Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

 

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

For the quarterly period ended March 31, 2010.

or

 

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

For the transition period from ___________ to ____________.

Commission File Number: 000-30269

 

 

PIXELWORKS, INC.

(Exact name of registrant as specified in its charter)

 

 

 

OREGON   91-1761992
(State or other jurisdiction of incorporation)   (I.R.S. Employer Identification No.)

16760 SW Upper Boones Ferry Road, Suite 101

Portland, OR 97224

(503) 601-4545

(Address of principal executive offices, including zip code,

and Registrant’s telephone number, including area code)

 

 

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 last 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

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

 

  Large accelerated filer  ¨      Accelerated filer  ¨
  Non-accelerated filer  ¨ (Do not check if a smaller reporting company)      Smaller reporting company  x

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

Number of shares of Common Stock outstanding as of April 30, 2010: 13,474,012

 

 

 


Table of Contents

PIXELWORKS, INC.

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2010

TABLE OF CONTENTS

 

PART I – FINANCIAL INFORMATION
Item 1.    Financial Statements.    3
  

Condensed Consolidated Balance Sheets

   3
  

Condensed Consolidated Statements of Operations

   4
  

Condensed Consolidated Statements of Cash Flows

   5
  

Notes to Condensed Consolidated Financial Statements

   6
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations.    19
Item 3.    Quantitative and Qualitative Disclosures About Market Risk.    25
Item 4.    Controls and Procedures.    26
PART II – OTHER INFORMATION
Item 1.    Legal Proceedings.    27
Item 1A.    Risk Factors.    27
Item 6.    Exhibits.    40
SIGNATURE


Table of Contents

PART I – FINANCIAL INFORMATION

 

Item 1. Financial Statements.

PIXELWORKS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

 

     March 31,
2010
   December  31,
2009
ASSETS      

Current assets:

     

Cash and cash equivalents

     $ 11,022        $ 17,797  

Short-term marketable securities

     15,295        9,822  

Accounts receivable, net

     5,930        5,619  

Inventories, net

     6,136        6,158  

Prepaid expenses and other current assets

     2,419        2,265  
             

Total current assets

     40,802        41,661  

Long-term marketable security

     6,380        3,240  

Property and equipment, net

     4,610        5,121  

Other assets, net

     4,544        5,006  

Acquired intangible assets, net

     477        1,050  
             

Total assets

     $ 56,813        $ 56,078  
             
LIABILITIES AND SHAREHOLDERS’ EQUITY      
     

Current liabilities:

     

Accounts payable

     $ 6,302        $ 7,680  

Accrued liabilities and current portion of long-term liabilities

     7,992        8,513  

Current portion of income taxes payable

     109        109  
             

Total current liabilities

     14,403        16,302  

Long-term liabilities, net of current portion

     1,404        1,462  

Income taxes payable, net of current portion

     4,319        9,462  

Long-term debt

     15,779        15,779  
             

Total liabilities

     35,905        43,005  

Commitments and contingencies (Note 11)

     

Shareholders’ equity:

     

Preferred stock

     —        —  

Common stock

     335,163        334,849  

Accumulated other comprehensive income

     4,006        1,087  

Accumulated deficit

             (318,261)               (322,863) 
             

Total shareholders’ equity

     20,908        13,073  
             

Total liabilities and shareholders’ equity

     $ 56,813        $ 56,078  
             

See accompanying notes to condensed consolidated financial statements.

 

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Table of Contents

PIXELWORKS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

 

     Three Months Ended
March 31,
     2010    2009

Revenue, net

     $           18,692        $           10,780  

Cost of revenue (1)

     10,036        6,624  
             

Gross profit

     8,656        4,156  

Operating expenses:

     

Research and development (2)

     5,340        4,776  

Selling, general and administrative (3)

     3,793        3,873  

Restructuring

     94        37  
             

Total operating expenses

     9,227        8,686  
             

Loss from operations

     (571)       (4,530) 

Interest expense

     (123)       (251) 

Interest income

     13        98  

Amortization of debt issuance costs

     (18)       (61) 

Gain on repurchase of long-term debt, net

     —          9,024  
             

Interest and other income (expense), net

     (128)       8,810  
             

Income (loss) before income taxes

     (699)       4,280  

Benefit for income taxes

     (5,301)       (1,617) 
             

Net income

     $ 4,602        $ 5,897  
             

Net income per share:

     

Basic

     $ 0.34        $ 0.44  
             

Diluted

     $ 0.32        $ 0.44  
             

Weighted average shares outstanding:

     

Basic

     13,363        13,352  
             

Diluted

     14,220        14,023  
             

 

     

(1) Includes:

     

Amortization of acquired developed technology

     $ 573        $ 617  

Stock-based compensation

     10        7  

Additional amortization of non-cancelable prepaid royalty

     2        68  

Restructuring

     —        47  

(2) Includes stock-based compensation

     96        118  

(3) Includes stock-based compensation

     117        252  

See accompanying notes to condensed consolidated financial statements.

 

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PIXELWORKS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

     Three Months Ended
March 31,
     2010    2009

Cash flows from operating activities:

     

Net income

     $ 4,602        $ 5,897  

Adjustments to reconcile net income to net cash used in operating activities:

     

Reversal of uncertain tax positions

     (5,284)       (1,815) 

Depreciation and amortization

     1,114        1,294  

Amortization of acquired intangible assets

     573        617  

Stock-based compensation

     223        377  

Other non-cash tax benefits

     (221)       —  

Gain on repurchase of long-term debt, net

     —        (9,024) 

Other

     43        84  

Changes in operating assets and liabilities:

     

Accounts receivable, net

     (311)       1,692  

Inventories, net

     22        816  

Prepaid expenses and other current and long-term assets, net

     89        (30) 

Accounts payable

               (1,410)       (1,541) 

Accrued current and long-term liabilities

     (122)       (2,785) 

Income taxes payable

     141        122  
             

Net cash used in operating activities

     (541)       (4,296) 
             

Cash flows from investing activities:

     

Purchases of marketable securities

     (6,683)       (1,197) 

Proceeds from maturities of marketable securities

     1,200        3,500  

Purchases of property and equipment

     (242)       (127) 

Purchases of other assets

     —        (27) 
             

Net cash provided by (used in) investing activities

     (5,725)       2,149  
             

Cash flows from financing activities:

     

Payments on asset financings

     (600)       (523) 

Proceeds from issuances of common stock

     91        5  

Repurchase of long-term debt

     —                (17,778) 

Repurchase of common stock

     —        (167) 
             

Net cash used in financing activities

     (509)       (18,463) 
             

Net change in cash and cash equivalents

     (6,775)       (20,610) 

Cash and cash equivalents, beginning of period

     17,797        53,149  
             

Cash and cash equivalents, end of period

     $ 11,022        $ 32,539  
             

See accompanying notes to condensed consolidated financial statements.

 

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PIXELWORKS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except share and per share data)

(Unaudited)

NOTE 1: BASIS OF PRESENTATION

Nature of Business

We are an innovative designer, developer and marketer of video and pixel processing semiconductors and software for high-end digital video applications and hold 124 patents related to the visual display of digital image data. Our solutions enable manufacturers of digital display and projection devices, such as large-screen flat panel displays and digital front projectors, to differentiate their products with a consistently high level of video quality, regardless of the content’s source or format. Our core technology leverages unique proprietary techniques for intelligently processing video signals from a variety of sources to ensure that all resulting images are optimized. Additionally, our products help our customers reduce costs and differentiate their display and projection devices, an important factor in industries that experience rapid innovation. Pixelworks was founded in 1997 and is incorporated under the laws of the state of Oregon.

Condensed Consolidated Financial Statements

These condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted pursuant to such regulations, although we believe that the disclosures provided are adequate to prevent the information presented from being misleading.

The financial information included herein for the three month periods ended March 31, 2010 and 2009 is unaudited; however, such information reflects all adjustments, consisting of normal recurring adjustments, that are, in the opinion of management, necessary for a fair presentation of the financial position, results of operations and cash flows of the Company for these interim periods. The financial information as of December 31, 2009 is derived from our audited consolidated financial statements and notes thereto for the fiscal year ended December 31, 2009, included in Item 8 of our Annual Report on Form 10-K, filed with the SEC on March 10, 2010, and should be read in conjunction with such consolidated financial statements.

The results of operations for the three month period ended March 31, 2010 are not necessarily indicative of the results expected for the entire fiscal year ending December 31, 2010.

Reclassifications

Certain reclassifications have been made to the 2009 condensed consolidated financial statements to conform with the 2010 presentation.

Use of Estimates

The preparation of consolidated financial statements in conformity with U.S. GAAP requires us to make estimates and judgments that affect amounts reported in the financial statements and accompanying notes. Our significant estimates and judgments include those related to product returns, warranty obligations,

 

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bad debts, inventories, property and equipment, intangible assets, impairment of long-lived assets, valuation of investments, amortization of prepaid royalties, valuation of share-based payments, income taxes, litigation and other contingencies. The actual results experienced could differ materially from our estimates.

NOTE 2: BALANCE SHEET COMPONENTS

Marketable Securities – See Note 3

Accounts Receivable, Net

Accounts receivable are recorded at invoiced amount and do not bear interest when recorded or accrue interest when past due. Accounts receivable are stated net of an allowance for doubtful accounts, which is maintained for estimated losses that may result from the inability of our customers to make required payments. Accounts receivable consists of the following:

 

        March 31,   
2010
   December  31,
2009

Accounts receivable, gross

     $             6,357        $             6,047  

Less: allowance for doubtful accounts

     (427)       (428) 
             

Accounts receivable, net

     $ 5,930        $ 5,619  
             

The following is the change in our allowance for doubtful accounts:

 

     Three Months Ended
March  31,
           2010                2009      

Balance at beginning of period

     $                428        $                542  

Additions charged (reductions credited)

     (1)       —  

Accounts written-off, net of recoveries

     —        —  
             

Balance at end of period

     $ 427        $ 542  
             

Inventories, Net

Inventories consist of finished goods and work-in-process, and are stated at the lower of standard cost (which approximates actual cost on a first-in, first-out basis) or market (net realizable value), net of a reserve for slow-moving and obsolete items.

 

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Inventories consist of the following:

 

         March 31,    
2010
     December 31,  
2009

Finished goods

     $ 3,456        $ 2,888  

Work-in-process

                5,043                   5,410  
             
     8,499        8,298  

Less: reserve for slow-moving and obsolete items

     (2,363)       (2,140) 
             

Inventories, net

     $ 6,136        $ 6,158  
             

The following is the change in our reserve for slow-moving and obsolete items:

 

     Three Months Ended
March 31,
             2010                    2009        

Balance at beginning of period

     $ 2,140        $ 4,994  

New provision

                   402                      136  

Sales of previously reserved inventory

     (32)       (296) 
             

Net provision (benefit) for obsolete inventory

     370        (160) 

Final scrap of previously reserved inventory

     (147)       (1,131) 
             

Balance at end of period

     $ 2,363        $ 3,703  
             

Based upon our forecast and backlog, we do not currently expect to be able to sell or otherwise use the reserved inventory we have on hand at March 31, 2010. However, it is possible that a customer will decide in the future to purchase a portion of the reserved inventory. It is not possible for us to predict if or when this may happen, or how much we may sell. If such sales occur, we do not expect that they will have a material effect on gross profit margin.

Property and Equipment, Net

Property and equipment consists of the following:

 

         March 31,    
2010
     December 31,  
2009

Gross carrying amount

     $ 18,874        $ 18,472  

Less: accumulated depreciation and amortization

             (14,264)               (13,351) 
             

Property and equipment, net

     $ 4,610        $ 5,121  
             

 

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Acquired Intangible Assets, Net

Acquired intangible assets consist of the following developed technology:

 

        March 31,   
2010
   December 31,
2009

Gross carrying amount

     $ 19,170        $ 19,170  

Less: accumulated amortization

             (18,693)               (18,120) 
             

Acquired intangible assets, net

     $ 477        $ 1,050  
             

Estimated future amortization of acquired intangible assets is $477 for the year ending December 31, 2010.

Accrued Liabilities and Current Portion of Long-Term Liabilities

Accrued liabilities and current portion of long-term liabilities consist of the following:

 

        March 31,   
2010
   December 31,
2009

Accrued payroll and related liabilities

     $ 2,239        $ 2,279  

Current portion of accrued liabilities for asset financings

                1,773                   2,068  

Accrued commissions and royalties

     949        853  

Reserve for warranty returns

     478        304  

Accrued interest payable

     363        257  

Accrued costs related to restructuring

     174        190  

Reserve for sales returns and allowances

     55        55  

Other

     1,961        2,507  
             
     $ 7,992        $ 8,513  
             

The following is the change in our reserves for warranty returns and sales returns and allowances:

 

     Three Months Ended
March 31,
     2010    2009

Reserve for warranty returns:

     

Balance at beginning of period

     $ 304        $ 593  

Provision (benefit)

     486                       (98) 

Charge-offs

                  (312)       (19) 
             

Balance at end of period

     $ 478        $ 476  
             

Reserve for sales returns and allowances:

     

Balance at beginning of period

     $ 55        $ 100  

Provision

     —        14  

Charge-offs

     —        (14) 
             

Balance at end of period

     $ 55        $ 100  
             

 

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Long-Term Liabilities, Net of Current Portion

Long-term liabilities, net of current portion, consist of the following:

 

        March 31,   
2010
   December 31,
2009

Deferred rent

     $ 447        $ 494  

Accrued liabilities for asset financings

     379        553  

Accrued costs related to restructuring

     242        218  

Payroll and related liabilities

     136        136  

Other

     200        61  
             
     $         1,404        $         1,462  
             

Long-Term Debt

In 2004, we issued $150,000 of 1.75% convertible subordinated debentures (the “debentures”) due 2024. In 2006, we repurchased and retired $10,000 principal amount of the debentures and in 2008, we repurchased and retired $79,366 principal amount of the debentures. In February 2009, we repurchased and retired $27,090 of the debentures for $17,778 in cash. We recognized a net gain on the repurchase of $9,024, which included a $9,346 discount, offset by a write-off of debt issuance costs of $288 and other fees of $34. In May 2009, we repurchased and retired $17,765 of the debentures for $13,754 in cash. We recognized a net gain of $3,836 on the repurchase, which included a $4,011 discount, offset by a write-off of debt issuance costs of $175.

As of March 31, 2010, $15,779 of the debentures are outstanding. The remaining debentures are convertible, under certain circumstances, into our common stock at a conversion rate of 13.6876 shares of common stock per $1 principal amount of debentures for a total of 215,977 shares. This is equivalent to a conversion price of approximately $73.06 per share. The debentures are convertible if (a) our stock trades above 130% of the conversion price for 20 out of 30 consecutive trading days during any calendar quarter, (b) the debentures trade at an amount less than or equal to 98% of the if-converted value of the debentures for five consecutive trading days, (c) a call for redemption occurs, or (d) in the event of certain other specified corporate transactions. If our debentures are converted into common stock, they can not be settled in cash or other assets.

We may redeem some or all of the debentures for cash on or after May 15, 2011 at a price equal to 100% of the principal amount of the debentures plus accrued and unpaid interest. The holders of the debentures have the right to require us to purchase all or a portion of the $15,779 debentures outstanding at each of the following dates: May 15, 2011, May 15, 2014, and May 15, 2019, at a purchase price equal to 100% of the principal amount plus accrued and unpaid interest. The debentures are unsecured obligations and are subordinated in right of payment to all of our existing and future senior debt.

 

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NOTE 3: MARKETABLE SECURITIES AND FAIR VALUE MEASUREMENTS

As of March 31, 2010 and December 31, 2009, all of our marketable securities are classified as available-for-sale and consist of the following:

 

           Cost          Unrealized
Gain (Loss)
   Fair
      Value     

Short-term marketable securities:

        

As of March 31, 2010:

        

US government agencies debt securities

     $         10,017        $ —        $ 10,017  

Commercial paper

     3,597        —        3,597  

Corporate debt securities

     1,683        (2)       1,681  
                    
     $ 15,297        $ (2)       $         15,295  
                    

As of December 31, 2009:

        

US government agencies debt securities

     $ 6,286        $ (3)       $ 6,283  

Commercial paper

     2,996        —        2,996  

Corporate debt security

     542        1        543  
                    
     $ 9,824        $ (2)       $ 9,822  
                    
     Cost    Unrealized Gain    Fair
Value

Long-term marketable security:

        

As of March 31, 2010:

        

Equity security

     $ 2,110        $           4,270        $ 6,380  

As of December 31, 2009:

        

Equity security

     $ 2,110        $ 1,130        $ 3,240  

Unrealized holding gains and losses are recorded in accumulated other comprehensive income, a component of shareholders’ equity, in the condensed consolidated balance sheets.

Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Three levels of inputs may be used to measure fair value:

 

Level 1:

   Valuations based on quoted prices in active markets for identical assets and liabilities.

Level 2:

   Valuations based on inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

Level 3:

   Valuations based on unobservable inputs in which there is little or no market data available, which require the reporting entity to develop its own assumptions.

 

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The following tables present information about our assets measured at fair value on a recurring basis in the condensed consolidated balance sheets at March 31, 2010 and December 31, 2009:

 

     Level 1    Level 2    Level 3    Total

As of March 31, 2010:

           

Money market funds

     $ 9,984        $ —        $ —        $ 9,984  

Certificates of deposit

     200        —        —        200  

US government agencies debt securities

     —        10,017        —        10,017  

Commercial paper

     —        3,597        —        3,597  

Corporate debt securities

     —        1,681        —        1,681  

Long-term marketable security

     6,380        —                     —        6,380  
                           

Total

     $       16,564        $       15,295        $ —        $       31,859  
                           

As of December 31, 2009:

           

Money market funds

     $ 16,873        $ —        $ —        $ 16,873  

Certificates of deposit

     200        —        —        200  

US government agencies debt securities

     —        6,283        —        6,283  

Commercial paper

     —        2,996        —        2,996  

Corporate debt security

     —        543        —        543  

Long-term marketable security

     3,240        —        —        3,240  
                           

Total

     $ 20,313        $ 9,822        $ —        $ 30,135  
                           

We primarily use the market approach to determine the fair value of our financial assets.

The fair value of our current assets and liabilities, including accounts receivable and accounts payable, approximates the carrying value due to the short-term nature of these balances. As of March 31, 2010, the fair value of our long-term debt is $14,899 based on the most recent sales of our debt. The carrying value of our long-term debt at March 31, 2010 is $15,779. We have currently chosen not to elect the fair value option for any items that are not already required to be measured at fair value in accordance with GAAP.

NOTE 4: RESTRUCTURING PLANS

In December 2008, we initiated a restructuring plan to reduce our operating expenses in response to decreases in current and forecasted revenue which resulted primarily from the global economic crisis. This plan reduced operations, research and development and administrative headcount in our San Jose, Taiwan and China offices and was completed during the second quarter of 2009.

In November 2006, we initiated a restructuring plan to reduce operating expenses. This plan included consolidation of our operations in order to reduce compensation and rent expense. As part of this plan we also narrowed and redefined our product development strategy which resulted in the write-off of intellectual property assets, tooling, software development tools and charges for related non-cancelable contracts. Although this plan was completed during the fourth quarter of 2008, lease termination costs were recorded in the first quarters of 2010 and 2009 due to decreases in estimated future sublease income.

 

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Total restructuring expenses related to these plans is as follows:

 

     Three Months
Ended
March 31, 2010
   Cumulative
Amount
Incurred To
March 31, 2010

Cost of revenue - restructuring:

     

Termination and retention benefits

     $ —        $ 353  

Net write-off of assets and reversal of related liabilities

     —        2,072  
             
     —        2,425  

Operating expenses - restructuring:

     

Consolidation of leased space

     94        2,286  

Termination and retention benefits

     —        7,780  

Net write-off of assets and reversal of related liabilities

     —        13,224  

Contract termination fee

     —        1,693  

Payments, non-cancelable contracts

     —        827  

Other

     —        88  
             
     94        25,898  
             

Total restructuring expense

     $            94        $     28,323  
             

Accrued expenses related to the restructuring plans are included in current and non-current accrued liabilities in the consolidated balance sheets. The following is a summary of the change in accrued liabilities related to our restructuring plans:

 

     December 31,
2009
      Expensed          Payments       March 31,
        2010       

Lease termination costs

     $     408        $     94        $     (86)       $     416  

The remaining liability for lease termination costs was accrued under the November 2006 plan and will be paid in cash over the remaining lease terms.

NOTE 5: INCOME TAXES

The benefit for income taxes recorded for the first quarter of 2010 was primarily due to a benefit of $5,284 for the reversal of previously recorded tax contingencies due to the expiration of the applicable statutes of limitation, partially offset by current and deferred tax expense in profitable foreign jurisdictions and accruals for tax contingencies in foreign jurisdictions. In the first quarter of 2010 we also recorded a non-cash income tax benefit of $221 related to gains recorded within other comprehensive income during the quarter. In accordance with GAAP, this benefit was exactly offset by income tax expense included in other comprehensive income.

The benefit for income taxes recorded for the first quarter of 2009 was primarily due to a benefit of $1,815 for the reversal of a previously recorded tax contingency due to the expiration of the applicable statute of limitation, partially offset by current and deferred tax expense in profitable foreign jurisdictions and accruals for tax contingencies in foreign jurisdictions.

 

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As of March 31, 2010, we continued to provide a full valuation allowance against essentially all of our U.S. and Canadian net deferred tax assets as we do not believe that it is more likely than not that we will realize a benefit from those assets. We have not recorded a valuation allowance against our other foreign net deferred tax assets as we believe that it is more likely than not that we will realize a benefit from those assets.

As of March 31, 2010 and December 31, 2009, the amount of our uncertain tax positions was a liability of $4,319 and $9,462, respectively. A number of years may elapse before an uncertain tax position is resolved by settlement or expiration of the statute of limitations. Settlement of any particular position could require the use of cash. If the uncertain tax positions we have accrued for are sustained by the taxing authorities in our favor, the reduction of the liability will reduce our effective tax rate in that period. We reasonably expect reductions in the liability for unrecognized tax benefits of approximately $1,012 within the next twelve months due to the expiration of statutes of limitation in foreign jurisdictions. We recognize interest and penalties related to uncertain tax positions in income tax expense in our consolidated statements of operations.

NOTE 6: COMPREHENSIVE INCOME

Total comprehensive income is as follows:

 

     Three Months Ended
March 31,
     2010    2009

Net income

     $ 4,602        $ 5,897  

Unrealized gain (loss) on available-for-sale investments

     3,140        (238) 

Tax effect of unrealized gain (loss) on available-for-sale investments

     (221)       —  
             

Total comprehensive income

     $         7,521        $         5,659  
             

NOTE 7: EARNINGS PER SHARE

Basic earnings per share amounts are computed based on the weighted average number of common shares outstanding. Diluted weighted average shares outstanding includes the increased number of common shares that would be outstanding assuming the exercise of certain outstanding stock options, when such exercise would have the effect of reducing earnings per share, and the conversion of our debentures, using the if-converted method, when such conversion is dilutive. If our convertible debentures are dilutive, interest expense and amortization of debt issuance costs, net of tax, are added to net income used in calculating basic net income per share to arrive at net income used in calculating diluted net income per share.

 

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The following schedule reconciles the computation of basic net income per share and diluted net income per share (in thousands, except per share data):

 

     Three Months Ended
March 31,
     2010    2009

Net income used in basic net income per share

     $ 4,602        $ 5,897  

Interest expense on long-term debt and amortization of debt issuance costs, each net of tax

     —        275  
             

Net income used in diluted net income per share

     $ 4,602        $ 6,172  
             

Basic weighted average shares outstanding

             13,363                13,352  

Common share equivalents:

     

Dilutive effect of stock options

     857        1  

Dilutive effect of conversion of long-term debt

     —        670  
             

Diluted weighted average shares outstanding

     14,220        14,023  
             

Net income per common share:

     

Basic

     $ 0.34        $ 0.44  
             

Diluted

     $ 0.32        $ 0.44  
             

The following weighted average shares were excluded from the calculation of diluted weighted average shares outstanding as their effect on net income would have been anti-dilutive (in thousands):

 

     Three Months Ended
March  31,
     2010    2009

Stock options

                  1,404                     2,031  

Conversion of debentures

     216        —  

NOTE 8: SUPPLEMENTAL CASH FLOW INFORMATION

Supplemental disclosure of cash flow information is as follows:

 

     Three Months Ended
March  31,
     2010    2009

Cash paid during the period for:

     

Interest

     $ 17        $ 140  

Income taxes

                    66                       68  

Non-cash investing and financing activities:

     

Acquisitions of property and equipment and other assets under extended payment terms

     $ 131        $ 390  

 

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NOTE 9: SEGMENT INFORMATION

We have identified a single operating segment: the design and development of integrated circuits for use in electronic display devices. A majority of our assets are located in the U.S.

Geographic Information

Revenue by geographic region, attributed to countries based on the domicile of the end customer, is as follows:

 

     Three Months Ended
March 31,
     2010    2009

Japan

     $         11,105        $ 4,547  

Taiwan

     4,232        2,046  

Europe

     845        1,100  

Korea

     641        1,089  

U.S.

     532        645  

China

     489        304  

Other

     848        1,049  
             
     $ 18,692        $         10,780  
             

Significant Customers

The percentage of revenue attributable to our distributors, top five end customers, and individual distributors or end customers that represented more than 10% of revenue in at least one of the periods presented, is as follows:

 

     Three Months Ended March 31,
     2010    2009

Distributors:

     

All distributors

                    55%                      48% 

Distributor A

   37%     28% 

Distributor B

   0%     10% 

End Customers: (1)

     

Top five end customers

   62%     49% 

End customer A

   22%     14% 

End customer B

   13%     10% 

End customer C

   10%     3% 

End customer D

   1%     11% 

 

(1)

End customers include customers who purchase directly from us, as well as customers who purchase our products indirectly through distributors.

 

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The following accounts represented 10% or more of total accounts receivable in at least one of the periods presented:

 

     March 31,
2010
   December 31,
2009

Account A

           37%              34%  

Account B

   23%      22%  

Account C

   12%      11%  

NOTE 10: RISKS AND UNCERTAINTIES

Concentration of Suppliers

We do not own or operate a semiconductor fabrication facility and do not have the resources to manufacture our products internally. We rely on three third-party foundries to produce all of our wafers and three assembly and test vendors for completion of finished products. We do not have any long-term agreements with any of these suppliers. In light of these dependencies, it is reasonably possible that failure to perform by one of these suppliers could have a severe impact on our results of operations. Additionally, the concentration of these vendors within the People’s Republic of China and Taiwan increases our risk of supply disruption due to natural disasters, economic instability, political unrest or other regional disturbances.

Risk of Technological Change

The markets in which we compete, or seek to compete, are subject to rapid technological change, frequent new product introductions, changing customer requirements for new products and features and evolving industry standards. The introduction of new technologies and the emergence of new industry standards could render our products less desirable or obsolete, which could harm our business.

Concentrations of Credit Risk

Financial instruments that potentially subject us to concentrations of credit risk consist of cash equivalents, short- and long-term marketable securities and accounts receivable. We limit our exposure to credit risk associated with cash equivalent and marketable security balances by placing our funds in various high-quality securities and limiting concentrations of issuers and maturity dates. We limit our exposure to credit risk associated with accounts receivable by carefully evaluating creditworthiness before offering terms to customers.

NOTE 11: COMMITMENTS AND CONTINGENCIES

Indemnifications

Certain of our agreements include limited indemnification provisions for claims from third-parties relating to our intellectual property. It is not possible for us to predict the maximum potential amount of future payments or indemnification costs under these or similar agreements due to the conditional nature of our obligations and the unique facts and circumstances involved in each particular agreement. We

 

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have not made any payments under these agreements in the past, and as of March 31, 2010, we have not incurred any material liabilities arising from these indemnification obligations. In the future, however, such obligations could immediately impact our results of operations but are not expected to materially affect our business.

Legal Proceedings

On February 26, 2010, we filed an action against Intersil Corporation (“Intersil”) in the Superior Court of the State of California for the County of Santa Clara, Case No. 1-10-CV-164894. The Complaint filed by the Company alleges breach by Intersil of a license agreement between Intersil and the Company, as well as causes of action for breach of the implied covenant of good faith and fair dealing and declaratory relief. The Complaint alleges that the technology provided by Intersil under the license agreement is defective, and as a result the Company was entitled to stop making payments under the agreement. Payments not made under the agreement will total $1.25 million as of the end of the second quarter of 2010. Intersil contends that the technology provided is not defective, that it is entitled to the additional payments of $1.25 million, and that it had the right to terminate the license agreement for the Company's failure to make the additional payments. The Company believes that it is not obligated to make the payments due to breach of the license agreement by Intersil, and seeks declaratory relief from the Court that the payments are not due. The first Case Management Conference in the case is scheduled for July 20, 2010.

On April 1, 2010, Intersil filed an Answer to the Complaint and a Cross-Complaint against the Company. The Answer denies the material allegations of the Company's Complaint and asserts various affirmative defenses. The Cross-Complaint alleges that the Company breached the license agreement when it stopped making the royalty payments provided for in the license agreement and violated the Uniform Trade Secrets Act by continuing to use the technology provided by Intersil after Intersil terminated the license agreement. The Cross-Complaint also seeks a judicial declaration that the technology provided by Intersil is not defective, that Intersil did not breach the license agreement and that Intersil had a right to terminate the license agreement. As the Complaint and the Cross-Complaint were just recently filed, discovery has only just begun. The Company filed its Answer to the Cross-Complaint on May 3, 2010 denying the claims made by Intersil and asserting a number of affirmative defenses. The Company intends to vigorously prosecute the action and defend the Cross-Complaint to enforce its rights under the license agreement.

Although the Company believes that our potential liability related to this issue will not exceed the scheduled payments of $1.25 million, it is reasonably possible that a change could occur in the near term related to this matter.

In addition to the specific issue described above, we are subject to legal matters that arise from time to time in the ordinary course of our business. Although we currently believe that resolving such matters, individually or in the aggregate, will not have a material adverse effect on our financial position, our results of operations, or our cash flows, these matters are subject to inherent uncertainties and our view of these matters may change in the future.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Forward-looking Statements

This Management’s Discussion and Analysis of Financial Condition and Results of Operations contains “forward-looking statements” that are based on current expectations, estimates, beliefs, assumptions and projections about our business. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and variations of such words and similar expressions are intended to identify such forward-looking statements. Such forward-looking statements include the disclosure contained under the caption “Results of Operations—Business Outlook” below. These statements are not guarantees of future performance and involve certain risks and uncertainties that are difficult to predict and which may cause actual outcomes and results to differ materially from what is expressed or forecasted in such forward-looking statements. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in Part II, Item 1A of this Quarterly Report on Form 10-Q. These forward-looking statements speak only as of the date on which they are made, and we do not undertake any obligation to update any forward-looking statement to reflect events or circumstances after the date of this Quarterly Report on Form 10-Q. If we do update or correct one or more forward-looking statements, you should not conclude that we will make additional updates or corrections with respect thereto or with respect to other forward-looking statements. Except where the context otherwise requires, in this Quarterly Report on Form 10-Q, the “Company,” “Pixelworks,” “we,” “us” and “our” refer to Pixelworks, Inc., an Oregon corporation, and, where appropriate, its subsidiaries.

Overview

We are an innovative designer, developer and marketer of video and pixel processing semiconductors and software for high-end digital video applications and hold 124 patents related to the visual display of digital image data. Our solutions enable manufacturers of digital display and projection devices, such as large-screen flat panel displays and digital front projectors, to differentiate their products with a consistently high level of video quality, regardless of the content’s source or format. Our core technology leverages unique proprietary techniques for intelligently processing video signals from a variety of sources to ensure that all resulting images are optimized. Additionally, our products help our customers reduce costs and differentiate their display and projection devices, an important factor in industries that experience rapid innovation. Pixelworks was founded in 1997 and is incorporated under the laws of the state of Oregon.

Factors Affecting Results of Operations and Financial Condition

General Market Conditions

Financial, commercial and consumer markets experienced significant disruption during the last quarter of 2008 and throughout 2009 which adversely affected our results of operations during 2009. We experienced a significant decrease in revenue during the first and second quarters of 2009 as consumer demand decreased and our customers reduced their inventory levels in response to economic uncertainty and lack of visibility regarding expected future sales. Although the macroeconomic environment and our business appear to have stabilized during the second half of 2009 and into 2010, consumer confidence and spending are still down significantly and we are unable to predict how the challenging global economic environment may impact our future results of operations and financial position.

 

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Results of Operations

Revenue, net

Revenue, net was as follows (dollars in thousands):

 

     Three months ended
March 31,
   2010 v 2009
     2010    2009    $ change    % change

Revenue, net

     $         18,692        $         10,780        $         7,912                  73% 

Net revenue increased $7.9 million, or 73%, from the first quarter of 2009 to the first quarter of 2010. The increase was attributable to a 76% increase in units sold, partially offset by a 1% decrease in average selling price. The increase in revenue resulted primarily from increased sales into the digital projector market as customer demand strengthened due to improvements in the world wide economy. The increase in revenue in the digital projector market was partially off-set by lower sales of legacy products that we acquired in conjunction with our acquisition of Equator Technologies, Inc. and other markets which we no longer pursue as well as decreased sales into the advanced television market due to the timing of customer orders and new product transitions.

Cost of revenue and gross profit

Cost of revenue and gross profit were as follows (dollars in thousands):

 

     Three months ended March 31,
     2010    % of
revenue
   2009    % of
revenue

Direct product costs and related overhead 1

     $ 9,081      49%            $ 6,045      56%     

Amortization of acquired intangible assets

     573      3                617      6         

Provision (benefit) for obsolete inventory, net of usage

     370      2                (160)     (1)        

Other 2

     12      0                122      1         
                   

Total cost of revenue

     $         10,036      54%            $           6,624      61%     
                   

Gross profit

     $ 8,656          46%            $ 4,156          39%     
                   

 

1

Includes purchased materials, assembly, test, labor, employee benefits, warranty expense and royalties.

 

2

Includes stock based compensation, additional amortization of non-cancelable prepaid royalty and restructuring.

Cost of revenue decreased to 54% of total revenue in the first quarter of 2010, down from 61% of total revenue in the first quarter of 2009. The decrease resulted primarily from improved overhead cost absorption due to increased revenue in the first quarter of 2010. The decrease was also attributable to improvements in our manufacturing processes and reductions in our material costs. These decreases were partially off-set by an increase in our provision for obsolete inventory during the first quarter of 2010 as we transitioned customers to our next generation products.

 

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Research and development

Research and development expense includes compensation and related costs for personnel, development-related expenses including non-recurring engineering and fees for outside services, depreciation and amortization, expensed equipment, facilities and information technology expense allocations and travel and related expenses. Research and development expense was as follows (dollars in thousands):

 

     Three months ended
March  31,
   2010 v 2009
     2010    2009    $ change    % change

Research and development

     $         5,340        $         4,776        $         564              12%  

Research and development expense increased $0.6 million, or 12%, from the first quarter of 2009 to the first quarter of 2010. The increase is primarily due to a $0.3 million increase in development related expenses, including non-recurring engineering and outside services and smaller increases in compensation expense, software maintenance expense and expensed equipment.

Selling, general and administrative

Selling, general and administrative expense includes compensation and related costs for personnel, sales commissions, allocations for facilities and information technology expenses, travel, outside services and other general expenses incurred in our sales, marketing, customer support, management, legal and other professional and administrative support functions. Selling, general and administrative expense was as follows (dollars in thousands):

 

     March 31,    2010 v 2009
     2010    2009    $ change    % change

Selling, general and administrative

     $         3,793        $         3,873        $         (80)             (2)%  

Selling, general and administrative expense decreased $0.1 million, or 2%, from the first quarter of 2009 to the first quarter of 2010. The small decrease reflects the stable nature of our selling, general and administrative activities over this time period and consists of small decreases in several expense categories which were partially off-set by an increase of $0.2 million in compensation expense.

Restructuring

We recorded restructuring expense in cost of revenue and operating expenses. Restructuring expense was comprised of the following amounts (in thousands):

 

     Three months ended
March  31,
     2010    2009

Consolidation of leased space 1

     $             94        $ 7  

Termination benefits 2

     —        77  
             

Total restructuring expenses

     $ 94        $             84  
             

Included in cost of sales

     $ —        $ 47  

Included in operating expenses

     94        37  

 

1

Expenses related to the consolidation of leased space included future non-cancelable rent payments due for vacated space (net of estimated sublease income) and related professional fees.

 

2

Includes severance payments for terminated employees.

 

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In December 2008, we initiated a restructuring plan to reduce our operating expenses in response to decreases in current and forecasted revenue which resulted from global economic uncertainty. The plan reduced operations, research and development and administrative headcount in our San Jose, Taiwan and China offices, and was completed during the second quarter of 2009. All termination benefits recorded during the first quarter of 2009 were attributable to the plan initiated in December 2008.

In November 2006, we initiated a restructuring plan that included consolidation of our operations in order to reduce compensation and rent expense, while at the same time making critical infrastructure investments in people, processes and information systems to improve our operating efficiency. Although this plan was completed in the fourth quarter of 2008, lease termination costs were recorded in the first quarters of 2010 and 2009 due to decreases in estimated future sublease income related to accruals made under the plan initiated in November 2006.

Interest and other income (expense), net

Interest and other income (expense), net consisted of the following (in thousands):

 

     Three months ended
March  31,
     2010    2009

Interest expense 1

     $ (123)       $ (251) 

Interest income 2

     13        98  

Amortization of debt issuance costs 3

     (18)       (61) 

Gain on repurchase of long-term debt, net 4

     —        9,024  
             

Total interest and other income (expense), net

     $             (128)       $             8,810  
             

 

1

Interest expense primarily relates to interest payable on our long-term debt. The decrease in the first quarter of 2010 is primarily due to the reduced outstanding principal balance which resulted from our February 2009 and May 2009 debt repurchases.

 

2

Interest income is earned on cash equivalents and short-term marketable securities. The decrease in the first quarter of 2010 is primarily due to lower balances of marketable securities which resulted from our repurchases of long-term debt as well as decreased yields.

 

3

The fees associated with the 2004 issuance of our long-term debt have been capitalized and are being amortized over a period of seven years. The decrease in the first quarter of 2010 is due to the write-off of fees associated with the portions of our long-term debt repurchased in February 2009 and May 2009. The remaining amortization period is approximately one year as of March 31, 2010.

 

4

In February 2009, we repurchased and retired $27.1 million of our outstanding long-term debt for $17.8 million in cash. We recognized a net gain on the repurchase of $9.0 million, which includes a $9.3 million discount, offset by a write-off of debt issuance costs of $0.3 million.

 

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Benefit for income taxes

The benefit for income taxes recorded for the first quarter of 2010 was primarily due to a benefit of $5.3 million for the reversal of previously recorded tax contingencies, partially offset by current and deferred tax expense in profitable foreign jurisdictions and accruals for tax contingencies in foreign jurisdictions. In the first quarter of 2010 we also recorded a non-cash income tax benefit of approximately $0.2 million related to gains recorded within other comprehensive income during the quarter. In accordance with U.S. generally accepted accounting principles (“GAAP”), this benefit was exactly offset by income tax expense included in other comprehensive income.

The benefit for income taxes recorded for the first quarter of 2009 was primarily due to a benefit of $1.8 million for the reversal of a previously recorded tax contingency, partially offset by current and deferred tax expense in profitable foreign jurisdictions and accruals for tax contingencies in foreign jurisdictions.

Business Outlook

On April 22, 2010, we provided an outlook for the second quarter of 2010 in our earnings release, which was furnished on a current report on Form 8-K. The outlook provided the following anticipated financial results prepared in accordance with GAAP:

We expect to record net loss per share in the second quarter of 2010 of $(0.04) to $(0.24), based on the following estimates:

 

   

Second quarter revenue of $17.5 million to $19.5 million.

 

   

Gross profit margin of approximately 45% to 47%.

 

   

Operating expenses of $9.5 million to $10.5 million.

Liquidity and Capital Resources

Cash and short- and long-term marketable securities

Our cash and cash equivalents and short- and long-term marketable securities were as follows (dollars in thousands):

 

     March 31,
2010
   December 31,
2009
   $ change    % change

Cash and cash equivalents

     $ 11,022        $ 17,797        $         (6,775)         (38)%      

Short-term marketable securities

     15,295        9,822        5,473      56           

Long-term marketable security

     6,380        3,240        3,140      97           
                       

Total cash and marketable securities

     $         32,697        $         30,859        $ 1,838      6%       
                       

Total cash and marketable securities increased 6% from December 31, 2009 to March 31, 2010. The net increase in the first quarter of 2010 resulted primarily from a $3.1 million increase in the valuation of our long-term marketable security, partially offset by $0.6 million in payments on property and equipment and other asset financing, $0.5 million used by operating activities and $0.2 million for purchases of property and equipment.

 

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At March 31, 2010, cash equivalents and short-term marketable securities included $10.2 million in money market funds and certificates of deposit, $3.6 million in commercial paper, $10.0 million in U.S. government agencies debt securities, and $1.7 million in corporate debt securities. At March 31, 2010, we also held a $6.4 million long-term strategic equity investment in a publicly traded corporation. All of our investments were denominated in U.S. dollars, and our portfolio did not contain direct exposure to subprime mortgages or structured vehicles that derive their value from subprime collateral.

Despite the difficult credit environment, the quality of our short-term investment portfolio remains high. Our investment policy requires that at least 25% of our portfolio matures within 90 days. Additionally, no maturities can extend beyond 24 months and concentrations with individual securities are limited. Investments must be rated at least A-1 / P-1 by Standard & Poor’s / Moody’s, and our investment policy is reviewed at least annually by our Audit Committee.

The valuations of our short-term marketable securities are affected by a variety of factors, including changes in interest rates and the actual or perceived financial stability of the issuer. However, due to the high quality of our investments and their short-term nature, there has not been, and we do not expect there to be, a significant fluctuation in the valuation of these investments. Accordingly, we do not expect a materially negative impact on our financial condition from fluctuations in the value of our short-term investments. As of March 31, 2010, we had a nominal unrealized loss on these investments.

The valuation of our long-term equity investment has fluctuated significantly, and could continue to fluctuate significantly, due to a variety of factors including changes in the global economy and changes in the actual or expected performance of the issuing company. We have recorded other-than-temporary impairments related to this investment of $7.9 million. Although the valuation of our investment has increased $4.3 million since we recorded our last other-than-temporary impairment in December 2008, we may record additional impairment charges in the future if we determine that any future declines in value are other-than-temporary. Such an impairment would negatively impact our results of operations, but would not materially impact our financial condition.

When available, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our cash equivalents and marketable securities. If quoted prices in active markets for identical assets or liabilities are not available, we use quoted prices for similar assets or liabilities, or use observable inputs other than the quoted prices, to determine fair value. We have no investments which are fair valued based on unobservable inputs.

We anticipate that our existing cash and investment balances will be adequate to fund our operating and investing needs for the next twelve months. From time to time, we may evaluate acquisitions of businesses, products or technologies that complement our business. We may also repurchase additional amounts of our long-term debt and common stock, as we did during the first quarter of 2009, and as described below under “capital resources.” Any further transactions, if consummated, may consume a material portion of our working capital or require the issuance of equity securities that may result in dilution to existing shareholders.

Accounts receivable, net

Accounts receivable, net increased to $5.9 million at March 31, 2010 from $5.6 million at December 31, 2009. The average number of days sales outstanding increased to 29 days at March 31, 2010 from 26 days at December 31, 2009. This change was due to normal fluctuation in the timing of cash receipts.

 

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Inventories, net

Inventories, net decreased to $6.1 million at March 31, 2010 from $6.2 million at December 31, 2009. Inventory turnover on an annualized basis decreased to 6.1 at March 31, 2010 from 7.0 at December 31, 2009. The decrease in inventory turnover was due to an increase in our average inventory balance during the first quarter of 2010.

Capital resources

In 2004, we issued $150.0 million of 1.75% convertible subordinated debentures (the “debentures”) due 2024. In 2006, we repurchased and retired $10.0 million principal amount of the debentures and in 2008 we repurchased and retired $79.4 million principal amount of the debentures. In 2009, we repurchased and retired $44.9 million principal amount of the debentures for $31.5 million in cash, reducing the balance of our outstanding debentures to $15.8 million.

We may redeem some or all of the outstanding debentures for cash on or after May 15, 2011 at a price equal to 100% of the principal amount of the debentures plus accrued and unpaid interest. The holders of the debentures have the right to require us to purchase all or a portion of the debentures outstanding at each of the following dates: May 15, 2011, May 15, 2014, and May 15, 2019, at a purchase price equal to 100% of the principal amount plus accrued and unpaid interest. The debentures are unsecured obligations and are subordinated in right of payment to all of our existing and future senior debt.

In September 2007, the Board of Directors authorized the repurchase of up to $10.0 million of the Company’s common stock under a share repurchase program that expired in September 2009. We repurchased 228,600 shares for approximately $0.2 million in the first quarter of 2009 and no shares were repurchased during the remainder of 2009. Total cumulative repurchases under the plan were $7.1 million.

Contractual Payment Obligations

Our contractual obligations for 2010 and beyond are included in our Annual Report on Form 10-K for the year ended December 31, 2009, filed with the Securities and Exchange Commission (“SEC”) on March 10, 2010. Our obligations for 2010 and beyond have not changed materially as of March 31, 2010.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements that have, or are reasonably likely to have, a material current or future effect on our financial condition, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources.

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

Interest rate fluctuations impact the interest income that we earn on our investment portfolio and the value of our investments. Factors that could cause interest rates to fluctuate include volatility in the credit and equity markets, such as the current uncertainty in global economic conditions; changes in the monetary policies of the United States and other countries and inflation. We mitigate risks associated with such fluctuations, as well as the risk of loss of principal, by investing in high-credit quality securities and limiting concentrations of issuers and maturity dates. Derivative financial instruments are not part of our investment portfolio.

 

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During the first quarter of 2010 and as of March 31, 2010, a significant majority of our financial assets were held as cash equivalents or high quality short-term marketable securities with yields approaching zero. Accordingly, a hypothetical decrease in interest rates would not have a significant impact on our results of operations or financial position.

As of March 31, 2010, we had convertible subordinated debentures of $15.8 million outstanding with a fixed interest rate of 1.75%. Interest rate changes affect the fair value of the debentures, but do not affect our earnings or cash flow.

All of our sales and inventory purchases are denominated in U.S. dollars and, as a result, we have relatively little exposure to foreign currency exchange risk with respect to our sales or cost of goods sold. We have employees located in offices in Japan, Taiwan, Korea and the People’s Republic of China and as such, a portion of our operating expenses as well as foreign income taxes payable are denominated in foreign currencies. Accordingly, our operating results are affected by changes in the exchange rate between the U.S. dollar and those currencies. Any future strengthening of those currencies against the U.S. dollar could negatively impact our operating results by increasing our operating expenses as measured in U.S. dollars. We cannot reasonably estimate the effect that an immediate change in foreign currency exchange rates would have on our operating results or cash flows. Currently, we do not hedge against foreign currency rate fluctuations.

 

Item 4. Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

Based on management’s evaluation (with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”)), as of the end of the period covered by this report, our CEO and CFO have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”)) are effective to provide reasonable assurance that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and is accumulated and communicated to management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

Changes in Internal Control over Financial Reporting

There were no changes to our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Inherent Limitations on Effectiveness of Controls

Our management, including the CEO and CFO, does not expect that our Disclosure Controls or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, have been detected. The design of any system of controls is based in part on certain

 

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assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.

PART II – OTHER INFORMATION

 

Item 1. Legal Proceedings.

For a discussion of legal proceedings, see “Note 11: Commitments and Contingencies” in the Notes to Condensed Consolidated Financial Statements of this Form 10-Q.

 

Item 1A. Risk Factors.

Investing in our shares of common stock involves a high degree of risk, and investors should carefully consider the risks described below before making an investment decision. If any of the following risks occur, the market price of our shares of common stock could decline and investors could lose all or part of their investment. Additional risks that we currently believe are immaterial may also impair our business operations. In assessing these risks, investors should also refer to the other information contained or incorporated by reference in this Quarterly Report on Form 10-Q and our Annual Report on Form 10-K for the year ended December 31, 2009, including our consolidated financial statements and related notes, and our other filings made from time to time with the Securities and Exchange Commission.

Company Specific Risks

Our product strategy, which is targeted at markets demanding superior video and image quality, may not lead to new design wins or significantly increased revenue in a timely manner or at all, which could materially adversely affect our results of operations and limit our ability to grow.

We have adopted a product strategy that focuses on our core competencies in pixel processing and delivering high levels of video and image quality. With this strategy, we continue to make further investments in the development of our ImageProcessor architecture for the digital projector market, with particular focus on adding increased performance and functionality. For the advanced television market, we have shifted away from our previous approach of implementing our intellectual property (“IP”) exclusively in system-on-chip integrated circuits (“ICs”), to an approach designed to improve video performance of our customers’ image processors through the use of our line of Motion Estimation Motion Compensation (“MEMC”) co-processor ICs. This strategy is designed to address the needs of the large-screen, high-resolution, high-quality segment of the television market. Although our new product strategy is developed to take advantage of market trends, such markets may not develop or may take longer to develop than we expect. We cannot assure you that the products we are developing will adequately address the demands of our target customers, or that we will be able to produce our new products at costs that enable us to price these products competitively.

Even if our product strategy is properly targeted, we cannot assure you that the products we are developing will lead to a significant increase in revenue from new design wins. To achieve design wins, we must design and deliver cost-effective, innovative and integrated semiconductors that overcome the significant costs associated with qualifying a new supplier and which make developers reluctant to change component sources. Further, design wins do not necessarily result in developers ordering large volumes of our products. Developers can choose at any time to discontinue using our products in their designs or product development efforts. A design win is not a binding commitment by a developer to purchase our products, but rather a decision by a developer to use our products in its design process. Even if our

 

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products are chosen to be incorporated into a developer’s products, we may still not realize significant revenue from the developer if its products are not commercially successful or it chooses to qualify, or incorporate the products, of a second source.

Dependence on a limited number of sole-source, third-party manufacturers for our products exposes us to shortages based on capacity allocation or low manufacturing yield, errors in manufacturing, price increases with little notice, volatile inventory levels and delays in product delivery, which could result in delays in satisfying customer demand, increased costs and loss of revenue.

We do not own or operate a semiconductor fabrication facility and do not have the resources to manufacture our products internally. We rely on three third-party foundries to produce all of our wafers and three assembly and test vendors for completion of finished products. The wafers used in any one of our products are fabricated by only one foundry. Sole sourcing each product increases our dependence on our suppliers.

We have limited control over delivery schedules, quality assurance, manufacturing yields, potential errors in manufacturing and production costs. We do not have long-term supply contracts with our third-party manufacturers, so they are not obligated to supply us with products for any specific period of time, quantity or price, except as may be provided in a particular purchase order. From time to time, our suppliers increase the prices of the products we purchase from them with little notice, which may cause us to increase the prices to our customers and harm our competitiveness. Because our requirements represent only a small portion of the total production capacity of our contract manufacturers, they are more likely to, and have in the past, reallocated capacity to other customers even during periods of high demand for our products. We expect this may occur again in the future.

Establishing a relationship with a new contract manufacturer in the event of delays or increased prices with our current contract manufacturers would be costly and cumbersome. The lead time to make such a change would be at least nine months, and the estimated time for us to adapt a product’s design to a particular contract manufacturer’s process is at least four months. If we have to qualify a new foundry or packaging, assembly and testing supplier for any of our products or if we are unable to obtain our products from our contract manufacturers on schedule, or at all, we could incur significant delays in shipping products, our ability to satisfy customer demand could be harmed, our revenue from the sale of products may be lost or delayed and our customer relationships and ability to obtain future design wins could be damaged.

We may fail to retain or attract the specialized technical and management personnel required to successfully operate our business.

Our success depends on the continued services of our executive officers and other key management, engineering, and sales and marketing personnel and on our ability to continue to attract, retain and motivate qualified personnel. Competition for skilled engineers and management personnel is intense within our industry, and we may not be successful in hiring and retaining qualified personnel. The loss of, or inability to hire, key personnel could limit our ability to develop new products and adapt existing products to our customers’ requirements, and may result in lost sales and a diversion of management resources. In the past three years we have experienced turn-over in several of our executive management positions and we have also experienced, and may continue to experience difficulty in hiring and retaining qualified engineering personnel in our Shanghai office.

Because of our long product development process and sales cycles, we may incur substantial costs before we earn associated revenue and ultimately may not sell as many units of our products as we originally anticipated.

We develop products based on anticipated market and customer requirements and incur substantial product development expenditures, which can include the payment of large up-front, third-party license fees and royalties, prior to generating associated revenue. Our work under these projects is technically

 

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challenging and places considerable demands on our limited resources, particularly on our most senior engineering talent. Because the development of our products incorporates not only our complex and evolving technology but also our customers’ specific requirements, a lengthy sales process is often required before potential customers begin the technical evaluation of our products. Our customers typically perform numerous tests and extensively evaluate our products before incorporating them into their systems. The time required for testing, evaluation and design of our products into a customer’s system can take up to nine months or more. It can take an additional nine months or longer before a customer commences volume shipments of systems that incorporate our products. We cannot assure you that the time required for the testing, evaluation and design of our products by our customers would not be significantly longer than nine months.

Because of the lengthy development and sales cycles, we will experience delays between the time we incur expenditures for research and development, sales and marketing and inventory and the time we generate revenue, if any, from these expenditures. Additionally, if actual sales volumes for a particular product are substantially less than originally anticipated, we may experience large write-offs of capitalized license fees, software development tools, product masks, inventories or other capitalized or deferred product-related costs, or increased amortization of non-cancelable prepaid royalties, any of which would negatively affect our operating results. For example, our provisions for obsolete inventory were $1.2 million and $1.5 million in 2009 and 2008, respectively. Additionally, in 2007, we wrote off assets with a net book value of $6.9 million due to reductions in research and development personnel and changes in product development strategy.

We may be unable to successfully manage any future growth, including the integration of any future acquisition or equity investment, which could disrupt our business and severely harm our financial condition.

We may determine that it is beneficial to increase our capacity to develop new and enhanced products in the future. If we fail to effectively manage internal growth, our operating expenses may increase more rapidly than our revenue, adversely affecting our financial condition and results of operations. To manage any future growth effectively in a rapidly evolving market, we must be able to maintain and improve our operational and financial systems, train and manage our employee base and attract and retain qualified personnel with relevant experience. We must also manage multiple relationships with customers, business partners, contract manufacturers, suppliers and other third parties. We could spend substantial amounts of time and money in connection with expansion efforts for which we may not realize any profit. Our systems, procedures or controls may not be adequate to support our operations and we may not be able to grow quickly enough to exploit potential market opportunities.

In addition, we may not be able to successfully integrate the businesses, products, technologies or personnel of any entity that we might acquire in the future, and any failure to do so could disrupt our business and seriously harm our financial condition. Our operation of any acquired business would involve numerous risks, including, but not limited to:

 

   

problems combining the acquired operations, technologies or products;

 

   

unanticipated costs;

 

   

diversion of management’s attention from existing operations;

 

   

adverse effects on existing business relationships with customers;

 

   

risks associated with entering markets in which we have no or limited prior experience;

 

   

potential loss of key employees, particularly those of the acquired organizations; and

 

   

risks associated with implementing adequate internal control, management, financial and operating reporting systems.

 

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Any future acquisitions and investments could also result in any of the following negative events, among others:

 

   

issuance of stock that dilutes current shareholders’ percentage ownership;

 

   

incurrence of debt;

 

   

assumption of liabilities;

 

   

amortization expenses related to acquired intangible assets;

 

   

impairment of goodwill;

 

   

large and immediate write-offs; and

 

   

decreases in cash and marketable securities that could otherwise serve as working capital.

We have incurred indebtedness as a result of the sale of convertible debentures. We anticipate that we must repay or refinance the debentures by May 2011. We may be unable to meet this, or other, future capital requirements.

As of March 31, 2010, $15.8 million of our 1.75% convertible subordinated debentures (the “debentures”) were outstanding. Although the debentures are not due until 2024, the holders have the right to require us to purchase all or a portion of the debentures at each of the following dates: May 15, 2011, May 15, 2014 and May 15, 2019. Since the market price of our common stock is significantly below the conversion price of the debentures, we expect the holders to exercise their put option on May 15, 2011. We may not be able to refinance the debentures at terms that are as favorable as those currently contained in the debentures, or at terms that are acceptable to us at all. While we believe that our current cash and marketable securities balances will be sufficient to meet our capital requirements for the next twelve months, we cannot assure you that we will be able to maintain sufficient cash and marketable security balances to refinance or pay off the debentures when and if the put option is exercised, or that such a repurchase would not result in cash reserves too low for us to continue our business as a going concern. We may need, or could elect to seek, additional funding through public or private equity or debt financing, which we may not be able to obtain. If we issue equity securities, our shareholders may experience additional dilution or the new equity securities may have rights, preferences or privileges senior to those of our common stock.

If we are not profitable in the future, we may be unable to continue our operations.

Excluding gains on the repurchase of our convertible subordinated debentures, 2004 is our only year of profitability since inception and we have incurred operating losses since 2004. If and when we achieve profitability depends upon a number of factors, including our ability to develop and market innovative products, accurately estimate inventory needs, contract effectively for manufacturing capacity and maintain sufficient funds to finance our activities. If we are not profitable in the future, we may be unable to continue our operations.

A significant amount of our revenue comes from a limited number of customers and distributors, exposing us to increased credit risk and subjecting our cash flow to the risk that any of our customers or distributors could decrease or cancel its orders.

The display manufacturing market is highly concentrated and we are, and will continue to be, dependent on a limited number of customers and distributors for a substantial portion of our revenue. Sales to our top distributor represented 37%, 35% and 32% of revenue for the three month period ended March 31, 2010 and years ended December 31, 2009 and 2008, respectively. Revenue attributable to our top five end

 

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customers represented 62%, 56% and 55% of revenue for the three month period ended March 31, 2010 and the years ended December 31, 2009 and 2008, respectively. As of March 31, 2010 and 2009, we had three accounts that each represented 10% or more of accounts receivable. A reduction, delay or cancellation of orders from one or more of our significant customers, or a decision by one or more of our significant customers to select products manufactured by a competitor or to use its own internally-developed semiconductors, would significantly impact our revenue. Further, the concentration of our accounts receivable with a limited number of customers increases our credit risk. The failure of these customers to pay their balances, or any customer to pay future outstanding balances, would result in an operating expense and reduce our cash flows.

Our dependence on selling to distributors and integrators increases the complexity of managing our supply chain and may result in excess inventory or inventory shortages.

Selling to distributors and original equipment manufacturers (“OEMs”) that build display devices based on specifications provided by branded suppliers, also referred to as integrators, reduces our ability to forecast sales accurately and increases the complexity of our business. Our sales are made on the basis of customer purchase orders rather than long-term purchase commitments. Our distributors, integrators and customers may cancel or defer purchase orders at any time but we must order wafer inventory from our contract manufacturers three to four months in advance.

The estimates we use for our advance orders from contract manufacturers are based, in part, on reports of inventory levels and production forecasts from our distributors and integrators, which act as intermediaries between us and the companies using our products. This process requires us to make numerous assumptions concerning demand and to rely on the accuracy of the reports and forecasts of our distributors and integrators, each of which may introduce error into our estimates of inventory requirements. Our failure to manage this challenge could result in excess inventory or inventory shortages that could materially impact our operating results or limit the ability of companies using our semiconductors to deliver their products. For example, we overestimated demand for certain of our products which led to significant charges for obsolete inventory in 2009, 2008 and 2007. On the other hand, if we underestimate demand, we would forego revenue opportunities, lose market share and damage our customer relationships.

International sales account for almost all of our revenue, and if we do not successfully address the risks associated with international sales, our revenue could decrease.

Sales outside the U.S. accounted for approximately 97%, 97% and 95% of revenue for the three month period ended March 31, 2010 and the years ended December 31, 2009 and 2008, respectively. We anticipate that sales outside the U.S. will continue to account for a substantial portion of our revenue in future periods. In addition, customers who incorporate our products into their products sell a substantial portion of their products outside of the U.S., and all of our products are manufactured outside of the U.S. We are, therefore, subject to many international risks, including, but not limited to:

 

   

increased difficulties in managing international distributors and manufacturers due to varying time zones, languages and business customs;

 

   

foreign currency exchange fluctuations in the currencies of Japan, the People’s Republic of China (“PRC”), Taiwan or Korea;

 

   

reduced or limited protection of our IP, particularly in software, which is more prone to design piracy;

 

   

difficulties in collecting outstanding accounts receivable balances;

 

   

potentially adverse tax consequences;

 

   

difficulties regarding timing and availability of export and import licenses;

 

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political and economic instability, particularly in the PRC, Japan, Taiwan, or Korea;

 

   

difficulties in maintaining sales representatives outside of the U.S. that are knowledgeable about our industry and products;

 

   

changes in the regulatory environment in the PRC, Japan, Taiwan and Korea that may significantly impact purchases of our products by our customers; and

 

   

outbreaks of health epidemics in the PRC or other parts of Asia;

The concentration of our manufacturers and customers in the PRC, Japan, Korea and Taiwan increases our risk that a natural disaster, work stoppage or economic or political instability in the region could disrupt our operations.

Most of our current manufacturers and customers are located in the PRC, Japan, Korea or Taiwan. In addition, a significant percentage of our employees are located in this region. Disruptions from natural disasters, health epidemics and political, social and economic instability may affect the region and would have a negative impact on our results of operations. In addition, the economy of the PRC differs from the economies of many countries in respects such as structure, government involvement, level of development, growth rate, capital reinvestment, allocation of resources, self-sufficiency, rate of inflation, foreign currency flows and balance of payments position, among others. We cannot be assured that the PRC’s economic policies will be consistent or effective. Our results of operations and financial position may be harmed by changes in the PRC’s political, economic or social conditions.

In addition, the risk of earthquakes in the Pacific Rim region is significant due to the proximity of major earthquake fault lines in the area. Common consequences of earthquakes include power outages and disruption or impairment of production capacity. Earthquakes, fire, flooding, power outages and other natural disasters in the Pacific Rim region, or political unrest, labor strikes or work stoppages in countries where our manufacturers and customers are located, would likely result in the disruption of our manufacturers’ and customers’ operations. Any disruption resulting from extraordinary events could cause significant delays in shipments of our products until we are able to shift our manufacturing from the affected contractor to another third-party vendor. There can be no assurance that alternative capacity could be obtained on favorable terms, or in a timely manner, if at all.

We may be unable to successfully implement new products or enhancements to our current products due to our prior or any potential future restructuring actions, which could adversely affect our future sales and financial condition.

We initiated restructuring plans in November 2006 and December 2008 which were completed in December 2008 and June 2009, respectively. These restructuring plans included consolidation and closure of certain offices, reductions in headcount and significant write-offs of assets. Although our restructuring plans were intended to improve efficiency and return the Company to profitability, these restructuring plans and any future restructuring actions may slow our development of new or enhanced products by limiting our research and development and engineering activities. If we are unable to successfully introduce new or enhanced products, our sales and financial condition will be adversely affected.

Continued compliance with regulatory and accounting requirements will be challenging and will require significant resources.

We spend a significant amount of management time and external resources to comply with changing laws, regulations and standards relating to corporate governance and public disclosure, including evolving Securities and Exchange Commission rules and regulations, NASDAQ Global Market rules and the Sarbanes-Oxley Act of 2002, which requires management’s annual review and evaluation of internal control over financial reporting. If we are unable to maintain an effective system of internal controls, our shareholders could lose confidence in the accuracy and completeness of our financial reports which in turn could cause our stock price to decline.

 

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Additionally, one of the covenants of the indenture governing the debentures could possibly be interpreted such that if we are late with any of our required filings under the Securities Exchange Act of 1934, as amended (“Exchange Act”), and if we fail to affect a cure within 60 days, the holders of the debentures can put the debentures back to the Company, whereby the debentures become immediately due and payable. As a result of our restructuring efforts, we have fewer employees to perform day-to-day controls, processes and activities and, additionally, certain functions have been transferred to new employees who are not as familiar with our procedures. These changes increase the risk that we will be unable to make timely filings in accordance with the Exchange Act. Any resulting default under our debentures would have a material adverse effect on our cash position and operating results.

Our effective income tax rate is subject to unanticipated changes in, or different interpretations of tax rules and regulations and forecasting our effective income tax rate is complex and subject to uncertainty.

As a global company, we are subject to taxation by a number of taxing authorities and as such, our tax rates vary among the jurisdictions in which we operate. Unanticipated change in our tax rates could affect our future results of operations. Our effective tax rates could be adversely affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in tax laws or the interpretation of tax laws either in the United States or abroad, or by changes in the valuation of our deferred tax assets and liabilities. The ultimate outcomes of any future tax audits are uncertain, and we can give no assurance as to whether an adverse result from one or more of them would have a material effect on our operating results and financial position.

The computation of income tax expense is complex as it is based on the laws of numerous tax jurisdictions and requires significant judgment on the application of complicated rules governing accounting for tax provisions under U.S. generally accepted accounting principles. Income tax expense for interim quarters is based on a forecast of our global tax rate for the year, which includes forward looking financial projections, including the expectations of profit and loss by jurisdiction, and contains numerous assumptions. For these reasons, our global tax rate may be materially different than our forecast.

Company Risks Related to the Semiconductor Industry and Our Markets

If we are not able to respond to the rapid technological changes and evolving industry standards in the markets in which we compete, or seek to compete, our products may become less desirable or obsolete.

The markets in which we compete or seek to compete are subject to rapid technological change and miniaturization capabilities, frequent new product introductions, changing customer requirements for new products and features and evolving industry standards. The introduction of new technologies and emergence of new industry standards could render our products less desirable or obsolete, which could harm our business and significantly decrease our revenue. Examples of changing industry standards include the growing use of broadband to deliver video content, increased display resolution and size, faster screen refresh rates, video capability such as high definition and 3D, the proliferation of new display devices and the drive to network display devices together. Our products are incorporated into our customers’ products, which have different parts and specifications and utilize multiple protocols that allow them to be compatible with specific computers, video standards and other devices. If our customers’ products are not compatible with these protocols and standards, consumers will return, or not purchase, these products and the markets for our customers’ products could be significantly reduced. As a result, a portion of our market would be eliminated, and our business would be harmed.

 

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Intense competition in our markets may reduce sales of our products, reduce our market share, decrease our gross profit and result in large losses.

We compete with specialized and diversified electronics and semiconductor companies that offer display processors or scaling components. Some of these include Broadcom Corporation, i-Chips Technologies Inc., Integrated Device Technology, Inc., Intersil Corporation, MediaTek Inc., MStar Semiconductor, Inc., Realtek Semiconductor Corp., Renesas Electronics America., Sigma Designs, Inc., Silicon Image, Inc., STMicroelectronics N.V., Sunplus Technology Co., Ltd., Trident Microsystems, Inc., Zoran Corporation and other companies. Potential and current competitors may include diversified semiconductor manufacturers and the semiconductor divisions or affiliates of some of our customers, including Intel Corporation, LG Electronics, Inc., Matsushita Electric Industrial Co., Ltd., Mitsubishi Digital Electronics America, Inc., National Semiconductor Corporation, NEC Corporation, NVIDIA Corporation, NXP Semiconductors, Samsung Electronics Co., Ltd., SANYO Electric Co., Ltd., Seiko Epson Corporation, Sharp Electronics Corporation, Sony Corporation, Texas Instruments Incorporated and Toshiba America, Inc. In addition, start-up companies may seek to compete in our markets.

Many of our competitors have longer operating histories and greater resources to support development and marketing efforts than we do. Some of our competitors operate their own fabrication facilities. These competitors may be able to react more quickly and devote more resources to efforts that compete directly with our own. Our current or potential customers have developed, and may continue to develop, their own proprietary technologies and become our competitors. Increased competition from both competitors and our customers’ internal development efforts could harm our business, financial condition and results of operations by, for example, increasing pressure on our profit margin or causing us to lose sales opportunities. We cannot assure you that we can compete successfully against current or potential competitors.

Our highly integrated products and high-speed mixed signal products are difficult to manufacture without defects and the existence of defects could result in increased costs, delays in the availability of our products, reduced sales of products or claims against us.

The manufacture of semiconductors is a complex process and it is often difficult for semiconductor foundries to produce semiconductors free of defects. Because many of our products are more highly integrated than other semiconductors and incorporate mixed analog and digital signal processing, multi-chip modules and embedded memory technology, they are even more difficult to produce without defects. Defective products can be caused by design or manufacturing difficulties. Therefore, identifying quality problems can occur only by analyzing and testing our semiconductors in a system after they have been manufactured. The difficulty in identifying defects is compounded because the process technology is unique to each of the multiple semiconductor foundries we contract with to manufacture our products. Despite testing by both our customers and us, errors or performance problems may be found in existing or new semiconductors.

Failure to achieve defect-free products may result in increased costs and delays in the availability of our products. Additionally, customers could seek damages from us for their losses and shipments of defective products may harm our reputation with our customers. We have experienced field failures of our semiconductors in certain customer applications that required us to institute additional testing. As a result of these field failures, we incurred warranty costs due to customers returning potentially affected products. Our customers have also experienced delays in receiving product shipments from us that resulted in the loss of revenue and profits. Shipments of defective products could cause us to lose customers or to incur significant replacement costs, either of which would harm our business.

 

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We use a customer owned tooling process for manufacturing most of our products which exposes us to the possibility of poor yields and unacceptably high product costs.

We build most of our products on a customer owned tooling basis, also known in the semiconductor industry as COT, whereby we directly contract the manufacture of our products, including wafer production, assembly and test. As a result, we are subject to increased risks arising from wafer manufacturing yields and risks associated with coordination of the manufacturing, assembly and testing process. Poor product yields result in higher product costs, which could make our products less competitive if we increase our prices to compensate for our higher costs, or could result in lower gross profit margins if we do not increase our prices.

The development of new products is extremely complex and we may be unable to develop our new products in a timely manner and without defects, errors or bugs, or at all, which would result in a failure to obtain new design wins and/or maintain our current revenue levels.

The development of semiconductors is a complex and time-consuming process and many of our products are highly integrated and incorporate mixed analog and digital signal processing, multichip modules and embedded memory technology, further complicating the development process. In addition to the inherent difficulty of designing complex ICs, product development delays may result from:

 

   

difficulties in hiring and retaining necessary technical personnel;

 

   

difficulties with contract manufacturers;

 

   

difficulties in reallocating engineering resources and overcoming resource limitations;

 

   

changes to product specifications and customer requirements;

 

   

changes to market or competitive product requirements; and

 

   

unanticipated engineering complexities.

Even if we are able to meet our customers’ design windows, the highly complex products we provide to our customers may contain defects, errors and bugs when they are first introduced. We have in the past and may in the future experience these defects, errors and bugs. In addition, if any of our products do contain defects, errors or bugs when first introduced, we may be unable to correct the problems. Consequently, our reputation may be damaged and customers may be reluctant to buy our products, which could harm our ability to retain existing customers and to attract new customers. In addition, any defects, errors or bugs could interrupt or delay sales of our new products to our customers. If we are not successful in development of new products, our financial results will be adversely affected.

Our developed software may be incompatible with industry standards and challenging and costly to implement, which could slow product development or cause us to lose customers and design wins.

We provide our customers with software development tools and with software that provides basic functionality for our ICs and enables enhanced connectivity of our customers’ products. Software development is a complex process and we are dependent on software development languages and operating systems from vendors that may limit our ability to design software in a timely manner. Also, as software tools and interfaces change rapidly, new software languages introduced to the market may be incompatible with our existing systems and tools, requiring significant engineering efforts to migrate our existing systems in order to be compatible with those new languages. Software development disruptions could slow our product development or cause us to lose customers and design wins. The integration of software with our products adds complexity, may extend our internal development programs and could impact our customers’ development schedules. This complexity requires increased coordination between hardware and software development schedules and increases our operating expenses without a corresponding increase in product revenue. This additional level of complexity lengthens the sales cycle and may result in customers selecting competitive products requiring less software integration.

 

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The competitiveness and viability of our products could be harmed if necessary licenses of third-party technology are not available to us or are only available on terms that are not commercially viable.

We license technology from independent third parties that is incorporated into our products or product enhancements. Future products or product enhancements may require additional third-party licenses that may not be available to us or may not be available on terms that are commercially reasonable. In addition, in the event of a change in control of one of our licensors, it may become difficult to maintain access to its licensed technology. If we are unable to obtain or maintain any third-party license required to develop new products and product enhancements, we may have to obtain substitute technology with lower quality or performance standards, or at greater cost, either of which could seriously harm the competitiveness of our products.

See “Note 11: Commitments and Contingencies” in the Notes to Condensed Consolidated Financial Statements of this Form 10-Q for additional information on current litigation related to licensed technology.

Our limited ability to protect our IP and proprietary rights could harm our competitive position by allowing our competitors to access our proprietary technology and to introduce similar products.

Our ability to compete effectively with other companies will depend, in part, on our ability to maintain the proprietary nature of our technology, including our semiconductor designs and software code. We provide the computer programming code for our software to customers in connection with their product development efforts, thereby increasing the risk that customers will misappropriate our proprietary software. We rely on a combination of patent, copyright, trademark and trade secret laws, as well as nondisclosure agreements and other methods, to help protect our proprietary technologies. As of March 31, 2010 we held 124 patents and had 35 patent applications pending for protection of our significant technologies. Competitors in both the U.S. and foreign countries, many of whom have substantially greater resources than we do, may apply for and obtain patents that will prevent, limit or interfere with our ability to make and sell our products, or they may develop similar technology independently or design around our patents. Effective copyright, trademark and trade secret protection may be unavailable or limited in foreign countries.

We cannot assure you that the degree of protection offered by patent or trade secret laws will be sufficient. Furthermore, we cannot assure you that any patents will be issued as a result of any pending applications or that any claims allowed under issued patents will be sufficiently broad to protect our technology. In addition, it is possible that existing or future patents may be challenged, invalidated or circumvented.

Others may bring infringement actions against us that could be time consuming and expensive to defend.

We may become subject to claims involving patents or other IP rights. IP claims could subject us to significant liability for damages and invalidate our proprietary rights. In addition, IP claims may be brought against customers that incorporate our products in the design of their own products. These claims, regardless of their success or merit and regardless of whether we are named as defendants in a lawsuit, would likely be time consuming and expensive to resolve and would divert the time and attention of management and technical personnel. Any IP litigation or claims also could force us to do one or more of the following:

 

   

stop selling products using technology that contains the allegedly infringing IP;

 

   

attempt to obtain a license to the relevant IP, which may not be available on reasonable terms or at all;

 

   

attempt to redesign those products that contain the allegedly infringing IP; or

 

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pay damages for past infringement claims that are determined to be valid or which are arrived at in settlement of such litigation or threatened litigation.

If we are forced to take any of the foregoing actions, we may incur significant additional costs or be unable to manufacture and sell our products, which could seriously harm our business. In addition, we may not be able to develop, license or acquire non-infringing technology under reasonable terms. These developments could result in an inability to compete for customers or otherwise adversely affect our results of operations.

We are dependent on manufacturers of our semiconductor products not only to respond to changes in technology and industry standards but also to continue the manufacturing processes on which we rely.

To respond effectively to changes in technology and industry standards, we are dependent on our foundries to implement advanced semiconductor technologies and our operations could be adversely affected if those technologies are unavailable, delayed or inefficiently implemented. In order to increase performance and functionality and reduce the size of our products, we are continuously developing new products using advanced technologies that further miniaturize semiconductors and we are dependent on our foundries to develop and provide access to the advanced processes that enable such miniaturization. We cannot be certain that future advanced manufacturing processes will be implemented without difficulties, delays or increased expenses. Our business, financial condition and results of operations could be materially adversely affected if advanced manufacturing processes are unavailable to us, substantially delayed or inefficiently implemented.

Creating the capacity for new technological changes may cause manufacturers to discontinue older manufacturing processes in favor of newer ones. We must then either retire the affected part or develop a new version of the part that can be manufactured with a newer process. In the event that a manufacturing process is discontinued, our current suppliers may be unwilling or unable to manufacture our current products. We may not be able to place last time buy orders for the old technology or find alternate manufacturers of our products to allow us to continue to produce products with the older technology while we expend the significant costs for research and development and time to migrate to new, more advanced processes. For instance, a portion of our products use embedded dynamic random access memory (“DRAM”) technology, which requires manufacturing processes that are being phased out. We also utilize 0.18um and 0.15um standard logic processes, which may only be available for the next five to seven years.

Shortages of materials used in the manufacturing of our products and other key components of our customers’ products may increase our costs, impair our ability to ship our products on time and delay our ability to sell our products.

From time to time, shortages of components and materials that are critical to the design and manufacture of our products and our customers’ products may occur. Such critical components and materials include semiconductor wafers and packages, display components, analog-to-digital converters, digital receivers and video decoders. If material shortages occur, we may incur additional costs or be unable to ship our products to our customers in a timely fashion, both of which could harm our business and adversely affect our results of operations.

Our products are characterized by average selling prices that decline over relatively short periods of time, which will negatively affect our financial results unless we are able to reduce our product costs or introduce new products with higher average selling prices.

Average selling prices for our products decline over relatively short periods of time, while many of our product costs are fixed. When our average selling prices decline, our gross profit declines unless we are able to sell more units or reduce the cost to manufacture our products. We have experienced declines in our average selling prices and expect that we will continue to experience them in the future, although we

 

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cannot predict when they may occur or how severe they will be. Our financial results will suffer if we are unable to offset any reductions in our average selling prices by increasing our sales volumes, reducing our costs, adding new features to our existing products or developing new or enhanced products in a timely manner with higher selling prices or gross profits.

The cyclical nature of the semiconductor industry may lead to significant variances in the demand for our products and could harm our operations.

In the past, the semiconductor industry has been characterized by significant downturns and wide fluctuations in supply and demand. Also, the industry has experienced significant fluctuations in anticipation of changes in general economic conditions, including economic conditions in Asia and North America. The cyclical nature of the semiconductor industry has also led to significant variances in product demand and production capacity. We have experienced, and may continue to experience, periodic fluctuations in our future financial results because of changes in industry-wide conditions.

Environmental laws and regulations have caused us to incur, and may again cause us to incur, significant expenditures to comply with applicable laws and regulations, and we may be assessed considerable penalties for noncompliance.

We are subject to numerous environmental laws and regulations. Compliance with current or future environmental laws and regulations could require us to incur substantial expenses which could harm our business, financial condition and results of operations. We have worked, and will continue to work, with our suppliers and customers to ensure that our products are compliant with enacted laws and regulations. Failure by us or our contract manufacturers to comply with such legislation could result in customers refusing to purchase our products and could subject us to significant monetary penalties in connection with a violation, either of which would have a material adverse effect on our business, financial condition and results of operations. Current environmental laws and regulations could become more stringent over time, imposing even greater compliance costs and increasing risks and penalties associated with violations, which could seriously harm our business, financial condition and results of operations. There can be no assurance that violations of environmental laws or regulations will not occur in the future as a result of our inability to obtain permits, human error, equipment failure or other causes.

Other Risks

The current adverse global economic environment and volatility in global credit and financial markets could materially and adversely affect our business and results of operations.

Slow economic activity, increased unemployment, decreased business and consumer confidence, reduced corporate profits and capital spending, adverse business conditions and liquidity concerns have contributed to and continue to contribute to a challenging economic environment. This environment has led to reduced spending in the markets in which we compete and made it difficult for our customers, our vendors and us to accurately forecast and plan future business activities. Furthermore, the constraints in the capital and credit markets may limit the ability of our customers to meet their liquidity needs, which could result in an impairment of their ability to make timely payments to us and to reduce their demand for our products, adversely impacting our results of operations and cash flows.

The price of our common stock has and may continue to fluctuate substantially.

Our stock price and the stock prices of technology companies similar to Pixelworks have been highly volatile. The price of our common stock may decline and the value of your investment may be reduced regardless of our performance. Market fluctuations, as well as general economic and political conditions, including recessions, interest rate changes or international currency fluctuations, may negatively impact the market price of our common stock. Additional factors that could negatively impact our stock price include:

 

   

actual or anticipated fluctuations in our operating results;

 

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changes in expectations as to our future financial performance;

 

   

changes in financial estimates of securities analysts;

 

   

announcements by us or our competitors of technological innovations, design wins, contracts, standards or acquisitions;

 

   

the operating and stock price performance of other comparable companies;

 

   

inconsistent trading volume levels of our common stock; and

 

   

changes in market valuations of other technology companies.

Any inability or perceived inability of investors to realize a gain on an investment in our common stock could have an adverse effect on our business, financial condition and results of operations by potentially limiting our ability to retain our customers, to attract and retain qualified employees and to raise capital.

We may be unable to maintain compliance with NASDAQ Marketplace Rules which could cause our common stock to be delisted from the NASDAQ Global Market. This could result in the lack of a market for our common stock, cause a decrease in the value of an investment in us, and adversely affect our business, financial condition and results of operations.

On June 4, 2008, we effected a one-for-three reverse split of our common stock. We effected the reverse split to regain compliance with NASDAQ Marketplace Rules, particularly the minimum $1.00 per share requirement for continued inclusion on the NASDAQ Global Market. Though the per share price of our common stock was $4.80 on April 30, 2010, the price has fluctuated significantly and was below $1.00 as recently as May 6, 2009. We cannot guarantee that it will remain at or above $1.00 per share and if the price again drops below $1.00 per share, the stock could become subject to delisting again, and we may seek shareholder approval for an additional reverse split. A second reverse split could produce adverse effects and may not result in a long-term or permanent increase in the price of our common stock.

If our common stock is delisted, trading of the stock will most likely take place on an over-the-counter market established for unlisted securities. An investor is likely to find it less convenient to sell, or to obtain accurate quotations in seeking to buy, our common stock on an over-the-counter market, and many investors may not buy or sell our common stock due to difficulty in accessing over-the-counter markets, or due to policies preventing them from trading in securities not listed on a national exchange or other reasons. For these reasons and others, delisting would adversely affect the liquidity, trading volume and price of our common stock, causing the value of an investment in us to decrease and having an adverse effect on our business, financial condition and results of operations by limiting our ability to attract and retain qualified executives and employees and limiting our ability to raise capital.

The anti-takeover provisions of Oregon law and in our articles of incorporation could adversely affect the rights of the holders of our common stock by preventing a sale or takeover of us at a price or prices favorable to the holders of our common stock.

Provisions of our articles of incorporation and bylaws and provisions of Oregon law may have the effect of delaying or preventing a merger or acquisition of us, making a merger or acquisition of us less desirable to a potential acquirer or preventing a change in our management, even if our shareholders consider the merger, acquisition or change in management favorable or if doing so would benefit our shareholders. In addition, these provisions could limit the price that investors would be willing to pay in the future for shares of our common stock. The following are examples of such provisions in our articles of incorporation or bylaws:

 

   

our board of directors is authorized, without prior shareholder approval, to change the size of the board (our articles of incorporation provide that if the board is increased to eight or more members, the board will be divided into three classes serving staggered terms, which would make it more difficult for a group of shareholders to quickly change the composition of our board);

 

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our board of directors is authorized, without prior shareholder approval, to create and issue preferred stock with voting or other rights or preferences that could impede the success of any attempt to acquire us or to effect a change of control, commonly referred to as “blank check” preferred stock;

 

   

members of our board of directors can be removed only for cause and at a meeting of shareholders called expressly for that purpose, by the vote of 75 percent of the votes then entitled to be cast for the election of directors;

 

   

our board of directors may alter our bylaws without obtaining shareholder approval; and shareholders are required to provide advance notice for nominations for election to the board of directors or for proposing matters to be acted upon at a shareholder meeting.

 

Item 6. Exhibits.

 

10.1    Summary of Pixelworks Non-Employee Director Compensation.+
31.1    Certification of Chief Executive Officer.
31.2    Certification of Chief Financial Officer.
32.1*    Certification of Chief Executive Officer.
32.2*    Certification of Chief Financial Officer.

 

+ Indicates a management contract or compensation arrangement.

 

* Exhibits 32.1 and 32.2 are being furnished and shall not be deemed to be “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), or otherwise subject to the liability of that section, nor shall such exhibits be deemed to be incorporated by reference in any registration statement or other document filed under the Securities Act of 1933, as amended, or the Exchange Act, except as otherwise stated in such filing.

 

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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

    PIXELWORKS, INC.
Dated: May 6, 2010     /s/ Steven L. Moore
   

Steven L. Moore

Vice President, Chief Financial

Officer, Secretary and Treasurer

 

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