Investing in our common stock involves a high degree of risk. Before deciding to purchase, hold, or sell our common stock, you should
carefully consider the risks described below in addition to the cautionary statements and risks described elsewhere and the other information contained in this Report and in our other filings with the SEC, including subsequent reports on Forms 10-Q
and 8-K. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our business operations or financial condition. The
descriptions below include any material changes to and supersede the description of the risk factors affecting our business previously disclosed in “Part I, Item 1A. Risk Factors” of our Annual Report on Form 10-K for the fiscal year
ended December 31, 2012.
If any of these known or unknown risks or uncertainties actually occur, our business,
financial condition, results of operations and/or liquidity could be seriously harmed, which could cause our actual results to vary materially from recent results or from our anticipated future results. In addition, the trading price of our common
stock could decline due to any of these known or unknown risks or uncertainties, and you could lose all or part of your investment.
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Risks Related to the Proposed Merger with WDC
The announcement and pendency of the proposed Merger with WDC could adversely affect our business, financial results and operations.
The announcement and pendency of the proposed Merger with WDC could cause disruptions in and create uncertainty
surrounding our business, including affecting our relationships with our existing and future customers, suppliers and employees, which could have an adverse effect on our business, financial results and operations. We may potentially lose important
employees who decide to pursue other opportunities in light of the proposed Merger, and we may also have difficulty hiring new employees. We may also potentially lose customers or suppliers, and new customer or supplier contracts could be delayed or
decreased. In addition, we have diverted, and will continue to divert, significant management resources towards the completion of the Merger, which may adversely affect our business and results of operations.
Pursuant to the Merger Agreement, we are subject to restrictions on the conduct of our business prior to the consummation of the Merger
as provided in the Merger Agreement, including, among other things, certain restrictions on our ability to make certain capital expenditures, sell or otherwise dispose of our assets and incur indebtedness. These restrictions could prevent us from
pursuing attractive business opportunities, result in our inability to respond effectively to industry developments and future opportunities and may otherwise harm our business, financial results and operations.
Failure to complete the proposed Merger with WDC could adversely affect our business and the market price of our common stock.
There is no assurance that the closing of the Merger will occur. The consummation of the Merger is subject to a number
of conditions, including the approval and adoption of the Merger Agreement by our shareholders, and certain other customary conditions, including the absence of laws or judgments prohibiting or restraining the Merger and the receipt of certain
regulatory approvals. We cannot predict with certainty whether and when any of these conditions will be satisfied, if at all. In addition, the Merger Agreement may be terminated under certain specified circumstances, including, a change in the
recommendation of the board of directors of the Company or a termination of the Merger Agreement by the Company to enter into an agreement for a superior proposal, as defined in the Merger Agreement. If the Merger is not consummated, and there are
no other parties willing and able to acquire the Company at a price of $6.85 per share or higher and on other terms acceptable to us, our stock price may decline as our common stock has recently traded at prices based on the proposed per share price
for the Merger.
In addition, we have incurred, and will continue to incur, significant costs, expenses and fees for
professional services and other transaction costs in connection with the proposed Merger, as well as the diversion of management resources, for which we will have received little or no benefit if the closing of the Merger does not occur. Many of the
fees and costs will be payable by us even if the Merger is not completed and may relate to activities that we would not have undertaken other than to consummate the Merger. Under certain circumstances specified in the Merger Agreement, in connection
with termination of the Merger Agreement, we may also be required to pay WDC a termination fee of $9,400,000. Furthermore, if the Merger is not consummated, this may result in negative publicity and a negative impression of the Company, including in
the investment community.
If the Merger Agreement is not approved and adopted by our shareholders, or if the Merger is not
consummated for any other reason, there can be no assurance that any other acceptable transaction will be offered or that our business, prospects or results of operations will not be adversely affected. The occurrence of any of these events could
have a material adverse impact on our results of operations and our stock price.
Risks Related to Our Business and Industry
The introduction and acceptance of new and enhanced versions of our products may cause fluctuations in our operating
results.
Our ability to compete depends in significant part upon our ability to successfully
develop, introduce and sell new and enhanced versions of our products. The introduction of new and enhanced versions of our products may shorten the life cycle of our existing products, or replace sales of some of our existing products, thereby
offsetting the benefits of even a successful product introduction, and may cause customers to defer purchasing our existing products in anticipation of the new and enhanced versions. For example, we believe that in addition to increased competition
in the enterprise market, the decline in our sales in the second quarter of 2013 as compared to the second quarter of 2012 was significantly impacted by delays in the transition to the next-generation of our ZeusIOPS
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and MACH16™ SSDs and gradual customer adoption of those products. Conversely, when we introduce new and
enhanced versions of our products, customers may accelerate purchases of existing products and defer purchases of new life cycle products due to the cost and lead times involved in the qualification of new products. Any of these instances may cause
fluctuations in our inventory levels. The complexity and difficulties in managing product transitions at the end-of-life stage of a product can also create excess inventory associated with the outgoing product that can also lead to product
obsolescence and increased expenses. Any or all of the above responses to the introduction of new and enhanced versions of our products could cause volatility in our operating results or have a material adverse effect on our business, financial
condition, results of operations and cash flows.
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We may be less competitive if we fail to develop new and enhanced products and
introduce them in a timely manner and gain market acceptance.
We compete in the enterprise-storage, enterprise-server,
and government, defense and industrial applications markets. These markets are subject to rapid technological change, product obsolescence, frequent new product introductions and enhancements, changes in end-user requirements and evolving industry
standards. Our ability to compete in these markets will depend in significant part upon our ability to successfully develop, introduce and sell new and enhanced products on a timely and cost-effective basis and to respond to changing customer
requirements. Delays in the development and introduction of our new or enhanced products could provide a competitor a first-to-market opportunity and allow a competitor to take market share. Once a customer designs a competitor’s product into
its product offering, it becomes significantly more difficult for us to sell our products to that customer for that product offering because changing suppliers involves significant cost, time, effort and risk for the customer.
Our product development is inherently risky because it is difficult to foresee developments in technology, anticipate the adoption of new
industry standards and identify and eliminate design flaws. Defects or errors found in our products after commencement of production could result in significant delays and damage our reputation and competitive position. New products, even if first
introduced by us, may not gain market acceptance or result in future profitability. Lack of market acceptance for our new or enhanced products will jeopardize our ability to recoup research and development expenditures, hurt our reputation and harm
our business, financial condition, results of operations and cash flows.
We may also seek to develop products with new
standards for our industry; however, it will take time for these new standards and products to be adopted, for customers to accept and transition to these new products and for significant sales to be generated from them, if this happens at all.
There can be no assurances that any new products or standards we develop will be commercially successful.
In addition, after
we have developed a new product, if selected, our OEM customers will usually test and evaluate our products for three or more months before potentially qualifying them for production and an additional three or more months to begin volume production
of the equipment that incorporates our products. Even if an OEM customer selects our product to incorporate into its equipment, we have no assurance that the customer will ultimately bring its product to market or that such effort by our customer
will be successful.
We may not be successful with respect to our expansion into new markets.
Our growth strategy includes diversifying our customer base, including targeting enterprise end user customers, and improving the
availability of our products worldwide. The entry into new markets presents challenges, including new distribution and service levels compared to those of our traditional OEM channels. In addition, we have less experience selling to these
alternative customers and markets. Other challenges of targeting new markets include the need to devote additional resources to develop new sales and marketing strategies, including hiring a new sales team; the expenditure of significant resources
and the efforts and attention of our management; the ability to anticipate demand and monitor, control and manage inventory; the need to develop relationships with new customers; and the need to provide additional or different levels of service and
support than what we have historically provided. The failure to successfully manage the risks associated with the expansion into new markets, particularly because of our inexperience in these channels, could have a material adverse effect on our
business, financial condition, results of operations and cash flows.
The length of our sales cycle depends on many
factors outside of our control and could cause us to incur significant expenses without offsetting revenues, or revenues that vary significantly from quarter to quarter.
The sales cycle for our products is lengthy and unpredictable. Our customers often undertake a significant evaluation process in the
qualification of new products, which contributes to a lengthy sales cycle. Our sales efforts involve communicating with our customers about the technical capabilities, use and benefits of our products and the potential cost savings achievable by
customers choosing our products. In addition, a customer’s decision to purchase our products typically requires a lengthy approval process undertaken by several decision makers at the customer. Typically, our sales cycle for OEM customers is
six to nine months, but may be longer in some cases. Our sales cycle for direct enterprise customers may be shorter depending upon the user environment. With both customer profiles we may spend substantial time, effort and money in our sales efforts
without being successful in producing any sales. Moreover, providing any additional functionality at the request of a customer may prolong the sales cycle. The lengthy and variable sales cycle may also have a negative impact on the timing of our
revenues, causing our revenues and results of operations to vary significantly from quarter to quarter.
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Historically, sales to a limited number of customers have comprised a significant
portion of our revenues and the loss of, or significant reduction in purchases by, any key customer would harm our financial results.
The major industries in which we have participated are dominated by a limited number of OEM companies. As a result, historically, sales to a relatively limited number of customers have accounted for a
significant percentage of our revenues. In the second quarter of 2013 and second quarter of 2012, sales to our ten largest customers accounted for an aggregate of 78% and 85%, respectively, of our total revenues.
The percentage of our revenues from our major customer base changes from quarter to quarter as the market demand for our customers’
products changes, and we expect this variability to continue in the future. In addition, the industries in which many of our customers compete have experienced, and may continue to experience, consolidation, which may result in increased customer
concentration and/or the loss of customers. Most of our customers are not required to purchase any specific volumes, and may discontinue their relationships with us at any time. The loss of, or a significant reduction in purchases by, any of our
major customers or significant pricing and margin pressures exerted by any of our significant customers could materially harm our business, financial condition, results of operations and cash flows.
We may not be able to maintain or improve our competitive position because of the intense competition in the memory and storage
industry.
We conduct business in an industry characterized by intense competition. We primarily compete with
Fusion-io, Hitachi GST, Intel, LSI, Micron, OCZ, Samsung, SanDisk, Seagate, SMART Modular, Toshiba and WDC in connection with the sale of our products. Our competitors include many large U.S. and international companies that have substantially
greater financial, technical, marketing, distribution and other resources, broader product lines, lower cost structures, greater brand recognition and longer-standing relationships with customers and suppliers. The recently closed mergers between
Hitachi GST and WDC and between Samsung’s HDD business and Seagate could exacerbate the degree of competition that we face. Our larger, more heavily resourced competitors may be in a better position than we are to influence or respond to new or
emerging technologies or standards and changes in customer requirements. Our competitors may also be able to devote greater resources to the development, promotion and sale of products and may be able to deliver more competitive products, or
products more quickly or at a lower price.
In addition, some of our competitors earn a significant portion of their revenue
from business units outside the storage industry. Because they do not depend solely on sales of storage products to achieve profitability, they may sell storage devices at lower prices and operate their storage business unit at a loss over an
extended period of time while choosing to offset these losses with profits from other business units.
Moreover, some of our customers have integrated and may continue to integrate lower cost, lower performance Serial
Advanced Technology Attachment (“SATA”) drives with a SAS or FC connectivity bridge instead of our native SAS and Fibre Channel ZeusIOPS
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products, thereby offering a lower cost alternative to our products and negatively affecting the sales of our products to those customers. Furthermore, lower-priced
SAS and/or FC based SSDs sold by some of our competitors have already been qualified at certain of our customers, which has led to a reduction in orders of our ZeusIOPS
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SSDs. Our operating results may continue to be adversely affected if we cannot successfully compete with the pricing by these companies.
Some of our significant suppliers, including Samsung and Toshiba, are also our competitors, and have the ability to manufacture
competitive products at lower costs as a result of their higher levels of integration. In addition, these suppliers may reduce the supply of memory chips available to the industry or us. We also face competition from current and prospective
customers that evaluate our capabilities against the merits of manufacturing products internally. Competition may arise from new and emerging companies or from the development of cooperative relationships among our current and potential competitors
or third parties to develop products that address the needs of our customers. We expect our competitors will continue to improve the performance of their current products, reduce their prices and introduce new products that may offer greater
performance, or otherwise render our technology or products obsolete or uncompetitive, any of which could cause a decline in our operating results or loss of market acceptance of our products.
It is difficult to forecast customer demand, in part because the market for enterprise Flash-based SSD products is still rapidly
evolving, and becoming increasingly competitive.
The enterprise Flash-based SSD market is still rapidly evolving and
becoming increasingly competitive. As a result, it is difficult to predict, with any precision, customer demand for our products or the future growth rate and size of this market. In addition, our customers’ demand for our products depends on
demand for their product, inventory levels and other factors, and can vary considerably from quarter to quarter, therefore it is difficult for us to forecast our customers’ demand beyond the current quarter as purchases in one period may not be
indicative of purchases in future periods.
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Our dependence on a small number of component suppliers, including integrated circuit
device suppliers, and our inability to obtain a sufficient supply of these components on a timely basis could harm our ability to fulfill orders.
Typically, integrated circuit (“IC”) devices represent more than 80% of the component costs of our products. We are dependent on a small number of suppliers that supply key components and
important component-related information used in the development and manufacture of our products. Since we have no long-term supply contracts, there is no assurance that our suppliers will agree to supply the quantities of components we may need to
meet our production requirements or the component information required to optimize these components in our finished products. In recent years, Hynix, Samsung, and Toshiba supplied substantially all of the Flash IC devices used in our Flash-based
products while Micron and Samsung supplied substantially all of the DRAM IC devices used in our DRAM products.
As part of the
qualification process for our products, our customers typically qualify the specific controller and Flash and DRAM ICs that are components in our products. If any of our suppliers experience quality control problems, our products that utilize that
supplier’s ICs may be disqualified by one or more of our customers. A supplier disqualification would disrupt our supply of ICs, reduce the number of suppliers available to us and adversely affect our ability to fulfill our customers’
product orders. In some instances, we may be required to qualify a new supplier’s ICs, which could negatively impact our revenues during the new qualification process. There can be no assurance that we would be able to find and successfully
qualify new suppliers in a timely manner or obtain ICs from new suppliers on commercially reasonable terms, which could damage our relationships with existing or potential customers and could materially harm our operating results.
Moreover, from time to time, our suppliers experience shortages in IC devices and foundry services which have resulted in placing their
customers, including us, on component allocation. This means that while we may have customer orders, we may not be able to obtain the materials that we need to fill those orders in a timely manner or at competitive prices. As a result, our
reputation could be harmed, we may lose business from our customers, our revenues may decline, and we may lose market share to our competitors.
In addition to Flash and DRAM ICs, a number of other components that we use in our products are available from only a single or limited number of suppliers. Furthermore, our suppliers rely upon certain
rare earth materials that are necessary for the manufacturing of components for some of our products, and our business could be harmed if these suppliers experience shortages or delays of these rare earth materials. In addition, in the development
of application-specific ICs (“ASICs”), we also depend on certain foundry subcontractors to manufacture these ASICs as well as on certain third-party subcontractors to assemble, obtain packaging materials for and test these ASICs.
Our dependence on a small number of suppliers and the lack of any guaranteed sources of supply expose us to a number of
risks, including:
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The inability to obtain component information that is used in the optimization of a supplier’s components in our finished products;
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Price increases, late deliveries and poor component quality;
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An unwillingness of a supplier to supply components to us;
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A key supplier’s or sub-supplier’s inability to access credit or other financial resources necessary to operate its business;
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A supplier’s or sub-supplier’s inability to source certain necessary rare earth materials to build its products;
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Failure of a key supplier to remain in business or adjust to market conditions;
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Consolidation among suppliers, resulting in some suppliers exiting the industry or discontinuing the manufacture of components;
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An inability to directly control component delivery schedules; or
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Failure of a supplier to meet our quality, yield or production requirements.
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Since we have no long-term supply contracts with these third-party foundry subcontractors, there is no guarantee that they will devote
sufficient resources to manufacture our components. If we are unable to maintain or increase the capacity of our current subcontractors or qualify and engage additional subcontractors, we may not be able to meet demand for our products, which could
have a material adverse effect on our business, financial condition, results of operations and cash flows.
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If our products fail to meet our or our customers’ specifications for quality and
reliability, our results of operations may be adversely impacted and our competitive position may suffer.
Although we
place great emphasis on product quality, we may from time to time experience problems with the performance of our products, which could result in one or more of the following:
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Increased costs related to fulfillment of our warranty obligations;
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The reduction, delay or cancellation of orders or the return of a significant amount of products;
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Focused failure analysis causing distraction of the sales, operations and management teams; or
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These factors could have a material adverse effect on our business, financial condition, results of operations and cash flows.
Demand for storage capacity may not continue to grow at current industry estimates, which may lower the prices our customers are willing to pay for new products.
Our customers’ demand for storage capacity may not continue to grow at current industry estimates as a result of developments in the
regulation and enforcement of digital rights management, the emergence of processes such as cloud computing, data de-duplication and storage virtualization, or otherwise. These factors could lead to a situation in which our customers are not willing
to pay higher prices for our products, thereby decreasing our revenue. Even with increasing aggregate demand for storage capacity, our average selling prices could decline, which could have a material adverse effect on our business, financial
condition, results of operations and cash flows.
Our business could be adversely affected by the cyclical nature of the
semiconductor industry.
The semiconductor industry, including the memory markets in which we compete, is highly
cyclical and characterized by constant and rapid technological change, rapid product obsolescence and price erosion, evolving standards and wide fluctuations in product supply and demand. The industry has experienced significant downturns often
connected with, or in anticipation of, maturing product cycles of both semiconductor companies’ and their customers’ products and declines in general economic conditions.
These industry downturns have been characterized by diminished product demand, production overcapacity, high inventory levels and
accelerated erosion of average sales prices, which have negatively impacted our average sales prices, revenues and earnings. Any future industry downturns could have a material adverse effect on our business, financial condition, results of
operations and cash flows.
Further industry consolidation could harm our business by increasing the resources of our
competitors, reducing the number of suppliers available to us for our product components and increasing competition for customers.
The storage industry has experienced consolidation over the past several years. Consolidation by our competitors may enhance their capacities, abilities and resources and lower their cost structure,
causing us to be at a competitive disadvantage. Additionally, continued industry consolidation may lead to a reduction in the number of suppliers and uncertainty in areas such as component availability, which could negatively impact our cost
structure. Further consolidation among our customers may harm our business by increasing competition for customers and reducing the number of customer-purchasing decisions.
Global economic conditions and the global financial crisis may have an impact on our business and financial condition in ways that we currently cannot predict.
As a result of the prolonged downturn in global economic activity and the ongoing sovereign debt crisis in Europe, spending on information
technology has deteriorated significantly in the U.S. and many other countries and may remain depressed for the foreseeable future. Uncertainty in the financial and credit markets has caused many of our customers to postpone or cancel purchases.
These worldwide economic conditions make it extremely difficult for our customers, our vendors and us to accurately forecast and plan future business activities, and they could cause our customers to further reduce or slow spending on our products,
which would delay and lengthen sales cycles.
Furthermore, during challenging economic times, our customers may face issues in
attempting to gain timely access to sufficient credit, which could result in an impairment of their ability to make timely payments to us. If that were to occur, we may experience increased collection times or write-offs, which could have a material
adverse effect on our revenues and cash flow. Similarly, our vendors may also face issues in attempting to gain timely access to sufficient credit, which could result in an impairment of their ability to supply us with components that are needed in
the manufacture of our products. If that were to occur, we may experience delays in our production and increased costs associated with our qualification of additional new vendors and replacement of their components, which could have a material
adverse effect on our revenues and cash flow.
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Finally, our ability to access the capital markets may be restricted, which could have an
impact on our flexibility to pursue additional expansion opportunities and maintain our desired level of revenue growth in the future. These and other economic factors could have a material adverse effect on demand for our products and services and
on our business, financial condition, results of operations and cash flows.
We have been named as a party to class
action lawsuits and purported shareholder derivative actions, and we may be named in additional litigation, all of which could require significant management time and attention and result in significant legal expenses. An unfavorable outcome in one
or more of these lawsuits could have a material adverse effect on our business, financial condition, results of operations and cash flows.
As described in detail in Note 8 – “Commitments and Contingencies” to the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q, a class
action is pending in the United States District Court for the Central District of California, alleging, among other things, that sTec and certain of our senior officers and directors violated the federal securities laws by issuing materially false
and misleading statements. On October 5, 2012, we entered into a Stipulation and Agreement of Settlement (the “Settlement Agreement”) to settle the federal class action. The Settlement Agreement provides for the resolution of all the
pending claims in the federal class action litigation, without any admission or concession of wrongdoing by sTec or the other defendants. sTec and the other defendants have entered into the Settlement Agreement to eliminate the uncertainty,
distraction, burden and expense of further litigation. The Settlement Agreement provides for a fund of $35.8 million in exchange for a full and complete release of all claims that were or could have been asserted in the federal class action. On
May 23, 2013, the Court entered a final order and judgment, affirming the preliminary approval order and certification of the class as set forth in the Court’s June 16, 2012 Order and for purposes of the Securities Act claims asserted
by persons and entities that, between June 16, 2009 and February 23, 2010, purchased or otherwise acquired publicly traded common stock of sTec, and were damaged thereby, subject to certain self-exclusions. In light of the settlement of
the federal class action, the parties have filed a voluntary stipulation of dismissal of the previously disclosed class action in the Superior Court of Orange County, California.
The amount of the settlement exceeds the liability coverage available currently under our insurance policies and thus has negatively
impacted our results of operations – See Part I, Item 2 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for details. Our contribution to the settlement was made at the end of
the first quarter of 2013, which negatively impacted our cash flows in the first quarter of 2013.
In addition, purported
shareholder derivative actions are pending in the Superior Court for the County of Orange, California and the United States District Court for the Central District of California against certain of our senior officers and directors based on
allegations substantially similar to those set forth in the class action. In the lawsuit filed on October 25, 2012, in addition to derivative claims, the plaintiff has also asserted individual claims against certain of our senior officers and
directors. Since the announcement of the Merger Agreement, the plaintiffs in the state court derivative action have filed a motion seeking leave to amend their complaint to include claims related to the merger. In addition, the plaintiffs in the
federal court derivative action have indicated their intention to seek leave to amend the operative complaints to add claims arising from the Merger Agreement. The Company intends to oppose any attempt by the plaintiffs in these actions to amend the
complaints to assert new and unrelated claims based on the Merger Agreement. In addition, as described in detail in Note 8 – “Commitments and Contingencies” to the Unaudited Condensed Consolidated Financial Statements included in this
Quarterly Report on Form 10-Q, seven putative class action lawsuits have been filed by shareholders in Superior Court of the State of California, County of Orange against the Company, members of its board of directors, WDC and Merger Sub related to
the proposed merger.
In addition, as described in detail in Note 8 – “Commitments and Contingencies” to the
Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q, seven putative class action lawsuits have been filed by shareholders in Superior Court of the State of California, County of Orange against sTec,
members of our board of directors, WDC and Merger Sub related to the proposed Merger.
Regardless of the merits, the cost of
defending the litigation described above and any future litigation to which we may be subject if our insurance carriers fail to cover, or provide adequate coverage given policy limits, and the diversion of management’s attention from the
day-to-day operations of our business, could adversely affect our business, results of operations and cash flows. An unfavorable outcome in any such litigation could have a material adverse effect on our business, financial condition, results of
operations and cash flows.
Our Founder’s litigation with the U.S. Securities and Exchange Commission could require
him to spend significant time and attention on his defense of the case and could result in significant legal expenses. An unfavorable outcome could bar him from returning to service as our CEO or as a Director and could have a material adverse
effect on our business, financial condition, results of operations and cash flows.
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During 2009, the SEC commenced a formal investigation involving trading in our securities.
On July 19, 2011, we received a “Wells Notice” from the SEC stating that the Staff of the SEC was considering recommending that the SEC initiate a civil injunctive action against sTec, our founder, Manouch Moshayedi, and our CEO and
President, Mark Moshayedi, for violations of the antifraud and reporting provisions of the federal securities laws. On July 19, 2012, the SEC filed a civil action against Manouch Moshayedi. At the same time, the SEC also notified us that it
would not bring an enforcement action against sTec or any of our other executive officers. The SEC’s civil complaint, filed in the United States District Court for the Central District of California, alleges that Manouch Moshayedi violated the
antifraud provisions of the federal securities laws. The complaint seeks (1) an injunction against future violations of the federal securities laws; (2) disgorgement of any ill-gotten gains as well as pre-judgment interest; (3) civil
monetary penalties; and (4) a bar from serving as an officer or director of a public company. Manouch Moshayedi has informed us that he believes that the SEC’s complaint is without merit and that he intends to contest vigorously the
enforcement action. Regardless of the merits, the cost of defending such claims, potential indemnification obligations, and the diversion of management’s attention from the day-to-day operations of our business, could adversely affect our
business, results of operations and cash flows.
In connection with entry into the Merger Agreement, Manouch Moshayedi entered
into a release and covenant not to sue in favor of WDC, effective as of the date of the Merger Agreement. The release and covenant not to sue provides that should Mr. Moshayedi seek indemnification from the Company in connection with the
SEC’s civil action described above, and Mr. Moshayedi is otherwise entitled to be indemnified, Mr. Moshayedi has released the Company, its subsidiaries, WDC and other specified persons from all claims for indemnification, except for
an aggregate underlying total of up to $20 million. In exchange for such limited release, WDC has agreed to continue to pay Mr. Moshayedi’s legal fees in connection with the action consistent with past practice and has released him from
any obligation to reimburse the Company for such legal fees under his indemnification agreement with the Company. The release and covenant not to sue will terminate in the event the Merger Agreement is terminated pursuant to its terms.
We are involved from time to time in claims and litigation over intellectual property rights, which may adversely affect our
ability to manufacture and sell our products.
Our industry is characterized by vigorous protection and pursuit of
intellectual property rights. It may be necessary, from time to time, to initiate litigation against third parties to preserve our intellectual property rights. In addition, a third party could claim that our products infringe or contribute to the
infringement of a patent or other proprietary right. From time to time, we have received, and may continue to receive in the future, notices that claim we have infringed upon, misappropriated or misused other parties’ proprietary rights. Any of
the foregoing events or claims could result in litigation. For example, as described in detail in Note 8 – “Commitments and Contingencies” to the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report
on Form 10-Q, on September 7, 2011, Solid State Storage Solutions, Inc. filed a complaint in the U.S. District Court for the Eastern District of Texas against us and several other defendants alleging that certain of our products and or/services
infringe certain patents allegedly owned by Solid State Storage Solutions, Inc. On December 19, 2012, the parties resolved this matter pursuant to a confidential agreement that releases us from past claims and precludes the plaintiff from again
claiming that our products infringe its patents. Although we continue to dispute that our products infringe any valid claims of patents, the settlement enables us to avoid further legal defense costs and the diversion of management resources, and
the settlement should not be deemed an admission of any liability. On January 2, 2013, the U.S. District Court for the Eastern District of Texas approved the parties’ joint motion to dismiss the matter with prejudice.
From time to time, we receive letters from third parties suggesting that some or all of our products may infringe third party patents. In
each instance, our management determines whether the allegations in the letters have sufficient justification and specificity to require a response. When we believe it is appropriate to do so, our management seeks the advice of counsel on these
matters. In the event of an adverse outcome from such claims, we could be required to pay substantial damages, cease the manufacture, use and sale of certain products, expend significant resources to develop, license or acquire non-infringing
technology, discontinue the use of certain processes or obtain licenses to use the infringed technology.
Our failure to
obtain a required license on commercially reasonable terms, or at all, could cause us to incur substantial costs and suspend manufacturing products using the infringed technology. If we obtain a license, we would likely be required to pay license
fees or make royalty payments for sales under the license. Such payments would increase our cost of revenues and reduce our gross margins and gross profit. If we are unable to obtain a license from a third party for technology, we could incur
substantial liabilities or be required to expend substantial resources redesigning our products to eliminate the infringement. We may not be successful in redesigning our products. Product development related to redesigning our products or license
negotiating would likely result in significant expense to us and divert the efforts of our technical and management personnel.
Some of our suppliers and licensors have generally agreed to provide us with various levels of intellectual property indemnification for
products and technology that we purchase or license from them. However, our suppliers’ and licensors’ obligation to indemnify us for intellectual property infringement may be insufficient or inapplicable to any such litigation or other
claims of intellectual property infringement.
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Our indemnification obligations for products that infringe the intellectual property
rights of others could require us to pay substantial damages.
We currently have in effect a number of agreements in
which we have agreed to defend, indemnify and hold harmless our customers and suppliers from damages and expenses that may arise from the infringement by our products and services of third-party patents, trademarks or other proprietary rights.
Although the scope of such indemnity varies, the term of these indemnification agreements is generally perpetual and the maximum potential amount of future payments we could be required to make under these indemnification agreements is generally
unlimited. We may periodically have to respond to claims and litigate these types of indemnification obligations. Given that our insurance does not cover intellectual property infringement, any such indemnification claims could require us to pay
substantial damages that may result in a material adverse effect on our business, financial condition, results of operations and cash flows.
Our insurance coverage is limited, and any incurred liability resulting from inadequately covered claims could have a material adverse effect on our business, financial condition, results of
operations and cash flows.
Our insurance policies may not be adequate to fully offset losses from covered claims, and
we do not have coverage for certain losses. We believe our existing insurance coverage is consistent with common practice and economic and availability considerations. Nevertheless, as described in Note 8 – “Commitments and
Contingencies” to the Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q, the settlement amount under the terms of the Settlement Agreement with the federal class action Lead Plaintiff is in
excess of our director and officer insurance coverage limits for the applicable insurance claim period, and has negatively impacted our results of operations—See Item 2, Part I—“Management’s Discussion and Analysis of
Financial Condition and Results of Operations” for details. Our contribution to the settlement was made at the end of the first quarter of 2013, which negatively impacted our cash flows in the first quarter of 2013. If our insurance coverage
for future insurance claim periods is inadequate to protect us against catastrophic losses or unpredictable liabilities, any uncovered losses or claims could have a material adverse effect on our business, financial condition, results of operations
and cash flows.
If we do not successfully manage any reductions in workforce, our business could be disrupted and have
a material adverse effect on our financial condition, results of operations and cash flows.
We have recently
implemented changes to reduce operating expenditures, including certain reductions in workforce. Our inability to successfully manage these changes, and detect and address any issues that may arise, including retention of our remaining employees,
could disrupt our business and have a material adverse effect on our financial condition, results of operations and cash flows. Moreover, these steps may not reduce our cost structure to a level sufficient to enable us to be profitable.
Disruptions to our operations could substantially harm our business.
Substantially all of our manufacturing operations are located in Penang, Malaysia. In addition, a substantial amount of our supply chain
is dependent on international suppliers and a significant amount of our products are shipped to international customers. Further, we undertake various research and development, sales and marketing activities through regional offices in a number of
foreign countries. These international operations are subject to many inherent risks, including but not limited to, government intervention, political instability, acts of terrorism, power failures, health pandemics and natural disasters, including
earthquakes, tsunamis, fires or floods, and disruptions in global transportation arising from labor difficulties, natural disasters and political instability. Our U.S. operations are also subject to many of these inherent risks. For example, our
headquarters and various U.S.-based research and development activities are located in Southern California, an area with above average seismic activity due to the proximity of major earthquake fault lines. In addition, our Santa Ana, California
headquarters and our facility in Penang, Malaysia are located within close proximity to airports and flight paths, and we may be more susceptible to potential disruptions from aviation related issues.
A disruption to our facility in Penang, Malaysia could substantially limit our manufacturing capabilities. In addition, natural disasters
in Southeast Asia may threaten the ability of our suppliers to provide us with required components or customers to obtain a sufficient supply of components required for their end products, causing them to postpone or cancel orders for our products.
Any of these risks could have a material adverse effect on our business, financial condition, results of operations and cash flows.
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The operation of our business is dependent on effective and secure information
systems.
In the ordinary course of our business, we collect and store electronically sensitive data, including our
intellectual property, our proprietary business information and that of our customers, suppliers and business partners and employee data. The secure maintenance, use and transmission of this information are critical to our operations. Despite our
security measures, our information technology systems and infrastructure may be vulnerable to cyber-security attacks by hackers or breached due to employee error, malfeasance or other disruptions. Because the techniques used to obtain unauthorized
access, or to sabotage systems, change frequently, we may be unable to anticipate these techniques or to implement adequate preventative measures. Any such breach could compromise our information technology systems and networks, and the information
stored there could be accessed, publicly disclosed, lost or stolen. Any such access, disclosure or other loss of information could result in legal claims or proceedings, disrupt our operations (including supply chain) and the services we provide to
customers and damage our reputation, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.
We may make acquisitions and strategic investments that are dilutive to existing shareholders, resulting in unanticipated accounting charges or otherwise adversely affect our results of operations.
We may decide to grow our business through business combinations or other acquisitions of businesses, products or
technologies that allow us to complement our existing product offerings, expand our market coverage, increase our engineering workforce or enhance our technological capabilities. If we make any future acquisitions:
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We could issue stock that would dilute our current shareholders’ percentage ownership;
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We may incur substantial debt, reduce our cash reserves and/or assume contingent liabilities; and
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Such acquisitions may result in material charges, adverse tax consequences, substantial depreciation, deferred compensation charges, in-process
research and development charges, and the amortization of amounts related to deferred compensation and identifiable purchased intangible assets or impairment of goodwill.
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Any of these could negatively impact our results of operations. In addition, we have made and expect that we may continue to make
strategic investments in early-stage companies. These investments may require us to consolidate or record our share of the earnings or losses of those companies. Furthermore, we may have little or no influence over the early-stage companies in which
we have made or may make strategic investments. Each of these investments in pre-public companies involves a high degree of risk, and we may not achieve liquidity in these investments for a number of years after the date of the investment, if at
all. We may not be successful in achieving the financial, technological or commercial advantage upon which any given investment is premised, and failure by the early-stage company to achieve its own business objectives or to raise capital needed on
acceptable economic terms could result in a loss of all or part of our invested capital. Any losses or impairments arising from our investment in these early-stage companies may adversely affect our financial results until we exit from or reduce our
exposure to these investments.
If the return on our investments in our core technologies, certain revenue growth
initiatives and complementary new technologies is lower or develops more slowly than we expect, or if we are required to invest substantially more resources than anticipated, our business, financial condition and results of operations could be
materially and adversely affected.
In order to remain competitive, we have been realigning and are dedicating
significant resources to focus on our core technologies, certain revenue growth initiatives and complementary new technologies that will help us solve our customers’ most complex storage and server issues. There is no assurance that our
investment in these areas will lead to successful results. We could also be required to devote substantially more resources than anticipated due to the entry of new competitors, technological advances by competitors or other competitive factors. If
the return on these investments is lower or develops more slowly than we expect, or if we are required to devote substantially more resources than anticipated without a corresponding increase in revenue, our business, financial condition and results
of operations could be materially and adversely affected.
Our limited experience in acquiring other businesses, product
lines and technologies may make it difficult for us to overcome problems encountered in connection with any acquisitions we may undertake.
Our experience in acquiring other businesses, product lines and technologies is limited. The attention of our management team may be diverted from our core business if we undertake any future
acquisitions. Any potential future acquisition could involve numerous risks, including, among others:
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Problems or delays in successfully closing the acquisition;
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Problems or delays assimilating and integrating the purchased operations, personnel, technologies, products and information systems;
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Unanticipated costs and expenditures associated with the acquisition, including any need to infuse significant capital into the acquired operations;
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Adverse effects on existing business relationships with suppliers, customers and strategic partners;
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Risks associated with entering markets and foreign countries in which we have limited or no prior experience;
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Contractual, intellectual property or employment issues;
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Potential loss of key employees of purchased organizations; and
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Potential litigation arising from the acquired company’s operations before the acquisition.
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These risks could disrupt our ongoing business, distract our management and employees, harm our reputation and increase our expenses. Our
inability to overcome problems encountered in connection with any acquisition could further divert the attention of management, utilize scarce corporate resources and otherwise harm our business. These challenges may be magnified as the size of an
acquisition increases. In addition, we may not realize the intended benefits of any acquisition.
We may not be able to find
suitable acquisition opportunities and even if we do find acquisition opportunities we believe are suitable, we may not be able to consummate the acquisitions on commercially acceptable terms or realize the anticipated benefits of any acquisitions
we do undertake.
Ineffective management of inventory levels or product mix, order cancellations, product returns and
inventory write-downs could have a material adverse effect on our business, financial condition, results of operations and cash flows.
With certain exceptions, sales of our products are generally made through individual purchase orders and, in certain cases, are made under master agreements governing the terms and conditions of the
customer relationships. Some customers may have the ability to change, cancel or delay orders with limited or no penalties. It is difficult to accurately predict what or how many products our customers will need in the future. Anticipating demand is
challenging because our customers face volatile pricing and unpredictable demand for their products and are increasingly focused on cash preservation and tighter inventory management. We have experienced cancellations of orders and changes in order
levels from period-to-period, and we expect to continue to experience similar cancellations and changes in the future, which could result in fluctuations in our revenues.
If we are unable to properly monitor, control and manage our inventory and maintain an appropriate level and mix of products to support our customers’ needs, we may incur increased and unexpected
costs associated with our inventory. If we manufacture products in anticipation of future demand that does not materialize, or if a customer cancels outstanding orders, we could experience an unanticipated increase in our inventory that we may be
unable to sell in a timely manner, if at all. If demand does not meet our expectations, we could incur increased expenses associated with writing off excess or obsolete inventory.
We also maintain third-party inventory hubbing arrangements with certain of our customers. Pursuant to these arrangements, we deliver
products to a customer or a designated third-party warehouse based upon the customer’s projected needs but do not recognize product revenue unless and until the customer has removed our product from the warehouse to incorporate into its end
products. If a customer does not take our products under a hubbing arrangement in accordance with the schedule it originally provided us, our predicted future revenue stream could vary substantially from our forecasts and our results of operations
could be materially and adversely affected. Additionally, because we own inventory that is physically located in a third party’s warehouse, our ability to effectively manage inventory levels may be impaired, causing our total inventory turns to
decrease, which could increase expenses associated with excess and obsolete inventory and negatively impact our cash flow.
In
addition, while we may not be contractually obligated to accept returned products, we may determine that it is in our best interest to accept returns in order to maintain good relationships with our customers. Product returns would increase our
inventory and reduce our revenues. Alternatively, we could end up with too little inventory and we may not be able to satisfy demand, which could have a material adverse effect on our customer relationships. Our risks related to inventory management
are exacerbated by our strategy of closely matching inventory levels with product demand, leaving limited margin for error. We have had to in the past and may need to in the future write down inventory for reasons such as obsolescence, excess
quantities and declines in market value below our costs. These inventory write-downs can have a material adverse effect on our business, financial condition, results of operations and cash flows.
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Declines in our average sales prices may result in declines in our revenues and gross
profit.
Our industry is competitive and historically has been characterized by declines in average sales prices. Our
average sales prices may decline due to several factors, including competition, overcapacity in the worldwide supply of DRAM and Flash memory components as a result of worldwide economic conditions, increased manufacturing efficiencies,
implementation of new manufacturing processes and expansion of manufacturing capacity by component suppliers. In the past, overcapacity has resulted in significant declines in component prices, which in turn has negatively impacted our average sales
prices, revenues and gross profit. In addition, because a large percentage of our sales are to a small number of customers that are primarily distributors and large OEMs, these customers have exerted, and we expect they will continue to exert,
pressure on us to make price concessions. If not offset by increases in volume of sales or the sales of newly-developed products with higher margins, decreases in average sales prices may have a material adverse effect on our business, financial
condition, results of operations and cash flows.
The manufacturing of our products is complex and subject to production
output yield problems, which could decrease available supply and increase costs.
The manufacture of our SSD
controllers, Flash-based products and stacked DRAM products is a complex process, and it is often difficult for companies such as ours to achieve, after completed assembly and testing, acceptable production output yields (i.e., the ratio of usable
product output to expected output based on given component inputs). Reduced production yields could decrease available supply and increase costs. SSD controller production output yields depend on both our product design and the manufacturing process
technology unique to our semiconductor foundry partners. Because low yields may result from either design defects or process difficulties, we may not identify yield problems until well into the production cycle, when an actual product defect exists
and can be analyzed and tested. In addition, many of these yield problems are difficult to diagnose and time consuming or expensive to remedy.
The execution of our business strategy depends on our ability to retain key personnel, including our executive officers, and to attract qualified personnel.
Competition for employees in our industry is intense. We have had and may continue to have difficulty hiring the necessary engineering,
sales and marketing and management personnel to support our business strategy. The successful implementation of our business model and business strategy depends on the continued contributions of our senior management and other key research and
development, sales and marketing and operations personnel, including Mark Moshayedi, our CEO and President and a Director; Manouch Moshayedi, our Founder and a Director; and Raymond D. Cook, our Chief Financial Officer.
We believe that our ability to offer competitive equity packages to new and existing employees is important to our continued growth and
success and to hiring and retaining key employees. Our shareholders approved an increase to the share reserve under our 2010 Incentive Award Plan at our 2012 annual meeting. If our shareholders fail to approve future increases, our ability to
continue to offer competitive equity packages will be negatively impacted. Furthermore, in such event, we may need to instead offer material cash-based incentives to compete for talent, which may not be competitive and would have a negative impact
on our financial condition, results of operations and cash flows.
The inability to hire and retain key employees, the loss of
any key employee, the failure of any key employee to perform in his or her current position or the inability of our officers and key employees to expand, train and manage our employee base would have an adverse effect on the execution of our
business strategy.
Our efforts to expand our business internationally may not be successful and may expose us to
additional risks that may not exist in the United States.
We sell our products to customers in foreign countries and
seek to increase our level of international business activity through the expansion of our operations into select markets, including Asia and Europe. Such strategy may include opening sales offices in foreign countries, outsourcing of manufacturing
operations, establishing joint ventures with foreign partners and establishing additional manufacturing operations in foreign countries.
A failure to successfully and timely integrate these operations into our global infrastructure could have a negative impact on our overall operations, cause us to delay or forego some of the original
perceived benefits of operating internationally, such as lower average production and engineering labor costs, better access to global markets, improved supply chain efficiency, reduced lead times, increased manufacturing efficiency through
investments in new state-of-the-art equipment and a lower overall long-term effective tax rate. Establishing and running operations in a foreign country or region presents numerous risks, including:
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Difficulties and costs of staffing and managing operations in certain foreign countries;
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Foreign laws and regulations, which may vary country by country, and may impact how we conduct our business;
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Higher costs of doing business in certain foreign countries, including different employment laws;
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Difficulty protecting our intellectual property rights from misappropriation or infringement;
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Political or economic instability;
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Changes in import/export duties;
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Necessity of obtaining government approvals;
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Work stoppages or other changes in labor conditions;
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Difficulties in collecting accounts receivables on a timely basis or at all;
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Changes in local tax regulations;
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Changes to or untimely terminations in government incentives;
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Longer payment cycles and foreign currency fluctuations; and
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Seasonal reductions in business activity in some parts of the world, such as Europe.
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In addition, changes in policies and/or laws of the U.S. or foreign governments resulting in, among other things, higher taxation,
currency conversion limitations, restrictions on fund transfers or the expropriation of private enterprises, could reduce the anticipated benefits of our international expansion. Moreover, as a result of our international operations, we are subject
to tax in multiple jurisdictions. If any taxing authority (in the U.S. or otherwise) were to successfully challenge our interpretation of the applicable tax laws or our determination of the income and expenses attributable to operations in a
specific jurisdiction, we could be required to pay additional taxes, interest and penalties. Furthermore, any actions by countries in which we conduct business to reverse policies that encourage foreign trade or investment could adversely affect our
business. If we fail to realize the anticipated revenue growth of our future international operations, our business and operating results could suffer.
We expect that our strategy to expand our international operations will require the expenditure of significant resources and the efforts and attention of our management. Unlike some of our competitors, we
have limited experience operating our business in foreign countries. Some of our competitors may have a substantial advantage over us in attracting customers in certain foreign countries due to earlier established operations in such countries,
greater knowledge with respect to cultural differences of customers residing in such countries and greater brand recognition and longer-standing relationships with customers in such countries. If our international expansion efforts in any foreign
country are unsuccessful, it could harm our reputation and cause us to incur expenses and losses, and we may decide to cease these foreign operations.
Our intellectual property may not be adequately protected, which could harm our competitive position.
Our intellectual property is critical to our success. As of August 1, 2013, we owned 57 patents and 76 additional patent applications were pending. Although we protect our intellectual property
rights through patents, trademarks, copyrights and trade secret laws, confidentiality procedures and employee disclosure and invention assignment agreements, it is possible that our efforts to protect our intellectual property rights may not:
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Prevent the challenge, invalidation or circumvention of our existing patents;
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Prevent our competitors from independently developing similar products, duplicating our products or designing around the patents owned by us;
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Prevent third-party patents from having an adverse effect on our ability to do business;
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Prevent third parties from copying or otherwise obtaining and making unauthorized use of our technologies;
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Provide adequate protection for our intellectual property rights;
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Prevent disputes with third parties regarding ownership of our intellectual property rights;
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Prevent disclosure of our trade secrets and know-how to third parties or into the public domain; and
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Result in patents from any of our pending applications.
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In addition, despite our efforts to protect our intellectual property rights and confidential information, third parties could copy or otherwise obtain and make unauthorized use of our technologies or
independently develop similar technologies. Furthermore, if any of our patents are challenged and found to be invalid, our ability to exclude competitors from making, using or selling the same or similar products related to such patents would cease.
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On September 16, 2011, the Leahy-Smith America Invents Act (the “Leahy-Smith
Act”) was signed into law. The Leahy-Smith Act includes a number of significant changes to the U.S. patent laws, such as, among other things, changing from a “first to invent” to a “first inventor to file” system,
establishing new procedures for challenging patents and establishing different methods for invalidating patents. The U.S. Patent and Trademark Office is still in the process of implementing regulations relating to these changes, and the courts have
yet to address many of the new provisions of the Leahy-Smith Act. Some of these changes or potential changes may not be advantageous to us, and it may become more difficult to obtain adequate patent protection or to enforce our patents against third
parties. While we cannot predict the impact of the Leahy-Smith Act at this time, these changes or potential changes could increase the costs and uncertainties surrounding the prosecution of our patent applications and adversely affect our ability to
protect our intellectual property.
We have, on at least one occasion, applied for and may in the future apply for patent
protection in foreign countries. The laws of foreign countries, however, may not adequately protect our intellectual property rights. Many U.S. companies have encountered substantial infringement problems in foreign countries. Because we sell some
of our products overseas, we have exposure to foreign intellectual property risks.
Our indemnification obligations to
our customers and suppliers for product defects could require us to pay substantial damages.
A number of our product
sales and product purchase agreements provide that we will defend, indemnify and hold harmless our customers and suppliers from damages and costs which may arise from product warranty claims or claims for injury or damage resulting from defects in
our products. We maintain insurance to protect against certain claims associated with the use of our products, but our insurance coverage may not be adequate to cover all or any part of the claims asserted against us. A successful claim brought
against us that is in excess of, or excluded from, our insurance coverage could substantially harm our business, financial condition, results of operations and cash flows.
Failure to comply with governmental laws and regulations could harm our business.
Our business is subject to regulation by various U.S. federal, state, local and foreign governmental authorities and agencies. Such regulation includes employment and labor laws, workplace safety, product
safety, environmental laws, consumer protection laws, import/export controls, federal securities laws and tax laws.
As a
global company, we are subject to varied and complex laws, regulations and customs domestically and internationally. These laws and regulations relate to a number of aspects of our business, including trade protection, import and export control,
data and transaction processing security, records management, gift policies, employment and labor relations laws, workplace safety, product safety, environmental laws, federal securities laws, tax regulations and other regulatory requirements
affecting our operations. The application of these laws and regulations to our business is often unclear and may at times conflict. Compliance with these laws and regulations may involve significant costs or require changes in our business practices
that result in reduced revenue and profitability. We incur additional legal compliance costs associated with our global operations and could become subject to legal penalties in foreign countries if we do not comply with local laws and regulations,
which may be substantially different from those in the U.S. In many foreign countries, particularly in those with developing economies, it may be common to engage in business practices that are prohibited by U.S. and other regulations applicable or
that may be applicable to us, such as the U.S. Foreign Corrupt Practices Act and the U.K. Bribery Act. Although we implement policies and procedures designed to ensure compliance with these laws, certain of our employees, contractors and agents, as
well as those companies to which we outsource certain aspects of our business operations, including those based in foreign countries where practices, which violate such laws and regulations may be customary, may take actions in violation of our
internal policies.
Non-compliance with applicable regulations or requirements could subject us or our employees to
investigations, sanctions, mandatory product recalls, enforcement actions, disgorgement of profits, fines, damages, civil and criminal penalties or injunctions, prohibitions on the conduct of our business and damage to our reputation. These actions
could harm our business, financial condition, results of operations and cash flows. If any governmental sanctions or fines are imposed, or if we do not prevail in any possible civil or criminal litigation, our business, financial condition, results
of operations and cash flows could be materially adversely affected. In addition, responding to any action will likely result in a significant diversion of management’s attention and resources and an increase in professional fees.
In addition, from time to time, we have received, and expect to continue to receive, complaints from former employees who threaten to
bring claims against us alleging that we have violated one or more labor and employment regulations. In certain of these instances, the former employees have brought formal claims against us and we expect that we will encounter similar actions
against us in the future. An adverse outcome in any such litigation or resulting settlement could require us to pay contractual damages, compensatory damages, punitive damages, attorneys’ fees and costs.
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Compliance with evolving environmental regulations and standards could harm our
business.
We may be required to meet and adjust to evolving environmental requirements relating to the material
composition of our products. As environmental requirements change, substituting particular components with conforming components to meet new environmental standards may prove to be difficult or costly and additional redesign efforts could result in
production delays. Our operations may be affected by significant changes to existing or future environmental laws and regulations, including those imposed in response to climate change concerns and other actions commonly referred to as “green
initiatives.” Although we cannot predict the ultimate impact of any such new laws and regulations, they may result in additional costs or decreased revenue, which could have a material adverse effect on our business, financial condition,
results of operations and cash flows.
Foreign currency fluctuations could lead to a decrease in demand for our products
or an increase in the cost of the components used in our products.
The volatility of general global economic
conditions and fluctuations in currency exchange rates affect the prices of our products and the prices of the components used in our products. International sales, which are derived from billings to foreign customers, accounted for 36% and 49%, of
our total revenues in the second quarter of 2013 and 2012, respectively. In second quarter of 2012, 22% and 11% of our revenues were derived from billings to customers in Singapore and the Czech Republic, respectively. For the second quarter of both
2013 and 2012 more than 95% of our international sales were denominated in U.S. dollars, and if the U.S. dollar experiences significant appreciation relative to the currency of a specific country, the prices of our products will rise in such country
and our products may be less competitive. In addition, our international customers may not be willing to continue to place orders denominated in U.S. dollars. If they do not, our revenues and results of operations will be subject to greater
variations from foreign exchange fluctuations, which could harm our business. We do not hedge against foreign currency exchange rate risks.
Furthermore, we purchase a majority of the Flash and DRAM components used in our products from foreign suppliers. Although our purchases of Flash and DRAM components are currently denominated in U.S.
dollars, a devaluation of the U.S. dollar relative to the currency of a foreign supplier would result in an increase in our cost of Flash and DRAM components.
We may have exposure to greater than anticipated tax liabilities.
We operate in different countries throughout the world and are subject to taxation in a variety of jurisdictions. Our future income taxes
could be adversely affected if earnings are higher than anticipated in jurisdictions where we are subject to higher statutory tax rates, by changes in the valuation of our deferred tax assets and liabilities, or changes in tax laws, regulations,
accounting principles, or interpretations thereof. For example, recent proposals for changes in U.S. tax laws that may be considered or adopted in the future could subject us to higher taxes or result in changes to tax law provisions that currently
provide favorable tax treatment.
A substantial portion of our assets, including employees of our foreign subsidiaries are
located outside of the U.S. The earnings generated by our foreign subsidiaries are needed to fund the working capital needs of our foreign subsidiaries. As such, we have not provided for U.S. taxes or foreign withholding taxes on our undistributed
earnings from our foreign subsidiaries because such earnings are expected to be reinvested indefinitely. Based on our current liquidity position and business plan, we do not anticipate a need to utilize these funds for our U.S. operations in the
foreseeable future. However, if we are not able to achieve the planned improvements in the financial performance of our U.S. operations, which is contemplated in our business plan, we may need to re-assess our conclusion that these foreign funds
will not need to be remitted to the U.S. in the foreseeable future. If this change in circumstance were to occur and it became apparent that some or all of the undistributed earnings will be remitted in the foreseeable future for which we have not
recognized income taxes, we may be required to accrue additional income tax expense attributable to the portion of the remittance for which we do not have sufficient U.S. net operating loss carryforwards, tax credit carryforwards, and additional tax
deductions available to offset the additional taxable income.
Further, as an incentive to establish operations in Malaysia,
we were provided a tax holiday effective through September 29, 2027. The eventual expiration or an early revocation of our tax holiday in Malaysia, if certain conditions are not met, may result in an increase to our future tax liabilities.
In addition, we evaluate our deferred tax assets on a quarterly basis to determine whether all or any portion of the asset is
more likely than not realizable under ASC 740. We are required to establish or maintain a valuation allowance against any portion of the asset we conclude is more likely than not to be unrealizable. In assessing whether a valuation allowance is
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required or whether an existing valuation allowance should be maintained or reversed, significant weight is given to evidence that can be objectively verifiable. In accordance with ASC 740, we
consider key positive and negative evidence using a “more likely than not” realization standard in making the determination of whether a valuation allowance is required or whether an existing valuation allowance should be maintained or
reversed. The ultimate realization of our deferred tax assets depends primarily on our ability to generate future taxable income during the periods in which the related temporary differences become deductible. The assessment of a valuation allowance
includes giving appropriate consideration to all positive and negative evidence related to the realization of the deferred tax asset. This assessment considers, among other things, the nature, frequency and severity of current and cumulative losses,
forecasts of future taxable income, the duration of statutory carryforward periods, our utilization experience with operating losses and tax credit carryforwards and tax planning alternatives. Significant judgment is required in determining the
future tax consequences of events that have been recognized in our consolidated financial statements and/or tax returns. Differences between anticipated and actual outcomes of these future tax consequences could have a material impact on our
consolidated financial position or results of operations.
We are also subject to regular review and audit by both domestic
and foreign tax authorities. Any adverse outcome of such a review or audit could negatively impact our operating results and financial condition. The determination of our global provision for income taxes and other tax liabilities requires
significant judgment and in the ordinary course of our business, there are many transactions where the ultimate tax determination is uncertain. Additionally, our calculations of income taxes are based on our interpretations of applicable tax laws in
the jurisdictions in which we file. Although we believe our tax estimates are reasonable, the ultimate tax outcome may differ from the amounts recorded in our financial statements and may materially affect our financial results in the period or
periods for which such determination is made.
We could be required to record impairment charges relating to goodwill
and other intangible assets, which could have a material adverse effect on our results of operations.
In accordance
with ASC 350, “Intangibles—Goodwill and Other” (“ASC 350”), goodwill and other intangible assets with indefinite lives are no longer subject to amortization but are tested for impairment annually or whenever events or
changes in circumstances indicate that the asset might be impaired. Subsequent to the sale of the Consumer Division in 2007, we operate in one operating segment and have one reporting unit. We assess potential impairment of goodwill and
other intangible assets on an annual basis on the last day of the year and compare the market capitalization of the reporting unit to its carrying amount, including goodwill. If goodwill is considered impaired, the impairment loss to be
recognized is measured by the amount by which the carrying amount of the goodwill exceeds the implied fair value of that goodwill. A future decrease in our stock price could indicate the impairment of goodwill, which could have a material
adverse effect on our results of operations.
Intangible assets with finite lives and other long-lived assets continue to be
subject to amortization, and any impairment is determined in accordance with ASC 360, “Property, Plant, and Equipment” (“ASC 360”). We continually monitor events and changes in circumstances that could indicate that the
carrying balances of our intangible assets may not be recoverable in accordance with the provisions of ASC 360. When such events or changes in circumstances are present, we assess the recoverability of long-lived assets by determining whether
the carrying value of such assets will be recovered through undiscounted expected future cash flows. If the total of the future cash flows is less than the carrying amount of those assets, we recognize an impairment loss based on the excess of
the carrying amount over the fair value of the assets. Inherent in our fair value determinations are certain judgments and estimates, including projections of future cash flows, the discount rate reflecting the risk inherent in future cash
flows, the interpretation of current economic indicators and market valuations, and strategic plans with regard to operations. A change in these underlying assumptions could cause a change in the results of the tests and could require us to
record impairment charges to our other long-lived assets, which could have a material adverse effect on our results of operations.
Risks
Related to Our Common Stock
Our stock price is highly volatile.
Our common stock has been publicly traded since September 2000. The market price of our common stock has fluctuated substantially in the
past and is likely to continue to be highly volatile and subject to wide fluctuations. From January 1, 2011 to August 1, 2013 our common stock has traded at prices as low as $3.32 and as high as $25.44 per share. These fluctuations
have occurred and may continue to occur in response to various factors, many of which we cannot control. The stock market has from time to time experienced significant price and volume fluctuations that have affected the market prices of securities,
particularly securities of technology companies. This volatility has significantly affected the market prices of securities of many technology companies for reasons frequently unrelated to the operating performance of the specific companies. As a
result of volatility, the market price of our common stock may materially decline, regardless of our operating performance. Accordingly, you may not be able to resell your shares of common stock at or above the price you paid.
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In the past, we and other companies that have experienced volatility in the market price of
their securities have been, and we currently are, the subject of securities class action litigation. Litigation of this type is often expensive, diverts management’s attention and resources and could have a material adverse effect on our
business, results of operations and market price of our common stock.
Our quarterly operating results have fluctuated
in the past, and we expect our quarterly operating results to continue to fluctuate in future periods, which could cause our stock price to fluctuate or decline.
Our quarterly operating results have fluctuated in the past, and we believe they will continue to do so in the future. Some of these fluctuations may be more pronounced than they were in the past due to
the uncertain current global economic environment. Fluctuations in our operating results may be due to a number of factors, including, but not limited to, those identified throughout this “Risk Factors” section and the following:
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Impact of changing and recently volatile U.S. and global economic conditions, including the ongoing European debt crisis and resulting instability (and
potential dissolution) of the Euro;
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The downgrade by Standard & Poor’s of the United States’ sovereign credit rating and its impact on financial markets and
companies’ ability to raise capital;
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Our suppliers’ production levels of the components used in our products;
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Our ability to procure required components;
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Market acceptance of new and enhanced versions of our products;
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Expansion of our international business, including the opening of offices and facilities in foreign countries;
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The timing of the introduction of new products or components and enhancements to existing products or components by us, our competitors or our
suppliers;
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Fluctuations in the cost of components and changes in the average sales prices of our products;
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Fluctuating market demand for our products;
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Changes in our customer or product revenue mix;
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The loss of one or more of our customers;
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Our ability to successfully integrate any acquired businesses or assets;
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Expenses associated with the startup of new operations or divisions;
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Order cancellations, product returns, inventory buildups by customers and inventory write-downs;
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Manufacturing inefficiencies associated with the start-up of new manufacturing operations, new products and volume production;
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Expenses associated with strategic transactions, including acquisitions, joint ventures and capital investments;
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Our ability to adequately support potential future rapid growth;
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Our ability to absorb manufacturing overhead if revenues decline;
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The effects of litigation; and
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Increases in our sales and marketing and research and development expenses in connection with decisions to pursue new product initiatives.
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Due to such factors, quarterly revenues and results of operations are difficult to forecast, and
period-to-period comparisons of our operating results may not be predictive of future performance.
Failure to maintain
effective internal control over financial reporting could cause our investors to lose confidence in our reported financial information and operating results and adversely affect the market price of our common stock.
Section 404 of the Sarbanes-Oxley Act of 2002 requires that we maintain effective internal control over financial reporting that
meets applicable standards. We may err in the design or operation of our controls, and all internal control
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systems, no matter how well designed and operated, can provide only reasonable assurance that the objectives of the control system are met. Because there are inherent limitations in all control
systems, there can be no absolute assurance that all control issues have been or will be detected. In addition, a failure to maintain such controls could result in misstatements in our financial statements. If we are unable, or are perceived as
unable, to produce reliable financial reports due to internal control deficiencies, investors could lose confidence in our reported financial information and operating results, which could result in a negative market reaction.
Two of our largest shareholders are executives and directors of the Company and their interests may diverge from other
shareholders.
Mark Moshayedi and Manouch Moshayedi are brothers who (along with a third brother Mike Moshayedi)
founded sTec. They have owned a substantial amount of the Company’s shares since its inception. As of June 30, 2013 Mark and Manouch Moshayedi beneficially owned, in the aggregate, approximately 14% of our outstanding common stock. This
beneficial ownership percentage does not include shares that were gifted by Mark Moshayedi to an irrevocable trust for the benefit of his descendants and shares that were gifted by Manouch Moshayedi to an irrevocable trust for the benefit of his
descendants, which totals to approximately 5% of our outstanding common stock, but to which Mark and Manouch Moshayedi each disclaim beneficial ownership. As shareholders, Mark and Manouch Moshayedi may have interests that diverge from those of
other holders of our common stock. In addition, Mark Moshayedi is our CEO and President and Manouch Moshayedi is our founder, and both are sTec Board members. As a result, they have the potential or perceived ability to influence all matters
requiring approval by our shareholders, including approval of significant corporate transactions and the decision of whether a change in control will occur. This potential or perceived influence could affect the price that certain investors may be
willing to pay for shares of our common stock.
Certain provisions in our charter documents and equity incentive plans
could prevent or delay a change in control and, as a result, negatively impact our shareholders.
Certain provisions in
our charter documents and equity incentive plans could have the effect of discouraging a takeover attempt. For example, provisions in our articles of incorporation and bylaws could make it more difficult for a third party to acquire us, even if
doing so would be beneficial to our shareholders. These provisions also could limit the price that certain investors might be willing to pay in the future for shares of our common stock.
These provisions include:
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Limitations on how special meetings of shareholders can be called;
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Advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon by shareholders at
shareholder meetings;
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Elimination of cumulative voting in the election of directors;
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The right of a majority of directors in office to fill vacancies on the board of directors; and
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The ability of our board of directors to issue, without shareholder approval, “blank check” preferred stock to increase the number and type
of outstanding shares.
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In addition, provisions of our 2000 Stock Incentive Plan and 2010 Incentive Award
Plan allow for the automatic vesting of all outstanding equity awards granted under the 2000 Stock Incentive Plan and 2010 Incentive Award Plan upon a change in control under certain circumstances. Such provisions may have the effect of discouraging
a third party from acquiring us, even if doing so would be beneficial to our shareholders.