Annual Report

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

 

 

Form 10-K

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2007

Commission file number 000-26887

          

 

 

 

 

Registrant’s telephone number, including area code

(408) 616-4000

 

Securities registered pursuant to section 12(b) of the Act:

Common Stock, $0.001 par value per share

 

Securities registered pursuant to section 12(g) of the Act:

None

 

 

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  o      No  þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes  o      No  þ

 

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  þ      No  o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer,” “accelerated filer, and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes  o      No  þ

 

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $726,794,477 as of the last business day of the registrant’s most recently completed second fiscal quarter, based upon the closing sale price on the Nasdaq National Market reported for such date. Shares of common stock held by each officer and director and by each person who owned 5% or more of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination for other purposes.

 

The number of shares of the Registrant’s common stock outstanding as of January 31, 2008 was 84,345,350.

 

Portions of the Definitive Proxy Statement for the 2008 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year covered by this report, are incorporated by reference in Part III of this Form 10-K.

 

 

TABLE OF CONTENTS

 

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. These forward-looking statements involve a number of risks and uncertainties, including those identified in the section of this Annual Report on Form 10-K entitled “Factors Affecting Future Results,” that may cause actual results to differ materially from those discussed in, or implied by, such forward-looking statements. Forward-looking statements within this Annual Report on Form 10-K are identified by words such as “believes,” “anticipates,” “expects,” “intends,” “may,” “will”, “can”, “should”, “could”, “estimate”, based on”, “intended”, “would”, “projected”, “forecasted” and other similar expressions. However, these words are not the only means of identifying such statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. We undertake no obligation to publicly release the results of any updates or revisions to these forward-looking statements that may be made to reflect events or circumstances occurring subsequent to the filing of this Form 10-K with the Securities and Exchange Commission (SEC). Our actual results could differ materially from those anticipated in, or implied by, forward-looking statements as a result of various factors, including the risks outlined elsewhere in this report. Readers are urged to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the SEC that attempt to advise interested parties of the risks and factors that may affect our business.

PART I

 

relationships with the eco-system of companies that provide the products that drive digital content creation and consumption, including the major Hollywood studios, consumer electronics companies, retailers and service providers. To that end, we have developed relationships with Hollywood studios such as Universal, Warner Brothers, Disney and Fox and with major consumer electronics companies such as Sony, Hitachi, Toshiba, Matsushita, Phillips and Thomson. Through these and other relationships, we have formed a strong understanding of the requirements for storing, distributing and viewing high quality digital video and audio in the home and mobile environments, especially in the area of High Definition (HD) content. We have also developed a substantial intellectual property 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 standards and entering new markets. We collaborated with several companies and jointly developed the DVI and HDMI standards. Our first products addressed the PC market. Subsequently, we introduced products for a variety of CE market segments, including DVD, STB, game console and digital television (DTV) markets. More recently, we have expanded our research and development activities and are developing products based on our innovative digital interconnect core technology for the mobile device market, including digital still cameras, HD camcorders, portable media players and smart phones. We are also developing a personal networking technology solution that will enable a consumer to access and display digital content from and to the various devices in the consumer’s personal domain.

 

We are headquartered in Sunnyvale, California. Our Internet website address is www.SiliconImage.com. We are not including the information contained on our web site as a part of, or incorporating it by reference into, the Annual Report on Form 10-K. We make available through our Internet website free of charge, our Annual Report on Form 10-K quarterly reports on Form 10-Q current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable, after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.

 

Strategy

 

Our goal is to enable the access and presentation of high-definition digital content anytime, anywhere, on any device. Our business strategy is to grow the available market for our products and IP solutions through the development, introduction and promotion of industry standards such as HDMI, DVI and Serial Advanced Technology Attachment (SATA). In 2006, Gartner/Dataquest ranked Silicon Image as the sixth largest semiconductor IP licensing vendor in the world, based on revenue. We are active in existing industry standards bodies; however, we believe that it is our formation of and participation in, new industry standards organizations that have had and will continue to have, the greatest impact on our business.

 

We are directly involved in the following standards efforts:

 

High-Definition Multimedia Interface (HDMI)

 

In 2002, we entered into a Founder’s Agreement with Sony, Matsushita Electric Industrial Co. (Panasonic), Philips, Thomson, Hitachi and Toshiba, under which we formed a working group to develop the HDMI specification, a next-generation digital interface for consumer electronics. The HDMI specification is based on our market-proven Transition Minimized Differential Signaling (TMDS) technology, the same technology underlying the HDMI specification’s predecessor specification, DVI, which we also developed. As an HDMI founder, we have actively participated in the evolution of the HDMI specification and we anticipate that our involvement in this and in other digital interface connectivity standards will continue.

 

Our leadership in the market for HDMI-enabled products has been based on our ability to introduce first-to-market semiconductor and IP solutions to manufacturers. We introduced the industry’s first products for each new version of the HDMI standard, providing a time-to-market advantage to our customers. For consumers, HDMI has provided a simpler way to connect and use devices and enjoy the higher-quality entertainment experience available with digital content. More than 750 manufacturers around the world have become HDMI adopters. For CE manufacturers, HDMI is a low-cost, standardized means of interconnecting CE devices, which enables these manufacturers to build feature-rich products that deliver a true home theater entertainment

experience. For PC and monitor manufacturers, HDMI enables a PC connection to digital TVs and monitors at HD quality levels. The market acceptance and adoption of HDMI enabled products have been significant factors in our growth over the last several years, driving both our product and licensing revenues. According to the market research firm In-Stat, an estimated over 143 million HDMI-enabled products were expected to ship worldwide in 2007.

 

High-bandwidth Digital Content Protection (HDCP)

 

In 2000, the HDCP specification HDCP 1.0 was published by Intel, with contributions from Silicon Image acknowledged in the specification. The specification was developed to add content protection to DVI in order to prevent unauthorized copying of content when transmitted between source and display over a DVI link. In 2003, the HDCP specification was updated to revision level 1.1 and made available for use with HDMI. This technology has been widely adopted in consumer electronics products, initially in combination with DVI and more recently and more prevalently in combination with HDMI. In 2007, the HDCP specification was again revised in VI.3.b.1. The HDCP Compliance Test Specification VI.1 was released in 2006.

 

Digital Visual Interface (DVI)

 

In 1998, together with Intel, Compaq, IBM, Hewlett-Packard, NEC and Fujitsu, we announced the formation of the Digital Display Working Group (DDWG) and in 1999, published the DVI 1.0 specification. The DVI 1.0 standard defines a high-speed serial data communication link between computers and digital displays. According to In-Stat, over 112 million DVI-enabled products were expected to ship in 2007. Today, in many applications, DVI is being replaced by the more feature-rich HDMI.

 

Serial Advanced Technology Attachment (SATA)

 

We have been a contributor to the SATA standard and a leading supplier of discrete SATA solutions including controllers, storage processors, port multipliers and bridges. Based on serial signaling technology, the SATA standard specifies a computer bus technology for connecting hard disk drives and other devices and was formed by Intel, Dell, Maxtor, Seagate and Vitesse in 1999. We sell SATA semiconductors primarily to merchant motherboard suppliers, computer OEMs and external drive manufacturers.

 

Recent Strategic Transactions

 

We completed two important transactions in 2007 intended to enhance our ability to offer higher levels of integration and greater price/performance value to our customers. In February 2007, we entered into a cross-license agreement with Sunplus Technology Company, Ltd. granting us the right to use certain advanced IP in DTV semiconductor products, which we believe will offer us greater opportunities to develop semiconductor solutions for the home and mobile device environment. The license agreement provided for the payment of an aggregate of $40.0 million to Sunplus by Silicon Image, $35.0 million of which was payable in consideration for the licensed technology and related deliverables and $5.0 million of which was payable in consideration for Sunplus support and maintenance obligations. In addition, our acquisition in January 2007 of sci-worx GmbH (sci-worx), now Silicon Image, GmbH provides us a combination of additional advanced IP and a highly skilled pool of engineers who we believe will help leverage our research and development efforts into new products. We acquired sci-worx GmbH for a net cash consideration of $13.8 million. We believe that the intellectual property licensed from Sunplus, along with the engineering talent and intellectual property acquired in the sci-worx transaction, will enhance our ability to develop a broader array of product offerings.

 

Consumer Electronics

 

Our HDMI products have been selected by many of the world’s CE companies. Our products have driven the transition to industry-leading HDMI products with features including Deep Color ^tm and lossless HD audio. During the past year, we have seen a rapid penetration of HDMI 1.3 into the home theater and DTV markets. Beyond the outstanding video and sound quality enabled by HDMI technology, our latest products also include HDMI Consumer Electronics Control (CEC) functionality, which allows a single remote controller to operate all CEC enabled devices connected to the HDTV.

 

DTV

 

In 2007, we focused our activities on a new DTV architecture that, we believe, provides OEMs with best-in-class performance relating to DTV inputs and allows these manufacturers to bring their products to market more quickly. In 2007, we launched the SiI915x family of input processors, which are highly integrated HDTV processing solutions that include HDMI 1.3 with Deep Color and x.v.Color extended color gamut coupled with high-definition legacy analog video support. Our SiI915x family of input processors expands the number of HDMI ports available to consumers and augments the HDMI functionality with high-quality, high-definition analog video support. These new HDTV input processor solutions allow consumers to enjoy the highest quality content currently available on their HDTVs, including the new, lossless compressed digital audio formats available in HDMI 1.3: Dolby ^® TrueHD and DTS-HD Master Audio ^tm , as well as high-bandwidth uncompressed digital audio and compressed formats such as Dolby Digital, DTS and Super Audio CD (SACD). Complemented by advanced and thorough testing performed for us by Simplay Labs, these new products offer rapid time-to-market solutions and allow OEMs to significantly reduce cross-platform compatibility issues.

 

We also introduced our first-generation HDMI 1.3 switch products (SiI9181 and SiI9185) with integrated HDMI CEC functionality. These HDMI switches enable multiple HDMI source devices to connect to HDTVs with frequency of operation up to 225 megahertz (MHz), allowing consumers to enjoy Deep Color content.

 

Additionally, in 2007 we released several new integrated receivers that deliver advanced HDMI 1.3 HDTV features including 1080p Deep Color and x.v.Color expanded color gamut. Our two-port receiver (SiI9125), designed for use in HDTVs, is an advanced dual-input receiver that fits directly into the HDTV unit, offering manufacturers a low cost, easily implemented upgrade to add HDMI 1.3 capabilities to their full range of HDTVs. Our new four-port receiver (SiI9135), designed for use in audio/video receivers, is the first HDMI 1.3 receiver chip to support advanced HD features such as compressed lossless audio. HDMI 1.3 products represented 39.0% of CE product sales.

 

Mobile Devices

 

Our new Mobile High-Definition Link ^tm (MHL) technology is a low-pin-count link for low-power mobile devices with a direct HDMI connector for mobile phones, digital cameras and camcorders media players and other mobile devices enabling consumers to watch and listen to content from these devices on their HDTVs with pristine digital quality. In 2007, we introduced the industry’s first three products that enable MHL: two transmitters (SiI9220

and SiI9222) which are the first MHL transmitters for mobile devices and the first MHL-to-HDMI bridge chip (SiI9290) for the docking station. We also introduced what we believe to be the lowest power consuming HDMI transmitters in the mobile device market. Our next generation of HDMI transmitters for mobile devices (SiI9022 and SiI9024) delivers reduced power consumption, improving reliability and battery life in mobile devices.

 

Our HDMI products are branded under the VastLane ^tm product family and have been selected by many of the world’s CE companies.

 

VastLane HDMI Transmitters.   Our VastLane HDMI transmitter products reside in CE and PC products, such as DVD players, DVD recorders, game consoles, STBs, digital camcorders, A/V receivers and digital video recorders (DVRs). VastLane HDMI transmitters convert digital video and audio into a multi-gigabit per second (Gbps) encrypted serialized stream and transmit the secure content to an HDMI receiver that is built into televisions and A/V receivers.

 

VastLane HDMI Receivers.   Our VastLane HDMI receiver products reside in display systems, such as HDTVs, plasma TVs, LCD TVs, rear-projection TVs, front projectors, PC monitors as well as A/V receivers. VastLane HDMI receivers convert an incoming encrypted serialized stream to digital video and audio, which is then processed by a television or PC monitor for display.

 

We offer a broad line of products targeting the CE market including:

 

 

PC

 

While the PC market has become an increasingly smaller portion of our business over time, a trend that we anticipate will continue, the growth of digital TVs with HDMI inputs provides a source of demand for our PC products as consumers increasingly seek to connect their PCs to their DTVs to play games, watch high-definition DVDs and view photos. Because HDMI is backward compatible with the DVI standard, HDMI-enabled PCs can also connect directly to the enormous installed base of PC monitors with DVI inputs.

 

Our DVI products are marketed under our VastLane product family. Market researcher In-Stat estimated that 92 million DVI-enabled PC devices were shipped by industry participants in 2006. Although DVI is being replaced by the more feature-rich HDMI in many applications, In-Stat projects that approximately 112 million DVI-enabled devices were expected to ship in 2007.

 

Silicon Image offers a line of receivers and transmitters for the PC marketplace, including:

 

 

Storage

 

We believe the consumer trend of increasingly purchasing and downloading content (e.g. music, TV programs and movies) from the internet will create a growing awareness and need for low-cost, simple, secure and reliable storage. In 2007, we released our second-generation storage processors (SiI5733) compatible with SATA, external SATA (eSATA) and Universal Serial Bus (USB) hosts. Storage processors provide an extremely cost-effective storage solution that is both fast and reliable. Our SATA controllers, built on the new Unified Extensible Firmware Interface (UEFI) model, give manufacturers of DVRs, STBs and PC motherboards an easy way to add SATA connectivity.

 

In the storage market, we continue our leadership role in SATA, a standard that has replaced PATA in desktop storage. Through several SATA generations, we have introduced higher levels of SATA integration, driving higher SATA performance and functionality and delivering a family of SATA system-on-a-chip (SoC) solutions for the consumer electronics environment. SATA offers a number of benefits over PATA interfaces, including higher bandwidth, scalability, lower voltage and narrower cabling. As a result, SATA is quickly becoming the standard drive interface for desktop and notebook PCs and is establishing a significant presence in CE applications through e-SATA connections. eSATA extends the SATA connection outside the device enclosure providing a storage interface that is six times faster than Universal Serial Bus (USB) 2.0 and three times faster than IEEE 1394. The latest generation of digital video recorders (DVRs) from Scientific Atlanta, Motorola and TiVo, as well as PCs & motherboards from HP, Dell, ASUS, MSI, ECS, Foxconn, ASRock and iWill are equipped with eSATA ports.

 

We introduced our SteelVine architecture in 2004. SteelVine integrates the capabilities of a complex redundant array of independent disks (RAID) controller into a single-chip architecture. Our storage products fall into three categories: controllers, bridges and storage processors, each of which is branded under the SteelVine ^tm product family.

 

SteelVine Storage Controllers  — We provide a full line of SATA controllers used in PC, DVR and network attached storage (NAS) applications. The current generation of SteelVine controllers provides the latest SATA Gen II features including eSATA signal levels, 3.0 Gb/s, native command queuing (NCQ), hot-plug and port multiplier support.

 

SteelVine Bridges  — Our bridge products such as the SiI3811 provide PC OEMs with a solution that connects legacy PATA optical drives to the current generation of motherboard chip sets and are used primarily in desktop and laptop PC applications.

 

SteelVine Storage Processors  — Our SteelVine storage processors represent a completely new product category that enables a new class of storage solutions for the PC, CE and external storage markets. SteelVine storage processors deliver enterprise-class features such as virtualization, RAID, hot-plug and hot spare, in a single very low cost SoC. These unique SoCs allow system builders to produce appliance-like solutions that are simple,

reliable, affordable and scalable without the need for host software. Storage processors are currently shipping in PC motherboards as well as external storage solutions.

 

We believe that our multi-layer approach to providing robust, cost-effective, multi-gigabit semiconductor solutions on a single chip for high-bandwidth applications, lends itself well to SATA storage market applications.

 

Our storage products include the following:

 

 

Simplay Labs, LLC

 

We believe Simplay Labs LLC, our wholly owned subsidiary, has further enhanced our reputation for quality, reliable products and leadership in the HDMI market. The Simplay HD Testing Program offers one of the most robust and comprehensive testing platforms in the consumer electronics industry as device interoperability is a significant issue to retailers and consumers in the HD market. Devices that pass the Simplay HD test are certified to meet the HDMI and HDCP specifications and have demonstrated interoperability through empirical testing against over 80 “peer” devices maintained by the labs. We have service centers operating in the US, China, we opened two new Simplay Labs European HD service centers in 2007 in the UK and Germany, providing global compatibility and performance testing centers. By December 31, 2007, more than 160 product lines had been Simplay HD-verified and 75 manufacturers, installers and retailers had become members of the Simplay HD Testing Program, enabling a higher level of consumer trust that their products are fully interoperable with other HDMI products.

 

In 2007, Simplay introduced the Simplay Pre-test System (SPS), designed to identify interoperability, usability and performance issues before products are submitted to a Simplay Labs service center. The first test tool of its kind for CE manufacturers, the SPS sets a higher performance standard for the CE industry and enables manufacturers to bring products to market faster. We also launched a new Simplay HD Consumer Support Service for end-to-end Simplay HD verified products, which provides consumers with complimentary installation assistance and troubleshooting services in the set-up, operation and performance of their new HD home theater products.

HDMI Licensing, LLC

 

The HDMI specification is experiencing rapid growth in the consumer electronics, mobile device and PC markets, as manufacturers meet consumer demand for multimedia convergence. The market acceptance and adoption of the HDMI specification has been a significant factor the growth of both our product and licensing revenues over the past several years.

 

As of December 31, 2007, more than 750 manufacturing companies had licensed HDMI from HDMI Licensing, LLC, our wholly-owned subsidiary and the agent responsible for the licensing of HDMI. We believe the adoption by additional manufacturers during 2007, further strengthens the specification’s position as the worldwide standard for high-definition digital connectivity. According to market researcher In-Stat, the HDMI specification has become widely adopted and has moved from an emerging standard to a prevalent connectivity standard used in many consumer applications. In-Stat reports that 143 million HDMI enabled devices incorporating HDMI were expected to be shipped in 2007, with over 229 million devices expected to ship in 2008 and an installed base of nearly 1.2 billion HDMI-enabled devices projected by 2010. Our licensing activity is complementary to our product sales and it helps us to monetize our intellectual property and accelerate market adoption curves associated with our technology. Most of the intellectual property we license includes a field of use restriction that prevents the licensee from building a chip in direct competition with those market segments we have chosen to pursue.

 

Markets and Customers

 

We focus our sales and marketing efforts on achieving design wins with OEMs of CE, PC and storage products. Historically, a relatively small number of customers and distributors have generated a significant portion of our revenue. Our top five customers, including distributors, generated 57.7%, 57.3% and 53.5%, of our revenue in 2007, 2006 and 2005, respectively. For the year ended December 31, 2007, shipments to Innotech Corporation, generated 15.6% of our revenue, shipments to Microtek Corporation, generated 14.2% of our revenue and shipments to World Peace Industrial, generated 13.6% of our revenue. The percentage of revenue generated through distributors tends to be significant, since many OEMs rely upon third-party manufacturers or distributors to provide purchasing and inventory management functions. Our revenue generated through distributors was 49.5%, 50.2% and 51.7% of our total revenue in 2007, 2006 and 2005, respectively.

 

A substantial portion of our business is conducted outside the United States; therefore, we are subject to foreign business, political and economic risks. Nearly all of our products are manufactured offshore, primarily in Asia and for the years ended December 31, 2007, 2006 and 2005, approximately 79.8%, 78.6% and 74.3%, of our revenue respectively, was generated from customers and distributors located outside the United States, primarily in Asia. Please refer to the section of this report titled “Risk Factors” for a discussion of risks associated with the sell-through arrangement with our distributors.

 

Research and Development

 

Our research and development efforts continue to focus on innovative technologies and standards, higher-bandwidth, lower-power links, efficient algorithms, architectures and feature-rich implementations for higher-level SoCs, for CE (including DTV), PC, mobile and storage applications. By utilizing our patented technologies and optimized architectures, we believe our products can scale with advances in semiconductor manufacturing process technology, simplify system design and provide innovative solutions for our customers. As of December 31, 2007, we had been issued more than 100 United States patents and had in excess of 85 United States patent applications pending. Our U.S. issued patents expire in 2015 or later, subject to our payment of periodic maintenance fees. A discussion of risks related to our intellectual property is set forth in the section of this report titled “Risk Factors”.

 

We have assembled a team of engineers and technologists with extensive experience in the areas of high-speed interconnect architecture, circuit design, digital audio-visual (A/V) processor architecture, storage architecture, logic design/verification, firmware/software, flat panel displays, digital video/audio systems and storage systems. We have invested and expect that we will continue to invest, significant funds for research and development activities. Our research and development expenses were approximately $78.0 million, $63.6 million and $44.9 million, in 2007, 2006 and 2005, respectively, including stock-based compensation expense (benefit) of $8.4 million, $11.1 million and ($3.9) million for 2007, 2006 and 2005, respectively.

Sales and Marketing

 

We sell our products using a direct sales force with field offices located in North America, Europe, Turkey, Taiwan, China, Japan and Korea and through a network of distributors located throughout North America, Asia and Europe. Our sales strategy for all products is to achieve design wins with key industry companies in order to grow the markets in which we participate and to promote and accelerate the adoption of industry standards that we support or are developing.

 

Manufacturing

 

Wafer Fabrication

 

Our semiconductor products are designed using standard, complementary metal – oxide – semiconductor (CMOS) processes, which permit us to use independent wafer foundries to fabricate them. By outsourcing the manufacture of our semiconductor products, we are able to avoid the high-cost of owning and operating a semiconductor wafer fabrication facility and to take advantage of our contract manufacturers’ high-volume economies of scale. Outsourcing our manufacturing also gives us direct and timely access to various process technologies. This allows us to focus our resources on the innovation, design and quality of our products.

 

Our semiconductor products are currently fabricated using 0.35, 0.25, 0.18 and 0.13 micron processes. We continuously evaluate the benefits, primarily the improved performance, costs and feasibility, of migrating our products to smaller geometry process technologies. We have conducted certain development projects for some of our customers, involving smaller and more cost effective geometries, namely 90 nm and 65 nm designs. We rely almost entirely on Taiwan Semiconductor Manufacturing Company (TSMC) to produce all of our semiconductor products. Because of the cyclical nature of the semiconductor industry, capacity availability can change quickly and significantly. We attempt to optimize wafer availability by continuing to use less advanced wafer geometries, such as 0.35, 0.25, 0.18 and 0.13 micron, for which foundries generally have more available capacity.

 

Assembly and Test

 

Our semiconductor products are designed to use low-cost standard packages and to be tested with widely available semiconductor test equipment. We outsource all of our packaging and the majority of our test requirements. This enables us to take advantage of high-volume economies of scale and supply flexibility and gives us direct and timely access to advanced packaging and test technologies. We test a small portion of our products in-house. Since the fabrication yields of our products have historically been high and the costs of our packaging have historically been low, we test our products after they are assembled. This testing method has not caused us to experience unacceptable failures or yields. Our operations personnel closely review the process and control and monitor information provided to us by our foundries. To ensure quality, we have established firm guidelines for rejecting wafers that we consider unacceptable. However, lack of testing prior to assembly could have adverse effects if there are significant problems with wafer processing. Additionally, for newer products and products for which yield rates have not stabilized, we may conduct bench testing using our personnel and equipment, which is more expensive than fully automated testing.

 

During 2007, we purchased and installed additional pieces of equipment at third-party testing facilities to ensure we receive priority on such equipment and to obtain lower test prices from these facilities. In the fourth quarter of 2007, in an effort to improve control, increase operational flexibility and lower costs, we began internally managing the relationships with our other third party subcontractors who handle our wafer assembly and test process and terminated our reliance on third-party management of this process.

 

Quality Assurance

 

We focus on product quality through all stages of the design and manufacturing process. Our designs are subjected to in depth circuit simulation at temperature, voltage and processing extremes before being fabricated. We pre-qualify each of our subcontractors through an audit and analysis of the subcontractor’s quality system and manufacturing capability. We also participate in quality and reliability monitoring through each stage of the production cycle by reviewing data from our wafer foundries and assembly subcontractors. We closely monitor

wafer foundry production to ensure consistent overall quality, reliability and yields. Our independent foundries and our assembly and test subcontractors have achieved International Standards Organization (ISO) 9001 certification.

 

Competition

 

The markets in which we participate are intensely competitive and are characterized by rapid technological change, evolving standards, short product life cycles and decreasing prices. We believe that some of the key factors affecting competition in our markets are levels of product integration, compliance with industry standards, time-to-market, cost, product capabilities, system design costs, intellectual property, customer support, quality and reputation.

 

CE

 

In the consumer electronics market, our digital interface products are used to connect a variety of devices to DTVs including cable set-top boxes, satellite set-top boxes, A/V receivers, game consoles, digital/personal video recorders (DVR/PVR), DVD players and a growing number of mobile devices such as camcorders and cameras. These products incorporate HDMI technology with HDCP or DVI and HDCP support. Companies competing for sales of HDMI and DVI solutions include among others, Analog Devices, Analogix, Broadcom, Conexant, Genesis, Mstar, NXP, Texas Instruments and Thine. We also compete in some instances against in-house processing solutions designed by large consumer electronics OEMs.

 

PC

 

In the PC market, our products face competition from a number of sources. We offer a number of HDMI and DVI solutions to the PC market and we compete against several companies such as AMD, Analog Devices, Broadcom, Chrontel, Conexant, Genesis, MRT, National Semiconductor, nVidia, Pixelworks, SIS, Smart ASIC, ST Microelectronics, Texas Instruments and Thine. In addition, Intel and other competitors have announced plans to integrate HDMI into their PC chips sets. Our HDMI products may also face competition from DisplayPort, which is a new digital display interface standard being put forth by the Video Electronics Standards Association (VESA) that defines a digital audio/video interconnect intended to be used primarily between a computer and its display monitor, or a computer and a home-theater system. Several other companies have announced that they expect to introduce products based on the DisplayPort standard including AMD, Genesis and nVidia.

 

Storage

 

Our SATA products compete with similar products from Atmel, J-Micron, Marvell Technology, Promise Technology, Silicon Integrated Systems and VIA Technologies. In addition, other companies, such as APT, Intel and LSI Logic, have developed, or announced intentions to develop, SATA products. We also compete against AMD, Intel, nVidia, Silicon Integrated Systems, VIA Technologies and other motherboard chip-set makers, which have intentions, or have announced intentions to integrate SATA functionality into their chipsets.

 

Many of our competitors have longer operating histories and greater presence in key markets, greater name recognition, access to larger customer bases and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other resources than we do. In particular, well-established semiconductor companies such as Analog Devices, Intel, National Semiconductor and Texas Instruments and consumer electronics manufacturers, such as Hitachi, Matsushita, Sony, Thomson and Toshiba, may compete against us in the future. We cannot assure that we can compete successfully against current or potential competitors, or that competition will not seriously harm our business.

 

Employees

 

As of December 31, 2007, we had a total of 635 employees, including 265 located outside of the United States. In January 2007 we purchased sci-worx GmbH, now Silicon Image, GmbH and as a result of the acquisition, we added approximately 172 employees. None of our employees are represented by a collective bargaining agreement, except, as is customary, our employees in Germany are represented by a work council. We have never experienced any work stoppages. We consider our relations with our employees to be good. If we are unable to hire and retain

qualified personnel, our business will be seriously harmed. We depend on the continued service of our key technical, sales and senior management personnel and our ability to attract and retain additional qualified personnel.

 

 

 

If we fail to effectively manage our business, this could adversely affect our results of operations.

 

Our business may be significantly impacted by a downturn in the economy

 

Our CE product revenue, which comprised of approximately 63.7%, 56.9% and 51.2% of total revenue in 2007, 2006 and 2005 respectively, is dependant on continued demand for consumer electronics, including but not limited to, DTVs, STBs, DVDs and game consoles. Demand for consumer electronics business is a function of the health of the economies in the United States and around the world. If the US economy or other economies around the world move into recession, we expect that the demand for overall consumer electronics will be adversely affected and therefore, demand for our CE, PC and storage products and our operating results will be adversely affected as well.

 

The licensing component of our business strategy increases business risk and volatility.

 

Part of our business strategy is to license intellectual property (IP) or sell “virtual products” through agreements with companies for whereby companies incorporate our IP into their respective technologies that address markets in which we do not want to directly participate. There can be no assurance that additional companies will be interested in purchasing these virtual products on commercially favorable terms or at all. We also cannot ensure that companies who purchase our technology will introduce and sell products incorporating our technology, will accurately report royalties owed to us, will pay agreed upon royalties, will honor agreed upon market restrictions, will not infringe upon or misappropriate our intellectual property and will maintain the confidentiality of our proprietary information. The virtual product agreements are complex and depend upon many factors including completion of milestones, allocation of values to delivered items and customer acceptances. Many of these factors require significant judgments. Licensing revenue could fluctuate significantly from period to period because it is heavily dependent on a few key deals being completed in a particular period, the timing of which is difficult to predict and may not match our expectations. Because of its high margin content, the sales of these virtual products can have a disproportionate impact on gross profit and profitability. Also, generating revenue from these arrangements is a lengthy and complex process that may last beyond the period in which efforts begin and once an agreement is in place, the timing of revenue recognition may be dependent on customer acceptance of deliverables, achievement of milestones, our ability to track and report progress on contracts, customer commercialization of the licensed technology and other factors. Licensing that occurs in connection with actual or contemplated litigation is

subject to risk that the adversarial nature of the transaction will induce non-compliance or non-payment. The accounting rules associated with recognizing revenue from these transactions are increasingly complex and subject to interpretation. Due to these factors, the amount of license revenue recognized in any period may differ significantly from our expectations.

 

We face intense competition in our markets, which may lead to reduced revenue from sales of our products and increased losses.

 

The CE, PC and storage markets in which we operate are intensely competitive. These markets are characterized by rapid technological change, evolving standards, short product life cycles and declining selling prices. We expect competition for many of our products to increase, as industry standards become widely adopted and as new competitors enter our markets.

 

Our products face competition from companies selling similar discrete products and from companies selling products such as chipsets with integrated functionality. Our competitors include semiconductor companies that focus on the CE, display or storage markets, as well as major diversified semiconductor companies and we expect that new competitors will enter our markets. Current or potential customers, including our own licensees, may also develop solutions that could compete with us, including solutions that integrate the functionality of our products into their solutions. In addition, current or potential OEM customers may have internal semiconductor capabilities and may develop their own solutions for use in their products rather than purchasing them from companies such as us. Some of our competitors have already established supplier or joint development relationships with current or potential customers and may be able to leverage their existing relationships to discourage these customers from purchasing products from us or persuade them to replace our products with theirs. Many of our competitors have longer operating histories, greater presence in key markets, better name recognition, access to larger customer bases and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other resources than we do and as a result, they may be able to adapt more quickly to new or emerging technologies and customer requirements, or devote greater resources to the promotion and sale of their products. In particular, well-established semiconductor companies, such as Analog Devices, Intel, National Semiconductor and Texas Instruments and CE manufacturers, such as Hitachi, Matsushita, Philips, Sony, Thomson and Toshiba, may compete against us in the future. Some of our competitors could merge, which may enhance their market presence. Existing or new competitors may also develop technologies that more effectively address our markets with products that offer enhanced features and functionality, lower power requirements, greater levels of integration or lower cost. Increased competition has resulted in and is likely to continue to result in price reductions and loss of market share in certain markets. We cannot assure you that we can compete successfully against current or potential competitors, or that competition will not reduce our revenue and gross margins.

 

We operate in rapidly evolving markets, which makes it difficult to evaluate our future prospects.

 

The markets in which we compete are characterized by rapid technological change, evolving customer needs and frequent introductions of new products and standards. As we adjust to evolving customer requirements and technological advances, we may be required to further reposition our existing offerings and to introduce new products and services. We may not be successful in developing and marketing such new offerings, or we may experience difficulties that could delay or prevent the development and marketing of such new offerings. Moreover, new standards that compete with DVI and HDMI have been and in the future may be introduced from time to time, which could impact our success. Accordingly, we face risks and difficulties frequently encountered by companies in new and rapidly evolving markets. If we do not successfully address these risks and difficulties, our results of operations could be negatively affected.

 

Our success depends on demand for our new products.

 

Our future growth and success depends on our ability to develop and bring to market on a timely basis new products, such as our HDTV input processors and MHL products, which we have recently introduced into the market. There can be no assurance that we will be successful in developing and marketing new products. Moreover, there is no assurance that our new products will achieve the desired level of market acceptance in the anticipated timeframes or that any such new products will contribute significantly to our revenue. Our new products face

significant competition from established companies that have been selling competitive products for longer periods of time than we have.

 

Demand for our HDMI based products is dependent on continued adoption and widespread implementation of the HDMI specification.

 

Our success in the HDMI market is largely dependent upon the continued adoption and widespread implementation of the HDMI specification. Demand for our products may be inhibited by unanticipated unfavorable changes in or new regulations that delay or impede the transition to digital broadcast technologies in the U.S. or abroad. Demand for our consumer electronics products may also be inhibited in the event of negative consumer experience with HDMI technology as more consumers put it into service. Transmission of audio and video from “player devices” (such as a DVD player or set-top box) to intermediary devices (such as an audio-video receiver (AVR)) to displays (such as an HDTV) over HDMI with HDCP represents a combination of new technologies working in concert. Complexities with these technologies, the interactions between content protection technologies and HDMI with HDCP and the variability in HDMI implementations between manufacturers may cause some of these products to work incorrectly, or for the transmissions to not occur correctly, or for certain products not to be interoperable. Also, the user experience associated with audiovisual transmissions over HDMI with HDCP is unproven and users may reject products incorporating these technologies or they may require more customer support than expected. Delays or difficulties in integration of these technologies into products or failure of products incorporating this technology to achieve market acceptance could have an adverse effect on our business. In addition, we believe that the rate of HDMI adoption may be affected by changes in FCC rules and European Information Communications and Consumer Electronics Technology Industry Associations (EICTA) and Cable & Satellite Broadcasting Association of Asia (CASBAA) recommendations described below.

 

In the United States, the FCC issued its Plug and Play order in October 2003. In November 2003 and March 2004, these rules, known as the Plug & Play Final Rules (Plug & Play Rules), became effective. The Plug and Play Rules are relevant to DVI and HDMI with respect to high definition set-top boxes and the labeling of digital cable ready televisions. Regarding high-definition set-top boxes, the FCC stated that, as of July 1, 2005, all high definition set-top boxes acquired by cable operators for distribution to subscribers would need to include either a Digital Visual Interface (DVI) or High-Definition Multimedia Interface (HDMI) with HDCP. Regarding digital cable ready televisions, the FCC stated that a 720p or 1080i unidirectional digital cable television may not be labeled or marketed as digital cable ready unless it includes the following interfaces DVI or HDMI with HDCP according to a phase-in timetable. In the past, the FCC has made modifications to its rules and timetable for the DTV transition and it may do so in the future. We cannot predict whether these FCC rules will be amended prior to completion of the phase-in dates or that such phase-in dates will not be delayed. In addition, we cannot guarantee that the FCC will not in the future reverse these rules or adopt rules requiring or supporting different interface technologies, either of which would adversely affect our business.

 

In January 2005, the European Industry Association for Information Systems, Communication Technologies and Consumer Electronics (EICTA) issued its “Conditions for High Definition Labeling of Display Devices” which requires all HDTVs using the “HD Ready” logo to have either an HDMI or DVI input with HDCP. In August 2005, EICTA issued its “Minimum Requirements for HD Television Receivers” which requires HD Receivers without an integrated display (e.g. HD STBs) utilizing the “HDTV” logo and intended for use with HD sources (e.g. television broadcasts), some of which require content protection in order to permit HD quality output, to have either a DVI or HDMI output with HDCP.

 

In August 2005, the Cable and Satellite Broadcasting Association of Asia (CASBAA) issued a series of recommendations in its “CASBAA Principles for Content Protection in the Asia-Pacific Pay-TV Industry” for handling digital output from future generations of set-top boxes for VOD, PPV, Pay-TV and other encrypted digital programming applications. These recommendations include the use of one or more HDMI with HDCP or DVI with HDCP digital outputs for set-top boxes capable of outputting uncompressed high-definition content.

 

With respect to the EICTA and CASBAA recommendations, we cannot predict the rate at which manufacturers will implement the HDMI-related recommendations in their products.

The HDMI founders decided to reduce the annual license fee payable by HDMI adopters from $15,000 to $10,000 per year effective on November 1, 2006 for all adopters after that date in order to encourage more widespread adoption of HDMI. The annual fees collected by our subsidiary HDMI Licensing, LLC are recognized as revenues by us. Accordingly, if there are not sufficient new adopters of HDMI to offset the reduction in the annual license fee payable per adopter, our revenues will be negatively impacted. In addition, during 2007, at a founders meeting, the founders decided to share the HDMI adopter’s royalty revenues among the various founders. The company no longer receives 100% of the HDMI adopter royalty revenues.

 

We will have difficulty selling our products if customers do not design our products into their product offerings or if our customers’ product offerings are not commercially successful.

 

Our products are generally incorporated into our customers’ products at the design stage. As a result, we rely on equipment manufacturers to select our products to be designed into their products. Without these “design wins,” it is very difficult to sell our products. We often incur significant expenditures on the development of a new product without any assurance that an equipment manufacturer will select our product for design into its own product. Additionally, in some instances, we are dependent on third parties to obtain or provide information that we need to achieve a design win. Some of these third parties may be our competitors and, accordingly, may not supply this information to us on a timely basis, if at all. Once an equipment manufacturer designs a competitor’s product into its product offering, it becomes significantly more difficult for us to sell our products to that customer because changing suppliers involves significant cost, time, effort and risk for the customer. Furthermore, even if an equipment manufacturer designs one of our products into its product offering, we cannot be assured that its product will be commercially successful or that we will receive any revenue from that product. Sales of our products largely depend on the commercial success of our customers’ products. Our customers generally can choose at any time to stop using our products if their own products are not commercially successful or for any other reason. We cannot assure you that we will continue to achieve design wins or that our customers’ equipment incorporating our products will ever be commercially successful.

 

Our products typically have lengthy sales cycles. A customer may decide to cancel or change its product plans, which could cause us to lose anticipated sales. In addition, our average product life cycles tend to be short and, as a result, we may hold excess or obsolete inventory that could adversely affect our operating results.

 

After we have developed and delivered a product to a customer, the customer will usually test and evaluate our product prior to designing its own equipment to incorporate our product. Our customers generally need three months to over six months to test, evaluate and adopt our product and an additional three months to over nine months to begin volume production of equipment that incorporates our product. Due to this lengthy sales cycle, we may experience significant delays from the time we incur operating expenses and make investments in inventory until the time that we generate revenue from these products. It is possible that we may never generate any revenue from these products after incurring such expenditures. Even if a customer selects our product to incorporate into its equipment, we have no assurances that the customer will ultimately market and sell its equipment or that such efforts by our customer will be successful. The delays inherent in our lengthy sales cycle increase the risk that a customer will decide to cancel or change its product plans. Such a cancellation or change in plans by a customer could cause us to lose sales that we had anticipated. In addition, anticipated sales could be materially and adversely affected if a significant customer curtails, reduces or delays orders during our sales cycle or chooses not to release equipment that contains our products.

 

While our sales cycles are typically long, our average product life cycles tend to be short as a result of the rapidly changing technology environment in which we operate. As a result, the resources devoted to product sales and marketing may not generate material revenue for us and from time to time, we may need to write off excess and obsolete inventory. If we incur significant marketing expenses and investments in inventory in the future that if we are not able to recover and we are not able to compensate for those expenses, our operating results could be adversely affected. In addition, if we sell our products at reduced prices in anticipation of cost reductions but still hold higher cost products in inventory, our operating results would be harmed.

Our customer may not purchase anticipated levels of products, which can result in increased inventory levels

 

We generally do not obtain firm, long-term purchase commitments from our customers and, in order to accommodate the requirements of certain customers, we may from time to time build inventory that is specific to that customer in advance of receiving firm purchase orders. The short-term nature of our customers’ commitments and the rapid changes in demand for their products reduce our ability to accurately estimate the future requirements of those customers. Should the customer’s needs shift so that they no longer require such inventory, we may be left with excessive inventories, which could adversely affect our operating results.

 

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

 

Historically, a relatively small number of customers and distributors have generated a significant portion of our revenue. For the year ended December 31, 2007, shipments to Innotech Corporation, generated 15.6% of our revenue, shipments to Microtek Corporation, generated 14.2% of our revenue and shipments to World Peace Industrial, generated 13.6% of our revenue. For the year ended December 31, 2006, shipments to Microtek Corporation, generated 16.3% of our revenue, shipments to Innotech Corporation, generated 15.7% of our revenue and shipments to World Peace Industrial, generated 11.6% of our revenue. In addition, an end-customer may buy through multiple distributors, contract manufacturers and /or directly, which could create an even greater concentration. We cannot be certain that customers and key distributors that have accounted for significant revenue in past periods, individually or as a group, will continue to sell our products and generate revenue. As a result of this concentration of our customers, our results of operations could be negatively affected if any of the following occurs:

 

 

While our participation in multiple markets, has broadened our customer base, as product mix fluctuates from quarter to quarter, we may become more dependent on a small number of customers or a single customer for a significant portion of our revenue in a particular quarter, the loss of which could adversely affect our operating results.

 

We sell our products through distributors, which limits our direct interaction with our customers, therefore reducing our ability to forecast sales and increasing the complexity of our business.

 

Many original equipment manufacturers rely on third-party manufacturers or distributors to provide inventory management and purchasing functions. Distributors generated 49.5% of our revenue for the year ended December 31, 2007, 50.2% of our revenue for the year ended December 31, 2006 and 51.7% of our revenue for the year ended December 31, 2005. Selling through distributors reduces our ability to forecast sales and increases the complexity of our business, requiring us to:

 

 

Since we have limited ability to forecast inventory levels at our end customers, it is possible that there may be significant build-up of inventories in the distributor channel, with the OEM or the OEM’s contract manufacturer. Such a buildup could result in a slowdown in orders, requests for returns from customers, or requests to move out planned shipments. This could adversely impact our revenues and profits.

 

Any failure to manage these challenges could disrupt or reduce sales of our products and unfavorably impact our financial results.

Our success depends on the development and introduction of new products, which we may not be able to do in a timely manner because the process of developing high-speed semiconductor products is complex and costly.

 

The development of new products is highly complex and we have experienced delays, some of which exceeded one year, in the development and introduction of new products on several occasions in the past. We have recently introduced new products and will continue to introduce new products in the future. As our products integrate new, more advanced functions, they become more complex and increasingly difficult to design, manufacture and debug. Successful product development and introduction depends on a number of factors, including, but not limited to:

 

 

Accomplishing all of this is extremely challenging, time-consuming and expensive and there is no assurance that we will succeed. Product development delays may result from unanticipated engineering complexities, changing market or competitive product requirements or specifications, difficulties in overcoming resource constraints, the inability to license third-party technology or other factors. Competitors and customers may integrate the functionality of our products into their own products, thereby reducing demand for our products. If we are not able to develop and introduce our products successfully and in a timely manner, our costs could increase or our revenue could decrease, both of which would adversely affect our operating results. In addition, it is possible that we may experience delays in generating revenue from these products or that we may never generate revenue from these products. We must work with a semiconductor foundry and with potential customers to complete new product development and to validate manufacturing methods and processes to support volume production and potential re-work. Each of these steps may involve unanticipated difficulties, which could delay product introduction and reduce market acceptance of the product. In addition, these difficulties and the increasing complexity of our products may result in the introduction of products that contain defects or that do not perform as expected, which would harm our relationships with customers and our ability to achieve market acceptance of our new products. There can be no assurance that we will be able to achieve design wins for our planned new products, that we will be able to complete development of these products when anticipated, or that these products can be manufactured in commercial volumes at acceptable yields, or that any design wins will produce any revenue. Failure to develop and introduce new products, successfully and in a timely manner, may adversely affect our results of operations.

There are risks to our global strategy

 

In 2006, we commenced the implementation of our global strategy. As of December 31, 2007, the global strategy is fully operational. We continue to believe that with our global structure, we will in the long run, realize certain operational benefits from this global strategy as well as achieve an overall lower tax rate. The effectiveness of the strategy requires, in addition to on-going and increasing profitability, management to maintain certain structural and various compliance activities in support of the structure. Should management fail to adhere to the various compliance requirements or fail to maintain supportive processes, the ability to realize the expected benefits may be jeopardized which may adversely affect our business, operating results or financial condition.

 

We have made acquisitions in the past and may make acquisitions in the future, if advisable and these acquisitions involve numerous risks.

 

Our growth depends upon market growth and our ability to enhance our existing products and introduce new products on a timely basis. Acquisitions of companies or intangible assets is a strategy we may use to develop new products and enter new markets. In January 2007, we completed the acquisition of sci-worx, now Silicon Image, GmbH. We may acquire additional companies or technologies in the future. Acquisitions involve numerous risks, including, but not limited to, the following:

 

 

No assurance can be given that our prior acquisitions or our future acquisitions, if any, will be successful or provide the anticipated benefits, or that they will not adversely affect our business, operating results or financial condition. Failure to manage growth effectively and to successfully integrate acquisitions made by us could materially harm our business and operating results.

 

Our acquisition of sci-worx GmbH exposes us to a variety of risks.

 

We acquired sci-worx, now Silicon Image, GmbH, a limited liability company based in Germany, in January 2007. In addition to the acquisition-related risks described in the risk factor above, this acquisition exposes us to complexities of operating in Germany, a country in which we had not previously had significant operations and whose regulatory framework with which we have only recently become familiar and of difficulties in managing and integrating approximately 172 employees based in Germany. In addition, the technologies acquired from sci-worx may require significant additional development before they can be marketed and may not generate sufficient revenue to offset expenses associated with the acquisition. Any of these problems or factors with respect to this acquisition could adversely affect our business, financial condition or results of operations.

 

Industry cycles may strain our management and resources.

 

Cycles of growth and contraction in our industry may strain our management and resources. To manage these industry cycles effectively, we must:

 

 

 

If we cannot manage industry cycles effectively, our business could be seriously harmed.

 

The cyclical nature of the semiconductor industry may create constrictions in our foundry, test and assembly capacity.

 

The semiconductor industry is characterized by significant downturns and wide fluctuations in supply and demand. This cyclicality has led to significant fluctuations in product demand and in the foundry, test and assembly capacity of third-party suppliers. Production capacity for fabricated semiconductors is subject to allocation, whereby not all of our production requirements would be met. This may impact our ability to meet demand and could also increase our production costs and inventory levels. Cyclicality has also accelerated decreases in average selling prices per unit. We may experience fluctuations in our future financial results because of changes in industry-wide conditions. Our financial performance has been and may in the future be, negatively impacted by downturns in the semiconductor industry. In a downturn situation, we may incur substantial losses if there is excess production capacity or excess inventory levels in the distribution channel.

 

We depend on third-party sub-contractors to manufacture, assemble and test nearly all of our products, which reduce our control over the production process.

 

We do not own or operate a semiconductor fabrication facility. We rely on third party semiconductor manufacturing companies overseas to produce the vast majority of our semiconductor products. We also rely on outside assembly and test services to test all of our semiconductor products. Our reliance on independent foundries, assembly and test facilities involves a number of significant risks, including, but not limited to:

 

 

In addition, our semiconductor products are assembled and tested by several independent subcontractors. We do not have a long-term supply agreement with all of our subcontractors and instead obtain production services on a purchase order basis. Our outside sub-contractors have no obligation to supply products to us for any specific period of time, in any specific quantity or at any specific price, except as set forth in a particular purchase order. Our requirements represent a small portion of the total production capacity of our outside foundries, assembly and test facilities and our sub-contractors may reallocate capacity to other customers even during periods of high demand for our products. These foundries may allocate or move production of our products to different foundries under their control, even in different locations, which may be time consuming, costly and difficult, have an adverse affect on quality, yields and costs and require us and/or our customers to re-qualify the products, which could open up design wins to competition and result in the loss of design wins and design-ins. If our subcontractors are unable or unwilling to continue manufacturing our products in the required volumes, at acceptable quality, yields and costs and in a timely manner, our business will be substantially harmed. As a result, we would have to identify and qualify substitute contractors, which would be time-consuming, costly and difficult. This qualification process may also require significant effort by our customers and may lead to re-qualification of parts, opening up design wins to competition and loss of design wins and design-ins. Any of these circumstances could substantially harm our business. In addition, if competition for foundry, assembly and test capacity increases, our product costs may increase and we may be required to pay significant amounts or make significant purchase commitments to secure access to production services.

The complex nature of our production process, which can reduce yields and prevent identification of problems until well into the production cycle or, in some cases, after the product has been shipped.

 

The manufacture of semiconductors is a complex process and it is often difficult for semiconductor foundries to achieve acceptable product yields. Product yields depend on both our product design and the manufacturing process technology unique to the semiconductor foundry. Since low yields may result from either design or process difficulties, identifying problems can often only occur well into the production cycle, when an actual product exists that can be analyzed and tested.

 

Further, we only test our products after they are assembled, as their high-speed nature makes earlier testing difficult and expensive. As a result, defects often are not discovered until after assembly. This could result in a substantial number of defective products being assembled and tested or shipped, thus lowering our yields and increasing our costs. These risks could result in product shortages or increased costs of assembling, testing or even replacing our products.

 

Although we test our products before shipment, they are complex and may contain defects and errors. In the past we have encountered defects and errors in our products. Because our products are sometimes integrated with products from other vendors, it can be difficult to identify the source of any particular problem. Delivery of products with defects or reliability, quality or compatibility problems, may damage our reputation and our ability to retain existing customers and attract new customers. In addition, product defects and errors could result in additional development costs, diversion of technical resources, delayed product shipments, increased product returns, warranty and product liability claims against us that may not be fully covered by insurance. Any of these circumstances could substantially harm our business.

 

We face foreign business, political and economic risks because a majority of our products and our customers’ products are manufactured and sold outside of the United States.

 

A substantial portion of our business is conducted outside of the United States. As a result, we are subject to foreign business, political and economic risks. Nearly all of our products are manufactured in Taiwan or elsewhere in Asia. For the years ended December 31, 2007, 2006 and 2005, approximately 79.8%, 78.6% and 74.3% of our revenue, respectively was generated from customers and distributors located outside of the United States, primarily in Asia. We anticipate that sales outside of the United States will continue to account for a substantial portion of our revenue in future periods. In addition, we undertake various sales and marketing activities through regional offices in several other countries and we have significantly expanded our research and development operations outside of the United States. We intend to continue to expand our international business activities. Accordingly, we are subject to international risks, including, but not limited to:

 

 

 

Any of the factors described above may have a material adverse effect on our ability to increase or maintain our foreign sales. In addition, original equipment manufacturers that design our semiconductors into their products sell them outside of the United States. This exposes us indirectly to foreign risks. Because sales of our products are denominated exclusively in United States dollars, relative increases in the value of the United States dollar will increase the foreign currency price equivalent of our products, which could lead to a change in the competitive nature of these products in the marketplace. This in turn could lead to a reduction in sales and profits.

 

The success of our business depends upon our ability to adequately protect our intellectual property.

 

We rely on a combination of patent, copyright, trademark, mask work and trade secret laws, as well as nondisclosure agreements and other methods, to protect our proprietary technologies. We have been issued patents and have a number of pending patent applications. However, we cannot assure you that any patents will be issued as a result of any applications or, if issued, that any claims allowed will protect our technology. In addition, we do not file patent applications on a worldwide basis, meaning we do not have patent protection in some jurisdictions. It may be possible for a third-party, including our licensees, to misappropriate our copyrighted material or trademarks. It is possible that existing or future patents may be challenged, invalidated or circumvented and effective patent, copyright, trademark and trade secret protection may be unavailable or limited in foreign countries. It may be possible for a third-party to copy or otherwise obtain and use our products or technology without authorization, develop similar technology independently or design around our patents in the United States and in other jurisdictions. It is also possible that some of our existing or new licensing relationships will enable other parties to use our intellectual property to compete against us. Legal actions to enforce intellectual property rights tend to be lengthy and expensive and the outcome often is not predictable. As a result, despite our efforts and expenses, we may be unable to prevent others from infringing upon or misappropriating our intellectual property, which could harm our business. In addition, practicality also limits our assertion of intellectual property rights. Patent litigation is expensive and its results are often unpredictable. Assertion of intellectual property rights often results in counterclaims for perceived violations of the defendant’s intellectual property rights and/or antitrust claims. Certain parties after receipt of an assertion of infringement will cut off all commercial relationships with the party making the assertion, thus making assertions against suppliers, customers and key business partners risky. If we forgo making such claims, we may run the risk of creating legal and equitable defenses for an infringer.

 

Our participation in working groups for the development and promotion of industry standards in our target markets, including the Digital Visual Interface and HDMI specifications, requires us to license some of our intellectual property for free or under specified terms and conditions, which may make it easier for others to compete with us in such markets.

 

A key element of our business strategy includes participation in working groups to establish industry standards in our target markets, promote and enhance specifications and develop and market products based on such specifications and future enhancements. We are a promoter of the Digital Display Working Group (DDWG), which published and promotes the DVI specification and a founder in the working group that develops and promotes the HDMI specification. In connection with our participation in such working groups:

 

 

 

Accordingly, certain companies that implement the DVI and HDMI specifications in their products can use specific elements of our intellectual property to compete with us, in certain cases for free. Although in the case of the HDMI specification, there are annual fees and royalties associated with the adopters’ agreements, there can be no assurance that such annual fees and royalties will adequately compensate us for having to license our intellectual property. Fees and royalties received during the early years of adoption of HDMI will be used to cover costs we incur to promote the HDMI standard and to develop and perform interoperability tests; in addition, after an initial period during which we received all of the royalties associated with HDMI adopters’ agreements, in 2007, the HDMI founders reallocated the royalties to reflect each founder’s relative contribution of intellectual property to the HDMI specification. We no longer receive 100% of these royalties.

 

We intend to promote and continue to be involved and actively participate in other standard setting initiatives. Accordingly, we may license additional elements of our intellectual property to others for use in implementing, developing, promoting or adopting standards in our target markets, in certain circumstances at little or no cost. This may make it easier for others to compete with us in such markets. In addition, even if we receive license fees and/or royalties in connection with the licensing of our intellectual property, there can be no assurance that such license fees and/or royalties will adequately compensate us for having to license our intellectual property.

 

Our success depends in part on our relationships with Sunplus and other strategic partners.

 

We have entered into and expect to continue to enter into, strategic partnerships with third parties. In February 2007, we entered into a licensing agreement with Sunplus Technology, which grants us the rights to use and further develop advanced intellectual property (IP) technology. We believe that the IP licensed under this agreement will enhance our ability to develop DTV technology and other consumer product offerings. but the success of the arrangement depends upon our successful integration of the operations of the former sci-worx, which will be critical to our ability to develop products based on the licensed IP. The success of this strategic relationship also depends upon the continued market acceptance of our HDTV and consumer products. There is no assurance that we will be successful in integrating the operations of sci-worx or in developing successful products based on the Sunplus technology. While our relationship with Sunplus and other strategic partners are designed to drive revenue growth and adoption of our technologies and industry standards promulgated by us and also reduce our research and development expenses, there is no guarantee that these strategic partnerships will be successful. Negotiating and performing under these strategic partnerships involves significant time and expense; we may not realize anticipated increases in revenue, standards adoption or cost savings; and these strategic partnerships may make it easier for the third parties to compete with us; any of which may have a negative effect our business and results of operations.

 

Our success depends on managing our relationship with Intel.

 

Intel has a dominant role in many of the markets in which we compete, such as PCs and storage and is a growing presence in the CE market. We have a multi-faceted relationship with Intel that is complex and requires significant management attention, including:

 

 

 

Our cooperation and competition with Intel can lead to positive benefits, if managed effectively. If our relationship with Intel is not managed effectively, it could seriously harm our business, negatively affect our revenue and increase our operating expenses.

 

We have granted Intel rights with respect to our intellectual property, which could allow Intel to develop products that compete with ours or otherwise reduce the value of our intellectual property.

 

We entered into a patent cross-license agreement with Intel in which each of us granted the other a license to use the patents filed by the grantor prior to a specified date, except for identified types of products. We believe that the scope of our license to Intel excludes our current products and anticipated future products. Intel could, however, exercise its rights under this agreement to use our patents to develop and market other products that compete with ours, without payment to us. Additionally, Intel’s rights to our patents could reduce the value of our patents to any third-party who otherwise might be interested in acquiring rights to use our patents in such products. Finally, Intel could endorse competing products, including a competing digital interface, or develop its own proprietary digital interface. Any of these actions could substantially harm our business and results of operations.

 

We may become engaged in additional intellectual property litigation that could be time-consuming, may be expensive to prosecute or defend and could adversely affect our ability to sell our product.

 

In recent years, there has been significant litigation in the United States and in other jurisdictions involving patents and other intellectual property rights. This litigation is particularly prevalent in the semiconductor industry, in which a number of companies aggressively use their patent portfolios to bring infringement claims. In addition, in recent years, there has been an increase in the filing of so-called “nuisance suits,” alleging infringement of intellectual property rights. These claims may be asserted as counterclaims in response to claims made by a company alleging infringement of intellectual property rights. These suits pressure defendants into entering settlement arrangements to quickly dispose of such suits, regardless of merit. In addition, as is common in the semiconductor industry, from time to time we have been notified that we may be infringing certain patents or other intellectual property rights of others. Responding to such claims, regardless of their merit, can be time consuming, result in costly litigation, divert management’s attention and resources and cause us to incur significant expenses. As each claim is evaluated, we may consider the desirability of entering into settlement or licensing agreements. No assurance can be given that settlements will occur or that licenses can be obtained on acceptable terms or that litigation will not occur. In the event there is a temporary or permanent injunction entered prohibiting us from marketing or selling certain of our products, or a successful claim of infringement against us requiring us to pay damages or royalties to a third-party and we fail to develop or license a substitute technology, our business, results of operations or financial condition could be materially adversely affected.

 

We may also initiate litigation against third parties in order to protect our intellectual property rights. On January 31, 2007, we filed a lawsuit in the United States District Court for the Northern District of California against Analogix Semiconductor, Inc. a semiconductor company based in California. The complaint charges Analogix with copyright infringement, misappropriation of trade secrets and unlawful, unfair and fraudulent business practices.

The lawsuit alleges that Analogix, without authorization and in violation of our intellectual property rights, copied and used our proprietary register maps by gaining unauthorized access to our proprietary and confidential information, illegally copied and modified the Company’s semiconductor configuration software and knowingly and unlawfully encouraged its existing and prospective customers to modify and use the Company’s semiconductor configuration software with Analogix’s chips, a use that is beyond the scope and in violation of, the rights granted under, our software license agreements. In addition to seeking monetary damages in an amount to be determined at trial, we sought an injunction barring Analogix from misappropriation of Silicon Image’s trade secrets. Our motion for an injunction was denied. On June 18, 2007, Analogix filed a counterclaim alleging that we breached a confidentiality agreement by purportedly disclosing Analogix’s confidential information within the Company. A trial date has been set for April 21, 2008. This and other litigation initiated by us may be expensive and time-consuming and may divert our resources and the attention of our executives.

 

Any potential intellectual property litigation against us or in which we become involved could also force us to do one or more of the following:

 

 

If we take any of these actions, we may be unable to manufacture and sell our products. We may be exposed to liability for monetary damages, the extent of which would be very difficult to accurately predict. In addition, we may be exposed to customer claims, for potential indemnity obligations and to customer dissatisfaction and a discontinuance of purchases of our products while the litigation is pending. Any of these consequences could substantially harm our business and results of operations.

 

We have entered into and may again be required to enter into, patent or other intellectual property cross-licenses.

 

Many companies have significant patent portfolios or key specific patents, or other intellectual property in areas in which we compete. Many of these companies appear to have policies of imposing cross-licenses on other participants in their markets, which may include areas in which we compete. As a result, we have been required, either under pressure of litigation or by significant vendors or customers, to enter into cross licenses or non-assertion agreements relating to patents or other intellectual property. This permits the cross-licensee, or beneficiary of a non-assertion agreement, to use certain or all of our patents and/or certain other intellectual property for free to compete with us.

 

We indemnify certain of our licensing customers against infringement.

 

We indemnify certain of our licensing agreements customers for any expenses or liabilities resulting from third-party claims of infringements of patent, trademark, trade secret, or copyright rights by the technology we license. 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 any claim. In the event that we were required to defend any lawsuits with respect to our indemnification obligations, or to pay any claim, our results of operations could be materially adversely affected.

 

We must attract and retain qualified personnel to be successful and competition for qualified personnel is increasing in our market.

 

Our success depends to a significant extent upon the continued contributions of our key management, technical and sales personnel, many of who would be difficult to replace. The loss of one or more of these employees could harm our business. Although we have entered into a limited number of employment contracts with certain executive officers, we generally do not have employment contracts with our key employees. Our success also depends on our ability to identify, attract and retain qualified technical, sales, marketing, finance and managerial personnel.

Competition for qualified personnel is particularly intense in our industry and in our location. This makes it difficult to retain our key personnel and to recruit highly qualified personnel. We have experienced and may continue to experience, difficulty in hiring and retaining candidates with appropriate qualifications. To be successful, we need to hire candidates with appropriate qualifications and retain our key executives and employees. Replacing departing executive officers and key employees can involve organizational disruption and uncertain timing.

 

The volatility of our stock price has had an impact on our ability to offer competitive equity-based incentives to current and prospective employees, thereby affecting our ability to attract and retain highly qualified technical personnel. If these adverse conditions continue, we may not be able to hire or retain highly qualified employees in the future and this could harm our business. In addition, regulations adopted by The NASDAQ National Market requiring shareholder approval for all stock option plans, as well as regulations adopted by the New York Stock Exchange prohibiting NYSE member organizations from giving a proxy to vote on equity compensation plans unless the beneficial owner of the shares has given voting instructions, could make it more difficult for us to grant options to employees in the future. In addition, SFAS No. 123R, Share Based Payment , requires us to record compensation expense for options granted to employees. To the extent that new regulations make it more difficult or expensive to grant options to employees, we may incur increased cash compensation costs or find it difficult to attract, retain and motivate employees, either of which could harm our business.

 

We had a material weakness in internal control over financial reporting in 2005 which was remediated in 2006. We cannot assure you that additional material weaknesses will not be identified in the future. If our internal control over financial reporting or disclosure controls and procedures are not effective, there may be errors in our financial statements that could require a restatement or our filings may not be timely and investors may lose confidence in our reported financial information, which could lead to a decline in our stock price.

 

Section 404 of the Sarbanes-Oxley Act of 2002 requires us to evaluate the effectiveness of our internal control over financial reporting as of the end of each year and to include a management report assessing the effectiveness of our internal control over financial reporting in each Annual Report on Form 10-K. Section 404 also requires our independent registered public accounting firm to report on, our internal control over financial reporting.

 

Our management concluded that there was a material weakness, as defined in Public Company Accounting Oversight Board Auditing Standard No. 2, in our internal control over financial reporting as of December 31, 2005. Management believes this material weakness was remediated as of December 31, 2006.

 

Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefits of controls must be considered relative to their costs. Controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. Over time, controls may become inadequate because changes in conditions or deterioration in the degree of compliance with policies or procedures may occur. In addition, we may reassess the implementation or testing of certain of our current controls as a result of the recent release of Public Company Accounting Oversight Board Auditing Standard No. 5, which may lead to modifications in such controls. These modifications could affect the overall effectiveness or evaluation of the control system in the future by us or our independent registered public accounting firm. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

 

As a result, we cannot assure you that significant deficiencies or material weaknesses in our internal control over financial reporting will not be identified in the future. Any failure to maintain or implement required new or improved controls, or any difficulties we encounter in their implementation, could result in significant deficiencies or material weaknesses, cause us to fail to timely meet our periodic reporting obligations, or result in material misstatements in our financial statements. Any such failure could also adversely affect the results of periodic management evaluations and annual auditor attestation reports regarding disclosure controls and the effectiveness of our internal control over financial reporting required under Section 404 of the Sarbanes-Oxley Act of 2002 and

the rules promulgated thereunder. The existence of a material weakness could result in errors in our financial statements that could result in a restatement of financial statements, cause us to fail to timely meet our reporting obligations and cause investors to lose confidence in our reported financial information, leading to a decline in our stock price.

 

We have experienced transitions in our management team, our board of directors and our independent registered public accounting firm in the past and may continue to do so in the future.

 

We have experienced a number of transitions with respect to our board of directors, executive officers and our independent registered public accounting firm in recent quarters, including the following:

 

 

 

Such past and future transitions may continue to result in disruptions in our operations and require additional costs.

 

We have been and may continue to become the target of securities class action suits and derivative suits which could result in substantial costs and divert management attention and resources.

 

Securities class action suits and derivative suits are often brought against companies, particularly technology companies, following periods of volatility in the market price of their securities. Defending against these suits, even if meritless, can result in substantial costs to us and could divert the attention of our management. On December 7, 2001, we and certain of our officers and directors were named as defendants along with the underwriters of the Company’s initial public offering, in a securities class action lawsuit. The lawsuit alleges that the defendants participated in a scheme to inflate the price of our stock in our initial public offering and in the aftermarket through a series of misstatements and omissions associated with the offering. The lawsuit is one of several hundred similar cases pending in the Southern District of New York that have been consolidated by the court. In February 2003, the District Court issued an order denying a motion to dismiss by all defendants on common issues of law. In July 2003, we, along with over 300 other issuers named as defendants, agreed to a settlement of this litigation with plaintiffs. While the parties’ request for court approval of the settlement was pending, in December 2006 the United States Court of Appeals for the Second Circuit reversed the District Court’s determination that six focus cases could be certified as class actions. In April 2007, the Second Circuit denied plaintiffs’ petition for rehearing, but acknowledged that the District Court might certify a more limited class. At a June 26, 2007 status conference, the Court terminated the proposed settlement as stipulated among the parties. Plaintiffs filed an amended complaint on August 14, 2007. On September 27, 2007, plaintiffs filed a motion for class certification in the six focus cases. The class certification is not expected to be resolved until after April 2008. On November 13, 2007 defendants in the six focus cases field a motion to dismiss the complaint for failure to state a claim, which the court has yet to rule on.

 

We and certain of our officers have also been named as defendants in a securities class action captioned “Curry v. Silicon Image, Inc., Steve Tirado and Robert Gargus,” commenced on January 31, 2005. Plaintiffs filed the action on behalf of a putative class of stockholders who purchased Silicon Image stock between October 19, 2004 and January 24, 2005. The lawsuit alleged that Silicon Image and certain of our officers and directors violated securities laws and made alleged misstatements of material facts. For more information, please see Part I, Item 3 of this report. Uncertainties inherent in litigation prevent us from predicting the outcome of this litigation and while it remains pending it may divert management attention, cause us to incur unanticipated expenses and consume other resources.

 

Our operations and the operations of our significant customers, third-party wafer foundries and third-party assembly and test subcontractors are located in areas susceptible to natural disasters.

 

Our operations are headquartered in the San Francisco Bay Area, which is susceptible to earthquakes.TSMC, the outside foundry that produces the majority of our semiconductor products, is located in Taiwan. Advanced

Semiconductor Engineering, or ASE, one of the subcontractors that assemble and test our semiconductor products, is also located in Taiwan. For the years ended December 31, 2007, 2006 and 2005 customers and distributors located in Japan generated 35.3%, 35.0% and 21.7%,of our revenue respectively and customers and distributors located in Taiwan generated 16.7%, 20.3% and 25.2% of our revenue, respectively. Both Taiwan and Japan are susceptible to earthquakes, typhoons and other natural disasters.

 

Our business would be negatively affected if any of the following occurred:

 

 

Terrorist attacks or war could lead to economic instability and adversely affect our operations, results of operations and stock price.

 

The United States has taken and continues to take, military action against terrorism and currently has troops in Iraq and in Afghanistan. In addition, the current nuclear arms crises in North Korea and Iran could escalate into armed hostilities or war. Acts of terrorism or armed hostilities may disrupt or result in instability in the general economy and financial markets and in consumer demand for the OEM’s products that incorporate our products. Disruptions and instability in the general economy could reduce demand for our products or disrupt the operations of our customers, suppliers, distributors and contractors, many of whom are located in Asia, which would in turn adversely affect our operations and results of operations. Disruptions and instability in financial markets could adversely affect our stock price. Armed hostilities or war in South Korea could disrupt the operations of the research and development contractors we utilize there, which would adversely affect our research and development capabilities and ability to timely develop and introduce new products and product improvements.

 

Changes in environmental rules and regulations could increase our costs and reduce our revenue.

 

Several jurisdictions have implemented rules that would require that certain products, including semiconductors, be made “green” which means that the products need to be lead free and be free of certain banned substances. All of our products are available to customers in a green format. While we believe that we are generally in compliance with existing regulations, such environmental regulations are subject to change and the jurisdictions may impose additional regulations which could require us to incur costs to develop replacement products. These changes will require us to incur cost or may take time or may not always be economically or technically feasible, or may require disposal of non-compliant inventory. In addition, any requirement to dispose or abate previously sold products would require us to incur the costs of setting up and implementing such a program.

 

Provisions of our charter documents and Delaware law could prevent or delay a change in control and may reduce the market price of our common stock.

 

Provisions of our certificate of incorporation and bylaws may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. These provisions include:

 

 

 

Provisions of Delaware law also may discourage, delay or prevent someone from acquiring or merging with us.

 

The price of our stock fluctuates substantially and may continue to do so.

 

The stock market has experienced extreme price and volume fluctuations that have affected the market valuation of many technology companies, including Silicon Image. These factors, as well as general economic and political conditions, may materially and adversely affect the market price of our common stock in the future. The market price of our common stock has fluctuated significantly and may continue to fluctuate in response to a number of factors, including, but not limited to:

 

 

Due to these factors, the price of our stock may decline. In addition, the stock market experiences volatility that is often unrelated to the performance of particular companies. These market fluctuations may cause our stock price to decline regardless of our performance.

 

 

 

several hundred similar cases pending in the Southern District of New York that have been consolidated by the court. In February 2003, the District Court issued an order denying a motion to dismiss by all defendants on common issues of law. In July 2003, we, along with over 300 other issuers named as defendants, agreed to a settlement of this litigation with plaintiffs. While the parties’ request for court approval of the settlement was pending, in December 2006 the United States Court of Appeals for the Second Circuit reversed the District Court’s determination that six focus cases could be certified as class actions. In April 2007, the Second Circuit denied plaintiffs’ petition for rehearing, but acknowledged that the District Court might certify a more limited class. At a June 26, 2007 status conference, the Court terminated the proposed settlement as stipulated among the parties. Plaintiffs filed an amended complaint on August 14, 2007. On September 27, 2007, plaintiffs filed a motion for class certification in the six focus cases. The class certification is not expected to be resolved until after April 2008. On November 13, 2007 defendants in the six focus cases field a motion to dismiss the complaint for failure to state a claim, which the court has yet to rule on.

 

On July 31, 2007, the Company received a demand on behalf of alleged shareholder Vanessa Simmonds that our board of directors prosecute a claim against the underwriters of the Company’s initial public offering, in addition to certain unidentified officers, directors and principal shareholders as identified in the Company’s IPO prospectus, for violations of sections 16(a) and 16(b) of the Securities Exchange Act of 1934. In October 2007, a lawsuit was filed in the United States District Court for the Western District of Washington by Ms. Simmonds against certain of the underwriters of our initial public offering. The plaintiff alleges that the underwriters engaged in short-swing trades and seeks disgorgement of profits in amounts to be proven at trial from the underwriters. The suit names us as a nominal defendant, contains no claims against us and seeks no relief from us.

 

In January 2005, we and certain of our officers were named as defendants in a securities class action captioned “Curry v. Silicon Image, Inc., Steve Tirado and Robert Gargus.” Plaintiffs filed the action on behalf of a putative class of stockholders who purchased Silicon Image stock between October 19, 2004 and January 24, 2005. The lawsuit alleged that the Company and certain of our officers and directors made alleged misstatements of material facts and violated certain provisions of Sections 20(a) and 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Final judgment was entered in favor of defendants on September 25, 2007. On October 19, 2007, plaintiffs filed notice of appeal of the court’s final judgment to the United States Court of Appeals for the Ninth Circuit. Appellants’ opening brief is currently due on or before February 28, 2008 and our answer is due on or before April 14, 2008.

 

On January 31, 2007, we filed a lawsuit in the United States District Court for the Northern District of California against Analogix Semiconductor, Inc. a semiconductor company based in California. The complaint charges Analogix with copyright infringement, misappropriation of trade secrets and unlawful, unfair and fraudulent business practices. The lawsuit alleges that Analogix, without authorization and in violation of our intellectual property rights, copied and used our proprietary register maps by gaining unauthorized access to our proprietary and confidential information, illegally copied and modified the Company’s semiconductor configuration software and knowingly and unlawfully encouraged its existing and prospective customers to modify and use the Company’s semiconductor configuration software with Analogix’s chips, a use that is beyond the scope and in violation of, the rights granted under, our software license agreements. In addition to seeking monetary damages in an amount to be determined at trial, we sought an injunction barring Analogix from misappropriation of Silicon Image’s trade secrets. Our motion for an injunction was denied. On June 18, 2007, Analogix filed a counterclaim alleging that we breached a confidentiality agreement by purportedly disclosing Analogix’s confidential information within the Company. A trial date has been set for April 21, 2008.

 

On January 14, 2005, we received a preliminary notification that the Securities and Exchange Commission had commenced a formal investigation involving trading in our securities. On February 14, 2005, through our legal counsel, we received a formal notification of that investigation and associated subpoenas. We cooperated with the SEC in this matter. On January 18, 2006, the SEC announced that it filed a civil complaint (Case No. CV 06-0256 DSF, C.D. Cal.) for insider trading against Deog Kyoon Jeong, a co-founder and consultant to the Company and that it was also entering into a consent judgment with Mr. Jeong. The SEC stated that Mr. Jeong had agreed to pay a civil penalty of $56,000 and to disgorge profits of $56,000, without admitting or denying the allegations in the SEC complaint. We are not aware of any further actions taken by the SEC in this matter. We intend to continue to fully cooperate with the SEC in the event that any further actions are necessary.

During 2006, we initiated a voluntary internal review of our historical stock option compensation practices. The Audit Committee of our Board of Directors reviewed and accepted management’s findings and conclusions upon the completion of the internal review. The review did not identify any wrongdoing or misconduct by past or current employees. As a result of the review, we recorded a net stock-based compensation charge in the fourth quarter of 2006 in the amount of $95,000 related to options granted on two dates where we concluded that a different measurement date was appropriate. We concluded that it was not necessary to make any adjustment to any previously issued financial statements. Subsequent to our initiation of this review, we received written notice from the SEC that it was conducting an informal inquiry into the Company’s option-granting practices during the period January 1, 2004 through October 31, 2006. In May 2007, we received notice from the SEC that it had completed its investigation without recommending that any enforcement action be taken.

 

In addition, we have been named as defendants in a number of judicial and administrative proceedings incidental to our business and may be named again from time to time.

 

We intend to defend such matters vigorously and although adverse decisions or settlements may occur in one or more of such cases, the final resolution of these matters, individually or in the aggregate, is not expected to have a material adverse effect on our results of operations, financial position or cash flows.

 

PART II

 

agreement (ASR) with Credit Suisse International, under which we will purchase shares of common stock from Credit Suisse for an aggregate purchase price of approximately $62.0 million, which we paid on February 19, 2008. The term of the ASR is expected to be completed by June 30, 2008, subject to Credit Suisse’s right to accelerate the completion to a date after May 8, 2008.

 

Also on February 7, 2008, the Company’s Board of Directors has also authorized an additional $100 million stock repurchase program, over a period of three years, to commence following completion of the ASR. Purchases under this program may be increased, decreased or discontinued at any time without prior notice. In addition please see Note 8 to our consolidated financial statements included in Item 15(a) of this report.

 

In December 2005, we repurchased 143,350 shares of restricted stock at an aggregate price of $573 from a former employee. These shares were originally issued in connection with our acquisition of Transwarp Networks, Inc. in April 2003.

 

For Securities authorized for issuance under equity compensation plans please See Note 5 to our consolidated financial statements included in Item 15(a) of this report.

 

The following selected financial data should be read in connection with our consolidated financial statements and notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual Report on Form 10-K. Historical results of operations are not necessarily indicative of future results.

 

 

Effective January 1, 2006, we adopted SFAS 123R “Share-Based Payment” . Stock-based compensation expense (benefit) for years prior to 2006 was calculated based on provisions of APB 25 “Accounting for Stock Issued to Employees”.

 

The results of operations for fiscal year 2007 includes the full year operations of sci-worx GmbH, now Silicon Image, GmbH in the Consolidated Financial Statements. See Note 10 to our consolidated financial statements included in Item 15(a) of this report.

 

Overview

 

Headquartered in Sunnyvale, California., we are a leader in semiconductors for the secure storage, distribution and presentation of high-definition content. We are dedicated to the promotion of technologies, standards and products that facilitate the movement of digital content between and among digital devices across the consumer electronics (CE), personal computer (PC) and storage spaces. We have shipped more than 140 million HDMI compliant chips to date. We are the leading provider of semiconductor intellectual property solutions for high-definition multimedia and data storage applications.

 

Silicon Image’s HDMI products have been selected by many of the world’s leading CE companies. Our products have driven the transition to industry-leading HDMI products with features including Deep Color ^tm and lossless HD audio.

 

In the PC market, we continue to be a leader in the DVI market. The growth of digital TVs with HDMI inputs provides a source of demand for our PC products as consumers increasingly seek to connect their PCs to their DTVs to play games, watch high-definition DVDs and view photos. Because HDMI is backwards compatible with the DVI standard, HDMI-enabled PCs can also connect directly to the enormous installed base of PC monitors with DVI inputs.

 

We believe the consumer trend of increasingly purchasing and downloading content (e.g. music, TV programs and movies) from the internet will create a growing awareness and need for low-cost, simple, secure and reliable storage. In 2007, we released our second-generation storage processors compatible with SATA, external SATA (eSATA) and Universal Serial Bus (USB) hosts.

 

In addition, we offer one of the most robust and comprehensively tested technology platforms in the consumer electronics industry through our Simplay Labs’ Simplay HD ^tm Testing Program. Simplay Labs, LLC, a wholly-owned subsidiary of Silicon Image, is a leading provider of testing technologies, tools and services for high- definition consumer electronics devices such as HDTVs, set-top boxes, A/V receivers and DVD players, helping manufacturers to achieve compatibility and deliver the highest- quality HDTV experience to consumers.

 

We completed two important transactions in 2007 that enhance our ability to offer higher levels of integration and greater price/performance value to our customers. We entered into a cross-license agreement with Sunplus Technology Company, Ltd. for advanced IP to use in DTV semiconductor products, which we believe will offer us greater opportunities to develop semiconductor solutions for the home and mobile device environment. The license agreement provides for the payment of an aggregate of $40.0 million to Sunplus by Silicon Image, $35.0 million of which is payable in consideration for the licensed technology and related deliverables and $5.0 million of which is payable in consideration for Sunplus support and maintenance obligations. As of December 31, 2007, we had paid approximately $18.8 million towards the $40.0 million obligation. In addition, while we are still validating the technology received from Sunplus, we began to integrate a portion of this technology into a new product development project. As a result, we began to amortize the $39.6 million in the fourth quarter of 2007. In addition, our acquisition of sci-worx GmbH (sci-worx), now Silicon Image, Germany provides us a combination of additional advanced IP and a highly skilled pool of engineers who will help leverage our research and development efforts into new products. We acquired sci-worx GmbH for a net cash consideration of $13.8 million. During 2007, the Company completed the integration of the sci-worx engineers and began utilizing this resource to drive development of existing and newly created product development projects. We believe that the intellectual property licensed from Sunplus, along with the engineering talent and intellectual property acquired in the sci-worx transaction, will enhance our ability to continue to develop a broader array of product offerings.

 

Critical Accounting Policies

 

The preparation of financial statements in conformity with generally accepted accounting principles 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 in our notes 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

 

The Company’s revenue recognition policy complies with Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition (SAB No. 104). We recognize revenue when persuasive evidence of an arrangement exists, delivery or performance has occurred, the sales price is fixed or determinable and collectability is reasonably assured.

 

Revenue from products sold directly to end-users, or to distributors that do not receive price concessions and rights of return, is generally recognized when title and risk of loss has passed to the buyer which typically occurs upon shipment. Reserves for sales returns are estimated based primarily on historical experience and are provided at the time of shipment.

 

For products sold to distributors with agreements allowing for price concessions and product returns, we recognize revenue based on our best estimate of when the distributor sold the product to its end customer. Our estimate of such distributor sell-through is based on point of sales reports received from our distributors. Revenue is not recognized upon shipment since, due to various forms of price concessions, the sales price is not substantially fixed or determinable at that time. Price concessions are recorded when incurred, which is generally at the time the distributor sells the product to an end-user. Additionally, these distributors have contractual rights to return products, up to a specified amount for a given period of time. Revenue is earned when the distributor sells the product to an end-user, at which time our sales price to the distributor becomes fixed. Pursuant to our distributor agreements, older or end-of-life products are sold with no right of return and are not eligible for price concessions. For these products, revenue is recognized upon shipment and title transfer assuming all other revenue recognition criteria are met. Revenue for 2007 includes approximately $6.7 million of product revenue and cost of revenue includes approximately $2.6 million related to distributor sales for the month of December 2007. Historically, the Company had deferred the recognition of sell-through revenue from distributor sales for the third month of a quarter until the following quarter due to the unavailability of reliable sell-through information in a timely manner. As a result of improved business processes, the Company was able to eliminate this delay beginning with the fourth quarter of 2007, resulting in fiscal year 2007 revenue including an additional month of product revenue from distributor sales in December 2007. This one-time effect of the inclusion of an additional month of revenue for fiscal year 2007 is an increase to net income by approximately $2.6 million and an increase to net income per share, basic and diluted, by approximately $0.03

 

At the time of shipment to distributors, we record a trade receivable for the selling price since there is a legally enforceable right to payment, relieve inventory for the carrying value of goods shipped since legal title has passed to the distributor and record the gross margin in “deferred margin on sale to distributors”, a component of current liabilities in our consolidated balance sheet. Deferred margin on the sale to distributor effectively represents the gross margin on the sale to the distributor. However, the amount of gross margin we recognize in future periods will be less than the originally recorded deferred margin on sale to distributor as a result of negotiated price concessions. We sell each item in our product price book to all of our 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’ resale are priced at a discount from 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 range and variability of negotiated price concessions granted to distributors does not allow us to accurately estimate the portion of the balance in the Deferred margin on the sale to distributor that will be remitted back to the distributors. We reduce deferred margin by anticipated or determinable future price concessions.

 

We derive revenue from license of our internally developed intellectual property (IP). 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. Revenue earned under contracts with our licensees is classified as development, licensing and royalties. Our license fee arrangements generally include multiple deliverables and for

multiple deliverable arrangements we follow the guidance in EITF 00-21, Revenue Arrangements with Multiple Deliverables , to determine whether there is more than one unit of accounting. To the extent that the deliverables are separable into multiple units of accounting, we allocate the total fee on such arrangements to the individual units of accounting using the residual method, if objective and reliable evidence of fair value does not exist for delivered elements. We then recognize revenue for each unit of accounting depending on the nature of the deliverable(s) comprising the unit of accounting in accordance with the provisions of SAB No. 104.

 

The IP licensing agreements generally include a nonexclusive license for the underlying IP. Fees under these agreements generally include (a) license fees relating to our IP (b) maintenance and support, typically for one year; and (c) royalties payable following the sale by our licensees of products incorporating the licensed technology. The license for our IP has standalone value and can be used by the licensee without maintenance and support. Further, objective and reliable evidence of fair value exists for maintenance and support. Accordingly, license fees and maintenance and support fees are each treated as separate units of accounting.

 

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 from a specific customer for us to make an estimate based on available information from the licensee such as quantities held, manufactured and other information. These estimates for royalties necessarily involve the application of management judgment. As a result of our use of estimates, period-to-period numbers are “trued-up” in the following period to reflect actual units shipped. To date, such “true-up” adjustments have not been significant. 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.

 

For contracts related to licenses of our technology that involve significant modification, customization or engineering services we recognize revenue in accordance the provisions of SOP 81-1 “Accounting for Performance of Construction-Type and Certain Production-Type Contracts” . 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. If there is significant uncertainty about customer acceptance, or the time to complete the development or the deliverables by either party, we consider applying completed contract method. 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 revenues.

 

Stock-based compensation

 

Prior to 2006, our stock-based employee compensation plans were accounted for under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees and related interpretations. Our Employee Stock Purchase Plan (ESPP) qualified as a non-compensatory plan under APB 25. Therefore, no compensation cost was recorded in relation to the discount offered to employees for purchases made under the ESPP.

 

Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123R, Share-Based Payment , (SFAS No. 123R), requiring us to recognize expense related to the fair value of our stock-based compensation awards. We elected to use the modified prospective transition method as permitted by SFAS No. 123R and therefore have not restated our financial results for prior periods. Under this transition method, stock-based compensation expense for the year ended December 31, 2006 includes compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of December 31, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, as adjusted for estimated forfeitures. Stock-

based compensation expense for all stock-based compensation awards granted subsequent to December 31, 2005 was based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R. Under SFAS No. 123R, our ESPP is considered a compensatory plan and we are required to recognize compensation cost for grants made under the ESPP. We recognize stock-based compensation expense on a straight-line basis for all share-based payment awards over the respective requisite service period of the awards. For purposes of calculating the pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123(R), we followed the alternative transition method discussed in FASB Staff Position No. 123(R)-3 “Transition Election to Accounting for the Tax Effects of Share-Based Payment Awards.”

 

Cash Equivalents and Short-Term Investments

 

We account for our investments in debt and equity securities under Statement of Financial Accounting Standards, or SFAS, No. 115, Accounting for Certain Investments in Debt and Equity Securities and FASB Staff Position, or FSP, SFAS No. 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. Management determines the appropriate classification of such securities at the time of purchase and reevaluates such classification as of each balance sheet date. The investments are adjusted for amortization of premiums and discounts to maturity and such amortization is included in interest income. We follow the guidance provided by EITF No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments , to assess whether our investments with unrealized loss positions are other than temporarily impaired. Realized gains and losses and declines in value judged to be other than temporary are determined based on the specific identification method and are reported in the statements of income. Factors considered in determining whether a loss is temporary include the length of time and extent to which fair value has been less than the cost basis, the financial condition and near-term prospects of the investee, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. We place our investments in instruments that meet high credit quality standards, as specified in our investment policy guidelines. These guidelines also limit the amount of credit exposure to any one issue, issuer or type of instrument.

 

The longer the duration of our investment securities, the more susceptible they are to changes in market interest rates and bond yields. As yields increase, those securities purchased with a lower yield-at-cost show a mark-to-market unrealized loss. All unrealized losses are due to changes in interest rates and bond yields. We expect to realize the full value of all these investments upon maturity or sale.

 

The classification of our investments into cash equivalents and short term investments is in accordance with Statement of Financial Accounting Standard No. 95 (SFAS No. 95)  Statement of Cash Flows. Cash equivalents consist of short-term, highly liquid financial instruments with insignificant interest rate risk that are readily convertible to cash and have maturities of three months or less from the date of purchase. Short-term investments consist of taxable commercial paper, United States government agency obligations, corporate/municipal notes and bonds with high-credit quality and money market preferred stock. These securities have maturities greater than three months from the date of purchase.

 

We believe all of the financial instruments’ recorded values approximate current fair values because of their nature and respective durations. The fair value of marketable securities is determined using quoted market prices for those securities or similar financial instruments.

 

Allowance for Doubtful Accounts

 

We review collectability of accounts receivable on an on-going basis and provide an allowance for amounts we estimate will not be collectible. During our review, we consider our historical experience, the age of the receivable balance, the credit-worthiness of the customer and the reason for the delinquency. Delinquent account balances are written-off after management has determined that the likelihood of collection is remote. Write-offs to date have not been material. Increase in the allowance in 2007 as compared to 2006 is primarily due to the inclusion of allowance on receivables due to the purchase accounting of sci-worx, now Silicon Image GmbH. While we endeavor to accurately estimate the allowance, we may record unanticipated write-offs in the future.

Inventories

 

We record inventories at the lower of actual cost, determined on a first-in first-out (FIFO) basis, or market. Actual cost approximates standard cost, adjusted for variances between standard and actual. Standard costs are determined based on our estimate of material costs, manufacturing yields, costs to assemble, test and package our products and allocable indirect costs. We record differences between standard costs and actual costs as variances. These variances are analyzed and are either included on the consolidated balance sheet or the consolidated statement of income in order to state the inventories at actual costs on a FIFO basis. Standard costs are evaluated at least annually.

 

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 management’s forecast of customer demand. Customer demand is dependent on many factors and requires us to use significant judgment in our forecasting process. We must 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 demand are written down to zero and the related provision is recorded as a cost of revenue. 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.

 

Long-lived assets

 

Consideration paid in connection with acquisitions is required to be allocated to the assets, including identifiable intangible assets and liabilities acquired. Acquired assets and liabilities are recorded based on our estimate of fair value, which requires significant judgment with respect to future cash flows and discount rates.

 

For certain long-lived assets, primarily fixed assets and identifiable intangible assets, we are required to estimate the useful life of the asset and recognize its cost as an expense over the useful life. We use the straight-line method to depreciate long-lived assets. We evaluate the recoverability of our long-lived assets in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Whenever events or circumstances indicate that the carrying amount of long-lived assets may not be recoverable, we compare the carrying amount of long-lived assets to our projection of future undiscounted cash flows, attributable to such assets. In the event that the carrying amount exceeds the future undiscounted cash flows, we record an impairment charge against income equal to the excess of the carrying amount over the asset’s fair value. Predicting future cash flows attributable to a particular asset is difficult and requires the use of significant judgment.

 

We assign the following useful lives to our fixed assets — three years for computers and software, one to five years for equipment and five to seven years for furniture and fixtures. Leasehold improvements and assets held under capital leases are amortized on a straight-line basis over the shorter of the lease term or the estimated useful life, which ranges from two to five years. Depreciation expense was $9.5 million, $7.1 million and $6.1 million, for the years ended December 31, 2007, 2006 and 2005.

 

Goodwill and intangible assets

 

The Company periodically reviews the carrying value of intangible assets not subject to amortization, including goodwill, to determine whether impairment may exist. Statement of Financial Accounting Standards No. 142 (SFAS 142), Goodwill and Other Intangible Assets, requires that goodwill and certain intangible assets be assessed annually for impairment using fair value measurement techniques. Specifically, goodwill impairment is determined using a two-step process. The first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of a reporting unit with its carrying amount, including goodwill. The Company has determined based on the criteria of SFAS 142 that we have one reporting unit for this purpose. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The implied fair value of goodwill is determined by comparing our market capitalization as of the date of the impairment testing to the carry amount of equity. The impairment test for

other intangible assets not subject to amortization consists of a comparison of the fair value of the intangible asset with its carrying value. If the carrying value of the intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. Furthermore, SFAS 142 requires purchased other intangible assets to be amortized over their useful lives unless these lives are determined to be indefinite. Significant assumptions are inherent and highly subjective in this process. However, there can be no assurance that we will not incur impairment losses for goodwill and other intangible assets in the future, which could adversely affect our earnings.

 

Advertising and Research and Development

 

Advertising and research and development costs are expensed as incurred. Advertising expenses were insignificant in 2007, 2006 and 2005. It is the company’s policy to record a reduction to research and development expense for funding received from outside parties for research and development projects. During the year ended December 31, 2007, such funding was immaterial. During the year ended December 31, 2006, the Company recorded a reduction to research and development expense totaling approximately $1.0 million related to funding received from outside parties for one engineering project. During the year ended December 31, 2005, the Company recorded a reduction to research and development expense totaling approximately $1.8 million related to funding received from outside parties for three engineering projects. Such funding was provided irrespective of the results of the projects.

 

Income Taxes

 

We must make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of tax credits, tax benefits and deductions and in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes. Significant changes to these estimates may result in an increase or decrease to our tax provision in a subsequent period.

 

Deferred tax assets

 

We account for deferred tax assets in accordance with the Statement of Financial Accounting Standard No. 109 (SFAS No. 109), Accounting for Income Taxes. In the first quarter of 2007, we adopted the Financial Accounting Standards Board (FASB) FIN No. 48, Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109 . FIN No. 48 requires that management determine whether a tax position is more likely than not to be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. For income taxes we use an asset and liability approach, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements, but have not been reflected in our taxable income. In general, a valuation allowance is established to reduce deferred tax assets to their estimated realizable value, if based on the weight of available evidence, it is more likely than not that some portion, or all, of the deferred tax asset will not be realized. We evaluate the realizability of the deferred tax assets quarterly and will continue to assess the need for valuation allowances.

 

At December 31, 2007, we had gross deferred tax assets, related primarily to stock-based compensation, accruals and reserves that are not currently deductible and tax credit carry forwards of $24.0 million. At December 31, 2006 our gross deferred tax assets of $23.4 million consisted primarily of tax credit carryforwards and stock-based compensation not currently deductible for tax purposes. Prior to 2006, we had provided a valuation allowance against 100% of our net deferred tax assets. In 2006, we determined that our net deferred tax assets as of December 31, 2006 were more likely than not to be realized. Therefore, in 2006, we released the remaining valuation allowance of approximately $52.3 million that had reduced the carrying value of our deferred tax assets as of December 31, 2005. Approximately $14.3 million of the valuation allowance release related to prior years windfall tax benefits on employee stock transactions that were included in the deferred tax asset for net operating loss carryforwards as of December 31, 2005. This portion of the valuation allowance release was recorded as a direct increase to additional paid-in capital instead of a reduction to the tax provision.

Accrued liabilities

 

Certain of our accrued liabilities are based largely on estimates. Our estimates are based on historical experience, input from sources outside the Company and other relevant facts and circumstances.

 

Guarantees, Indemnifications and Warranty Liabilities

 

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.

 

At the time of revenue recognition, we provide an accrual for estimated costs (included in accrued liabilities in the accompanying consolidated balance sheets) to be incurred pursuant to our warranty obligation. Our estimate is based primarily on historical experience.

 

Accumulated other comprehensive income (loss)

 

Accumulated other comprehensive loss of $150,000 as of December 31, 2007, was comprised of net unrealized gains on available-for-sale securities of $45,000 and foreign currency translation adjustments of $105,000. Accumulated other comprehensive loss of ($159,000) as of December 31, 2006, was comprised of net unrealized losses on available-for-sale securities of ($156,000) and foreign currency translation adjustments of ($3,000).

 

Commitments, Contingencies and Concentrations

 

Historically, a relatively small number of customers and distributors have generated a significant portion of our revenue. For instance, our top five customers, including distributors, generated 57.7%, 57.3% and 53.5% of our revenue in 2007, 2006 and 2005, respectively. The percentage of revenue generated through distributors tends to be significant, since many OEM’s rely upon third-party manufacturers or distributors to provide purchasing and inventory management functions. In 2007, 49.5% of our revenue was generated through distributors, compared to 50.2% in 2006 and 51.7% in 2005. Microtek comprised 14.2%, 16.3% and 10.6% of our revenue in 2007, 2006 and 2005, respectively. Innotech Corporation, comprised 15.6%, 15.7% and 9.0% of our revenue in 2007, 2006 and 2005 respectively. World Peace Inc., comprised 13.6%, 11.6% and 17.2% of our revenue in 2007, 2006 and 2005 respectively. Our licensing revenue is not generated through distributors and to the extent licensing revenue increases, we would expect a decrease in the percentage of our revenue generated through distributors.

 

A significant portion of our revenue is generated from products sold overseas. Sales (including licensing) to customers in Asia, including distributors, generated 71.7%, 72.2% and 74% of our revenue in 2007, 2006 and 2005, respectively. The reason for our geographical concentration in Asia is that most of our products are incorporated into flat panel displays, graphic cards and motherboards, the majority of which are manufactured in Asia. The percentage of our revenue derived from any country is dependent upon where our end customers choose to manufacture their products. Accordingly, variability in our geographic revenue is not necessarily indicative of any geographic trends, but rather is the combined effect of new design wins and changes in customer manufacturing locations. All revenue to date has been denominated in U.S. dollars.

 

Recent accounting pronouncements

 

In September, 2006, the FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles (GAAP) and expands disclosures about fair value measurements. SFAS 157 defines fair value as the price that would be received to sell an asset or that would be paid to transfer a liability in an orderly transaction between market participants at the measurement date. This statement also requires expanded disclosures on the inputs used to measure fair value and for recurring fair value measurements using unobservable inputs, which affects the earnings for the period. This statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. Additionally, prospective application of this

statement is required as of the beginning of the fiscal year in which it is initially applied. We are currently evaluating the impact of adopting this Statement but do not expect that it will have a material effect on our consolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159) which permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007. We are currently evaluating the impact of adopting this Statement but do not expect that it will have a material effect on our consolidated financial statements.

 

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (SFAS 141(R)) and SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51” (SFAS 160). SFAS 141(R) will significantly change current practices regarding business combinations. Among the more significant changes, SFAS 141(R) expands the definition of a business and a business combination; requires the acquirer to recognize the assets acquired, liabilities assumed and noncontrolling interests (including goodwill), measured at fair value at the acquisition date; requires acquisition-related expenses and restructuring costs to be recognized separately from the business combination; requires assets acquired and liabilities assumed from contractual and non-contractual contingencies to be recognized at their acquisition-date fair values with subsequent changes recognized in earnings; and requires in-process research and development to be capitalized at fair value as an indefinite-lived intangible asset. SFAS 160 will change the accounting and reporting for minority interests, reporting them as equity separate from the parent entity’s equity, as well as requiring expanded disclosures. SFAS 141(R) and SFAS 160 are effective for financial statements issued for fiscal years beginning after December 15, 2008. We are currently evaluating the impact that SFAS 141(R) and SFAS 160 will have on our consolidated financial statements.

 

had deferred the recognition of sell-through revenue from distributor sales for the third month of a quarter until the following quarter due to the unavailability of reliable sell-through information in a timely manner. As a result of improved business processes, the Company was able to eliminate this delay beginning with the fourth quarter of 2007, resulting in fiscal year 2007 revenue including an additional month of product revenue from distributor sales in December 2007. The increase in product revenue in 2007 as compared to 2006 and 2005 was primarily driven by increased unit shipments, recognition of distributor revenue for December 2007, partially offset by declines in average selling prices (ASP) across all product categories. We currently expect average selling prices to continue to decline for all of our product categories in the first quarter of 2008. Additionally, we expect 2008 to be a product transition year. As part of this transition we currently expect to sample and subsequently announce a number of design wins throughout 2008. We expect volume shipments for the new products to start occurring in the first half of 2009. Accordingly, we expect our total revenue to decline in 2008.

 

Total revenue for 2006 was $295.0 million and represented a sequential growth of 38.9% over 2005 driven by increased sales, of our CE products. The increase in the CE product revenue relative to 2005 was due primarily to strong sales volumes of HDMI receivers and transmitters. The increase in PC product revenue was driven primarily by PC transmitters that incorporate our DVI technology and our intelligent panel controllers, which are key components in LCD displays, partially offset by modest erosion in the average selling prices of products. Revenue from our DVI products are expected to decline in the future as DVI technology is replaced by HDMI and DisplayPort. The decrease in storage product revenue was due to the trend of declining sales of our legacy storage systems products, which are being phased out of customer applications, partially offset by contributions from our new SATA and SteelVine products. We have experienced erosion of average selling prices for all of our product categories.

 

Our licensing activity is complementary to our product sales and it helps us to monetize our intellectual property and accelerate market adoption curves associated with our technology. Most of the intellectual property we license includes a field of use restriction that prevents the licensee from building a chip in direct competition with those market segments we have chosen to pursue. Revenue from development for licensees, licensing and royalties accounted for 15.9%, 15.1% and 8.7% of our revenues for the years ended December 31, 2007, 2006 and 2005, respectively. The increase in licensing revenues in 2007 as compared to 2006 is primarily due to recognition of $4.9 million of revenue for the delivery of the IP technology sold, which represented the $5.0 million license amount less $0.1 million for the fair value of support and maintenance which we are required to provide to Sunplus for one year. We completed the delivery of IP technology sold to Sunplus under the license agreement and received final acceptance. The increase in 2006 was primarily due to recognition of $11.8 million of royalty revenues related to the settlement agreement with Genesis Microchip in the fourth quarter of 2006 and the recognition of revenue for certain development projects that were previously deferred. Licensing contracts are complex and the recognition of related revenue depends upon many factors that require significant judgments including completion of milestones, allocation of values to delivered items and customer acceptances.

 

Revenues from products sold into the CE market have been increasing as a percentage of our total revenues and generated 63.7%, 56.9% and 51.2% of our total revenues for the years ended December 31, 2007, 2006 and 2005, respectively. If we include licensing revenues, these percentages would be 75.2%, 66.0% and 55.8% for the years ended December 31, 2007, 2006 and 2005, respectively. The increase in the CE product revenue in 2007 was due primarily to strong sales volumes of HDMI 1.3 receivers and transmitters partially offset by decrease in ASPs. Our HDMI 1.3 chips are targeted towards the DTV, AV receiver, Blu Ray recorders, HD DVD, DVD, game console and mobile markets. We believe that as the market acceptance of the HDMI 1.3 standard continues to grow and with our anticipated new product offerings in 2008 are introduced sales of our CE products will contribute a significant percentage of our CE revenues.

 

Product revenues from the PC market have declined in 2007 as compared to 2006 and 2005 and generated 12.6% of our revenue in 2007, 16.7% of our revenue in 2006 and 23.2% of our revenues in 2005. If we include licensing revenues, these percentages would be 14.6%, 19.9% and 23.8% for the years ended December 31, 2007, 2006 and 2005, respectively. The decrease in PC revenues as compared to 2006 and 2005 is primarily due to lower shipments coupled with declines in ASPs of our HDMI and DVI products. The decrease in ASP in the PC business is due to the competitive nature of the PC business. We expect the PC revenues in absolute dollars to decline in 2008 as compared to 2007.

The slight increase in PC revenue for 2006 as compared to 2005 is primarily as a result of DVI sales increasing in 2006 due to the peaking of the adoption of the standard. While 2006 revenues grew in absolute dollars, our 2006 PC product revenues were negatively affected by battery recalls by major computer manufacturers as well as the late launch of Windows Vista operating system. Licensing revenues included in our revenues from the PC market increased substantially in 2006 due to the recognition of royalty revenues related to the settlement agreement with Genesis Microchip.

 

Products sold into the storage market, as a percentage of our total revenues, generated 7.9%, 11.2% and 16.9% of our revenue for the years ended December 31, 2007, 2006 and 2005, respectively. If we include storage related licensing revenues, these percentages were 10.1%, 14.1% and 20.4%, for the years ended December 31, 2007, 2006 and 2005, respectively. The decrease in storage revenues is due primarily to the integration of SATA into PC chipsets obviating the need for our SATA controllers in all but the highest value PC motherboards. The decline in storage revenue from 2006 to 2007 is primarily due to declining sales in SATA controllers partially offset by an increase in storage processor products. Demand for our storage products is dependent upon market acceptance of our SteelVine architecture and the extent to which SATA is integrated into chipsets and controllers offered by other companies, which would make our discrete devices unnecessary.

 

 

Cost of revenue consists primarily of costs incurred to manufacture, assemble and test our products, as well as related overhead costs. Gross margin (revenue minus cost of revenue), as a percentage of revenue was 56.2%, 58.9% and 60.9% for 2007, 2006 and 2005, respectively. The increase in cost of revenue in 2007 as compared to 2006 and 2005 is primarily due to increased unit volume associated with increased sales partially offset by manufacturing cost reductions and cost of sales associated with licensing revenue that has not increased proportionately to licensing sales. Cost of revenue for 2007 includes approximately $2.6 million related to $6.7 million of product revenue recognized from distributor sales for the month of December. Historically, we have deferred the recognition of sell-through revenue and the related costs from distributor sales for the third month of a quarter until the following quarter due to the unavailability of reliable sell-through information in a timely manner. As a result of improved business processes, we have been able to eliminate this delay beginning with the fourth quarter of 2007, resulting in the fourth quarter and the fiscal year 2007 cost of revenues to increase. This increase in cost of revenue was partially offset by reduced manufacturing costs by lower negotiated vendor expenses as well as increased use of company owned testers.

 

Decrease in gross margins in 2007 as compared to 2006 and 2005 is primarily due to increased competition in all business lines reflected in decline in ASPs erosion partially offset by increase in units sold. In 2008, we expect continued competitive pressures which may continue to reduce our ASPs. However, we plan to mitigate this ASP erosion through manufacturing cost reductions and anticipated new product launches with expected higher margins.

 

The decrease in gross margin from 2005 to 2006 was primarily due to the recognition of stock-based compensation expense of $2.4 million under FAS 123R “Share-Based Payment” as compared to the stock compensation benefit of $1.4 million recorded in 2005 under APB 25 “Accounting for Stock Issued to Employees” , erosion in the average selling prices of our products as a result of increased competition and to a lesser extent by higher overhead expenses as a result of increase in headcount and related compensation.

 

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, including stock-based compensation expense, was $78.0 million, or 24.3% of revenue for 2007 compared to $63.6 million, or 21.6% of revenue for 2006 and $44.9 million, or 21.1% of revenue for 2005. The increase in R&D expenses in 2007 was primarily due to the expansion of our R&D operations through the sci-worx acquisition and the establishment of a new China R&D facility in the third quarter of 2006. This expansion resulted in an increase in salaries, software and equipment and tape out costs. The increase in R&D costs was partially offset by decrease in stock-based compensation expense from 2006. We expect R&D expenses in absolute dollars (excluding stock-based compensation) to be relatively flat in 2008.

 

The increase in R&D expenses in 2006 as compared to 2005 was primarily due to an increased headcount, performance bonus incentives and implementation of FAS 123R “Share-Based Payment” resulting in a recognition of stock-based compensation expense of $11.1 million as compared to the net stock compensation benefit of $3.9 million recorded in 2005 under APB 25 “Accounting for Stock Issued to Employees” . In addition, the increase also reflected increased use of consultants and the number of R&D projects and lower credit to expense from engineering projects funded by outside parties.

 

 

Selling, general and administrative(SG&A).   SG&A expense consists primarily of employee compensation and benefits, sales commissions and marketing and promotional expenses including stock-based compensation expense. SG&A expense was $70.3 million or 21.9% of revenue in 2007 as compared to $67.6 million, or 22.9% of revenue for 2006 and $31.4 million, or 14.8% of revenue for 2005. The increase is primarily due to higher compensation expense, lower allocation of general and administrative costs to other functional lines, increase in consulting fees as a result of our global strategy, increase in litigation and patent related expenses and increase in facilities related expenses. These increases were partially offset by a decrease in the stock-based compensation expense in 2007. We expect SG&A expenses in absolute dollars (excluding stock-based compensation) to be relatively flat in 2008.

 

The increase in SG&A expense in 2006 as compared to 2005, was primarily due to the recognition of stock-based compensation expense of $13.7 million under FAS 123R “ Share-Based Payment ” as compared to the stock compensation benefit of $3.3 million recorded in 2005 under APB 25 “Accounting for Stock Issued to Employees” and to a lesser extent by an increase in headcount and performance incentives in the form of bonuses to employees.

 

 

Amortization of intangible assets.   Increase in amortization of intangible assets for 2007 as compared to 2006 and 2005 is primarily due to the increase in amortization as a result of capitalization of intangibles acquired from Sunplus and intangibles from our sci-worx acquisition during 2007. The amortization of intangibles for fiscal 2006

and 2005 was related to the intangibles acquired as part of the Transwarp acquisition in 2003 which was completely amortized in the first quarter of fiscal year 2007. See Note 1 to our consolidated financial statements for the future amortization schedule for the above referenced intangibles.

 

 

Patent assertion costs (reimbursement), net.   The reimbursement of patent assertion costs in the amount of $5.4 million recorded in 2006 as a contra expense, relates to the reimbursement of litigation expenses incurred in connection with the Genesis litigation. The reimbursement of $5.4 million had been offset by $143,000 in patent assertion costs incurred in 2006.

 

 

Interest income.   The increase in interest income for each year was attributable primarily to the increased cash, cash equivalents and short-term investments.

 

Other expenses, net.   Net other income (expenses) were $51,000, ($233,000) and ($195,000) for 2007, 2006 and 2005, respectively.

 

 

Provision for Income Taxes.   For the year ended December 31, 2007, we recorded income tax expense of $20.6 million, compared to $14.0 million in 2006 and $6.7 million in 2005. Our effective income tax rate was 52% in 2007. In 2007, the difference between the provision for income taxes and the income tax determined by applying the statutory federal income tax rate of 35% was due primarily to the following three items: (1) $3.1 million of tax benefits related to tax credits generated during 2007, (2) $2.8 million of additional tax charges associated with the certain foreign income and withholding taxes and (3) $5.1 million of additional tax charges related to foreign unbenefited losses associated with the implementation of our global business structure. The tax charges related to unbenefited foreign losses represent expenses for sharing in the costs of our ongoing research and development efforts as well as licensing commercial rights to exploit pre-existing intangibles to better align with customers outside the Americas. The new global strategy is designed to better align asset ownership and business functions with our expectations related to the sources, timing and amounts of future revenues and profits.

 

For the year ended December 31, 2006, we recorded income tax expense of $14.0 million, compared to $6.7 million in 2005. Our effective income tax rate was 25% in 2006. In 2006, the difference between the provision for income taxes and the income tax determined by applying the statutory federal income tax rate of 35% was due primarily to the following three items: (1) $18.5 million of federal loss carryforwards utilized, inclusive of $14.3 million related to excess stock option tax benefits for which the reduction of the related valuation allowance was recorded to additional paid-in capital, (2) $24.8 million associated with the impact of the release of our remaining valuation allowance inclusive of certain current year changes in the deferred tax asset to which the valuation allowance relates and (3) $22.8 million of tax charges related to unbenefited foreign losses in connection with the ongoing implementation of a new global strategy. The tax charges related to unbenefited foreign losses represent expenses for sharing in the costs of our ongoing research and development efforts as well as licensing commercial rights to exploit pre-existing intangibles to better align with customers outside the Americas. The fiscal year 2005 tax expense of $6.7 million was due primarily to a $5.4 million non-cash charge associated with stock option exercises, while the remaining $1.3 million was primarily for taxes in certain foreign jurisdictions and U.S. alternative minimum tax.

Liquidity and Capital Resources

 

 

Our principal source of liquidity is cash provided by operations and exercise of stock options. At December 31, 2007, we had $223.7 million of working capital and $249.7 million of cash, cash equivalents and short-term investments. In February 2008, we entered into an accelerated stock repurchase program to repurchase common stock for an aggregate of approximately $62.0 million as part of a previously announced $100 million stock repurchase program authorized in February 2007. Additionally, our Board of Directors has authorized a new stock repurchase program for the repurchase, in the open market from time to time as business conditions warrant, of up to $100 million of the company’s common stock over a three-year period commencing upon the completion of the aforementioned accelerated stock repurchase program. We believe that our current cash, cash equivalents and short-term investment balances together with income derived from sales of our products and licensing will be sufficient to meet our liquidity requirements in the foreseeable future.

 

Operating Activities

 

Operating activities provided $67.1 million of cash during 2007 primarily due to cash generated by operations. The cash generated from working capital consisted primarily of strong cash collections on our accounts receivables, cash generated by inventory management and accounts payable partially offset by cash used in prepaid accounts, accrued expenses and deferred revenue.

 

Net accounts receivable decreased to $21.3 million in 2007 from $40.0 million in 2006 reflecting the timing of invoicing and strong cash collections during the fourth quarter of 2007. We do not expect the decline in accounts receivable to continue in 2008. Inventories decreased to $20.2 million at December 31, 2007 from $28.3 million at December 31, 2006. This decrease is attributable primarily to increased sales and better inventory management including allowing our distributors to use up the existing inventory that was built up in 2006. Our inventory turns increased to 7.1 at December 31, 2007 from 4.7 at December 31, 2006. Inventory turns are computed on an annualized basis, using the most recent quarter results and are a measure of the number of times inventory is replenished during the year. Deferred revenue, which includes deferred intellectual property license revenue that is being recognized on a percentage of completion basis, decreased $1.4 million in 2007 as compared to 2006. This decrease is primarily related to the invoicing under the terms of the agreement and the recognition of revenue for which contracts exist. Deferred margin on sales to distributors increased $8.7 million in 2007 as compared to 2006, primarily due to the improved business processes which resulted in the company being able to eliminate the

previously existing delay in recognition of sell-through revenue from distributor sales for the third month of a quarter until the following quarter. Other current liabilities including accounts payable and accrued liabilities, increased to $54.9 million from $52.0 million attributable primarily with the volume of our business, the timing of vendor payments, the payments on accruals for inventory related items and miscellaneous other items.

 

Operating activities provided $46.0 million in 2006. Net accounts receivable increased to $39.9 million or 32.5% in 2006 reflecting increased revenue and the timing of sales. Inventories increased to $28.3 million at December 31, 2006 from $17.1 million at December 31, 2005. The increase is attributable primarily to increased sales, to a buildup of inventories of certain new products in advance of sales and to production levels of certain products that exceeded sales levels in late 2006. Our inventory turns decreased to 4.7 at December 31, 2006 from 6.0 at December 31, 2005. Deferred revenue decreased $3.0 million or 36.4% in 2006, which is primarily related to the timing and recognition of revenue for which contracts exist. Deferred margin on sales to distributors increased to $17.7 million or 28.6% in 2006 as a result of overall increased shipments to distributors. Other current liabilities including accounts payable and accrued liabilities, increased to $51.5 million or 88.5% attributable primarily with the volume of our business, the timing of vendor payments, the accrual for income taxes of $12.7 million and the accrual for inventory related items and other items of $6.1 million.

 

Operating activities provided $55.6 million of cash during 2005. Increases in accounts receivable, inventories, accounts payable, accrued liabilities, deferred license revenue and deferred margin on sales to distributors and decreases in prepaid assets and other current assets used $2.4 million in cash.

 

Investing Activities

 

Net cash provided by investing activities during 2007 consisted primarily of sale of investments of $137.1 million which was used to fund the purchase of sci-worx for $13.8 million, net of cash acquired, the acquisition of Sunplus IP for $40.0 million of which $18.8 million was paid in 2007 and purchases of property, plant and equipment of $13.4 million. Cash used in investing activities in 2006 and 2005 consisted primarily of purchases of short-term investments (net of proceeds from sales and maturities of investments) of $94.0 million and $8.2 million, respectively and purchases of property and equipment of $13.5 million and $6.2 million, respectively. Our investments are in U.S. government notes and bonds, corporate notes and bonds, commercial paper and asset backed securities. We are not a capital-intensive business. Our purchases of property and equipment in 2007, 2006 and 2005 related mainly to testing equipment, leasehold improvements and information technology infrastructure.

 

Financing Activities

 

Net cash used in financing activities in 2007 consisted primarily of repurchases of common stock of $38.1 million partially offset by proceeds from stock options exercises and purchases under our employee stock purchase program (ESPP) of $12.9 million. Net cash flows provided by financing activities in 2006 and 2005 consisted primarily of proceeds from stock options exercises and ESPP purchases of $35.1 million and $11.4 million, respectively.

 

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 acquisitions.

 

Specifically, we expect our cash requirements in 2008 to include the following:

 

 

Debt and Lease Obligations

 

In December 2002, we entered into a non-cancelable operating lease renewal for our principal operating facility. In June 2004, the lease terms were amended and we leased approximately 28,000 square feet of additional space (for a total leased area of approximately 109,803 square feet). In May 2006, we entered into an amendment to the operating lease agreement. The amendment expanded the leased premises to include approximately 34,000 square feet of space in an adjacent building. The lease expiration was extended to July 2011 and the monthly rental payments are $146,237 with annual increases of 3% thereafter.

 

In June 2001, in connection with our acquisition of CMD, we acquired the lease of an operating facility in Irvine, California. Effective December 2005, the original lease was terminated and we entered into a new non-cancelable operating lease agreement through November 2008. Under the terms of the new agreement, base monthly rental lease payments of $42,000 are required and increases annually 3% thereafter.

 

We also lease office space in China, Germany, Japan, Korea, Taiwan, Turkey and United Kingdom.

 

Rent expense totaled $3.8 million, $2.6 million and $1.7 million in 2007, 2006 and 2005, respectively. Future minimum lease payments under operating leases have not been reduced by expected sublease rental income or by the amount of our restructuring accrual that relates to leased facilities.

 

Future minimum payments for our software license commitments, operating leases, inventory and other purchase commitments at December 31, 2007 are as follows (in thousands):

 

 

The amounts above exclude liabilities under FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes” , as we are unable to reasonably estimate the ultimate amount or timing of settlement. See Note 3, “Income Taxes,” in the Notes to Consolidated Financial Statements for further discussion.

 

Long-term liquidity

 

Based on our estimated cash flows, we believe our existing cash and short-term investments are sufficient to meet our capital and operating requirements for at least the next twelve months. We expect to continue to invest in property and equipment in the ordinary course of business. Our future operating and capital requirements depend on many factors, including the levels at which we generate product revenue and related margins, the extent to which we generate cash through stock option exercises and proceeds from sales of shares under our employee stock purchase plan, the timing and extent of development, licensing and royalty revenue, investments in inventory, property, plant and equipment and accounts receivable, the cost of securing access to adequate manufacturing capacity, our operating expenses, including legal and patent assertion costs and general economic conditions. In addition, cash may be required for future acquisitions should we choose to pursue any. While, we believe that our current cash, cash equivalents and short-term investment balances together with income derived from sales of our products and licensing will be sufficient to meet our liquidity requirements in the foreseeable future, to the extent existing resources and cash from operations are insufficient to support our activities, we may need to raise additional funds through public or private equity or debt financing. These funds may not be available when we need them, or if available, we may not be able to obtain them on terms favorable to us.

 

Interest Rate Risk

 

The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. To achieve this objective, we maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including government and corporate securities and money market funds. These securities are classified as available for sale and consequently are recorded on the balance sheet at fair value with unrealized gains or losses reported as a separate component of accumulated other comprehensive income (loss). We also limit our exposure to interest rate and credit risk by establishing and monitoring clear policies and guidelines of our fixed income portfolios. The guidelines also establish credit quality standards, limits on exposure to any one issuer and limits on exposure to the type of instrument. Due to the limited duration and credit risk criteria established in our guidelines we do not expect the exposure to interest rate risk and credit risk to be material. If interest rates rise, the market value of our investments may decline, which could result in a realized loss if we are forced to sell an investment before its scheduled maturity. As of December 31, 2007, we had an investment portfolio of securities as reported in short-term investments, including those classified as cash equivalents of approximately $249.7 million. A sensitivity analysis was performed on our investment portfolio as of December 31, 2007. This sensitivity analysis was based on a modeling technique that measures the hypothetical market value changes that would result from a parallel shift in the yield curve of plus 50, 100, or 150 basis points over a twelve-month time horizon. The following represents the potential decrease to the value of our investments given a negative shift in the yield curve used in our sensitivity analysis.

 

 

As of December 31, 2006, we had an investment portfolio of securities as reported in short-term investments, including those classified as cash equivalents of approximately $250.6 million. These securities are subject to interest rate fluctuations. The following represents the potential decrease to the value of our fixed income securities given a negative shift in the yield curve used in our sensitivity analysis.

 

 

Financial instruments that potentially subject us to significant concentrations of credit risk consist primarily of cash equivalents and short-term investments and accounts receivable. A majority of our cash and investments are maintained with two major financial institutions headquartered in the United States. As part of our cash and investment management processes, we perform periodic evaluations of the credit standing of the financial institutions and we have not sustained any credit losses from investments held at these financial institutions. The counterparties to the agreements relating to our investment securities consist of various major corporations and financial institutions of high credit standing.

 

We perform on-going credit evaluations of our customers’ financial condition and may require collateral, such as letters of credit, to secure accounts receivable if deemed necessary. We maintain an allowance for potentially uncollectible accounts receivable based on our assessment of collectability.

 

Foreign Currency Exchange Risk

 

A majority of our revenue, expense, and capital purchasing activities are transacted in U.S. dollars. However, certain operating expenditures and capital purchases are incurred in or exposed to other currencies, primarily the Euro, British Pound, the South Korean Won, Taiwan Dollar and the Chinese Yuan. The effect of an immediate 10% change in foreign currency exchange rates may impact our future operating results or cash flows as any such increases in our currency exchange rate may result in increased wafer, packaging, assembly or testing costs as well as ongoing operating activities in our foreign operations. Additionally, many of our foreign distributors price our products in the local currency of the countries in which they sell. Therefore, significant strengthening or weakening of the U.S. dollar relative to those foreign currencies could result in reduced demand or lower U.S. dollar prices or vice versa, for our products, which would negatively affect our operating results. Cash balances held in foreign

countries are subject to local banking laws and may bear higher or lower risk than cash deposited in the United States. As of December 31, 2007, cash held in foreign countries was approximately $1.3 million.

 

 

 

 

Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting.

 

Management conducted an assessment of the Company’s internal control over financial reporting as of December 31, 2007 based on the framework established by the Committee of Sponsoring Organization (COSO) of the Treadway Commission in Internal Control — Integrated Framework. Based on this assessment, management concluded that, as of December 31, 2007, our internal control over financial reporting was effective. Management excluded from its assessment the internal control over financial reporting at Silicon Image, GmbH, which was acquired on January 2, 2007 and whose financial statements constitute 3.6% and 3.3% of net and total assets, respectively, and 3.0% of revenues of the consolidated financial statement amounts as of and for the year ended December 31, 2007.

 

The effectiveness of the Company’s internal control over financial reporting as of December 31, 2007 has been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report which appears herein.

 

Changes in Internal Control Over Financial Reporting

 

There were no changes in our internal controls over financial reporting during the fourth quarter of our 2007 fiscal year that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders of Silicon Image, Inc.
Sunnyvale, California

 

We have audited the internal control over financial reporting of Silicon Image, Inc. and subsidiaries (the “Company”) as of December 31, 2007, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. As described in the Management’s Report on Internal Control over Financial Reporting, management excluded from its assessment the internal control over financial reporting at Silicon Image, GmbH, which was acquired on January 2, 2007 and whose financial statements constitute 3.6% and 3.3% of net and total assets, respectively, and 3.0% of revenues of the consolidated financial statement amounts as of and for the year ended December 31, 2007. Accordingly, our audit did not include the internal control over financial reporting at Silicon Image, GmbH. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions and effected by the company’s board of directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

 

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2007 of the Company and our report dated February 27, 2008 expressed an unqualified opinion on those financial statements and included an explanatory paragraph related to the adoption of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an Interpretation of FASB No. 109, effective January 1, 2007, and the Statement of Financial Accounting Standards No. 123(R), Share-Based Payment, effective January 1, 2006.

 

 

San Jose, California

February 27, 2008

PART III

 

 

 

 

 

 

SILICON IMAGE, INC.

 

CONSOLIDATED BALANCE SHEETS

 

 

See accompanying Notes to Consolidated Financial Statements.