEM 10.  ADDITIONALINFORMATION

 

#  A.  SHARE CAPITAL 

** **

**- Not applicable**

 

#  B.  MEMORANDUM AND ARTICLES OF ASSOCIATION

 

**Objects and Purposes**

The objects and purposes of our company appear in our Memorandumof Association and include taking all actions permissible under applicablelaws. 

**Approval of Specified RelatedParty Transactions**

The Companies Law imposes a duty of care and a duty ofloyalty on all of a company`s office holders as defined below, includingdirectors and executive officers. The duty of care requires an office holder toact with the level of care that a reasonable office holder in the same positionwould have acted under the same circumstances. The duty of loyalty generallyrequires an office holder to act in good faith and for the good of the company.An "office holder" as defined in the Companies Law is a director, a generalmanager, a chief executive officer, a deputy general manager, a vice generalmanager, other managers directly subordinate to the general manager and anyperson who fills one of the above positions without regard to title.

The Companies Law requires that an office holder of acompany promptly disclose any personal interest that he may have and allrelated material information known to him, in connection with any existing orproposed transaction by the company. Once an office holder complies with thesedisclosure requirements, the board of directors may approve a transactionbetween the company and the office holder, or a third party in which an officeholder has a personal interest, unless the articles of association provideotherwise. A transaction that is adverse to the company`s interest cannot beapproved. If the transaction is an extraordinary transaction under theCompanies Law, then, in addition to any approval stipulated by the articles ofassociation, it also requires audit committee approval before board approvaland, in specified circumstances, subsequent shareholder approval. Anytransaction between a company and one of its directors relating to theconditions of the director`s service, including in relation to exculpation,insurance or indemnification, or in relation to the terms of the director`sservice in any other capacity requires audit committee approval before boardapproval and subsequent shareholder approval.

The Companies Law also provides that a director with aninterest in an extraordinary transaction brought before the board of directorsor the audit committee for its approval may not vote on the approval and maynot be present for the discussion of the issue. However, this rule would notapply if a majority of the directors or a majority of the members of the auditcommittee also possessed an interest in the transaction.

Under our Articles of Association, our Board of Directorsmay exercise all powers and take all actions that are not required under law orunder our Articles of Association to be exercised or taken by our shareholders,including the power to borrow money for the purposes of our company.

**___52___** 

Our directors are not subject to any age limitrequirement, nor are they disqualified from serving on the Board of Directorsbecause of a failure to own certain amount of our shares.

**Rights, Preferences andRestrictions on Shares**

Our Articles of Association authorize one class of shares,which are our ordinary shares. We may declare a dividend to be paid to theholders of our ordinary shares and allocated among them in proportion to thesums paid up or credited as paid up on account of the nominal value of theirrespective shareholdings, without taking into account any premium paid for theshares. Our Board of Directors may declare dividends only out of retainedearnings, or earnings derived over the two most recent fiscal years, whicheveris higher. Our Articles of Association provide that our Board of Directors maypropose a final dividend in respect of any fiscal period but that such dividendshall be payable only after approved by our shareholders. All unclaimeddividends may be invested or otherwise used by the Board of Directors for ourbenefit until those dividends are claimed. In the event an unclaimed dividendis claimed, only the principal amount of the dividend will be paid to theperson entitled to the dividend.  

If we liquidate, after satisfying liabilities to creditorsand subject to the rights of holders of shares, if any, with any special rightsupon winding up, our assets will be distributed to the holders of ordinaryshares in proportion to their holdings.

Holders of ordinary shares have one vote for each -paid-up ordinary share held of record on all matters submitted to a vote of ourshareholders. These voting rights may be affected by the grant of any specialvoting rights to the holders of a class of shares with preferential rights thatmay be authorized in the future.

Our Articles of Association provide that directors areelected by an ordinary resolution of a general meeting of our shareholders. Ourordinary shares do not have cumulative voting rights in the election of directors.Accordingly, the holders of ordinary shares representing more than 50% of thevoting power in our company have the power to elect all directors. 

We may, subject to the applicable provisions of theCompanies Law, issue redeemable shares and subsequently redeem them. Inaddition, our Board of Directors may make calls for upon shareholders inrespect of any sum that has not been paid up in respect of any shares held bythose shareholders.

Under the Companies Law, the disclosure requirements thatapply to an office holder also apply to a controlling shareholder of a publiccompany. A controlling shareholder includes a shareholder that holds 25% ormore of the voting rights in a public company if no other shareholder owns morethan 50% of the voting rights in the company. Extraordinary transactions with acontrolling shareholder or in which a controlling shareholder has a personalinterest, and the terms of compensation of a controlling shareholder who is anoffice holder, require the approval of the audit committee, the board ofdirectors and the shareholders of the company. The shareholder approvalrequires that: (a) the majority of shares voted at the meeting, including atleast one third of the shares of disinterested shareholders voted at themeeting, vote in favor of the transaction; or (b) the total number of shares ofdisinterested shareholders voted against the transaction does not exceed onepercent of the aggregate voting rights in the company.

The Companies Law also requires a shareholder to act ingood faith towards a company in which he holds shares and towards othershareholders and to refrain from abusing his power in the company, including inconnection 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 shareholder has the general duty to refrain fromdepriving other shareholders of their rights. Any controlling shareholder, anyshareholder that knows that it possesses the power to determine the outcome ofa shareholder vote and any shareholder that, under the provisions of thearticles of association, has the power to appoint an office holder in the company,is under a duty to act in fairness towards the company. The Companies Law doesnot describe the substance of this duty.

**___53___** 

**Modifications of Share Rights**

Under our Articles of Association, the rights attached toany class may be varied by adoption of the necessary amendment of the Company`sArticles of Association, provided that the holders of shares of the affectedclass approve the change by a class meeting in which the holders of at least75% of the shareholders present at the meeting, in person or by proxy, andvoting on the issue approve the change. Our Articles of Association differ fromthe Companies Law in this respect, as under the law changes in the rights ofshareholders require the consent of at least 50% of the voting power of theaffected class represented at the meeting and voting on the change. OurArticles of Association require for quorum at a meeting of a particular classof shares the presence of two shareholders holding at least 25% of the votingpower of that class. Our Articles of Association - may be amended by majorityof the voting power of our company represented at a shareholders meeting andvoting thereon, except that the provisions of our Articles of Associationrelating to mergers and acquisitions can only be amended by a vote of 75% ofthe voting power of our company represented at a meeting and voting thereon. 

**Shareholders Meetings andResolutions**

We are required to hold an annual general meeting of ourshareholders once every calendar year, but no later than 15 months after thedate of the previous annual general meeting. All meetings other than the annualgeneral meeting of shareholders are referred to as extraordinary generalmeetings. Our Board of Directors may call extraordinary general meetingswhenever it sees fit, at such time and place, within or without the State ofIsrael, as it may be determined. In addition, the Companies Law provides thatthe board of directors of a public company is required to convene anextraordinary meeting upon the request of (a) any two directors of the companyor one quarter of the company`s board of directors or (b) one or moreshareholders holding, in the aggregate, (i) five percent of the outstandingshares of the company and one percent of the voting power in the company or(ii) five percent of the voting power in the company.

The quorum required by our Articles of Association for ameeting of shareholders consists of at least two shareholders present in personor by proxy who hold or represent between them at least 25% of the voting powerin our company. A meeting adjourned for lack of quorum is adjourned to the sameday in the following week at the same time and place or any time and place asthe chairman of the meeting decides. At such reconvened meeting, the requiredquorum consists of any two shareholders present in person or by proxy.

Our Articles of Association enable our Board of Directorsto fix a record date to allow us to determine the shareholders entitled tonotice of, or to vote at, any general meeting of our shareholders. The recorddate may not be more than 40 days, or any longer period permitted under theCompanies Law, nor less than 4 days before the date of the meeting. Eachshareholder of record as of the record date determined by the Board ofDirectors may vote the shares then held by that shareholder unless all callsand other sums then payable by the shareholder in respect of its shares havenot been paid.

**Limitation on Ownership ofSecurities**

The ownership and voting of our ordinary shares bynon-residents of Israel are not restricted in any way by our Articles ofAssociation or by the laws of the State of Israel, except for shareholders whoare subjects of countries which are enemies of the State of Israel.

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

The Companies Law includes provisions allowing corporatemergers. These provisions require that the board of directors of each companythat is party to the merger approve the transaction. In addition, theshareholders of each company must approve the merger. Our Articles ofAssociation require approval of a merger or acquisition by a vote of the 75% ofour company`s voting power, present and voting on the proposed merger at ashareholders` meeting. In determining whether the requisite majority hasapproved the merger, shares held by the other party to the merger or by anyperson holding at least 25% of such other party are excluded from the vote. TheCompanies Law does not require court approval of a merger other than inspecified situations. However, upon the request of a creditor of either partyto the proposed merger, a court may delay or prevent the merger if it concludesthat there exists a reasonable concern that as a result of the merger, thesurviving company will be unable to satisfy the obligations of any of the partiesof the merger to their creditors.

A merger may not be completed unless at least 70 days havepassed from the time that a Merger Proposal (as defined in the Companies Law)has been filed with the Israeli registrarof companies.  

**___54___** 

The Companies Law also provides that the acquisition ofshares in a public company on the open market (i.e., from other shareholders ofthe company) must be made by means of a tender offer if, as a result of theacquisition, the purchaser would become a 25% shareholder of the company.  Therule does not apply if there already is another 25% shareholder of the company.Similarly, the law provides that an acquisition of shares in a public companymust be made by means of a tender offer if, as a result of the acquisition, thepurchaser would become a 45% shareholder of the company, unless there alreadyis a 50% shareholder of the company.  

If, following any acquisition of shares, the purchaserwould hold 90% or more of the shares of the company that acquisition must bemade by means of a tender offer for all of the target company`s shares. Anacquirer who wishes to eliminate all minority shareholders must do so by meansof a tender offer and acquire 95% of all shares not held by or for the benefitof the acquirer prior to the acquisition. However, in the event that the tenderoffer to acquire that 95% is not successful, the acquirer may not acquiretendered shares if by doing so the acquirer would own more than 90% of theshares of the target company.

**Changes in Capital**

Our Articles of Association enable us to increase orreduce our share capital. Any such changes are subject to the provisions of theCompanies Law and must be approved by a resolution passed by a majority of thevoting power of our company present, in person or by proxy, at a generalmeeting and voting on such change in the capital. In addition, certaintransactions which have the effect of reducing capital, such as the declarationand payment of dividends under certain conditions and the issuance of sharesfor less than their nominal value, require a resolution of the Board ofDirectors and court approval.

 

# C.  MATERIAL CONTRACTS

 

In April 2001, we signed an agreement with Aspen NadlanLtd. and Narkis Marom Mivnei Ta`asiya Ltd. to purchase the building in whichour headquarters` 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 that wefinanced ourselves. Some of the consideration has been placed in an escrow fundpending the receipt by the sellers of these properties of certain permits andthird party approvals. In addition, in April 2001 we entered into a developmentand supply agreement with Atmel Sarl. Under this agreement, Atmel is to layout,develop, manufacture, test and supply the ASIC components for our DiskOnKeyproducts. 

Other than the agreement referred to above, in the pasttwo years we have not entered into any material contracts other than contractsentered into in the ordinary course of our business.

 

#  D.  EXCHANGE CONTROLS

 

Under Israeli law, foreign currency transactions aregenerally permitted, except for transactions that are specifically restricted.Among these restricted transactions are foreign currency transactions byinstitutional investors, including investments outside of Israel by pensionfunds and insurers, as well as futures contracts by foreign residents forperiods of more than one month.

Holders of ordinary shares are able to convert dividendsand liquidation distributions into freely repatriable non-Israeli currencies atthe rate of exchange prevailing at the time of repatriation, pursuant to ageneral permit issued by the Controller of Foreign Exchange at the Bank ofIsrael under the Currency Control Law, 1978, provided that Israeli income taxhas been withheld by us with respect to such amounts.

Our ordinary shares may be freely held and traded pursuantto the General Permit and the Currency Control Law. The ownership or voting ofordinary shares by non-residents of Israel, except with respect to citizens ofcountries that are in a state of war with Israel, are not restricted in any wayby our Memorandum of Association or Articles of Association or by the laws ofthe State of Israel.

 

**___55___** 

#  E.  TAXATION

 

The following is a summary of the current tax structureapplicable to companies in Israel, with special reference to its effect on us.The following also contains a discussion of certain Israeli Government programsbenefiting us. To the extent that the discussion is based on new taxlegislation that has not been subject to judicial or administrativeinterpretation, there can be no assurance that the views expressed in thediscussion will be accepted by the tax authorities in question. The discussionis not intended, and should not be construed, as legal or professional taxadvice and is not exhaustive of all possible tax considerations.

**General Corporate TaxStructure**

Israeli companies are subject to corporate tax at the rateof 36%. However, the effective rate of tax of a company that derives incomefrom an `approved enterprise` (as referred to below) may be considerably lower(see in this Item 10.E below the paragraph titled "Law for the Encouragement ofCapital Investments, 1959").

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

We currently qualify as an "industrial company" under theLaw for the Encouragement of Industry (Taxes), 1969 (the "IndustryEncouragement Law"). A company qualifies as an "industrial company" if it isresident in Israel and at least 90% of its income in a given tax year,determined in NIS (other than income from certain types of loans, capitalgains, interest and dividends), is derived from industrial enterprises owned bythat company. An "industrial enterprise" is defined as an enterprise whosemajor activity in a particular tax year is industrial manufacturing activity.See Note 12 to our Consolidated Financial Statements.

Under the Industry Encouragement Law, an industrialcompany is entitled to deduct the purchase price of patents and certain otherintangible property rights (other than goodwill) over a period of eight years,beginning with the year in which such rights were first used.

An industrial company may be eligible for specialdepreciation rates for machinery, equipment and buildings. These rates differbased on various factors, including the date of commencement of operation andthe number of work shifts. An industrial company owning an `approvedenterprise` may choose between such special depreciation rates and thedepreciation rates available to `approved enterprises`.

Qualification as an industrial company under the IndustryEncouragement Law is not conditioned upon the receipt of prior approval fromany Israel government authority. No assurance can be given that we willcontinue to qualify as an industrial company or that we will, in the future, beable to take advantage of any tax benefits available to industrial companies.

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

The Investment Law provides that a capital investment ineligible facilities may, upon application to the Investment Center, bedesignated as an `approved enterprise`. Each certificate of approval for an`approved enterprise` relates to a specific investment program delineated bothby its financial scope, including its capital resources, and by its physicalcharacteristics, *e.g.*, the equipment to be purchased and utilizedpursuant to the program. The tax benefits derived from any such certificate ofapproval relate only to taxable income attributable to the specific `approvedenterprise`. If a company has more than one approval, its effective tax rate isthe result of a weighted combination of the applicable rates. Income derivedfrom activity that is not integral to the activity of the enterprise should notbe divided between the different enterprises and should not enjoy tax benefits.

Most of our current production facilities have beengranted the status of an `approved enterprise` under the Investment Law, in sixseparate investment programs. Under the Investment Law, we have chosen the"alternative benefits" option and have waived Government grants in return for atax exemption. These programs provide us with the tax benefits described below.Under the terms of our `approved enterprise` programs, our income from`approved enterprises` will be tax exempt for periods of 2-4 years (except withrespect to income from our Omer facility, which will be tax-exempt for 10years), commencing with the year in which we first earn taxable income from therelevant `approved enterprise`, and is subject to areduced tax rate for an additional period of up to a total of ten yearsfrom when the tax exemption began. The reduced taxrate is imposed at a rate of between 10% and 25%, depending on thepercentage of M-Systems` shares held by non-Israelis duringthat remaining period (the more shares held by non-Israelis, the lower the taxrate). The tax benefits periods described above will end upon theearlier of (a) 12 years from the year of commencement of production, or (b) 14years from the year of approval of `approved enterprise` status).

**___56___** 

A company that has elected the alternative package ofbenefits, like we have, and that subsequently pays dividend out of incomederived from the `approved enterprise` during the tax exemption period, will besubject to tax in respect of the amount distributed (including the tax thereon)at the rate that would have been applicable had it not elected the alternativepackage of benefits (generally 10%-25%, depending on the extent of foreignshareholders holding our ordinary shares). The dividend recipient is taxed atthe reduced rate applicable to dividends from `approved enterprises` (15%), ifthe dividend is distributed during the tax exemption period or within 12 yearsthereafter. 

The Investment Law also provides that an `approvedenterprise` is entitled to accelerated tax depreciation on property andequipment included in an approved investment program.

Any future applications we make to the Investment Centerwill be reviewed separately, and decisions as to whether or not to approve suchapplications will be based, among other things, on the then prevailing criteriaset forth in the Investment Law, on the specific objectives we set forth insuch applications and on certain financial criteria. Accordingly, there can beno assurance that any such applications will be approved. In addition, thebenefits available to an `approved enterprise` are conditional upon ourfulfilling certain conditions stipulated in the Investment Law and itsregulations and the criteria set forth in the specific certificate of approval,as described below. If we were to violate those conditions, in whole or inpart, we would be required to refund the amount of tax benefits, with theaddition of the CPI linkage adjustment and interest. We believe that our`approved enterprises` operate in substantial compliance with all of theseconditions and criteria.

As a result of the Investment Law benefits, as well as ouraccumulated net operating loss carry forwards, we do not anticipate beingsubject to income taxation in Israel until approximately 2005.

As of December 31, 2001, we generated a total of approximately $ 35 million of net operatingloss carryforwards in Israel. These Israeli net operating loss carryforwardshave no expiration date. The tax benefits granted to an `approved enterprise`are not available to us with respect to the income of our subsidiaries. Theactual amount of the benefits associated with the `approved enterprise` programwill depend upon a number of factors, including whether these tax incentivesare renewed or if the tax authorities successfully challenge the manner inwhich profits are recognized among our subsidiaries or within specified taxjurisdictions.  

**Taxation under InflationaryConditions**

The Income Tax (Inflationary Adjustments) Law, 1985 (the"Inflationary Adjustments Law"), was designed to neutralize the erosion ofcapital investments in business and to prevent tax benefits resulting fromdeduction of inflationary expenses. This law applies a supplementary set ofinflationary adjustments to the normal taxable profits computed under regularhistorical cost principles.

The Inflationary Adjustments Law introduced a special taxadjustment for the preservation of equity based on changes in the Israeli CPI,whereby certain corporate assets are classified broadly into fixed(inflation-resistant) assets and non-fixed assets. Where a corporation`s equityexceeds the depreciated cost of fixed assets, a tax deduction that takes intoaccount the effect of the annual rate of inflation on such excess is allowed(up to a ceiling of 70% of taxable income for companies in any single year,with the unused portion carried forward on a linked basis, without limit). Ifthe depreciated cost of fixed assets exceeds shareholders` equity, then suchexcess, multiplied by the annual inflation rate, is added to taxable income.

Under the Inflationary Adjustments Law, results for taxpurposes are measured in real terms, in accordance with changes in the IsraeliCPI. We are taxed under this law. The discrepancy between the change in (1) theIsraeli CPI and (2) the exchange rate of Israeli currency in relation to thedollar, may in future periods cause significant differences between taxableincome and the income measured in dollars as reflected by our financialstatements (which are measured in dollars). In addition, subject to certainlimitations, depreciation of fixed assets and losses carried forward are adjustedfor inflation on the basis of changes in the Israeli CPI.

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

The State of Israel imposes income tax on nonresidents ofIsrael on income accrued or derived from sources in Israel. These sources ofincome include passive income such as dividends, royalties and interest, aswell as non-passive income from services rendered in Israel. We are required towithhold income tax at the rate of 25%, or 15% for dividends of incomegenerated by an `approved enterprise`, on all distributions of dividends otherthan bonus shares (stock dividends), unless a different rate is provided in atreaty between Israel and the shareholder`s country 

**___57___** 

of residence. Under the income tax treaty between the UnitedStates and Israel, the maximum tax on dividends paid to a holder of ordinaryshares who is a U.S. resident (as defined in the treaty) is 25%.

**Capital Gains Taxes on Salesof our Ordinary Shares**

Israeli law imposes a capital gains tax on the sale of securitiesand other capital assets. In general, the capital gains tax rate on the sale ofpublicly-traded securities of an Israeli company is 15% for gains accrued afterDecember 31, 2002.  Non-residents of Israel, however, are exempt fromIsraeli capital gains tax on the sale of our shares.

A nonresident of Israel who receives interest, dividend orroyalty income derived from or accrued in Israel, from which tax was withheldat the source, is generally exempted from the duty to file tax returns inIsrael with respect to such income, provided such income was not derived from abusiness conducted in Israel by the taxpayer and the taxpayer has no othertaxable sources of income in Israel.

Israel presently has no estate or gift tax. 

**United States Federal Income TaxConsiderations**

The following discussion describes the material UnitedStates federal income tax consequences to a holder of our ordinary shares,referred to for purposes of this discussion as 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 summary does not purport to be a comprehensivedescription of all of the tax considerations that may be relevant to eachperson`s decision to purchase ordinary shares. This summary considers only U.S.Holders that will own ordinary shares as capital assets.

This discussion does not address all aspects of UnitedStates federal income taxation that may be relevant to any particularshareholder based on such shareholder`s individual circumstances. Inparticular, this discussion does not address the potential application of thealternative minimum tax or United States federal income tax consequences toU.S. Holders that are subject to special 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 aspectof state, local or non-United States tax laws.

Additionally, this discussion does not consider the tax treatmentof partnerships or persons who hold ordinary shares through a partnership orother pass-through entity or the possible application of United States federalgift or estate tax. 

INDIVIDUAL HOLDERS ARE ADVISED TO CONSULT WITH THEIR OWNTAX ADVISOR WITH RESPECT TO THE SPECIFIC TAX CONSEQUENCES TO THEM OFPURCHASING, HOLDING OR DISPOSING OF OUR ORDINARY SHARES.

**___58___** 

**Taxation of Ordinary Shares**

 

***Taxation of Dividends Paid On Ordinary Shares***

A U.S. Holder will be required to include in gross incomeas ordinary income the amount of any distribution paid on ordinary shares,including the amount of foreign taxes, if any, withheld from the amount paid,on the date the distribution is received to the extent the distribution is paidout of our current or accumulated earnings and profits as determined for UnitedStates federal income tax purposes. Distributions in excess of such earningsand profits will be applied against and will reduce the U.S. Holder`s basis inthe ordinary shares and, to the extent in excess of such basis, will be treatedas gain from the sale or exchange of a capital asset.

Distributions of current or accumulated earnings andprofits paid in foreign currency to a U.S. Holder will be includible in theincome of a U.S. Holder in a U.S. dollar amount calculated by reference to theexchange rate on the day the distributions received. A U.S. Holder thatreceives a foreign currency distribution and converts the foreign currency intoU.S. dollars subsequent to receipt will have foreign exchange gain or lossbased on any appreciation or depreciation in the value of the foreign currencyagainst the U.S. dollar, which will generally be U.S. source ordinary income orloss.

U.S. Holders will have the option of claiming the amountof any Israeli income taxes withheld at source either as a deduction from grossincome or as a dollar-for-dollar credit against their United States federalincome tax liability. Individuals who do not claim itemized deductions, butinstead utilize the standard deduction, may not claim a deduction for theamount of the Israeli income taxes withheld, but such amount may be claimed asa credit against the individual`s United States federal income tax liability.The amount of foreign income taxes that may be claimed as a credit in any yearis subject to complex limitations and restrictions, which must be determined onan individual basis by each shareholder. These limitations include, amongothers, rules that limit foreign tax credits allowable with respect to specificclasses of income to the United States federal income taxes otherwise payablewith respect to each such class of income. The total amount of allowableforeign tax credits in any year cannot exceed regular U.S. tax liability forthe year attributable to foreign source taxable income. A U.S. Holder will bedenied a foreign tax credit with respect to Israeli income tax withheld fromdividends received on the ordinary shares to the extent such U.S. Holder hasnot held the ordinary shares for at least 16 days of the 30-day period beginningon the date which is 15 days before the ex-dividend date or to the extent suchU.S. Holder is under an obligation to make related payments with respect tosubstantially similar or related property. Any days during which a U.S. Holderhas substantially 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 of Ordinary Shares***

Generally, upon the sale, exchange or other disposition ofour ordinary shares, a U.S. Holder will recognize capital gain or loss in anamount equal to the difference between such U.S. Holder`s basis in the ordinaryshares, which is usually the cost of such shares, and the amount realized onthe disposition. If, as anticipated, the ordinary shares are publicly traded, adisposition of shares will be considered to occur on the "trade date,"regardless of the holder`s method of accounting. Capital gain from the sale,exchange or other disposition of ordinary shares held more than one year islong-term capital gain and is eligible for a maximum 20% rate of taxation fornon-corporate holders. Gain or loss recognized by a U.S. Holder on a sale,exchange or other disposition of ordinary shares generally will be treated asUnited States source income or loss for United States foreign tax creditpurposes. The deductibility of a capital loss recognized on the sale, exchangeor other disposition of ordinary shares is subject to limitations.

***Information Reporting and Backup Withholding***

Dividend payments with respect to the ordinary shares andproceeds from the sale, exchange or redemption of ordinary shares may besubject to information reporting to the Internal Revenue Service ("IRS") andpossible U.S. backup withholding. Backup withholding will not apply, however,to a U.S. Holder who furnishes a correct taxpayer identification number andmakes any other required certification or who is otherwise exempt from backupwithholding. Generally, a U.S. Holder will provide such certification on IRSForm W-9 (Request for Taxpayer Identification Number and Certification).

**___59___** 

Amounts withheld under the backup withholding rules may becredited against a U.S. Holder`s tax liability, and a U.S. Holder may obtain arefund of any excess amount withheld under the backup withholding rules byfiling the appropriate claim for refund with the IRS.

***Tax Consequences of Passive Foreign InvestmentCompany (PFIC) Status***

We will be deemed a passive foreign investment company, orPFIC, if 75% or more of our gross income in a taxable year, including our prorata share of the gross income of any company, U.S. or foreign, in which we areconsidered to own 25% or more of the shares by value, is passive income.Alternatively, we will be deemed to be a PFIC if at least 50% of our assets in ataxable year, averaged over the year and ordinarily determined based on fairmarket value and including our pro rata share of the assets of any company inwhich we are considered to own 25% or more of the shares by value, are held forthe production of, or produce, passive income. Passive income includes, amongother things, amounts derived by reason of the temporary investment of fundsraised in offerings of our ordinary shares. If we were a PFIC, and a U.S.Holder did not make an election to treat us as a "qualified electing fund" (asdescribed below):
| ●*       *  | 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 describedabove will not apply to a U.S. Holder if the U.S. Holder makes an election totreat us as a `qualified electing fund` ("QEF") in the first taxable year inwhich the U.S. Holder owns ordinary shares and if we comply with certainreporting requirements. Instead, a shareholder of a qualified electing fund isrequired for each taxable year to include in income a pro rata share or theordinary earnings of the qualified electing fund as ordinary income and a prorata share or the net capital gain of the qualified electing fund as long-termcapital gain, subject to a separate election to defer payment of taxes, whichdeferral is subject to an interest charge. 

The QEF election is made on a shareholder-by-shareholderbasis and can be revoked only with the consent of the Internal Revenue Service,or IRS. A shareholder makes a QEF election by attaching a completed IRS Form8621, including the PFIC annual information statement, to a timely filed UnitedStates federal income tax return and by filing such form with the IRS ServiceCenter in Philadelphia, Pennsylvania. Even if a QEF election is not made, a shareholderin a PFIC who is a U.S. person must file a completed IRS Form 8621 every year.

A U.S. Holder of PFIC stock which is publicly tradedcould, instead of making a QEF election, elect to mark the stock to marketannually, recognizing as ordinary income or loss each year an amount equal tothe difference as of the close of the taxable year between the fair marketvalue of the PFIC stock and the U.S. Holder`s adjusted tax basis in the PFICstock. Losses would be allowed only to the extent or net mark-to-market gainpreviously included by the U.S. Holder under the election for prior taxableyears. If the mark-to-market election were made, then the rules set forth abovewould not apply for periods covered by the election.

**___60___** 

We reasonably believe that we were not a PFIC for 2002. Webase our belief that we were not a PFIC in 2002 on a tax valuation made by anindependent "big 4" U.S. accounting firm for the fiscal year 2001 and furthercalculations that we have made in comparison to such tax valuation and thefacts set forth in such tax valuation. However, we did not obtain any new taxvaluation with respect to 2002. There can be no assurance, however, that theIRS will not determine that we are a PFIC. Furthermore, the tests fordetermining PFIC status are applied annually and it is difficult to makeaccurate predictions of future income and assets, which are relevant to thisdetermination. Accordingly, we cannot assure you that we will not be treated asa PFIC in any of 2001, 2002 or in future years. 

U.S. Holders who hold ordinary shares during a period whenwe are a PFIC will be subject to the foregoing rules, even if we cease to be aPFIC, subject to certain exceptions for U.S. Holders who made a QEF election.U.S. Holders are urged to consult their tax advisors about the PFIC rules,including as to the advisability of choosing to make a QEF election, a"protective" QEF election, or an election to mark the shares to marketannually. 

 

#  F.  DIVIDENDS AND PAYING AGENTS 

** **

**- Not applicable**

 

 

#  G.  STATEMENT BY EXPERTS

** **

**- Not applicable**

 

 

# H.  DOCUMENTS ON DISPLAY

 

All documents referenced herein concerning us are archivedat our principal offices located at 7 Atir Yeda St., Kfar Saba, Israel.

 

# I.  SUBSIDIARY INFORMATION 

** **

**- Not applicable**

 

 

# ITEM 11.  QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

We are exposed to a variety of risks, including changes inforeign currency exchange rates, changes in interest rates and weak economicconditions in foreign markets. However, we do not use derivative financial instrumentsin our investment portfolio to hedge foreign currency, interest rate or othertypes of market risks.  

**Interest Rate Risk**

Our exposure to interest rate risk relates primarily toour short term deposits and investments. The majority of our cash is held inU.S. dollars and bears interest at various rates based upon the London InterBank Offered Rate (LIBOR). These deposits are placed with high quality U.S. andEuropean banks. Approximately half of our cash is currently invested in bondsfeaturing credit ratings of A or higher. The bonds possess terms of up to six(6) years.

**___61___** 

**Foreign Currency Exchange andInflation Risk**

Most of our revenues generated and costs incurred outsideof the United States are generally denominated in dollar currencies. Costs noteffectively denominated in United States dollars are translated to UnitedStates dollars, when recorded, at the prevailing exchange rates for thepurposes of our financial statements. Consequently, fluctuations in the ratesof exchange between the dollar and non-dollar currencies will affect ourresults of operations. An increase in the value of a particular currencyrelative to the dollar will increase the dollar reporting value fortransactions in that particular currency, and a decrease in the value of thatcurrency relative to the dollar will decrease the dollar reporting value forthose transactions. This effect on the dollar reporting value for transactionsis generally only partially offset by the impact that currency fluctuations mayhave on costs. We do not generally engage in currency hedging transactions tooffset the risks associated with variations in currency exchange rates.Consequently, significant foreign currency fluctuations and other foreignexchange risks may have a material adverse effect on our business, financialcondition and results of operations. Since our revenues are generated in UnitedStates dollars and currencies other than NIS, and a substantial portion of ourexpenses is incurred and will continue to be incurred in NIS, we are exposed torisk by the amount that the rate of inflation in Israel exceeds the rate ofdevaluation of the NIS in relation to the dollar and other currencies or if thetiming of the devaluation lags behind inflation in Israel.

 

 

# ITEM 12.  DESCRIPTION OFSECURITIES OTHER THAN EQUITY SECURITIES 

** **

**- Not applicable**

 

 

**___62___** 

PART II

 

 

# ITEM 13.  DEFAULTS, DIVIDENDARREARAGES AND DELINQUENCIES 

** **

**- Not applicable**

 

 

# ITEM 14.  MATERIALMODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS 

** **

**- Not applicable**

 

 

# ITEM 15.  CONTROLS ANDPROCEDURES  

 

(a)  Disclosure Controls and Procedures - TheCompany`s management evaluated, with the participation of the Company`sprincipal executive and principal financial officers, the effectiveness of theCompany`s disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the "ExchangeAct")), as of December 31, 2002.  Based on their evaluation, theCompany`s principal executive and principal financial officers concluded thatthe Company`s disclosure controls and procedures were effective as of December31, 2002.

 

(b)  Not applicable.

(c)  Not applicable.

 

(d)  Changes in InternalControl Over Financial Reporting - There has been no change in the Company`sinternal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) that occurred during 2002, that hasmaterially affected, or is reasonably likely to materially affect, theCompany`s internal control over financial reporting.

 

# ITEM 16A.  [RESERVED]

 

# ITEM 16B.  [RESERVED]

 

# ITEM 16C.  [RESERVED]

 

**___63___** 

PART III

 

 

# ITEM 17.  FINANCIAL STATEMENTS

** **

**- Not applicable**

 

 

# ITEM 18.  FINANCIAL STATEMENTS

 

See Consolidated Financial Statements, immediately followingItem 19 below.

 

**___64___** 

# ITEM 19.  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).3  | **            | Agreement, dated April 24, 2001,  by and between Aspen Real Estate Ltd., Narkis Marom Industrial Buildings  Ltd., and M-Systems Flash Disk Pioneers Ltd., together with an English summary  of the Agreement                                  |
| 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(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)                                                                                                                                                             |
| 13.1    |          | Certification of Chief Executive  Officer pursuant to 18 U.S.C. Section 1350                                                                                                                                                                  |
| 13.2    |          | Certification of Chief Financial  Officer pursuant to 18 U.S.C. Section 1350                                                                                                                                                                  |
| 14.1    |          | Consent of Kost Forer Gabbay  & Kasierer (formerly Kost Forer & Gabbay)                                                                                                                                                               |
| 14.2    |          | Consent of BDO Seidman, LLP                                                                                                                                                                                                                   |
|    |          |                                                                                                                                                                                                                                          |
|    |          |                                                                                                                                                                                                                                          |

____________________

** **
| *     | 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 submitted .                                                                                                                                         |
| !!    | Portions of the agreement or  exhibits have been omitted pursuant to a request for confidential treatment  approved by the SEC.                                |

**___65___** 

 

 

 

M-SYSTEMS FLASH DISK PIONEERS LTD. AND ITS SUBSIDIARIES

CONSOLIDATED FINANCIAL STATEMENTS

AS OF DECEMBER 31, 2002

 

IN U.S. DOLLARS 

 

 

 

 

 

 

INDEX

 
|                                          | Page   |
|-----------------------------------------------|--------|
|                                          |   |
| Report of Independent Auditors                | 2      |
|                                          |   |
| Consolidated Balance Sheets                   | 3 - 4  |
|                                          |   |
| Consolidated Statements of Operations         | 5      |
|                                          |   |
| Statements of Changes in Shareholders' Equity | 6      |
|                                          |   |
| Consolidated Statements of Cash Flows         | 7 - 8  |
|                                          |   |
| Notes to Consolidated Financial Statements    | 9 - 34 |
|                                          |   |
| Report of BDO Seidman                         | 35     |

 

 

- - - - - - - -

 

**___1___** 

| ***E******RNST************&************Y******OUNG*** |
|-----------------------------------------------------------|

 

 

 

 

 

 

 

REPORT OF INDEPENDENT AUDITORS

 

to the Shareholders of

M-SYSTEMS FLASH DISK PIONEERS LTD.

 

 

 

We have audited the accompanying consolidated balancesheets of M-Systems Flash Disk Pioneers Ltd. ("the Company") and itssubsidiaries as of December 31, 2001 and 2002, and the related consolidatedstatements of operations, changes in shareholders' equity and cash flows foreach of the three years in the period ended December 31, 2002. These financialstatements are the responsibility of the Company's management. Ourresponsibility is to express an opinion on these financial statements based onour audits. We did not audit the financial statements of a wholly-ownedsubsidiary, which statements reflect total assets of 2.5% and 2.9% out of totalconsolidated assets as of December 31, 2001 and 2002, respectively and totalrevenues of 28% and 26% out of total consolidated revenues for the years endedDecember 31, 2001 and 2002, respectively. This statement was audited by otherauditors whose report has been furnished to us, and our opinion, insofar as itrelates to data included for this subsidiary is based solely on the report ofthe other auditors.

 

We conducted our audits in accordance with auditingstandards generally accepted in the United States. Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits and the report of other auditors provide a reasonable basis for ouropinion.

 

In our opinion, based on our audits and the report ofother auditors, the consolidated financial statements referred to above presentfairly, in all material respects, the consolidated financial position of theCompany and its subsidiaries as of December 31, 2001 and 2002, and theconsolidated results of their operations and cash flows for each of the threeyears in the period ended December 31, 2002, in conformity with accountingprinciples generally accepted in the United States.

 

 

 

 

 
| Tel-Aviv, Israel                                                 | KOST FORER &  GABBAY              |
|------------------------------------------------------------------|---------------------------------------|
| January 23, 2003

(Except for Note 15 which date is May 1, 2003) | A Member of Ernst  & Young Global |

 

**___2___** 

** **

**CONSOLIDATED BALANCESHEETS**

**U.S. dollars in thousands**

 

 
|                                                                                       |   | December 31,   |
|--------------------------------------------------------------------------------------------|--------|----------------|
|                                                                                       |   | 2001           |   | 2002 |
| ASSETS                                                                                     |   |           |   |   |
|                                                                                       |   |           |   |   |
| CURRENT ASSETS:                                                                            |   |           |   |   |
| Cash and cash equivalents                                                                  |   | $ 75,914  |   | $ 29,833 |
| Short-term bank deposits                                                                   |   | ---            |   | 23,364 |
| Short-term marketable   securities (Note 3)                                                |   | 4,137          |   | 10,836 |
| Trade receivables (net of   allowance for doubtful accounts - $ 102 in 2001 and 2002) |   | 5,125          |   | 4,920 |
| Other accounts receivable and   prepaid expenses                                           |   | 1,008          |   | 1,962 |
| Inventories (Note 4)                                                                       |   | 11,631         |   | 17,100 |
|                                                                                       |   |           |   |   |
| Total current assets                                                                       |   | 97,815         |   | 88,015 |
|                                                                                       |   |           |   |   |
| LONG-TERM INVESTMENTS:                                                                     |   |           |   |   |
| Severance pay funds                                                                        |   | 1,338          |   | 1,763 |
| Long-term marketable   securities (Note 3)                                                 |   | 17,185         |   | 30,061 |
| Long-term investments (Note 5)                                                             |   | 10,391         |   | 10,616 |
|                                                                                       |   |           |   |   |
| Total long-term investments                                                                |   | 28,914         |   | 42,440 |
|                                                                                       |   |           |   |   |
| PROPERTY AND EQUIPMENT, NET (Note 6)                                                       |   | 17,206         |   | 16,756 |
|                                                                                       |   |           |   |   |
| GOODWILL (Note 7a)                                                                         |   | 477            |   | 477 |
|                                                                                       |   |           |   |   |
| OTHER INTANGIBLE ASSETS, NET (Note 7b)                                                     |   | 1,039          |   | 514 |
|                                                                                       |   |           |   |   |
| Total assets                                                                               |   | $ 145,451 |   | $ 148,202 |
|                                                                                       |   |           |   |   |

 

 

 

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

 

**___3___** 

 

**CONSOLIDATED BALANCESHEETS**

**U.S. dollars in thousands, except share data**

 

 
|                                                                                                                                                                                                                             |   | December 31,   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------|
|                                                                                                                                                                                                                             |   | 2001           |   | 2002 |
|                                                                                                                                                                                                                             |   |           |   |   |
| LIABILITIES AND SHAREHOLDERS' EQUITY                                                                                                                                                                                             |   |           |   |   |
|                                                                                                                                                                                                                             |   |           |   |   |
| CURRENT LIABILITIES:                                                                                                                                                                                                             |   |           |   |   |
| Trade payables                                                                                                                                                                                                                   |   | $ 2,796   |   | $ 8,044 |
| Deferred revenues                                                                                                                                                                                                                |   | 2,919          |   | 4,759 |
| Other accounts payable and   accrued expenses (Note 8)                                                                                                                                                                           |   | 4,836          |   | 4,915 |
|                                                                                                                                                                                                                             |   |           |   |   |
| Total current liabilities                                                                                                                                                                                                        |   | 10,551         |   | 17,718 |
|                                                                                                                                                                                                                             |   |           |   |   |
| ACCRUED SEVERANCE PAY                                                                                                                                                                                                            |   | 1,849          |   | 2,194 |
|                                                                                                                                                                                                                             |   |           |   |   |
| COMMITMENTS AND CONTINGENT LIABILITIES (Note 9)                                                                                                                                                                                  |   |           |   |   |
|                                                                                                                                                                                                                             |   |           |   |   |
| SHAREHOLDERS' EQUITY (Note 10):                                                                                                                                                                                                  |   |           |   |   |
| Share capital:                                                                                                                                                                                                                   |   |           |   |   |
| Ordinary shares of NIS 0.001   par value: Authorized - 100,000,000 shares as of December 31, 2001 and 2002;   Issued and outstanding - 26,860,379 shares as of December 31, 2001 and   27,485,361 shares as of December 31, 2002 |   | 8              |   | 8 |
| Additional paid-in capital                                                                                                                                                                                                       |   | 184,648        |   | 185,387 |
| Accumulated deficit                                                                                                                                                                                                              |   | (51,605)       |   | (57,105) |
|                                                                                                                                                                                                                             |   |           |   |   |
| Total shareholders' equity                                                                                                                                                                                                       |   | 133,051        |   | 128,290 |
|                                                                                                                                                                                                                             |   |           |   |   |
| Total liabilities and shareholders' equity                                                                                                                                                                                       |   | $ 145,451 |   | $ 148,202 |
|                                                                                                                                                                                                                             |   |           |   |   |

 

 

The accompanying notes are an integral part of theconsolidated financial statements.

 

**___4___** 

 

**CONSOLIDATED STATEMENTSOF OPERATIONS**

**U.S. dollars in thousands, except share and per sharedata**

 

 
|                                                               |   | Year ended December 31, |
|--------------------------------------------------------------------|--------|-------------------------|
|                                                               |   | 2000                    |   | 2001 |   | 2002 |
|                                                               |   |                    |   |   |   |   |
| Revenues (Note 14)                                                 |   | $ 92,589           |   | $ 44,678 |   | $ 64,817 |
| Cost of revenues                                                   |   | 64,281                  |   | 30,356 |   | 44,415 |
| Inventory write-down (Note 4)                                      |   | ---                     |   | 30,217 |   | --- |
|                                                               |   |                    |   |   |   |   |
| Gross profit (loss)                                                |   | 28,308                  |   | (15,895) |   | 20,402 |
|                                                               |   |                    |   |   |   |   |
| Operating expenses:                                                |   |                    |   |   |   |   |
|                                                               |   |                    |   |   |   |   |
| Research and development, net (Note 13a)                           |   | 7,364                   |   | 13,290 |   | 11,974 |
| Selling and marketing                                              |   | 11,535                  |   | 12,122 |   | 12,547 |
| General and administrative                                         |   | 2,809                   |   | 3,913 |   | 4,000 |
| In-process research and development write off                      |   | 6,215                   |   | --- |   | --- |
|                                                               |   |                    |   |   |   |   |
| Total operating expenses                                           |   | 27,923                  |   | 29,325 |   | 28,521 |
|                                                               |   |                    |   |   |   |   |
| Operating income (loss)                                            |   | 385                     |   | (45,220) |   | (8,119) |
| Other expenses                                                     |   | ---                     |   | (1,193) |   | --- |
| Financial income, net (Note 13b)                                   |   | 5,875                   |   | 4,628 |   | 2,619 |
|                                                               |   |                    |   |   |   |   |
| Income (loss) before minority interest in losses of a   subsidiary |   | 6,260                   |   | (41,785) |   | (5,500) |
| Minority interest in losses of a subsidiary                        |   | 19                      |   | --- |   | --- |
|                                                               |   |                    |   |   |   |   |
| Net income (loss)                                                  |   | $ 6,279            |   | $ (41,785) |   | $ (5,500) |
|                                                               |   |                    |   |   |   |   |
| Basic net earnings (loss) per share (Note 11)                      |   | $ 0.25             |   | $ (1.56) |   | $ (0.20) |
|                                                               |   |                    |   |   |   |   |
| Diluted net earnings (loss) per share (Note 11)                    |   | $ 0.22             |   | $ (1.56) |   | $ (0.20) |

 

 

 

 

The accompanying notes are an integral part of theconsolidated financial statements.

 

**___5___** 

**STATEMENTS OF CHANGES INSHAREHOLDERS' EQUITY**

**U.S. dollars in thousands**
|                                                                     |   | Share capital |   | Additional

paid-in

capital |   | Treasury

Stock |   | Accumulated

other

comprehensive income  (loss) |   | Accumulated deficit |   | Total

comprehensive income  (loss) |   | Total

shareholders'

equity |
|--------------------------------------------------------------------------|--------|---------------|--------|------------------------------|--------|-----------------|--------|--------------------------------------------------|--------|---------------------|--------|-------------------------------------|--------|------------------------------|
|                                                                     |   |          |   |                         |   |            |   |                                             |   |                |   |                                |   |                         |
| Balance as of January 1, 2000                                            |   | $ 4      |   | $ 38,307                |   | $ (4,738)  |   | $ ---                                       |   | $ (16,099)     |   |                                |   | $ 17,474                |
| Issuance of shares, net                                                  |   | 1             |   | 148,225                      |   | ---             |   | ---                                              |   | ---                 |   |                                |   | 148,226                      |
| Exercise of warrants to investors                                        |   | *) ---        |   | *) ---                       |   | ---             |   | ---                                              |   | ---                 |   |                                |   | ---                          |
| Exercise of options                                                      |   | *) ---        |   | 827                          |   | ---             |   | ---                                              |   | ---                 |   |                                |   | 827                          |
| Stock split effected as stock dividend (100%)                            |   | 3             |   | (3)                          |   | ---             |   | ---                                              |   | ---                 |   |                                |   | ---                          |
| Comprehensive income (loss):                                             |   |          |   |                         |   |            |   |                                             |   |                |   |                                |   |                         |
| Unrealized losses on available for sale marketable  securities           |   | ---           |   | ---                          |   | ---             |   | (7)                                              |   | ---                 |   | $ (7)                          |   | (7)                          |
| Net income                                                               |   | ---           |   | ---                          |   | ---             |   | ---                                              |   | 6,279               |   | 6,279                               |   | 6,279                        |
| Total comprehensive income                                               |   |          |   |                         |   |            |   |                                             |   |                |   | $ 6,272                        |   |                         |
|                                                                     |   |          |   |                         |   |            |   |                                             |   |                |   |                                |   |                         |
| Balance as of December 31, 2000                                          |   | 8             |   | 187,356                      |   | (4,738)         |   | (7)                                              |   | (9,820)             |   |                                |   | 172,799                      |
| Exercise of options                                                      |   | *) ---        |   | 562                          |   | ---             |   | ---                                              |   | ---                 |   |                                |   | 562                          |
| Reversal of accrued issuance expenses                                    |   | ---           |   | 1,315                        |   | ---             |   | ---                                              |   | ---                 |   |                                |   | 1,315                        |
| Issuance of shares related to employees stock purchase  plan             |   | *) ---        |   | 153                          |   | ---             |   | ---                                              |   | ---                 |   |                                |   | 153                          |
| Cancellation of treasury stock                                           |   | ---           |   | (4,738)                      |   | 4,738           |   | ---                                              |   | ---                 |   |                                |   | ---                          |
| Comprehensive income (loss):                                             |   |          |   |                         |   |            |   |                                             |   |                |   |                                |   |                         |
| Reclassification adjustment to available for sale  marketable securities |   | ---           |   | ---                          |   | ---             |   | 7                                                |   | ---                 |   | $ 7                            |   | 7                            |
| Net loss                                                                 |   | ---           |   | ---                          |   | ---             |   | ---                                              |   | (41,785)            |   | (41,785)                            |   | (41,785)                     |
| Total comprehensive loss                                                 |   |          |   |                         |   |            |   |                                             |   |                |   | $ (41,778)                     |   |                         |
|                                                                     |   |          |   |                         |   |            |   |                                             |   |                |   |                                |   |                         |
| Balance as of December 31, 2001                                          |   | 8             |   | 184,648                      |   | ---             |   | ---                                              |   | (51,605)            |   |                                |   | 133,051                      |
| Exercise of options                                                      |   | *) ---        |   | 303                          |   | ---             |   | ---                                              |   | ---                 |   |                                |   |   303              |
| Exercise of warrants to investors                                        |   | *) ---        |   | *) ---                       |   | ---             |   | ---                                              |   | ---                 |   |                                |   | *) ---                       |
| Issuance of shares related to employees stock purchase  plan             |   | *) ---        |   | 436                          |   | ---             |   | ---                                              |   | ---                 |   |                                |   |    436             |
| Net loss                                                                 |   | ---           |   | ---                          |   | ---             |   | ---                                              |   | (5,500)             |   | $ (5,500)                      |   | (5,500)                      |
| Total comprehensive loss                                                 |   |          |   |                         |   |            |   |                                             |   |                |   | $ (5,500)                      |   |                         |
| Balance as of December 31, 2002                                          |   | $ 8      |   | $ 185,387               |   | $ ---      |   | $ ---                                       |   | $ (57,105)     |   |                                |   | $ 128,290               |

* *

*)  Represents an amount lower than $ 1.

The accompanyingnotes are an integral part of the consolidated financial statements.

 

**___6___** 

**CONSOLIDATED STATEMENTSOF CASH FLOWS**

**U.S. dollars in thousands**

 
|                                                                                                  |   | Year ended December 31, |
|-------------------------------------------------------------------------------------------------------|--------|-------------------------|
|                                                                                                  |   | 2000                    |   | 2001 |   | 2002 |
|                                                                                                  |   |                    |   |   |   |   |
| Cash flows from operating activities:                                                                 |   |                    |   |   |   |   |
| Net income (loss)                                                                                     |   | $ 6,279            |   | $ (41,785) |   | $ (5,500) |
| Adjustments required to   reconcile net income (loss) to net cash used in operating activities:       |   |                    |   |   |   |   |
| Depreciation and amortization   of other intangible assets                                            |   | 895                     |   | 2,213 |   | 2,234 |
| Amortization of goodwill                                                                              |   | 19                      |   | 65 |   | --- |
| Accrued interest on short-term   bank deposits                                                        |   | (1,926)                 |   | (783) |   | (502) |
| Interest accrued and amortization   of premium and discount on held-to-maturity marketable securities |   | (6)                     |   | 27 |   | 167 |
| Write-off of long-term   investment in KeyNetica Inc.                                                 |   | ---                     |   | 1,012 |   | --- |
| Write-off of in-process   research and development                                                    |   | 6,215                   |   | --- |   | --- |
| Capital loss from sale of   property and equipment                                                    |   | ---                     |   | 181 |   | --- |
| Gain on sale of available for   sale and held to maturity marketable securities                       |   | ---                     |   | (106) |   | (70) |
| Accrued severance pay, net                                                                            |   | 103                     |   | 15 |   | (80) |
| Minority interest in losses of   a subsidiary                                                         |   | (19)                    |   | --- |   | --- |
| Decrease (increase) in trade   receivables                                                            |   | (1,533)                 |   | 2,031 |   | 205 |
| Decrease (increase) in other   accounts receivable and prepaid expenses                               |   | (245)                   |   | 477 |   | (903) |
| Decrease (increase) in   inventories                                                                  |   | (24,235)                |   | 25,907 |   | (5,469) |
| Increase (decrease) in trade   payables                                                               |   | (2,662)                 |   | (380) |   | 5,248 |
| Increase (decrease) in   deferred revenues                                                            |   | (1,081)                 |   | 1,755 |   | 1,840 |
| Increase (decrease) in other   accounts payable and accrued expenses                                  |   | 2,814                   |   | (455) |   | 79 |
|                                                                                                  |   |                    |   |   |   |   |
| Net cash used in operating activities                                                                 |   | (15,382)                |   | (9,826) |   | (2,751) |
|                                                                                                  |   |                    |   |   |   |   |
| Cash flows from investing   activities:                                                               |   |                    |   |   |   |   |
| Investment in   available-for-sale marketable securities                                              |   | (2,894)                 |   | --- |   | --- |
| Investment in held to maturity   marketable securities                                                |   | ---                     |   | (29,435) |   | (30,955) |
| Purchase of property and   equipment                                                                  |   | (3,192)                 |   | (14,735) |   | (1,292) |
| Investment in long-term lease   deposits                                                              |   | 41                      |   | (50) |   | 7 |
| Loans to employees, net                                                                               |   | (133)                   |   | (64) |   | (76) |
| Proceeds from sale and   maturity of available for sale and held to maturity marketable securities    |   | ---                     |   | 11,092 |   | 11,283 |
| Proceeds from sales of   property and equipment                                                       |   | 22                      |   | 86 |   | 33 |
| Short-term bank deposits, net                                                                         |   | (44,298)                |   | 47,709 |   | (22,862) |
| Investment in private company                                                                         |   | (11,012)                |   | --- |   | (207) |
| Payment for the acquisition of   Fortress' assets (a)                                                 |   | (8,456)                 |   | --- |   | --- |
| Purchase of the minority   interest in a subsidiary                                                   |   | ---                     |   | (235) |   | --- |
|                                                                                                  |   |                    |   |   |   |   |
| Net cash provided by (used in) investing activities                                                   |   | (69,922)                |   | 14,368 |   | (44,069) |

 

 

 

The accompanying notes are an integral part of theconsolidated financial statements.

**___7___** 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**U.S. dollars in thousands**

 

 
|                                                                        |                                                                                          | Year ended December 31, |
|-----------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------|-------------------------|
|                                                                        |                                                                                          | 2000                    |   | 2001 |   | 2002 |
|                                                                        |                                                                                          |                    |   |   |   |   |
| Cash flows from financing activities:                                       |                                                                                          |                    |   |   |   |   |
| Proceeds from issuance of   shares, net                                     |                                                                                          | 149,606                 |   | --- |   | --- |
| Proceeds from exercise of   options                                         |                                                                                          | 827                     |   | 562 |   | 303 |
| Proceeds from issuance of   shares related to employees stock purchase plan |                                                                                          | ---                     |   | 153 |   | 436 |
|                                                                        |                                                                                          |                    |   |   |   |   |
| Net cash provided by financing activities                                   |                                                                                          | 150,433                 |   | 715 |   | 739 |
|                                                                        |                                                                                          |                    |   |   |   |   |
| Increase (decrease) in cash and cash equivalents                            |                                                                                          | 65,129                  |   | 5,257 |   | (46,081) |
| Cash and cash equivalents at the beginning of the year                      |                                                                                          | 5,528                   |   | 70,657 |   | 75,914 |
|                                                                        |                                                                                          |                    |   |   |   |   |
| Cash and cash equivalents at the end of the year                            |                                                                                          | $ 70,657           |   | $ 75,914 |   | $ 29,833 |
|                                                                        |                                                                                          |                    |   |   |   |   |
| Non-cash activities:                                                        |                                                                                          |                    |   |   |   |   |
| Issuance expenses payable   (reversal)                                      |                                                                                          | $ 1,380            |   | $ (1,315) |   | $ --- |
|                                                                        |                                                                                          |                    |   |   |   |   |
| Realized (unrealized) losses   on available for sale marketable securities  |                                                                                          | $ (7)              |   | $ 7 |   | $ --- |
|                                                                        |                                                                                          |                    |   |   |   |   |   |
| (a)                                                                         | Payment for the acquisition of Fortress U&T Ltd.   assets:                                |                    |   |   |   |   |   |
|                                                                        |  

Estimated fair values of   assets acquired at the date of acquisition are as follows: |                    |   |   |   |   |   |
|                                                                        |                                                                                          |                    |   |   |   |   |   |
|                                                                        | Property and equipment                                                                        |                    | $ 172 |   | $ --- |   | $ --- |
|                                                                        | Core technology                                                                               |                    | 1,243 |   | - |   | - |
|                                                                        | In-process research and   development                                                         |                    | 6,215 |   | - |   | - |
|                                                                        | Assembled workforce                                                                           |                    | 252 |   | - |   | - |
|                                                                        | Goodwill                                                                                      |                    | 326 |   | - |   | - |
|                                                                        | Other assets - patents                                                                        |                    | 248 |   | - |   | - |
|                                                                        |                                                                                          |                    |   |   |   |   |   |
|                                                                        |                                                                                          |                    | $ 8,456 |   | $ --- |   | $ --- |
|                                                                        |                                                                                          |                    |   |   |   |   |   |

 

 

The accompanying notes are an integral part of theconsolidated financial statements.

 

**___8___** 

 

# NOTE 1:- GENERAL

M-Systems Flash Disk Pioneers Ltd. ("theCompany") is a developer, manufacturer and marketer of innovative datastorage products, known as flash disks. The Company's flash disks provide thefunctionality of a mechanical hard drive on a solid state silicon chip. TheCompany's products are based on its patented TrueFFS technology and include theDiskOnChip, DiskOnKey, and Fast Flash Disk (FFD) product families. DiskOnChip isprimarily targeted at the High-End Mobile Devices and Embedded Devices Markets,while the FFD product line is primarily targeted at military systems andnetwork infrastructure equipment. The DiskOnKey product family is targeted atthe PC and laptop markets (see also Note 14).

As of December 31, 2002, the Company has wholly-ownedsubsidiaries in the United States, Netherlands, Taiwan, U.K., Japan and Israel,and an office in China.

The Company depends on Toshiba as a single source for itsmobile DiskOnChip, DiskOnChip Millennium and DiskOnChip Millennium Plusproducts, and expects to be dependant DiskOnChip on them as a single source forfuture DiskOnChip products. Toshiba not only provides the flash components butalso manufactures and assembles the finished product. The Company is seeking todevelop, with other manufacturers, products that will be comparable to theDiskOnChip although possessing different features and capacity. This willrequire additional hardware and software development, and therefore it is notassured that the Company will be successful in developing such comparableproducts or that such other manufacturers will succeed in delivering products,which are of similar cost, quality and functionality. If Toshiba were to closedown or downsize its flash business, experience manufacturing problems ordelays for any reason, including difficulty in obtaining sufficient rawmaterials, work stoppages, excessive demand for its manufacturing capacity orother causes, the Company may be unable to fill its customers` orders for thisproduct or unable to fulfill them in a timely fashion, which would result inlost sales and significantly lower revenues. 

The Companyrelies on third parties to manufacture and supply components for its products,including the capacitors, printed circuit boards and the application specificintegrated circuit ("ASIC") components used in the DiskOnKey and in some of theDiskOnChip products. For some components, the Company relies on a single sourceof supply.  In particular, it has an agreement with Atmel Sarl, itssingle source for supply of ASIC components for the DiskOnKey products.  Becausethe Company depends on single suppliers for certain key components, and do nothave a long-term supply contract with its suppliers, it faces the risk ofinadequate component supply, price increases, late deliveries and poorcomponent quality, as any supplier may terminate their relationships with theCompany or pursue other relationships with its competitors.  If theCompany was to lose its relationship with these suppliers, the lead timerequired to qualify new suppliers could be as long as six months. Also, if theCompany were to lose its single suppliers or these suppliers are otherwiseunable to satisfy the volume and delivery schedule requirements, it may bedifficult to locate any suppliers who have the ability to develop, manufactureand deliver the specialized components the Company needs for its products inthe desired lead times and quality.

 

**___9___** 

# NOTE 1:- GENERAL (Cont.)

 

**Fortress U&TLtd. ("Fortress")**

In September 2000, the Company acquired certain assets of Fortress, inexchange for $ 8,456 in cash. Fortress was a privately held Israelicompany that was engaged in developing, marketing and selling products for thetechnology security market. The acquisition was accounted for by the purchasemethods of accounting.

The following table summarizes the fair value of the assets acquired inthe acquisition.
| In Process research and development | $ 6,215 |
|-------------------------------------|--------------|
| Assembled workforce                 | 252          |
| Core Technology                     | 1,243        |
| Patents                             | 248          |
| Property and Equipment              | 172          |
| Goodwill                            | 326          |
| Total Purchase Price                | $ 8,456 |

 

In Accordance with FASB Interpretation No. 4 "Applicability of FASBStatement No. 2 to Business Combinations Accounted for by the Purchase Method",the Company recorded a one-time expense in September 2000, in the amount of$ 6,215, to write off in-process research and development acquired fromFortress, for which technological feasibility had not yet been established andfor which no alternative future use existed.

Assembled workforce is amortized using the straight-line method overthe useful life, which is 5 years.

Core technology and patents are amortized using the straight-linemethod over the estimated useful life, which is 3 years.

Goodwill that arose from the acquisition was amortized until December31, 2001, on a five-year straight-line basis.

Pro forma information in accordance with APB-16 "Business Combination"has not been provided, since Fortress` revenues and net income for 1999 and2000 were not material in relation to total consolidated revenues and netincome (loss).

As to the principal markets and customers, see Note 14.

**___10___** 

 

# NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES

The consolidated financial statements have been preparedin accordance with United States generally accepted accounting principles("U.S. GAAP").

**Use ofestimates:**

The preparation of financial statements in conformity withgenerally accepted accounting principles requires management to make estimatesand assumptions that affect the amounts reported in the financial statementsand accompanying notes. Actual results could differ from those estimates.

**Financialstatements in U.S. dollars:**

A majority of the revenues of the Company and itssubsidiaries is generated in U.S. dollars ("dollars"). In addition, asubstantial portion of the Company and its subsidiaries' costs is incurred indollars. Since management believes that the dollar is the primary currency inthe economic environment in which the Company and each of its subsidiariesoperate, the dollar is their functional and reporting currency. Accordingly,monetary accounts maintained in currencies other than the dollar are remeasuredinto U.S. dollars in accordance with Statement of the Financial AccountingStandard No. 52 "Foreign Currency Translation" ("SFAS No.52"). All transaction gains and losses from the remeasurement of monetarybalance sheet items are reflected in the statement of operations as financialincome or expense, as appropriate.

**Principlesof consolidation:**

The consolidated financial statements include the accountsof the Company and its subsidiaries ("the Group"). Intercompanybalances and transactions including profits from inter-company sales not yetrealized outside the group, have been eliminated upon consolidation.

**Cash equivalents:**

Cash equivalents include short-term, highly liquidinvestments that are readily convertible to cash with maturities of threemonths or less, at the date acquired.

**Short-termbank deposits:**

Short-term bank deposits are deposits with maturities ofmore than three months, but less than one year. The short-term bank depositsare presented at their cost, including accrued interest. The deposits are inU.S. dollars and bear annual interest at an average rate of 2.5%.

**Marketablesecurities:**

The Company accounts for investments in marketablesecurities in accordance with Statement of Financial Accounting Standard No.115, "Accounting for Certain Investments in Debt and EquitySecurities" ("SFAS No. 115"). 

Management determines the appropriate classification ofits investments in marketable debt securities at the time of purchase andreevaluates such determinations at each balance sheet date.

Debt securities for which the Company does not have theintent or ability to hold to maturity are classified as available-for-sale,along with any investments in equity securities that have not been classifiedas trading securities. Securities available for sale are carried at fair value,with the unrealized gains and losses, net of income taxes, reported as a separatecomponent of shareholders' equity, accumulated other comprehensive income(loss). Realized gains and losses on sales of investments, as determined on aspecific identification basis, are included in the consolidated statement ofoperations.

Debt securities are classified as held-to-maturity whenthe Company has the positive intent and ability to hold the securities tomaturity and are stated at amortized cost. As of December 31, 2001 and 2002,the Company classified all its marketable securities as held to maturitywhereas in December 31, 2000 all the marketable securities were classified asavailable-for-sale.

The amortized cost of debt securities held to maturity isadjusted for amortization of premiums and accretion of discounts to maturity.Such amortization, interest and decline in value judged to be other thantemporary are included in financial income, net. The cost of securities sold isbased on the specific identification method.

**___11___** 

# NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES(Cont.)

 

**Inventories:**

Inventories are stated at the lower of cost or marketvalue. Inventory write-downs are provided to cover risks arising fromslow-moving items, excess inventories, technological obsolescence or marketprices lower than cost. In 2001, the Company re-evaluated the fair value of itsinventories and wrote-down $ 30,217.

Cost is determined as follows:

Raw materials, parts and supplies - using the movingaverage cost method.

Work in progress and finished products:

Raw materials and components - using the moving averagecost method.

Labor, overhead and subcontracted work - on the basis ofactual costs.

**Investmentin other companies:**

The investment in other companies is stated at cost, sincethe Company does not have the ability to exercise significant influence overoperating and financial policies of the investees.

The Company's investments in other companies are reviewedfor impairment whenever events or changes in circumstances indicate that thecarrying amount of an investment may not be recoverable, in accordance withAccounting Principle Board Opinion No. 18 "The Equity Method of Accountingfor Investments in Common Stock", ("APB No. 18"). During 2001,the Company recorded a write off of its investments in KeyNetica in the amountof $ 1,012. During 2002, based on managements` most recent analyses, noimpairment losses have been identified. 

**Propertyand equipment:**

Property and equipment are stated at cost, net ofaccumulated depreciation. Depreciation is calculated by the straight-linemethod over the estimated useful lives of the assets, at the following annualrates:
|                                              | %                           |
|---------------------------------------------------|-----------------------------|
|                                              |                        |
| Building                                          | 4                           |
| Computers, manufacturing and peripheral equipment | 20 - 33                     |
| Office furniture and equipment                    | 6   - 20          |
| Motor vehicles                                    | 15                          |
| Leasehold improvements                            | Over the term of  the lease |

 

The Company's and its subsidiaries long-lived assets arereviewed for impairment in accordance with Statement of Financial AccountingStandard No. 144 "Accounting for the Impairment for Disposal of Long-LivedAssets" ("SFAS No. 144") whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable.Recoverability of assets to be held and used is measured by a comparison of thecarrying amount of an asset to the future undiscounted cash flows expected tobe generated by the assets. If such assets are considered to be impaired, theimpairment to be recognized is measured by the amount by which the carryingamount of the assets exceeds the fair value of the assets. Assets to bedisposed of are reported at the lower of the carrying amount or fair value lesscosts to sell. As of December 31, 2002, no impairment losses have beenidentified.

**___12___** 

 

# NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES(Cont.)

 

**Otherintangible assets:**

Intangible assets subject to amortization arose fromacquisitions prior July 1, 2001, are being amortized on a straight-line basisover their useful life in accordance with APB Opinion No. 17 "IntangibleAssets" ("APB No. 17") at the following periods:

 
|                 | Weighted average amortization period, in Years |
|----------------------|------------------------------------------------|
|                 |                                           |
| Core Technology      | 3                                              |
| Patents and know-how | 3                                              |
| Other                | 5                                              |
| Total                | 3                                              |

 

Intangible assets acquired in a business combination forwhich date is on or after July 1, 2001, should be amortized over their usefullife using a method of amortization that reflects the pattern in which theeconomic benefits of the intangible assets are consumed or otherwise used up,in accordance with Statement of Financial Accounting Standards No. 142"Goodwill and Other Intangible Assets", ("SFAS No. 142").

The Company's and its subsidiaries long-lived assets arereviewed for impairment in accordance with Statement of Financial AccountingStandard No. 144 "Accounting for the Impairment for Disposal of Long-LivedAssets" ("SFAS No. 144") whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. Recoverability of assets to be held and used is measured by acomparison of the carrying amount of an asset to the future undiscounted cashflows expected to be generated by the assets. If such assets are considered tobe impaired, the impairment to be recognized is measured by the amount by whichthe carrying amount of the assets exceeds the fair value of the assets. Assetsto be disposed of are reported at the lower of the carrying amount or fairvalue less costs to sell.

As of December 31, 2002, no impairment losses have beenidentified.

Goodwill represents excess of the costs over the fairvalue of net assets of businesses acquired. Goodwill that arose fromacquisitions prior to July 1, 2001, was amortized until December 31, 2001, on astraight-line basis over 5 years. Under Statement of Financial AccountingStandard No. 142, "Goodwill and Other Intangible Assets" ("SFAS No.142") goodwill acquired in a business combination for which date is on or afterJuly 1, 2001, shall not be amortized. 

SFAS No. 142 requires goodwill to be tested for impairmenton adoption and at least annually thereafter or between annual tests in certaincircumstances, and written down when impaired, rather than being amortized asprevious accounting standards required. Goodwill attributable to each of thereporting units is tested for impairment by comparing the fair value of eachreporting unit with its carrying value. Fair value is determined usingdiscounted cash flows, market multiples and market capitalization. Significantestimates used in the methodologies include estimates of future cash flows,future short-term and long-term growth rates, weighted average cost of capitaland estimates of market multiples for the reportable unit. Based on its mostrecent analysis, management believes that no impairment of intangible assetsexists as of December 31, 2002.

**Incometaxes:**

The Company and its subsidiaries account for income taxesin accordance with Statement of Financial Accounting Standard No. 109,"Accounting for Income Taxes" ("SFAS No.109"). Thisstatement prescribes the use of the liability method whereby deferred tax assetand liability account balances are determined based on differences betweenfinancial reporting and tax bases of assets and liabilities and are measuredusing the enacted tax rates and laws that will be in effect when thedifferences are expected to reverse. The Company and its subsidiaries provide avaluation allowance, if necessary, to reduce deferred tax assets to theirestimated realizable value.

**___13___** 

 

# NOTE 2:-  SIGNIFICANTACCOUNTING POLICIES (Cont.)

 

**Revenuerecognition:**

The Company and its subsidiaries generate most of theirrevenues from selling their data storage products to end customers, resellersand to Original Equipment Manufacturers ("OEM").

Revenues from product sales are recognized in accordancewith Staff Accounting Bulletin No. 101 "Revenue Recognition in FinancialStatements" ("SAB 101") when delivery has occurred, persuasiveevidence of an arrangement exists, the vendor's fee is fixed or determinable,no further obligation exists, and collectibility is reasonably assured. Becauseof frequent sales price reductions and rapid technology obsolescence in theindustry, sales are made to distributors and retailers under agreementsallowing price protection and/or right of return and deferred until theretailers or distributors sell the merchandise to the end customer, or theright of return expire. Deferred revenues include amounts received fromcustomers for which revenue has not been recognized.

Revenues from royalties are accounted for uponnotification from licensees that royalties are due.

**Researchand development costs:**

Research and development costs, net of grants received,are charged to the statements of operations as incurred.

**Royaltyand non-royalty bearing grants:**

Royalty-bearing grants from the Government of Israel andothers for funding approved research and development projects and for fundingmarketing activities are recognized at the time the Company and itssubsidiaries are entitled to such grants, based on costs incurred, and arerecorded as a deduction of research and development costs, and selling andmarketing expenses, respectively (see also Note 13a).

In addition, during 2002, the Company receivednon-royalty-bearing grant in the amount of $ 212 for its participation inthe secure mobile payments and services on chip project("SN-PAYSOC").

The grants are not required to be repaid and arerecognized at the time the Company is entitled to such grants, on the basis ofthe costs incurred and are recorded as a deduction of research and developmentexpenses.

**Warrantycosts:**

The Company provides a warranty in a range between 12 to60 months at no extra charge. A provision is recorded for estimated warrantycosts based on the Company's experience. Warranty expenses for the years endedDecember 31, 2000, 2001 and 2002 were approximately $ 200, $ 200 and$ 272, respectively.

**Advertisingexpenses:**

Advertising expenses are charged to the statements of operationsas incurred. Advertising expenses for the years ended December 31, 2000, 2001and 2002 were $ 335, $ 195 and $ 132, respectively.

**Concentrationsof credit risk:**

Financial instruments that potentially subject the Companyand its subsidiaries to concentrations of credit risk consist principally ofcash and cash equivalents, short-term bank deposits, marketable securities andtrade receivables.

Cash and cash equivalents and short-term bank deposits areinvested mainly in  U.S dollars in deposits with major banksworldwide (mainly in Israel, the United States, Cayman, England and France).Such deposits may be in excess of insured limits and are not insured in otherjurisdictions. Management believes that the financial institutions that holdthe investments of the Company and its subsidiaries are financially sound and,accordingly, minimal credit risk exists with respect to these investments.

**___14___** 

 

# NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES(Cont.)

 

The trade receivables of the Company and its subsidiariesare derived from sales to customers located primarily in the United States, theFar East and Europe. The Company and its subsidiaries generally do not requirecollateral; however, in certain circumstances, the Company and its subsidiariesmay require letters of credit, other collateral, additional guarantees oradvanced  payments. The Company and its subsidiaries perform ongoingcredit evaluations of its customers and to date have not experienced materiallosses. An allowance for doubtful accounts is determined with respect tospecific debts that are doubtful of collection.

Investments in marketable securities are conducted throughinvestment banks in France and in the United States, and include investments ingovernment and corporate debts. Management believes that the financialinstitutions that hold the Company's investments are financially sound, theportfolio is well diversified and accordingly, minimal credit risk exists withrespect to these investments.

The Company and its subsidiaries have no significantoff-balance-sheet concentration of credit risk such as foreign exchangecontracts, option contracts or other foreign hedging arrangements.

**Accountingfor stock-based compensation:**

The Company has elected to follow Accounting PrinciplesBoard Opinion No. 25 "Accounting for Stock Issued to Employees"("APB No. 25") and FASB Interpretation No. 44 "Accounting forCertain Transactions Involving Stock Compensation" ("FIN No.44") in accounting for its employee stock option plans. Under APB 25, whenthe exercise price of the Company`s share options is less than the market priceof the underlying shares on the date of grant, compensation expense isrecognized.

Under SFAS 123, pro forma information regarding net income(loss) and net earnings (loss) per share is required, and has been determinedas if the Company had accounted for its employee stock options under the fairvalue method of that Statement. The fair value for these options was estimatedat the date of grant using a Black-Scholes Option pricing model, with thefollowing weighted- average assumptions for each of the years ended December31, 2000, 2001 and 2002: expected volatility of 108%, 104% and 62%,respectively; a risk-free interest rate of 6%, 2% and 1.5%, respectively;dividend yield of 0% for all years; and a weighted-average expected life of3.25 years for all years presented.

For purposes of pro-forma disclosure, the estimated fairvalue of the options is amortized to expenses over the options' vesting periodwhich is four years.

Pro forma information under SFAS 123:
|                                                                                        |   | Year ended December 31, |
|---------------------------------------------------------------------------------------------|--------|-------------------------|
|                                                                                        |   | 2000                    |   | 2001 |   | 2002 |
|                                                                                        |   |                    |   |   |   |   |
| Net income (loss) as reported                                                               |   | $ 6,279            |   | $ (41,785) |   | $ (5,500) |
|                                                                                        |   |                    |   |   |   |   |
| Add: stock-based compensation expenses included in  reported net income (loss)              |   | ---                     |   | --- |   | --- |
| Deduct: stock-based compensation expense determined under  fair value method for all awards |   | 3,318                   |   | 4,580 |   | 4,475 |
|                                                                                        |   |                    |   |   |   |   |
| Pro forma net income (loss)                                                                 |   | $ 2,961            |   | $ (46,365) |   | $ (9,975) |
|                                                                                        |   |                    |   |   |   |   |
| Pro forma basic net earnings (loss) per share                                               |   | $ 0.12             |   | $ (1.74) |   | $ (0.37) |
|                                                                                        |   |                    |   |   |   |   |
| Pro forma diluted net earnings (loss) per share                                             |   | $ 0.11             |   | $ (1.74) |   | $ (0.37) |

**___15___** 

 

# NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES(Cont.)

 

**Severancepay:**

The Company`s liability for severance pay is calculatedpursuant to Israeli and Taiwanese severance pay laws as applicable to therelevant employees, based on the most recent salary of the employees multipliedby the number of years of employment, as of the balance sheet date. Employeesare entitled to one month's salary for each year of employment or a portionthereof. The Company's liability for all of its employees in Israel, is fullycovered by monthly deposits with severance pay funds, insurance policies and byan accrual. The value of those policies is recorded as an asset in theCompany's balance sheet.

The Company's liability for all of its employees in Taiwanis not covered by deposits with severance pay funds or insurance policies, butonly by an accrual.

The deposited funds include profits accumulated up to thebalance sheet date. The deposited funds may be withdrawn only upon thefulfillment of the obligation pursuant to Israeli severance pay law or laboragreements. The value of the deposited funds is based on the cash surrenderedvalue of these policies, and includes immaterial profits.

Severance expenses for the years ended December 31, 2000,2001 and 2002, amounted to approximately $ 464, $ 501 and $ 531,respectively.

**Fair valueof financial instruments:**

The following methods and assumptions were used by theCompany and its subsidiaries in estimating their fair value disclosures forfinancial instruments:

The carrying amounts of cash and cash equivalents,short-term bank deposits, trade receivables and trade payables approximatetheir fair value due to the short-term maturities of such instruments. 

As of December 31, 2001 and 2002, the fair value ofmarketable securities was based on the quoted market prices.

**Basic anddiluted net earnings (loss) per share:**

Basic net earnings (loss) per share is computed based onthe weighted average number of Ordinary shares outstanding during each year.Diluted net earnings per share is computed based on the weighted average numberof Ordinary shares outstanding during each year, plus dilutive potentialOrdinary shares considered outstanding during the year, in accordance withStatement Financial Accounting Standard No. 128, "Earnings Per Share"("SFAS No. 128").

The total weighted average number of shares related to theoutstanding options and warrants excluded from the calculations of diluted netearnings (loss) per share since they had an anti-dilutive effect was 1,237,3,519,902 and 3,635,851 for 2000, 2001 and 2002, respectively.

**Impact ofrecently issued accounting standard:**

In April 2002, the FASB issued SFAS No. 145,"Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASBStatement No. 13, and Technical Corrections," which rescinds SFAS No. 4,"Reporting Gains and Losses from Extinguishment of Debt" and anamendment of that Statement, and SFAS No. 64, "Extinguishments of Debt Madeto Satisfy Sinking-Fund Requirements." SFAS No. 145 also rescinds SFAS No.44, "Accounting for Intangible Assets for Motor Carriers." SFAS No.145 amends SFAS No. 13, "Accounting for Leases," to eliminate aninconsistency between the required accounting for sale-leaseback transactionsand the required accounting for certain lease modifications that have economiceffects that are similar to sale-leaseback transactions. SFAS No. 145 alsoamends other existing authoritative pronouncements to make various technicalcorrections, clarify meanings, or describe their applicability under changedconditions. SFAS No. 145 is effective for fiscal years beginning after May 15,2002. The Company does not expect the adoption of SFAS No. 145 to have amaterial impact on its results of operations or financial position. 

In June 2002, the FASB issues SFAS No. 146,"Accounting for Costs Associated with Exit or Disposal Activities,"which addresses significant issue regarding the recognition, measurement, andreporting of costs associated with exit and disposal activities, includingrestructuring activities. SFAS No. 146 requires that costs associated with exitor disposal activities be recognized when they are incurred rather than at thedate of a commitment to an exit or disposal plan. SFAS No. 146 is effective forall exit or disposal activities initiated after December 31, 2002. The Companydoes not expect the adoption of SFAS No. 146 to have a material impact on ourresults of operations or financial position. 

**___16___** 

 

# NOTE 2:- SIGNIFICANT ACCOUNTING POLICIES(Cont.)

 

In November 2002, the FASB issued FASB Interpretation No.45, "Guarantor's Accounting and Disclosure Requirements for Guarantees,Including Indirect Guarantees of Indebtedness of Others, an interpretation ofFASB Statements No. 5, 57, and 107 and Rescission of FASB Interpretation No.34" ("FIN No. 45"). FIN No. 45 elaborates on the disclosures tobe made by a guarantor in its interim and annual financial statements about itsobligations under certain guarantees that it has issued. It also clarifies thata guarantor is required to recognize, at the inception of a guarantee, aliability for the fair value of the obligation undertaken in issuing theguarantee. FIN No. 45 does not prescribe a specific approach for subsequentlymeasuring the guarantor's recognized liability over the term of the relatedguarantee. It also incorporates, without change, the guidance in FASBInterpretation No. 34, "Disclosure of Indirect Guarantees of Indebtednessof Others," which is being superseded. The disclosure provisions of FINNo. 45 are effective for financial statements of interim or annual periods thatend after December 15, 2002 and the provisions for initial recognition andmeasurement are effective on a prospective basis for guarantees that are issuedor modified after December 31, 2002, irrespective of a guarantor's year-end.The Company does not expect the adoption of FIN No. 45 to have a materialimpact on its results of operations or financial position.

 

 

**___17___** 

# NOTE 3:- MARKETABLE SECURITIES

 

The following is a summary of held-to-maturity marketablesecurities:

 
|                  | December 31,    |
|-----------------------|-----------------|
|                  | 2001            | 2002 |
|                  | Amortized

cost | Gross

Unrealized

Gains | Gross

unrealized

losses | Estimated

fair

market

value | Amortized

cost | Gross

unrealized

gains | Gross

unrealized

losses | Estimated

fair

market

value |
|                  |
|                  |
|                  |
| **Held-to-maturity:** |            |   |   |   |   |   |   |   |
|                  |            |   |   |   |   |   |   |   |
| Government debts      | $ ---      | $ --- | $ --- | $ --- | $ 10,041 | $ 434 | $ (9) | $ 10,466 |
|                  |            |   |   |   |   |   |   |   |
| Corporate debts       | 21,322          | 662 | (365) | 21,619 | 30,856 | 975 | --- | 31,831 |
|                  |            |   |   |   |   |   |   |   |
|                  | $ 21,322   | $ 662 | $ (365) | $ 21,619 | $ 40,897 | $ 1,409 | $ (9) | $ 42,297 |

 

Aggregate maturities of held-to-maturity securities foryears subsequent to December 31, 2002 are:

 
|                                     |   | December 31, 2002 |
|------------------------------------------|--------|-------------------|
|                                     |   | Amortized cost    |   | Estimated fair market value |
| **Held-to-maturity:**                    |   |              |   |   |
|                                     |   |              |   |   |
| 2003 (short-term marketable  securities) |   | $ 10,836     |   | $ 10,991 |
| 2004                                     |   | 1,016             |   | 1,071 |
| 2005                                     |   | 10,342            |   | 10,810 |
| 2006                                     |   | 8,325             |   | 8,822 |
| 2007                                     |   | 7,279             |   | 7,484 |
| 2008                                     |   | 3,099             |   | 3,119 |
|                                     |   |              |   |   |
|                                     |   | $ 40,897     |   | $ 42,297 |
|                                     |   |              |   |   |

 

The net adjustment to unrealized holding gains (losses) onavailable-for-sale securities included as a separate component of shareholders'equity called "accumulated other comprehensive losses" amounted to$ (7), $ 7 and $ 0 in 2000, 2001 and 2002, respectively.

During 2002, the Company sold several marketablesecurities in consideration of $ 8,283 and several of the securities wereredeemed in consideration of $ 3,000. The marketable securities were soldbefore their maturity, due to deterioration of their credit rating. As a resultof the sale, the Company recorded gain in the amount of $ 70 in thefinancial income.

**___18___** 

# NOTE 4:- INVENTORIES

 
|              |   | December 31,  |
|-------------------|--------|---------------|
|              |   | 2001          |   | 2002 |
|              |   |          |   |   |
| Raw materials     |   | $ 1,832  |   | $ 3,021 |
| Work in progress  |   | 681           |   | 3,367 |
| Finished products |   | 9,118         |   | 10,712 |
|              |   |          |   |   |
|              |   | $ 11,631 |   | $ 17,100 |
|              |   |          |   |   |

 

During 2001, as a result of a sharp reduction in theprices of flash components, and the economic slowdown that caused a decline inthe Company's sales resulting in prolonged inventory cycles, the Companyre-evaluated the fair value of its inventories and recorded an inventorywrite-down in the cost of revenues at an approximate amount of $ 30,217.

 

# NOTE 5:- LONG-TERM INVESTMENTS

 
|                                         |   | December 31,  |
|----------------------------------------------|--------|---------------|
|                                         |   | 2001          |   | 2002 |
|                                         |   |          |   |   |
| Investment in Saifun Semiconductors Ltd. (1) |   | $ 10,000 |   | $ 10,000 |
| Investment in KeyNetica Inc. (2)             |   | ---           |   | --- |
| Investment in Phison Electronics Corp. (3)   |   | ---           |   | 207 |
| Employee loans and lease deposits            |   | 391           |   | 409 |
|                                         |   |          |   |   |
|                                         |   | $ 10,391 |   | $ 10,616 |

 

(1) In October 2000, the Company purchased 2.5% of theoutstanding Preferred B shares of NIS 0.01 par value of Saifun SemiconductorsLtd. ("Saifun") in consideration of $ 10,000. 

Saifun is a privately held Israeli company engaged inresearch, development, production and marketing of flash memory products andtechnology. Saifun`s founder, Chief Executive Officer and director was, upuntil December 2002, a member of the Board of Directors of the Company.

 

(2) In August 2000, the Company purchased 400,000Preferred A shares of $ 0.001 par value, representing approximately 19% ofthe outstanding shares, of KeyNetica Inc. ("KeyNetica"), inconsideration of $ 412. In addition, the Company provided a convertibleloan to KeyNetica in the amount of $ 600. 

On March 31, 2001, the Company decided to impair all ofits investments in Preferred A shares in KeyNetica and to write-off theconvertible loan, based on several indicators which supported KeyNetica`sinability to continue as a going concern. The Company recorded in the otherexpenses, a capital loss in the amount of $ 1,012, resulting fromassessing the impairment loss based upon the difference between the carryingamount and the fair value of the investment, as evaluated by the Company.

 

(3) During the first quarter of 2002, the Company signed ashare purchase agreement with Phison Electronics Corp. ("Phison") a Taiwanesecompany, to purchase 550,000 Preferred shares TWD 10 par value in considerationof $ 600.

In April 2002, the Company purchased 184,000 Preferredshares of TWD 10 par value of Phison in consideration of $ 207. The investmentrepresents approximately 2% of the outstanding shares of Phison. 

**___19___** 

 

# NOTE 6:- PROPERTY AND EQUIPMENT, NET

 
|                                                |   | December 31, |
|-----------------------------------------------------|--------|--------------|
|                                                |   | 2001         |   | 2002 |
| Cost:                                               |   |         |   |   |
| Land and building (1)                               |   | $ 14,475     |   | $ 14,633 |
| Computers, manufacturing and   peripheral equipment |   | 5,029        |   | 6,042 |
| Office furniture and equipment                      |   | 1,551        |   | 1,639 |
| Motor vehicles                                      |   | 257          |   | 182 |
| Leasehold improvements (1)                          |   | 433          |   | 433 |
|                                                |   |         |   |   |
|                                                |   | 21,745       |   | 22,929 |
|                                                |   |         |   |   |
| Accumulated depreciation                            |   | 4,539        |   | 6,173 |
|                                                |   |         |   |   |
| Depreciated cost                                    |   | $   17,206   |   | $   16,756 |
|                                                |   |         |   |   |

 

(1) In April 2001, the Company acquired its facility andnearby land in Kfar Saba, Israel, in consideration of approximately $ 10,500.In addition, the Company reclassified during 2001 the leasehold improvementsrelated to the facility in Kfar-Saba in the amount of $ 3,290 to the costof the building.

a. As for charges, see Note 9.

b. Depreciation expenses for the years ended December 31,2000, 2001 and 2002, were $ 820, $ 1,584 and $ 1,709,respectively.

 

**___20___** 

 

# NOTE 7:- OTHER INTANGIBLE ASSETS, NET 

 

**a.Goodwill:**
|                     |   | December 31, |
|--------------------------|--------|--------------|
|                     |   | 2001         |   | 2002 |
|                     |   |         |   |   |
| Original amount          |   | $ 561   |   | $ 561 |
| Accumulated amortization |   | 84           |   | 84 |
|                     |   |         |   |   |
| Amortized cost           |   | $ 477   |   | $ 477 |
|                     |   |         |   |   |

 

In June 1998, the Company established a subsidiary in Japan, M-SystemsFlash Disk Pioneers (Japan), Inc. ("MSJ"). The Company owned 67% ofthis company. In June 2001, the Company exercised its option and purchased allshares of MSJ held by minority for a total cash consideration of $ 235.The acquisition was accounted for on the basis of the purchase method ofaccounting and the purchase price has been allocated to goodwill.

** **

**b.  Otherassets:**
|                      |   | December 31, |
|---------------------------|--------|--------------|
|                      |   | 2001         |   | 2002 |
| Original amount:          |   |         |   |   |
|                      |   |         |   |   |
| Core Technology           |   | $ 1,243 |   | $ 1,243 |
| Patents and know-how      |   | 248          |   | 248 |
| Other                     |   | 252          |   | 252 |
|                      |   |         |   |   |
|                      |   | 1,743        |   | 1,743 |
| Accumulated Amortization: |   |         |   |   |
|                      |   |         |   |   |
| Core technology           |   | 535          |   | 931 |
| Patents and know-how      |   | 104          |   | 185 |
| Other                     |   | 65           |   | 113 |
|                      |   |         |   |   |
|                      |   | 704          |   | 1,229 |
|                      |   |         |   |   |
| Amortized cost            |   | $ 1,039 |   | $ 514 |
|                      |   |         |   |   |

** **

In September 2000, the Company acquired the business andassets of Fortress U&T Ltd. ("Fortress"), in exchange for $ 8,456 incash. Fortress was a privately held Israeli company that was engaged in datasecurity technologies.

The acquisition was treated on the basis of the purchasemethod of accounting in accordance with Accounting Principle Board Opinion No.16 "Business Combinations" ("APB No. 16") and accordinglythe purchase price, in the total amount of $ 8,456, has been allocatedaccording to the estimated fair value of the assets acquired. 

The Company recorded a one-time expense in September 2000,in the amount of $ 6,215, to write off in-process research and developmentacquired from Fortress, for which technological feasibility had not yet beenestablished and for which no alternative future use existed.

**___21___** 

 

 

# NOTE 7:- OTHER INTANGIBLE ASSETS, NET(Cont.)

** **

**c.Amortization expense amounted to $ 94, $ 694 and $ 525 for theyears ended December 31, 2000, 2001 and 2002, respectively.**

 

**d.Estimated amortization expenses for the year ended:**
|   | December 31, |
|--------|--------------|
|   |         |
|   |         |
| 2003   | $ 424   |
| 2004   | $ 51    |
| 2005   | $ 39    |

 

 

# NOTE 8:- OTHER ACCOUNTS PAYABLE ANDACCRUED EXPENSES

 
|                           |   | December 31, |
|--------------------------------|--------|--------------|
|                           |   | 2001         |   | 2002 |
|                           |   |         |   |   |
| Employees and payroll accruals |   | $ 2,191 |   | $ 2,187 |
| Accrued expenses               |   | 2,139        |   | 2,130 |
| Accrued royalty expenses       |   | 166          |   | 166 |
| Provision for warranty         |   | 200          |   | 272 |
| ESPP                           |   | 52           |   | 59 |
| Other                          |   | 88           |   | 101 |
|                           |   |         |   |   |
|                           |   | $ 4,836 |   | $ 4,915 |
|                           |   |         |   |   |

 

 

**___22___** 

# NOTE 9:- COMMITMENTS AND CONTINGENTLIABILITIES

 

**Royaltycommitments:**

a. Under the Company's research and development agreementswith the Office of the Chief Scientist ("OCS"), the Bi-nationalIndustrial Research and Development Foundation ("BIRD-F") andSingapore-Israel Industrial Research and Development ("SIIRD"), theCompany is required to pay royalties at the rate of 1.5%-5% of sales ofproducts developed with funds provided by the OCS, BIRD-F and SIIRD and incertain circumstances may be required to pay royalties at the rate of 30% underthe agreement with SIIRD, up to an amount equal to 150% of the OCS and BIRD-Fand 100% of the SIIRD research and development grants (dollar-linked) relatedto such projects. The obligation to pay these royalties is contingent on actualsales of the products and in the absence of such sales, no payment is required.Royalties payable with respect to grants received under programs approved bythe OCS after January 1, 1999, are subject to interest on the U.S.dollar-linked value of the total grants received at the annual rate of LIBORapplicable to U.S. dollar deposits. Royalties payable with respect to grantsreceived under programs approved by the BIRD-F, are linked to the ConsumerPrice Index in the United States.

The Company has expensed royalties relating to repaymentof grants from the OCS, BIRD-F and SIIRD of $ 312, $ 0 and $ 0for the years ended December 31, 2000, 2001 and 2002, respectively. Theroyalties were recorded in the cost of revenues.

As of December 31, 2002, the Company had an outstandingcontingent obligation to pay royalties of $ 281, in respect of thesegrants.

b. The Israeli Government, through the Fund forEncouragement of Marketing Activities, and the BIRD-F awarded the Company andits U.S. subsidiary grants for participation in expenses for overseasmarketing. The Company is committed to pay royalties to the Fund forEncouragement of Marketing Activities at the rate of 3% on the increase inexport sales, up to the amount of the grants received by the Company linked tothe dollar and to the BIRD-F as described in paragraph a. above.

The Company has expensed royalties relating to repaymentof grants from the Fund for Encouragement of Marketing Activities and theBIRD-F of $ 66, $ 5 and $ 0 for the years ended December 31,2000, 2001 and 2002, respectively. The royalties were recorded in the cost ofrevenues.

As of December 31, 2002, the Company had outstandingobligations to pay royalties of $ 166 in respect of these grants.

**Leasecommitments:**

The Company's facilities in Omer, its subsidiariesfacilities and its vehicles are leased under several operating leaseagreements, which expire on various dates, the latest of which is in 2005 .

Future minimum lease commitments under non-cancelableoperating leases, are as follows:

 
|   |   | Year ended December 31, |
|--------|--------|-------------------------|
|   |   | Facilities              |   | Vehicles |   | Total |
|   |   |                    |   |   |   |   |
| 2003   |   | $ 363              |   | $ 666 |   | $ 1,029 |
| 2004   |   | 369                     |   | 375 |   | 744 |
| 2005   |   | 305                     |   | 122 |   | 427 |
|   |   |                    |   |   |   |   |
|   |   | $ 1,037            |   | $ 1,163 |   | $ 2,200 |
|   |   |                    |   |   |   |   |

 

Facilities lease expenses for the years ended December 31,2000, 2001 and 2002, were approximately $ 798, $ 384 and $ 456,respectively.

Vehicles lease expenses for the years ended December 31,2000, 2001 and 2002 were approximately $ 234, $ 606 and $ 763,respectively.

 

**___23___** 

# NOTE 9:- COMMITMENTS AND CONTINGENTLIABILITIES (Cont.)

 

**Guarantees:**

The Company issued a guarantee in the amount of $ 127in connection with a lawsuit against one of its suppliers.

The Company has provided additional guarantees in theamount of approximately $ 30 in connection with its subsidiary's bank account.

**Lines ofcredit:**

As of December 31, 2002, the Company has authorized andavailable credit lines of $ 4,000 from banks.

In connection with the credit lines, the Company agreednot to place any liens on its assets without the respective bank's consent.

**Charges:**

The land and the building are free and clear of allencumbrances except for a mortgage taken out by the sellers of the buildingfrom Bank Leumi. The outstanding balance of that mortgage on the land and thebuilding 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 applied to pay off the mortgage andremove the lien.

 

**___24___** 

# NOTE 10:- SHAREHOLDERS' EQUITY

 

The Ordinaryshares of the Company are traded on NASDAQ National Market.

 

**General:**

The Ordinary shares entitle their holders to receivenotice to participate and vote in general meetings of the Company, the right toshare in distribution upon liquidation of the Company, and to receivedividends, if declared.

In July 1999, the Company issued an aggregate of 1,818,182Ordinary shares to investors for net proceeds of $ 4,753. The Company alsogranted to the investors warrants, exercisable into 1,038,962 Ordinary shares,at a price of $ 2.875 per share. The warrants were exercisable untilDecember 31, 2002. On April 1, 2000, 415,584 warrants were exercised to 383,508shares due to a cashless exercise mechanism and on December 31, 2002, theremaining 623,378 warrants were exercised to 406,140 shares also due to acashless exercise mechanism. 

In March 2000, the Company issued 4,735,000 Ordinaryshares at $ 34.125 per share in consideration of net proceeds ofapproximately $ 148,226 in a public offering.

In September 2000, the Company's Board of Directors hasapproved a two-for-one stock split effected as a 100% stock dividend from theCompany's additional paid-in capital. All Ordinary shares, options, warrantsand per share data have been retroactively adjusted for all periods presented.

**Stockoption plans:**

The Company has two share incentive and stock option plansfor directors, officers, employees, consultants and contractors of the Companyand its subsidiaries (the plans were adopted on February 16, 1993):

 

a. Incentive and restricted stock options ("the IRSOplan"):

Options to purchase 3,000,000 Ordinary shares may, fromtime to time, be granted to employees, directors, consultants and contractorsof the Company. Options granted under the IRSO plan in accordance with theterms thereof will be qualified as incentive stock options. As of December 31,2002, 1,324,384 options are available for future grant. Any options which arecanceled or forfeited before expiration become available for future grant.

The exercise price per share for a restricted stock optionis to be determined by the Board of Directors, but may not be less than thelower of 75% of the market value of the Ordinary shares on the date the optionis granted, or 75% of the book value per share of the Ordinary shares at theend of the year.

The options vest over a period of four years; 50% aftertwo years, and an additional 25% per each year thereafter.

The options granted generally expire no later than tenyears from the date of grant. This plan expires in 2003.

 

b. Employee Stock Options Plan ("the ESOP plan"):

Under the ESOP Plan, options to purchase an aggregate of4,000,000 Ordinary shares may, from time to time, be granted to Israeliemployees of the Company. The exercise prices of options granted under thisplan are to be determined by the Board of Directors at the time of the grantand shall not be less than the market value of the Ordinary shares on the dateof granting such options. The options granted expire no later than ten yearsfrom the date of grant. This plan expires in 2003. As of December 31, 2002,options to purchase 644,702 Ordinary shares were available for future grant.Any options that are canceled or forfeited before expiration become availablefor future grant.

The options vest over a period of four years; 50% aftertwo years, and an additional 25% per each year thereafter.

 

c. In November 2002, the Company approved a new optionplan "2003 Stock Option and Restricted Stock Incentive Plan". Underthis plan, 5,000,000 options to purchase Ordinary shares are available forfuture grant to employees, officers, directors, service providers andconsultants of the Company and its subsidiaries.

 

**___25___** 

 

# NOTE 10:- SHARE CAPITAL (cont.)

 

d. A summary of the Company's employees share optionactivity under the IRSO and ESOP plans and related information is as follows:

 
|                                                                                 |   | Year ended December 31, |
|--------------------------------------------------------------------------------------|--------|-------------------------|
|                                                                                 |   | 2000                    |   | 2001 |   | 2002 |
|                                                                                 |   | Amount                  |   | Weighted average exercise price |   | Amount |   | Weighted average exercise price |   | Amount |   | Weighted average exercise price |
|                                                                                 |   |                    |   | $ |   |   |   | $ |   |   |   | $ |
| Options outstanding at the beginning of the year                                     |   | 2,298,976               |   | 2.43 |   | 2,742,928 |   | 7.33 |   | 3,560,138 |   | 6.37 |
| Changes during the year:                                                             |   |                    |   |   |   |   |   |   |   |   |   |   |
| Granted                                                                              |   | 1,098,310               |   | 15.24 |   | 1,628,480 |   | 5.37 |   | 855,166 |   | 6.68 |
| Exercised                                                                            |   | (407,908)               |   | 2.02 |   | (294,370) |   | 1.92 |   | (154,250) |   | 1.96 |
| Forfeited or cancelled                                                               |   | (246,450)               |   | 5.55 |   | (516,900) |   | 10.87 |   | (447,400) |   | 9.04 |
|                                                                                 |   |                    |   |   |   |   |   |   |   |   |   |   |
| Options outstanding at the end of the year                                           |   | 2,742,928               |   | 7.33 |   | 3,560,138 |   | 6.37 |   | 3,813,654 |   | 6.30 |
|                                                                                 |   |                    |   |   |   |   |   |   |   |   |   |   |
| Options exercisable at the end of the year                                           |   | 398,968                 |   | 2.12 |   | 760,048 |   | 2.50 |   | 1,213,003 |   | 5.47 |
|                                                                                 |   |                    |   |   |   |   |   |   |   |   |   |   |
| Weighted average fair value of options granted during the  year, at their grant date |   |                    |   | 10.52 |   |   |   | 3.45 |   |   |   | 2.92 |
|                                                                                 |   |                    |   |   |   |   |   |   |   |   |   |   |

 

**___26___** 

 

# NOTE 10:- SHARE CAPITAL (cont.)

 

The options outstanding as of December 31, 2002, under theIRSO and ESOP plans have been separated into ranges of exercise prices asfollows:
|  

Range of

exercise

prices |   | Options

outstanding

at

December 31,

2002 |   | Weighted

average 

exercise

price |   | Weighted

average

remaining

contractual

life |   | Options

exercisable 

at

December 31,

2002 |   | Weighted

average

exercise 

price of

exercisable

options |
|------------------------------------|--------|----------------------------------------------|--------|-------------------------------------|--------|-------------------------------------------------|--------|-----------------------------------------------|--------|--------------------------------------------------------------|
| $                                  |   |                                         |   | $                                   |   | Years                                           |   |                                          |   | $                                                            |
|                               |   |                                         |   |                                |   |                                            |   |                                          |   |                                                         |
| 1.38 - 1.88                        |   | 580,438                                      |   | 1.83                                |   | 5.74                                            |   | 473,788                                       |   | 1.82                                                         |
| 2.00 - 2.75                        |   | 305,560                                      |   | 2.25                                |   | 4.35                                            |   | 293,560                                       |   | 2.26                                                         |
| 3.25 - 3.75                        |   | 66,000                                       |   | 3.61                                |   | 5.98                                            |   | 52,500                                        |   | 3.58                                                         |
| 4.01 - 4.3                         |   | 607,080                                      |   | 4.28                                |   | 8.80                                            |   | ---                                           |   | ---                                                          |
| 5.00 - 5.75                        |   | 226,500                                      |   | 5.46                                |   | 9.70                                            |   | 2,000                                         |   | 5.00                                                         |
| 6.00 - 6.2                         |   | 795,000                                      |   | 6.03                                |   | 8.01                                            |   | 88,650                                        |   | 6.13                                                         |
| 7.02 - 10.1                        |   | 641,366                                      |   | 7.39                                |   | 9.19                                            |   | 7,650                                         |   | 8.75                                                         |
| 12.00 - 12.75                      |   | 439,410                                      |   | 12.36                               |   | 7.54                                            |   | 219,705                                       |   | 12.36                                                        |
| 16.25 - 19.50                      |   | 90,600                                       |   | 18.80                               |   | 7.32                                            |   | 44,300                                        |   | 18.78                                                        |
| 21.75 - 25.00                      |   | 61,700                                       |   | 24.58                               |   | 7.55                                            |   | 30,850                                        |   | 24.58                                                        |
|                               |   |                                         |   |                                |   |                                            |   |                                          |   |                                                         |
|                               |   | 3,813,654                                    |   | 6.29                                |   | 7.68                                            |   | 1,213,003                                     |   | 5.47                                                         |
|                               |   |                                         |   |                                |   |                                            |   |                                          |   |                                                         |

 

All of the options were granted at exercise prices thatwere equal or higher to market prices at the date of grant and, therefore, nocompensation cost has been charged against income in respect of theaforementioned plans in the years ended December 31, 2000, 2001 and 2002.

**EmployeeStock Purchase Plan ("ESPP"):**

During 2001, the Company adopted its Global and U.S. ESPP(the "plans"). The plans provide eligible employees with theopportunity to purchase 550,000 Ordinary shares under the Global ESPP and200,000 Ordinary shares under the U.S. ESPP. Under the plans' terms theemployees may purchase the shares through periodic deduction between 1% and 10%of their salary. The number of shares to be issued in return for the amountsdeducted in a six-months period ("the offering period") will bedetermined at the end of the offering period and will be equal to the lower of85% of the closing bid of the Company's shares in the Stock Exchange Market onthe first day or the last day of the offering period.

In November 2001, at the end of the First Offering period,the Company issued 18,313 Ordinary shares to eligible employees inconsideration of $ 153.

In May 2002, at the end of the second offering period, theCompany issued 28,711 Ordinary shares to eligible employees in consideration of$ 214.

In November 2002, at the end of the third offering period,the Company issued 35,881 Ordinary shares to eligible employees inconsideration of $ 222. Subsequently, a new offering period commenced,which will elapse in May 2003.

As of December 31, 2002, 667,095 Ordinary shares wereavailable for future purchase by employees. The average weighted price of theOrdinary shares purchased in 2002 was $ 6.85.

** **

**___27___** 

 

# NOTE 10:- SHARE CAPITAL (cont.)

 

**Treasurystock:**

During 1998, the Company sold a former subsidiary based inTaiwan, to certain shareholders of the subsidiary. As part of the agreement,the Company returned 6,045,500 shares of the subsidiary to those shareholdersand in exchange, those shareholders transferred 1,330,000 shares of M-Systemsto one of M-Systems wholly-owned subsidiary.

The Company accounted for the investment by its subsidiaryin its shares as treasury stock at the cost of $ 4,738. During 2001, theCompany canceled the treasury stock and recorded the cancellation againstadditional paid in capital.

 

**Dividends:**

In the event that cash dividends are declared in the future,such dividends will be paid in NIS or in foreign currency subject to anystatutory limitations. The Company does not intend to pay cash dividends in theforeseeable future. The Company has decided not to declare dividends out oftax-exempt earnings.

 

# NOTE 11:- NET EARNINGS (LOSS) PER SHARE

 

The following table sets forth the computation ofhistorical basic and diluted net earnings (loss) per share:
|                                                                                                                                 |   | Year ended December 31, |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|
|                                                                                                                                 |   | 2000                    |   | 2001 |   | 2002 |
| Numerator:                                                                                                                           |   |                    |   |   |   |   |
| Net income (loss)                                                                                                                    |   | $ 6,279            |   | $ (41,785) |   | $ (5,500) |
| Numerator for basic net  earnings (loss) per share - income (loss) available to Ordinary shareholders                                |   | $ 6,279            |   | $ (41,785) |   | $ (5,500) |
| Numerator for diluted net  earnings (loss) per share - net income (loss) available to Ordinary  shareholders after assumed exercises |   | $ 6,279            |   | $ (41,785) |   | $ (5,500) |
|                                                                                                                                 |   |                    |   |   |   |   |
| Denominator:                                                                                                                         |   |                    |   |   |   |   |
| Weighted average shares                                                                                                              |   | 26,698,286              |   | 26,715,683 |   | 26,953,410 |
| Treasury stock                                                                                                                       |   | (1,330,000)             |   | --- |   | --- |
| Denominator for basic net  earnings (loss) per share-weighted-average shares                                                         |   | 25,368,286              |   | 26,715,683 |   | 26,953,410 |
| Effect of dilutive securities:                                                                                                       |   |                    |   |   |   |   |
| Employee stock options                                                                                                               |   | 2,020,185               |   | *) --- |   | *) --- |
| Warrants                                                                                                                             |   | 652,140                 |   | *) --- |   | *) --- |
|                                                                                                                                 |   |                    |   |   |   |   |
| Dilutive potential Ordinary shares                                                                                                   |   | 2,672,325               |   | --- |   | --- |
| Denominator for diluted net earnings (loss) per share                                                                                |   | 28,040,611              |   | 26,715,683 |   | 26,953,410 |
|                                                                                                                                 |   |                    |   |   |   |   |

*)   Anti-dilutive.

**___28___** 

 

# NOTE 12:- INCOME TAXES

**Taxbenefits under the Law for the Encouragement of Capital Investments, 1959 (the"Capital Investment Law"):**

Most of the Company's and its Israeli subsidiaryproduction facilities have been granted an "Approved Enterprise"status under the above Law under six separate investment programs. According tothe Capital Investments Law, the Company has elected the "alternativebenefits" - and has waived Government grants in return for a taxexemption. 

The Company is also a "foreign investors'company", as defined by the abovementioned law, and, as such, is entitledto a 10-year period of benefits and to an additional reduction in tax rates, upto 10% or 25% (based on the percentage of foreign ownership in each taxableyear).

Income derived from the first investment program whichcommenced in 1992 and expired in 1998 was tax-exempt for a period of two years(1992 and 1993), and was subject to tax at the reduced rate of 20%, for anadditional period of five years ended in 1998. The period of benefits for thisprogram ended in 1998.

For the Company's other five investment programs, the taxbenefits are as follows: Income derived from investment programs, whichcommenced operations prior to or during 1996 is tax exempt for the first fouryears of the 10-year tax benefit period, and is entitled to a reduced tax rateof 20% during the remaining benefit period. Income derived from investmentprograms that commenced operations subsequent to 1996, is tax exempt for thefirst two years of the 10-year tax benefit period, and is entitled to a reducedtax rate of 20% during the remaining benefit period. The period of benefits forall these investment programs has not yet commenced, since the Company does notyet have taxable income. 

The period of tax benefits detailed above is subject tolimits of the earlier of 12 years from commencement of production, or 14 yearsfrom receiving the approval. Accordingly, the period of benefits relating toall investment programs will expire in the years 2005 through 2012.

In connection with the purchase of Fortress, the Companyestablished a research and development facility in Omer, Israel, at the site ofFortress' facilities. Income derived from the Omer facility is tax exempt for a10-year period. The Company came to agreement with the Israeli tax authoritieson the percentage of revenues which are deemed attributable to the facility inOmer.

The entitlement to the above benefits is conditional uponthe Company's fulfilling the conditions stipulated by the above law,regulations published thereunder and the instruments of approval for thespecific investments in "approved enterprises". In the event offailure to comply with these conditions, the benefits may be canceled and theCompany may be required to refund the amount of the benefits, in whole or inpart, including interest.

The tax exempt income attributable to the "ApprovedEnterprise" can be distributed to shareholders without imposing taxliability on the Company only upon the complete liquidation of the Company. Inthe event of a distribution of such tax-exempt income as a cash dividend in amanner other than in the complete liquidation of the Company, the Company willbe required to pay tax at the rate of 20% on the amount distributed. Inaddition, these dividends will be subject to 15% withholding tax.

The Company's Board of Directors has determined that suchtax-exempt income will not be distributed as dividends. Accordingly, nodeferred taxes have been provided on income attributable to the Company's"Approved Enterprise".

The Capital Investments Law also grants entitlement toclaim accelerated depreciation on equipment used by the "ApprovedEnterprise" during five tax years.

If the Company derives income from sources other than an"Approved Enterprise", such income will be taxable at the regularcorporate tax rate of 36%.

**___29___** 

 

# NOTE 12:- INCOME TAXES (cont.)

 

**Taxbenefits under the Law for the Encouragement of Industry (Taxes), 1969:**

The Company and its Israeli subsidiary currently qualifyas an "industrial company" under the above law and, as such, areentitled to certain tax benefits, mainly accelerated depreciation of machinery,equipment, and building the rights to claim public issuance expenses andamortization of patents and other intangible property rights as a deduction fortax purposes.

 

**Taxableincome under the Inflationary Income Tax (Inflationary Adjustments) Law 1985:**

Results of the Company and its Israeli subsidiary for taxpurposes are measured and reflected in real terms in accordance with thechanges in the Israeli Consumer Price Index ("CPI"). As explained inNote 2, the financial statements are presented in U.S. dollars. The differencebetween the change in the Israeli CPI and in the NIS/U.S. dollar exchange ratecauses a difference between taxable income or loss and the income or lossbefore taxes reflected in the financial statements. In accordance withparagraph 9(f) of SFAS No. 109, the Company has not provided deferred incometaxes on this difference between the reporting currency and the tax bases ofassets and liabilities.

 

**Deferredincome taxes:**

Deferred income taxes reflect the net tax effects oftemporary differences between the carrying amounts of assets and liabilitiesfor financial reporting purposes and the amounts used for income tax purposes.Significant components of the Company's deferred tax assets are as follows:
|                                                |   | December 31, |
|-----------------------------------------------------|--------|--------------|
|                                                |   | 2001         |   | 2002 |
| Deferred tax assets:                                |   |         |   |   |
| Net operating loss carryforward   of subsidiaries   |   | $ 3,268 |   | $ 4,459 |
| Reserve and allowances                              |   | 727          |   | 1,041 |
|                                                |   |         |   |   |
| Total deferred tax asset before valuation allowance |   | 3,995        |   | 5,500 |
| Valuation allowance                                 |   | (3,995)      |   | (5,500) |
|                                                |   |         |   |   |
| Net deferred tax asset                              |   | $ ---   |   | $ --- |
|                                                |   |         |   |   |

As of December 31, 2002, the Company's subsidiaries haveprovided valuation allowances of approximately $ 5,500 in respect ofdeferred tax assets resulting from tax loss carryforwards and other temporarydifferences. The net change in the valuation allowance in the year 2002,amounted to $ (1,505). Management currently believes that since theCompany's subsidiaries have a history of losses it is more likely than not thatthe deferred tax regarding the loss carryforwards and other temporarydifferences will not be realized in the foreseeable future.

**___30___** 

 

# NOTE 12:- INCOME TAXES (cont.)

 

**Income(loss) before minority interest consists of the following:**

 
|     |   | Year ended December 31, |
|----------|--------|-------------------------|
|     |   | 2000                    |   | 2001 |   | 2002 |
|     |   |                    |   |   |   |   |
| Domestic |   | $ 6,177            |   | $ (36,356) |   | $ (1,509) |
| Foreign  |   | 83                      |   | (5,429) |   | (3,991) |
|     |   |                    |   |   |   |   |
|     |   | $ 6,260            |   | $ (41,785) |   | $ (5,500) |
|     |   |                    |   |   |   |   |

 

**Netoperating loss carryforwards:**

The Company and its Israeli subsidiary have accumulatedlosses for Israel income tax purposes as of December 31, 2002, in the amount ofapproximately $ 58,000. These losses may be carried forward (linked to theIsraeli CPI) and offset against taxable income in the future for an indefiniteperiod. The Company expects that during the period these tax losses areutilized, its income would be substantially tax exempt. Accordingly, there willbe no tax benefit available from such losses and no deferred income taxes havebeen included in these consolidated financial statements.

As of December 31, 2002, M-Systems Inc. had U.S. federalnet operating loss carryforwards of approximately $ 3,710, that can becarried forward and offset against taxable income and expire during the years2015 to 2022. Utilization of U.S. net operating losses may be subject tosubstantial annual limitations due to the "change in ownership"provisions of the Internal Revenue Code of 1986 and similar state lawprovisions. The annual limitations may result in the expiration of netoperating losses before utilization.

As of December 31, 2002, M-Systems Taiwan and M-SystemsJapan had a net operating loss carryforwards of approximately $ 2,700 and$ 2,070, respectively, which can be carried forward and offset againsttaxable income and expire during the years 2003 to 2005.

 

**Reconciliationof the theoretical tax expense (benefit) to the actual tax expense (benefit):**

In 2000, 2001 and 2002 the main reconciling item of thestatutory tax rate of the Company (36%) to the effective tax rate (0%) iscarryforward tax losses and other deferred taxes for which a full valuationallowance was provided.

 

**___31___** 

# NOTE 13:- SELECTED STATEMENTS OFOPERATIONS DATA

|   |                                                       |   | Year ended December 31, |
|--------|------------------------------------------------------------|--------|-------------------------|
|   |                                                       |   | 2000                    |   | 2001 |   | 2002 |
| a.     | Research and development expenses, net:                    |   |                    |   |   |   |   |
|   | Total expenses                                             |   | $ 7,364            |   | $ 13,350 |   | $ 12,249 |
|   | Less - grants and   participations                         |   | ---                     |   | 60 |   | 275 |
|   |                                                       |   |                    |   |   |   |   |
|   |                                                       |   | $ 7,364            |   | $ 13,290 |   | $ 11,974 |
| b      | Financial income, net:                                     |   |                    |   |   |   |   |
|   | Financial income:                                          |   |                    |   |   |   |   |
|   | Interest on marketable   securities, net                   |   | $ 10               |   | $ 729 |   | $ 1,391 |
|   | Interest on bank deposits                                  |   | 6,145                   |   | 4,018 |   | 1,164 |
|   | Gain on sale of held to   maturity marketable securities   |   | ---                     |   | 48 |   | 70 |
|   | Gain on sale of available for   sale marketable securities |   | ---                     |   | 58 |   | --- |
|   | Foreign currency translation   differences                 |   | 390                     |   | 225 |   | 157 |
|   | Other                                                      |   | 8                       |   | 62 |   | 117 |
|   |                                                       |   |                    |   |   |   |   |
|   |                                                       |   | 6,553                   |   | 5,140 |   | 2,899 |
|   | Financial expenses:                                        |   |                    |   |   |   |   |
|   | Foreign currency translation   differences                 |   | 480                     |   | 389 |   | 174 |
|   | Bank commissions                                           |   | 153                     |   | 77 |   | 74 |
|   | Other                                                      |   | 45                      |   | 46 |   | 32 |
|   |                                                       |   |                    |   |   |   |   |
|   |                                                       |   | 678                     |   | 512 |   | 280 |
|   |                                                       |   |                    |   |   |   |   |
|   | Financial income, net                                      |   | $ 5,875            |   | $ 4,628 |   | $ 2,619 |
|   |                                                       |   |                    |   |   |   |   |

**___32___** 

 

# NOTE 14:- CUSTOMERS AND GEOGRAPHICINFORMATION

 

The Company manages its business on a basis of one reportablesegment. See Note 1 for a description of the Company's business. Total revenuesare attributed to geographic areas based on the location of customers inaccordance with Statement of Financial Accounting Standard of No. 131,"Disclosures about Segments of an Enterprise and Related Information("SFAS 131").

The following presents total revenues and long-livedassets as of and for the years ended December 31, 2000, 2001 and 2002:
|                                  |   | 2000           |   | 2001               |   | 2002           |
|---------------------------------------|--------|----------------|--------|--------------------|--------|----------------|
|                                  |   | Total revenues |   | Long-lived

assets |   | Total revenues |   | Long-lived

assets |   | Total

revenues |   | Long-

Lived assets |
|                                  |   |           |   |               |   |           |   |   |   |   |   |   |
| Israel                                |   | $ 4,584   |   | $ 4,226       |   | $ 2,435   |   | $ 17,346 |   | $ 1,678 |   | $ 16,923 |
| United States                         |   | 42,172         |   | 217                |   | 17,130         |   | 157 |   | 17,248 |   | 117 |
| Europe (excluding France)             |   | 6,732          |   | 20                 |   | 5,533          |   | 15 |   | 7,648 |   | 4 |
| France                                |   | 11,911         |   | ---                |   | 3,690          |   | --- |   | 2,957 |   | --- |
| Taiwan                                |   | 12,742         |   | 145                |   | 7,835          |   | 114 |   | 8,282 |   | 100 |
| Japan                                 |   | 6,776          |   | 23                 |   | 4,635          |   | 31 |   | 22,177 |   | 76 |
| Far East (excluding Taiwan and Japan) |   | 7,626          |   | ---                |   | 3,420          |   | 20 |   | 4,827 |   | 15 |
| Other                                 |   | 46             |   | ---                |   | ---            |   | --- |   | --- |   | --- |
|                                  |   |           |   |               |   |           |   |   |   |   |   |   |
|                                  |   | $ 92,589  |   | $ 4,631       |   | $ 44,678  |   | $ 17,683 |   | $ 64,817 |   | $ 17,235 |
|                                  |   |           |   |               |   |           |   |   |   |   |   |   |

**AccumulatedAmortization**

Total revenues from external customers, divided on thebasis of the Company's product lines, are as follows:
|                   |   | Year ended December 31, |
|------------------------|--------|-------------------------|
|                   |   | 2000                    |   | 2001 |   | 2002 |
|                   |   |                    |   |   |   |   |
| DiskOnChip             |   | $ 72,950           |   | $ 27,440 |   | $ 29,366 |
| DiskOnKey              |   | ---                     |   | 6,606 |   | 26,810 |
| Fast Flash Disks (FFD) |   | 8,002                   |   | 5,389 |   | 5,926 |
| PC Cards               |   | 9,024                   |   | 3,402 |   | 1,154 |
| Other                  |   | 2,613                   |   | 1,841 |   | 1,561 |
|                   |   |                    |   |   |   |   |
|                   |   | $ 92,589           |   | $ 44,678 |   | $ 64,817 |
|                   |   |                    |   |   |   |   |

**___33___** 

 

# NOTE 14:- CUSTOMERS AND GEOGRAPHICINFORMATION (Cont.)

 

**Majorcustomers data as a percentage of total revenues:**

 
|       |   | Year ended December 31, |
|------------|--------|-------------------------|
|       |   | 2000                    |   | 2001 |   | 2002 |
|       |   |                    |   |   |   |   |
| Customer A |   | 15%                     |   | 4% |   | 1% |
|       |   |                    |   |   |   |   |
| Customer B |   | 12%                     |   | 4% |   | --- |
|       |   |                    |   |   |   |   |
| Customer C |   | ---                     |   | 3% |   | 15% |
|       |   |                    |   |   |   |   |
| Customer D |   | 3%                      |   | 6% |   | 10% |

 

 

# NOTE 15:- SUBSEQUENT EVENTS

 

a. In May 2003, the Company entered into a share purchaseagreement with one of its directors according to which, the director is topurchase within no later than 60 days, 500,000 ordinary shares of the Companyfor an aggregate amount of $ 4,105.

b. In April 2003, the Company established a subsidiary inIsrael named Smart Caps Ltd. ("Smart Caps") for the purpose ofdeveloping and marketing smart applications for M-Systems` line of DiskOnKeyproducts. 

The State of Israel, through the Office of the ChiefScientist, has committed to investing up to approximately $ 550 in SmartCaps. This investment by the State of Israel is to at least match the Company'sinvestment in Smart Caps. In consideration for such investments, the Companyand the State of Israel are to be issued shares in Smart Caps pro rata to eachof their relative investments.

 

- -- - - - - -

**___34___** 

 
| BDO |   | **BDO Seidman, LLP**

Accountants and Consultants

  | 125 South Market Street, Suite 800

San Jose, California 95113-2205

Telephone: (408) 278-0220

Fax: (408) 278-0230 |
|-----|--------|-----------------------------------------------------------|---------------------------------------------------------------------------------------------------------------------|

 

* *

* *

* *

**Report of IndependentCertified Public Accountants**

* *

* *

The Board of Directors of

M-Systems, Inc.

* *

Wehave audited the accompanying balance sheets of M-Systems, Inc. (a wholly ownedsubsidiary of M-Systems Flash Disk Pioneers Ltd.) as of December 31, 2002 and2001 and the related statements of operations, shareholders deficiency, andcash flows for the years then ended.  These financial statements arethe responsibility of the Company`s management.  Our responsibilityis to express an opinion on these financial statements based on our audits.

* *

Weconducted our audits in accordance with auditing standards generally acceptedin the United States of America.  Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

* *

Inour opinion, the financial statements referred to above present fairly, in allmaterial respects, the financial position of M-Systems, Inc. as of December 31,2002 and 2001, and the results of its operations and its cash flows for theyears then ended in conformity with accounting principles generally accepted inthe United States of America.

* *

Asdiscussed in Notes 1 and 5, the Company`s revenues consist of commission incomefrom its parent company that are generated under terms and conditionsprescribed by its parent company.  Further, as of December 31, 2002,the Company has a net liability of $ 10,354,000 due to its parent companyand is economically dependant upon its parent company for continuing financialsupport.  The accompanying financial statements of M-Systems, Inc.may not necessarily be indicative of the financial position, results ofoperations and cash flows of the Company had it operated without itsaffiliation with and continuing financial support of its parent company.

* *

/S/BDO Seidman, LLP

* *

SanJose, California

January8, 2003

* *

**___35___** 

 

SIGNATURES

 

Pursuant to the requirements of Section 12 of theSecurities Exchange Act of 1934, M-Systems hereby certifies that it meets allof the requirements for filing on Form 20-F/A, and that it has duly caused andauthorized the undersigned to sign this Amendment No. 5 to its Annual Report onits behalf on the 26th day of January, 2004.

 

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

 

By: /s/ Dov Moran

Dov Moran,

President and Chief Executive Officer

 

**___36___**