SANDISK CORP (SNDK) Annual Report (SEC form 10-K)
ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Certain statements in this discussion and analysis are forward looking statements based on current
expectations, and entail various risks and uncertainties that could cause actual results to differ materially from those expressed
in such forward looking statements. Such risks and uncertainties are set forth in "Item 1: Business - Risk Factors." The
following discussion should be read in conjunction with the Company's consolidated financial statements and the notes thereto.
Overview The Company was founded in 1988 to develop and market flash data storage systems. The Company sells its
products to the consumer electronics and industrial/communications markets. During the course of 1997, the percentage of the
Company's product sales attributable to the consumer electronics market, particularly sales of CompactFlash for use in digital
camera applications, increased substantially. This increase in sales to the consumer market resulted in a shift to lower capacity
products, which typically have lower average selling prices and gross margins than higher capacity products. In addition, these
products are frequently sold into the retail channel, which usually has shorter customer order lead-times than the other channels
used by the Company, thereby decreasing the Company's ability to accurately forecast future production needs. Subject to
market acceptance of its CompactFlash products, the Company believes these products will continue to represent a majority of
the Company's sales as the popularity of consumer applications, including digital cameras, increases. The percentage of sales
attributable to orders received and fulfilled in the same quarter has increased over time and, in response, the Company is
continuing to work to shorten its manufacturing cycle times. The Company's operating results are affected by a number of
factors including the volume of product sales, the timing of significant orders, competitive pricing pressures, the ability of the
Company to match supply with demand, changes in product and customer mix, market acceptance of new or enhanced
versions of the Company's products, changes in the channels through which the Company's products are distributed, timing of
new product announcements and introductions by the Company and its competitors, the timing of license and royalty revenues,
fluctuations in product costs, availability of foundry capacity, variations in manufacturing cycle times, fluctuations in
manufacturing yields and manufacturing utilization, increased research and development expenses, exchange rate fluctuations,
and an expected significant increase in the Company's effective tax rate in 1998. In addition, as the proportion of the
Company's products sold for use in consumer electronics applications increases, the Company's revenues may become subject
to seasonal declines in the first quarter of each year. See "Item 1: Business - Risk Factors - Fluctuations in Operating Results"
and "- Seasonality." Beginning in late 1995, the Company adopted a strategy of licensing its flash technology, including its
patent portfolio, to selected third party manufacturers of flash products. To date, the Company has entered into patent
cross-license agreements with five major companies, and it intends to pursue opportunities to enter into additional licenses. The
Company's current license agreements provide for the payment of license fees, royalties, or a combination thereof, to the
Company. The timing and amount of these payments can vary substantially from quarter to quarter, depending on the terms of
each agreement and, in some cases, the timing of sales of products by the other parties. As a result, license and royalty
revenues have fluctuated significantly in the past and are likely to continue to fluctuate in the future. Given the relatively high
gross margins associated with license and royalty revenues, gross margins and net income are likely to fluctuate more with
changes in license and royalty revenues than with changes in product revenues. SanDisk markets its products using a direct
sales organization, distributors, manufacturers' representatives, private label partners, OEMs and retailers. The Company
expects that sales through the retail channel will comprise an increasing share of total revenues in the future, and that a
substantial portion of its sales into the retail channel will be made to participants that will have the right to return unsold
products. The Company does not expect to recognize revenues from these sales until the products are sold to the end
customers. See "Item 1: Business - Sales and Distribution." 28 Historically, a majority of the Company's sales have been to a
limited number of customers. Product sales to the Company's top 10 customers accounted for approximately 67%, 71% and
80%, respectively, of the Company's product revenues for 1997, 1996 and 1995. The Company expects that sales of its
products to a limited number of customers will continue to account for a substantial portion of its product revenues for the
foreseeable future. The Company has also experienced significant changes in the composition of its customer base from year to
year and expects this pattern to continue as market demand for such customers' products fluctuates. For example, during the
fourth quarter of 1996, the volume of large OEM orders decreased due to the timing of customers' product introductions. The
loss of, or significant reduction in purchases by major customers, could have a material adverse effect on the Company's
business, financial condition and results of operations. See "Item 1: Business - Risk Factors - Customer Concentration" and
"Business - Sales and Distribution." Due to the emerging nature of the Company's markets and certain planned product
transitions, the Company has had difficulty forecasting future inventory levels required to meet customer demand. As a result of
both contractual obligations and manufacturing cycle time, the Company has been required to order wafers from its foundries
several months in advance of the ultimate shipment of its products. Under the Company's wafer supply agreements, there are
limits on the number of wafers the Company can order and the Company's ability to change that quantity is restricted.
Accordingly, the Company's ability to react to significant fluctuations in demand for its products is limited. As a result, the
Company has not been able to match its purchases of wafers to specific customer orders and therefore the Company has from
time to time taken write downs for potential excess inventory purchased prior to the receipt of customer orders. These
adjustments decrease gross margins in the quarter reported and have resulted, and could in the future result, in fluctuations in
gross margins on a quarter to quarter basis. See "Item 1: Business - Risk Factors - Fluctuations in Operating Results." Export
sales are an important part of the Company's business, constituting 57%, 55% and 57% of the Company's total revenues in
1997, 1996 and 1995, respectively. In 1997, 38% of the Company's product revenues came from sales to Japan and 4% from
other Asian countries. While a majority of the Company's revenues from sales to Asian countries are derived from OEM
customers who plan to export their products to countries outside of Asia, the Asian economic crisis may adversely effect the
Company's revenues to the extent that demand for the Company's products in Asia declines. Given the recent economic
conditions in Asia and the weakness of many Asian currencies relative to the United States dollar, the Company's products
may be relatively more expensive in Asia, which could result in a decrease in the Company's sales in that region. The Company
may also experience pressure on its gross margins as a result of increased price competition from Asian competitors. While
most of the Company's sales are denominated in U.S. Dollars, the Company invoices certain Japanese customers in Japanese
Yen and is subject to exchange rate fluctuations on these transactions. To date, a significant portion of the Company's
purchases of wafers, which constitute a significant part of its cost of goods sold, have been denominated in Japanese Yen.
While this percentage has been decreasing, exchange rate fluctuations can affect the Company's business, financial condition
and results of operations. See "Item 1: Business - Risk Factors - International Operations." For the foreseeable future, the
Company expects to realize a significant portion of its revenues from recently introduced and new products. Typically new
products initially have lower gross margins than more mature products because the manufacturing yields are lower at the start of
manufacturing each successive product generation. In addition, manufacturing yields are generally lower at the start of
manufacturing any product at a new foundry, such as NEC and USIC. To remain competitive, the Company is focusing on a
number of programs to lower its manufacturing costs. These include transitioning from single to double density flash designs,
from 0.5 to 0.4 micron manufacturing processes, and from six inch to eight inch wafers. These transitions are expected to occur
over the next several quarters. As a result of these factors, the Company expects that product gross margins may decline in the
near term from the levels experienced in 1997, and product gross margins are expected to be subject to fluctuation for the
foreseeable future. Moreover, there can be no assurance that such products or processes will be successfully developed by the
Company or that development of such processes will lower manufacturing costs. In addition, the Company anticipates that
price competition will increase in the future, which will likely result in decreased average selling prices and lower gross margins.
See "Item 1: Business Risk Factors -Manufacturing Yields" and "- Declining Average Sales Prices." 29 The Company is aware
of problems associated with computer systems as the year 2000 approaches. Year 2000 problems are the result of common
computer programming techniques that result in systems that do not function properly when manipulating dates later than
December 31, 1999. The issue is complex and wide ranging. The problem may affect transaction processing computer
applications used by the Company for accounting, distribution, manufacturing, and planning. The problem may also affect
embedded systems such as building security systems, machine controllers and production test equipment. Year 2000 problems
with these systems may affect the ability or efficiency with which the company can perform many significant functions, including
but not limited to: order processing, material planning, product assembly, product test, invoicing, and financial reporting. In
addition, the problem may affect the computer systems of vendors and customers, disrupting their operations. Year 2000
problems with the Company's business partners may impact the company's sources of supply and demand. The Company is
currently in the process of upgrading the core management information systems that are known to not be Year 2000 compliant.
The Company believes that these upgrades will be completed before the end of 1998. These upgrades are intended to address
the Year 2000 issues with respect to the internal budgeting, financial planning, material planning, sales order processing,
accounting, inventory control, shop floor control, and purchasing business processes. The Company has also initiated a formal
Year 2000 Risk Management program to identify, and mitigate to the best of its ability, any remaining internal and external risks
associated with the Year 2000 problem. The cost of the Year 2000 project related to upgrading the Company's core
management information system is estimated to be $1.2 million. Of this, the Company estimates that approximately $400,000 is
attributable to the purchase of new software, which will be capitalized. The costs associated with the other Year 2000 risks
have not been quantified. The costs and time schedule for the Year 2000 problem abatement are based on management's best
estimates for the implementation of its new management information system. These were derived utilizing numerous
assumptions, including that the most significant Year 2000 risks have already been identified, that certain resources will continue
to be available, that third party plans will be fulfilled, and other factors. However, there can be no guarantee that these
estimates will be achieved or that the anticipated time schedule will be met and actual results could differ materially from those
anticipated. Any year 2000 compliance problem of either the Company, or its suppliers or customers could materially
adversely affect the Company's business, results of operations, financial condition, and prospects. Results of Operations
Product Revenues. SanDisk's product revenues increased 18% to $105.7 million in 1997 from $89.6 million 1996. The
increase of $16.1 million consisted of a 146% increase in units shipped offset by a 51% decline in average selling prices. Fiscal
year 1996 revenues of $89.6 million were 45% higher than 1995 due to increased sales of the Chipset, CompactFlash and
FlashDisk products. In 1997, the largest increase in unit volume came from sales of CompactFlash products, primarily for use
in digital cameras and other consumer electronics applications. In 1997, sales of CompactFlash products exceeded sales of
PCMCIA flash cards for the first time. CompactFlash products represented approximately 73% of all units shipped and 49%
of product revenues in 1997. This shift in product mix from PCMCIA flash cards to CompactFlash cards, which have lower
capacities, contributed the decline in average selling prices in 1997. The Company anticipates that lower capacity products will
continue to represent a significant portion of its sales as consumer applications such as digital cameras become more popular.
Sales of these lower capacity products generally have lower average selling prices and gross margins than higher capacity
products. The mix of products sold varies from quarter to quarter and may vary in the future, affecting the Company's overall
average selling prices and gross margins. The Company has experienced and expects to continue to experience seasonality in
its product sales. Due to the shift in product mix towards CompactFlash products which are sold primarily for consumer
electronics applications, the Company expects that its product sales will be increasingly impacted by seasonal purchasing
patterns, with 30 higher sales in the second half of each year as compared to the first half of each such year. In the past, the
Company has experienced a reduction in order quantities in the first quarter from Japanese OEM customers, reflecting the fact
that most customers in Japan operate on a fiscal year ending in March and prefer to delay purchases until the beginning of their
next fiscal year. Although the Company has limited visibility as to customer orders, the Company expects product revenues in
the first quarter of 1998 to decline relative to the fourth quarter of 1997 due to these seasonal factors. In addition, the effects of
the Asian economic crisis on the Company's revenues is uncertain. The Company's ability to adjust its operating expenses is
limited in the short term due to a number of factors described herein and in "Risk Factors." As a result, if product revenues are
lower than anticipated, the Company's results of operations will be adversely affected. SanDisk's backlog at the end of 1997
was $18.6 million compared to $5.8 million in 1996. See "Risk Factors - Fluctuations in Operating Results" and " -
Seasonality." License and Royalty Revenues. The Company currently earns patent license fees and royalties under five
cross-license agreements, of which agreements with Hitachi, Toshiba and Samsung were entered into in the third quarter of
1997. SanDisk also has cross-license agreements with Intel and Sharp. License and royalty revenue from patent cross-license
agreements was $19.6 million in 1997, up from $8.0 million in 1996 and $1.3 million in 1995. Revenues from licenses and
royalties increased to 16% of total revenues in 1997 from 8% in 1996 and 2% in 1995. Gross Profits. In fiscal 1997, gross
profits increased to $53.0 million or 42.3% of total revenues from $38.9 million or 39.8% of total revenues in 1996 and $26.2
million or 41.7% of total revenues in 1995. In 1997, the growth in overall gross profits resulted from an increase in license and
royalty revenues, which was partially offset by a decline in gross profit from product sales. Product gross profits declined as a
percentage of product revenues to 31.6% in 1997 compared to 34.5% in 1996 and 40.6% in 1995. This decline was primarily
due to the shift in product mix to lower capacity CompactFlash products that have lower average selling prices and gross
margins. This decline in gross margins was partially offset by cost reductions related to the Company's shift to in-house
assembly and test. The Company anticipates that lower capacity products will continue to represent a significant portion of its
sales as consumer applications such as digital cameras become more popular. The Company expects product gross margins
may continue to decrease in 1998 due to anticipated increased competition. Research and Development. Research and
development expenses consist principally of salaries and payroll related expenses for design and development engineers,
prototype supplies and contract services. Research and development expenses increased to $13.6 million in 1997 from $10.2
million in 1996 and $8.0 million in 1995. As a percentage of revenues, research and development expenses represented 10.8%
in 1997, 10.4% in 1996 and 12.8% in 1995. In 1997 and 1996, the increase in research and development expenses was
primarily due to an increase in salaries and payroll-related expenses associated with additional personnel. Increased
depreciation due to capital equipment additions and higher project related expenses also contributed to the growth in research
and development expenses in both years. The Company expects research and development expenses to continue to increase to
support the development of new generations of flash data storage products and the addition of new foundries to manufacture
the Company's products. Sales and Marketing. Sales and marketing expenses include salaries, sales commissions, benefits and
travel expenses for the Company's sales, marketing, customer service and applications engineering personnel. These expenses
also include other selling and marketing expenses, such as independent manufacturer's representative commissions, advertising
and tradeshow expenses. Sales and marketing expenses increased to $12.6 million in 1997 from $8.8 million in 1996 and $6.6
million in 1995. The increase in sales and marketing expenses in 1997 and 1996 was primarily due to an increase in salaries
and payroll related expenses associated with additional personnel. Higher marketing, travel and selling expenses also
contributed to this increase in both years. Sales and marketing expenses increased to 10.0% of total revenues in 1997
compared to 9.0% in 1996 primarily due to increased marketing expenses related to the development of the retail channel. In
1995, sales and marketing expenses were 10.4% of revenues. The Company expects sales and marketing expenses to increase
as sales of its products grow and as it develops the retail channel for its products. General and Administrative. General and
administrative expenses include the cost of the Company's finance, information systems, human resources, shareholder
relations, legal and administrative functions. General and administrative expenses were to $7.1 million in 1997 compared to
$7.4 million in 1996 and $3.8 million in 1995. 31 The decrease in 1997 was primarily due to a decrease in legal fees which
was partially offset by increased salaries and payroll related expenses associated with increased personnel, higher recruiting
expenses, increased allowance for doubtful accounts and higher consulting expenses related to the Company's management
information system. In 1996, the increase in general and administrative expenses was primarily due to an increase in legal fees
associated with the Samsung litigation and an increase in salary and benefit expenses. General and administrative expenses
represented 5.7% of revenues in 1997, 7.6% in 1996 and 6.1% in 1995. The Company expects general and administrative
expenses to increase as the general and administrative functions grow to support the overall growth of the Company. General
and administrative expenses could also increase substantially in the future if the Company pursues litigation to defend its patent
portfolio. See "Risk Factors - Patents, Proprietary Rights and Related Litigation." Interest and Other Income, Net. Interest and
other income, net, was $3.7 million in 1997, $3.2 million in 1996 and $1.7 million in 1995. The increase in interest and other
income since 1995 is primarily due to increased cash and investment balances and higher interest rates. Provision for Income
Taxes. The Company's 1997, 1996 and 1995 effective tax rates were approximately 15.0%, 7.3% and 4.5% respectively.
The Company's 1997 effective tax rate is substantially higher than its 1996 rate due to the utilization of all remaining federal net
operating loss carryforwards in 1996. The 1996 effective tax rate was substantially higher than the 1995 rate as net operating
loss carryforwards were available to offset essentially all of the 1995 taxable income. Due to increased license and royalty
revenues and growth in the Company's net income in 1997, the Company utilized the remainder of its tax credit carryforwards
during the 1997 fiscal year. The Company's effective tax rate is expected to increase significantly in 1998 and is expected to be
near the statutory tax rate. Liquidity and Capital Resources As of December 31, 1997, the Company had working capital of
$134.3 million, which included $20.9 million in cash and cash equivalents and $114.0 million in short-term investments. The
Company has a line of credit facility with a commercial bank under which it can borrow up to $10.0 million at the bank's prime
rate. This line of credit facility expires in July 1998. As of December 31, 1997, the Company had $7.2 million committed under
the line of credit facility for standby letters of credit. The facility contains covenants that require the Company to maintain
certain financial ratios and levels of net worth, and prohibits the payment of cash dividends to stockholders. The Company is
currently in compliance with all covenants in the line of credit agreement. The Company intends to either renew its line of credit
or negotiate a new line of credit upon the expiration of its current line. Operating activities provided $26.8 million of cash in
1997. In addition to net income, sources of cash included increased deferred revenue of $22.3 million, primarily from the
receipt of funds under license and royalty agreements. Cash provided by operations was $13.4 million in 1996 and $12.4
million in 1995. Net cash used in investing activities of $108.9 million in 1997 consisted of net purchases of investments of
$59.0 million, an investment of $40.3 in the USIC foundry and $9.6 million of capital equipment purchases. In 1996 and 1995,
cash used in investing activities was $22.2 million and $35.4 million, respectively. In 1996, cash used for investing purposes
included net purchases of short term investments of $13.8 million and capital equipment purchases of $8.4 million. In 1995,
cash used in investing activities included $31.6 million net purchases of short term investments and $3.8 million of capital
equipment purchases. During 1997, cash provided by financing activities of $83.7 million was primarily from the sale of
common stock in the Company's November 1997 follow on public offering. Financing activities provided $0.8 million in 1996
primarily from the sale of common stock through the SanDisk stock option and employee stock purchase plans and $39.1
million in 1995 primarily from the sale of common stock in the Company's initial public offering and the sale of preferred stock.
32 Depending on the demand for the Company's products, the Company may decide to make additional investments, which
could be substantial, in assembly and test manufacturing equipment to support its business in the future. Management believes
the existing cash and cash equivalents, short-term investments and available line of credit will be sufficient to meet the
Company's currently anticipated working capital and capital expenditure requirements for the next 12 months. Impact of
Currency Exchange Rates The Company currently purchases wafers from Matsushita under purchase contracts denominated in
Japanese Yen. A portion of the Company's revenues are also denominated in Japanese Yen. Foreign exchange exposures
arising from the Company's Japanese Yen denominated commitments and related accounts payable are offset to the extent the
Company has Japanese yen denominated accounts receivable and cash balances. To the extent such foreign exchange
exposures are not offset, the Company enters into foreign exchange forward contracts to hedge against changes in foreign
currency exchange rates. At December 31, 1997, there were no forward contracts outstanding. Future exchange rate
fluctuations could have a material adverse effect on the Company's business, financial condition and results of operations. 33
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA SANDISK CORPORATION
CONSOLIDATED FINANCIAL STATEMENTS Contents Page Report of Ernst & Young LLP, Independent Auditors 35
Consolidated Balance Sheets 36 Consolidated Statements of Income 37 Consolidated Statements of Stockholders' Equity 38
Consolidated Statements of Cash Flows 39 Notes to Consolidated Financial Statements 40 34 REPORT OF ERNST &
YOUNG LLP, INDEPENDENT AUDITORS The Board of Directors and Stockholders SanDisk Corporation We have
audited the accompanying consolidated balance sheets of SanDisk Corporation as of December 31, 1997 and 1996, and the
related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended
December 31, 1997. Our audits also included the financial statement schedule listed in the Index at Item 14(a). These financial
statements and schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on
these financial statements and schedule based on our audits. We conducted our audits in accordance with generally accepted
auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements. An audit also includes 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, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of SanDisk Corporation at December 31, 1997 and
1996 and the consolidated results of its operations and its cash flows for each of the three years in the period ended December
31, 1997, in conformity with generally accepted accounting principles. Also, in our opinion, the related financial statement
schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects
the information set forth therein. /s/ Ernst & Young LLP --------------------- Ernst & Young LLP San Jose, California
January 16, 1998 35 SanDisk Corporation CONSOLIDATED BALANCE SHEETS (In thousands, except share and per
share amounts) December 31, 1997 1996 --------- --------- ASSETS Current assets: Cash and cash equivalents $ 20,888 $
19,323 Short-term investments 114,037 54,965 Accounts receivable, net of allowance for doubtful accounts of $756 in 1997
and $593 in 1996 19,352 11,885 Inventories 15,648 9,630 Deferred tax assets 17,060 900 Prepaid expenses and other
current assets 1,406 784 --------- --------- Total current assets 188,391 97,487 Property and equipment, at cost: Machinery
and equipment 27,244 17,937 Leasehold improvements 1,981 1,695 --------- --------- 29,225 19,632 Accumulated
depreciation and amortization 13,333 9,347 --------- --------- 15,892 10,285 Investment in foundry 40,284 - Deposits and
other assets 900 496 --------- --------- Total assets $ 245,467 $ 108,268 ========= ========= LIABILITIES AND
STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 14,111 $ 7,595 Accrued payroll and related expenses
4,674 2,857 |
