UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 20-F
(Mark One)
[_] Registration statement pursuant to Section 12(b) or 12(g) of the
Securities Exchange Act of 1934
or
[X] Annual report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 For the fiscal year ended December 31, 2005
or
[_] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 For the transition period from ____ to_____.
or
[_] Shell company report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 Date of event requiring this shell company report
Commission file number: 0-30910
O2 MICRO INTERNATIONAL LIMITED
(Exact Name of Registrant as Specified in Its Charter)
The Cayman Islands
(Jurisdiction of Incorporation or Organization)
Grand Pavilion Commercial Centre, West Bay Road
P.O. Box 32331 SMB, George Town
Grand Cayman, Cayman Islands
(Address of Principal Executive Offices)
Securities registered or to be registered pursuant to Section 12(b) of the
Act:
Title of Each Class Name of Each Exchange On Which Registered
------------------- -----------------------------------------
American Depositary Shares Nasdaq National Market
Ordinary Shares, par value The Stock Exchange of Hong Kong Limited
$0.00002 per share Cayman Islands Stock Exchange
Securities registered or to be registered pursuant to Section 12(g) of
the Act:
None
(Title of Class)
Securities for which there is a reporting obligation pursuant to Section 15(d)
of the Act:
None
(Title of Class)
Indicate the number of outstanding shares of each of the issuer's
classes of capital or common stock as of the close of the period
covered by the annual report.
As of December 31, 2005, there were 1,967,824,350 ordinary shares, par
value US$0.00002 per share, outstanding.
Indicate by check mark if the registrant is a well-known seasoned
issuer, as defined in Rule 405 of the Securities Act.
Yes [_] No [X]
If this report is an annual or transition report, indicate by check
mark if the registrant is not required to file reports pursuant to
Section 13 or 15(d) of the Securities Exchange Act of 1934.
Yes [_] No [X]
Note - Checking the box above will not relieve any registrant required
to file reports pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 from their obligations under those Sections.
Indicate by check mark whether the registrant: (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such
shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90
days.
Yes [X] No [_]
Indicate by check mark whether the registrant is a large accelerated
filer, an accelerated filer, or a non-accelerated filer. See definition
of "accelerated filer and large accelerated filer" in Rule 12b-2 of the
Exchange Act. (Check one):
Large accelerated filer [_] Accelerated filer [X] Non-accelerated filer [_]
Indicate by check mark which financial statement item the registrant
has elected to follow:
Item 17 [_] Item 18 [X]
If this is an annual report, indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act).
Yes [_] No [X]
2
TABLE OF CONTENTS
PART I
Item 1. Identity of Directors, Senior Management and Advisors............5
Item 2. Offer Statistics and Expected Timetable..........................5
Item 3. Key Information..................................................6
Item 4. Information on the Company......................................19
Item 4A. Unresolved Staff Comments.......................................30
Item 5. Operating and Financial Review and Prospects....................30
Item 6. Directors, Senior Management and Employees......................39
Item 7. Major Shareholders and Related Party Transactions...............46
Item 8. Financial Information...........................................47
Item 9. The Offer and Listing...........................................47
Item 10. Additional Information..........................................48
Item 11. Quantitative and Qualitative Disclosures About Market Risk......58
Item 12. Description of Securities Other Than Equity Securities..........60
PART II
Item 13. Defaults, Dividend Arrearages and Delinquencies.................60
Item 14. Material Modifications to the Rights of Security Holders
and Use of Proceeds.............................................60
PART III
Item 15. Controls and Procedures.........................................60
Item 16. Reserved........................................................61
Item 16A Audit Committee Financial Expert................................61
Item 16B Code of Ethics..................................................61
Item 16C Principal Accountant Fees and Services .........................61
Item 16D Exemption from the Listing Standards for Audit Committee........62
Item 16E Purchases of Equity Securities by the Issuer and
Affiliated Purchasers...........................................62
3
PART IV
Item 17. Financial Statements............................................63
Item 18. Financial Statements............................................63
Item 19. Exhibits........................................................63
Index to Consolidated Financial Statements...............................F-1
Signatures
4
Certain Definitions and Conventions
In this annual report on Form 20-F (the "Annual Report"), references to
"$" and "dollars" are to United States dollars. Percentages and certain amounts
contained herein have been rounded for ease of presentation. Any discrepancies
in any table between totals and the sums of amounts listed are due to rounding.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report contains statements of a forward-looking nature. These
statements are made under the "safe harbor" provisions of the U.S. Private
Securities Litigation Reform Act of 1995. You can identify these forward-looking
statements by terminology such as "may," "will," "expects," "should," "could,"
"plans," "intends," "anticipates," "believes," "estimates," "predicts,"
"potential" or "continue" or the negative of these terms and other comparable
terminology. These forward-looking statements include, without limitation,
statements regarding our expectation to increase expenses for personnel, new
product development, to protect our technology and expand our product offerings,
our anticipation that sales to a relatively small number of customers will
continue to account for significant portion of net sales, our expectation that
non-U.S. operations and sales will continue to grow, our belief that we
participate in large and growing markets, our intention to build and operate a
semiconductor testing facility that will provide us with the test capability and
flexibility needed to meet future customer requirements, our ability to develop
products in a timely manner to meet customer demands, our ability to take
advantage of cost-efficiencies associated with the "fabless" semiconductor
business model, our future gross profits, continued expansion of our
engineering, research and development resources, our efforts to reduce costs and
expenses, our expectation that selling, general and administrative expenses will
continue to increase in absolute dollars, and our expectation that patent
litigation expenses will continue to fluctuate in absolute dollars, our
expectations regarding outcome of litigation matters, our belief that cash
balances will be sufficient to meet our capital requirements for at least the
next 12 months, our belief that our research and development staffing will
increase in the next 12 months primarily due to expansion of existing design
centers and the opening of additional design centers and our intention to
continue expanding research and development operations, and our statements
regarding the effect of adoption of certain accounting policies. These
forward-looking statements are based on our current assumptions and beliefs in
light of the information currently available to us. Actual results, levels of
activity, performance or achievements may differ materially from those expressed
or implied in these forward-looking statements for a variety of reasons,
including: changes in demand for devices that use our products; market
conditions in the semiconductor industry and the economy as a whole; the stages
of our products in their life cycles, variations, expansions or reductions in
the mix of our product offerings, the timing of our product introductions,
specific product manufacturing costs, increased competition, introduction of new
competing technologies and the increase of unexpected expenses, and such other
factors discussed under "Key Information - Risk Factors", "Operating and
Financial Review and Prospects" and elsewhere in this Annual Report. We assume
no obligation to update or revise any forward-looking information, whether as a
result of new information, future events or otherwise. You are cautioned not to
place undue reliance on these forward-looking statements which apply only as of
the date of this Annual Report.
PART I
ITEM 1. IDENTITY OF DIRECTORS, SENIOR MANAGEMENT AND ADVISORS
Not applicable.
ITEM 2. OFFER STATISTICS AND EXPECTED TIMETABLE
Not applicable.
5
ITEM 3. KEY INFORMATION
SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data for the years ended December 31,
2003, 2004 and 2005, and the selected consolidated financial data as of December
31, 2004 and 2005, set forth below, are derived from our audited consolidated
financial statements included herein, and should be read in conjunction with,
and are qualified in their entirety by reference to, these consolidated
financial statements, including the notes to these consolidated financial
statements and "Item 5. Operating and Financial Review and Prospects" included
elsewhere in this annual report on Form 20-F. The selected consolidated
financial data for the years ended December 31, 2001 and 2002 and the selected
consolidated financial data as of December 31, 2001, 2002 and 2003, set forth
below, are derived from our audited consolidated financial statements and
related notes which do not appear in this annual report on Form 20-F. Our
consolidated financial statements are prepared and presented in accordance with
generally accepted accounting principles in the United States.
Year Ended December 31,
-------------------------------------------------------------
2001 2002 2003 2004 2005
--------- ---------- ---------- ---------- ----------
(in thousands, except per share data)
Consolidated Statement of Operations
Data:
Net sales ...................... $ 45,819 $ 70,187 $ 88,599 $ 92,196 $ 105,552
Cost of sales .................. 16,465 28,143 38,314 37,403 40,741
--------- ---------- ---------- ---------- ----------
Gross profit ................... 29,354 42,044 50,285 54,793 64,811
Operating expenses:
Research and development .... 14,320 18,935 19,219 20,260 25,421
Selling, general and
administrative ............ 9,561 11,790 13,522 16,348 20,279
Patent litigation ........... 348 535 3,954 5,334 10,174
Stock-based compensation .... 166 44 -- -- --
--------- ---------- ---------- ---------- ----------
Total operating expenses .. 24,395 31,304 36,695 41,942 55,874
--------- ---------- ---------- ---------- ----------
Income from operations ......... 4,959 10,740 13,590 12,851 8,937
Non-operating income - net ..... 1,827 1,662 1,437 2,705 244
--------- ---------- ---------- ---------- ----------
Income before income tax ....... 6,786 12,402 15,027 15,556 9,181
Income tax expense ............. 1,152 1,673 1,826 1,472 1,034
--------- ---------- ---------- ---------- ----------
Net income ..................... 5,634 10,729 13,201 14,084 8,147
========= ========== ---------- ========== ==========
Earnings per share(1):
Basic ................... 0.0033 0.0056 0.0069 0.0072 0.0042
Diluted ................. 0.0032 0.0054 0.0066 0.0070 0.0041
Shares used to compute basic
earnings per share(1): ..... 1,701,000 1,915,000 1,918,700 1,957,800 1,961,168
========= ========== ---------- ========== ==========
Shares used to compute diluted
earnings per share(1): ..... 1,778,000 1,979,550 1,986,800 2,005,100 1,997,459
========= ========== ---------- ========== ==========
Earnings per ADS(2):
Basic ................... 0.17 0.28 0.34 0.36 0.21
Diluted ................. 0.16 0.27 0.33 0.35 0.20
ADS equivalents used to compute
basic earnings per ADS(2): . 34,020 38,300 38,374 39,156 39,223
========= ========== ---------- ========== ==========
ADS equivalents used to compute
diluted earnings per ADS(2): 35,576 39,591 39,736 40,102 39,949
========= ========== ---------- ========== ==========
6
December 31,
----------------------------------------------------
2001 2002 2003 2004 2005
------- -------- -------- -------- --------
(in thousands)
Consolidated Balance Sheet Data:
Cash and cash equivalents ............... $ 98,814 $ 69,334 $ 66,489 $ 56,320 $ 46,375
Short-term investments .................. 20,136 42,675 53,923 63,768 55,653
Working capital ......................... 122,990 120,793 130,510 132,713 117,942
Total assets ............................ 136,419 145,836 169,293 185,196 199,655
Long-term debt, excluding current portion 7 -- -- -- --
Net assets .............................. 128,424 135,148 154,727 170,781 175,896
Ordinary shares and additional paid-in
capital .............................. 130,235 126,232 137,115 139,620 138,275
(1) All share information has been adjusted retroactively to reflect the
50-for-1 share split effected on November 25, 2005.
(2) Fifty ordinary shares equal one American Depositary Share ("ADS").
CAPITALIZATION AND INDEBTEDNESS
Not applicable.
REASONS FOR THE OFFER AND USE OF PROCEEDS
Not applicable.
RISK FACTORS
If the markets for consumer electronics, computers, industrial or communications
products do not grow substantially or even decrease, our net sales may be
harmed.
Our business focuses on designing, developing and marketing high
performance integrated circuits for manufacturers of products for the consumer
electronics, computer, industrial and communications markets. As many of the
leading sellers of these products have an intermediary manufacture their
products or those portions of their products containing our components, we
currently derive substantially all of our product revenues from sales to these
intermediaries or their suppliers. We also have targeted and are designing
products for applications such as LCD monitors, LCD televisions, notebook
computers, Internet security, mobile phones, GPS and portable media players,
such as portable DVD players. We believe that the important factors driving
growth in these markets have been the growing popularity of thinner displays,
mobile computing and portable devices, and the emergence and continued
development of the Internet and wireless communications networks. If demand for
products using LCDs or other devices using our products declines, or does not
grow as quickly as we anticipate, our customers may experience lower demand for
their products that use our products, which may cause our net sales to suffer.
We cannot be certain that the markets for these products will continue to grow
as rapidly as they have in the past or that a significant slowdown in these
markets will not occur.
In addition, we have experienced, and may experience in the future,
shortages of LCDs and semiconductors caused by industry market trends or by
natural disasters, such as earthquakes, that are outside of our control. These
shortages may increase the costs of components used in those products containing
our products. This may cause an increase in the cost of such products, thus
lowering the demand for such products.
Finally, the semiconductor industry has historically been highly cyclical
and, at various times, has experienced significant downturns and wide
fluctuations in supply and demand. This has caused significant variances in
product demand, production capacity and rapid erosion of average selling prices.
Industry-wide fluctuations in the future could result in pricing pressure on our
products as well as lower demand for our products. If such fluctuations were to
occur, they could materially adversely affect our operating margins and net
sales.
7
Fluctuations in our quarterly operating results due to factors such as changes
in the demand for electronic devices that utilize our products could adversely
affect the trading price of our ordinary shares and/or our ADSs.
We believe that quarter-to-quarter comparisons of our financial results
are not necessarily meaningful indicators of our future results of operations,
and they should not be relied upon as an indication of our future performance.
If our quarterly operating results fail to meet the expectations of securities
analysts, the trading price of our ordinary shares and/or our ADSs could be
adversely affected. Our quarterly operating results have varied substantially in
the past and may vary substantially in the future depending upon a number of
factors described below and elsewhere in this Risk Factors section, including
many factors that are beyond our control. These factors include changes in
demand for devices that use our products; market conditions in the semiconductor
industry and the economy as a whole; the timing and cancellation of customer
orders; the level of orders received that can be shipped in a quarter; the
availability of third party semiconductor foundry, assembly and test capacities;
fluctuations in manufacturing yields; delays in the introduction of new
products; changes in the mix of sales of higher margin products and lower margin
products; seasonal changes in demand during the year-end holiday season for
devices that use our products; and the amount of legal and other expenses
incurred in a particular quarter.
In addition, the trading price of our ordinary shares and/or our ADSs may
be affected by factors such as: significant price and volume fluctuations in our
ordinary shares and/or our ADSs and financial markets in the U.S. and other
countries, as well as relatively thin trading volume of our ordinary shares
and/or our ADSs on Nasdaq and the HKSE, respectively. Further, the trading
markets for our ordinary shares and/or our ADSs are affected by the research
reports that securities or industry analysts publish about us or our business.
We do not have control over such coverage. If one or more analysts were to
downgrade our ordinary shares and/or our ADSs, the price of our ordinary shares
and/or our ADSs may decline. If one or more analysts cease coverage of our
company or does not regularly publish reports on us, we may lose visibility in
the financial markets, which could cause the price of our ordinary shares and/or
our ADSs or trading volume to decline.
If orders for our products are cancelled or deferred, our net sales, operating
margins and net income could be substantially reduced.
Orders for our products can be cancelled or deferred with little notice
from and without significant penalty to our customers. A significant portion of
our net sales in any financial reporting period depends on orders booked and
shipped in that period. If a large amount of orders placed is cancelled or
deferred, our net sales in that period could be substantially reduced. Since we
do not have significant non-cancellable backlog, we typically plan our
production and inventory expenses based on internal forecasts of customer
demand, which are highly unpredictable and can fluctuate substantially. In
particular, in response to anticipated lengthy lead times, which in the past
have been as much as ten weeks or more, to obtain inventory and materials from
our suppliers, we place orders with these suppliers in advance of anticipated
customer demand, which can result in excess inventory if the expected orders
fail to materialize. We also expect to increase our expenses for personnel and
new product development. It is difficult for us to reduce our production,
inventory, personnel and new product development expenses quickly in response to
any shortfalls in net sales resulting from cancelled or deferred orders. As a
result, any cancellation or deferral of orders would not only harm our net
sales, it would also likely have a disproportionately adverse effect on our
operating margins and net income.
8
If we cannot compete effectively against new and existing competitors, our net
sales and gross margins could be harmed.
Our ability to compete successfully in the market for integrated circuit
products depends on factors both within and outside our control, including: our
success in designing and subcontracting the manufacture of new products that
implement new technologies and satisfy our customers' needs; the performance of
our products across a variety of parameters such as reliability and cost
efficiency; the price of our products and those of our competitors; our ability
to control production costs; and the features of our competitors' products.
We believe our principal competitors include Intersil Corporation, Linear
Technology Corporation, Maxim Integrated Products, Inc., Microsemi Corporation,
Monolithic Power Systems, Inc., Ricoh Company, Ltd., Rohm Co., Ltd and Texas
Instruments Incorporated. There is also competition from the internal integrated
circuit design and manufacturing capabilities of some of our existing and
potential customers, such as Toshiba and Fujitsu. In addition to these
competitors, other integrated circuit companies may decide to enter the market
with mixed-signal integrated circuit products that compete with our products or
incorporate functions similar to those provided by our products.
Some of our competitors, such as Texas Instruments, have greater name
recognition, their own manufacturing capabilities, significantly greater
financial and technical resources, and the sales, marketing and distribution
strengths that are normally associated with large multinational companies. These
competitors may also have pre-existing relationships with our customers or
potential customers. These competitors may be able to introduce new technologies
more quickly, address customer requirements more rapidly and devote greater
resources to the promotion and sale of their products than we do. Further, in
the event of a manufacturing capacity shortage, these competitors may be able to
manufacture products themselves or obtain third-party manufacturing capability
when we are unable to do so.
We depend on third parties to manufacture, assemble and test our products and,
if they are unable to do so, our ability to ship products and our business and
results of operations will be harmed.
We do not own or operate the integrated circuit fabrication facilities
that manufacture the products we design. Two foundries, TSMC and X-FAB,
manufactured most of the integrated circuit products that we sold in 2005. These
foundries manufacture integrated circuit products for us according to purchase
orders. We do not have a guaranteed level of production capacity at any of these
foundries, and any one or more could raise prices without notice. Although we
provide the foundries with rolling forecasts of our production requirements, the
ability of each foundry to provide wafers to us is limited by the foundry's
available capacity. The term "wafers" refers to slices of silicon used to
manufacture integrated circuits, and it is one of the principal raw materials in
our products. Our foundries could choose to prioritize capacity for other
customers, particularly larger customers, reduce or eliminate deliveries to us
on short notice or increase the prices they charge us. Accordingly, we cannot be
certain that these foundries will allocate sufficient capacity, if any, to
satisfy our requirements particularly during any industry-wide capacity
shortages. In addition, if any of these foundries were unable to continue
manufacturing our products in the required volumes at acceptable quality, yields
and costs or in a timely manner, our business and results of operations would be
seriously harmed.
There are other significant risks associated with our reliance on these
outside foundries, including the disruption in our ability to ship products
caused by the length of time, as much as six-to-12 months, required for us to
find alternative foundries for existing or new products; the reduction or
elimination of deliveries to us by these outside foundries caused by a sudden
increase in demand for semiconductor devices or a sudden reduction or
elimination of manufacturing capacity by any existing manufacturers of
semiconductor devices; the unavailability of, or delays in obtaining access to,
key process technologies used by these foundries; and the susceptibility of our
outside foundries to production interruptions resulting from natural disasters,
such as the interruptions experienced in Taiwan in the past due to earthquake
activity. Any of these events could cause our outside foundries to reduce or
eliminate deliveries to us and cause disruption in our ability to ship products
to our customers which could negatively affect our business and results of
operations.
9
We also rely on independent subcontractors to assemble and test
substantially all of our integrated circuit products. We do not have long-term
agreements with any of these subcontractors but obtain services from them
primarily on a purchase order basis. Our reliance on these subcontractors
involves risks such as reduced control over delivery schedules, quality
assurance and costs. These risks could result in product shortages or increase
our costs of manufacturing, assembling or testing our products. If these
subcontractors were unable or unwilling to continue to provide assembly and test
services and deliver products at acceptable quality, yields and costs or in a
timely manner, our business would be seriously harmed. We would also have to
identify and qualify substitute subcontractors, which would be time consuming
and costly and could result in unforeseen operational difficulties.
If we do not develop and introduce new products in a timely manner, our net
sales and gross margins could be harmed.
Our success depends upon our ability to develop and introduce new products
selected for design into products for the consumer electronics, computer,
industrial and communications markets. If we are unable to develop new products
in a timely manner, our net sales will suffer. In addition, because our gross
margins typically decline over the life cycle of our products as a result of
competitive pressures and voluntary pricing arrangements, any failure to develop
new products in a timely manner will likely cause our gross margins to decline.
The development of our new products is highly complex, and from time to time we
have experienced delays in the introduction of new products of as much as
eight-to-twelve weeks or more. Successful product development and introduction
of new products depend on a number of factors, including accurate new product
definition; timely completion of new product designs; achievement of
manufacturing yields; timely and cost-effective production of new products; and
timely delivery of new third-party supplied products used as key components in
devices that incorporate our products. We often incur significant expenditures
in the development of a new product without any assurance that it will be
selected for design into our customers' products. If we incur such expenditures
but fail to be selected, our results of operations will be adversely affected
and may fluctuate significantly from period to period. Furthermore, even if our
products were selected for design into our customers' products, we cannot be
certain that these products will be commercially successful or that we will
benefit from any associated sales.
It is difficult to evaluate our future prospects, and we cannot assure you that
we will not incur future losses.
Our past results cannot be relied upon to predict our future performance.
We incurred net losses in each year prior to the year ended December 31, 1999.
We then experienced significant quarter-to-quarter sales growth in each of the
years ended December 31, 2001, 2002 and 2003. However, in the first quarter
ended March 31, 2004, in the third quarter ended September 30, 2004 and in the
first quarter ended March 31, 2005, we experienced a decrease in net sales
compared to the previous quarter. Our net sales are subject to fluctuation from
quarter to quarter, our previous overall growth may not continue, and we may not
be able to sustain or increase profitability in the future. We anticipate that
our expenses will increase substantially in the foreseeable future as we
continue to develop our technology, protect our technology, expand our product
offerings and expand our testing capabilities. These efforts may prove more
expensive than we currently anticipate, and we may not succeed in increasing our
net sales sufficiently to offset our increased expenses. If we fail to increase
our net sales to keep pace with our increased expenses, we may again experience
net losses in future periods, which could cause the trading price of our
ordinary shares and/or our ADSs to decline.
10
If we cannot adapt our product offerings to respond to rapid technological
changes, our net sales will be harmed.
The markets for consumer electronics, computer, industrial and
communications products, and the components used in these products, are
characterized by rapidly changing technology and very frequent new product
introductions by our direct customers and our competitors. For example, the
microprocessor, display and battery technologies with which our products
inter-operate change very rapidly. Although our products integrate analog and
mixed-signal circuits and therefore have substantially longer life-cycles than
digital integrated circuits, we must still update our products or introduce new
ones on a regular basis. If we do not respond in a timely manner to
technological changes and new product introductions by our direct customers and
competitors, we will be unable to maintain and grow our product sales. In
addition, the emergence of significantly more efficient or cost-effective
microprocessor, display and battery technologies could lessen the need for the
power management functionality of our products, which would harm our net sales.
Defects in our products could result in significant costs and could impair our
ability to sell our products.
Detection of any significant defects in our products may result in, among
other things, loss of or delay in market acceptance and sales of our products,
diversion of development resources, injury to our reputation and increased
service and warranty costs. Because our products are complex, they may contain
defects that can be detected at any point in a product's life cycle. These
defects could harm our reputation, which could result in significant costs to us
and could impair our ability to sell our products. The costs we may incur in
correcting any product defects may be substantial and could materially adversely
affect our results of operations. While we continually test our products for
defects and work with customers through our customer support services to
identify and correct problems, defects in our products may be found in the
future. Testing for defects is complicated in part because it is difficult to
simulate the highly complex environments in which our customers may use our
products. In the past, we have discovered defects in our products and have
experienced delays in the shipment of our products. These delays have
principally related to new product update releases. To date, none of these
delays has materially affected our business. However, product defects or delays
in the future could be material, and could adversely affect our reputation and
our ability to sell our products.
If we fail to protect our intellectual property rights, competitors may be able
to use our technology or trademarks, and this could weaken our competitive
position, increase our costs, reduce our margins and reduce our net sales.
Our success is heavily dependent upon our proprietary technology. We rely
primarily on a combination of patent, copyright and trademark laws, trade
secrets, confidentiality procedures and contractual provisions to protect our
proprietary technology and prevent competitors from using our technology in
their products. These laws and procedures provide only limited protection. Our
patents may not provide sufficiently broad protection or they may not prove to
be enforceable in actions against alleged infringement.
Our ability to sell our products and prevent competitors from
misappropriating our proprietary technology and trade names is dependent upon
protecting our intellectual property. Despite the precautions we take,
unauthorized third parties may copy aspects of our current or future products or
obtain and use information that we regard as proprietary. Additionally, our
competitors may independently develop similar or superior technology. Policing
unauthorized use of software, circuit design or semiconductor design is
difficult and some countries' laws do not protect our proprietary rights to the
same extent as the laws of the United States, Hong Kong and other developed
countries. We have in the past and currently have initiated litigation to
protect our intellectual property rights. Litigation may be necessary in the
future to enforce our intellectual property rights, to protect our trade secrets
or to determine the validity and scope of the proprietary rights of others.
Litigation could result in substantial costs and diversion of resources, and
could also result in a decision that our intellectual property is invalid or
unenforceable and, could adversely affect our business, future results of
operations and financial condition. See the section headed "Business
Overview--Intellectual Property".
11
A substantial portion of our net sales is generated by a small number of
customers. If any of these customers delays or reduces its orders, our net sales
and earnings may be harmed.
Historically, a relatively small number of customers has accounted for a
significant portion of our net sales in any particular period. We have no
long-term volume purchase commitments from any of our significant customers. We
cannot be certain that our current customers will continue to place orders with
us, that orders by existing customers will continue at the levels of previous
periods or that we will be able to obtain orders from new customers. In
addition, some of our customers, acting as intermediary manufacturers, supply
products to end-market purchasers, and any of these end-market purchasers could
choose to reduce or eliminate orders for our customers' products. This would in
turn lower our customers' orders for our products.
In 2005, no customer accounted for 10% or more of net sales. In 2004, one
customer accounted for 17.5% of our net sales. In 2003, one customer accounted
for 13.5% of our net sales. The variations in sales to these customers as a
percentage of our total net sales have been caused by a number of factors, some
of which were outside our control. We anticipate that sales of our products to a
relatively small number of customers will continue to account for a significant
portion of our net sales. The reduction, delay or cancellation of orders from
one or more of our significant customers would have a disproportionately
negative impact on our results of operations.
Sales of our products could decline if our products fail to support evolving
industry standards.
Our net sales are derived from sales of integrated circuit products that
are components of electronic devices built to industry standards and widely
accepted specifications. For example, the hardware specification for the voltage
of most notebook computers is currently either 3.3 or 5.0 volts and the software
used to control the power management functions of many notebook computers
conforms to the industry's Advanced Configuration Power Interface specification.
Our products must be designed to conform to these standards and specifications
in order to achieve market acceptance. Technology standards and specifications
continually evolve, and we may not be able to successfully design and
manufacture new products in a timely manner that conform to these new standards
or specifications. Additionally, new products we develop to conform to new
specifications may not be accepted in the market.
We have substantial operations outside of the United States that expose us to
risks specific to our international operations that could harm our net sales and
net income.
As of December 31, 2005, a substantial portion of our operations, most of
our employees, and most of the third parties we use to manufacture, assemble and
test our products were located in Japan, Korea, China, Singapore and Taiwan. In
addition, sales outside the United States as a percentage of net sales were
almost 100% in the years ended December 31, 2002, December 31, 2003, December
31, 2004 and December 31, 2005. We expect our non-U.S. operations to grow and
non-U.S. sales to continue to account for a substantial percentage of our net
sales.
We are subject to risks specific to our international business operations,
including: the risk of supply disruption, production disruption or other
disruption arising from the outbreak of any severe communicable disease or other
widespread health problems; the risk of potential conflict and further
instability in the relationship between Taiwan and China; risks related to
international political instability and to the recent global economic turbulence
and adverse economic circumstances in Asia, such as in Japan and Korea;
unpredictable consequences on the economic conditions in the U.S. and the rest
of the world arising from terrorist attacks, such as the attacks of September
11, 2001 in the U.S. and other military or security operations, particularly
with regard to the conflicts in the Middle East involving Iraq; unexpected
changes in regulatory requirements or legal uncertainties regarding tax regimes,
such as the change to the tax code of Taiwan in 2001 that resulted in a higher
income tax rate on our retained earnings; tariffs and other trade barriers,
including current and future import and export restrictions; difficulties in
staffing and managing international operations; adverse effects of changes in
foreign currency exchange rates on our results of operations; limited ability to
enforce agreements and other rights in foreign countries; changes in labor
conditions; longer payment cycles and greater difficulty in collecting accounts
receivables; burdens and costs of compliance with a variety of foreign laws;
expropriation of private enterprises; and reversal of the current policies
(including favorable tax and lending policies) encouraging foreign investment or
foreign trade by our host countries. In addition, the geographical distances
between Asia, the U.S., the Cayman Islands and Europe also create a number of
logistical and communication challenges. Although we have not experienced any
serious harm in connection with our international operations, we cannot assure
you that such problems will not arise in the future.
12
In addition, our reporting currency is the U.S. dollar. However, a
significant portion of our operating expenses is denominated in currencies other
than the U.S. dollar, primarily the New Taiwan dollar and the Renminbi. As a
result, appreciation or depreciation of other currencies in relation to the U.S.
dollar could result in material transaction or translation gains or losses that
could adversely affect, or cause fluctuations in, our results of operations. We
do not currently engage in currency hedging activities.
Our ability to manage growth will affect our ability to achieve and maintain
profitability.
Our ability to maintain profitability will depend in part on our ability
to implement and expand operational, customer support and financial control
systems and to train and manage our employees. We may not be able to augment or
improve existing systems and controls or implement new systems and controls in
response to future growth, if any. In addition, we will need to expand our
facilities to accommodate the growth in our personnel. Any failure to manage
growth could divert management attention from executing our business plan and
adversely affect our ability to expand our business successfully. Our historical
growth has placed, and any further growth is likely to continue to place, a
significant strain on our resources. In order to grow successfully, we will need
to maintain close coordination among our executive, engineering, accounting,
finance, marketing, sales, operations and customer support organizations,
particularly in light of the internationally dispersed nature of our operations.
We will need to recruit and retain qualified personnel to grow our business
successfully.
Our future success will depend on our ability to attract and retain
experienced sales, research and development, marketing, customer support and
management personnel. If we do not attract and retain these personnel, our
ability to grow our business, sell our products, enter new markets and increase
our share of existing markets could be harmed. There can be no assurance that we
will be successful in hiring for these positions in the near future. Our sales
strategy requires that we hire additional direct sales persons and independent
sales representatives in our major markets. Moreover, our independent sales
representatives and direct sales personnel must market our products effectively
and be qualified to provide timely and cost-effective customer support and
service. If they are unable to do so or if we are unable to expand these
organizations, this could harm our ability to increase our net sales and limit
our ability to sell our products or expand our market share. Competition for
qualified personnel in digital, analog and mixed-signal integrated circuit
design is intense. In the past, we have experienced difficulty in recruiting
qualified personnel, especially technical and sales personnel. As we intend to
expand the scope of our international operations, this will require us to
attract experienced management, research and development, marketing, sales and
customer support personnel for our international offices. We expect competition
for qualified personnel to remain intense, and we may not succeed in attracting
or retaining such personnel. In addition, new employees generally require
substantial training in our design methodology, design flow and technology,
which in turn requires significant resources and management attention. There is
a risk that, even if we invest significant resources in attempting to attract,
train and retain qualified personnel, we will not be successful in our efforts.
In that event, our costs of doing business would increase without a
corresponding increase in net sales.
Our success will depend to a significant extent on the continued service
of our executive officers, including Sterling Du, our chief executive officer
and chairman of our board, and other key employees, including key sales,
consulting, technical, marketing and legal personnel. If we lose the services of
one or more of our executives or key employees, our business and ability to
implement our business objectives successfully could be harmed, particularly if
one or more of our executives or key employees decide to join a competitor or
otherwise compete directly or indirectly with us.
13
Third parties have asserted, and in the future could assert, that our products
infringe their intellectual property rights. These claims could harm our ability
to sell our products and expose us to litigation.
As is typical in the semiconductor industry, we have from time to time
received communications from third parties asserting patents that cover certain
of our technologies or products and alleging infringement of certain of their
intellectual property rights. We may receive similar communications in the
future. In the event any third party were to make a valid claim against us or
our customers, we could be enjoined from selling selected products such as our
inverter or power products or could be required to pay royalties to third
parties. Third-party infringement claims, with or without merit, have been and
could continue to be time consuming, result in substantial diversion of our
resources and potentially significant litigation costs, including costs related
to any damages we may owe, cause product shipment delays or require us to enter
into license agreements. Such license agreements may not be available on
acceptable terms, or at all. Any such event could seriously harm our business
and our results of operations. We expect that semiconductor companies will
increasingly be subject to infringement claims as the number of products and
competitors in the semiconductor industry grows. See the section headed
"Business Overview--Intellectual Property."
From time to time, in the normal course of business, we agree to indemnify
third parties with whom we enter into contractual relationships, including
customers and parties to other transactions with us, with respect to certain
matters. We have agreed, under certain conditions, to hold these third parties
harmless against specified losses, such as those arising from a breach of
representations or covenants, other third-party claims that our products when
used for their intended purposes infringe the intellectual property rights of
such other third parties or other claims made against certain parties. It is not
possible to determine the maximum potential amount of liability under these
indemnification obligations due to our limited history of prior indemnification
claims and the unique facts and circumstances that are likely to be involved in
each particular claim. To date, we have not made any payments under these
obligations.
Until all outstanding litigation is resolved, we will continue to incur
substantial legal expenses that vary with the level of activity in the legal
proceedings. This level of activity is not entirely within our control as we may
need to respond to legal actions. Consequently, we may find it difficult to
predict the legal expenses for any given period, which will impair our ability
to forecast our results of operations for that period. It is likely that these
expenses will remain significant leading up to and during our trials scheduled
for September 2006 and July 2007.
Given the inherent uncertainties in litigation, there cannot be any
assurance that we will prevail in any particular litigation matter, and we
cannot predict the outcome of any such litigation. If any party were to prevail
in its claims against us, our rights to certain patents and results of
operations could be materially adversely affected. In any litigation arising
from claims that we infringe on the intellectual property rights of others, an
adverse result could involve an injunction to prevent the sales of a material
portion of our products, and a reduction or the elimination of the value of
related inventories, any of which could have a material adverse effect on our
net sales, results of operations and financial condition. See the section headed
"Business Overview--Intellectual Property."
We may be subject to lawsuits from third parties.
We are a defendant or plaintiff in actions that arise in the normal course
of business as well as actions that arose as counterclaims in response to our
patent infringement actions, including actions for antitrust, unfair competition
and interference. While we currently believe the amount of ultimate liability,
if any, with respect to these actions will not materially affect our financial
position, overall trends in results of operations, or liquidity, the ultimate
outcome of any litigation or claim is uncertain, and the impact of an
unfavorable outcome could be material to us.
14
Our transfer pricing procedures may be challenged, which may subject us to
higher taxes and adversely affect our earnings.
Transfer pricing refers to the prices that one member of a group of
affiliated corporations charges to another member of the group for goods,
services or the use of intellectual property. If two or more affiliated
corporations are located in different countries, the laws or regulations of each
country generally will require that transfer prices be the same as those charged
by unrelated corporations dealing with each other at arm's length. If one or
more of the countries in which our affiliated corporations are located believe
that transfer prices were manipulated by our affiliated corporations in a way
that distorts the true taxable income of the corporations, the laws of such
countries could require us to redetermine transfer prices and thereby reallocate
the income of our affiliate corporations in order to reflect such income
clearly. Any reallocation of income from one of our corporations in a lower tax
jurisdiction to an affiliated corporation in a higher tax jurisdiction would
result in a higher overall tax liability to us. Moreover, if the country from
which the income is being reallocated does not agree to the reallocation, the
same income could be subject to taxation by both countries.
We have adopted transfer pricing agreements with our subsidiaries located
in the United States, China, Taiwan, Japan and Singapore to regulate
inter-company transfers. A transfer pricing agreement is a contract for the
transfer of goods, services or intellectual property from one corporation to a
related corporation that sets forth the prices that the related parties believe
are those charged by unrelated corporations dealing with each other at arm's
length. We have entered into these types of agreements because a portion of our
assets, such as intellectual property developed in our U.S. and foreign
subsidiaries, is transferred among our affiliated corporations. In such
agreements, we have determined transfer prices that we believe are the same as
the prices that would be charged by unrelated parties dealing with each other at
arm's length. In this regard, we are subject to risks not faced by other
companies with international operations that do not create inter-company
transfers. If the taxing authorities of any jurisdiction, including Taiwan and
the United States, were to challenge these agreements successfully or require
changes in our transfer pricing practices, we could become subject to higher
taxes and our earnings would be adversely affected. We believe that we operate
in compliance with all applicable transfer pricing laws in all of the
jurisdictions in which we operate. However, there can be no assurance that we
will continue to be found to be operating in compliance with transfer pricing
laws, or that such laws will not be modified, which, as a result, may require
changes to our transfer pricing practices or operating procedures. Any
determination of income reallocation or modification of transfer pricing laws
could result in an income tax assessment of the portion of income deemed to be
derived from the taxing jurisdiction that so reallocates the income or modifies
its transfer pricing laws.
We have incurred, and continue to incur, significant costs with respect to
corporate governance and financial reporting compliance.
The Sarbanes-Oxley Act of 2002, as well as new rules subsequently
implemented by the Securities Exchange Commission, or SEC, and adopted by the
Nasdaq in response to Sarbanes-Oxley, have increased and will continue to
increase the scope, complexity and costs of our financial reporting, securities
disclosure and corporate governance practices. These new or revised rules,
regulations, and listing requirements are subject to varying interpretations in
many cases and their application in practice may evolve over time as new
guidance is provided by regulatory and governing bodies. As a result, we may
incur further legal and financial compliance costs and be required to make
unanticipated changes to our reporting, disclosure and governance practices.
These rules may divert management time and resources, make it more difficult for
us to attract and retain qualified executive officers and members of our board,
and make it more costly to obtain liability insurance coverage for our officers
and directors which could prove disruptive to our business. In particular, the
Sarbanes-Oxley Act requires that, among other things: our chief executive
officer and chief financial officer personally certify our annual report on Form
20-F which is filed with the SEC each year, which certification includes
statements as to the accuracy and fair presentation of the report's disclosure,
the establishment and maintenance of controls and procedures related to our
disclosure and issues regarding our internal accounting controls; we refrain
from making most types of loans to our officers and directors after the adoption
of that Act or from making any material modifications to loans that existed
prior to the adoption of the Act; we furnish a report in certain SEC filings in
the future pursuant to Section 404 of the Sarbanes-Oxley Act, as discussed in
the following risk factor and our audit committee pre-approve all audit and
non-audit services provided by our outside auditor except for de minimis
services; be directly responsible for the appointment, compensation and
oversight of the work of our outside auditor; establish procedures for the
receipt and treatment of complaints received by us regarding accounting,
controls or auditing matters and any confidential submissions by our employees
regarding questionable accounting or auditing; comprise independent directors,
as defined under the Sarbanes-Oxley Act and applicable Nasdaq rules. If we fail
to comply with new or revised rules, regulations, and listing requirements in a
timely manner, we may be exposed to liability and public perception of our
financial reporting, securities disclosure and corporate governance practices
could be negatively affected. As a result, the price of our ordinary shares
and/or our ADSs could decline.
15
If we fail to maintain an effective system of internal controls, we may not be
able to report our financial results accurately. As a result, we may fail to
meet our reporting obligations and current and potential holders of ADSs and/or
ordinary shares could lose confidence in our financial reporting, which could
adversely affect the trading price of our ADS and/or ordinary shares.
Effective internal controls are necessary for us to provide reliable
financial reports. If we cannot provide reliable financial reports or prevent
fraud, our results of operations could be misstated, our reputation may be
harmed and the trading price of our ADSs and/or ordinary shares could be
adversely affected. In connection with the audit of our financial statements for
the years ended December 31, 2002, 2003 and 2004, in May 2005 our independent
registered public accounting firm reported to our audit committee a matter that
was a "reportable condition" in our internal controls as defined in standards
established by the American Institute of Certified Public Accountants. In
general, reportable conditions are significant deficiencies in a company's
internal controls that, in the auditor's judgment, could adversely affect the
ability to record, process and report financial data consistent with the
assertions of management in the financial statements. During 2005, we devoted
significant resources to remediate and improve our internal controls. We believe
that these efforts have remediated the concerns that gave rise to the
"reportable condition." However, we cannot be certain that our controls over our
financial processes and reporting will continue to be adequate in the future.
Any failure of our internal controls over financial reporting could cause us to
fail to meet our reporting obligations, including those with the SEC and the
HKSE.
In addition, under Section 404 of the Sarbanes-Oxley Act of 2002,
beginning with our annual report on Form 20-F for the fiscal year ending
December 31, 2006, we will be required to furnish a report by our management on
our internal control over financial reporting. Such a report will contain, among
other matters, an assessment of the effectiveness of our internal control over
financial reporting as of the end of our fiscal year, including a statement as
to whether or not our internal control over financial reporting is effective.
This assessment must include disclosure of any material weaknesses in our
internal control over financial reporting identified by management. Such report
must also contain a statement that our independent auditors have issued an
attestation report on management's assessment of such internal controls. We are
still performing the system and process documentation and evaluation needed to
comply with Section 404, which is both costly and challenging.
During this process, if our management identifies one or more material
weaknesses in our internal control over financial reporting, we may be unable to
assert that such internal control is effective. If we were unable to assert that
our internal control over financial reporting is effective (or if our
independent auditors were unable to attest that our management's report is
fairly stated or they are unable to express an opinion on the effectiveness of
our internal controls), we could lose investor confidence in the accuracy and
completeness of our financial reports, which could have an adverse effect on the
price of our ordinary shares and/or our ADSs.
16
Changes in accounting standards for stock option plans may impact our results of
operations and our ability to use stock options to recruit, retain and motivate
employees.
The Financial Accounting Standards Board has published revisions to
Statement of Financial Accounting Standards No. 123, or SFAS 123R, that require
all public entities to treat the value of stock options granted to employees as
an expense. As a public entity under SFAS 123R, we are required to record, as of
the first annual reporting period beginning after June 15, 2005, a compensation
expense equal to the value of each stock option granted. This expense would
likely be recognized over the vesting period of the stock option. The
requirement to expense stock option grants reduces the attractiveness of
granting stock options because the additional expense associated with these
grants may adversely affect our results of operations. Accordingly, we may not
be able to attract and retain key personnel if any future adverse effects on our
profitability resulting from the application of SFAS 123R compel us to reduce
the scope of our employee stock option plans. In addition, as a result of the
requirement to adopt SFAS 123R to expense stock option grants beginning with the
first fiscal year after June 15, 2005, our future profitability may be reduced.
We have never declared or paid dividends on our ordinary shares or other
securities and do not anticipate paying dividends in the foreseeable future.
We have not declared or paid dividends on our ordinary shares or other
securities since our incorporation of the company. We do not anticipate
declaring any dividend in the foreseeable future. Future dividends, if any, will
be at the discretion of our board and will depend upon our future results of
operations, capital requirements, general financial condition, legal and
contractual restrictions and other factors our board may deem relevant.
Provisions in our Memorandum and Articles of Association may discourage
potential acquisition bids for us and prevent changes in our management that our
shareholders may favor.
Provisions in our Memorandum and Articles of Association could discourage
potential acquisition proposals and could delay or prevent a change in control
transaction that our shareholders favor. These provisions could have the effect
of discouraging others from making offers for our ordinary shares. As a result,
these provisions may prevent the market price of our ordinary shares or ADSs
from reflecting the effects of actual or rumored takeover attempts and may
prevent shareholders from reselling their ordinary shares or ADSs at or above
the price at which they purchased their ordinary shares or ADSs. These
provisions may also prevent changes in our management that our shareholders may
favor. Our Memorandum and Articles do not permit shareholders to act by written
consent, do not permit shareholders to call a general meeting and provide for a
classified board of directors, which means shareholders can only elect a limited
number of our directors in any given year. Furthermore, our board has the
authority to issue up to 250,000,000 preference shares in one or more series.
Our board can fix the price, rights, preferences, privileges and restrictions of
such preference shares without any further vote or action by our shareholders
but subject to any direction that may be given by the shareholders in a general
meeting. The issuance of preference shares may delay or prevent a change in
control transaction without further action by our shareholders or make removal
of management more difficult.
As we are a Cayman Islands company, it could be difficult for investors to
effect service of process on and recover against us or our directors and
officers and our shareholders may face difficulties in protecting their
interest.
We are a Cayman Islands company, and many of our officers and directors
are residents of various jurisdictions outside the United States. A substantial
portion of our assets and the assets of our officers and directors, at any one
time, are and may be located in jurisdictions outside the United States.
Although we have irrevocably agreed that we may be served with process in Santa
Clara, California with respect to actions arising out of or in connection with
United States federal securities laws relating to offers and sales of our
ordinary shares and/or our ADSs, it could be difficult for investors to effect
service of process within the United States on our directors and officers who
reside outside the United States or to recover against us or our directors and
officers on judgments of the United States courts predicated upon the civil
liability provisions of the United States federal securities laws.
17
Our corporate affairs are governed by our charter documents, consisting of
our Memorandum and Articles of Association, and by the companies law and common
law of the Cayman Islands. The rights of our shareholders and the fiduciary
responsibilities of our directors are governed by Cayman Islands law, which are
not as clearly established as under statutes or judicial precedent in
jurisdictions such as the United States. While there is some case law in the
Cayman Islands on these matters, it is not as developed as, for example, in the
United States. In addition, the laws of the Cayman Islands relating to the
protection of the interests of minority shareholders differ in some respects
from those established under statutes or judicial precedent in existence in the
United States. Such differences may mean that our minority shareholders may have
less protection than they would have under the laws of the United States. Due to
the less protective nature of such laws in the Cayman Islands, our shareholders
may have more difficulty in protecting their interests in the face of actions by
our management or directors than would shareholders of a corporation
incorporated in some other jurisdictions.
We may become a passive foreign investment company, which could result in
adverse U.S. tax consequences to U.S. investors.
We may be classified as a passive foreign investment company by the U.S.
Internal Revenue Service for U.S. federal income tax purposes. Such
characterization could result in adverse U.S. tax consequences to you if you are
a U.S. investor. For example, if we are a passive foreign investment company,
our U.S. investors will become subject to increased tax liabilities under U.S.
tax laws and regulations and will become subject to burdensome reporting
requirements. The determination of whether or not we are a passive foreign
investment company will be made on an annual basis and will depend on the
composition of our income and assets, including goodwill, from time to time.
Specifically, we will be classified as a passive foreign investment company for
U.S. tax purposes if, after the application of look-through rules, either (a)
75% or more of our gross income in a taxable year is passive income, or (b) the
average percentage of our assets (by value) in a taxable year that produce or
are held for production of passive income is at least 50%. Our judgment is not
binding on the Internal Revenue Service. In the future, the valuation of our
intangible assets will be based in part on the then market value of our ADSs and
ordinary shares which is subject to change. We cannot assure you that we will
not be a passive foreign investment company for the current or any future
taxable year. See "Taxation--United States Federal Income Taxation--Passive
Foreign Investment Company."
Holders of ADSs may not be able to exercise their right to vote.
Holders of our ADSs may instruct the depositary of our ADSs to vote the
ordinary shares underlying their ADSs but only if we ask the depositary to ask
for instructions. Otherwise, they will not be able to exercise their right to
vote unless they withdraw the ordinary shares underlying the ADSs they hold.
However, they may not know about the meeting sufficiently enough in advance to
withdraw those ordinary shares. If we ask for instructions, the depositary will
notify the holders of the upcoming vote and arrange to deliver our voting
materials to them. We cannot assure you that holders will receive the voting
materials in time to ensure that they can instruct the depositary to vote their
ordinary shares. In addition, the depositary and its agents are not responsible
for failing to carry out voting instructions or for the manner of carrying out
voting instructions. This means that holders may not be able to exercise their
right to vote, and there is no guarantee that the ordinary shares underlying
your ADSs would be voted as requested.
18
The depositary for our ADSs may give us a discretionary proxy to vote the
ordinary shares underlying your ADSs if holders of ADSs do not vote at
shareholders' meetings which could adversely affect their interests.
Under the deposit agreement for the ADSs, the depositary will give us a
discretionary proxy to vote the ordinary shares underlying ADSs at shareholders'
meetings if the holder of the ADSs did not vote, unless we notify the depositary
that we do not wish to receive a discretionary proxy, we think there is
substantial shareholder opposition to the particular question, or we think the
particular question would have a material adverse impact on our shareholders.
The effect of this discretionary proxy is that holders of ADSs cannot
prevent the ordinary shares underlying their ADSs from being voted, absent the
situation described above, and it may make it more difficult for shareholders to
influence the management of our company. Holders of our ordinary shares are not
subject to discretionary proxy.
Holders of ADSs may not receive distributions on ordinary shares or any value
for them if it is illegal or impractical to make them available.
The depositary of our ADSs has agreed to pay to ADS holders the cash
dividends or other distributions it or the custodian for our ADSs receives on
ordinary shares or other deposited securities after deducting its fees and
expenses. Holders of our ADSs will receive these distributions in proportion to
the number of ordinary shares the ADSs represent. However, the depositary is not
responsible if it decides that it is unlawful or impractical to make a
distribution available to any holders of ADSs. We have no obligation to take any
other action to permit the distribution of our ADSs, ordinary shares, rights or
anything else to holders of our ADSs. This means that ADS holders may not
receive the distributions we make on ordinary shares or any value for them if it
is illegal or impractical for us to make them available. These restrictions may
have a material adverse effect on the value of the ADSs.
Holders of ADSs may be subject to limitations on transfer of ADSs.
ADSs represented by American Depositary Receipts, or ADRs, are
transferable on the books of the depositary. However, the depositary may close
its books at any time or from time to time when it deems expedient in connection
with the performance of its duties. The depositary may refuse to deliver,
transfer or register transfers of our ADSs generally when our books or the books
of the depositary are closed, or at any time if we or the depositary thinks it
is advisable to do so because of any requirement of law or any government or
governmental body, or under any provision of the deposit agreement, or for any
other reason.
ITEM 4. INFORMATION ON THE COMPANY
HISTORY AND DEVELOPMENT OF THE COMPANY
Our legal name is O2Micro International Limited. We are incorporated in
Cayman Islands. Our registered office is located at M&C Corporate Services
Limited, P.O. Box 309, Ugland House, South Church Street, George Town, Grand
Cayman, Cayman Islands. Our principal executive offices are located at Grand
Pavilion Commercial Centre, West Bay Road, P.O. Box 32331 SMB, George Town,
Grand Cayman, Cayman Islands. Our telephone number is (345) 945-1110. We have a
subsidiary, O2Micro, Inc., which was incorporated as a California corporation in
March 1995. In March 1997, O2 Micro International Limited was incorporated as a
Cayman Islands company. In March 1997, we exchanged our ordinary shares and
preference shares for common stock and preferred stock of O2 Micro, Inc. After
the exchange, we held all of the outstanding capital stock of O2 Micro, Inc.,
our wholly owned subsidiary in the United States. On November 25, 2005, we
effected a 50-for-1 share split of our ordinary shares and created an ADS
program for our ADSs to be quoted on Nasdaq, with each ADS representing 50
ordinary shares. We delisted our ordinary shares from Nasdaq on November 25,
2005 and listed our ADSs on Nasdaq on November 28, 2005, the next trading day.
We subsequently listed our ordinary shares on the Main Board of the Stock
Exchange of Hong Kong Limited on March 2, 2006 by way of introduction.
19
Our agent for service of process in the U.S. for the purpose of our
securities filings is our chief executive officer, Sterling Du, c/o O2Micro,
Inc., 3118 Patrick Henry Drive, Santa Clara, CA 95054.
Since January 1, 2003, our principal capital expenditures were investments
in various companies of approximately $13.8 million in the aggregate, $42.5
million in the purchase of land, property and equipment, and $15.6 million
deposited for Taiwan court bonds in connection with preliminary injunction
actions in Taiwan. In April 2006, we purchased 29,935 square feet of land in
Hsin-Chu, Taiwan for a future facility. The purchase price was approximately
$8.7 million.
BUSINESS OVERVIEW
We design, develop and market high performance integrated circuits for
power management and security applications. We focus our product design efforts
on integrated circuits for consumer electronics, computer, industrial and
communications products, including LCD computer monitors, LCD televisions,
notebook computers, Internet security devices, GPS, mobile phones and portable
DVD players. Our integrated circuit products manage and provide power for
lighting of LCDs, provide connections between notebook computers and external
plug-in cards, provide Internet security, control and monitor battery charging
and discharging, and select and switch between power sources.
We believe that our focus on these products provides us with an
opportunity to participate in large and growing markets. Potential future growth
in the LCD television market, especially units with larger-size panels,
represents an attractive growth opportunity for us because larger LCD panels
require more of our inverters for cold cathode fluorescent lamps, or CCFLs.
Our integrated circuit products use analog, digital or mixed-signal
designs that combine analog and digital circuits on a single chip, reducing the
number of components needed and allowing our customers to reduce the size,
weight, power requirements or cost of their products. We offer a wide range of
proprietary application specific standard products as well as customized
products. We work closely with our customers to identify their product needs and
establish engineering priorities for new product designs and development. We
believe that our system-level expertise and extensive experience with power
management systems allow us to develop proprietary solutions and foster
long-term relationships with our customers.
We sell our products to OEMs, ODMs and module makers. Our integrated
circuits have been incorporated into products sold by Acer, Apple Computer,
Dell, Fujitsu, Hewlett-Packard, Lenovo, LG Electronics, NEC, Samsung
Electronics, Sharp, Sony and Toshiba, among others. We sell our products through
our direct sales force, independent sales representatives and distributors in
China, Japan, Korea, Singapore, Taiwan and the United States. We also have
design centers in many of our key markets to provide design and engineering
support to our customers. We outsource the fabrication of our products to
standard, high volume semiconductor foundries. This "fabless" approach allows us
to focus on product development, minimize fixed costs and capital expenditures,
and access diverse manufacturing technologies.
Our net sales have grown from US$88.6 million in 2003 to US$92.2 million
in 2004 and US$105.6 million in 2005. In the three months ended March 31, 2006,
our net sales were US$29.1 million, an increase of 25.1% as compared with net
sales of US$23.3 million in the same period in 2005.
20
Industry Background
The markets for consumer electronics, mobile computing and communications
products, such as LCD monitors, LCD televisions, notebook computers, mobile
handsets and portable entertainment devices, are large and growing as
functionality increases and prices decrease. One of the most significant
challenges in these markets remains the efficient management of power. As the
number of applications and features available for these products has increased,
the number and variety of power loads, or individual subsystems requiring
voltage or current regulation, has also grown. Each additional application or
feature can require multiple functions and circuits that, in turn, require more
individually-regulated and managed power sources. Increasingly, manufacturers
are turning to innovative new semiconductor technologies to manage the available
power source capacity more efficiently.
Power management integrated circuits deliver power and regulate voltage,
controlling the flow of electrical energy among the various power loads and
energy sources in a product or system. Power management requires a combination
of two distinct technological disciplines: digital integrated circuit design and
analog integrated circuit design. Digital circuits, such as microprocessor and
memory semiconductors, provide most of the functionality of computer processing.
However, digital circuits generally cannot handle significant amounts of current
or multiple voltage levels. In contrast, analog circuits use and manipulate
continuously varying voltage and current levels. Battery power systems, which
have relatively high and continuously varying power levels, are inherently
analog systems.
Digital integrated circuit technology can be used to manage power systems
more intelligently and efficiently and help to prolong battery life in mobile
applications. However, since battery power systems are analog by nature,
mixed-signal integrated circuits, or circuits that incorporate both digital and
analog technologies, are necessary in order to harness the intelligence provided
by digital technology. Designing mixed-signal integrated circuits poses a number
of difficulties: analog circuits are more sensitive than digital circuits to the
physical layout and electrical characteristics of the circuit; analog circuit
designers must have a very high level of circuit design experience; and basic
differences in the technologies used in digital and analog circuit design make
combining the technologies problematic.
In addition, mixed-signal integrated circuits comprise both digital and
analog components, and the trend toward more complex devices has increased the
number of components substantially. Integrating the functions of those
components on a single chip, known as a system-on-a-chip, can enable
manufacturers to make products smaller, lighter and more reliable. Thus, as
mobile computing and communications devices grow in complexity and
functionality, there is an increasing need for higher levels of systems
integration. In addition, variances in battery designs among manufacturers make
it more difficult to design intelligent systems that are optimized for
particular power systems.
Most consumer electronics, mobile computing and communications product
manufacturers need mixed-signal and analog integrated circuits specifically
designed to optimize the power system usage in their devices to enable them to
offer new devices with richer functionality and longer battery lives. These
semiconductors should also be highly integrated and standards-based to help
manufacturers create products that are smaller, lighter, easier to use, more
reliable and more cost-efficient to design and produce. In addition, in mobile
device markets where product life cycles can be less than one year, these
solutions typically need to be developed using advanced design methodologies to
allow manufacturers to achieve rapid time-to-market with their new products.
Several different process technologies are available for designing and
fabricating analog and digital integrated circuits. Of these, complementary
metal oxide semiconductor, or CMOS, is the most widely used process technology,
especially for purely digital integrated circuits. CMOS processes are described
in terms of feature size, or geometry, and are measured in microns. One micron
equals one millionth of a meter. Currently, the most advanced process
technologies achieve feature sizes of 0.13 micron, 0.09 micron and smaller.
However, small feature size circuits can become damaged when exposed to high
voltages and therefore power management integrated circuits are typically
fabricated using larger feature sizes. For this reason, older manufacturing
facilities, or fabs, having feature sizes of 0.25 micron and 0.80 micron or
greater, have traditionally been used in fabricating power management integrated
circuits, while the most advanced, and most expensive fabs are used for digital
and non-power management analog integrated circuits.
21
Products
Our products manage and provide power for lighting of LCDs, provide
connections between notebook computers and external plug-in cards, provide
Internet security, control and monitor battery charging and discharging, and
select and switch between power sources. We sell our products into the following
four end-markets:
o Consumer electronics market, including desktop monitors, LCD televisions,
digital cameras and camcorders and portable media players;
o Computer market, including notebook computers, desktop computers and
desktop servers;
o Industrial market, including any product that is specified to operate over
an extended temperature range, for instance, beyond the standard
commercial operating temperature range of standard semiconductor products
of zero degrees to 70 degrees centigrade. Products that operate over an
extended temperature range include industrial tools, automobile GPS
systems, and other automobile systems; and
o Communications market, including portable GPS systems, data communications
security and networking systems, Internet and Internet related systems and
mobile phone handsets.
Historically, the majority of our revenue was derived from the sale of our
products in the notebook computer market. However, more recently, we have begun
to sell products for use in other end-markets. As part of this diversification
effort, we have increased our focus on the consumer electronics market,
particularly on LCD monitors for desktop computers and LCD televisions.
Additionally, we have increased our efforts on expanding our product portfolio
to address opportunities in the communications and industrial markets. Our major
products that we sell in one or more of these end-markets are set out below:
CCFL Inverters
We believe that we are one of the most experienced suppliers of CCFL
inverters in the world, with one of the highest market shares worldwide for
these products.
We sell a variety of both fixed and variable input voltage CCFL inverters.
These CCFL inverters convert direct current power to alternating current power
required for backlighting of LCD screens. Our CCFL inverters use our patented
High Efficiency CCFL Intelligent Inverter technology which allows conversion of
direct current power to alternating current power in a single step without
requiring an intermediate voltage level. A result of the single step conversion
is a more efficient power transformation process yielding longer battery life
for portable electronics products. Our CCFL inverters increase the efficiency of
the lighting system, extend the overall battery run-time in mobile devices and
allow the use of smaller and simpler circuitry which reduces system costs.
Additionally, our CCFL inverter controllers span a broad range of products from
those that are capable of driving single-lamp notebook computer panels with one
CCFL to those that are capable of driving as many as 50 CCFLs or more required
for LCD televisions. Our CCFL inverters also improve the quality of the output
signal, which increases the overall lamp life, and accept digital instructions
that enable the operating system to control features such as dimming and
contrast. We believe that our CCFL inverters are well-suited for driving various
sizes of LCD backlight lamps currently being designed into next generation LCD
displays.
22
CardBus Controllers
Our CardBus controllers provide a high speed connection between PC cards
and the central processing unit of a computer, or CPU, that add features such as
removable data storage to a notebook computer. Our CardBus controllers provide
advanced design flexibility for PC cards that interface with advanced notebook
designs, allowing the user to add high-performance enhancements and new
functions easily. In addition, our CardBus controllers incorporate a power
saving feature that shuts down most of their operations when the system is
powered down, so that they only monitor external events such as local area
network activity and modem activity.
SmartCardBus Controllers
Our SmartCardBus controllers combine a Smart Card Reader, or SCR, which
reads data from a smart card, and a CardBus controller, which controls the
connection to the computer, in one integrated circuit. Our SmartCardBus
controllers enable standard smart cards, which are credit card-like devices that
store digital information in an embedded microchip, to connect directly with a
notebook computer equipped with a CardBus socket. By reading encrypted
information embedded in smart cards, our SmartCardBus controllers add
significant new features to notebook computers at a low cost, such as network
security and security for e-commerce transactions. Using our patented
SmartCardSensing technology, our SmartCardBus controllers have the ability to
recognize and read both smart cards, which are issued to customers by banks and
credit agencies to store account information, and PC cards, which provide
removable data storage and other functions to notebook computers. This ability
eliminates the need for separate integrated circuits for both cards and allows
the user to switch between cards while the computer is in operation.
E-Guardian
Our E-Guardian integrated circuit products provide PC users with the
ability to transact secure e-commerce transactions on the Internet using their
desktop computer keyboard and a financial smart card. E-Guardian integrated
circuits combine a standard Universal Serial Bus, or USB, hub with SCR
functionality, eliminating the need for an external smart card reader.
4-in-1 MemoryCardBus
Our 4-in-1 MemoryCardBus controllers combine a CardBus controller and a
4-in-1 flash memory card reader on a single integrated circuit. Our 4-in-1
MemoryCardBus controllers support four widely used flash media formats,
including the SmartMedia(TM) (a trademark of Toshiba), the Memory Stick(TM) (a
trademark of Sony), the MultiMediaCard(TM) (a trademark of Infineon
Technologies) and the SDTM Memory Card (a trademark of SanDisk).
CardBus Power Switches
Our CardBus power switches provide an integrated power management solution
for PC cards. They are used in conjunction with a data output CardBus controller
to control and distribute voltages to PC card slots.
Intelligent Charger
Our Intelligent Chargers control and monitor battery charging and
discharging in notebook computer systems. Our Intelligent Chargers optimize
battery charging based on battery chemistry and capacity. To ensure safe and
reliable charging, our Intelligent Chargers have built-in temperature monitors,
voltage monitors, current monitors, voltage limiting devices and current
limiting devices to prevent overcharging and other hazards while maximizing
charging current and voltage. Our Intelligent Chargers are embedded with a set
of standard instructions, thus easing the programming burden for our customers.
23
DC/DC Converters
Our DC/DC converters are high efficiency products that power mobile and
desktop PCs. We offer two types of DC/DC converters: the mobile CPU core power
controller chipset and the server CPU core power controller.
The mobile CPU core power controller chipset is specially designed for
next generation portable computing microprocessors. It is an Intel Mobile
Voltage Positioning, or IMVP, specification compliant solution that provides
processor core and peripheral voltages using one controller integrated circuit.
This architecture allows flexible print circuit board layout possibilities,
while isolating high power driver circuitry away from complex
temperature-sensitive controller and reference circuitry.
The server CPU core power controller is designed for high-speed DC/DC
power conversion, which is useful for powering high wattage desktop and server
microprocessors. This architecture provides high currents, while utilizing a
lower number of power delivery phases, and therefore fewer external components
than other modern multi-phase, high current power solutions.
SuperDJ and AudioDJ
Our SuperDJ and AudioDJ allow notebook computers to play music CDs without
starting up the entire system or activating the CPU. This feature substantially
reduces battery consumption, allowing longer playing time and providing easier
access to music CDs with a notebook computer.
Intelligent Manager
Our Intelligent Manager integrated circuit products provide numerous
programmable functions that manage and control the flow of electrical power in a
notebook computer beyond the standard features offered with the standard
advanced configuration and power interface, or ACPI, specification and Intel
architecture power management methods. ACPI is a power management specification
developed by Intel, Microsoft and Toshiba which enables the operating system of
a computer to control the amount of power given to each device attached to the
computer. Some of the features made possible with these products include a
flashing indicator that indicates the presence of new e-mail messages after a
button is pushed, a sensor that detects when a notebook computer is connected to
a docking station and a suspend/wake-up button that allows a user to switch
easily in and out of a low power sleep mode.
Systems Security Solutions
Our system security solutions product category includes VPNs and firewalls
which provide security functions for communications between computer systems and
networks, including the transmission of data across the Internet. VPNs and
firewalls are installed by our customers to protect their computer systems
against corruption and/or theft of data by outside influences such as viruses or
hackers. These products combine our internally developed software and integrated
circuits designed by us which are manufactured by third party foundries. The
products are then assembled by independent assembly suppliers. Our direct sales
force markets these products, principally to small and medium-sized enterprises.
Marketing, Sales, and Customer Support
Our marketing strategy is focused on the sale of proprietary analog and
mixed-signal integrated circuits to customers in the consumer electronics,
computer, industrial and communications markets. These markets tend to be
dominated by a small number of major brand name companies. As a result, we focus
our resources on the major vendors in each market.
We primarily sell proprietary application specific products to our
customers and work with them on new product development. We also design
customized products for our customers. We work directly with our customers to
create demand for our products by providing them with application specific
product information for their system design, engineering and procurement groups.
We actively participate in their design processes to introduce them to our
products and the target applications our products address. We endeavor to design
products that will meet increasingly complex and specific design requirements,
but which will also support widespread demand for these future products. We
typically undertake a four-to-eight month development process with our
customers. If successful, this process culminates in a customer deciding to use
our product in its system, which we refer to as a design win. Volume production
generally takes an additional three-to-six months after the initial design win
confirmation. Once our products are accepted and designed into an application,
the customer is likely to continue to use the same power architecture and
derivative products in a number of its models, which tends to extend our product
life cycles.
24
We sell our products to OEMs, ODMs and module makers. We market and sell
these products through a combination of our direct sales force, independent
sales representatives and distributors in Asia, Europe and North America. We
sell most of our products through direct sales. We maintain direct sales offices
in most of our major markets which include Texas, California, China, Taiwan,
Korea and Japan. Additionally, we have sales representatives in China, Singapore
and Taiwan, as well as one distributor in Japan.
We pay our direct sales force on a salary and performance bonus basis
only. Our independent sales representatives are paid on a commission basis,
based on a percentage of the actual sales referred by them. For sales through
sales representatives, we invoice and deliver our products directly to the
customers. We have entered into a distributorship arrangement with a distributor
on a non-exclusive basis for the sale of our products in Japan as a principal at
the request of certain of our major end-customers in Japan. For our other
customers in Japan, sales are made through our direct sales offices in Japan. In
Japan, it is customary practice for OEMs, ODMs and module makers to purchase
products like ours through distributors because of the ancillary services
provided by them such as inventory storage, payment terms and conditions and
just-in-time delivery. We provide a discount on the prices of the products we
sell to our distributors (as compared to the prices we offer to end customers),
depending on the term and conditions of the individual purchases. We defer
recognition of such sales until the product is sold by the distributor to its
end customers. In addition, products held by the distributor are considered part
of our inventory and included in our inventory balance. Sales to the distributor
are recognized and inventory is adjusted upon shipment to its end-customers as
title to inventories generally transfers upon shipment. We receive monthly
inventory and sales reports from the distributor in Japan, which we use as part
of our overall inventory control. We evaluate our inventory on a quarterly basis
and full provision is made for inventory which is over six months old and for
which there is not end customer demand based on forecasted product demand and
market conditions.
Our marketing efforts include market analysis, participation in industry
trade shows and technical conferences, sales training, publication of technical
articles, maintenance of our web site and advertising. In addition, we maintain
customer support staff in United States, Taiwan, China, Japan and Korea for post
order servicing and applications support.
Seasonality
The consumer electronics and computer markets are characterized by
seasonal volume increases in the latter part of the year primarily driven by
increased consumer spending during the holiday season. We normally experience
the highest sales volume to our customers in these market in the third and
fourth quarter of each year, when such customers increase their inventories in
anticipation on increased seasonal demand. Our customers in the industrial and
communications markets are to a lesser extent subject to seasonal consumer
demand. As a result, our sales volume to those customers has been largely
consistent from quarter-to-quarter.
Customers
We focus on the major OEMs (or brand owners) in the consumer electronics,
computer, industrial and communications markets. Many of these major OEMs use
third-party providers, such as ODMs, module makers or other intermediaries, to
produce their products or portions of their products containing our components.
Hence, the majority of our direct sales are to these third-party providers. We
have maintained long-term relationships with our major customers for a number of
years.
We have no long-term volume purchase contracts with any of our major
customers. The majority of our sales to customers are conducted on the basis of
purchase orders, which set out the specific terms for a particular sale. We
price our products primarily with reference to the prevailing market conditions,
taking into consideration the complexity, technology and features of the
product, the order size and the relationship with the customer.
25
The table below sets forth, for the periods indicated, the dollar amount
of our net sales derived from Asia, United States and other regions:
Years Ended December 31
(In Thousands)
Location of customers 2003 2004 2005
--------------------- -------- -------- --------
Asia $ 88,548 $ 92,105 $105,517
United States 51 53 29
Other regions -- 38 6
-------- -------- --------
$ 88,599 $ 92,196 $105,552
======== ======== ========
We generally extend to our customers credit terms varying from 30 to 45
days. We may adjust our usual credit terms according to each customer's credit
history as well as local market practice. Our customers generally pay us either
by direct wire transfer or under letter of credit arrangement. To date, we have
not experienced any material problems relating to customer payments or material
write-offs of accounts receivable due to uncollectibility.
Manufacturing
We subcontract the manufacture of our products to semiconductor foundries,
assembly and testing service providers. This "fabless" approach allows us to
focus on product development, minimize fixed costs and capital expenditures, and
access diverse manufacturing technologies.
We use established mainstream processes for the manufacture of our
products. This approach reduces our technical risks and minimizes the risks
related to production capacity constraints.
Wafer Manufacturing
Wafer manufacturing is a capital intensive and complex operation which
takes place at dedicated facilities of semiconductor foundries. After we have
designed our integrated circuits, we place orders with a semiconductor foundry
to fabricate wafers with our integrated circuits embedded in them. The
semiconductor foundry purchases raw unprocessed wafers, or silicon substrates,
and processes them according to our specifications to fabricate the wafers used
in our products. Currently, the majority of our wafers are fabricated using 0.25
to 0.80 micron CMOS semiconductor processes, which are the standard
semiconductor processes used by semiconductor foundries. The wafer fabrication
process generally takes six to 10 weeks. Fabricated wafers are then shipped by
the semiconductor foundry, according to our instructions, to either an assembly
service provider for electrical wafer sort and assembly or to an electrical
wafer sort service provider for electrical wafer sort only.
Our major semiconductor foundry providers are X-FAB and TSMC. We do not
enter into long-term contracts with our semiconductor foundry providers. They
manufacture our products on a purchase-order basis in accordance with our
specifications and requirements. In general, the cost charged to us for the
foundry services depends on prevailing wafer costs, which, in turn, depends on
industry capacity and the state of manufacturing process technologies as well as
on the complexity of our product designs, order size, cycle time and foundry
capacity utilization.
26
Assembly and Testing
After the fabricated wafers have been electrically sorted, they are ready
for assembly and are either sent to an assembly service provider for assembly or
held at our warehouse facilities, or an "inventory hub," for assembly at a later
date. An inventory hub is a provider of warehousing services. We often hold
inventory of our semi-finished products in the form of electrically sorted
wafers because it is at this manufacturing stage that most time has been
invested, with the least costs, and we then have the flexibility of choosing the
type of packaging into which they are to be assembled. The wafer sort and
assembly process generally takes three to six weeks.
Once our integrated circuits are assembled and packaged, they are ready
for final electrical testing. We instruct the assembly service provider to send
our packaged integrated circuits to either a testing service provider for final
testing or our warehouse facilities (or an inventory hub) for testing at a later
date. The electrical testing process generally takes a few days. Once our
products have been tested, they are ready for use by our customers.
Finished products may be sent from the testing service provider to our
customers or their designees such as third party service providers that
manufacture their products or a portion of their products containing our
integrated circuits. Our customers may request for our integrated circuits to be
shipped in plastic tubes, several to a tube, or use a form of packaging called
"tape and reel" that more readily provides for automated assembly of our
integrated circuits into their products. If a customer orders "tape and reel"
packaging, this is done either at a testing service provider or a "tape and
reel" service provider prior to shipment of our products to the customer.
We utilize several assembly and testing service providers in Taiwan and
other parts of Asia on a purchase order basis. They assemble and test our
products based on our specifications and requirements. In general, the cost
charged to us for these assembly and testing services depends on prevailing
market rates for these services and our relationship with the service provider.
We intend to build and operate a semiconductor testing facility to test a
portion of our products prior to shipment. We believe that the new facility will
provide us with the test capability and flexibility needed to meet future
customer requirements. Typically analog and mixed-signal products have a greater
portion of their product cost associated with product testing than digital
products. In addition, we control the technologies of our products during the
final testing stage. Having a greater share of the product testing performed
in-house will enable us to have more direct control over our testing cost and
technologies, and more flexibility in the management and apportionment of test
capability.
Our current credit terms with our foundry, assembly and testing service
providers vary from 30 to 45 days, depending on our relationships with each of
them. We generally pay our service providers by direct wire transfer.
We also have made investments in certain of our current suppliers and
potential future suppliers, including software developers, foundries and testing
service providers. These investments enable us to enhance our business
relationships with these suppliers to ensure the adequacy of foundry capacity
allocation and quality of services provided to us. We plan to continue to
evaluate additional investment opportunities in our supply chain.
Competition
We compete in the market for analog and mixed-signal integrated circuits
based on such factors as product performance, power efficiency, new
technologies, functional innovation, reliability, price and availability. We
believe our principal competitors include Intersil Corporation, Linear
Technology Corporation, Maxim Integrated Products, Inc., Microsemi Corporation,
Monolithic Power Systems, Inc., Ricoh Company, Ltd., Rohm Co., Ltd and Texas
Instruments Incorporated. There is also competition from internal integrated
circuit design and manufacturing capabilities of some of our existing and
potential customers, such as Toshiba and Fujitsu. In addition to these
competitors, other integrated circuit companies may decide to enter the market
with analog and mixed signal integrated products that compete with our products
or incorporate functions similar to those provided by our products.
Intellectual Property
Our intellectual property is primarily developed in-house. We do, from
time to time, acquire intellectual property from third parties which we believe
is instrumental or complementary to our business. We also on occasion license
our intellectual property to third parties in exchange for royalties or other
consideration.
27
Our success depends significantly upon our ability to protect our
intellectual property. Despite our efforts to protect our proprietary rights,
unauthorized parties may attempt to copy aspects of our products or obtain and
use information that we regard as proprietary. Competitors may recruit our
employees who have access to our proprietary technologies, processes and
operations.
We rely in part on patents to protect our intellectual property. As of
December 31, 2005, we had approximately 75 patents issued in the United States
and approximately 100 patents issued in other countries. In addition, we had
approximately 129 patent applications pending in the United States Patent and
Trademark Office. We also had approximately 273 patent applications pending in
various countries other than the United States. These patents may never be
issued. Even if these patents are issued, taken together with our existing
patents, they may not be sufficiently broad to protect our proprietary rights,
or they may prove to be unenforceable. To protect our proprietary rights, we
also rely on a combination of copyrights, trademarks, trade secret laws,
contractual provisions, licenses and maskwork protection under the Federal
Semiconductor Chip Protection Act of 1984 and similar laws in other
jurisdictions. We also enter into confidentiality agreements with our employees,
consultants and customers and seek to control access to, and distribution of,
our proprietary information.
We may from time to time grant rights to third parties for our patents and
other intellectual property. In March 2003, we granted a limited non-exclusive
license to Ricoh Company, Ltd. for our patents entitled "Integrated PC Card Host
Controller for the Detection and Operation of a Plurality of Expansion Cards"
(U.S. Patent No. 6,470,284 and Taiwan Patent No. 155891) and their foreign
counterparts.
The laws of some foreign countries do not protect our proprietary rights
to the same extent as do the laws of the United States, and many companies have
encountered substantial infringement problems in these countries, including
countries in which we have sold and continue to sell a significant portion of
our products. There is a risk that our means of protecting our proprietary
rights may not be adequate. For example, our competitors may independently
develop similar technology, duplicate our products or design around our patents
or our other intellectual property rights. If we fail to protect our
intellectual property adequately, it would make it easier for our competitors to
sell competing products.
We are involved in a variety of litigation matters involving intellectual
property. For example, we have initiated and are pursuing certain patent
infringement actions in Taiwan. We have obtained preliminary injunctions and
provisional attachment orders against numerous competitors, their customers and
users. As of December 31, 2005, we have deposited an amount of New Taiwan
dollars equivalent to approximately US$14.5 million with the Taiwan courts for
court bonds in connection with the preliminary injunction actions and related
provisional attachment actions. The court bonds provide security for the
enjoined party to claim damages incurred from the preliminary injunctions,
provisional attachments or the provision of a countersecurity against us in the
event we do not ultimately succeed in the underlying infringement actions.
However, these preliminary injunctions or provisional attachments may be
rescinded if the relevant court allows the opposing party to make its own
deposit or countersecurity with the court.
We are currently in litigation against MPS in the United States District
Court in the Northern District of California. MPS has alleged that certain of
our products infringe on one of its patents and a continuation of that patent.
In May 2004, the court granted our motion for summary judgment that MPS lacked
evidence of damages. Trial on MPS' claim commenced in June 2005 and, in July
2005, we received a jury verdict that all claims asserted by MPS were invalid
and were not infringed by us. MPS has filed a notice of appeal of the verdict.
As the case currently stands, MPS will not be able to recover damages unless it
is able to overturn the summary judgment and the jury verdict or seek injunctive
relief or attorneys' fees unless it is able to overturn the jury verdict.
28
We are also involved in several other patent litigations in the United
States. Given the inherent uncertainties in litigation, there cannot be any
assurance that we will prevail in any of the pending litigations, and we cannot
predict the outcome of any such litigation. Litigation is costly, time
consuming, and may distract management from other important tasks and, in patent
litigations where we are the plaintiff, there is a risk that our patents may be
held invalid or unenforceable. In addition, in any litigation arising from
claims that we infringe on the intellectual property rights of others, an
adverse result could involve an injunction to prevent the sales of a material
portion of our products, a reduction or the elimination of the value of related
inventories, and the assessment of a substantial monetary award for damages
related to past sales, any of which could have a material adverse effect on our
result of operations and financial condition.
ORGANIZATIONAL STRUCTURE
We are incorporated under the laws of the Cayman Islands and we are the
parent company for the various subsidiaries that conduct our business on a
worldwide basis. Our significant subsidiaries, all of which are wholly-owned,
are:
---------------------------------------- -------------------------------------- --------------------------------------
Significant Subsidiary Country of Incorporation Date of Incorporation
---------------------------------------- -------------------------------------- --------------------------------------
O2Micro, Inc. U.S.A. March 1995
---------------------------------------- -------------------------------------- --------------------------------------
O2Micro Electronics, Inc. Taiwan March 1999
---------------------------------------- -------------------------------------- --------------------------------------
O2Micro International Japan Limited Japan August 1999
---------------------------------------- -------------------------------------- --------------------------------------
O2Micro PTE Limited-Singapore Singapore September 1999
---------------------------------------- -------------------------------------- --------------------------------------
Aotu Micro (Wuhan) Co., Ltd. China January 2001
---------------------------------------- -------------------------------------- --------------------------------------
O2Micro (Beijing) Co., Ltd. China February 2001
---------------------------------------- -------------------------------------- --------------------------------------
O2Micro (China) Co., Ltd. China April 2001
---------------------------------------- -------------------------------------- --------------------------------------
O2Micro (Chengdu) Co., Ltd. China July 2004
---------------------------------------- -------------------------------------- --------------------------------------
PROPERTY, PLANT AND EQUIPMENT
The table below describes our headquarters and the facilities where the
above subsidiaries are located as of December 31, 2005:
Approx. Available
Location Square Feet Lease Expiration
-------------------------------------------------------- ----------------- ----------------
California, USA......................................... 37,180 not applicable
Taipei, Taiwan.......................................... 22,103 2006
Hsin-Chu, Taiwan........................................ 23,630 2006
Singapore............................................... 7,104 2008
Shanghai, China......................................... 30,448 not applicable
Beijing, China.......................................... 16,070 2007
Wuhan, China............................................ 11,220 2006
Chengdu, China.......................................... 13,552 2006
Grand Cayman, Cayman Islands............................ 600 2006
Tokyo, Japan............................................ 1,302 2006
29
We maintain our Cayman Islands office to process invoices and receive
amounts payable. Research and development, marketing, applications and
administrative staff are located in California. We also have sales offices in
Pfluggerville, Texas and Houston, Texas. Marketing, sales, applications, design,
worldwide production support, final inspection and shipping, and general and
administrative staff are located in Taiwan. We have offices Japan, Singapore,
Korea and China for marketing, sales, design, warehousing and applications. We
believe our current facilities are adequate for our needs for the foreseeable
future, and that any additional space required will be available to us on
commercially reasonable terms.
In May 2004, we purchased a 37,180 square foot building in Santa Clara,
California housing our California operations. The purchase price was
approximately $4.6 million. In October 2005, we purchased a 30,448 square foot
facility in Shanghai, China for approximately $7.1 million. In April 2006, we
purchased 29,935 square feet of land in Hsin-Chu, Taiwan for a future facility.
The purchase price was approximately $8.7 million.
ITEM 4A. UNRESOLVED STAFF COMMENTS
None.
ITEM 5. OPERATING AND FINANCIAL REVIEW AND PROSPECTS
Overview
We design, develop and market high performance integrated circuits for
power management and security applications. We also license a limited portion of
our proprietary intellectual property to third parties. Our net sales have been
derived primarily from the sale of analog and mixed-signal integrated circuit
products to customers in the consumer electronics, computer, industrial and
communications markets.
Our net sales have grown from $88.6 million in 2003 to $92.2 million in
2004 and $105.6 million in 2005. This increase in net sales was due primarily to
introduction of our new products, higher unit shipments of our existing products
and expansion of our customer base. We have continued to diversify our customer
base and market focus by entering additional market segments in the consumer
electronics, computer, industrial and communications markets. Our overall gross
margin has fluctuated in the past and is likely to fluctuate in the future due
to the stages of our products in their life cycles, variations in our product
mix, the timing of our product introductions and specific product manufacturing
costs. New products typically have higher gross margins than products that are
more mature. Gross margins on specific products we sell will typically decline
over the life of these products due to competitive pressures and volume pricing
agreements.
Operating expenses grew from $36.7 million in 2003 to $41.9 million in
2004 and $55.9 million in 2005. Our operating expenses increased as we continued
our new product development efforts, expanded our operations and hired
additional personnel.
Our net income was $13.2 million in 2003, $14.1 million in 2004 and $8.1
million in 2005. We have been profitable in each quarter since the quarter ended
September 30, 1999. We believe this profitability has been the result of our
strategy to make investments to develop new products and grow net sales, while
maintaining a high level of fiscal control, product quality and customer
satisfaction. Our profitability resulted in retained earnings of $38.7 million
at December 31, 2005.
We utilize a fabless semiconductor business model, which means we focus on
designing, developing and marketing products, while having these products
manufactured by large independent semiconductor foundries. As a fabless
semiconductor company, we do not need to invest significant capital to
manufacture semiconductor devices, and can take advantage of some of the
cost-efficiencies of third-party foundries. We place purchase orders for
specific quantities of packaged semiconductor devices or wafers at set prices.
We currently use third parties to test and assemble substantially all of our
products, which reduces the capital we need to invest in these activities.
However, we intend to bring some of the more critical semiconductor testing
activities in-house to safeguard our proprietary technologies. We also use
independent assembly suppliers for the production of our systems security
solutions products.
30
We sell our products through a combination of direct sales offices, sales
representatives and distributors. We have sales representatives in China,
Singapore and Taiwan, as well as one distributor in Japan. In the year ended
December 31, 2005, we continued to experience increased sales to customers in
China.
Revenue from product sales to customers, other than distributors, is
recognized at the time of shipment, including revenue that has been realized and
earned. Sales through distributors are recognized when the distributors make a
sale. Under certain conditions, customers may return defective products.
Allowances for sales returns are provided on the basis of past experience; these
provisions are deducted from sales.
Critical Accounting Policies--
Revenue Recognition and Accounts Receivable Allowances
We recognize revenue on sales to direct customers in accordance with SEC
Staff Accounting Bulletin No. 104, "Revenue Recognition in Financial Statements"
("SAB 104"). SAB 104 requires that four basic criteria must be met before
revenue can be recognized: (1) persuasive evidence of an agreement exists, (2)
delivery has occurred or services have been rendered, (3) the fee is fixed and
determinable, and (4) collectibility is reasonably assured. Determination of
criteria (4) is based on the management's judgments regarding the collectibility
of those fees.
For sales made through distributors, we defer recognition of such sales
until the product is sold by the distributors to their end customers. Since we
have limited control over these distributors' sales to third parties, we
recognize revenues on these sales only when the distributors sell the products.
In addition, products held by distributors are included in our inventory
balance. Accounts receivable from distributors are recognized and inventory is
relieved upon shipment to end customers as title to inventories generally
transfers upon shipment.
We make allowances for future product returns in the current period
revenue. We analyze historical returns, changes in current demand and acceptance
of products when evaluating the adequacy of such allowances. Estimates may
differ from actual product returns and allowances and these differences may
materially affect our reported revenue and amounts ultimately collected on
accounts receivable. In addition, we monitor collectibility of accounts
receivable primarily through review of the accounts receivable aging. When facts
and circumstances indicate the collection of specific amounts or from specific
customers is at risk, we assess the impact on amounts recorded for bad debts
and, if necessary, will record a charge in the period such determination is
made. To date, we have not experienced material write-offs of accounts
receivable due to uncollectibility.
Inventories
Our inventories are stated at the lower of standard cost or market value.
Cost is determined on a currently adjusted standard basis, which approximates
actual cost on a first-in first-out basis. Because of the cyclicality of the
market, inventory levels, obsolescence of technology and the product life
cycles, we write down inventories to net realizable value based on backlog,
forecasted product demand and historical sales levels. Backlog is subject to
revisions, cancellations and rescheduling. Actual demand and market conditions
may be lower than those projected by us. This difference could have a material
adverse effect on our gross margin should additional inventory write downs
become necessary.
31
Long-Lived Assets
We evaluate the recoverability of property, plant and equipment in
accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets." We perform periodic reviews to determine whether facts and
circumstances exist that would indicate that the carrying amounts of property,
plant and equipment might not be fully recoverable. If facts and circumstances
indicate that the carrying amount of property, plant and equipment might not be
fully recoverable, we compare projected undiscounted net cash flows associated
with the related assets over their estimated remaining useful life against their
respective carrying amounts. In the event that the projected undiscounted cash
flows are not sufficient to recover the carrying value of the assets, the assets
are written down to their estimated fair values based on the expected discounted
future cash flows attributable to the assets. Evaluation of impairment of
property, plant and equipment requires estimates in the forecast of future
operating results that are used in the preparation of the expected future
undiscounted cash flows. Actual operating results and remaining economic lives
of the property, plant and equipment could differ from the estimates used in
assessing the recoverability of these assets. These differences could result in
additional impairment charges, which could have a material adverse impact on the
results of operations.
Income Taxes
Our income taxes are accounted in accordance with SFAS No. 109 "Accounting
for Income Taxes". The provision for income tax represents income tax paid and
payable for the current year plus the changes in the deferred income tax assets
and liabilities during the years. Deferred income tax assets are primarily the
tax effects of the operating loss carry-forwards, research and development
credit carryforwards and temporary differences. On a periodic basis we evaluate
the deferred tax assets balance for realizability. To the extent we believe it
is more likely than not that some portion of deferred tax assets will not be
recognized, we will increase the valuation allowance against the deferred tax
assets. Realization of the deferred tax assets is dependent primarily upon
future taxable income, changes in tax laws and other factors. These changes, if
any, may require possible material adjustment to the deferred tax assets,
resulting in a reduction in net income in the period when such determinations
are made.
Legal Contingencies
We are currently involved in various claims and legal proceedings. We
periodically assess each matter in order to determine if a contingent liability
in accordance with SFAS No. 5, "Accounting for Contingencies," should be
recorded. In making the determination, we may, depending on the nature of the
matter, consult with external counsel and technical experts. Based on the
information obtained combined with our judgment regarding all the facts and
circumstances of each matter, we determine whether it is probable that a
contingent loss may be incurred and whether the amount of such loss can be
estimated. Should a loss be probable and estimable, we record a contingent loss
in accordance with SFAS No. 5. In determining the amount of a contingent loss,
we take into consideration advice received from experts in the specific matter,
current status of legal proceedings, prior case history and other factors.
Should the judgments and estimates be incorrect, we may need to record
additional contingent losses that could materially adversely impact our results
of operations.
Stock-based compensation
We have elected to follow Accounting Principles Board Opinion ("APB") No.
25, "Accounting for Stock Issued to Employees" and comply with the disclosure
provisions of SFAS No. 123, "Accounting for Stock-Based Compensation" for our
employee stock options. Under APB No. 25, compensation expense is measured based
on the difference, if any, on the date of the grant, between the fair value of
the ordinary shares and the exercise price of the stock option.
At the end of June 2005, our Board approved the acceleration of the
vesting of options with exercise prices greater than $17.00 (pre-split basis).
Our Board evaluated the minimal benefit to our employees of accelerating the
remaining vesting on these significantly underwater options against the value to
shareholders of not having earnings materially affected and the impact that this
may have on the Company's market value. In addition, these options had exercise
prices in excess of the then current market values and were not fully achieving
their original objectives of incentive compensation and employee retention.
Accelerating the vesting of these options accelerated the recognition of any
remaining expense associated with these options which is zero under APB No. 25.
32
However, had the compensation expense for these options been determined on
the basis of the fair values under SFAS No. 123, we would have had to record a
charge of approximately $1.8 million as the remaining expense associated with
accelerating the vesting of these options. Such impact has been included in the
disclosures of our pro forma net income and net income per share information.
See Note 2 of the consolidated financial statements
Research and development costs
Our research and development costs consist of expenditures incurred during
the course of planned research and investigation aimed at the discovery of new
knowledge that will be useful in developing new products or processes, or at
significantly enhancing existing products or production processes as well as
expenditures incurred for the design and testing of product alternatives or the
construction of prototypes. We charge all of our expenditures related to
research and development activities to operating expenses when incurred.
Recent Accounting Pronouncements
In December 2004, the FASB issued SFAS No. 123R "Share-Based Payment."
SFAS No. 123R requires that companies recognize compensation expense equal to
the fair value of stock options or other share based payments for the annual
reporting period that begins after June 15, 2005. SFAS No. 123R applies to all
awards granted after June 15, 2005, and prior periods' awards that are modified,
repurchased, or cancelled after June 15, 2005. The impact on our net income will
include the remaining amortization of the fair value of existing options
currently disclosed as a pro forma expense and is contingent upon the number of
future options granted, the selected transition method and the selection of
either the Black-Scholes or the binominal lattice model for valuing options. The
adoption of this standard will have no impact on our cashflows.
On January 1, 2006, we adopted SFAS No. 123R, using a modified prospective
application. Accordingly, prior period amounts have not been restated. In the
first quarter of 2006, the adoption of FAS 123R resulted in incremental
stock-based compensation expense of $689,000. The incremental stock-based
compensation expense caused income before income taxes and net income to
decrease by $689,000.
In May 2005, the FASB issued SFAS No. 154 "Accounting Changes and Error
Corrections." SFAS No. 154 requires that companies apply accounting changes and
error corrections to financial statements retrospectively from the previous
period unless it is impracticable and is effective for the fiscal years
beginning after December 15, 2005. There is no impact to our company as a result
of the adoption of this standard as we do not currently intend to change our
accounting principles, estimates or reporting entity.
33
Operating Results
The following table summarizes historical results of operations as a
percentage of net sales for the periods shown.
Year Ended December 31,
---------------------------
2003 2004 2005
----- ----- -----
Consolidated Statement of Operations Data:
Net sales ..................................... 100.0% 100.0% 100.0%
Cost of sales ................................. 43.2 40.6 38.6
----- ----- -----
Gross margin .................................. 56.8 59.4 61.4
Operating expenses:
Research and development ................. 21.7 22.0 24.1
Selling, general and administrative ...... 15.3 17.7 19.2
Patent litigation ........................ 4.4 5.8 9.6
----- ----- -----
Total operating expenses ............. 41.4 45.5 52.9
----- ----- -----
Income from operations ........................ 15.4 13.9 8.5
Non-operating income-net ...................... 1.6 2.9 0.2
Income tax expenses ........................... 2.1 1.6 1.0
----- ----- -----
Net income .................................... 14.9% 15.2% 7.7%
===== ===== =====
Years Ended December 31, 2005 and 2004
Net Sales. Net sales consisted of product revenues generated principally
by sales of our integrated circuit products. Net sales for the year ended
December 31, 2005 were $105.6 million, an increase of $13.4 million or 14.5%
from $92.2 million for the year ended December 31, 2004. The increase in net
sales resulted from increased unit shipments to our existing customers and
expansion of our customer base. In 2005, we introduced new Cardbus and CCFL
inverter controller products. We also enhanced the features of certain products
in every existing product group in 2004 (except for Audio DJ products).
Gross Profit. Gross profit represents net sales less cost of sales. Cost
of sales primarily consists of the cost of purchasing packaged integrated
circuit products manufactured and assembled for us by independent foundries and
packaging vendors and other costs associated with the procurement, storage and
shipment of these products. Gross profit for the year ended December 31, 2005
was $64.8 million, an increase of $10.0 million or 18.3% from $54.8 million for
the year ended December 31, 2004. This increase was due to increased sales.
Gross profit as a percentage of net sales for the year ended December 31, 2005
increased to 61.4% from 59.4% for the year ended December 31, 2004 due to
increased sales of our higher margin products. We expect that our gross profit
as a percentage of net sales will continue to fluctuate in the future as a
result of the stages of our products in their life cycles, variations in our
product mix, the timing of our product introductions and specific product
manufacturing costs.
Research and Development Expenses. Research and development expenses
consist primarily of salaries and related costs of employees engaged in
research, design and development activities and, to a lesser extent, expenses
for outside engineering consultants. Research and development expenses for the
year ended December 31, 2005 were $25.4 million, an increase of $5.1 million or
25.5% from $20.3 million for the year ended December 31, 2004. This increase
reflected the increased hiring of design engineers resulting from our increased
operations and increased consultancy fees paid to outside consultants in respect
of certain research and development projects. As a percentage of net sales,
research and development expenses were 24.1% for the year ended December 31,
2005, an increase from 22.0% for the year ended December 31, 2004. Research and
development expenses as a percentage of net sales will fluctuate from quarter to
quarter depending on the amount of net sales and the success of new product
development efforts, which we view as critical to our future growth. At any
point in time, we have many research and development projects underway, and we
believe that none of these projects is material on an individual basis. We
expect to continue the development of innovative technologies and processes for
new products and we believe that a continued commitment to research and
development is essential in order to maintain the competitiveness of our
existing products and to provide innovative new product offerings. Therefore, we
expect to continue to invest significant resources into research and development
in the future.
34
Selling, General and Administrative Expenses. Selling, general and
administrative expenses consist primarily of employee-related expenses, sales
commissions to agents, professional fees, legal fees, travel and other
promotional expenses. Selling, general and administrative expenses for the year
ended December 31, 2005 were $20.3 million, an increase of $4.0 million or 24.1%
from $16.3 million for the year ended December 31, 2004. This increase was
primarily due to additional hiring of sales, operations and administrative
personnel, increased sales commissions relating to higher sales and increased
professional fees to external auditors. As a percentage of net sales, selling,
general and administrative expenses were 19.2% for the year ended December 31,
2005, an increase from 17.7% for the year ended December 31, 2004. We expect
that selling, general and administrative expenses will continue to increase in
absolute dollars for the foreseeable future.
Patent Litigation Expenses. Patent litigation expenses consist primarily
of fees paid to outside counsel and consultants engaged by outside counsel.
Patent litigation expenses for the year ended December 31, 2005 were $10.2
million, an increase of $4.9 million or 90.7% from $5.3 million for the year
ended December 31, 2004. This increase in absolute dollars was primarily due to
the MPS trial commencing in June 2005, Taiwan Sumida trial in November 2005,
increased litigation activity in other litigation matters and filing of
additional litigation by us. As a percentage of net sales, patent litigation
expenses were 9.6% for the year ended December 31, 2005, an increase from 5.8%
for the year ended December 31, 2004. We expect that patent litigation expenses
will continue to fluctuate for the foreseeable future. (Please see also,
"Business Overview - Intellectual Property.")
Non-operating Income-net. Non-operating income-net reflects primarily
interest earned on cash and cash equivalents and short-term investments, Stock
Exchange listing expenses, foreign exchange transaction gains and losses and the
gain on sales of long-term investments and cash dividend received on investment
in shares of stock. Non-operating income-net was $244,000 for the year ended
December 31, 2005 decreasing from $2.7 million for the year ended December 31,
2004, reflecting expenses of $2.5 million for the Hong Kong Stock Exchange
listing and a foreign exchange loss of $443,000 offset by more interest earned
on our cash and cash equivalents and short term investments.
Income Tax Expenses. Income tax expenses were approximately $1.0 million
for the year ended December 31, 2005, compared to $1.5 million for the year
ended December 31, 2004. This decrease was primarily due to an accrual of
approximately $658,000 for Taiwan income tax due on imported products as of
December 31, 2004, which was reversed and applied as a credit on our income tax
due in the year ended December 31, 2005, and a decrease in our income before
income tax as a result of an accrual for Stock Exchange listing expenses of $2.5
million in December 2005. The accrual and reversal related to our application on
May 24, 2004 to the Taiwan Customs Authority for the rectification of the value
of the imported goods reported for the period from March 2003 to March 2004. We
had mistakenly reported a lower amount to the Taiwan Customs Authority than the
correct amount that was reported on our tax return for the years ended December
31, 2003 and 2004. However, a rectification of the Taiwan Customs Authority's
records usually cannot be made after six months have elapsed, in which case the
understated cost of the imported goods reported to the customs officials would
have been deemed to be the actual cost, and thus the taxable income for the
years ended December 31, 2003 and 2004 would have been higher. We therefore
accrued the provision for income tax of $658,000 based on our estimate of the
most probable impact on income tax as at December 31, 2004. As we have addressed
the design flaw in the customized report that was submitted to the Taiwan
Customs Authority, we have confirmed that there was no need to make a similar
accrual for Taiwan income tax in 2005. Adding back the Stock Exchange listing
expenses of $2.5 million to our income before income tax and excluding the
impact of the reversal of approximately $658,000 on our income tax expenses, our
effective income tax rate for 2005 would have been 14.5%. Our effective tax rate
was 11.3% for the year ended December 31, 2005, compared to 9.5% for the year
ended December 31, 2004.
35
Years Ended December 31, 2004 and 2003
Net Sales. Net sales for the year ended December 31, 2004 were $92.2
million, an increase of $3.6 million or 4.1% from $88.6 million for the year
ended December 31, 2003. This increase in net sales resulted from increased unit
shipments of our existing products as well as shipments of new products and
expansion of our customer base and the number of intermediaries we supply to. In
2004, we introduced new Cardbus and CCFL inverter controller products. We also
enhanced the features of certain products in every existing product group in
2004 (except for Audio DJ products).
Gross Profit. Gross profit for the year ended December 31, 2004 was $54.8
million, an increase of $4.5 million or 9.0% from $50.3 million for the year
ended December 31, 2003. This increase in absolute dollars was due to increased
sales. Gross profit as a percentage of net sales for the year ended December 31,
2004 increased to 59.4% from 56.8% for the year ended December 31, 2003 due to
increased sales of higher margin products.
Research and Development Expenses. Research and development expenses for
the year ended December 31, 2004 were $20.3 million, an increase of $1.1 million
or 5.4% from $19.2 million for the year ended December 31, 2003. This increase
primarily reflected the addition of research and development personnel. As a
percentage of net sales, research and development expenses were 22.0% for the
year ended December 31, 2004, an increase from 21.7% for the year ended December
31, 2003.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses for the year ended December 31, 2004 were $16.3 million,
an increase of $2.8 million or 20.9% from $13.5 million for the year ended
December 31, 2003. This increase in absolute dollars was primarily due to hiring
of additional personnel, additional traveling and sales and marketing expenses.
As a percentage of net sales, selling, general and administrative expenses were
17.7% for the year ended December 31, 2004, an increase from 15.3% for the year
ended December 31, 2003.
Patent Litigation Expenses. Patent litigation expenses for the year ended
December 31, 2004 were $5.3 million, an increase of $1.3 million or 34.9% from
$4.0 million for the year ended December 31, 2003. This increase in absolute
dollars was primarily due to increased litigation activity in existing cases and
filing of additional litigation by us. As a percentage of net sales, patent
litigation expenses were 5.8% for the year ended December 31, 2004, an increase
from 4.4% for the year ended December 31, 2003.
Non-operating Income-net. Non-operating income-net was $2.7 million for
the year ended December 31, 2004 increasing from $1.4 million for the year ended
December 31, 2003, reflecting additional foreign exchange transaction gains and
gains on sales of long-term investments.
Income Taxes. Income tax expenses were $1.5 million for the year ended
December 31, 2004, compared to US$1.8 million for the year ended December 31,
2003. Taxation expenses were reduced in 2004 as we reversed an income tax
expense of approximately $375,000 in the third quarter of 2004. We had
recognized a provision for income taxes that would have resulted from a
successful challenge by the Taiwan Tax Authorities on the allocation of our head
office's administrative expenses in previous years. In August 2004, the Taiwan
Tax Authorities examined and approved our income tax filing for 2000 and did not
raise any concerns on the allocation of administrative expenses. Therefore, we
reversed the provision of income tax expenses of approximately $375,000 for 2000
in respect of the impact on the potential challenge from the Taiwan Tax
Authorities. Excluding the impact of the reversal of approximately US$375,000 on
our income tax expenses, our effective income tax rate for 2004 would have been
11.9%. Our effective tax rate was 9.5% for the year ended December 31, 2004,
compared to 12.2% for the year ended December 31, 2003.
36
Liquidity and Capital Resources
Since our inception, we have financed our operations primarily through
private sales of securities and through our initial public offering in August
2000 and our public offering in November 2001 as well as cash provided by
operating activities in recent years. Cash and short-term investments were
$102.0 million at December 31, 2005 as compared to $120.1 million at December
31, 2004. Our operating activities provided cash in the amount of $11.0 million
in the year ended December 31, 2005, $14.1 million in the year ended December
31, 2004 and $14.8 million in the year ended December 31, 2003. In April 2006,
we purchased 29,935 square feet of land in Hsin-Chu, Taiwan for a future
facility. The purchase price was approximately $8.7 million.
Non-cash charges consist of depreciation of fixed assets, impairment of
investment in shares of stock, changes of deferred income tax assets and
amortization of stock-based compensation from stock options and warrants. The
working capital components that have a significant impact on our cash flows are
accounts receivable, inventory, notes, accounts payable, prepaid expenses and
other current assets, income tax payable and accrued liabilities.
These net cash inflows for operations resulted from net income offset by
increases in inventory and accounts receivable due to increased sales and also
resulted from increases in notes and accounts payable, income tax payable and
accrued liabilities.
In 2005, we had a net cash outflow from investing activities of $19.3
million as compared to a net cash outflow of $25.2 million in 2004. This
decrease in net cash used in investing activities between 2004 and 2005 was
principally due to a net sale of $6.6 million in short-term investments in 2005
as compared to a net purchase of $11.0 million in 2004 and a decrease of
$306,000 in restricted assets in 2005 as compared to an increase of $1.9 million
in 2004. This decrease was partially offset by an increase of $5.8 million in
the net purchase of long-term investments, an increase of $14.9 million in the
purchase of fixed assets and an increase of $5.5 million in restricted cash and
other assets in 2005. The increase in restricted cash and other assets was
mainly due to an increase in time deposits pledged to a bank for the issuance of
letters of credit to purchase certain testing equipment and an increase in the
amount of court bonds deposited with the Taiwan courts for preliminary
injunctions and provisional attachments.
In 2004, we had a net cash outflow from investing activities of $25.2
million as compared to a net cash outflow of $23.5 million in 2003. This
increase in net cash used between 2003 and 2004 was principally due to an
increase of $8.4 million in the purchase of fixed assets and an increase of
$14.9 million in the net purchase of short-term and long-term investments, which
was partially offset by a smaller increase of $1.9 million in restricted assets
in 2004 as compared to an increase of $10.0 million in 2003.
Net cash inflow from our financing activities in 2003 was $5.9 million,
principally due to the to exercise of stock options and issuance of shares under
our Employee Stock Purchase Plan, which was partially offset by the repurchase
of our shares under a share repurchase program. Net cash inflow from our
financing activities in 2004 was $0.9 million, primarily due to the exercise of
stock options and issuance of shares under our Employee Stock Purchase Plan,
which was partially offset by the repurchase of our shares under a share
repurchase program. Net cash outflow from our financing activities in 2005 was
$2.1 million, primarily due to the repurchase of our shares and ADSs under a
share repurchase program, which was partially offset by proceeds from the
exercise of stock options and warrants and issuance of shares under our Employee
Stock Purchase Plan. The listing of our ordinary shares on the Main Board of the
Stock Exchange of Hong Kong Limited may or may not enhance our ability to obtain
additional financing in the future.
We believe our cash balances will be sufficient to meet our capital
requirements for at least the next 12 months. Our future capital requirements
will depend on many factors, including the inventory levels we maintain, the
level of investments we make in new technology and improvements to existing
technology, the levels of promotion and advertising required to launch new
products and attain a competitive position in the marketplace, and the market
acceptance of our products. Thereafter, we may need to raise additional funds
through public or private financing. No assurance can be given that additional
funds will be available or that we can obtain additional funds on terms
favorable to us.
37
Research and Development, Patents and Licenses, etc.
We believe that the continued introduction of new products in our target
markets is essential to our growth. As of December 31, 2005, we had
approximately 420 full-time employees world-wide engaged in research and
development efforts. Our total expenditures for research and development were
$25.4 million for the year ended December 31, 2005, $20.3 million for the year
ended December 31, 2004 and $19.2 million for the year ended December 31, 2003.
We believe that our research and development staffing will increase in the next
12 months primarily due to the expansion of our existing design centers and the
opening of additional design centers. We intend to continue to expand our
research and development operations, including increasing the number of design
engineers.
We employ designers who are experienced in system architecture, analog,
digital, mixed signal and software design and development. We also utilize
independent contractors from time-to-time for specific research and development
projects. Our internal research and development personnel thoroughly review the
external development processes and the design of these products as part of our
quality assurance process. All development is carried out using ISO 9001
certified design processes, and our design tools are continuously enhanced to
improve design, fabrication and verification of our products.
Our research and development activities are a constantly evolving process
which reflects the results on our ongoing projects, our expectations regarding
market developments and changes in customer demand and industry specifications.
We commence new projects or alter the scope or direction of existing projects on
a regular basis under the guidance of our management and senior research
personnel.
We work with our customers to monitor the performance of our product
designs and to provide support at each stage of customer product development.
Due to the complexity of our products, we maintain a significant direct
applications support staff for customer technical support in our key markets
including in Japan, Taiwan, China, Korea and the United States. These direct
applications engineering personnel assist with supporting existing products at
key customers. Additionally, we work closely with our customers to develop
highly efficient power management products for specific applications.
Trend Information
See "Risk Factors" and "Operating and Financial Review and Prospects"
above.
Off-Balance Sheet Arrangements
There are no off-balance sheet arrangements that have or are reasonably
likely to have a current or future effect on our financial condition, changes in
financial condition, revenues or expenses, results of operations, liquidity,
capital expenditures or capital resources that is material to investors.
38
Tabular Disclosure of Contractual Obligations
The table below describes our contractual obligations as of December 31,
2005:
Payments due by period
--------------------------------------------------------
Total Less than 1-3 years 3-5 years More than
Contractual Obligations 1 year 5 years
------- --------- --------- --------- ---------
(in thousands)
Operating Lease Obligations............. $ 1,334 $ 1,009 $ 325 $ -- $ --
Purchase Commitments..................... 486 486 -- -- --
Licenses, Maintenance and Support........ 1,020 279 494 247 --
Total.................................... 2,840 1,774 819 247 --
ITEM 6. DIRECTORS, SENIOR MANAGEMENT AND EMPLOYEES
Directors and Senior Management
Our executive officers and directors and their ages as of December 31,
2005, were as follows:
Name Age Position
---- --- --------
Sterling Du............................ 46 Chief Executive Officer, Class I Director and Chairman of the
Board
Chuan Chiung "Perry" Kuo............... 46 Chief Financial Officer, Joint Secretary and Class I Director
James Keim............................. 61 Class II Director and Head of Marketing and Sales
Michael Austin......................... 70 Independent Non-executive Director, Class III Director and
member of Compensation Committee
Geok Ling Goh.......................... 64 Independent Non-executive Director, Class I Director and member
of Audit Committee
Lawrence Lin........................... 55 Independent Non-executive Director, Class II Director and member
of Audit Committee and Compensation Committee
Keisuke Yawata......................... 71 Independent Non-executive Director, Class III Director and
member of Audit Committee
Xiaolang Yan........................... 59 Independent Non-executive Director and Class III Director
Ivan Chang............................. 43 Vice-President, Finance
Johnny Chiang.......................... 48 Vice-President, Logistics and Backend
Jane Liang............................. 37 Qualified Accountant
Our Class I Directors have held office from the date of the annual general
meeting in 2005 for a three year term until 2008; our Class II Directors are
currently holding office and have been nominated for re-election at the annual
general meeting that will be held in June 2006 and if re-elected will hold
office for a three year term until 2009; and our Class III Directors have held
office from the date of the annual general meeting held in 2004 for a three year
term until 2007.
Executive Directors
Sterling Du has served as our chief executive officer and chairman of our
board of directors since March 1997 and as a Class I Director since June 2001.
He also served as our chief financial officer from March 1997 to March 1999.
From May 1995 to March 1997, Mr. Du was president and chief executive officer of
O2Micro, Inc., our predecessor entity. From October 1993 to April 1995, Mr. Du
was vice president of engineering at GreenLogic, Inc., a semiconductor design
company, which he co-founded. Mr. Du received a B.S. in chemical engineering
from National Taiwan University and an M.S. in electrical engineering from the
University of California, Santa Barbara.
Chuan Chiung "Perry" Kuo has served as our general manager of Taiwan
operations since January 1997, as chief financial officer and a director since
March 1999, as secretary since October 1999 and as a Class I director since June
2001. From February 1992 to December 1996, he was executive vice president of
Pac Net Group, a holding company with investments in chemicals, electronics and
real estate. From July 1983 to February 1992, he held various positions at
Formosan Rubber Group, a rubber manufacturer, including product design engineer,
plant manager, research and development director, and vice president. Mr. Kuo
received a B.S. in chemical engineering from National Taiwan University and an
M.B.A. from the Rotterdam School of Management, Erasmus University in The
Netherlands.
39
James Keim has served as a director since March 1999 and as Head of
Marketing and Sales since December 2001 and a Class II director since June 2001.
He also served as our chief operating officer from June 1998 to June 2001. From
March 1995 to June 1998, Mr. Keim was a principal in Global Marketing
Associates, an international consulting firm. Prior to March 1995, he had been
vice president of sales at Alliance Semiconductor Corporation, vice president of
marketing at Performance Semiconductor Corporation and worldwide linear
marketing manager at Fairchild Semiconductor Corporation. Mr. Keim received a
B.S. in engineering from Iowa State University, an M.S. in electrical
engineering and an M.B.A. from the University of Illinois.
Independent Non-Executive Directors
Michael Austin has served as a director since October 1997 and as a Class
III director since June 2001. Mr. Austin is a resident of the Cayman Islands and
is a Chartered Accountant. Mr. Austin was admitted as an Associate of the
Institute of Chartered Accountants in England and Wales in 1964 and as a Fellow
in 1969. Mr. Austin is also an Associate Member of The Chartered Institute of
Taxation, a Member of the Society of Trust and Estate Practitioners, and a
Notary Public of the Cayman Islands. Mr. Austin served as the managing partner
of the Cayman Islands office of KPMG Peat Marwick, an international accounting
firm, for 23 years. Since retiring in July 1992, Mr. Austin has been a
consultant and currently serves as a non-executive director on several company
boards, including those of a number of mutual funds, trust and insurance
companies. He serves as a director of Scottish Re, a public company. Mr. Austin
served as a director of the Cayman Islands Monetary Authority from January 1997,
and was appointed Chairman of the Board in January 2003, a position he held
until his retirement on July 31, 2004. He has also served on a variety of other
government committees and government related boards, including the Cayman
Islands Agricultural and Industrial Development Board, as Chairman; the Stock
Exchange Committee; and the Government/Private Sector Consultative Committee. In
1990 Mr. Austin was awarded an M.B.E. by Her Majesty the Queen in recognition of
services to the public and business community.
Geok Ling Goh has served as a director since January 2000, as a member of
the Audit Committee since August 2000 and as a Class I director since June 2001.
From October 1998 to October 1999, he was the managing director of Micron
Semiconductor Asia Pte Ltd. From June 1970 to October 1998, he held various
positions at Texas Instruments Singapore Pte Ltd, including Vice-President of
Marketing and in 1993, the first local managing director of Texas Instruments
Singapore Pte Ltd. He serves as a director on the boards of Sembcorp Industries
Ltd., Venture Corporation Ltd., DBS Group Holdings Ltd. and DBS Bank Ltd. He is
also the chairman of Sembcorp Marine Ltd. and serves as a trustee of Nanyang
Technology University. He received a bachelor of engineering degree from Sydney
University.
Lawrence Lin has served as a Class II Director, a member of the audit
committee and chairman of the Compensation Committee since June 2003. He is a
Certified Public Accountant in Taiwan. Since 1990, Mr. Lin has been a partner of
L&C Company, Certified Public Accountants, which is a member firm of Urbach
Hacker Young International, and a director of Urbach Hacker Young International
from October 1994 to October 1998. Prior to L&C Company, he was a partner at T N
Soong & Co. Mr. Lin serves as an Independent Director and Corporate Supervisor
for two Taiwan public companies, Yageo Corporation and Tex Year Industries Inc.,
respectively. He graduated from Taipei Vocational Commercial School in 1969.
Keisuke Yawata has served as a director since October 1999, as a member of
the Audit Committee since August 2000 and as a Class III director since June
2001. Mr. Yawata has been a partner and director of Start-up101, a venture
capital firm, since 1999 and is the Chief Executive Officer of The Future
International, a consulting firm he founded in 1997. From 1995 to 1997, he was
the president and chief executive officer of Applied Materials Japan and a
senior vice president of Applied Materials, Inc. From 1985 to 1994, he was at
LSI Logic KK, serving as president and chief executive officer from 1985 to
1992, and as chairman of the board from 1993 to 1994. From 1958 to 1984, he was
employed by NEC Corporation and its subsidiaries where he held various
positions, the last position being president and chief executive officer of NEC
Electronics, Inc. from 1981 to 1984. In addition, Mr. Yawata was a vice
president of the Semiconductor Industry Association Japan Chapter from 1989 to
1994. Mr. Yawata serves as a director on the boards of U10 Networks, DigiPub
Japan, Sequence Design KK and NanoGeometry Research. He received a B.S. in
electrical engineering from Osaka University in Osaka, Japan and an M.S. in
electrical engineering from Syracuse University.
40
Xiaolang Yan has served as a Class III Director since July 2005. Mr.
Yan is a professor and Dean of the Electrical Engineering College, Dean of the
Information Science & Engineering College and Director of Institute of VLSI
Design at Zhejiang University in China. He is also the Director of China's
National Integrated Circuit Talent Education Program and the Director of the
Strategic Expert Committee for VLSI Design of the China State High Technology
Program (863 Program). From May 1994 to March 1999, he was Professor and Dean of
Hangzhou Institute of Electronic Engineering and Director of its ICCAD Research
Institute. From September 1993 to May 1994, he was a visiting scholar at
Stanford University. From March 1990 to September 1993, he was Executive
Vice-President and Chief Engineer at Beijing IC Design Center in Beijing, China.
Mr. Yan received his bachelor of science and master of science degrees in
electrical engineering from Zhejiang University in Hangzhou, China.
Senior Management
Ivan Chang has served as our Vice-President, Finance since February 2003.
He also served as our Controller from July 1999 until February 2003. From August
1996 to July 1999, he was Finance Manager at Siemens Limited in Taiwan. Mr.
Chang received a B.S. in Accounting from Soochow University and an M.S. in
Accounting Information from University of Maryland, College Park.
Johnny Chiang has served as our Vice-President, Logistics and Backend
since February 2003. He also served as our Director of Operations from March
1999 to February 2003 and our Operations Manager from November 1997 to March
1999. Mr. Chiang received a B.S. in Industrial Engineering from Chung Yung
University.
Jane Liang has served as our Qualified Accountant since November 2005. She
is a fellow of the Association of Chartered Certified Accountants and a member
of the Chinese Institute of Certified Public Accountants. From July 2000 to
October 2003, she was senior finance manager at Bausch & Lomb (Shanghai) Trading
Co. From August 1999 to June 2000, she was an accounting supervisor at Exxon
Chemical (Shanghai) Trading Co. Ms. Liang received her bachelors and masters
degree in Philosophy from Fudan University.
There are no family relationships among any of our directors or executive
officers. There are no arrangements or understandings with major shareholders,
customers, suppliers or others, pursuant to which any person referred to above
was selected as a director or member of senior management.
Compensation
We paid an aggregate amount of compensation during 2005 to our directors
and members of our administrative, supervisory or management bodies as a group
equal to approximately $2,424,000. All of our officers and directors are
eligible to participate in our employee benefit plans except non-employee
directors are not eligible to participate in our ESPP plan.
41
Share Ownership of Directors and Senior Management
As of March 31, 2006, the aggregate number of ordinary shares
beneficially owned by our directors and members of our administrative,
supervisory or management bodies was 264,487,300. This number includes options
to purchase an aggregate of 104,100,400 ordinary shares under our 1997 Stock
Plan and 1999 Stock Plan exerciseable within 60 days of March 31, 2006.
Employee Benefit Plans
1997 Stock Plan. Our 1997 stock plan was adopted by our board of directors
and approved by our shareholders in 1997. The 1997 stock plan provides for the
granting to our employees of incentive stock options within the meaning of
Section 422 of the United States Internal Revenue Code, and for the granting to
employees and independent contractors of nonstatutory stock options and stock
purchase rights. Our board of directors and our shareholders authorized a total
of 3,700,000 ordinary shares for issuance pursuant to the 1997 stock plan, as
amended or 185,000,000 ordinary shares after taking into account the 50-to-1
stock split on November 25, 2005. As of December 31, 2005, options outstanding
and exercisable under the 1997 stock plan were 21,408,700. No more grants have
been made under this plan after the consummation of our initial public offering
on August 23, 2000. Our 1997 stock plan was terminated effective on March 2,
2006, the date of the listing of our ordinary shares on the Hong Kong Stock
Exchange; provided that options granted under the plan remain outstanding in
accordance with their terms.
1999 Stock Incentive Plan. Our 1999 stock plan was adopted by our board of
directors in October 1999 and was approved by our shareholders prior to the
consummation of our initial public offering in August 2000. The 1999 stock plan
provides for the granting to employees of incentive stock options within the
meaning of Section 422 of the Internal Revenue Code and the granting of
nonstatutory stock options, stock appreciation rights, dividend equivalent
rights, restricted stock, performance units, performance shares and other
equity-based rights to our employees, directors and consultants. Initially, we
have reserved 3,000,000 ordinary shares for issuance under the 1999 stock plan
or 150,000,000 ordinary shares after taking into account the 50-to-1 stock split
on November 25, 2005. Commencing January 1, 2001, the number of ordinary shares
of stock reserved for issuance under the 1999 stock plan will be increased
annually by a number equal to 4% of the fully-diluted number of ordinary shares
outstanding as of December 31 of the immediately preceding calendar year or a
lesser number determined by the administrator. However, the maximum number of
ordinary shares available for issuance as incentive stock options will be
increased by the least of 4% of the fully-diluted number of ordinary shares
outstanding on December 31 of the immediately preceding calendar year, 1,500,000
ordinary shares (or 75,000,000 ordinary shares after taking into account the
50-to-1 stock split on November 25, 2005) or a smaller number as determined by
the administrator. In the year ended December 31, 2005, the number of shares
reserved under the 1999 stock plan was not increased. Where an award agreement
permits the exercise or purchase of the award for a specified period of time
following the recipient's termination of service with us, or the recipient's
disability or death, the award will terminate to the extent not exercised or
purchased on the last day of the specified period or the last day of the
original term of the award, whichever occurs first. As of December 31, 2005,
options outstanding under the 1999 stock plan were 289,075,650, of which
203,810,500 were exercisable. Our 1999 stock plan was terminated effective on
March 2, 2006, the date of the listing of our ordinary shares on the Hong Kong
Stock Exchange; provided that options granted under the plan remain outstanding
in accordance with their terms.
1999 Employee Stock Purchase Plan. Our 1999 purchase plan was approved by
our board of directors in October 1999, was approved by our shareholders prior
to the consummation of our initial public offering in August 2000 and is
intended to qualify as an "employee stock purchase plan" under Section 423 of
the Internal Revenue Code and to provide our employees with an opportunity to
purchase ordinary shares or ADSs through payroll deductions. In May 2005, our
board of directors adopted certain amendments to the 1999 purchase plan and in
October 2005 our board of directors adopted and approved an amendment and
restatement of 1999 purchase plan to amend various administrative terms in
anticipation of our listing on the Hong Kong Stock exchange. We have reserved
50,000,000 ordinary shares for issuance under our 1999 purchase plan, subject to
adjustment upon certain changes in our capitalization. The number of ordinary
shares which shall be made available for sale under the 1999 purchase plan, any
share options granted pursuant to our 2005 share option plan and any other plan
(but not including our 2005 share incentive plan) will not exceed 10% of the
number of ordinary shares to be issued and outstanding immediately following the
listing of our ordinary shares on the Hong Kong Stock Exchange. In no event may
an option be granted under our 1999 purchase plan if such grant would result in
the total aggregate number of ordinary shares subject to all then outstanding
purchase rights granted by us pursuant to our 1999 purchase plan, any share
option granted pursuant to our 2005 share option plan or any other plan (but not
including our 2005 share incentive plan) to exceed 30% of the issued and
outstanding ordinary shares from time to time. As of December 31, 2005,
27,168,000 shares had been issued under the 1999 purchase plan.
42
Our board of directors or a committee designated by our board of
directors, referred to as the "plan administrator", administers our 1999
purchase plan. All of our employee who are regularly employed for more than five
months in any calendar year and work more than 20 hours per week are eligible to
participate in our 1999 purchase plan, subject to a 10 day waiting period after
hiring. Non-employee directors, consultants and employees subject to the rules
or laws of a non-U.S. jurisdiction that prohibit or make impractical their
participation in the plan will not be eligible to participate.Our 1999 purchase
plan designates offer periods, purchase periods and exercise dates. Offer
periods are periods of three months commencing on each February 1, May 1, August
1 and November 1. Purchase periods will generally be three month periods.
Exercise dates are the last day of each purchase period. In the event of a
corporate transaction, the plan administrator may elect to shorten the offer
periods then in progress and set a new exercise date for the purchase of
ordinary shares or ADSs.
On the first day of each offer period, a participating employee will be
granted a purchase right. A purchase right is a form of option to be
automatically exercised on the forthcoming exercise dates within the offer
period during which authorized deductions are to be made from the pay of
participants and credited to their accounts under our 1999 purchase plan. When
the purchase right is exercised, the participant's withheld salary is used to
purchase the ordinary shares or ADSs. The price per share at which the ordinary
shares or ADSs are to be purchased under our 1999 purchase plan during any
purchase period will be expressed as a percentage not less than the lower of (a)
90% of the fair market value of the ordinary shares or ADSs on the date of grant
of the purchase right (which is the commencement of the offer period) or (b) 90%
of the fair market value of the ordinary shares or ADSs on the date the purchase
right is exercised. Purchase rights may not be assigned, transferred, pledged or
otherwise disposed of in any way by the participant, other than by will or the
laws of descent and distribution.
Payroll deductions may range from 1% to 10% in whole percentage increments
of a participant's regular base pay. The maximum number of ordinary shares or
ADSs that any employee may purchase under our 1999 purchase plan during a
purchase period is 100,000 ordinary shares or 2,000 ADSs. In addition, Section
423 of the U.S. Internal Revenue Code imposes a US$25,000 limit on the maximum
amount of ordinary shares or ADSs that may be purchased under a tax-qualified
employee stock purchase plan during any calendar year. The US$25,000 limit is
determined at the fair market value of the ordinary shares or ADSs at the time
such option is granted for each calendar year in which such option is
outstanding.
The plan administrator has the authority to amend or terminate our 1999
purchase plan. The plan administrator may terminate any offer period on any
exercise date if the plan administrator determines that the termination of the
offer period is in the best interests of our company and its shareholders.
2005 Share Option Plan. Our 2005 share option plan was adopted by our
board of directors in August 2005, was approved by our shareholders in November
2005 and took effect on March 2, 2006. The 2005 share option plan provides for
the granting to employees of incentive stock options within the meaning of
Section 422 of the Internal Revenue Code and the granting of nonstatutory stock
options to our employees, directors and consultants. Initially, the maximum
aggregate number of shares reserved for issuance pursuant to all options
(including incentive stock options) under the 2005 share option plan is
100,000,000 ordinary shares after taking into account the 50-to-1 stock split on
November 25, 2005 and such number of shares shall not, when added to the
remaining number of ordinary shares available for the grant of options under any
other plan or employee share purchase plan, be greater than 10% of the number of
ordinary shares outstanding as of the date of adoption of the 2005 share option
plan. The maximum number of shares that may be issued upon exercise of all
outstanding (and unexercised) options under the 2005 share option plan and any
other plan of ours and any purchase rights granted by us pursuant to any
employee share repurchase plan must not, in aggregate, exceed 30% of the number
of ordinary shares outstanding from time to time. Where an award agreement
permits the exercise or purchase of the award for a specified period of time
following the recipient's termination of service with us, or the recipient's
disability or death, the award will terminate to the extent not exercised or
purchased on the last day of the specified period or the last day of the
original term of the award, whichever occurs first. As of December 31, 2005, no
options were outstanding under the 2005 share option plan.
43
2005 Share Incentive Plan. Our 2005 share incentive plan was adopted by
our board of directors in August 2005, was approved by our shareholders in
November 2005 and took effect on March 2, 2006. The 2005 share incentive plan
provides for the granting to our employees, directors and consultants of
restricted shares, cash dividend equivalent rights, restricted share units or
stock appreciation rights or similar right with a fixed or variable price
related to the fair market value of our ordinary shares and with an exercise or
conversion privilege related to the passage of time, the occurrence of one or
more events, or the satisfaction of performance criteria or other conditions.
Initially, the maximum aggregate number of shares which may be issued pursuant
the 2005 share incentive plan is 75,000,000 ordinary shares after taking into
account the 50-to-1 stock split on November 25, 2005. In addition, a right
entitling a grantee to compensation measured by dividends paid with respect to
ordinary shares shall be payable solely in cash and shall not be deemed to
reduce the maximum aggregate number of shares which may be issued under our 2005
share incentive plan. Where an award agreement permits the exercise or purchase
of the award for a specified period of time following the recipient's
termination of service with us, or the recipient's disability or death, the
award will terminate to the extent not exercised or purchased on the last day of
the specified period or the last day of the original term of the award,
whichever occurs first. As of December 31, 2005, no shares were outstanding
under the 2005 share incentive plan.
Board Practices
Duties of Directors
Under Cayman Islands law, our directors have a duty of loyalty to act
honestly in good faith with a view to promoting our best interests. Our
directors also have a duty of care to exercise the care, diligence and skills
that a reasonably prudent person would exercise in comparable circumstances. In
fulfilling their duty of care to us, our directors must ensure compliance with
our memorandum and articles of association and the class rights vested under our
memorandum and articles of association in the holders of the shares.
Terms of Directors and Officers
Our articles of association provide for not less than five nor more than
nine directors although the holders of a majority of our shares may increase or
reduce such limits. Our articles of association provide for our board of
directors to be divided into three classes, designated Class I, Class II and
Class III, with each class consisting of an equal number of directors or as
nearly equal in number as the then total number of directors permits. The
directors of each class have been elected for terms of three years ending in
consecutive years. At each annual general meeting, successors to the class of
directors whose terms expire at that annual general meeting are elected for new
three year terms. If the number of directors is changed, any increase or
decrease is apportioned among the classes so as to maintain the number of
directors in each class as nearly equal as possible and any additional directors
of any class elected to fill a vacancy resulting from an increase in such class
shall hold office for a term that shall coincide with the remaining term of that
class, but in no case will a decrease in the number of directors shorten the
term of any incumbent directors. The term of executive officers is determined by
our board of directors. There are no provisions of Cayman Islands law which
require the term of executive officers to be for a particular period.
44
Our board of directors has the power at any time and from time to time to
appoint any person to be a director, either to fill a casual vacancy or as an
additional to the existing directors provided that the appointment does not
cause the number of directors to exceed any number fixed by or in accordance
with the articles of association as a maximum number of directors. Any director
so appointed shall hold office only until one next annual general meeting and is
then eligible for re-election at that meeting.
Our shareholders may by special resolution remove any directors before the
expiration of his period of office notwithstanding anything in the articles of
association or in any agreement we have entered into with such director (but
without prejudice to any claim for damages under any such agreement).
There is no shareholding qualification for directors nor is there any
specified age limit for directors.
Committees of the Board of Directors
We have an audit committee and a compensation committee. Each of our audit
committee members qualifies as an "independent" director for purposes of the
rules and regulations of the Nasdaq National Market System. The Audit Committee
is established by the Board primarily for the purpose of overseeing the
accounting and financial reporting processes of the Company and audits of the
financial statements of the Company. The Committee's responsibilities include
(1) the appointment, retention, compensation and oversight of the work of our
independent auditors, and for review of its qualifications, and (2) review of
our system of internal controls. The Committee also maintains procedures for the
receipt, retention and treatment of complaints received by the Company regarding
accounting, internal controls, or auditing matters and for the confidential,
anonymous submission by employees of the company of concerns regarding
accounting or auditing matters. The Audit Committee meets at least four times
per year, and also meets separately with the representatives of management at
least annually. The Audit Committee held five meetings in 2005. Currently,
Messrs. Yawata, Goh and Lin serve on the audit committee.
The compensation committee establishes remuneration levels for our
officers, performs the functions that are provided under our employee benefit
programs and administers our long-term incentive, compensation and equity plans
including our 1999 stock incentive plan, our 1999 employee stock purchase plan,
our 2005 share incentive plan and 2005 share option plan. Currently, Messrs. Lin
and Austin serve on the compensation committee.
Compensation Committee Interlocks and Insider Participation
No member of our compensation committee serves as a member of the board of
directors or the compensation committee of any entity that has one or more
executive officers serving as a member of our board of directors or our
compensation committee.
Employees
As of December 31, 2005, we had 644 full-time employees, 109 of which were
based in the United States, 503 in Asia,29 in Europe and 3 in Cayman Islands.
Our employees are not represented by any collective bargaining agreements, and
we have never experienced a work stoppage. We believe our employee relations are
good.
45
ITEM 7. MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS
MAJOR SHAREHOLDERS
The following table sets forth information known to us with respect to the
beneficial ownership of our ordinary shares, as of March 31, 2006, by each
shareholder known by us to own beneficially more than 5% of our ordinary shares
based on SEC filings as of March 31, 2006.
Shares Beneficially Owned
-------------------------------
Name of Beneficial Owner Number Percent
------------------------ ----------- ---------
Wasatch Advisors, Inc. 342,407,750 17.4%
Fidelity Management & Research Company 249,053,900 12.7%
RS Investment Management LP 200,665,550 10.2%
Capital Research & Management Co. 194,750,000 9.9%
Directors and members of our administrative, supervisory or 264,487,000 12.9%
management bodies
None of the major shareholders listed above have differing voting rights
with respect to the ordinary shares of the Company. We do not know of any
arrangements the operation of which may at a subsequent date result in a change
in control of the Company. To our knowledge, we are not directly or indirectly
owned or controlled by another corporation, by a foreign government or any other
natural or legal person.
RELATED PARTY TRANSACTIONS
Loans
In 2001, James Keim, one of our directors, accepted the assignment of Head
of Marketing and Sales in the Cayman Islands, and moved to the Cayman Islands in
December 2001. In connection with the move and to assist Mr. Keim to purchase a
residence in the Cayman Islands, we entered into a term loan agreement with Mr.
Keim in February 2002, under which we made an interest free, unsecured loan in
the amount of $400,000 to Mr. Keim. The loan is repayable in February 2007. As
of December 31, 2005, approximately $18,000 had been repaid.
In February 2000, we loaned $750,000 to 360o Web Ltd (360o Web). The loan
accrued interest at a rate of USD-LIBOR + 1% and was to be paid semiannually
until the loan was fully repaid or until the loan was converted into up to
2,083,333 shares of Series B preference shares of 360o Web. The conversion price
was $0.36 per share, convertible at any time before February 1, 2005 or before
360o Web offers its shares in an initial public offering. In February 2002, we
made an additional loan of $1.0 million to 360o Web on terms similar to the
February 2000 loan. The February 2002 loan was also convertible, into a maximum
of 1,000,000 Series B2 preference shares of 360o Web at a conversion price of
$1.00 per share. On January 3, 2003, we exercised our option to convert both the
February 2000 and February 2002 loans (aggregate principal of $1,750,000) into
2,083,333 Series B preference shares at $0.36 per share and 1,000,000 Series B2
preference shares at $1.00 per share. After the conversion, we owned a 35.18%
interest in 360(degree) Web. We did not participate in 360(degree) Web's
additional financing rounds during 2003, and our ownership was diluted to 29.33%
as of December 31, 2003. In March 2004, we sold 1,000,000 shares of our stock in
360(degree) Web and recognized a gain of $340,000. In January 2005, we purchased
180,769 Series D preference shares of 360o Web at $1.30 per share. As of
December 31, 2005, we held 19.52% ownership of 360o Web. From time to time, we
may make additional loans to 360o Web on similar terms.
46
ITEM 8. FINANCIAL INFORMATION
CONSOLIDATED STATEMENTS AND OTHER FINANCIAL INFORMATION
Consolidated Financial Statements
Our financial statements set forth in the accompanying index to
Consolidated Financial Statements included in this Annual Report following Part
IV beginning on page F-1 are hereby incorporated in this Annual Report. Our
Consolidated Financial Statements are filed as part of this Annual Report.
DIVIDEND POLICY
We have never declared or paid any cash dividends on our ordinary shares
or other securities and do not anticipate paying cash dividends in the
foreseeable future.
ITEM 9. THE OFFER AND LISTING
ADS AND ORDINARY SHARE PRICES AND RELATED MATTERS
Our ADSs are quoted and traded on the Nasdaq National Market and the
Cayman Islands Stock Exchange. Our ordinary shares are listed on the Stock
Exchange of Hong Kong Limited and the Cayman Islands Stock Exchange.
Ordinary Shares Prior to Close of Trading on November 25, 2005 and ADSs After
Commencement of Trading on November 28, 2005
The following table sets forth for the periods indicated the high and low last
reported sales prices per ordinary share prior to the close of trading on
November 25, 2005 and the high and low last reported sales prices per ADS after
the commencement of trading on November 28, 2005 as furnished by the Nasdaq
National Market.
(a) Annual high and low market prices
High Low
---- ---
January 1, 2001 through December 31, 2001 $24.05 $5.50
January 1, 2002 through December 31, 2002 $25.28 $5.30
January 1, 2003 through December 31, 2003 $25.29 $8.01
January 1, 2004 through December 31, 2004 $24.98 $9.04
January 1, 2005 through December 31, 2005 $17.72 $8.74
(b) Quarterly high and low market prices
First Quarter 2004 $24.98 $14.10
Second Quarter 2004 $18.30 $13.44
Third Quarter 2004 $16.20 $9.04
Fourth Quarter 2004 $13.16 $10.27
First Quarter 2005 $10.95 $8.74
Second Quarter 2005 $14.72 $9.35
Third Quarter 2005 $17.72 $14.10
Fourth Quarter 2005 $15.83 $9.24
First Quarter 2006 $13.55 $9.95
(c) Monthly high and low market prices
December 2005 $11.91 $9.24
January 2006 $12.14 $9.95
February 2006 $12.72 $11.69
March 2006 $13.55 $10.63
April 2006 $10.98 $10.14
May 2006 $10.89 $8.68
47
Ordinary Shares After Commencement of Trading On March 2, 2006
The following table sets forth for the periods indicated the high and low last
reported sales prices per ordinary share in Hong Kong dollars (HK$) as furnished
by the Hong Kong Stock Exchange. Our ordinary shares commenced trading on the
Hong Kong Stock Exchange on March 2, 2006
(a) Monthly high and low market prices
High Low
---- ---
March 2006 HK$2.40 HK$1.73
April 2006 HK$1.70 HK$1.55
May 2006 HK$1.70 HK$1.41
ITEM 10. ADDITIONAL INFORMATION
The following are summaries of material provisions of our memorandum and
articles of association and the Companies Law (2004 Revision). The summary is
qualified in its entirety by reference to our memorandum and articles of
association (see Item 19-Exhibit 1).
Registered Office
The Company has been assigned registration number CR-72204 by the
registrar of companies in the Cayman Islands. The registered office is located
at the offices of M&C Corporate Services Limited, P.O. Box 309, Ugland House,
South Church Street, George Town, Grand Cayman, Cayman Islands. The telephone
number at that location is (345) 949-8066.
Objects and Purposes
Paragraph 3 of the memorandum of association provides that the objects and
purposes of the Company are unlimited and the Company may perform all corporate
activities not prohibited by any law as provided by the Companies Law.
Directors
Article 117 of the articles of association of the Company provides that a
director will not be disqualified by his office from contracting with the
Company notwithstanding such director's interest and that such an interested
director will not be liable to the Company for any profit realized through such
contract or arrangement, provided, the interested director declares such
interest at the earliest meeting of the board. Article 127 provides that
directors' compensation shall from time to time be determined by the Company in
general meeting or by the board in accordance with the articles of association.
Article 136 provides that the directors may exercise all the powers of the
Company to borrow money and to mortgage or charge its undertaking, property and
uncalled capital or any part thereof and to issue debentures, debenture stock
and other securities whether outright or as security for any debt, liability or
obligation of the Company or of any third party.
48
Ordinary Shares
General. The Company's articles of association authorize the issuance of
4,750,000,000 ordinary shares with a par value of US $0.00002. All the
outstanding ordinary shares are fully paid and nonassessable and accordingly no
further capital may be called for by the Company from any holder of the ordinary
shares outstanding. Certificates representing the ordinary shares are issued in
registered form. The ordinary shares are not entitled to any sinking fund or
pre-emptive or redemption rights. Under Cayman Islands Law, non-residents may
freely hold, vote and transfer ordinary shares in the same manner as Cayman
Islands residents, subject to the provisions of the Companies Law and the
articles of association. No Cayman Islands laws or regulations restrict the
export or import of capital or affect the payment of dividends to non-residents
holders of the ordinary shares.
Dividends. The holders of our ordinary shares are entitled to receive the
dividends that are declared by the board of directors. Dividends may be paid
only out of profits, which include net earnings and retained earnings
undistributed in prior years, and out of share premium, a concept analogous to
paid-in-surplus in the United States, subject to a statutory solvency test.
Voting Rights. Each ordinary share is entitled to one vote on all matters
upon which the ordinary shares are entitled to vote, including the election of
directors. Voting at any meeting of shareholders is by show of hands unless a
poll is demanded. A poll may be demanded by the chairman of the meeting or any
shareholder present in person or by proxy, before or on the declaration of the
result of the show of hands.
A quorum required for a meeting of shareholders consists of at least a
number of shareholders present in person or by proxy and entitled to vote
representing the holders of not less than a majority of our issued voting share
capital. Shareholders' meetings are held annually and may be convened by the
board of directors on its own initiative. Advanced notice of at least twenty-one
days in the case of annual general meetings or any meeting at which the passing
of a special resolution is to be considered and fourteen days in all other cases
is required for the convening of shareholders' meetings.
Any ordinary resolution to be made by the shareholders requires the
affirmative vote of a simple majority of the votes attaching to the ordinary
shares and preference shares, if any, cast in a general meeting, while a special
resolution requires the affirmative vote of two-thirds of the votes cast
attaching to the ordinary shares and preference shares, if any. Holders of
ordinary shares, which are currently the only shares, carrying the right to vote
at our general meetings, have the power, among other things, to elect directors,
appoint auditors and make changes in the amount of our authorized share capital.
Material issues that require a special resolution of the shareholders
under the Companies Law include resolutions to alter the memorandum of
association with respect to any objects, powers or other matters specified
therein, any alteration of the articles of association, any reduction of
capital, any change of name, the appointment of an inspector for examining into
the affairs of the company, requiring the company to be wound up by a court, any
voluntary winding up, delegating to creditors the power of appointing
liquidators, making binding arrangements between the company and its creditors,
sanctioning the transfer of the business or property of the company being wound
up to another company whether established in the Cayman Islands or in any other
jurisdiction and sanctioning the re-registration of an ordinary non-resident
company as an exempted company.
Liquidation. If we are to be liquidated, the liquidator may, with the
approval of the shareholders, divide among the shareholders in cash or in kind
the whole or any part of our assets, in a manner proportionate to their
shareholdings, and may vest the whole or any part of those assets in trustees of
those trusts for the benefit of the shareholders that the liquidator, with the
approval of the shareholders, thinks fit, provided that a shareholder may not be
compelled to accept any shares or other assets that would subject that
shareholder to liability.
49
Preference Shares
The articles of association authorizes the issuance of 250,000,000
preference shares with a par value of $0.00002 per share. Pursuant to our
articles of association, the board of directors has the authority, without
further action by the shareholders, to issue preference shares in one or more
series. It also has the authority to fix the designations, powers, preferences,
privileges and relative participating, optional or special rights and the
qualifications, limitations or restrictions of those shares, including dividend
rights, conversion rights, voting rights, terms of redemption and liquidation
preferences, any or all of which may be greater than the rights of the ordinary
shares. The board of directors, without shareholder approval, can issue
preference shares with voting, conversion or other rights that could harm the
voting power and other rights of the holders of ordinary shares. Subject to the
directors' duty of acting in our best interest, preference shares can be issued
quickly with terms calculated to delay or prevent a change in control or make
removal of management more difficult. Additionally, the issuance of preference
shares may have the effect of decreasing the market price of the ordinary
shares, and may harm the voting and other rights of the holders of ordinary
shares. We have confirmed that as long as our ordinary shares or preference
shares are listed on the Stock Exchange of Hong Kong Limited, we will comply
with the listing rules of the Stock Exchange of Hong Kong Limited and any
preference shares issued or to be issued shall carry the same voting rights as
the ordinary shares.
Anti-takeover Effects of Provisions in Our Charter Documents
Provisions in our charter documents could discourage potential acquisition
proposals and could delay or prevent a change in control transaction that our
shareholders favor. These provisions could have the effect of discouraging
others from making tender offers for our shares. As a result, these provisions
may prevent the market price of our ordinary shares from reflecting the effects
of actual or rumored takeover attempts and may prevent shareholders from
reselling their shares at or above the price at which they purchased their
shares. These provisions may also prevent changes in our management that our
shareholders may favor. Our charter documents do not permit shareholders to act
by written consent, do not permit shareholders to call a general meeting and
provide for a classified board of directors, which means shareholders can only
elect, or remove, a limited number of our directors in any given year.
Furthermore, as discussed above, our board of directors have the authority to
issue up to 250,000,000 preference shares in one or more series. Our board of
directors can fix the price, rights, preferences, privileges and restrictions of
such preference shares without any further vote or action by our shareholders.
The issuance of preference shares may delay or prevent a change in control
transaction without further action by our shareholders or make removal of
management more difficult.
Differences in Corporate Law
The Companies Law of the Cayman Islands is modeled after that of England
but does not follow recent United Kingdom statutory enactments and differs from
laws applicable to United States corporations and their shareholders. The
following paragraphs are a summary of the significant differences between the
provisions of the Companies Law applicable to us and the laws applicable to
companies incorporated in the United States and to their shareholders.
Mergers and Similar Arrangements. Cayman Islands law does not provide for
mergers as that expression is understood under United States corporate law.
However, there are statutory provisions that facilitate the reconstruction and
amalgamation of companies, provided that the arrangement in question is approved
by a majority in number of each class of shareholders and creditors with whom
the arrangement is to be made, and who must in addition represent three-fourths
in value of each class of shareholders or creditors, as the case may be, that
are present and voting either in person or by proxy at a meeting or meetings
convened for that purpose. The convening of the meetings and subsequently the
arrangement must be sanctioned by the Grand Court of the Cayman Islands. While a
dissenting shareholder would have the right to express to the court the view
that the transaction ought not to be approved, the court can be expected to
approve the arrangement if it satisfies itself that:
50
o the parties have complied with the statutory provisions regarding
majority vote;
o the shareholders have been fairly represented at the meeting in
question;
o the arrangement is one that a businessman would reasonably approve;
and
o the arrangement is not one that would more properly be sanctioned
under some other provision of the Companies Law.
When a take-over offer is made and accepted by holders of 90% of the
shares within four months, the offeror may, within a two-month period require
the holders of the remaining shares to transfer these shares on the terms of the
offer. An objection can be made to the Grand Court of the Cayman Islands but
this is unlikely to succeed unless there is evidence of fraud, bad faith or
collusion.
If the arrangement and reconstruction is approved, the dissenting
shareholder would have no rights comparable to appraisal rights, which would
otherwise ordinarily be available to dissenting shareholders of United States
corporations, providing rights to receive payment in cash for the judicially
determined value of the shares.
Shareholders' Suits. Maples and Calder has advised us that no significant
or major reported class action or derivative action has been brought in a Cayman
Islands court. In principle, we will normally be the proper plaintiff and a
derivative action may not be brought by a minority shareholder. However, based
on English authorities, which would in all likelihood be of persuasive authority
in the Cayman Islands, exceptions to the foregoing principle apply in
circumstances in which:
o a company is acting or proposing to act illegally or outside of its
powers;
o the act complained of, although not outside of its powers, could be
effected only if authorized by more than a simple majority vote;
o the individual rights of the plaintiff shareholders have been
infringed or are about to be infringed; or
o those who control the company are perpetrating a "fraud on the
minority."
Indemnification
Cayman Islands law does not limit the extent to which a company's articles
of association may provide for indemnification of officers and directors, except
to the extent that a provision may be held by the Cayman Islands courts to be
contrary to public policy, such as to provide indemnification against civil
fraud or the consequences of committing a crime. Our articles of association
provide for indemnification of officers and directors for losses, damages, costs
and expenses incurred in their capacities as such, except if they acted in a
willfully negligent manner or defaulted in any action against them.
Insofar as indemnification for liabilities arising under the Securities
Act may be permitted to our directors, officers or persons controlling us
pursuant to these provisions, we have been informed that, in the opinion of the
Securities and Exchange Commission, this indemnification is against public
policy as expressed in the Securities Act and therefore is unenforceable.
51
Enforceability of Civil Liabilities
We are a Cayman Islands company. We incorporated in the Cayman Islands
because of the following benefits associated with being a Cayman Islands
company:
o political and economic stability;
o an effective judicial system;
o unlike some jurisdictions which impose taxes on worldwide income, no
taxation of companies based upon profits, income, gains or
appreciation;
o the absence of exchange control or currency restrictions; and
o the availability of professional and support services.
However, the Cayman Islands has a less developed body of securities laws
than the United States and provides less protection for investors. For example,
the remedies of shareholders and fiduciary responsibilities of our directors are
governed by Cayman Islands law and are not as clearly established as under
statutes or judicial precedent in existence in jurisdictions in the United
States. While there is some case law in the Cayman Islands on these matters, it
is not as developed as, for example, English law. However, we believe that
English case law, although not binding in the courts of the Cayman Islands,
would be regarded as persuasive. Based on English case law, we believe under
Cayman Islands law, our directors have a duty of loyalty to act honestly in good
faith with a view to promoting our best interests. Our directors also have a
duty of care to exercise the care, diligence and skills that a reasonably
prudent person would exercise in comparable circumstances. In fulfilling their
duty of care to us, our directors must ensure compliance with our memorandum and
articles of association and the class rights vested under our memorandum and
articles of association in the holders of the shares.
A substantial majority of our assets are located outside the United
States. In addition, a majority of our directors and officers are nationals
and/or residents of countries other than the United States, and all or a
substantial portion of our assets and the assets of our directors and officers
are located outside the United States. As a result, it may be difficult to
effect service of process within the United States upon us or our directors and
officers or to enforce against us or against them judgments obtained in United
States courts, including judgments predicated upon the civil liability
provisions of the securities laws of the United States or any state thereof.
Maples and Calder, our counsel as to Cayman Islands law, has advised us
that there is uncertainty regarding whether the courts of the Cayman Islands
would (1) recognize or enforce judgments of United States courts obtained
against us or our officers and directors predicated upon the civil liability
provisions of the securities laws of the United States or any state thereof or
(2) be competent to hear original actions brought in their jurisdiction against
us or our officers and directors predicated upon the securities laws of the
United States or any state thereof.
There is no statutory enforcement in the Cayman Islands of judgments
obtained in the United States. Instead, such a judgment must be enforced by
action at common law. Maples and Calder have advised us that a final and
conclusive judgment in a federal or state court of the United States under which
a sum of money is payable, other than a sum payable in respect of taxes, fines,
penalties or similar charges, may be subject to enforcement proceedings as a
debt in the Courts of the Cayman Islands under the common law doctrine of
obligation.
52
Material Contracts
Other than the contacts listed under Item 19--Exhibits, in the past two
years we have not entered into any material contracts other than contracts
entered into in the ordinary course of business.
Exchange Control
Our articles of association authorizes us to issue an aggregate of
4,750,000,000 ordinary shares with a par value of $0.00002 per share. Of those
4,750,000,000 authorized ordinary shares, 1,967,824,350 shares were issued and
outstanding as of December 31, 2005, all of which are fully paid or credited as
fully paid. We may not call for any further capital from any holder of ordinary
shares outstanding. Under Cayman Islands law, non-residents of the Cayman
Islands may freely hold, vote and transfer ordinary shares in the same manner as
Cayman Islands residents, subject to the provisions of the Companies Law and our
articles of association. No Cayman Islands laws or regulations restrict the
export or import of capital, or affect the payment of dividends to non-resident
holders of ordinary shares.
TAXATION
Cayman Islands Taxation
The Cayman Islands currently levy no taxes on individuals or corporations
based upon profits, income, gains or appreciation and there is no taxation in
the nature of inheritance tax or estate duty. There are no other taxes likely to
be material to us levied by the Government of the Cayman Islands except for
stamp duties that may be applicable on instruments executed in, or after
execution brought within, the jurisdiction of the Cayman Islands. The Cayman
Islands are not party to any double tax treaties. There are no exchange control
regulations or currency restrictions in the Cayman Islands.
No stamp duties are payable on the issue or transfer of shares. An
agreement to transfer shares may be subject to stamp duty if the agreement is
executed in the Cayman Islands or, if executed outside the Cayman Islands,
subsequently brought into the Cayman Islands. The Stamp Duty Law (2005 Revision)
does not provide who is liable to pay stamp duty on any document but, in
practice, the person who seeks to rely on the document in any civil court
proceedings will be required to pay stamp duty in order to have the document
admitted in evidence.
United States Federal Income Taxation
On November 25, 2005, we effected a 50 for 1 share split of all of our
outstanding ordinary shares and implemented an ADS program with respect to all
ordinary shares quoted on the Nasdaq National Market, with each ADS representing
50 ordinary shares. On November 25, 2005, the ordinary shares ceased trading on
the Nasdaq National Market and on November 28, 2005 ADSs commenced trading on
the Nasdaq National Market. Our ordinary shares began trading on the Hong Kong
stock exchange on March 2, 2006.
The following discussion addresses the material United States federal
income tax consequences of the ownership and disposition of ordinary shares or
ADSs held as a capital asset by a "U.S. Investor" (as defined below). This
summary does not provide a complete analysis of all potential tax consequences.
This summary is based on the Internal Revenue Code of 1986, as amended (the
"Code"), final, temporary and proposed Treasury Regulations thereunder, and
administrative and judicial interpretations thereof, all as in effect as of the
date hereof, and all of which are subject to change at any time (possibly on a
retroactive basis) by legislative, judicial or administrative action, and to
differing interpretations. There can be no assurance that the Internal Revenue
Service (the "IRS") will not take a contrary view. This summary does not discuss
state or local tax consequences of the ownership of ordinary shares or ADSs.
53
A "U.S. Investor" means a beneficial owner of ordinary shares or ADSs who
is any of the following:
o a citizen or resident of the United States or someone treated as a
U.S. citizen or resident for U.S. federal income tax purposes;
o a corporation or other entity taxable as a corporation for U.S.
federal income tax purposes created or organized in or under the
laws of the United States or any political subdivision thereof;
o an estate the income of which is subject to U.S. federal income
taxation regardless of its source;
o a trust that is subject to the primary supervision of a court within
the United States and one of more U.S. persons have the authority to
control all of its substantial decisions;
o a trust that has a valid election in effect under applicable U.S.
Treasury regulations to be treated as a U.S. person; or
o a person that is otherwise subject to U.S. federal income taxation
on its net income.
If a partnership (including for this purpose any entity treated as a
partnership for U.S. tax purposes) is a beneficial owner of ordinary shares or
ADSs, the U.S. tax treatment of a partner in the partnership will generally
depend on the status of the partner and the activities of the partnership. A
holder of ordinary shares or ADSs that is a partnership and partners in such
partnership should consult their individual tax advisors about the U.S. federal
income tax consequences of holding or disposing of the ordinary shares or ADSs.
This summary does not address the United States federal income tax
treatment of investors having a special legal status, including without
limitation the following types of investors, who may be subject to tax rules
that differ significantly from those summarized below:
o life insurance companies;
o tax-exempt investors;
o banks and financial institutions;
o dealers in securities or foreign currencies;
o traders in securities that elect to use a mark-to-market method of
accounting for their securities holdings;
o persons liable for alternative minimum tax;
o U.S. investors who or that actually or constructively hold 10% or
more of our voting shares or ADSs;
o investors who hold our ordinary shares or ADSs as part of straddles,
hedging or integrated or conversion transactions; or
o persons whose "functional currency" is not the U.S. dollar.
This summary is not a comprehensive description of all of the tax
considerations that may be relevant with respect to your ownership of ordinary
shares or ADSs. You are advised to consult your own tax adviser with respect to
your particular circumstances and with respect to the effects of federal, state,
local or foreign tax laws to which you may be subject. The United States does
not have an income tax treaty with the Cayman Islands.
54
Dividends and Other Distribution on Ordinary Shares or ADSs. Subject to
the discussion in "Passive Foreign Investment Company Status" below, in the
event that a U.S. Investor receives a distribution on the ordinary shares or
ADSs, the U.S. Investor will be required to include the distribution in gross
income as a taxable dividend on the date of receipt by the depositary, in the
case of ADSs, or by the U.S. Investor, in the case of ordinary shares, but only
to the extent that a distribution is paid from our current or accumulated
earnings and profits as determined for United States federal income tax
purposes. Dividends paid by us will not be eligible for the corporate dividends
received deduction. For taxable years beginning before January 1, 2011,
"qualified dividend income" paid to a noncorporate U.S. Investor will be subject
to tax at the rates applicable to long-term capital gains (which are currently
taxed at the maximum rate of 15%) if (1) our ordinary shares or ADSs are readily
tradable on an established securities market in the United States, (2) we are
not a passive foreign investment company (as discussed below) for either our
taxable year in which the dividend was paid or the preceding taxable year and
(3) certain holding period requirements must be met. It is expected that our
ADSs will satisfy the "readily tradable" requirement as a result of being traded
on the Nasdaq National Market. However, any U.S. Investor that exchanges its
ADSs for ordinary shares, or that holds only ordinary shares, may not be
eligible for the reduced rate of taxation on dividends if the ordinary shares
are not readily tradable on an established securities market in the United
States. In order for dividends to constitute "qualified dividend income," a U.S.
Investor generally must have held the ADSs for more than 60 days during the
120-day period beginning 60 days before the ex-dividend date; however, because
the holding period rules are intricate and because an owner's holding period is
reduced for periods during which the risk of loss is diminished, U.S. Investors
should consult their own advisors concerning the calculation of their holding
periods. Moreover, a dividend will not be treated as a qualified dividend income
to the extent that the taxpayer is under an obligation (whether pursuant to a
short sale or otherwise) to make related payments with respect to positions in
substantially similar or related property. U.S. Investors should consult their
own tax advisers regarding the availability of the lower rate for dividends paid
with respect to our ADSs or ordinary shares.
The Company has the right to pay dividends in any currency. If dividends
are paid in a currency other than the U.S. dollar, the dividends will be
included in a U.S. Investor's income as a U.S. dollar amount based on the
exchange rate in effect on the date that the U.S. Investor receives the
dividend, regardless of whether the payment is in fact converted into U.S.
dollars. If the U.S. Investor does not receive U.S. dollars on the date the
dividend is distributed, the U.S. Investor will be required to include either
gain or loss in income when the U.S. Investor later exchanges the foreign
currency for U.S. dollars. The gain or loss will be equal to the difference
between the U.S. dollar value of the amount that the U.S. Investor includes in
income when the dividend is received and the amount that the US. Investor
receives on the exchange of the foreign currency for U.S. dollars. The gain or
loss generally will be ordinary income or loss from U.S. sources. If we
distribute as a dividend non-cash property, the U.S. Investor will generally
include in income an amount equal to the U.S. dollar equivalent of the fair
market value of the property on the date that it is distributed.
Dividends will constitute foreign source income for foreign tax credit
limitation purposes. The limitation on foreign taxes eligible for credit is
calculated separately with respect to specific classes of income. For this
purpose, dividends distributed by us with respect to the ordinary shares or ADSs
will, under current law, be "passive income" or in certain circumstances
"financial services income" to a U.S. Investor. Recently enacted legislation
will modify the foreign tax credit limitation by reducing the number of classes
of foreign source income to two for taxable years beginning after December 31,
2006. Under this recently enacted legislation, dividends distributed by us with
respect to ordinary shares or ADSs would generally constitute "passive category
income" but could, in the case of certain U.S. Investors, constitute "general
category income." Special rules apply to individuals whose foreign source income
during the taxable year consists entirely of "qualified passive income" and
whose creditable foreign taxes paid or accrued during the taxable year do not
exceed $300 ($600 in the case of a joint return). Further, in particular
circumstances, a U.S. Investor that (i) has held the ordinary shares or ADSs for
less than a specified minimum period during which it is not protected from risk
of loss, (ii) is obligated to make payments related to the dividends, or (iii)
holds the ordinary shares or ADSs in arrangements in which the U.S. Investor's
expected economic profit, after non-U.S. taxes, is insubstantial, will not be
allowed a foreign tax credit for foreign taxes imposed on dividends paid on the
ordinary shares or ADSs.
55
Distributions in excess of our current and accumulated earnings and
profits will be treated as a nontaxable return of capital to the extent of the
U.S. Investor's basis in the ordinary shares or ADSs and thereafter as gain from
the sale or exchange of a capital asset. We do not generally intend to calculate
our earnings and profits under U.S. federal income tax principles. Therefore a
U.S. Investor should expect that a distribution will generally be treated as a
dividend even if that distribution would otherwise be treated as a nontaxable
return of capital or as capital gain under the rules described above.
Distributions to a U.S. Investor of new ordinary shares or ADSs or rights
to subscribe for new ordinary shares or ADSs that are received as part of a pro
rata distribution to all our shareholders will not be subject to United States
federal income tax. The basis of the new ordinary shares or ADSs or rights so
received will be determined by allocating the U.S. investor's basis in the old
ordinary shares or ADSs between the old ordinary shares or ADSs and the new
ordinary shares or ADSs or rights received, based on their relative fair market
values on the date of distribution. However, the basis of the new ordinary
shares or ADSs or rights will be zero if the fair market value of the new rights
is less than 15% of the fair market value of the old ordinary shares or ADSs at
the time of distribution and the U.S. Investor does not make an election to
determine the basis of the rights by allocation as described above. A U.S.
Investor's holding period in the new ordinary shares or ADSs or rights will
generally include the holding period of the old ordinary shares or ADSs on which
the distribution was made.
Dispositions of ordinary shares or ADSs. Subject to the discussion in
"Passive Foreign Investment Company Status" below, gain or loss realized by a
U.S. Investor on the sale or other disposition of the ordinary shares or ADSs
will be subject to United States federal income tax as capital gain or loss in
an amount equal to the difference between the amount realized on the disposition
and that U.S. Investor's basis in the ordinary shares or ADSs. The capital gain
or loss will be long-term capital gain or loss if the U.S. Investor has held the
ordinary shares or ADSs for more than one year at the time of the sale or
exchange. A noncorporate U.S. investor will be eligible for reduced rates of
taxation (currently, at a maximum rate of 15% for sales occurring in taxable
years beginning before January 1, 2011) on long-term capital gain. The
deductibility of capital losses is subject to limitations. Any gain or loss
recognized by a U.S. Investor will generally be treated as U.S. source income or
loss for U.S. foreign tax credit purposes, except that losses will be treated as
foreign source losses to the extent that a U.S. Investor received dividends that
were includible in the financial services income basket during the 24-month
period prior to the sale.
Passive Foreign Investment Company Status. We believe that we are not a
passive foreign investment company and do not expect to become a passive foreign
investment company in the future. We will be classified as a passive foreign
investment company if, after the application of "look through" rules, either (a)
75% or more of the gross income of the company in a taxable year is passive
income, or (b) the average percentage of assets by value of the company in a
taxable year that produce or are held for the production of passive income
(which includes cash) is at least 50%, the income or assets test. Whether or not
we are a passive foreign investment company will be determined annually based
upon the composition of our income and assets including goodwill, from time to
time. In determining that we are not a passive foreign investment company, we
are relying on the current valuation of our assets, including goodwill. In
calculating goodwill, we have valued our total assets based on our total market
value determined using the then market price of our ordinary shares and ADSs and
have made a number of assumptions regarding the amount of this value allocable
to goodwill. Because the determination of goodwill will be based on the price of
our ordinary shares and ADSs, it is subject to change. We believe our valuation
approach is reasonable. However, it is possible that the Internal Revenue
Service will challenge the valuation of our goodwill, which may result in our
being classified as a passive foreign investment company. In addition, the
composition of our income and assets will be affected by how we spend the cash
we have raised, which is a passive asset for purposes of the passive foreign
investment company asset test discussed above. We intend to use the cash we have
raised in the past and conduct our business activities in an effort to reduce
the risk of our classification as a passive foreign investment company. Because
the passive foreign investment company determination is made at the end of each
taxable year, we cannot determine in advance whether we will be considered a
passive foreign investment company for any future taxable year. If we determine
that we have become a passive foreign investment company, we will notify the
Bank of New York and all U.S. investors who have been record holders of our
ordinary shares or ADSs during any period in which we determine that we are a
passive foreign investment company, within 60 days of the end of our taxable
year for which we make such determination. If we are a passive foreign
investment company for any year during which a U.S. Investor holds ordinary
shares or ADSs, we generally will continue to be treated as a passive foreign
investment company for all succeeding years during which the U.S. Investor holds
ordinary shares or ADSs.
56
Special U.S. tax rules apply to U.S. Investors of interests in a passive
foreign investment company. Subject to the discussion of the market-to-market
election and qualified electing fund election below, if we were a passive
foreign investment company for any taxable year during which a U.S. Investor
held ordinary shares or ADSs, the U.S. Investor would be subject to special tax
rules regardless of whether we meet the income or assets test for any other year
with respect to:
o any "excess distribution" by us to the U.S. Investor, which means
any distributions received by the U.S. Investor on the ordinary
shares or ADSs in a taxable year that are greater than 125% of the
average annual distributions received by the U.S. Investor in the
three preceding taxable years, or, if shorter, the U.S. Investor's
holding period for the ordinary shares or ADSs; and
o any gain realized on the sale or other disposition, including a
pledge, of ordinary shares or ADSs.
Under these special tax rules:
o the excess distribution or gain would be allocated ratably over the
U.S. Investor's holding period for the ordinary shares or ADSs;
o the amount allocated to the current taxable year and any taxable
year prior to the first taxable year in which we are a passive
foreign investment company would be treated as ordinary income;
o the amount allocated to each of the other years would be taxed as
ordinary income at the highest tax rate in effect for that year; and
o the interest charge applicable to underpayments of tax would be
imposed with respect to the resulting tax attributable to each prior
year in which we were a passive foreign investment company to
recover the deemed benefit from the deferred payment of the tax
attributable to each prior year.
In addition, dividends that a U.S. Investor receives from us will not be
eligible for the special tax rates applicable to "qualified dividend income"
(see "-- United States Federal Income Taxation --- Dividends") if we are a
passive foreign investment company either in the taxable year of the
distribution or the preceding taxable year, but will instead be taxable at rates
applicable to ordinary income.
If we are a passive foreign investment company in any year, a U.S.
Investor would be required to file an annual return on Internal Revenue Service
Form 8621 regarding distributions received with respect to the ordinary shares
or ADSs and any gain realized on the disposition of the ordinary shares or ADSs.
A U.S. Investor in a passive foreign investment company is allowed to make
a mark-to-market election with respect to the stock of the passive foreign
investment company, provided that the stock of the passive foreign investment
company is "marketable" within the meaning of the Code. The ordinary shares will
be "marketable" as long as they remain listed on the Nasdaq National Market and
are "regularly traded." The ordinary shares or ADSs will be considered
"regularly traded" for any calendar year during which the ordinary shares or
ADSs are traded, other than in de minimis quantities, on at least fifteen days
during each calendar quarter. If the election is made, a U.S. Investor would be
required to mark the ordinary shares or ADSs to market each taxable year and
recognize ordinary income for any increase in market value for that taxable year
and would be allowed to recognize an ordinary loss for any decrease in that
market value to the extent that prior gains exceed prior losses. The adjusted
basis in the ordinary shares or ADSs would be adjusted to reflect that gain or
loss. The mark-to-market election will be effective for the taxable year for
which the election is made and all subsequent taxable years, unless the ordinary
shares cease to be marketable or the Internal Revenue Service consents to the
revocation of the election.
57
Alternatively, for each year we meet the income or assets test, a U.S.
Investor can make an election to include in income annually its pro rata share
of our earnings and net capital gains. This election is referred to as a
qualified electing fund election. To make a qualified electing fund election, a
U.S. Investor will need to have an annual information statement from us
documenting the earnings and capital gain for the year. If we were to become a
passive foreign investment company, we would furnish the passive foreign
investment company annual information statement to any shareholder or former
shareholder who requested it. In general, a U.S. Investor must make a qualified
electing fund election on or before the due date for filing its income tax
return for the first year to which the qualified electing fund election will
apply. U.S. Investors are permitted to make retroactive elections in particular
circumstances, including if the U.S. Investor had a reasonable belief that the
foreign corporation was not a passive foreign investment company and filed a
protective election. As discussed above, we will notify investors if we
determine that we have become a passive foreign investment company. This notice
will provide U.S. Investors on a calendar tax year with sufficient time to make
the qualified electing fund election. U.S. Investors (in particular those with a
tax year other than the calendar year) should consult their own tax advisors as
to the consequences of making a protective qualified electing fund election or
other consequences of the qualified electing fund election.
If we are a passive foreign investment company in any year, U.S. Investors
should consult with their tax advisers regarding whether to make a
mark-to-market or qualified electing fund election.
Information Reporting and Backup Withholding. In general, information reporting
requirements will apply to dividends in respect of our ordinary shares or ADSs
or the proceeds received on the sale, exchange or redemption of our ordinary
shares or ADSs paid within the United States (and, in certain cases, outside the
United States) to U.S. Investors other than certain exempt recipients, such as
corporations, and a 28% backup withholding tax may apply to such amounts if the
U.S. Investor fails to provide an accurate taxpayer identification number or to
report interest and dividends required to be shown on its U.S. federal income
tax returns. U.S. Investors who are required to establish their exempt status
generally must provide such certification on IRS Form W-9. The amount of any
backup withholding from a payment to a U.S. Investor will be allowed as credit
against the U.S. Investor's U.S. federal income tax liability provided that the
appropriate returns are filed.
DOCUMENTS ON DISPLAY
We file annual reports on Form 20-F and furnish current reports on Form
6-K with the SEC. You may read and copy this information at the SEC's Public
Reference Room at Judiciary Plaza, 100 F Street N.E., Washington, D.C. 20549,
and at the regional offices of the SEC located at 233 Broadway, New York, New
York 10279 and Citicorp Center, 500 West Madison Street, Suite 1400, Chicago,
Illinois 60661. You can also request copies of the documents, upon payment of a
duplicating fee, by writing to the Public Reference Section of the SEC. Please
call the SEC at 1-800-SEC-0330 for further information on the operation of the
Public Reference Room. Certain of our SEC filings are also available to the
public from the SEC's website at http://www.sec.gov.
ITEM 11. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the risk of loss related to adverse changes in market
prices, including interest rates and foreign exchange rates, of financial
instruments. In the normal course of business, our financial position is
routinely subject to a variety of risks, including market risk associated with
interest rate movements and currency rate movements on non-U.S. dollar
denominated assets and liabilities, as well as collectibility of accounts
receivable.
58
We regularly assess these financial instruments and their ability to
address market risk and have established policies and business practices to
protect against the adverse effects of these and other potential exposures.
Interest Rate Risk
Our major market risk exposure is changing interest rates. Our exposure to
market risk for changes in interest rates relates primarily to our investments
in government and corporate bonds.
We maintain an investment portfolio consisting mainly of fixed income
securities. These securities are subject to interest rate risk and will fall in
value if market interest rates increase. If market rates were to increase
immediately and uniformly by 10.0% from the levels at December 31, 2005, the
fair value of the portfolio would decline by an immaterial amount. We presently
intend to treat our fixed income investments as available for sale, and
therefore we do not expect our operating results or cash flows to be affected to
any significant degree by the effect of a sudden short-term change in market
interest rate exposures. We did not purchase or hold any derivative financial
instruments for trading purposes.
The table below provides information about our financial instruments whose
maturity dates are greater than three months as of December 31, 2005.
2006 2007 2008 2009 2010 Thereafter Total Fair Value
------ ------ ------ ------ ------ ---------- ----- ----------
US Treasury Bills:
Fixed rate (US$).......... 13,909 -- -- -- -- -- 13,909 13,909
Government Bonds:
Fixed rate (US$).......... 3,835 6,440 -- 1,589 -- -- 11,864 11,788
Time Deposit
Fixed rate (US$).......... 10,627 -- 27 -- -- -- 10,654 10,654
Corporate Bonds
Fixed rate (US$).......... -- -- -- -- -- -- -- --
Foreign currency risk
Fluctuations in exchange rates may adversely affect our financial results.
The functional currencies for our foreign subsidiaries are the local currency.
As a result, certain of our assets and liabilities, including certain bank
accounts, accounts receivable, restricted assets, short-term investments and
accounts payable, exist in non-US dollar-denominated currencies, which are
sensitive to foreign currency exchange rate fluctuations. If exchange rates were
to change immediately and uniformly from the levels at December 31, 2005, the
fair value of such assets and liabilities would change by an immaterial amount
beyond the change reflected by the exchange rates. As of December 31, 2005, we
held approximately $22.5 million in government bonds, certificates of deposits
and bank demand accounts denominated in foreign currencies.
We have not engaged in hedging techniques designed to mitigate foreign
currency exposures and we may experience economic losses as a result of foreign
currency exchange fluctuations. We will monitor the currency exchange
fluctuations periodically. For the year ended December 31, 2005, we experienced
a foreign exchange loss of approximately $443,000 due to foreign currency
exchange fluctuations, which are reflected in the results of operations.
59
ITEM 12. DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES
Not applicable.
PART II
ITEM 13. DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES
There are no defaults, dividend arrearages or delinquencies that are
required to be disclosed.
ITEM 14. MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF
PROCEEDS.
RIGHTS OF SECURITY HOLDERS
Effective March 2, 2006, upon the listing of our ordinary shares on the
Hong Kong Stock Exchange, certain amendments to our memorandum and articles of
association became effective. A summary of material provisions of our memorandum
and articles of association is included in Item 10 above.
USE OF PROCEEDS
As of December 31, 2005, the net proceeds from our initial public offering
in August 2000 and our public offering in November 2001 were primarily used for
general working capital and investment in interest income producing financial
instruments. None of the net proceeds from our initial public offering were
paid, directly or indirectly, to any of our directors, officers or general
partners or any of their associates, or to any person owning ten percent or more
of any class of our equity securities, or any of our affiliates.
PART III
ITEM 15. CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures that are designed to ensure
that information required to be disclosed in our reports filed pursuant to the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the time periods specified in the SEC's rules and forms, and that such
information is accumulated and communicated to the management, including the
Chief Executive Officer and Chief Financial Officer, as appropriate, to allow
timely decisions regarding required disclosure. In designing and evaluating the
disclosure controls and procedures, management recognizes that any controls and
procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives. In addition,
the design of any control system is based in part upon certain assumptions about
the likelihood of future events. Our disclosure controls and procedures are
designed to provide reasonable assurance of achieving their objectives.
As of December 31, 2005, we carried out an evaluation, under the
supervision and with the participation of the management, including the Chief
Executive Officer and the Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures. Based on the
foregoing, the Chief Executive Officer and the Chief Financial Officer concluded
that the Company's disclosure controls and procedures were effective.
60
There has been no change in our internal control over financial reporting
that occurred during our fiscal year 2005 that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.
ITEM 16. Not applicable.
ITEM 16A. AUDIT COMMITTEE FINANCIAL EXPERT
The Board of Directors has determined that Mr. Lawrence Lin is an "audit
committee financial expert" as defined in Item 16A of Form 20-F. We believe Mr.
Lin is "independent" as defined in Rule 4200(a)(15) of the Marketplace Rules of
the Nasdaq Stock Market.
ITEM 16B. CODE OF ETHICS
We have adopted the O2 Micro International Limited Code of Business
Conduct and Ethics ("Code of Conduct"), a code of business conduct and ethics
that applies to our employees, officers and non-employee directors, including
our principal executive officer, principal financial officer, principal
accounting officer or controller and persons performing similar functions. It is
publicly available on our website at www.o2micro.com. If we make any substantive
amendments or grant any waiver from a provision of the Code of Conduct to our
directors or executive officers, we will disclose the nature of such amendment
or waiver on that website or in a report on Form 6-K or in the next annual
report on Form 20-F.
ITEM 16C. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Deloitte & Touche has served as the Company's independent auditors for
each of the fiscal years in the two-year period ended December 31, 2005. The
appointment of the independent auditor is subject to approval and ratification
by the Company's shareholders at the annual general meeting of shareholders. The
following table presents the aggregate fees for professional services and other
services rendered by Deloitte & Touche in each of the years ended December 31,
2004 and 2005.
Year ended Year ended
December 31, 2005 December 31, 2004
Audit Fees $ 322,300 $ 312,000
Audit-related Fees 9,599 12,821
Tax Fees 85,761 111,785
All Other Fees 475,695 111,126
Total $ 893,355 $ 547,732
Audit Fees. This category includes the audit of our annual financial statements,
review of quarterly financial statements and services that are normally provided
by Deloitte & Touche in connection with statutory and regulatory filings or
engagements for those fiscal years.
Audit-related Fees. This category consists of assurance and related services by
Deloitte & Touche that are related to the performance of audit or review of our
financial statements and are reported above under "Audit Fees."
61
Tax Fees. This category consists of professional services rendered by Deloitte &
Touche for tax compliance and tax consultation. The services for fees disclosed
under this category include tax return preparation and technical tax
consultation.
All Other Fees: This category consists primarily of fees in connection with the
Hong Kong Stock Exchange listing and Sarbanes-Oxley Act readiness preparation.
The Audit Committee pre-approves all audit and permissible non-audit services
provided by the independent registered public accounting firm. These services
may include audit services, audit-related services, tax services and other
services. During the year ended December 31, 2005, the Audit Committee
pre-approved all audit and non-audit-fees of Deloitte & Touche.
ITEM 16D. EXEMPTION FROM THE LISTING STANDARDS FOR AUDIT COMMITTEE
Not applicable.
ITEM 16E. PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PERSONS
Period Total Number of Average Price Paid Total Number of Maximum Number of
Shares Purchased (2) per Share (2) Shares Purchased as Shares that May Yet
Part of Publicly Be Purchased Under
Announced Plans or the Plans or
Programs (1) (2) Programs (2)
------------------------- ---------------------- ----------------------- ---------------------- ----------------------
March 18, 2005 to March 3,500,000 $0.1982 3,500,000 100,580,000
22, 2005
------------------------- ---------------------- ----------------------- ---------------------- ----------------------
April 11, 2005 to April 1,890,000 $0.1982 1,890,000 98,690,000
18, 2005
------------------------- ---------------------- ----------------------- ---------------------- ----------------------
November 30, 2005 500,000 $0.2341 500,000 98,190,000
------------------------- ---------------------- ----------------------- ---------------------- ----------------------
December 1, 2005 to 14,530,000 $0.2188 14,530,000 83,660,000
December 30, 2005
------------------------- ---------------------- ----------------------- ---------------------- ----------------------
(1) In May 2002, we announced a share repurchase program to repurchase up to
3,000,000 shares of our ordinary shares or 150,000,000 shares after taking into
account the 50-to-1 stock split on November 25, 2005. There is no expiration
date for the share repurchase program.
(2) All share and price per share numbers reflect the 50-for-1 stock split which
occurred on November 25, 2005
62
PART IV
ITEM 17. FINANCIAL STATEMENTS
The Company's Consolidated Financial Statements have been prepared in
accordance with Item 18 hereof.
ITEM 18. FINANCIAL STATEMENTS
The Company's financial statements set forth in the accompanying Index to
Consolidated Financial Statements included in this annual report on Form 20-F
following Part IV beginning on page F-1 are hereby incorporated herein by this
reference. Such consolidated financial statements are filed as part of this
annual report on Form 20-F.
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2004 and 2005
Consolidated Statements of Operations and Comprehensive Income for the
years ended December 31, 2003, 2004 and 2005
Consolidated Statements of Shareholders' Equity for the years ended
December 31, 2003, 2004 and 2005
Consolidated Statements of Cash Flows for the years ended December 31,
2003, 2004 and 2005
Notes to Consolidated Financial Statements
ITEM 19. EXHIBITS
1. Memorandum and Articles of Association of the registrant (incorporated by
reference from Exhibits 3.1 and 3.2 to the Registration Statement on Form
F-1 (File No. 333-12386) filed by the registrant)
4.1 Standard NNN Lease dated July 29, 1999 by and between Limir Realty Corp.
#17 as landlord and O2Micro, Inc. as tenant (incorporated by reference
from Exhibit 10.5 to the Registration Statement on Form F-1 (File No.
333-12386) filed by the registrant)
4.2 Lease dated October 16, 1997 by and between Hung Kuo Development Corp. as
landlord and O2Micro, Inc. as tenant (incorporated by reference from
Exhibit 10.6 to the Registration Statement on Form F-1 (File No.
333-12386) filed by the registrant)
4.3 Agreement dated October 1, 1999 by and between PSA Corporation Limited as
landlord and O2Micro, Inc. as tenant (incorporated by reference from
Exhibit 10.8 to the Registration Statement on Form F-1 (File No.
333-12386) filed by the registrant)
8.1 List of registrant's subsidiaries
10.1 Consent of Deloitte & Touche, independent registered public accounting
firm
12.1 Certification of Chief Executive Officer of the Company, pursuant to
Section 302 of the Sarbanes-Oxley Act.
12.2 Certification of Chief Financial Officer of the Company, pursuant to
Section 302 of the Sarbanes-Oxley Act.
13. Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act.
63
SIGNATURES
Pursuant to the requirements of Section 12 of the Securities Exchange Act
of 1934, the registrant hereby certifies that it meets all of the requirements
for filing on Form 20-F and that it has duly caused and authorized the
undersigned to sign this annual report on its behalf.
O2 MICRO INTERNATIONAL LIMITED
Date: June 28, 2006 By: /s/ STERLING DU
-----------------------------
Name: Sterling Du
Title: Chief Executive Officer
64
O2 MICRO INTERNATIONAL LIMITED
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Report of Independent Registered Public Accounting Firm.....................F-1
Consolidated Balance Sheets.................................................F-2
Consolidated Statements of Operations and Comprehensive Income..............F-3
Consolidated Statements of Shareholders' Equity.............................F-4
Consolidated Statements of Cash Flows.......................................F-5
Notes to Consolidated Financial Statements..................................F-6
O2Micro International Limited and Subsidiaries
Consolidated Financial Statements as of
December 31, 2004 and 2005 and
Report of Independent Registered Public
Accounting Firm
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and the Shareholders
O2Micro International Limited
We have audited the accompanying consolidated balance sheets of O2Micro
International Limited and subsidiaries (the "Company") as of December 31, 2004
and 2005 and the related consolidated statements of operations and comprehensive
income, shareholders' equity, and cash flows for each of the years ended
December 31, 2003, 2004 and 2005 (expressed in United States dollars). These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The Company is not required to
have, nor were we engaged to perform, an audit of its internal control over
financial reporting. Our audit included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of O2Micro International Limited and
subsidiaries as of December 31, 2004 and 2005, and the results of their
operations and their cash flows for each of the years ended December 31, 2003,
2004 and 2005, in conformity with accounting principles generally accepted in
the United States of America.
February 17, 2006
F-1
O2MICRO INTERNATIONAL LIMITED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In Thousand U.S. Dollars, Except Per Share Amounts)
--------------------------------------------------------------------------------
December 31
-------------------------
ASSETS 2004 2005
CURRENT ASSETS
Cash and cash equivalents $ 56,320 $ 46,375
Restricted cash 1,887 5,605
Short-term investments 63,768 55,653
Accounts receivable, net 9,431 11,460
Inventories 11,231 15,943
Prepaid expenses and other current assets 4,491 6,665
--------- ---------
Total current assets 147,128 141,701
--------- ---------
LONG-TERM INVESTMENTS 11,781 16,898
--------- ---------
LAND, PROPERTY AND EQUIPMENT, NET 10,758 23,319
--------- ---------
RESTRICTED ASSETS 13,873 14,492
--------- ---------
OTHER ASSETS 1,656 3,245
--------- ---------
TOTAL $ 185,196 $ 199,655
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Notes and accounts payable $ 3,635 $ 5,760
Income tax payable 3,751 3,907
Accrued expenses and other current liabilities 7,029 14,092
--------- ---------
Total current liabilities 14,415 23,759
--------- ---------
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS' EQUITY
Preference shares at $0.00002 par value per share
Authorized - 250,000,000 shares -- --
Ordinary shares at $0.00002 par value per share
Authorized - 4,750,000,000 shares
Issued - 1,959,403,100 shares and 1,967,824,350 shares
as of December 31, 2004 and 2005, respectively 39 39
Treasury stock - 0 and 15,030,000 shares as of December 31,
2004 and 2005, respectively -- (3,296)
Additional paid-in capital 139,581 141,532
Accumulated other comprehensive loss (110) (1,118)
Retained earnings 31,271 38,739
--------- ---------
Total shareholders' equity 170,781 175,896
--------- ---------
TOTAL $ 185,196 $ 199,655
========= =========
The accompanying notes are an integral part of the
consolidated financial statements.
F-2
O2MICRO INTERNATIONAL LIMITED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(In Thousand U.S. Dollars, Except Per Share Amounts)
--------------------------------------------------------------------------------
Years Ended December 31
---------------------------------------------------
2003 2004 2005
NET SALES $ 88,599 $ 92,196 $ 105,552
COST OF SALES 38,314 37,403 40,741
----------- ----------- -----------
GROSS PROFIT 50,285 54,793 64,811
----------- ----------- -----------
OPERATING EXPENSES
Research and development 19,219 20,260 25,421
Selling, general and administrative 13,522 16,348 20,279
Patent litigation 3,954 5,334 10,174
----------- ----------- -----------
Total operating expenses 36,695 41,942 55,874
----------- ----------- -----------
INCOME FROM OPERATIONS 13,590 12,851 8,937
----------- ----------- -----------
NON-OPERATING INCOME (EXPENSES)
Interest income 1,283 1,455 2,824
Impairment loss on long-term investments (17) -- --
Gain on sale of long-term investments -- 340 --
Foreign exchange gain (loss), net 287 648 (443)
Hong Kong Stock Exchange listing expenses -- -- (2,460)
Other, net (116) 262 323
----------- ----------- -----------
Total non-operating income 1,437 2,705 244
----------- ----------- -----------
INCOME BEFORE INCOME TAX 15,027 15,556 9,181
INCOME TAX EXPENSE 1,826 1,472 1,034
----------- ----------- -----------
NET INCOME 13,201 14,084 8,147
----------- ----------- -----------
OTHER COMPREHENSIVE INCOME (LOSS)
Translation adjustments on subsidiaries (90) 714 (238)
Unrealized gain (loss) on available-for-sale
securities 261 (303) (770)
----------- ----------- -----------
Total other comprehensive income (loss) 171 411 (1,008)
----------- ----------- -----------
COMPREHENSIVE INCOME $ 13,372 $ 14,495 $ 7,139
=========== =========== ===========
EARNINGS PER SHARE:
Basic $ 0.0069 $ 0.0072 $ 0.0042
=========== =========== ===========
Diluted $ 0.0066 $ 0.0070 $ 0.0041
=========== =========== ===========
SHARES USED IN EARNINGS PER SHARE
CALCULATION:
Basic (in thousands) 1,918,700 1,957,800 1,961,168
=========== =========== ===========
Diluted (in thousands) 1,986,800 2,005,100 1,997,459
=========== =========== ===========
The accompanying notes are an integral part of the
consolidated financial statements.
F-3
O2MICRO INTERNATIONAL LIMITED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
(In Thousand U.S. Dollars, Except Per Share Amounts)
--------------------------------------------------------------------------------
Additional Paid-in Capital
Ordinary Shares ---------------------------------------
---------------------------- Ordinary Stock
Shares Amount Shares Options Total
BALANCE, JANUARY 1, 2003 1,942,854,700 $ 39 $ 131,793 $ 1,223 $ 133,016
Issuance of:
Shares issued for exercise of stock options 43,199,350 1 6,135 (503) 5,632
Shares issued for 1999 Purchase Plan 5,486,750 -- 942 -- 942
Cancellation of stock options -- -- -- (23) (23)
Acquisition of treasury stock - 3,875,000 shares -- -- -- -- --
Retirement of treasury stock (39,910,000) (1) (2,793) -- (2,793)
Options granted to nonemployees -- -- -- 302 302
Net income for 2003 -- -- -- -- --
Translation adjustments on subsidiaries -- -- -- -- --
Unrealized gain on available-for-sale securities -- -- -- -- --
----------------- -------- ------------ --------- ------------
BALANCE, DECEMBER 31, 2003 1,951,630,800 39 136,077 999 137,076
Issuance of:
Shares issued for exercise of stock options 7,858,350 -- 1,359 (77) 1,282
Shares issued for 1999 Purchase Plan 5,923,950 -- 1,032 -- 1,032
Acquisition and retirement of treasury stock (6,010,000) -- (422) -- (422)
Options granted to nonemployees -- -- -- 613 613
Net income for 2004 -- -- -- -- --
Translation adjustments on subsidiaries -- -- -- -- --
Unrealized loss on available-for-sale securities -- -- -- -- --
----------------- -------- ------------ --------- ------------
BALANCE, DECEMBER 31, 2004 1,959,403,100 39 138,046 1,535 139,581
Issuance of:
Shares issued for exercise of stock options 7,422,050 -- 1,203 (18) 1,185
Shares issued for 1999 Purchase Plan 6,389,200 -- 1,110 -- 1,110
Acquisition of treasury stock - 20,420,000 shares -- -- -- -- --
Retirement of treasury stock (5,390,000) -- (380) -- (380)
Options granted to nonemployees -- -- -- 36 36
Net income for 2005 -- -- -- -- --
Translation adjustments on subsidiaries -- -- -- -- --
Unrealized loss on available-for-sale securities -- -- -- -- --
----------------- -------- ------------ --------- ------------
BALANCE, DECEMBER 31, 2005 1,967,824,350 $ 39 $ 139,979 $ 1,553 $ 141,532
================= ======== ============ ========= ============
Accumulated Other
Comprehensive Income (Loss)
-------------------------------------
Unrealized Cumulative
Treasury Investment Translation
Stock Gain (Loss) Adjustment Total
BALANCE, JANUARY 1, 2003 $ (6,823) $ (112) $ (580) $ (692)
Issuance of:
Shares issued for exercise of stock options -- -- -- --
Shares issued for 1999 Purchase Plan -- -- -- --
Cancellation of stock options -- -- -- --
Acquisition of treasury stock - 3,875,000 shares (647) -- -- --
Retirement of treasury stock 7,470 -- -- --
Options granted to nonemployees -- -- -- --
Net income for 2003 -- -- -- --
Translation adjustments on subsidiaries -- -- (90) (90)
Unrealized gain on available-for-sale securities -- 261 -- 261
---------- ------- ------- ---------
BALANCE, DECEMBER 31, 2003 -- 149 (670) (521)
Issuance of:
Shares issued for exercise of stock options -- -- -- --
Shares issued for 1999 Purchase Plan -- -- -- --
Acquisition and retirement of treasury stock -- -- -- --
Options granted to nonemployees -- -- -- --
Net income for 2004 -- -- -- --
Translation adjustments on subsidiaries -- -- 714 714
Unrealized loss on available-for-sale securities -- (303) -- (303)
---------- ------- ------- ---------
BALANCE, DECEMBER 31, 2004 -- (154) 44 (110)
Issuance of:
Shares issued for exercise of stock options -- -- -- --
Shares issued for 1999 Purchase Plan -- -- -- --
Acquisition of treasury stock - 20,420,000 shares (4,355) -- -- --
Retirement of treasury stock 1,059 -- -- --
Options granted to nonemployees -- -- -- --
Net income for 2005 -- -- -- --
Translation adjustments on subsidiaries -- -- (238) (238)
Unrealized loss on available-for-sale securities -- (770) -- (770)
---------- ------- ------- ---------
BALANCE, DECEMBER 31, 2005 $ (3,296) $ (924) $ (194) $ (1,118)
========== ======= ======= =========
Total
Retained Shareholders'
Earnings Equity
BALANCE, JANUARY 1, 2003 $ 9,608 $ 135,148
Issuance of:
Shares issued for exercise of stock options -- 5,633
Shares issued for 1999 Purchase Plan -- 942
Cancellation of stock options -- (23)
Acquisition of treasury stock - 3,875,000 shares -- (647)
Retirement of treasury stock (4,676) --
Options granted to nonemployees -- 302
Net income for 2003 13,201 13,201
Translation adjustments on subsidiaries -- (90)
Unrealized gain on available-for-sale securities -- 261
----------- ------------
BALANCE, DECEMBER 31, 2003 18,133 154,727
Issuance of:
Shares issued for exercise of stock options -- 1,282
Shares issued for 1999 Purchase Plan -- 1,032
Acquisition and retirement of treasury stock (946) (1,368)
Options granted to nonemployees -- 613
Net income for 2004 14,084 14,084
Translation adjustments on subsidiaries -- 714
Unrealized loss on available-for-sale securities -- (303)
----------- ------------
BALANCE, DECEMBER 31, 2004 31,271 170,781
Issuance of:
Shares issued for exercise of stock options -- 1,185
Shares issued for 1999 Purchase Plan -- 1,110
Acquisition of treasury stock - 20,420,000 shares -- (4,355)
Retirement of treasury stock (679) --
Options granted to nonemployees -- 36
Net income for 2005 8,147 8,147
Translation adjustments on subsidiaries -- (238)
Unrealized loss on available-for-sale securities -- (770)
----------- ------------
BALANCE, DECEMBER 31, 2005 $ 38,739 $ 175,896
=========== ============
The accompanying notes are an integral part of the
consolidated financial statements.
F-4
O2MICRO INTERNATIONAL LIMITED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousand U.S. Dollars)
--------------------------------------------------------------------------------
Years Ended December 31
-----------------------------------------------
2003 2004 2005
OPERATING ACTIVITIES
Net income $ 13,201 $ 14,084 $ 8,147
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 2,623 2,692 3,684
Amortization of stock options granted for services 335 386 264
Gain on sale of long-term investments -- (340) --
Loss (gain) on sale of short-term investments 5 -- (10)
Deferred income tax assets and liabilities 386 (68) 527
Impairment loss on long-term investments 17 -- --
Loss on sale/disposal of property and equipment 68 3 18
Changes in operating assets and liabilities:
Accounts receivable, net (2,199) 363 (2,029)
Inventories (2,646) (1,618) (4,712)
Prepaid expenses and other current assets (474) (1,278) (2,721)
Notes and accounts payable 1,132 (2,699) 2,125
Income tax payable 895 899 156
Accrued expenses and other current liabilities 1,413 1,705 5,570
--------- --------- ---------
Net cash provided by operating activities 14,756 14,129 11,019
--------- --------- ---------
INVESTING ACTIVITIES
Receivables from employees (104) 116 --
Acquisition of:
Land, property and equipment (1,749) (8,354) (14,870)
Long-term investments (147) (4,861) (5,819)
Short-term investments (116,138) (166,045) (151,562)
(Increase) decrease in:
Restricted assets (10,044) (1,945) 306
Restricted cash 127 5 (3,718)
Other assets (612) (187) (1,750)
Proceeds from:
Sale of short-term investments 105,146 155,021 158,132
Sale of long-term investments -- 1,020 --
Sale of property and equipment 1 2 --
--------- --------- ---------
Net cash used in investing activities (23,520) (25,228) (19,281)
--------- --------- ---------
FINANCING ACTIVITIES
Acquisition of treasury stock (647) (1,368) (4,355)
Proceeds from:
Exercise of stock options 5,633 1,282 1,185
Issuance of ordinary shares under 1999 Purchase Plan 942 1,032 1,110
Payment of principal of capital leases (6) -- --
--------- --------- ---------
Net cash provided by (used in) financing activities 5,922 946 (2,060)
--------- --------- ---------
EFFECTS OF CHANGES IN FOREIGN EXCHANGE RATE (3) (16) 377
--------- --------- ---------
NET DECREASE IN CASH AND CASH EQUIVALENTS (2,845) (10,169) (9,945)
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 69,334 66,489 56,320
--------- --------- ---------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 66,489 $ 56,320 $ 46,375
========= ========= =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOWS
Cash paid for interest $ 1 $ -- $ --
Cash paid for tax $ 600 $ 641 $ 292
NON-CASH INVESTING AND FINANCING ACTIVITIES
Payable for acquisition of equipment $ -- $ -- $ 1,183
Short-term investments reclassified to restricted assets $ -- $ 1,144 $ 1,430
Convertible loans converted to long-term investments $ 1,750 $ -- $ --
Unrealized gain (loss) on investments accounted for
available-for-sale $ 261 $ (303) $ (770)
The accompanying notes are an integral part of the
consolidated financial statements.
F-5
O2MICRO INTERNATIONAL LIMITED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Expressed in United States Dollars Unless Otherwise Noted)
--------------------------------------------------------------------------------
1. GENERAL
Business
O2Micro, Inc. was incorporated in the state of California in the United
States of America on March 29, 1995 to design, develop, and deliver
semiconductor components primarily for mobile applications. In March 1997,
O2Micro International Limited (the "Company") was formed in the Cayman
Islands and all authorized and outstanding common stock, preferred stock
and stock options of O2Micro, Inc. were exchanged for the Company's
ordinary shares, preference shares and stock options with identical rights
and preferences. O2Micro, Inc. became the Company's subsidiary after the
share exchange.
The Company has incorporated various wholly-owned subsidiaries, including
(among others) O2Micro Electronics, Inc. (O2Micro-Taiwan), O2Micro
International Japan Ltd. (O2Micro-Japan), O2Micro Pte Limited - Singapore
(O2Micro-Singapore). O2Micro-Taiwan is engaged in operations and
O2Micro-Japan is engaged in trading while O2Micro-Singapore and other
subsidiaries are mostly engaged in research and development. The Company
also established a Taiwanese branch office, O2Micro International Limited -
Taiwan Branch (O2Micro-Taiwan Branch) to engage in marketing and customer
support related services. Due to the duplication of functions between
O2Micro-Taiwan Branch and O2Micro-Taiwan, the Board of Directors determined
to dissolve O2Micro-Taiwan Branch on October 31, 2002. The dissolution
process of O2Micro-Taiwan Branch was not completed as of December 31, 2005.
At the extraordinary general meeting of shareholders of the Company held on
November 14, 2005, the shareholders approved a public global offering of
the Company"s Ordinary Shares and the proposed listing of the Company's
Ordinary Shares on the Main Board of The Stock Exchange of Hong Kong
Limited ("HKSE") and various matters related to the proposed listing and
offering, including the adoption of Amended and Restated Memorandum and
Articles of Association, the 2005 Share Incentive Plan and the 2005 Share
Option Plan, general issue and repurchase mandates which would authorize
the Company for a period of time to issue or purchase a limited number of
shares in accordance with the Listing Rules of the HKSE; and a 50-for-1
share split and the implementation of an American depositary share ("ADS")
program with respect to the Company's Ordinary Shares quoted on The Nasdaq
National Market. Following approval of these matters, the Company effected
the cessation of trading of its Ordinary Shares on Nasdaq and share split
of Ordinary Shares on November 25, 2005, and the commencement of trading of
ADSs on Nasdaq on November 28, 2005. All share and per share data have been
retroactively restated in the accompanying consolidated financial
statements and notes to the consolidated financial statements for all
periods presented to reflect the share split.
The adoption of the Amended and Restated Memorandum and Articles of
Association, the 2005 Share Incentive Plan and the 2005 Share Option Plan,
general issue and repurchase mandates will only become effective upon the
listing of the Ordinary Shares on the HKSE.
F-6
On December 30, 2005, the board of directors determined to file with HKSE
the listing by way of introduction without issuing new shares instead of a
global offering after taking market conditions and other factors into
consideration.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The consolidated financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America.
The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries. All intercompany accounts and
transactions have been eliminated on consolidation.
Use of Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect certain reported
amounts and disclosures. Accordingly, actual results could differ from
those estimates.
Concentration of Credit Risk
Financial instruments that potentially subject the Company to a
concentration of credit risk consist of cash, cash equivalents, short-term
investments and accounts receivable. Cash is deposited with high credit
quality financial institutions. For cash equivalents and short-term
investments, the Company invests in debt securities with credit rating of A
and better. For accounts receivable, the Company performs ongoing credit
evaluations of its customers' financial condition and the Company maintains
an allowance for doubtful accounts receivable based upon a review of the
expected collectibility of individual accounts.
Fair Value of Financial Instruments
The Company's financial instruments, including cash and cash equivalents,
restricted cash, accounts receivable, and notes and accounts payable are
carried at cost, which approximates the fair value due to the short-term
maturity of those instruments. Fair values of available-for-sales
investments including short-term investments and long-term investments
represent quoted market prices. Long-term investments in private company
equity securities are accounted for under the cost method because the
Company does not exercise significant influence over the entities. The
Company evaluates related information including operating performance,
subsequent rounds of financings, advanced product development and related
business plan in determining the fair value of these investments and
whether an other-than-temporary decline in value exists. Fair value of
restricted assets, which are composed of foreign government bonds,
negotiated certificates of deposit and cash, is estimated based on the
combination of fair value of each component.
Cash and Cash Equivalents
The Company considers all highly liquid investments with maturities of not
more than three months when purchased to be cash equivalents.
F-7
Restricted Assets
The Company classifies deposits made for customs, collateral for obtaining
foundry capacity, cash pledged to a bank for the issuance of letters of
credit and office leases as restricted cash. The deposits are classified as
current assets if refundable within a twelve-month period. Restricted
assets consist of deposits made for Taiwan court cases in the form of
Taiwan Government bonds, negotiated certificates of deposit and cash.
Restricted assets can be released upon the resolution of litigation.
Short-term Investments
The Company maintains its excess cash in U.S. treasury bills and notes,
government and corporate bonds issued with strong ratings. The specific
identification method is used to determine the cost of securities sold,
with realized gains and losses reflected in non-operating income and
expenses. As of December 31, 2005, all of the Company's investments were
classified as available-for-sale securities and were recorded at market
value. Unrealized gains and losses on these investments are included with
accumulated other comprehensive income and loss as a separate component of
shareholders' equity, net of any related tax effect, unless unrealized
losses are deemed other than temporary. Unrealized losses are recorded as a
charge to income when deemed other than temporary.
Inventories
The Company outsources the wafer fabrication, assembly, and testing of its
products. Inventories are stated at the lower of standard cost or market
value. Cost is determined on a currently adjusted standard basis, which
approximates actual cost on a first-in, first-out basis.
Long-term Investments
Long-term investments in private companies over which the Company does not
exercise significant influence are accounted for under the cost method of
accounting. Management evaluates related information in addition to quoted
market prices, if any, in determining the fair value of these investments
and whether an other-than-temporary decline in value exists. Factors
indicative of an other-than- temporary decline include recurring operating
losses, credit defaults and subsequent rounds of financings at an amount
below the cost basis of the investment. The list is not all-inclusive and
management periodically weighs all quantitative and qualitative factors in
determining if any impairment loss exists.
Long-term investments in listed companies are classified as
available-for-sales securities and are recorded at market value. Unrealized
gains and losses on these investments are included with accumulated other
comprehensive income and loss as a separate component of shareholders'
equity, net of any related tax effect, unless unrealized losses are deemed
other than temporary. Unrealized losses are recorded as a charge to income
when deemed other than temporary.
Land, Property and Equipment
Land, property and equipment are stated at cost less accumulated
depreciation. Major additions, renewals and betterments are capitalized,
while maintenance and repairs are expensed as incurred.
Depreciation is provided on the straight-line method over estimated service
lives that range as follows: buildings - 35 to 49.7 years, equipment - 3 to
10 years, furniture and fixtures - 3 to 15 years, leasehold improvements -
the shorter of the estimated useful life or the lease term, which is 2 to 6
years, and transportation equipment - 5 years. Depreciation expense
recognized during the years ended December 31, 2003, 2004 and 2005 were
approximately $2,325,000, $2,391,000 and $3,388,000, respectively.
F-8
Long-lived Asset Impairment
The Company evaluates the recoverability of long-lived assets whenever
events or changes in circumstances indicate the carrying value may not be
recoverable. The carrying value of a long-lived asset is considered
impaired when the anticipated undiscounted cash flows from such asset is
separately identifiable and is less than the carrying value. If impairment
occurs, a loss based on the excess of carrying value over the fair market
value of the long-lived asset is recognized. Fair market value is
determined by reference to quoted market prices, if available, or
discounted cash flows, as appropriate.
Treasury Stock
The Company retires ordinary shares repurchased under a share repurchase
plan. Accordingly, the excess of the purchase price over par value was
allocated between additional paid-in capital and retained earnings based on
the average issuance price of the shares repurchased. A repurchase of ADSs
is recorded as treasury stock until the Company completes the withdrawal of
the underlying ordinary shares from the ADS program.
Revenue Recognition
Revenue from product sales to customers, other than distributors, is
recognized at the time of shipment and when title and right of ownership
transfers to customers. The four criteria for revenue being realized and
earned are the existence of evidence of sale, actual shipment, fixed or
determinable selling price, and reasonable assurance of collectibility.
Allowances for sales returns and discounts are provided at the time of the
recognition of the related revenues on the basis of experience and these
provisions are deducted from sales.
In certain limited instances, the Company sells its products through
distributors. The Company has limited control over these distributors'
selling of products to third parties. Accordingly, the Company recognizes
revenue on sales to distributors when the distributors sell the Company's
products to third parties. Thus, products held by distributors are included
in the Company's inventory balance.
Research and Development
Research and development costs consist of expenditures incurred during the
course of planned research and investigation aimed at the discovery of new
knowledge that will be useful in developing new products or processes, or
at significantly enhancing existing products or production processes as
well as expenditures incurred for the design and testing of product
alternatives or construction of prototypes. All expenditures related to
research and development activities of the Company are charged to operating
expenses when incurred.
Advertising Expenses
The Company expenses all advertising and promotional costs as incurred.
These costs were $795,000 in 2003, $1,108,000 in 2004 and $1,447,000 in
2005, respectively. A portion of these costs was for advertising, which
amounted to $153,000 in 2003, $367,000 in 2004 and $453,000 in 2005,
respectively.
F-9
Income Tax
The Company is not subject to income or other taxes in the Cayman Islands.
However, subsidiaries are subject to taxes of the jurisdictions where they
are located.
Under current Republic of China ("ROC") tax regulations, the current year's
tax-basis earnings that are not distributed in the following year are
subject to a 10% additional income tax. This 10% additional income tax is
recognized in the period during which the related income is generated.
Income taxes are accounted for in accordance with Statement of Financial
Accounting Standards ("SFAS") No. 109 "Accounting for Income Taxes". The
provision for income tax represents income tax paid and payable for the
current year plus the changes in the deferred income tax assets and
liabilities during the relevant years. Deferred income tax assets are
recognized for operating loss carryforwards, research and development
credits, and temporary differences. The Company believes that uncertainty
exists regarding the realizability of certain deferred income tax assets
and, accordingly, has established a valuation allowance for those net
deferred income tax assets to the extent the realizability is not deemed
more likely than not.
Stock-based Compensation
The Company has elected to follow Accounting Principles Board Opinion
("APB") No. 25, "Accounting for Stock Issued to Employees" and complies
with the disclosure provisions of SFAS No. 123, "Accounting for
Stock-Based Compensation" for its employee stock options. Under APB No.
25, compensation expense is measured based on the difference, if any, on
the date of the grant, between the fair value of the Company's stock and
the exercise price.
At the end of June 2005, the Board of Directors of the Company (the "BOD")
approved the acceleration of the vesting of options with exercise prices
greater than $17 (pre-split basis). The BOD evaluated the minimal benefit
to its employees of accelerating the remaining vesting on these
significantly underwater options against the value to stockholders of not
having earnings materially affected and the impact that this may have on
the Company's market value. In addition, these options have exercise prices
in excess of current market values and are not fully achieving their
original objectives of incentive compensation and employee retention.
Accelerating the vesting of these options accelerated the recognition of
any remaining expense associated with these options which is zero under APB
No. 25.
Had the compensation expense for the Company's stock-based compensation
plans been determined on the basis of the fair values under SFAS No. 123,
the Company's net income and net income per share for the years ended
December 31, 2003, 2004 and 2005 would be the following:
F-10
Years Ended December 31
--------------------------------------------------------
2003 2004 2005
Net income as reported (in thousands) $ 13,201 $ 14,084 $ 8,147
Add: Stock-based compensation expense included
in net income, including tax expense of $0 for
2003, 2004 and 2005 -- -- --
Deduct: Stock-based compensation expense
determined under SFAS No. 123 including tax
expense of $0 for 2003, 2004 and 2005 (8,061) (6,940) (15,862)
----------------- ----------------- -----------------
Pro forma net income (loss) $ 5,140 $ 7,144 $ (7,715)
================= ================= =================
Pro forma shares used in calculation - basic (in
thousands) 1,918,700 1,957,800 1,961,168
================= ================= =================
Pro forma earnings (loss) per share - basic $ 0.0027 $ 0.0036 $ (0.0039)
================= ================= =================
Earnings per share - basic as reported $ 0.0069 $ 0.0072 $ 0.0042
================= ================= =================
Pro forma shares used in calculation - diluted (in
thousands) 1,986,800 2,005,100 1,997,459
================= ================= =================
Pro forma earnings (loss) per share - diluted $ 0.0026 $ 0.0036 $ NA
================= ================= =================
Earnings per share - diluted as reported $ 0.0066 $ 0.0070 $ 0.0041
================= ================= =================
Pro forma loss per share for the year ended December 31, 2005 was not
disclosed because the results were antidilutive.
This table includes a pro forma charge of $1,831,000 for the year ended
December 31, 2005 related to the above accelerated vesting event.
In September, November and December, 2005, the Company granted 1,100,000,
100,000 and 70,600,000 shares of stock options to employees with the
following features:
a. Employees will be granted fully vested, immediately exercisable stock
options to purchase the Company's ordinary shares.
b. The Company has the right but is not required to repurchase exercised
stock options upon termination of an employee's service with the
Company at the closing market price on the date of repurchase. The
shares subject to repurchase are those which qualify as mature shares
at the date of such employee's termination. Mature shares are those
that have been held by the employee for a period of more than six
months.
c. Employees are restricted from selling shares which are issued upon the
exercise of stock options for a total of four years with 25% of the
restriction lapsing each year.
d. There is no requisite service period or other performance criteria
required by the employee to earn the stock option.
The total pro forma charge for the immediately vested options was
$8,588,000 in 2005.
Foreign Currency Transactions
The functional currency is the local currency of the respective entities.
Foreign currency transactions are recorded at the rate of exchange in
effect when the transaction occurs. Gains or losses, resulting from the
application of different foreign exchange rates when cash in foreign
currency is converted into the entities' functional currency, or when
foreign currency receivable and payable are settled, are credited or
charged to income in the period of conversion or settlement. At year-end,
the balances of foreign currency monetary assets and liabilities are
restated based on prevailing exchange rates and any resulting gains or
losses are credited or charged to income.
F-11
Translation of Foreign Currency Financial Statements
The reporting currency of the Company is the U.S. dollar. Accordingly, the
financial statements of the foreign subsidiaries are translated into U.S.
dollars at the following exchange rates: Assets and liabilities - current
rate on balance sheet date; shareholders' equity - historical rate; income
and expenses - weighted average rate during the year. The resulting
translation adjustment is recorded as a separate component of shareholders'
equity.
Comprehensive Income (Loss)
Comprehensive income represents net income plus the results of certain
changes in shareholders' equity during a period from non-owner sources that
are not reflected in the consolidated statement of operations.
Legal Contingencies
The Company is currently involved in various claims and legal proceedings.
Periodically, the Company reviews the status of each significant matter and
assesses the potential financial exposure. If the potential loss from any
claim or legal proceeding is considered probable and the amount can be
estimated, the Company accrues a liability for the estimated loss. In view
of uncertainties related to these matters, accruals are based only on the
best information available at the time. As additional information becomes
available, the Company reassesses the potential liability related to the
pending claims and litigation and revises these estimates as appropriate.
Such revisions in the estimates of the potential liabilities could have a
material impact on the results of operations and financial position.
The Company indemnifies third parties with whom it enters into contractual
relationships, including customers, however, it is not possible to
determine the range of the amount of potential liability under these
indemnification obligations due to the lack of prior indemnification
claims. These indemnities typically hold these third parties harmless
against specified losses, such as those arising from a breach of
representation or covenant, or other third party claims that the Company's
products when used for their intended purposes infringe the intellectual
property rights of such other third parties. The indemnities are triggered
by any claim of infringement of intellectual property rights brought out by
a third party with respect to the Company's products. The terms of these
indemnities may not be waived or amended except by written notice signed by
the both parties and may only be terminated with respect to the Company's
products not yet purchased upon written notice.
Recent Accounting Pronouncements
In December 2004, the FASB issued SFAS No. 123(R) "Share-Based Payment".
SFAS No. 123(R) requires that companies recognize compensation expense
equal to the fair value of stock options or other share based payments for
the annual reporting period that begins after June 15, 2005. SFAS No.
123(R) applies to all awards granted after June 15, 2005, and prior
periods' awards that are modified, repurchased, or cancelled after June 15,
2005. The impact on the Company's net income will include the remaining
amortization of the fair value of existing options currently disclosed as a
pro forma expense in Note 2 in addition to the number of future options
granted, the selected transition method and the selection of either the
Black-Scholes or the binominal lattice model for valuing options. The
adoption of this standard will have no impact on the Company's cashflows.
In May 2005, the FASB issued SFAS No. 154 "Accounting Changes and Error
Corrections." SFAS No. 154 requires that companies apply accounting changes
and error corrections to financial statements retrospectively from the
previous period unless it is impracticable and is effective for the fiscal
years beginning after December 15, 2005. There is no impact to the Company
as a result of the adoption of this standard as the Company does not
currently intend to change its accounting principles, estimate or reporting
entity.
F-12
Reclassifications
Certain amounts reported in previous years have been reclassified to
conform to the presentation for the year ended December 31, 2005.
3. CASH AND CASH EQUIVALENTS
(In Thousands)
December 31
------------------------
2004 2005
Time deposits $ 19,383 $ 23,444
Savings and checking accounts 15,389 18,411
Cash management account -- 4,506
US treasury bills and corporate bonds 21,534 --
Petty cash 14 14
----------- -----------
$ 56,320 $ 46,375
=========== ===========
The Company's cash management account is administered by the Bank of China
to receive a fixed-rate return and as of December 31, 2005, it held foreign
currency which was equivalent to $4,506,000. The cash management account
came due on January 16, 2006 and the Company received $4,528,000. It
reinvested this amount at 3.9% which will become due on February 21, 2006.
4. SHORT-TERM INVESTMENTS
The following is a summary of available-for-sale securities:
(In Thousands)
December 31
------------------------
2004 2005
Time deposits $ 23,038 $ 15,993
US treasury bills 19,967 13,909
Corporate bonds 17,014 24,642
Foreign government bonds 3,724 1,075
Others 25 34
----------- -----------
$ 63,768 $ 55,653
=========== ===========
Available-for-sale securities by contractual maturity are as follows:
(In Thousands)
December 31
------------------------
2004 2005
Due within one year $ 61,023 $ 55,592
Due after one year through two years 1,698 --
Due after two years 1,047 61
----------- -----------
$ 63,768 $ 55,653
=========== ===========
The Company's gross realized gains and losses on the sale of investments
for the year ended December 31, 2003 were $0 and $5,000, respectively, for
the year ended December 31, 2004 were both $0, and for the year ended
December 31, 2005 were $12,000 and $2,000, respectively. Gross unrealized
gains and losses at December 31, 2004 were $293,000 and $182,000,
respectively, and at December 31, 2005 were $55,000 and $11,000,
respectively.
F-13
The following table shows the gross unrealized losses and fair value of the
Company's investments with unrealized losses that are not deemed to be
other-than-temporarily impaired, aggregated by investment category and
length of time that individual securities have been in a continuous
unrealized loss position, at December 31, 2004 and 2005.
(In Thousands)
December 31
-----------------------------------------------------------------------------------------------
2004 2005
---------------------- ----------------------
Less Than 12 Months Less Than 12 Months 12 Months or Greater Total
---------------------- ---------------------- ---------------------- ----------------------
Unrealized Unrealized Unrealized Unrealized
Fair Value Losses Fair Value Losses Fair Value Losses Fair Value Losses
US treasury bills $ 20,442 $ 83 $ -- $ -- $ -- $ -- $ -- $ --
Corporate bonds 5,106 94 24,642 11 -- -- 24,642 11
Foreign government
bonds 1,003 5 -- -- -- -- -- --
Investment in
CSMC (Note 8) 4,283 265 -- -- 3,580 968 3,580 968
---------- ---------- ---------- --------- ---------- ---------- ---------- ----------
$ 30,834 $ 447 $ 24,642 $ 11 $ 3,580 $ 968 $ 28,222 $ 979
========== ========== =========== ========= ========== ========== ========== ==========
5. ACCOUNTS RECEIVABLE, NET
(In Thousands)
December 31
------------------------
2004 2005
Accounts receivable $ 9,838 $ 11,810
Allowances for
Doubtful receivable (90) (34)
Sales returns and discounts (317) (316)
----------- -----------
$ 9,431 $ 11,460
=========== ===========
The changes in the allowances are summarized as follows:
(In Thousands)
Years Ended December 31
------------------------------------------
2003 2004 2005
Allowances for doubtful receivables
Balance, beginning of the year $ 64 $ 86 $ 90
Additions 22 4 --
Reversal and Write off -- -- (56)
------------ ------------ ------------
Balance, end of the year $ 86 $ 90 $ 34
============ ============ ============
Allowances for sales returns and discounts
Balance, beginning of the year $ 314 $ 315 $ 317
Additions 663 252 587
Write off (662) (250) (588)
------------ ------------ ------------
Balance, end of the year $ 315 $ 317 $ 316
============ ============ ============
F-14
6. INVENTORIES
(In Thousands)
December 31
------------------------
2004 2005
Finished goods $ 2,844 $ 2,954
Work-in-process 4,336 8,401
Raw materials 4,051 4,588
----------- -----------
$ 11,231 $ 15,943
=========== ===========
7. PREPAID EXPENSES AND OTHER CURRENT ASSETS
(In Thousands)
December 31
------------------------
2004 2005
Prepayment to foundry providers $ -- $ 3,000
Interest receivable 1,543 1,656
Other receivable 674 211
Prepaid expense 798 895
Value-added-tax paid 671 309
Deferred tax assets 289 10
Others 516 584
----------- -----------
$ 4,491 $ 6,665
=========== ===========
8. LONG-TERM INVESTMENTS
(In Thousands)
December 31
------------------------
2004 2005
Cost method
X-FAB Semiconductor Foundries AG (X-FAB) $ 4,968 $ 4,968
360 Degree Web Ltd. (360 Degree Web) 1,070 1,305
GEM Services, Inc. (GEM) 500 500
Etrend Hightech Corporation (Etrend) 960 960
Asia SinoMOS Semiconductor Inc. (Sinomos) -- 5,000
Philip Ventures Enterprise Fund (PVEF) -- 585
----------- -----------
7,498 13,318
Available for sale securities - noncurrent
CSMC Technologies Corporation (CSMC) 4,283 3,580
----------- -----------
$ 11,781 $ 16,898
=========== ===========
F-15
The Company invested in X-FAB's ordinary shares in July 2002. X-FAB is a
European-American foundry group that specializes in mixed signal
applications. As of December 31, 2005, the Company held 530,000 shares at
the value of $4,968,000 (4,982,000 EURO), which represents a 2.39%
ownership of X-FAB.
On January 3, 2003, the Company exercised its option to convert its
convertible loans of $1,750,000 in 360 Degree Web to 2,083,333 Series B
preference shares of capital stock at $0.36 per share and 1,000,000 Series
B2 preference shares of capital stock at $1.00 per share. 360 Degree Web
designs, develops and markets intelligent security software solutions that
provide secure computing environment for personal computer mobile devices
and the internet. After the conversion, the Company had a 35.2% ownership
in 360 Degree Web. The Company did not participate in 360 Degree Web's
financing during 2003 and the ownership was diluted to 29.3% as of December
31, 2003. The Company accounts for its investment under the cost method of
accounting as it cannot exercise significant influence over 360 Degree Web.
In March 2004, the Company sold 1,000,000 shares of its stock in 360 Degree
Web and recognized a gain of $340,000. Upon completion of the transaction,
the Company"s ownership was reduced to 19.8% as of December 31, 2004. In
January 2005, the Company purchased 180,769 Series D preference shares of
360 Degree Web at $1.3 per share. As of December 31, 2005, the Company held
19.52% of ownership to 360 Degree Web.
The Company invested in GEM's preferred shares in August 2002. GEM is a
multinational semiconductor assembly and test company. As of December 31,
2005, the Company held 333,334 shares at the value of $500,000, which
represented a 1.07% ownership of GEM.
The Company invested in Etrend's ordinary shares in December 2002, July
2003 and March 2004. Etrend is a wafer probing, packing and testing
company. As of December 31, 2003, the Company held 2,189,288 shares at the
value of $647,000, which represents approximately 12.5% ownership of
Etrend. The Company invested an additional $313,000 for Etrend's financing
in March 2004. As of December 31, 2005, the Company's ownership was reduced
to 11.20%.
The Company invested in Silicon Genesis Corporation (SiGen) preferred
shares in December 2000. SiGen is an advanced nanotechnology company that
develops Silicon-on-insulator "SOI", strained-silicon products and other
engineered multi-layer structures to microelectronics and photonics
industries for advanced electronic and opto-electronic device applications.
In 2002 and 2003, the Company reviewed the qualitative factors of the
investment, determined that the decline in value was other-than-temporary
and recognized an impairment loss of $483,000 and $17,000, respectively.
The Company held 23,946 shares of SiGen as of December 31, 2005
representing a 0.09% ownership in SiGen with a carrying value of zero.
In August 2004, the Company invested in CSMC's ordinary shares which are
listed on The Stock Exchange of Hong Kong Limited. CSMC is a semiconductor
foundry company. The Company held 70,200,000 shares at a purchase price of
$4,547,000, which represents approximately 2.62% ownership of CSMC. As of
December 31, 2005, the Company recognized unrealized losses of $968,000.
The Company evaluated the near-term prospects of CSMC in relation to the
severity and duration of the impairment. Based on the evaluation and the
Company's ability and intent to establish a strategic partnership with CSMC
for a reasonable period of time sufficient for a forecasted recovery of
fair value, the Company does not consider the investment to be
other-than-temporarily impaired at December 31, 2005.
In January 2005, the Company purchased 5,882,353 ordinary shares of
Sinomos, a privately owned foundry company, at $0.85 per share for a total
amount of $5,000,000. The Company held 9.69% ownership of Sinomos as of
December 31, 2005.
In November 2005, the Company invested in PVEF, a fund management company
in Singapore, with investment amount of SGD 1,000,000 for 20 units in the
placement at SGD 50,000 per unit. The Company held 10.8% of the fund as of
December 31, 2005.
F-16
9. LAND, PROPERTY AND EQUIPMENT, NET
(In Thousands)
December 31
------------------------
2004 2005
Cost
Land $ 2,510 $ 2,510
Buildings 2,150 8,055
Equipment 13,195 19,056
Furniture and fixtures 1,054 1,229
Leasehold improvements 1,309 2,045
Transportation equipment 56 241
Prepayment for property and equipment 179 3,034
----------- -----------
20,453 36,170
(Continued)
December 31
------------------------
2004 2005
Accumulated depreciation
Buildings $ 39 $ 132
Equipment 8,497 11,116
Furniture and fixtures 420 586
Leasehold improvements 698 966
Transportation equipment 41 51
----------- -----------
9,695 12,851
$ 10,758 $ 23,319
=========== ===========
In view of the expansion of the Company's operations in the People's
Republic of China (the "PRC"), the Company acquired buildings located in
Shanghai, PRC in October 2005. The total purchase price was $7,077,000 of
which $1,414,000 was paid for land use rights and the balance of $5,663,000
was paid for the building. The land use right was accounted for as other
assets (see Note 10).
10. OTHER ASSETS
(In Thousands)
December 31
------------------------
2004 2005
Land use rights, net $ -- $ 1,407
Deferred charges, net 789 665
Long-term notes receivable from employees 435 410
Refundable deposits 432 493
Prepayment for land use rights -- 208
Deferred income tax assets - noncurrent -- 62
----------- -----------
$ 1,656 $ 3,245
=========== ===========
All land within municipal zones in the PRC is owned by the PRC government.
Limited liability companies, joint stock companies, foreign-invested
enterprises, privately held companies and individual natural persons must
pay fees for granting of rights to use land within municipal zones. Legal
use of land is evidenced and sanctioned by land use certificates issued by
the local municipal administration of land resources. Land use rights
granted for industrial purposes are limited to a term of no more than 50
years.
F-17
Land use rights are recorded at cost less accumulated amortization.
Amortization is provided on the straight-line method over the term of the
land use rights agreement which is 49.7 years.
In view of the expansion of the Company's operations in the PRC, the
Company entered into a purchase contract to acquire land use rights located
in Ningbo, PRC. The total contracted price was $694,000 of which $208,000
has been paid as of December 31, 2005 and such amount has been included in
the prepayment for land use rights..
Deferred charges consist of consultant and maintenance contracts and are
amortized over the term of the contract which is 3 to 8 years.
In 2001, James Keim, one of the Company's directors, accepted the
assignment of Head of Marketing and Sales in the Cayman Islands, and moved
to the Cayman Islands in December 2001. In connection with the move and to
assist Mr. Keim to purchase a residence in the Cayman Islands, the Company
entered into a loan agreement with Mr. Keim in February 2002, under which
the Company made an interest free, unsecured loan in the amount of $400,000
to Mr. Keim. The loan is repayable in February 2007. As of December 31,
2005, $18,000 had been repaid.
11. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES
(In Thousands)
December 31
------------------------
2004 2005
Salaries, bonus and benefits $ 2,150 $ 3,424
Legal and audit fees 1,917 3,916
Hong Kong Stock Exchange listing expenses - 1,970
Payable for acquisition of equipment - 1,183
Deferred income tax liabilities 388 698
Withholding tax payable 168 223
Value-added tax payable 90 209
Commissions 126 145
Other accrued expenses 2,190 2,324
----------- -----------
$ 7,029 $ 14,092
=========== ===========
F-18
12. INCOME TAX
Income before income taxes consisted of:
(In Thousands)
Years Ended December 31
------------------------------------------
2003 2004 2005
Cayman Islands $ 12,159 $ 15,496 $ 6,226
Foreign 2,868 60 2,955
------------ ------------ ------------
$ 15,027 $ 15,556 $ 9,181
============ ============ ============
Income tax expense consisted of:
(In Thousands)
Years Ended December 31
------------------------------------------
2003 2004 2005
Current $ 1,440 $ 1,540 $ 507
Deferred 386 (68) 527
------------ ------------ ------------
Income tax expense $ 1,826 $ 1,472 $ 1,034
============ ============ ============
The Company and its subsidiaries file separate income tax returns.
Reconciliation of the significant differences between the statutory income
tax rate and the effective income tax rate on pretax income is as follows:
Years Ended December 31
------------------------------------------
2003 2004 2005
Cayman statutory rate 0% 0% 0%
Foreign in excess of statutory rate 10.72% 7.09% 15.69%
Research and development credits (4.39%) (6.08%) (9.56%)
Adjustments to prior years' taxes 0.09% 3.49% (9.11%)
Change in valuation allowance 2.55% 4.59% 9.74%
Others 3.18% 0.37% 4.50%
------------ ------------ ------------
Effective tax rate 12.15% 9.46% 11.26%
============ ============ ============
F-19
The deferred income tax assets and liabilities as of December 31, 2004 and
2005 consisted of the following:
(In Thousands)
December 31
------------------------
2004 2005
Deferred income tax assets
Research and development credits $ 4,443 $ 5,189
Net operating loss carryforwards 254 46
Accrued vacation 117 30
Depreciation and amortization 7 238
Others 149 121
----------- -----------
4,970 5,624
Valuation allowance (4,681) (5,552)
----------- -----------
Total net deferred income tax assets 289 72
----------- -----------
Deferred income tax liabilities
Withholding tax liabilities 413 647
Unrealized foreign exchange (64) --
Unrealized capital allowance 39 51
----------- -----------
Total deferred income tax liabilities 388 698
----------- -----------
Net deferred income tax liabilities $ (99) $ (626)
=========== ===========
Balance sheet caption reported in:
Prepaid expenses and other current assets $ 289 $ 10
Other assets -- 62
Accrued expenses and other current liabilities 388 698
----------- -----------
$ (99) $ (626)
=========== ===========
The valuation allowance shown in the table above relates to net operating
loss and credit carryforwards and temporary differences for which the
Company believes that realization is uncertain. The valuation allowance
increased $772,000 and $871,000 for the years ended December 31, 2004 and
2005, respectively.
As of December 31, 2005, O2 Micro, Inc. had U.S. state net operating loss
carryforwards of approximately $583,000, and federal and state research and
development credit carryforwards of approximately $3,115,000 and
$3,143,000, respectively. The state net operating loss carryforwards will
expire in 2014 through 2015 if not utilized. The U.S. federal research and
development credit will expire from 2012 through 2025 if not utilized,
while the state research and development credit will never expire.
Utilization of the net operating loss carryforwards may be subject to
significant annual limitation due to the ownership change limitations
provided by the U.S. Internal Revenue Code of 1986 and similar provisions
in the State of California's tax regulations. The annual limitation may
result in the expiration of net operating losses before utilization.
The Company reversed $375,000 of income tax payable for the 2000 tax year
in September 2004 due to completion of the examination and approval of its
filed income tax return for the year ended December 31, 2000.
On May 24, 2004, O2 Micro-Taiwan applied to the Taiwan Customs officials
for the rectification of the value of the imported goods reported for the
period from March 2003 to March 2004. The Company had mistakenly reported a
lower amount to the Taiwan Customs Authority than the correct amount that
was reported on the Company's tax return for the years ended December 31,
2003 and 2004. However, rectification of Customs' records usually cannot
extend beyond the latest six month period reported. If the Company's
rectification application for the period beyond the latest six months had
been rejected, the understated cost of the imported goods reported to the
Customs officials would have been deemed to be the actual cost and thus the
taxable income for the years ended December 31, 2003 and 2004 would have
been higher. The Company determined the maximum impact on income tax would
be $1,680,000 (NT$52,000,000) for O2 Micro-Taiwan. Accordingly, the Company
estimated the probable outcome and accrued $658,000 (NT$22,000,000) at
December 31, 2004. Subsequently, the Company has obtained confirmation from
Taiwan's Ministry of Finance that it will accept rectification of the value
of the imported goods prior to the latest six month period and the Company
had applied for and completed the rectification to the Taiwan Customs
Authority as of June 30, 2005. The accrual of $658,000 was reversed at June
30, 2005.
F-20
13. EMPLOYEE BENEFIT PLANS
Savings Plan
The Company has a savings plan that qualifies under Section 401(k) of the
U.S. Internal Revenue Code. Participating employees may defer up to the
U.S. Internal Revenue Service statutory limits amount of pretax salary. The
Company may make voluntary contributions to the savings plan but has made
no contributions since the inception of the savings plan in 1997.
1999 Employee Stock Purchase Plan ("1999 Purchase Plan")
In 1999, the Company's Board of Directors adopted the 1999 Purchase Plan,
which was approved by the shareholders prior to the consummation of its
initial public offering in August 2000. A total of 50,000,000 ordinary
shares have been reserved for issuance under the 1999 Purchase Plan, plus
annual increases on January 1 of each year, commencing in 2001, up to
40,000,000 shares as approved by the Board of Directors. The 1999 Purchase
Plan is subject to adjustment in the event of a stock split, stock dividend
or other similar changes in ordinary shares or capital structure.
The 1999 Purchase Plan permits eligible employees to purchase ordinary
shares through payroll deductions, which may range from 1% to 10% of an
employee's regular base pay. Beginning November 1, 2005, the 1999 Purchase
Plan shall be implemented through consecutive offer periods of 3 months'
duration commencing each February 1, May 1, August 1 and November 1. Under
the 1999 Purchase Plan, ordinary shares may be purchased at a price equal
to the lesser of 90% of the fair market value of the Company's ordinary
shares on the date of grant of the option to purchase (which is the first
day of the offer period) or 90% of the fair market value of the Company's
ordinary shares on the applicable exercise date (which is the last day of
the offer period). Employees may elect to discontinue their participation
in the purchase plan at any time, however, all of the employee's payroll
deductions previously credited to the employee's account will be applied to
the exercise of the employee's option on the next exercise date.
Participation ends automatically on termination of employment with the
Company. If not terminated earlier, the 1999 Purchase Plan will have a term
of 10 years. During 2004 and 2005, 5,923,950 and 6,389,200 ordinary shares,
respectively, had been purchased under the 1999 Purchase Plan. As of
December 31, 2005, 22,832,000 shares were available for issuance.
Stock Option Plans
In 1997, the Company's Board of Directors adopted the 1997 Stock Plan, and
in 1999, adopted the 1999 Stock Incentive Plan (collectively, the "Plans").
The Plans provide for the granting of stock options to employees, directors
and consultants of the Company. Options granted under the Plans may be
either incentive stock options ("ISO") within the meaning of Section 422 of
the U.S. Internal Revenue Code, or nonstatutory stock options ("NSO"). ISOs
may be granted only to Company employees and directors. NSOs may be granted
to Company employees and consultants.
Options under the Plans may be granted for periods of up to ten years and
at prices no less than 85% of the estimated fair value of the shares (in
the case of NSOs) on the date of grant as determined by the Board of
Directors, provided, however, that (i) the exercise price of an ISO may not
be less than 100% of the estimated fair value of the shares on the date of
grant, and (ii) the exercise price of an ISO granted to a 10% shareholder
may not be less than 110% of the estimated fair value of the shares on the
date of grant. Options may be exercised following the termination of a
grantee's continuous service only to the extent provided in the award
agreement. Options generally expire no later than ten years after grant, or
five years in the case of an ISO granted to a 10% shareholder. The options
generally vest over a period of four years from the vesting commencement
date. Options may be granted with different vesting terms from time to
time.
Under the 1997 Stock Plan, the Board of Directors reserved 185,000,000
ordinary shares for issuance. After the completion of an initial public
offering, no further options were granted under the 1997 Stock Plan. Under
the 1999 Stock Incentive Plan, the maximum aggregate number of shares
available for grant shall be 150,000,000 ordinary shares plus an annual
increase on January 1 of each year, commencing in 2001, equal to the least
of 75,000,000 shares (in the case of ISOs) or 4% of the outstanding
ordinary shares on the last day of the preceding fiscal year or a smaller
number determined by the administrator. As of December 31, 2005, the number
of options outstanding and exercisable were 21,408,700 and 21,408,700,
respectively, under the 1997 Stock Plan, and 289,075,650 and 203,810,500
under the 1999 Stock Incentive Plan, respectively.
F-21
A summary of the Company's stock option activity and related information is
as follows:
Weighted
Number of Average
Available Outstanding Exercise
for Grant Options Price
Balance, January 1, 2003 91,593,650 202,208,500
Additional shares authorized 75,000,000 --
Granted (45,665,000) 45,665,000 $ 0.2776
Exercised -- (43,199,350) $ 0.1304
Canceled 8,681,150 (8,681,150) $ 0.2610
----------------- -----------------
Balance, December 31, 2003 129,609,800 195,993,000
Additional shares authorized 50,000,000 --
Granted (45,202,500) 45,202,500 $ 0.2708
Exercised -- (7,808,350) $ 0.1630
Canceled 9,732,100 (9,732,100) $ 0.2804
----------------- -----------------
Balance, December 31, 2004 144,139,400 223,655,050
Granted (104,990,000) 104,990,000 $ 0.2178
Exercised -- (7,422,050) $ 0.1596
Canceled 10,738,650 (10,738,650) $ 0.2642
----------------- -----------------
Balance, December 31, 2005 49,888,050 310,484,350
================= =================
The following table summarizes information about the stock options
outstanding as of December 31, 2005:
Options Outstanding Options Exercisable
---------------------------------------------- -----------------------------
Weighted
Average Weighted Weighted
Remaining Average Number Average
Number Contractual Exercise Exercisable Exercise
Range of Exercise Prices and Vested
Outstanding Life Price Price
$0.0006-$0.0017 2,943,750 1.40 $ 0.0008 2,943,750 $ 0.0008
$0.0036-$0.0050 50,000 2.83 $ 0.0050 50,000 $ 0.0050
$0.0100 2,316,650 3.19 $ 0.0100 2,316,650 $ 0.0100
$0.0790-$0.1175 10,411,800 4.29 $ 0.0968 10,411,800 $ 0.0968
$0.1300-$0.1948 53,907,100 6.21 $ 0.1718 43,878,950 $ 0.1711
$0.2013-$0.2994 182,514,350 8.50 $ 0.2315 120,325,400 $ 0.2250
$0.3076-$0.4836 58,340,700 7.40 $ 0.3572 45,292,650 $ 0.3656
--------------- ---------------
310,484,350 7.64 $ 0.2364 225,219,200 $ 0.2317
=============== ===============
For purposes of measuring compensation expense under APB No. 25, the fair
value of the shares on the date of grant was determined by the Board of
Directors for grants prior to August 23, 2000. The fair value of subsequent
option grants were based on the market price of ordinary shares on the day
of grant.
F-22
The Company calculated the fair value of each option grant on the date of
grant using the Black-Scholes option pricing model as prescribed by SFAS
No. 123. The Black-Scholes option valuation model was developed for
estimating the fair value of traded options that have no vesting
restrictions and are fully transferable. In addition, option valuation
model requires the input of highly subjective assumptions, including the
expected stock price volatility. The Company used the following
weighted-average assumptions in calculating the fair value of the options
granted:
Stock Options Employee Stock Purchase Plan
------------------------------------- ------------------------------------
Years Ended December 31 Years Ended December 31
------------------------------------- ------------------------------------
2003 2004 2005 2003 2004 2005
Risk-free interest rate 3.34% 3.54% 4.06% 1.58%- -- 2.20%-
1.80% 3.96%
Expected life 5-9 years 5-7 years 5-7 years 0.51-1.53 -- 0.26-0.51
years years
Volatility 70% 65% 65% 65% -- 38%-78%
Dividend -- -- -- -- -- --
Expected life of stock options is estimated to be one year after vesting.
The weighted average fair values under SFAS No. 123 for options granted
during the years ended December 31, 2003, 2004 and 2005 were $0.1528,
$0.1726 and $0.1338, respectively. The weighted average fair values under
SFAS No. 123 for purchase rights granted pursuant to the Employee Stock
Purchase Plan during the years ended December 31, 2003 and 2005 were
$0.1080 and $0.0675, respectively. There is no purchase rights granted
pursuant to the Employee Stock Purchase Plan during the year ended December
31, 2004.
Ordinary Shares Reserved
As of December 31, 2005, ordinary shares reserved for future issuance were
as follows:
Outstanding stock options 310,484,350
Shares reserved for future stock option grants 49,888,050
Shares reserved for employee stock purchase plan 22,832,000
-------------
383,204,400
F-23
14. EARNINGS PER SHARE
Basic earnings per share is calculated by dividing net income by the
weighted average number of ordinary shares outstanding during the period.
Diluted earnings per share is calculated by dividing net income by the
weighted average number of ordinary and dilutive ordinary equivalent shares
outstanding during the period, using either the "as if converted" method
for convertible preference shares or the treasury stock method for options
and warrants.
A reconciliation of the numerator and denominator of basic and diluted
earnings per share calculations is provided as follows:
Years Ended December 31
------------------------------------------------
2003 2004 2005
Net income (in thousands) $ 13,201 $ 14,084 $ 8,147
============== ============== ==============
Weighted average thousand shares outstanding - basic 1,918,700 1,957,800 1,961,168
Effect of dilutive securities:
Options (in thousands) 68,100 47,300 36,291
-------------- -------------- --------------
Weighted average thousand shares outstanding - diluted 1,986,800 2,005,100 1,997,459
============== ============== ==============
Earnings per share - basic $ 0.0069 $ 0.0072 $ 0.0042
============== ============== ==============
Earnings per share - diluted $ 0.0066 $ 0.0070 $ 0.0041
============== ============== ==============
Certain antidilutive outstanding options were excluded from the computation
of diluted EPS since their exercise prices exceeded the average market
price of the ordinary shares during the period. The antidilutive stock
options excluded and their associated exercise prices per share were
45,832,300 shares at $0.3076 to $0.4836 as of December 31, 2003, 61,351,850
shares at $0.2994 to $0.4836 as of December 31, 2004 and 128,293,200 shares
at $0.2538 to $0.4836 as of December 31, 2005.
15. COMMITMENTS
Capital Commitments
As described in note 10, the land use right purchase commitment was
$486,000 as of December 31, 2005.
Lease Commitments
The Company leases office space and certain equipment under non-cancelable
operating lease agreements that expire at various dates through December
2008. The Company's office lease provides for periodic rental increases
based on the general inflation rate.
As of December 31, 2005, minimum lease payments under all noncancelable
leases were as follows:
Year Operating Leases
(In Thousands)
2006 $ 1,009
2007 204
2008 121
---------
Total minimum lease payments $ 1,334
=========
F-24
16. CONTINGENCIES
The Company is involved in a variety of litigation matters involving
intellectual property. For example, the Company has initiated and is
pursuing certain patent infringement actions in Taiwan. In January 2003,
the Shilin District Court in Taiwan issued a preliminary injunction
prohibiting Monolithic Power Systems, Inc., or MPS, from designing,
manufacturing, selling, importing or displaying certain of its products
which infringe on the Company's Taiwan patents. MPS filed counterclaims for
unfair competition and impairment of business reputation. The Company's
litigation with MPS is ongoing. MPS has also filed a petition with the
Taiwan Fair Trade Commission, or the FTC, claiming that the Company has
violated the Taiwan Fair Trade Law. The Company has filed a response to
this claim with the FTC, but no further action has been taken by the FTC to
date.
In February 2003, the Taipei District Court in Taiwan issued a preliminary
injunction prohibiting Beyond Innovation Technology Co., Ltd., or BiTEK,
from making, selling, using, or importing for the purposes of making,
selling and using, its BIT3105, BIT3105-P and BIT3106 "high efficiency ZVS
CCFL controller" related products. In August 2003, the Taipei District
Court issued a preliminary injunction prohibiting BiTEK from designing,
making, selling, displaying and importing and all other disposing acts
related to its products, including, without limitation, BIT3107.
In September 2003, December 2003, February 2004, May 2004, September 2004
and March 2005, the Company was also granted similar preliminary
injunctions or provisional attachments against Clevo Computer Company,
Asustek Computer Inc., Silicon Motion, Inc. and Micro-Star International
Co., Ltd. and Silicon Motion, Inc., Samsung Electronics Co., Ltd. and
Taiwan Sumida Electronics, Inc., respectively, in the Company's patent
infringement actions against these companies. As of December 31, 2005, the
Company has deposited an amount of New Taiwan dollars equivalent to
approximately US$14.5 million with the Taiwan courts for court bonds, which
was accounted for as restricted assets, in connection with those and other
preliminary injunction actions and related provisional attachment actions.
The court bonds provide security for the enjoined party to claim damages
against the Company in the event the Company does not ultimately succeed in
the underlying infringement actions. However, these preliminary injunctions
or provisional attachments may be rescinded if the relevant court allows
the opposing party to make its own deposit with the court.
The Company has been in litigation against MPS in the United States
District Court in the Northern District of California. MPS has alleged that
certain of the Company's products infringe on one of its patents and a
continuation of that patent. In May 2004, the court granted the Company's
motion for summary judgment that MPS lacked evidence of damages. Trial on
MPS' claim commenced in June 2005 and, in July 2005, the Company received a
jury verdict that all patent claims asserted by MPS were invalid and were
not infringed by the Company. In November 2005, the court entered judgment
in the Company's favour on MPS' patent claims. The verdict is subject to
further post-trial motions with the court to challenge the verdict and
possible subsequent appeal by MPS. If MPS is able to overturn the summary
judgment and/or jury verdict, then it may attempt to seek injunctive relief
and legal costs.
In addition, the Company has filed patent infringement actions in the U.S.
District Court in the Eastern District of Texas, the U.S. District Court in
the Northern District of California and the Taiwan District Courts against
various defendants. In response, several defendants have counterclaimed for
antitrust violations, interference, unfair competition and trade secrets
misappropriation.
While the Company cannot make any assurance regarding the eventual
resolution of these matters, the Company does not believe the final outcome
will have a material adverse effect on its consolidated results of
operations or financial condition.
F-25
The Company, as a normal course of business, is a party to various
litigation matters, legal proceedings and claims. These actions may be in
various jurisdictions, and may involve patent protection and/or patent
infringement. While the results of such litigations and claims cannot be
predicted with certainty, the final outcome of such matters is not expected
to have a material adverse effect on its consolidated financial position or
results of operations. No assurance can be given, however, that these
matters will be resolved without the Company becoming obligated to make
payments or to pay other costs to the opposing parties, with the potential
for having an adverse effect on the Company's financial position or its
results of operations. As of December 31, 2005, no provision for any
litigation has been provided.
17. FINANCIAL INSTRUMENTS
Information on the Company's financial instruments is as follows:
(In Thousands)
December 31
--------------------------------------------------
2004 2005
------------ -----------
Carrying Fair Carrying Fair
Amount Value Amount Value
Assets
Cash and cash equivalents $ 56,320 $ 56,320 $ 46,375 $ 46,375
Restricted cash 1,887 1,887 5,605 5,605
Short-term investments 63,768 63,768 55,653 55,653
Long-term investment in CSMC 4,283 4,283 3,580 3,580
Restricted assets 13,873 13,577 14,492 14,416
The carrying amounts of cash and cash equivalents and restricted cash
reported in the consolidated balance sheets approximate their estimated
fair values. The fair values of short-term investments and long-term
investment in CSMC are based on quoted market prices.
Fair value of restricted assets made in the form of Taiwan Government bonds
are based on quoted market price; the remaining restricted assets are
carried at amounts which approximate fair value.
Long-term investments, except for investment in CSMC, are in privately-held
companies where there is no readily determinable market value. The Company
periodically evaluates these investments for impairment. If it is
determined that an other-than-temporary decline has occurred in the
carrying value, an impairment loss is recorded in the period of decline in
value.
F-26
18. SEGMENT INFORMATION
The Company designs, develops and markets high performance semiconductors
for power management and security applications. The Company's semiconductor
products are produced with digital, analog, and mixed signal integrated
circuit manufacturing processes. The Company's Chief Operating Decision
Maker ("CODM"), the Chief Executive Officer, reviews information on an
enterprise-wide basis to assess performance and allocate resources and has
determined the Company has one reporting segment.
Net sales to unaffiliated customers by geographic region are based on the
customer's ship-to location and were as follows:
(In Thousands)
Years Ended December 31
------------------------------------------------
2003 2004 2005
People's Republic of China $ 23,024 $ 55,930 $ 60,889
Korea 9,353 10,345 22,957
Taiwan 41,819 18,898 14,891
Japan 9,177 6,092 6,323
Others 5,226 931 492
-------------- -------------- --------------
$ 88,599 $ 92,196 $ 105,552
============== ============== ==============
Long-lived assets consist of land, property and equipment and are based on
the physical location of the assets at the end of each year, and were as
follows:
(In Thousands)
December 31
-------------------------------
2004 2005
Taiwan $ 2,772 $ 7,795
U.S.A. 6,551 6,804
Singapore 327 274
People's Republic of China 757 8,244
Others 351 202
-------------- --------------
$ 10,758 $ 23,319
============== ==============
For the year ended December 31, 2003, one customer accounted for 13.5% of
net sales and the same customer accounted for 17.5% of net sales for the
year ended December 31, 2004. For the year ended December 31, 2005, no
customers accounted for 10% or more of net sales.
F-27