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SILICON IMAGE INC - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Overview Silicon Image is a leading provider of connectivity solutions that enable the reliable distribution and presentation of high-definition (HD) content for mobile, consumer electronics (CE), and personal computing (PC) markets. We deliver our technology via semiconductor and intellectual property (IP) products that are compliant with global industry standards and feature market leading Silicon Image innovations such as InstaPort™ and InstaPrevue™. Silicon Image's products are deployed by the world's leading electronics manufacturers in devices such as smartphones, tablets, digital televisions (DTVs), Blu-ray Disc™ players, audio-video receivers, digital cameras, as well as desktop and notebook PCs. Silicon Image has driven the creation of the highly successful High-Definition Multimedia Interface (HDMI®), the latest standard for mobile devices-Mobile High-Definition Link (MHL®), Digital Visual Interface (DVI™) industry standards and the leading 60GHz wireless HD video standard-WirelessHD®. Via its wholly-owned subsidiary, Simplay Labs, Silicon Image offers manufacturers comprehensive standards interoperability and compliance testing services. Silicon Image was founded in 1995. We are a Delaware corporation headquartered in Sunnyvale, California, with regional engineering and sales offices in China, Japan, Korea, Taiwan and India. Our Internet website address is www.siliconimage.com. Our mission is to be the leader in advanced HD connectivity solutions for mobile, CE, and PC markets to enhance the consumer experience. Our "standards plus" business strategy is to grow the available market for our products and IP solutions through the development, introduction and promotion of market leading products which are based on industry standards but also include Silicon Image innovations that our customers value. We believe that our innovation around our core competencies, establishing industry standards and building strategic relationships, positions us to continue to drive change in the emerging world of high quality digital media storage, distribution and presentation. Our customers are product manufacturers in each of our target markets -mobile, CE, and PC. Because we leverage our technologies across different markets, certain of our products may be incorporated into our customers' products used in multiple markets. We sell our products to original product manufacturers (OEMs) throughout the world using a direct sales force and through a network of distributors and manufacturer's representatives. Our revenue is generated principally by sales of our semiconductor products, with other revenues derived from IP core/design licensing and royalty and adopter fees from our standards licensing activities. We maintain relationships with the eco-system of companies that make the products that drive digital content creation, distribution and consumption, including major Hollywood studios, service providers, consumer electronics companies and retailers. Through these and other relationships, we have formed a strong understanding of the requirements for distributing and presenting HD digital video and audio in the home and mobile environments. We have also developed a substantial IP base for building the standards and products necessary to promote opportunities for our products. Historically, we have grown our business by introducing and promoting the adoption of new technologies and standards and entering new markets. We collaborated with other companies to jointly develop the DVI and HDMI standards. Our first DVI products addressed the PC market. We then introduced products for a variety of CE market segments, including the set top box (STB), game console and DTV markets. In 2011, we began selling products in the mobile device market using our innovative interconnect core technology. In May 2011, we acquired SiBEAM, Inc., a provider of high-speed wireless communication products for uncompressed HD video in consumer electronics and personal computer applications. With this acquisition, we became a promoter of the WirelessHD standard for transmitting HD content using 60GHz wireless technology. SiBEAM's 60GHz wireless technology enables us to rapidly bring the highest quality of wirelessly transmitted HD video and audio to market. 36-------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and Estimates Preparation of financial statements in conformity with U.S. Generally Accepted Accounting Principles (GAAP) requires management to make estimates and assumptions that affect amounts reported in our consolidated financial statements and accompanying notes. We base our estimates on historical experience and all known facts and circumstances that we believe are relevant. Actual results may differ materially from our estimates. We believe the accounting policies discussed below to be most critical to an understanding of our financial condition and results of operations because they require us to make estimates, assumptions and judgments about matters that are inherently uncertain. Revenue Recognition We recognize revenue when the earnings process is complete, as evidenced by an agreement with the customer, delivery or performance has occurred, pricing is fixed or determinable and collectability is reasonably assured. Product Revenue "Sell-In"-Product revenue is generally recognized at the time of shipment to customers not eligible for price concessions and rights of return (including shipments to direct customers and certain shipments to distributors). Revenue from products sold to distributors with agreements allowing for stock rotations, but not price protection, is generally recognized upon shipment. Reserves for stock rotations are estimated based primarily on historical experience and provided for at the time of shipment, and are not significant. "Sell-Through"-Product revenue is recognized only when the distributor reports that it has sold the product to its end customer. This method of product revenue recognition is used for products sold to distributors with agreements allowing for price concessions and stock rotation or product return rights, as the sales price is not fixed or determinable at the time of shipment to the distributor. Our recognition of such distributor sell-through is based on point of sales reports received from the distributor which establish a customer, quantity and final price. Price concessions are recorded when incurred, which is generally at the time the distributor sells the product to its customer. Once we receive the point of sales reports from the distributor, our sales price for the products sold to end customers is fixed, as any product returns, stock rotation and price concession rights for that product lapse upon the sale to the end customer. From time to time, at our distributors' request, we enter into "conversion agreements" to convert certain products, which are designated for a specific end customer, from "sell-through" to "sell-in" products. The effect of these conversions is to eliminate any price protection or return rights on such products. Revenue for such conversions is recorded at the time such conversion agreements are signed, as it is at that point that the distributor ceases to have any price protection or return rights for such products. At the time of shipment to distributors for which revenue is recognized on a sell-through basis, we record a trade receivable for the selling price (since there is a legally enforceable right to payment), we relieve inventory for the carrying value of goods shipped (since legal title has passed to the distributor) and, until revenue is recognized, we record the gross margin in "deferred margin on sale to distributors," a component of current liabilities in our consolidated balance sheet. However, the amount of gross margin we recognize in future periods will be less than the originally recorded deferred margin on sales to distributor as a result of negotiated price concessions. We sell each item in our product price book to all of our "sell-through" distributors worldwide at a relatively uniform list price. However, distributors resell our products to end customers at a very broad range of individually negotiated price points based on customer, product, quantity, geography, competitive pricing and other factors. The majority of our distributors' resales are priced at a discount from the list price. Often, under these circumstances, we remit back to the distributor a portion of their original purchase price after the resale transaction is completed. Thus, a portion of the "deferred margin on the sale to distributor" balance represents a portion of distributors' original purchase price that will be remitted back to the distributor in the future. The wide 37-------------------------------------------------------------------------------- Table of Contents range and variability of negotiated price concessions granted to the distributors does not allow us to accurately estimate the portion of the balance in the deferred margin on the sale to distributors that will be remitted back to the distributors. In addition to the above, we also reduce the deferred margin by anticipated or determinable future price protections based on revised price lists, if any. Licensing Revenue We enter into IP licensing agreements that generally provide licensees the right to incorporate our IP components in their products with terms and conditions that vary by licensee and revenue earned under such agreements is classified as licensing revenue. Our IP licensing agreements generally include multiple elements, which may include one or more off-the-shelf and/or customized IP licenses bundled with support services covering a fixed period of time, usually one year. During 2010, we followed the guidance in Financial Accounting Standard Board (FASB) Accounting Standards Codification (ASC) No. 605-25-25, "Multiple-Element Arrangements Revenue Recognition ," to determine whether there was more than one unit of accounting. To the extent that the deliverables were separable into multiple units of accounting, we allocated the total fee on such arrangements to the individual units of accounting using the residual method, if objective and reliable evidence of fair value did not exist for delivered elements. We then recognized revenue for each unit of accounting depending on the nature of the deliverable(s) comprising the unit of accounting in accordance with the revenue recognition criteria. Beginning in the year ended December 31, 2011, for such multiple element IP licensing arrangements, we follow the guidance in FASB Accounting Standards Update (ASU) No. 2009-13, "Revenue Recognition (ASC Topic 605)-Multiple-Deliverable Revenue Arrangements.", to determine whether there is more than one unit of accounting. For multiple-element arrangements, we allocate revenue to all deliverables based on their relative selling prices. In such circumstances, we use a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (VSOE), (ii) third-party evidence of selling price (TPE), and (iii) best estimate of the selling price (ESP). VSOE generally exists only when we sell the deliverable separately and is the price actually charged by us for that deliverable. ESPs reflect our best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis. For the elements of IP licensing agreements we concluded that VSOE exists only for our support services based on periodic stand-alone renewals. For all other elements in IP licensing agreements, we concluded that no VSOE or TPE exists because these elements are almost never sold on a stand-alone basis by us or our competitors. Our process for determining ESP for deliverables without VSOE or TPE considers multiple factors that may vary depending upon the unique facts and circumstances related to each deliverable. The key factors considered by us in developing the ESPs include prices charged by us for similar offerings, if any, our historical pricing practices, the nature and complexity of different technologies being licensed. Amounts allocated to the delivered off-the-shelf IP licenses are recognized at the time of sale provided the other conditions for revenue recognition have been met. Amounts allocated to the support services are deferred and recognized on a straight-line basis over the support period, usually one year. Certain licensing agreements provide for royalty payments based on agreed upon royalty rates. Such rates can be fixed or variable depending on the terms of the agreement. The amount of revenue we recognize is determined based on a time period or on the agreed-upon royalty rate, extended by the number of units shipped by the customer. To determine the number of units shipped, we rely upon actual royalty reports from our customers when available and rely upon estimates in lieu of actual royalty reports when we have a sufficient history of receiving royalties to enable us to make a reliable estimate of the amount of royalties owed to us. These estimates for royalties necessarily involve the application of management judgment. As a result of our use 38-------------------------------------------------------------------------------- Table of Contents of estimates, period-to-period numbers are "trued-up" in the following period to reflect actual units shipped per the royalty reports ultimately received from the customer. In cases where royalty reports and other information are not available to allow us to estimate royalty revenue, we recognize revenue only when royalty reports are received. We also perform compliance audits for our licenses and any additional royalties as a result of the compliance audits are recorded as revenue in the period when the compliance audits are settled and the customers agrees to pay the amounts due. For contracts related to licenses of our technology that involve significant modification, customization or engineering services, we recognize revenue in accordance with the provisions of FASB ASC No. 605-35-25, "Construction-Type and Production-Type Contracts Revenue Recognition." Revenues derived from such license contracts are accounted for using the percentage-of-completion method. We determine progress to completion based on input measures using labor-hours incurred by our engineers. The amount of revenue recognized is based on the total contract fees and the percentage of completion achieved. Estimates of total project requirements are based on prior experience of customization, delivery and acceptance of the same or similar technology and are reviewed and updated regularly by management. The estimates for labor-hours have not been significantly different as compared to actual labor-hours. If there is significant uncertainty about customer acceptance, or the time to complete the development or the deliverables by either party, we apply the completed contract method. The contract is considered substantially complete upon customer acceptance. If application of the percentage-of-completion method results in recognizable revenue prior to an invoicing event under a customer contract, we recognize the revenue and record an unbilled receivable assuming collectability is reasonably assured. Amounts invoiced to our customers in excess of recognizable revenues are recorded as deferred revenue. Stock-based Compensation We account for stock-based compensation in accordance with the provisions of ASC No. 718-10-30, "Stock Compensation Initial Measurement," which requires the measurement and recognition of compensation expense for all stock-based awards made to employees and directors including employee stock options, restricted stock units (RSUs), performance share awards and employee stock purchases under our Employee Stock Purchase Plan (ESPP) based on estimated fair values. Following the provisions of ASC No. 718-50-25, "Employee Share Purchase Plans Recognition," our ESPP is considered a compensatory plan, therefore, we are required to recognize compensation cost for grants made under the ESPP. We estimate the fair value of stock options granted using the Black-Scholes-Merton (BSM) option-pricing model and a single option award approach. The BSM model requires various highly subjective assumptions including volatility, expected option life, and risk-free interest rate. Management estimates volatility for a given option grant by evaluating the historical volatility of the period immediately preceding the option grant date that is at least equal in length to the option's expected term. Consideration is also given to unusual events (either historical or projected) or other factors that might suggest that historical volatility will not be a good indicator of future volatility. The expected life of an award is based on historical experience and on the terms and conditions of the stock awards granted to employees, as well as the potential effect from options that had not been exercised at the time. In accordance with ASC No. 718-10-35 , "Subsequent Measurement of Stock Compensation," we recognize stock-based compensation expense, net of estimated forfeitures, on a ratable basis for all share-based payment awards over the requisite service periods of the awards, which is generally the vesting period or the remaining service (vesting) period. The assumptions used in calculating the fair value of share-based payment awards represent management's best estimates. These estimates involve inherent uncertainties and the application of management's judgment. If factors change and we use different assumptions, our stock-based compensation expense could be materially different in the future. In addition, we are required to estimate the expected forfeiture rate and recognize expense only for those shares expected-to-vest. If our actual forfeiture rate is materially different from our estimate, our recorded stock-based compensation expense could be different. 39-------------------------------------------------------------------------------- Table of Contents The fair value of market-based RSUs has been determined by management, with the assistance of an independent valuation firm using the Monte Carlo Simulation method which takes into account multiple input variables that determine the probability of satisfying the market conditions stipulated in the award. This method requires the input of assumptions, including the expected volatility of our common stock, and a risk-free interest rate. Compensation expense related to awards that are expected to vest with a market-based condition is recognized on a straight-line basis regardless of whether the market condition is satisfied, provided that the requisite service has been achieved. The amount of expense attributed to market-based RSUs is based on the estimated forfeiture rate, which is updated according to our actual forfeiture rates. The financial statements include amounts that are based on our best estimates and judgments. Allowance for Doubtful Accounts We maintain allowances for doubtful accounts, when appropriate, for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, our actual losses may exceed our estimates, and additional allowances would be required. To date, our actual results have not been materially different than our estimates. Inventories and Inventory Valuation We record inventories at the lower of actual cost, or market value. Market value is based upon an estimated average selling price reduced by the estimated costs of disposal. The determination of market value involves numerous judgments including estimating average selling prices based up recent sales, industry trends, existing customer orders, and other factors. Should actual market conditions differ from our estimates, our future results of operations could be materially affected. Provisions are recorded for excess and obsolete inventory and are estimated based on a comparison of the quantity and cost of inventory on hand to our forecast of customer demand. Customer demand is dependent on many factors and requires us to use significant judgment in our forecasting process. We also make assumptions regarding the rate at which new products will be accepted in the marketplace and at which customers will transition from older products to newer products. Generally, inventories in excess of six months forecasted demand are written down to zero (unless specific facts and circumstances warrant no write-down or a write-down to a different value) and the related provision is recorded as a cost of sales. Once a provision is established, it is maintained until the product to which it relates is sold or otherwise disposed of, even if in subsequent periods we forecast demand for the product. To the extent our demand forecast for specific products is less than the combination of our product on-hand and our non-cancelable orders from suppliers, we could be required to record additional inventory reserves, which would have a negative impact on our gross margin. If we ultimately sell inventory that we have previously written down, our gross margins in future periods will be positively impacted. Valuation of Long-Lived Assets, Intangible Assets and Goodwill We test long-lived assets, including intangible assets with finite lives for impairment whenever events or circumstances suggest that such assets may not be recoverable. An impairment is only deemed to have occurred if the sum of the forecasted undiscounted future cash flows related to the assets are less than the carrying value of the asset we are testing for impairment. If the forecasted cash flows are less than the carrying value, then we must write down the carrying value to its estimated fair value based primarily upon forecasted discounted cash flows. These forecasted discounted cash flows include estimates and assumptions related to revenue growth rates and operating margins, risk-adjusted discount rates based on our weighted average cost of capital, future economic and market conditions and determination of appropriate market comparables. If future forecasts are revised, they may indicate or require future impairment charges. We base our fair value estimates on assumptions we believe to be reasonable but that are unpredictable and inherently uncertain. Actual future results may differ from those estimates. 40-------------------------------------------------------------------------------- Table of Contents We amortize our intangible assets with finite lives over their estimated useful lives. We are currently amortizing our acquired intangible assets with definite lives over periods ranging from two to six years. Goodwill is tested for impairment on an annual basis (on September 30th) using a two-step model. The first step, identifying a potential impairment, compares the fair value of the reporting unit with its carrying amount. Management has determined that we have one reporting unit. If the carrying value of the reporting unit exceeds its fair value, the second step would need to be conducted; otherwise, no further steps are necessary as no potential impairment exists. The second step, measuring the impairment loss, compares the implied fair value of the goodwill with the carrying amount of that goodwill. Any excess of the goodwill carrying value over the respective implied fair value is recognized as an impairment loss, and the carrying value of goodwill is written down to fair value. In each period presented the fair value of the reporting unit exceeded its carrying value, thus the we were not required to perform the second step of the analysis, and no goodwill impairment charges were recorded Investments in Privately Held Companies Investments in privately-held companies are reviewed on a quarterly basis to determine if their values have been impaired and adjustments are recorded as necessary. We assess the potential impairment of these investments by considering available evidence such as the investee's historical and projected operating results, progress towards meeting business milestones, ability to meet expense forecasts, and the prospects for industry or market in which the investee operates. Upon disposition of these investments, the specific identification method is used to determine the cost basis in computing realized gains or losses. Declines in value that are judged to be other-than-temporary are reported in interest income and other, net in the accompanying consolidated statements of operations. Income Taxes Income tax expense is an estimate of current income taxes payable or refundable in the current fiscal year based on reported income before income taxes. Deferred income taxes reflect the effect of temporary differences and carry-forwards that are recognized for financial reporting and income tax purposes. We account for income taxes under the provisions of ASC 740, "Income Taxes." Under the provisions of ASC 740, deferred tax assets and liabilities are recognized based on the differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, utilizing the tax rates that are expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. We recognize valuation allowances to reduce any deferred tax assets to the amount that we estimate will more likely than not be realized based on available evidence and management's judgment. In addition, the calculation of liabilities for uncertain tax positions involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with our expectations could have a material impact on our results of operations and financial position. Loss Contingencies We are subject to the possibility of various loss contingencies arising in the ordinary course of business. We consider the likelihood of loss or impairment of an asset, or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss, in determining loss contingencies. An estimated loss contingency is accrued when it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. We record a charge equal to the minimum estimated liability for litigation costs or a loss contingency only when both of the following conditions are met: (i) information available prior to issuance of our consolidated financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements and (ii) the range of loss can be reasonably estimated and 41-------------------------------------------------------------------------------- Table of Contents no point within the range of probable loss is more likely than other points within the range. We regularly evaluate current information available to us to determine whether such accruals should be adjusted and whether new accruals are required. From time to time, we are involved in disputes, litigation, and other legal actions. We are aggressively defending our current litigation matters. However, there are many uncertainties associated with any litigation and these actions or other third-party claims against us may cause us to incur costly litigation and/or substantial settlement charges. In addition, the resolution of any future intellectual property litigation may require us to make royalty payments, which could adversely affect gross margins in future periods. If any of those events were to occur, our business, financial condition, results of operations, and cash flows could be adversely affected. The actual liability in any such matters may be materially different from our estimates, which could result in the need to adjust our liability and record additional expenses. Certain of our licensing agreements indemnify our customers for expenses or liabilities resulting from claimed infringements of patent, trademark or copyright by third parties related to the intellectual property content of our products. Certain of these indemnification provisions are perpetual from execution of the agreement and, in some instances; the maximum amount of potential future indemnification is not limited. To date, we have not paid any such claims or been required to defend any lawsuits with respect to a claim. Recent Accounting Pronouncements In December 2011, the FASB issued ASU No. 2011-11, "Disclosures about Offsetting Assets and Liabilities." ASU 2011-11 will require us to disclose information about offsetting related arrangements to enable users of our financial statements to understand the effect of those arrangements on our financial position. The new guidance is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The disclosures required are to be applied retrospectively for all comparative periods presented. We do not expect that this standard will materially impact our disclosures included in condensed consolidated financial statements. Annual Results of Operations Revenue by product line was as follows: 2012 Change 2011 Change 2010 (Dollars in thousands) Mobile $ 120,936 83.8 % $ 65,789 525.1 % $ 10,525 Consumer Electronics 62,236 -29.2 % 87,922 -25.6 % 118,192 Personal Computers 20,315 -1.0 % 20,523 -14.9 % 24,124 Total product revenue $ 203,487 16.8 % $ 174,234 14.0 % $ 152,841 Percentage of total revenue 80.6 % 78.8 % 79.9 % Licensing revenue $ 48,877 4.5 % $ 46,775 21.5 % $ 38,506 Percentage of total revenue 19.4 % 21.2 % 20.1 % Total revenue $ 252,364 14.2 % $ 221,009 15.5 % $ 191,347 Product Revenue The increase in product revenue was primarily due to increased demand for our mobile products offset in part by lower CE and PC revenue. The increase in our mobile products from 2011 to 2012 was primarily due to the continued success of our MHL product line. These products were introduced in the latter part of fiscal year 2010. Since then, we have seen increased shipments of MHL products quarter over quarter. For the fourth quarter, mobile revenue grew 42.4% year over year and represented over 64.3% of our total product revenue. For the year, our mobile revenue grew 83.8 % and represented over 59.4% of total product revenue up from 37.8% a 42 -------------------------------------------------------------------------------- Table of Contents year ago. Our MHL products represent the majority of our mobile revenue. The decrease in our CE revenue from 2011 to 2012 was primarily the result of a broad-based market shift to lower-end DTV products that incorporate our semiconductor products less frequently. Our PC revenue continued to decline in 2012 as we did not make any investments in these legacy products in prior years. However, our MHL and HDMI technologies are applied in various PC devices, and we also expect our 60GHz WirelessHD to be a key technology in the coming years Revenue from our mobile products increased from 2010 to 2011 primarily due to the successful launch of our newest MHL transmitter product. The revenue growth in our mobile market was partially offset by the decrease in revenue in our CE market. Revenue from our CE market decreased from 2010 to 2011 primarily due to global macro-economic pressures that drove consumers to purchase lower priced CE products, and the 9.0 magnitude earthquake and subsequent tsunami that hit Japan in March 2011, which has affected both demand in Japan and the global supply chain for CE products. High-end DTVs with the latest features and capabilities (the market segment where we typically deliver our latest CE innovations) have been particularly affected by this trend. The earthquake in Japan had a two-fold impact. First, it reduced demand for higher-end TVs in the domestic Japanese market. Secondly, as a result of damage to the production facilities, the Japanese OEM manufacturers shifted a portion of their TV production to original design manufacturers (ODMs) outside of Japan which typically supply the lower-end to mid-range DTV market. Our revenue from Japan for the year ended December 31, 2011 was 19.7% as compared to 29.9% for the same period in 2010. Licensing Revenue Our licensing activity is complementary to our product sales and helps us to monetize our intellectual property and accelerate market adoption curves associated with our technology and standards. The increase in licensing revenue from 2011 to 2012 was primarily the result of increased in MHL adopter base due to the continued success of our MHL product adoption in various segments and an increase in royalty revenues. Our licensing revenue may fluctuate year over year as a result of the timing of completion of IP license arrangements. Licensing revenue increased from 2010 to 2011 primarily due to increase in new IP licenses sold by us during 2011, increase in HDMI licensing and increase in royalties. HDMI LLC revenue was higher mainly due to increase in HDMI product shipment activity reported by adopters in 2011 as compared to 2010. Revenue by Geography Based on Customers' Headquarters 2012 Change 2011 Change 2010 (Dollars in thousands) Asia Pacific $ 216,389 15.9 % $ 186,712 14.4 % $ 163,164 United States 18,686 -2.8 % 19,226 21.6 % 15,810 Europe 16,138 19.1 % 13,555 20.8 % 11,225 Others 1,151 -24.1 % 1,516 32.1 % 1,148 Total revenue $ 252,364 14.2 % $ 221,009 15.5 % $ 191,347 The increase in revenues in Asia-Pacific or APAC, which includes Japan and Korea, from 2011 to 2012, was primarily due to increased demand for our MHL products by our customers who have their headquarters in APAC. The increase in revenues in Europe from 2011 to 2012 was primarily due to increase demand for our legacy control module business, which is part of our PC category. Revenues in the United States decreased from 2011 to 2012 due to more of our customers moving their manufacturing offshore. The increase in revenue for APAC and Europe from 2010 to 2011 was primarily due to the Company's entry into the mobile market with the introduction of HDMI transmitter products. Revenue for the United States increased from 2010 to 2011 primarily due to additional revenues relating to the acquisitions of SiBEAM and ABT. 43 -------------------------------------------------------------------------------- Table of Contents COST OF REVENUE AND GROSS MARGIN 2012 Change 2011 Change 2010 (Dollars in thousands) Cost of product revenue (1) $ 109,815 22.0 % $ 90,035 16.2 % $ 77,480 Product gross profit 93,672 11.3 % 84,199 11.7 % 75,361 Product gross profit margin 46.0 % 48.3 % 49.3 % (1) Includes stock-based compensation expense $ 523 $ 670 $ 558 Cost of licensing revenue $ 626 -21.2 % $ 794 195.2 % $ 269 Licensing gross profit 48,251 4.9 % 45,981 20.3 % 38,237 Licensing gross profit margin 98.7 % 98.3 % 99.3 % Total cost of revenue $ 110,441 21.6 % $ 90,829 16.8 % $ 77,749 Total gross profit 141,923 9.0 % 130,180 14.6 % 113,598 Total gross profit margin 56.2 % 58.9 % 59.4 % Cost of Revenue Cost of revenue consists primarily of costs incurred to manufacture, assemble and test our products, and costs to license our technology which involves modification, customization or engineering services, as well as other overhead costs relating to the aforementioned costs including stock-based compensation expense. Total cost of revenue increased from 2011 to 2012 primarily due to the growth in revenue volume and a $6.2 million write down of unusable parts as a result of defective material used by one of our vendors. We are seeking compensation for this loss from our supplier, but no assurance can be provided regarding the amount of such compensation, if any. Total cost of revenue increased from 2010 to 2011 primarily due to the growth in revenue volume during the same comparative periods. Product Gross Profit Margin Our product gross profit margin decreased from 2011 to 2012 primarily due to the decrease in average selling price (ASP) per unit from $1.23 in 2011 to $1.03 in 2012, which was primarily driven by the increase in mobile revenue-which carries a lower ASP-as a share of total revenue and a $6.2 million write down of unusable parts as a result of defective material used by one of our vendors, partially offset by decreases in wafer, assembly, packaging and testing costs, improved freight and warehouse efficiencies, better absorption of fixed and semi-variable overheads as a result of increased revenue and lower depreciation expense due to fully depreciated testers. Product mix is a major factor in the changes in our overall ASP for products. Product gross profit margin decreased from 2010 to 2011 primarily due to the decrease in ASP per unit from $1.45 in 2010 to $1.23 in 2011, partially offset by decrease in wafer, testing and assembly cost in 2011 than in 2010 and better overhead absorption due to the increase in volume. Licensing Gross Profit Margin Licensing gross profit margin was comparable in 2012 and 2011. Licensing gross profit margin decreased from 2010 to 2011 primarily due to higher mix of IP customization projects during 2011. OPERATING EXPENSES Research and development 2012 Change 2011 Change 2010 (Dollars in thousands) Research and development(1) $ 77,372 16.3 % $ 66,533 20.3 % $ 55,313 Percentage of total revenue 30.7 % 30.1 % 28.9 % (1) Includes stock-based compensation expense 3,585 3,774 2,631 44 -------------------------------------------------------------------------------- Table of Contents Research and development (R&D). R&D expense consists primarily of employee compensation and benefits, fees for independent contractors, the cost of software tools used for designing and testing our products and costs associated with prototype materials. R&D expense increased from 2011 to 2012 primarily due to an increase in compensation related expenses as a result of the SiBEAM acquisition in May 2011 of $3.6 million, higher mask-set costs and project related expenses of approximately $5.9 million and $2.0 million of additional costs as a result of our expansion in India. Our R&D headcount as of December 31, 2012 was 350 employees as compared to 257 employees as of December 31, 2011 primarily due to the expansion of our R&D capabilities in India. R&D expense increased from 2010 to 2011 primarily due to the increase in compensation related expenses as a result of the two acquisitions that we completed in 2011, increase in project related expenses and increase in stock-based compensation expense. R&D expense for the year ended December 31, 2011 included stock-based compensation expense of $3.8 million, as compared to $2.6 million for the year ended December 31, 2010. Our R&D headcount as of December 31, 2011 was 257 employees as compared to 207 employees as of December 31, 2010 with the increase primarily due to the acquisitions of SiBEAM and ABT. Selling, general and administrative 2012 Change 2011 Change 2010 (Dollars in thousands) Selling, general and administrative (1) $ 57,446 3.9 % $ 55,277 18.3 % $ 46,710 Percentage of total revenue 22.8 % 25.0 % 24.4 % (1) Includes stock-based compensation expense 5,096 5,076 4,152 Selling, general and administrative (SG&A). SG&A expense consists primarily of compensation, including stock-based compensation expense, sales commissions, professional fees, and marketing and promotional expenses. SG&A expense increased from 2011 to 2012 primarily due to an increase in consultant expense of approximately $1.5 million. Our SG&A headcount as of December 31, 2012 were 198 employees as compared to 187 employees as of December 31, 2011. SG&A expense increased from 2010 to 2011 primarily due to the increase in compensation related expenses of approximately $2.7 million, additional marketing activities of approximately $2.8 million, stock-based compensation expense of approximately $0.9 million and transaction expenses of approximately $1.0 million in relation to the two business acquisitions that we completed during the year ended December 31, 2011. Our SG&A headcount as of December 31, 2011 was 187 employees as compared to 156 employees as of December 31, 2010. Restructuring 2012 Change 2011 Change 2010 (Dollars in thousands) Restructuring expense $ 110 -95.2 % $ 2,269 -30.4 % $ 3,259 Percentage of total revenue 0.0 % 1.0 % 1.7 % Restructuring. The total restructuring expense for the year ended December 31, 2012 primarily related to adjustments to previously established accrual for facility exit costs. The total restructuring expense for the year ended December 31, 2011 consisted primarily of $0.9 million related to severance benefits and exit costs we incurred as a result of SiBEAM acquisition, $0.4 million related to our storage business restructuring, $0.3 million relating to operating lease termination costs and $0.7 million related to severance benefits for the headcount reduction in the fourth quarter of 2011. The total restructuring expense for the year ended December 31, 2010 consisted primarily of $2.0 million related to contract termination cost, a charge of $0.9 million relating to operating lease termination costs and a charge of $0.3 million related to retirement of certain fixed assets. During 2010, we were in the process of transitioning certain R&D work from Europe to Asia and as a result of this transition, we decided to cease using 45-------------------------------------------------------------------------------- Table of Contents the services of certain European engineers which resulted in an accrual of future costs of $2.0 million payable under the related contract without any future economic benefit to us. We recorded such future costs as restructuring expense in 2010. Amortization of acquisition-related intangible assets 2012 Change 2011 Change 2010 (Dollars in thousands) Amortization of acquisition-related intangible assets $ 599 -62.2 % $ 1,585 963.8 % $ 149 Percentage of total revenue 0.2 % 0.7 % 0.1 % Amortization of acquisition-related intangible assets. The decrease in amortization expense from 2011 to 2012 was primarily due to the reversal of amortization expense related to the trademark acquired in the SiBEAM acquisition of $825,000 and correcting the useful life of the core technology acquired in the ABT acquisition from three to five years of approximately $355,000. See Note 1 to our consolidated financial statements for further discussion of these out-of-periods adjustments. The increase in the amortization of intangible assets for the year ended December 31, 2011 as compared to the same period in 2010 was primarily due to amortization of the intangible assets acquired from the two acquisitions completed during 2011. Impairment of intangible assets. In the fourth quarter of 2011, we assessed our advances to a third party for intellectual properties for impairment. We concluded that the intangible assets related to these advances amounting to $8.5 million were fully impaired as of December 31, 2011, and recorded an impairment charge for the full amount in 2011. Interest income and others, net 2012 Change 2011 Change 2010 (Dollars in thousands) Interest income $ 1,654 -13.9 % $ 1,920 -17.8 % $ 2,335 Impairment of investment in an unconsolidated affiliate (7,467 ) 0.0 % - 0.0 % - Reversal of a subsidiary's accumulated currency translation adjustment - 100.0 % (132 ) -109.7 % 1,366 Other income (expense), net 7 -94.6 % 130 268.8 % (77 ) Total $ (5,806 ) -402.7 % $ 1,918 -47.1 % $ 3,624 Percentage of total revenue -2.3 % 0.9 % 1.9 % Interest income decreased from 2011 to 2012 primarily due to the decrease in our short-term investments as a result of the cash used in the repurchase of treasury stock. Interest income decreased from 2010 to 2011 primarily due to the decrease in our short-term investments as a result of the cash used in business acquisitions. In 2012, we recorded a non-cash impairment charge of $7.5 million representing the carrying value of our investment in a U.S. based privately-held company. See Note 5 to our consolidated financial statements for further discussion of this impairment of investment in privately-held company. In 2010, we recognized as income the accumulated foreign currency translation adjustment of our wholly owned subsidiary in Germany whose facilities and offices had been substantially liquidated during 2010. Provision for income taxes 2012 Change 2011 Change 2010 (Dollars in thousands) Provision for income taxes $ 9,979 16.3 % $ 8,583 137.8 % $ 3,609 Percentage of total revenue 3.9 % 3.9 % 1.9 % 46 -------------------------------------------------------------------------------- Table of Contents Provision for income taxes. For the year ended December 31, 2012, we recorded an income tax provision of $10.0 million, as compared to income tax provision of $8.6 million and $3.6 million in 2011 and 2010, respectively. Our effective income tax rate was 1,691% in 2012. In 2012, the primary reconciling items between our effective tax rate and the U.S. statutory tax rate of 35% included approximately $6.7 million of income tax expense primarily due to foreign withholding taxes and foreign income inclusions. In addition, we provided approximately $10.3 million for an increase to the valuation allowance to offset deferred tax assets which are not more likely than not to be realized and approximately $1.0 million for stock based compensation. The primary benefit provided was for approximately $6.6 million related to the use of foreign tax credits. Our effective income tax rate was (415.4%) in 2011. In 2011, the primary reconciling items between our effective tax rate and the U.S. statutory tax rate of 35% included approximately $8.9 million of income tax expense primarily due to foreign withholding taxes and foreign income inclusions. In addition, we provided approximately $ 8.2 million for an increase to the valuation allowance to offset deferred tax assets which are not more likely than not to be realized and approximately $1.0 million for stock based compensation. The primary benefit provided was for approximately $6.8 million related to the use of foreign tax credits and R&D tax credits. Our effective income tax rate was 30.6% in 2010. In 2010, the difference between the expense for income taxes and the income tax expense determined by applying the statutory federal income tax rate of 35% was due primarily to foreign withholding taxes and changes in the valuation allowance. Liquidity and Capital Resources The following sections discuss the effects of changes in our balance sheet and cash flows, contractual obligations and other commitments on our liquidity and capital resources. Cash and Cash Equivalents, Short-term Investments and Working Capital. The table below summarizes our cash and cash equivalents, investments and working capital and the related movements (in thousands). 2012 Change 2011 Change 2010 (Dollars in thousands) Cash and cash equivalents $ 29,069 $ (8,056 ) $ 37,125 $ 7,183 $ 29,942 Short term investments 78,398 (45,903 ) 124,301 (36,237 ) 160,538 Total cash, cash equivalents and short term investments $ 107,467 $ (53,959 ) $ 161,426 $ (29,054 ) $ 190,480 Percentage of total assets 47.4 % 60.7 % 76.0 % Total current assets $ 165,617 $ (43,048 ) $ 208,665 $ (22,148 ) $ 230,813 Total current liabilities (42,815 ) 3,927 (46,742 ) (675 ) (46,067 ) Working capital $ 122,802 $ (39,121 ) $ 161,923 $ (22,823 ) $ 184,746 As of December 31, 2012, $12.1 million of the cash and cash equivalents and short term investments was held by foreign subsidiaries. Local government regulations may restrict our ability to move cash balances from our foreign subsidiaries to meet cash needs under certain circumstances; however, any current restrictions are not material. We do not currently expect such regulations and restrictions to impact our ability to pay vendors and conduct operations. If these funds are needed for our operations in the U.S., we may be required to accrue and pay U.S. taxes to repatriate these funds. However, our intent is to indefinitely reinvest these funds outside of the U.S. and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations. The significant components of our working capital are cash and cash equivalents, short-term investments, accounts receivable, inventories and prepaid expenses and other current assets, reduced by accounts payable, accrued and other current liabilities, deferred license revenue and deferred margin on sales to distributors. 47 -------------------------------------------------------------------------------- Table of Contents The net decrease in current assets at December 31, 2012 as compared to December 31, 2011 was primarily due to a $54.0 million decrease in total cash and cash equivalents and short-term investments, partially offset by $10.5 million increase in accounts receivable. The net change in the Company's cash position on a year over year basis was primarily the results of cash used for share repurchases, long term strategic investments and working capital coverage. The increase in accounts receivable was primarily due to timing of invoicing relative to the quarter end over collections during the year ended December 31, 2012. The net decrease in current liabilities at December 31, 2012 as compared to December 31, 2011 was mainly due to a $3.6 million decrease in accrued and other current liabilities, partially offset by a $2.5 million increase in deferred margin on sales to distributors. The increase in deferred margin on sales to distributors was mainly due to the increasing activities with our distributors driven by the acceleration of demand for our products while the decrease in accrued and other current liabilities was mainly attributable to the payment of 2011 bonus accrued at the end of 2011 and paid in the first quarter of 2012, product rebates and payment of milestone to ABT. Summary of Cash Flows. The table below summarizes the cash and cash equivalents provided by (used in) in our operating, investing and financing activities. 2012 2011 2010 (Dollars in thousands) Cash provided by operating activities $ 4,676 $ 7,458 $ 46,494 Cash provided by (used in) investing activities 24,076 (4,762 ) (50,725 ) Cash provided by (used in) financing activities (36,788 ) 4,501 3,954 Effect of exchange rate changes on cash and cash equivalents (20 ) (14 ) 463 Net increase (decrease) in cash and cash equivalents $ (8,056 ) $ 7,183 $ 186 Operating Activities Cash provided by operating activities is generated by net income (loss) adjusted for certain non-cash items and changes in assets and liabilities. During the year ended December 31, 2012, we incurred a net loss of $11.2 million which included non-cash charges of approximately $28.5 million (primarily related to stock based compensation, depreciation and amortization, and impairment charges). Changes in assets and liabilities that generated cash were primarily prepaid expenses and other current assets and deferred margin on sales to distributors. These increases were offset by changes in operating assets and liabilities that used cash, primarily accounts receivable, inventories and accrued and other liabilities. During the year ended December 31, 2011, we incurred a net loss of $11.6 million which included non-cash charges of approximately $30.2 million (primarily related to stock based compensation, depreciation and amortization, and impairment charges). Changes in assets and liabilities that generated cash were primarily inventories and accrued and other liabilities. These increases were offset by changes in operating assets and liabilities that used cash, primarily accounts receivable, prepaid expenses and other current assets, accounts payable, deferred margin on sales to distributors and deferred license revenue. During the year ended December 31, 2010, we had a net income of $8.2 million which included non-cash charges of approximately $14.0 million (primarily related to stock based compensation, depreciation and amortization, and impairment charges). Changes in assets and liabilities that generated cash were primarily prepaid expense and other current assets, accounts payable, deferred license revenue and deferred margin on sales to distributors. These increases were offset by changes in operating assets and liabilities that used cash, primarily accounts receivable, inventories and accrued and other liabilities. 48 -------------------------------------------------------------------------------- Table of Contents Investing Activities Cash provided by investing activities during the year ended December 31, 2012 was primarily a result of $44.2 million net proceeds from the sales and maturities of short-term investments, partially offset by $8.9 million used for capital expenditures, $10.0 million used for various strategic business investments and $1.2 million used for purchases of intellectual properties. During the year ended December 31, 2012, we sold $104.8 million and purchased $60.6 million of short-term investments. Cash used in our investing activities during the year ended December 31, 2011 was due primarily to $15.9 million used in connection with our business acquisitions, $7.5 million used to make an investment in an unconsolidated affiliate, $7.2 million used for advances for intellectual properties, net of repayments of secured notes and $7.8 million net investment in property and equipment, partially offset by $33.7 million net proceeds from the sales and maturities of short-term investments. During the year ended December 31, 2011, we sold $147.0 million and purchased $113.3 million of short-term investments. Cash used in investing activities during the year ended December 31, 2010 was due primarily to net purchases of short-term investments of approximately $42.8 million, net investment in property and equipment of approximately $4.7 million and other investing activities amounting to approximately $3.2 million. During the year ended December 31, 2010, we purchased $166.9 million and sold $124.1 million of short-term investments. We are not a capital-intensive business. Our purchases of property and equipment in 2012, 2011 and 2010 related mainly to testing equipment, leasehold improvements and information technology infrastructure. Financing Activities Cash used in our financing activities during the year ended December 31, 2012 was primarily due to $39.7 million used to repurchase our common stock, $2.2 million used to repurchase restricted stock units for minimum statutory income tax withholding and $1.1 million cash paid to settle contingent consideration liabilities, partially offset by the proceeds from stock option exercises and purchases under our employee stock purchase program of approximately $5.6 million. Cash generated from our financing activities during the year ended December 31, 2011 was primarily due to the proceeds from stock option exercises and purchases under our employee stock purchase program of approximately $6.2 million and to the excess tax benefits from employee stock-based transactions of approximately $2.1 million, partially offset by $3.3 million used to repurchase restricted stock units for minimum statutory income tax withholding and $0.5 million used to pay a line of credit assumed from business acquisition. Cash generated from our financing activities during the year ended December 31, 2010 was primarily due to the proceeds from stock option exercises and purchases under our employee stock purchase program totaling approximately $5.6 million and to the excess tax benefits from employee stock-based transactions of approximately $0.8 million, partially offset by payments to vendor of financed purchases of software and intangibles of approximately $1.2 million and cash to repurchase restricted stock units for income tax withholding of approximately $1.2 million. Cash Requirements and Commitments In addition to our normal operating cash requirements, our principal future cash requirements will be to fund capital expenditures, share repurchases and any strategic investments or acquisitions, in addition we have approximately $13.9 million in commitments for fiscal years including and beyond 2013 as disclosed in the contractual obligations section below. 49-------------------------------------------------------------------------------- Table of Contents Contractual Obligations Our contractual obligations as of December 31, 2012 were as follows (in thousands): Payments Due In Less Than More Than Contractual Obligations: Total 1 Year 1-3 Years 3-5 Years 5 Years Operating lease obligations $ 12,933 $ 3,115 $ 5,058 $ 3,837 $ 923 Contingent payment to acquire additional preferred stock 1,000 - 1,000 - - $ 13,933 $ 3,115 $ 6,058 $ 3,837 $ 923 On December 21, 2012, we signed a Securities Purchase Agreement and agreed to purchase a 17.7% equity ownership interest in a privately-held company for $3.5 million in cash. We have paid $2.5 million in 2012 and the remaining $1.0 million is in the form of contingent payment to acquire additional preferred stock in the privately-held Company, over a period of time based on achievement of certain milestones by the privately-held company. The amounts above exclude liabilities under FASB ASC 740-10, "Income Taxes - Recognition section" amounting to approximately $27.2 million as of December 31, 2012 as we are unable to reasonably estimate the ultimate amount or timing of settlement. See Note 12, "Income Taxes," in our notes to consolidated financial statements included in Item 15(a) of this report for further discussion. Liquidity and Capital Resource Requirements Based on our estimated cash flows, we believe our existing cash and cash equivalents and short-term investments are sufficient to meet our capital and operating requirements for at least the next 12 months. |