Item 1A
.
Risk Factors
The following description of the risk factors associated with our business includes material changes to and supersedes the description of the risk factors associated with our business previously disclosed in Part I, Item 1A of our
Annual
Report on Form
10‑K
for the
year
ended
January 3, 2016
filed with the SEC on
February 12, 2016
.
Our operating results may fluctuate significantly, which may harm our financial condition and our stock price.
Our quarterly and annual operating results have fluctuated significantly in the past and we expect that they will continue to fluctuate in the future. Our results of operations are subject to fluctuations and other risks, including, among others:
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the announcement and pendency of our agreement to be acquired by Western Digital may have an adverse effect on our business, operating results and our stock price and could increase the likelihood or negative impact of any of the other risks to our business or operations;
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the failure of our pending acquisition by Western Digital to be completed on a timely basis, or at all, or any materially burdensome conditions that may be imposed, may adversely affect our business, operating results and our stock price;
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competitive pricing pressures or product mix changes, resulting in lower average selling prices, lower revenue and reduced margins;
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excess or mismatched captive memory output, capacity or inventory, resulting in lower average selling prices, financial charges and impairments, lower gross margin or other consequences, or insufficient or mismatched captive memory output, capacity or inventory, resulting in lost revenue and growth opportunities;
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inability to successfully transition to 3D NAND technology or reduce product costs to keep pace with reductions in average selling prices, resulting in lower or negative product gross margin;
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potential delays in product development or lack of customer acceptance and qualification of our solutions, including on new technologies, such as
15-nanometer
(which we also refer to as
1Z-nanometer
) process technologies, X3 NAND memory architecture and 3D NAND technology, particularly our enterprise solutions, client SSDs and embedded flash storage solutions;
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weakness in demand for one or more of our product categories, such as SSDs, including enterprise solutions and client SSDs, or embedded products, or adverse changes in our product or customer mix;
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inability to develop, or unexpected difficulties or delays in developing or ramping with acceptable yields, new technologies such as 3D NAND technology, 3D ReRAM or other advanced technologies, or the failure of these new technologies to effectively compete with those of our competitors;
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fluctuations in customer concentration, the loss of, or reduction in orders from, one or more of our major customers and the financial and market position of those customers;
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inability to penetrate new or growing markets for flash memory, including the client SSD and enterprise storage markets, failure of existing or new markets for flash memory to grow or develop, or failure to maintain or improve our position in any of these markets;
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timing, volume and cost of wafer production from Flash Ventures as impacted by fab start-up delays and costs, technology transitions, lower than expected yields or production interruptions;
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fluctuations or declines in our license and royalty revenue due to license agreement renewals on less favorable terms, non-renewals, declines in sales of the products or use of technology underlying the license and royalty revenue by our licensees, or failure by our licensees to perform on contractual obligations;
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excess inventory or lost sales resulting from unpredictable or changing demand for our products;
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failure to manage the risks associated with our ventures and strategic partnerships, including with Toshiba;
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failure of the rate of growth of our captive flash memory supply to keep pace with that of our competitors for an extended period of time, resulting in lost sales opportunities and reduced market share;
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insufficient supply of materials other than flash memory, such as DRAM, or capacity from our suppliers and contract manufacturers to meet demand or increases in the cost of these materials or capacity;
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increased costs and lower gross margin due to potentially higher warranty claims from our more complex solutions;
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inability to realize the potential financial or strategic benefits of business acquisitions or strategic investments;
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disruptions to our supply chain or operations, for example, whether due to natural disasters, emergencies such as power outages, fires or chemical spills, or employee strikes or other job actions, or geopolitical unrest;
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inability to enhance current products, develop new products or transition products to new technologies on a timely basis or in advance of our competitors;
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inability to timely or cost effectively develop or source controllers, firmware or software that meet the requirements of our solutions;
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increased memory component and other costs as a result of currency exchange rate fluctuations for the U.S. dollar, particularly with respect to the Japanese yen;
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inability to obtain
non-captive
memory supply of the right product mix and quality in the time frame necessary to meet demand, or inability to realize an adequate margin on
non-captive
purchases;
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insufficient or excess assembly and test or retail packaging and shipping capacity from our facilities in China and Malaysia or our contract manufacturers, or labor unrest, employee strikes or other disruptions at any of these facilities;
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errors or defects in our products caused by, among other things, errors or defects in the memory or controller components, including memory and
non-memory
components we procure from
third-party
suppliers, our firmware and software; and
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the other factors described in this “Risk Factors” section and elsewhere in this report.
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The announcement and pendency of our agreement to be acquired by Western Digital may have an adverse effect on our business, operating results and stock price
.
On October 21, 2015, we signed a merger agreement, under which a wholly-owned subsidiary of Western Digital will, subject to the satisfaction or waiver of the conditions in the merger agreement, merge with and into SanDisk Corporation, and SanDisk Corporation will be the surviving corporation in the merger and a wholly-owned subsidiary of Western Digital (referred to below as the “merger”). SanDisk and Western Digital have operated and, until the completion of the merger, will continue to operate independently. Uncertainty about the merger may adversely affect our revenue, operating results and stock price, whether or not the merger is completed. For example, strategic partners, customers, suppliers or other business partners may:
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delay, defer or cease purchasing goods or services from us or providing goods or services to us;
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delay or defer other decisions concerning us, or refuse to extend credit to us;
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cease further joint development activities; or
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otherwise seek to change the terms on which they do business with us.
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The uncertainties around the acquisition could adversely impact our relationships or contract negotiations with third parties, including our strategic partners, such as Toshiba, customers, suppliers and other business partners, or those with which we are seeking to establish business relationships. We are subject to additional risks in connection with the announcement and pendency of the merger which could adversely impact our operating results, including:
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the pendency and outcome of any legal proceedings that may be instituted against us, our directors and others relating to the transactions contemplated by the Western Digital merger agreement;
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the restrictions imposed on our business and operations pursuant to certain covenants set forth in the Western Digital merger agreement, which may prevent us from pursuing certain strategic opportunities without Western Digital’s approval;
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during the period that the merger agreement is in effect, except as permitted by certain limited exceptions in the merger agreement or required by their fiduciary duties and subject to the other requirements of the merger agreement, our Board of Directors may not withdraw or adversely modify its recommendation of approval by the SanDisk stockholders of the proposed merger, which has the effect of delaying other strategic transactions and may, in some cases, make it impossible to pursue other strategic transactions that are available only for a limited time;
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that we may forego opportunities we might otherwise pursue absent the pending merger with Western Digital;
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potential adverse effects on our ability to retain and motivate current employees, and attract and recruit prospective employees who may be uncertain about their future roles and relationships with us following the completion of the merger; and
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the diversion of our employees’ and management’s attention due to activities related to the proposed merger, which could otherwise have been devoted to other opportunities that may have been beneficial to us.
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Since a portion of the merger consideration our stockholders will receive in the proposed merger will be in the stock of Western Digital, our stock price has been and will continue to be adversely impacted by a decline in Western Digital’s stock price and any adverse developments in Western Digital’s business outlook. Western Digital stock price changes may result from a variety of factors, including changes in its businesses operations and outlook, changes in general market and economic conditions, and regulatory considerations. These factors are beyond our control. In addition, the stock portion of the merger consideration received by our stockholders at closing will increase and the cash portion will decrease in the event our cash available for use in the United States, or U.S., as of the closing is below certain specified thresholds.
In addition, we have incurred, and will continue to incur, significant costs, expenses and fees for professional services, other transaction costs and employee retention costs in connection with the merger, and these fees and costs are payable by us regardless of whether the merger is consummated.
We have filed with the SEC a joint proxy statement/prospectus and other relevant materials in connection with the proposed merger on
February 5, 2016
. The joint proxy statement/prospectus
has been mailed
to our stockholders. We urge our stockholders to read the joint proxy statement/prospectus, including the section titled “Risk Factors” in the joint proxy statement/prospectus, filings made by Western Digital with the SEC, including its quarterly report for the fiscal quarter ended
January 1, 2016
, including the section titled “Risk Factors” in the quarterly report, and the other relevant materials because they contain important risks and information about the merger, including, but not limited to, other risks relating to the merger, the combined company following the merger, and risks related to Western Digital common stock.
Our pending acquisition by Western Digital may not be completed, may be delayed or may be approved subject to materially burdensome conditions, any of which may adversely affect our business, operating results and stock price.
Our and Western Digital’s obligations to consummate our acquisition by Western Digital are subject to the satisfaction or waiver of certain closing conditions, including (i) the required approval of the merger by our and Western Digital’s stockholders, which was obtained on March 25, 2016, (ii) receipt of regulatory clearance under certain anti-trust laws, (iii) the absence of any order prohibiting the merger or enactment of any law that makes the consummation of the merger illegal, (iv) the absence of any material adverse effect on either us or Western Digital since the date of the merger agreement that is continuing, (v) subject to certain exceptions, the accuracy of the representations and warranties of the parties in the definitive agreement, and (vi) performance by us and Western Digital of our respective obligations under the Western Digital merger agreement. Anti-trust clearance has been obtained in all required jurisdictions except for China. There can be no assurance that the remaining conditions to the completion of the merger will be satisfied in a timely manner, or at all. Although we and Western Digital have agreed to use reasonable best efforts to obtain the requisite governmental approvals, there can be no assurance that these approvals will be obtained, and the governmental entities from which these approvals are required may impose conditions on the completion of the merger or require changes to the terms of the merger. Any such conditions or changes could have the effect of jeopardizing or delaying completion of the merger. Any delay in completing the merger may significantly reduce the synergies projected to result from the merger and other benefits that the parties expect to achieve if they successfully complete the merger. In addition, other factors, such as Western Digital’s ability to obtain the debt financing it needs on acceptable terms and other sources of cash to consummate the merger, and any litigation challenging the merger, may affect when and whether the merger will occur. If the merger is not completed by October 21, 2016 (subject to potential extensions to January 21, 2017, in the event receipt of certain required regulatory approvals related to antitrust matters have not been obtained), either Western Digital or SanDisk may choose to terminate the merger agreement. Western Digital or SanDisk may also elect to terminate the merger agreement in certain other circumstances, and the parties can mutually decide to terminate the merger agreement at any time prior to the closing, before or after stockholder approval, as applicable.
If the merger is not completed, our stock price could fall to the extent that our current price reflects an assumption that the acquisition will be completed. Furthermore, if the merger is not completed, we may suffer other consequences that could adversely affect our business, results of operations and stock price, including the following:
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we could be required to pay a termination fee of approximately
$553 million
to Western Digital under certain circumstances as described in the Western Digital merger agreement;
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we will be required to pay warrant transaction counterparty banks approximately
$418 million
as termination payments;
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the warrant transactions with certain counterparty banks would be adjusted to lower strike prices to reflect the economic effect of the pending merger announcement on the warrant transactions;
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we would have incurred significant costs in connection with the acquisition that we would be unable to recover, including transaction, legal, employee-related and other costs;
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we may be subject to legal proceedings related to the acquisition;
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the failure of the acquisition to be consummated may result in negative publicity and a negative impression of us in the investment community;
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disruptions to our business resulting from the announcement and pendency of the acquisition, including any adverse changes in our relationships with our customers, strategic partners, suppliers, licensees, other business partners and employees, may continue or intensify in the event the merger is not consummated;
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we may not be able to take advantage of alternative business opportunities or effectively respond to competitive pressures; and
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we may experience an increase in employee departures.
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Competitive pricing pressures or product mix changes may result in lower average selling prices for our products, and if such price declines are not offset by a corresponding increase in demand for our products or a reduction in our costs, our revenue, margins or both may decline.
The price of NAND flash memory is influenced by, among other factors, the balance between supply and demand, including the effects of new fab capacity in the industry, macroeconomic factors and business conditions, technology transitions, conversion of industry DRAM capacity to NAND, development of new technologies such as 3D NAND or other actions taken by us or our competitors to gain market share. In particular, the NAND flash memory industry has, from time-to-time, experienced periods of excess supply, resulting in price declines. Industry bit supply is expected to continue to grow, and if bit supply grows at a faster rate than market demand, the industry could again experience unanticipated price declines. If we are not able to offset price declines with sufficient increases in unit sales or average memory capacity per unit or a shift in product mix towards products with higher average selling prices, our revenue may be harmed. In addition, our products have varying gross margins and, to the extent our revenue mix shifts towards products with lower gross margins, our overall profitability may decline or not grow as expected.
If we are unable to successfully transition to 3D NAND technology or to reduce our product costs to keep pace with reductions in average selling prices, our gross margin may be harmed.
Because of the historical and expected future declines in the price of NAND flash memory, we need to reduce our product costs in order to maintain adequate gross margin. Our ability to reduce our cost per gigabyte of memory produced primarily depends on technology transitions and the improvement of manufacturing efficiency, including manufacturing yields. If our technology transitions, including the production ramp of 3D NAND technology, take longer or are more costly to complete than anticipated, our flash memory costs may not remain competitive with other NAND flash memory producers or may not fall commensurate with price declines, which would harm our gross margin and financial results. As 2D NAND technology reaches its limits of cost-effective technology scaling, our successful development of 3D NAND and alternative technologies, such as 3D ReRAM, is crucial to continue the cost reductions necessary to maintain adequate gross margin. We are now receiving initial 3D NAND production output from New Fab 2, and we have also begun OEM qualification work on 3D NAND. In transitioning our 2D NAND manufacturing capacity to 3D NAND technology, we could experience delays or other challenges in the production ramp, qualification of wafers, shipment of samples to customers or customer approval process. Our failure to continue to develop 3D NAND or to develop alternative technologies and transition our customers to these technologies in a timely or effective manner, or at all, or the failure of these technologies to effectively compete with those of our competitors, could harm our revenue, gross margin and results of operations. Manufacturing yields are a function of both design and manufacturing process technology, and yields may also be impacted by equipment malfunctions, fabrication facility accidents or human error. 3D NAND and any new manufacturing node may be more susceptible to manufacturing yield issues. Manufacturing yield issues may not be identified during the development or production process or solved until an actual product is manufactured and tested, further increasing our costs. Given early yields and limited volumes, we do not expect our 3D NAND to deliver cost reduction compared to our
15-nanometer
2D NAND in 2016. If we are unable to improve manufacturing yields or other manufacturing efficiencies, our gross margin and results of operations would be harmed. In addition, our products contain materials other than flash memory and require product level assembly and test. As our product portfolio has evolved to include an increasing mix of complex products, the proportion of our product costs attributable to materials other than flash memory has increased. If we are unable to reduce the cost of these materials or manufacturing, our gross margin and results of operations would be harmed.
Our captive NAND flash memory manufacturing capacity requires significant investments by us, and our reliance on and investments in captive NAND flash memory manufacturing capacity limit our ability to respond to industry fluctuations in supply and demand
.
The semiconductor industry, and the NAND flash memory industry in particular, is highly cyclical and is characterized by constant and rapid technological change, rapid product obsolescence, price declines, evolving standards, short product life cycles and wide fluctuations in product supply and demand. Because we rely on our significant investments in Flash Ventures as a captive source of substantially all of our NAND flash memory supply, we are limited in our ability to react or adjust our cost structure and technology mix in response to these cyclical fluctuations.
Growth in our captive memory supply comes from investments in technology transitions, productivity improvements and new capacity at Flash Ventures. These investment decisions require significant planning and lead-time before an increase in supply can be realized, and are further determined by factors such as the timing, rate and type of investment by us and Toshiba, our partner in Flash Ventures, agreement between us and Toshiba as to these matters, our evaluation of the potential return on investment of the addition of new capacity, particularly in light of the timing, cost and availability of next generation technology, our profitability, our estimation of market demand and our liquidity position. A failure to accurately forecast demand for our products or industry capacity could cause us to over-invest or under-invest in technology transitions or the expansion of captive memory capacity in Flash Ventures. Over-investment could result in excess supply, which could cause significant decreases in our product prices, significant excess, obsolete or lower of cost or net realizable value inventory write-downs or under-utilization charges, and the potential impairment of our investments in Flash Ventures. In the past, we have recorded charges for adverse purchase commitments associated with under-utilization of Flash Ventures’ capacity. On the other hand, if we or Toshiba under-invest in captive memory capacity or technology transitions, if we grow capacity more slowly than the rest of the industry, if our technology transitions do not occur on the timeline that we expect or we encounter unanticipated difficulties in implementing these transitions, or if we implement technology transitions more slowly than our competitors, we may not have enough captive supply of the right type of memory or at all to meet demand on a timely and cost effective basis and we may lose opportunities for revenue and market share as a result, which would harm our ability to grow or maintain revenue. In such cases, we may have only a limited ability to satisfy our supply needs from non-captive supply sources and may not be able to obtain the right mix of non-captive product that meets our requirements within an adequate lead time or at a cost that allows us to generate an adequate gross margin, which may cause us to lose sales, market share and profits. Prolonged inability to meet customer demand could also cause us to lose revenue opportunities with both existing and potential customers beyond the duration of any given supply shortage. In addition, our multi-year transition to 3D NAND requires a significantly greater amount of equipment and, correspondingly, requires additional cleanroom space to house the new equipment necessary for the transition without reducing wafer capacity. We are investing in New Fab 2 with our manufacturing partner, Toshiba, to provide additional cleanroom space to support the transition to 3D NAND, which increases our capital requirements. We expect New Fab 2 to support the transition of somewhat less than half of existing 2D NAND capacity in Fab 3, Fab 4 and Fab 5. In March 2016, Toshiba announced plans to construct a new wafer fab in Yokkaichi, Japan to provide additional cleanroom space for expanded 3D NAND production. We intend to extend the joint venture partnership with Toshiba to the new wafer fab, providing the cleanroom space needed for continued conversion of 2D NAND capacity to 3D NAND. However, there is no certainty as to when, and on what terms, we will participate with Toshiba in any investment in, or use of, the new wafer fab, if at all. Failure to extend the joint venture partnership or failure to continue to secure and invest in additional cleanroom space to support the continued 3D NAND transition could adversely impact our supply of captive NAND flash memory and financial results.
Furthermore, if our memory supply is limited, we may make strategic decisions with respect to the allocation of our supply among our products and customers in an effort to preserve our long-term goals. However, these strategic allocation decisions may result in less favorable gross margin in the short term or damage certain customer relationships. Our customers also may not allow us to change the memory in the products that they have already qualified, which can further limit our ability to satisfy our supply needs from other sources for products that require long and extensive qualification cycles. For example, certain of our embedded products and SSDs utilize older memory technology nodes or different memory architectures for extended periods of time, based on customer demand, requiring us to produce multiple technology nodes and memory architectures in parallel, increasing the complexity and cost of our business, limiting our manufacturing flexibility and exposing us to greater inventory risk.
In addition, we are contractually obligated to pay for 50% of the fixed costs of Flash Ventures regardless of whether we purchase any wafers from Flash Ventures. Furthermore, purchase orders placed with Flash Ventures and under the foundry arrangements with Toshiba for up to three months are binding and cannot be canceled. Therefore, once our purchase decisions have been made, our production costs are fixed, and we may be unable to reduce costs to match any subsequent declines in pricing or demand, which would harm our gross margin. Our limited ability to react to fluctuations in supply and demand makes us particularly susceptible to variations from our forecasts and expectations, and even in times of excess demand, our operating results may be harmed.
The future growth of our business depends on the development and performance of new and existing markets for flash memory, including the SSD markets, which includes enterprise solutions and client SSDs, and on our ability to penetrate, maintain or improve our position in these markets.
Historically, removable flash memory imaging cards and USB drives, both sold primarily through the retail channel, provided the majority of our revenue. As growth in these retail products slowed, we increased sales of embedded NAND flash memory and cards for devices such as mobile phones, tablets and other mobile devices. More recently, we have relied on SSD products to generate a significant portion of our revenue growth. Our future growth is dependent on the development of new markets, new applications and new products for NAND flash memory, on the continued use of NAND flash memory in existing markets and on our ability to penetrate, maintain or improve our position in such markets. There can be no assurance that the use of NAND flash memory in existing markets and products will continue or grow fast enough, or at all, that we will be able to maintain or improve our position in existing markets, or that new markets will develop and adopt NAND flash technologies to enable us to grow.
We believe that, over the next several years, the largest growth areas for NAND flash will be SSDs and related solutions, whereas the mobile market for NAND flash is expected to grow at a slower rate than in the past, and the retail market for NAND flash is expected to modestly decline. We will continue to make significant investments in the development of hardware and software solutions for the enterprise data center and for client SSDs. However, our ability to succeed in the SSD or related solutions markets is subject to various risks and uncertainties, including, among other things:
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we may be unable to successfully develop or qualify solutions, on a timely basis or at all, that meet our customers’ requirements or are well matched to market demand, and even if we do, we cannot guarantee that customers will adopt our solutions;
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designing and qualifying products in the market for SSDs or related solutions requires significant investments and customization, which results in long development cycles and increased costs;
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the complexity and longer development cycles required for SSDs and related solutions increase the risk of development delays that can result in missing customer qualification cycles and other market opportunities;
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due to longer customer product cycles and end-of-life product support requirements in SSDs and related solutions, we may be unable to transition customers to our leading-edge products in a timely manner, or at all, which would prevent us from achieving the full cost advantage of new technology transitions, we may be unable to adequately supply products that utilize older memory technology nodes, or, in supplying the older memory technology nodes to customers for these solutions, we may not have sufficient supply of the newer memory technology nodes to meet the demand requirements of other customers;
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some customers have been developing and may continue to develop their own solutions, which could reduce demand for our system-level solutions, including SSDs, while potentially increasing demand for our component level products, which could harm our revenue and gross margins;
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we may transition fab capacity to new technology nodes too quickly, which could result in inadequate supply of older memory technology nodes required for certain solutions, limiting or reducing our revenue or market share;
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products that contain our leading-edge technologies, whether based on 2D NAND or our 3D NAND or 3D ReRAM technologies, may be unable to meet the performance requirements of SSD or other system-level solutions or to compete effectively with products from our competitors, which would inhibit our ability to succeed in these markets and could impair our growth and profitability prospects;
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we may be unable to realize the expected benefits of our acquisitions or investments related to enterprise solutions;
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SSDs and other system-level solutions require sophisticated firmware and software, and we must continue to develop firmware and software expertise;
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SSDs and other system-level solutions require complex controllers, and we or our
third-party
vendors, some of which are single-source suppliers, may be unable to develop the required controllers, or we may otherwise be unable to source the required controllers, that meet the requirements for these solutions in a timely or cost effective manner, or at all;
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SSDs and other system-level solutions incorporate unique parts, and if there is lower than expected demand, we may be unable to incorporate these unique parts in other products;
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SSDs and other system-level solutions require longer production cycle times due to, among other things, more complex assembly and testing to produce a finished product, as well as customer requirements for consigned inventory and increased use of hubs for order fulfillment, which could lead to higher levels and cost of inventory; and
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SSDs and other system-level solutions require different go-to-market strategies compared to our historical consumer and mobile products, which could increase our operating expenses, and we may be unable to build an effective sales and marketing operation to sell these solutions.
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If we are unable to successfully develop, qualify and sell SSDs, including enterprise solutions and client SSDs, and related system-level solutions, we could lose sales and corresponding profit opportunities, which would harm our operating results and financial condition.
Our revenue depends in large part on our ability to achieve design wins or sufficient sales volume with customers in our commercial channel and the success of these customers.
Our primary products sold in the commercial channel include cards for mobile devices, embedded memory products, and SSDs for the notebook, storage and server markets. Our revenue from these products is primarily dependent upon these products meeting customers’ specifications and the achievement of design wins with OEMs, hyperscale data centers and other customers in our commercial channel. Even if our products meet customer specifications, our sales to these customers are dependent upon the customers choosing our products over those of our competitors and purchasing our products in sufficient volume, our ability to supply our products in sufficient quantity and in a timely manner and, with respect to OEM partners, the OEMs’ ability to create, market and sell successfully products containing our solutions. In addition, direct sales of our products may compete with products sold by our OEM partners, which may affect the commitment of our OEM partners to sell our products. If our OEM partners are not successful in selling their current or future products in sufficient volume or in a timely manner, our customers do not purchase or use our products in the volumes and within the timeframes that we anticipate, or at all, or we are not be able to produce our products in sufficient quantity or quality, our revenue, operating results and financial condition could be harmed.
Sales to a small number of customers represent a significant portion of our revenue, and if we were to lose one or more of our major customers or licensees, or experience any material reduction in orders from any of our customers, our revenue and operating results could suffer
.
Our ten largest customers represented
42%
and
46%
of our revenue in the first quarter of
2016
and
2015
, respectively. No customer represented over 10% of our revenue in the first quarter of
2016
, and one customer accounted for
17%
of our revenue in the first quarter of
2015
. The composition of our major customer base has changed over time, including shifts between commercial and retail-based customers, and there have been changes in the market share concentration among our customers. Many of our commercial customers purchase more than one product category from us. We expect fluctuations in our customer and licensee base and the mix of our revenue by customer and licensee to continue as markets and strategies evolve, which could make our revenue less predictable from period-to-period. There may be consolidations of our customers which could reduce the number of customers to whom our products could be sold. Our sales are generally made from standard purchase orders and short-term commitments rather than long-term contracts. Accordingly, our customers, including our major customers, may generally terminate or reduce their purchases from us at any time with limited notice or penalty. If we were to lose one or more of our major customers or experience any material reduction in orders from, or a material shift in product mix by, any of these customers, or if we were to lose one or more of our licensees or any of our licensees were to materially reduce their sales of licensed products, our revenue and operating results could suffer.
Our solutions rely on sophisticated firmware that is complex and costly to develop and may require frequent product updates.
Our embedded, client SSD and enterprise solutions increasingly depend on sophisticated firmware that may require significant customization for customers in our commercial channel. The development of sophisticated, complex or customized firmware is lengthy and requires significant resources, which increases our costs and time to market. We may be required to develop or update firmware for our solutions, including due to changes in customer specifications, changes in industry standards or new product introductions, which would result in increased costs. For example, in embedded solutions, certain competitors have recently introduced a mobile storage standard referred to as Universal Flash Storage, or UFS. If UFS is widely adopted by our customers, we would need to update our embedded solutions to be compatible with this new standard in order to remain competitive. Furthermore, our failure to develop or update firmware in a timely manner, or at all, may result in reduced demand from our customers, notwithstanding the long design, qualification and test cycles we have undertaken as part of our sales process for a solution, which may harm our results of operations.
We sell our enterprise solutions to customers who have long design, qualification and sales processes, and to hyperscale customers whose demand is difficult to forecast.
The enterprise storage market is comprised of customers with long design, qualification and test cycles prior to sales. Customers in the enterprise storage market may also require us to customize our products, which could further lengthen the product design, qualification, manufacturing and sales process. We spend substantial time, money and other resources in our sales process without any assurance that our efforts will produce any customer orders on the timelines or in the quantities we expect. These lengthy and uncertain processes also make it difficult for us to forecast demand and timing of customer orders. Moreover, we start manufacturing our products and placing orders for materials and components based on non-binding forecasts that our customers provide to us, further increasing our inventory exposure when actual sales vary from the customer’s forecasts. The difficulty in forecasting demand and the customized nature of our products for certain customers makes it difficult to anticipate our inventory requirements, which may cause us to over-purchase materials and components or over-produce finished goods, resulting in inventory write-offs, or under-produce finished goods, harming our ability to meet customer requirements and generate sales. Furthermore, due to longer customer product cycles, we may not be able to transition customers to our leading edge products, which would prevent us from benefitting from the technology transitions that enable cost reductions, which may harm our gross margin. When we acquire companies that have products using flash memory other than our captive flash memory, we typically transition these products to our captive memory, and any delays in customer qualification of our captive memory for these products may cause unexpected declines in our revenue or margins from these products. We expect continued growth for our enterprise solutions from hyperscale customers; however, demand for our enterprise solutions from our hyperscale customers is correlated to large projects and expansions which can be sporadic, resulting in demand that is lumpy and less consistent than the consumer-driven demand for many of our solutions. Hyperscale customers may place orders for significant volumes with short lead times that may be difficult for us to fulfill, and sales to hyperscale customers may negatively impact gross margins due to product mix and pricing, each of which could adversely affect our business.
We rely substantially on our ventures and strategic partnerships with Toshiba, which subjects us to risks and uncertainties that could harm our business, financial condition and operating results.
Substantially all of our NAND flash memory is supplied by Flash Ventures. In addition, we partner with Toshiba on the development of NAND flash technology and we have entered into strategic partnerships with Toshiba relating to research and development for the next technology transitions of NAND flash and alternative technologies beyond NAND flash technologies. These ventures and strategic partnerships are subject to various risks that could harm the value of our investments, our revenue and costs, our future rate of spending, our technology plans and our future growth opportunities, including, among others:
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under the terms of our venture agreements with Toshiba, which govern the operations of Flash Ventures, we have limited power to unilaterally direct most of the activities that most significantly impact Flash Ventures’ performance, including technology transitions, capital investment and other manufacturing and operational activities at Flash Ventures;
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the process of reaching agreement with Toshiba may be time consuming and may result in delays or decisions that could harm our future results of operations, financial condition or competitiveness; leadership or organizational changes at Toshiba could lead to delays in decision-making or changes in strategic direction that could adversely impact Flash Ventures; and the announcement and pendency of our agreement to be acquired by Western Digital could adversely impact our relationship and agreements with Toshiba;
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the terms of our arrangements with Toshiba include provisions such as exclusivity, transfer restrictions and limited termination rights, which limit our flexibility;
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we may not always agree with Toshiba on the NAND research and development roadmap, the technology path beyond NAND flash memory, or expansions or conversions of fab capacity; we or Toshiba may have different priorities with respect to investment in Flash Ventures or future technologies, and divergent technology paths and investment priorities may adversely impact our results of operations, financial condition or competitiveness;
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Flash Ventures require significant investments by both Toshiba and us for technology transitions and capacity expansions; if Toshiba or we do not provide sufficient resources, these investments could be delayed or reduced, which could adversely impact our competitiveness; and if Toshiba, we or Flash Ventures do not have sufficient access to credit, such as lease financings for Flash Ventures, on favorable terms, or at all, Toshiba and we may need to delay or reduce investment in Flash Ventures or could be required to use more cash to fund investments in Flash Ventures, which would adversely impact our liquidity and financial position; and
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in March 2016, Toshiba announced plans to construct a new wafer fab in Yokkaichi, Japan to provide additional cleanroom space for expanded 3D NAND production. We intend to extend the joint venture partnership with Toshiba to the new wafer fab, providing the cleanroom space needed for continued conversion of 2D NAND capacity to 3D NAND. However, there is no certainty as to when, and on what terms, we will participate with Toshiba in any investment in, or use of, the new wafer fab, if at all.
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Future alternative non-volatile storage technologies or other disruptive technologies could make NAND flash memory or the alternative technologies that we are developing obsolete or less attractive, and we may not have access to those new technologies on a cost
‑
effective basis, or at all, or new technologies could reduce the demand for flash memory in a variety of applications or devices, any of which could harm our operating results and financial condition
. Due to inherent technology limitations, the bit growth and cost reduction from 2D NAND flash technology transitions is slowing down. We have transitioned a majority of our NAND manufacturing capacity to the
15-nanometer
node, and we expect
15-nanometer
to be our last technology node on 2D NAND flash architecture. We are investing in our 3D NAND flash architecture. We are now receiving initial 3D NAND production output from New Fab 2, and we have also begun OEM qualification work on 3D NAND. We are also investing in 3D ReRAM technology, which we believe may be a viable alternative to NAND flash memory in the future. We expect 2D NAND, 3D NAND and potential future technologies, including 3D ReRAM, to co-exist for an extended period of time. The success of our overall technology strategy is also dependent in part upon the development by
third-party
suppliers of advanced semiconductor materials and process technologies, such as extreme ultraviolet. Our technology development of 2D NAND, 3D NAND and 3D ReRAM is done in conjunction with Toshiba, and the success of our development could be influenced by whether we are able to agree with Toshiba on a technology path or the timing and amount of investment. In addition, we have entered into a long-term partnership with HPE to collaborate on the development of 3D ReRAM for Storage Class Memory applications. There can be no assurance that we will be successful in developing 3D NAND, 3D ReRAM or other technologies in a timely manner, or at all, or that we will be able to achieve the yields, quality or capacities to be cost competitive with existing or other alternative technologies. Furthermore, we cannot guarantee that 3D NAND, 3D ReRAM or other technologies we develop will match or exceed all of the performance characteristics of 2D NAND flash technology, will be developed at a rate that matches market needs, will result in cost reductions that will enable us to be competitive, or will be well-suited, in a timely manner, or at all, for all of the applications in the end markets that 2D NAND flash memory currently addresses or may address in the future. Additionally, 3D NAND, 3D ReRAM or other technologies may require different capital equipment or manufacturing processes than existing 2D NAND which could impact the cost reduction benefits obtainable through these technologies.
Many companies, including some of our competitors, have developed or are attempting to develop alternative non-volatile technologies. These include non-NAND technologies such as magneto-resistive RAM, ReRAM, 3D XPoint, phase change, and Memristor, as well as NAND based vertical or stacked 3D memories based on charge trap, floating gate and other cell architectures. Based upon public announcements, our competitors are in various stages of development and commercialization of their 3D NAND technologies, including shipping products and samples based on 3D NAND. At this time, these technologies are still emerging and it is unclear how they will compare to our 2D NAND or 3D NAND technologies and what implications 3D NAND approaches may have for our industry or our business in terms of cost leadership, technology leadership, supply increases and product specifications. For example, the specifications of competitors’ 3D NAND may make it more competitive in certain products than the 2D NAND currently produced by us. Successful broad-based commercialization of one or more competing technologies, as well as differing strategies and timing with respect to the transition from 2D NAND to 3D NAND, could reduce the competitiveness and future revenue and profitability of our 2D NAND and 3D NAND flash technologies, and the potential 3D ReRAM technology that we are developing with our partners. In addition, we generate license and royalty revenue from NAND flash technology, and if NAND flash technology is replaced by a technology where our IP is less relevant, our license and royalty revenue would decrease. Also, we may not have access to or we may have to pay royalties to access alternative technologies that we do not develop internally. If our competitors successfully develop new or alternative technologies, and we are unable to continue to develop our technologies on an equivalent basis, or if our competitors’ new or alternative technologies satisfy application-specific requirements that our technologies are not able to, we may not be able to compete effectively, and our operating results and financial condition would suffer.
Alternative technologies or storage solutions such as cloud storage, enabled by high bandwidth wireless or internet-based storage, could reduce the need for physical flash storage within electronic devices or reduce the rate by which average capacity increases in such devices, which could materially harm our operating results and financial condition.
Growth of our NAND flash memory bit supply at a slower rate than the overall industry for an extended period of time would result in lowering our industry market share which could limit our future opportunities and harm our financial results.
Our strategy has been to focus on increasing our share of
high-value solutions
and industry revenue rather than solely on our industry bit share. While our NAND bit supply grew at a faster rate than the industry in 2015, our NAND bit supply grew at a slower rate than the industry in 2013 and 2014 and is also expected to grow slower than the industry in 2016. Successful broad-based commercialization of 3D NAND may accelerate the growth of NAND flash bits more than we anticipate. If our bit growth lags behind our competitors for an extended period of time, it will reduce our captive flash bit market share in the industry. With lower bit market share, we may not be able to sufficiently address all market opportunities. Some of our customers may want to buy multiple types of products or specific quantities of our products and if we limit the growth of our production, we may not be able to meet customer requirements or our competitors may become more preferred suppliers based upon either the breadth of their product offerings or volume of their product supply. In addition to the potential loss of bit market share, our competitors may realize better cost declines than us enabled by improved economies of scale achieved through additional bit growth. If our competitors have lower costs, our competitors could offer similar products at a lower price than us which could harm our competitiveness and financial results. If we decide to purchase
non-captive
supply from competitors to provide supply to our customers, there is no guarantee we will be able to secure such supply at a competitive price, in the right product mix or quality level, or in sufficient volume, or at all.
Difficulty in forecasting demand for our products may result in excess inventory or lost sales, either of which could harm our financial results.
A significant portion of our quarterly sales are from orders received and fulfilled in that quarter. Additionally, we depend upon timely reporting from some of our customers as to their inventory levels and sales of our products in order to forecast demand for our products. Furthermore, the diversification of our product offerings and our customer base requires us to produce multiple technology nodes and memory architectures in parallel in order to meet demand. Demand for our enterprise solutions from our hyperscale customers is correlated to large projects and expansions which can be sporadic, resulting in demand that is lumpy and less consistent than the consumer-driven demand for many of our solutions. The failure to accurately forecast demand for our products may result in lost sales or excess inventory and associated reserves or write-downs, any of which could harm our business, financial condition and operating results.
The long lead times for some of our purchasing or other arrangements further restrict our ability to respond to variations from our forecasts. Some of our silicon purchasing arrangements provide that the first three months of our rolling six-month projected supply requirements are fixed and we may make only limited percentage changes in the second three months of the period covered by our supply requirement projections. Our products also contain non-silicon components that have long lead-times requiring us to place orders several months in advance of anticipated demand. In addition, purchasing decisions for manufacturing tools in Flash Ventures as well as tools in our captive assembly and test manufacturing facilities in Shanghai, China and Penang, Malaysia often need to be made several months in advance in order to ensure that the tools can be integrated into the manufacturing process when increased capacity is needed. These purchasing arrangements increase the risk of excess inventory or loss of sales in the event our forecasts vary substantially from actual demand.
Our license and royalty revenue may fluctuate or decline significantly in the future due to license agreement expirations or renewals, declines in sales of the products or use of technology underlying the license and royalty revenue by our licensees, or if licensees fail to perform on a portion or all of their contractual obligations.
If our existing licensees do not renew their licenses upon expiration, renew or sign new agreements on less favorable terms, exercise their option to terminate the license or fail to exercise their option to extend the licenses, or we are not successful in signing new licensees in the future, our license revenue, profitability and cash provided by operating activities would be harmed. As our older patents expire, and the coverage of our newer patents may be different, it may be more difficult to negotiate or renew favorable license agreement terms or a license agreement at all. For example, in the first quarter of 2010, our license and royalty revenue decreased sequentially, due primarily to a new license agreement with Samsung that was effective in the third quarter of 2009 and contains a lower effective royalty rate compared to the previous license agreement. The 2009 Samsung license agreement expires in August 2016. If we are unable to negotiate a new agreement or if we negotiate a new agreement on less favorable terms such as a lower effective royalty rate compared to the current license agreement, we will experience a decrease in license and royalty revenue when the license agreement expires. To the extent that we are unable to renew license agreements under similar terms, or at all, our financial results would be harmed by the reduced license and royalty revenue and we may incur significant patent litigation costs to enforce our patents against these licensees. Our agreements may require us in certain instances to recognize license revenue related to a particular licensee all in one period instead of over time which could create additional volatility in our licensing revenue. A portion of our license and royalty revenue is based on sales of product categories as well as underlying technology, and fluctuations in the sales of those products or technology adoption rates would also result in fluctuations in the license and royalty revenue due to us under our agreements. If our licensees or we fail to perform on contractual obligations, we may incur costs to enforce or defend the terms of our licenses and there can be no assurance that our enforcement, defense or collection efforts will be effective. If we license new IP from third parties or existing licensees, we may be required to pay license fees, royalty payments or offset existing license revenue. We may enter into agreements with customers, suppliers or partners that could limit our ability to monetize our IP or could result in us being required to provide IP indemnification to our customers, suppliers or partners. In addition, we may be subject to disputes, claims or other disagreements on the timing, amount or collection of royalties or license payments under our existing license agreements.
In transitioning to new technologies and products, we may not achieve design wins, our customers may delay transition to new technologies, our competitors may transition more quickly than we do, or we may experience product delays, cost overruns or performance issues that could harm our operating results and financial condition.
The transition to new generations of products, such as products containing 15-nanometer, 3D NAND or other memory architecture or new storage interfaces, is highly complex and may require new controllers, new test procedures and modifications to numerous aspects of our manufacturing processes, resulting in the need for extensive qualification of the new products by our customers and us. In addition, our competitors may transition to new technologies more quickly or more effectively than we are able to, which could harm our ability to compete effectively. If (i) we fail to develop, or achieve design wins for, products using new technologies, (ii) our customers choose to transition to these new technologies more slowly or faster than our roadmap plans, (iii) the demand for the products that we develop is lower than expected, (iv) the supporting technologies to implement these new technologies are not available, or (v) our competitors transition to these new technologies more quickly or more effectively than we are able to, then we may be unable to achieve the cost structure required to support our profit objectives or may be unable to grow or maintain our market position. Delays in our product qualifications could harm our gross margin and financial results. Furthermore, there can be no assurance that technology transitions will occur on schedule or at the yields or costs that we anticipate, that the tools and equipment required for the technology transitions will be available on a cost-effective basis, or at all, or that products based on the new technologies will meet customer specifications. The vast majority of our products require controllers and firmware. We rely on a limited number of third-party vendors to develop or supply controllers for many of our high-value solutions. Any delays or cost increases in developing or sourcing controllers or firmware, or incompatibility or quality issues relating to the controllers or firmware in our products, could harm our revenue and gross margin, as well as business relationships with our customers. Any material delay in a development or qualification schedule could delay deliveries and harm our operating results and financial condition.
We require an adequate level of product gross margin to continue to invest in our business, and our product gross margin may vary significantly depending on a number of factors.
Our ability to generate sufficient product gross margin and profitability to invest in our business is influenced by supply and demand balance in the flash memory industry, the mix of our product sales, our ability to reduce our cost per gigabyte at an equal or higher rate than the price decline per gigabyte, our ability to develop new products and technologies, market acceptance of our products and technologies, the rate of growth of our target markets, the competitive position of our products, the continued acceptance of our products by our customers and our management of production capacity and technology transitions. Other factors that could result in volatility in our product gross margin include fluctuations in customer mix, as well as variations in the technologies or form factors of our products. For example, we experienced negative product gross margin for 2008 and the first quarter of 2009 due to sustained aggressive industry price declines as well as inventory charges, due primarily to lower of cost or market write-downs. If we fail to maintain adequate product gross margin and profitability, our business and financial condition would be harmed and we may have to reduce, curtail or terminate certain business activities, including funding technology development and capacity expansion. Furthermore, as we diversify the products that we sell, changes in our product mix could result in volatility in our product gross margin, since we have significant variation in our product gross margin across product lines, and some of the products that we sell have product gross margins that are significantly below our overall average.
We may not be able to realize the potential financial or strategic benefits of business acquisitions or strategic investments, which could harm our ability to grow our business, develop new products or sell our products.
We have in the past and may in the future enter into acquisitions of, or investments in, businesses in order to complement or expand our current business or enter into new markets. Due to the pending acquisition by Western Digital, we may be precluded from any future acquisitions. Mergers and acquisitions of high-technology companies are inherently risky and subject to many factors outside of our control and no assurance can be given that our previous or future acquisitions will be successful, deliver the intended benefits and not materially harm our business, operating results or financial condition. Furthermore, negotiation and integration of acquisitions or strategic investments could divert management’s attention and other company resources.
Factors associated with past or future acquisitions or investments that could harm our growth prospects or results of operations include but are not limited to:
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difficulty in integrating the technology, products, operations or workforce of the acquired business into our business;
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failure of the markets addressed by the acquired business to grow as expected;
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failure to transition an acquired business from
third-party
sources of NAND flash memory to our captive supply of these materials, not having enough captive NAND flash memory to support the revenue growth of the acquired business or inability to procure sufficient NAND flash memory from
third-party
sources in a cost-effective manner, or at all, which could harm our ability to achieve the expected benefits from the acquisition;
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failure to leverage the cost benefits of using our captive assembly and test or manufacturing facilities for the operations of an acquired business, which could harm our ability to achieve the expected benefits from the acquisition;
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difficulty in entering into new markets in which we have limited or no experience, such as software solutions, and where competitors have stronger positions;
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loss of, or the impairment of or failure to maintain and grow relationships with, key employees, suppliers, vendors or customers of the acquired business, including those on which the acquired business is significantly reliant;
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difficulty in integrating the technology of the acquired business into our product lines in existence or in development, which could harm our ability to maintain the business after the acquisition or diminish the expected benefits of the acquisition;
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difficulty in operating in new and potentially dispersed locations;
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disruption of our ongoing business or the ongoing business of the company we invest in or acquire;
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failure to realize the potential financial or strategic benefits of the transaction, including but not limited to any expected cost savings or synergies from the acquisition;
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difficulty integrating the accounting, supply chain, human resources and other systems of the acquired business;
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disruption of or delays in ongoing research and development efforts and release of new products to market;
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diversion of capital, management attention and other resources;
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assumption of liabilities;
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issuance of equity securities that may be dilutive to our existing stockholders;
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diversion of resources and unanticipated expenses resulting from litigation arising from potential or actual business acquisitions or investments, including any ongoing litigation of the acquired business;
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failure of the due diligence processes to identify significant issues with product quality, technology and development, or legal and financial issues, among other things;
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incurring non-recurring charges, increased contingent liabilities, adverse tax consequences, depreciation or deferred compensation charges, amortization or impairment of intangible assets or impairment of goodwill, which could harm our results of operations;
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potential delay in customer purchasing decisions due to uncertainty about the direction of our product offerings or those of the acquired business; and
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for equity investments in privately held companies, in the event there is an other than temporary decline in the value of our investment, we may be required to reduce the carrying value on our balance sheet.
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In July 2014, we completed the acquisition of
Fusion‑io
, a developer of flash-based PCIe hardware and software solutions that enhance application performance in enterprise and hyperscale data centers. In addition to the risks described above, failure to leverage or delays in leveraging
Fusion‑io
’s go-to-market capabilities to generate revenues for our products could harm our ability to realize the potential financial or strategic benefits of the acquisition and thereby harm our growth prospects or results of operations. Failure to realize the anticipated benefits from acquisitions could result in the impairment of our acquisition-related intangible assets, which would harm our results of operations. For example, in the first quarter of 2015, we recorded an impairment charge of
$61 million
related to an in-process research and development, or IPR&D, asset from the acquisition of
Fusion‑io
. This impairment charge stemmed primarily from our decision to abandon this IPR&D project and redirect resources towards the next-generation PCIe and converged enterprise platform. As of
April 3, 2016
, the net book value of the
Fusion‑io
acquisition-related amortizable intangible assets was
$200 million
, some or all of which could be subject to impairment.
Any disruption or shortage in our supply chain could reduce our revenue, earnings and gross margin.
All of our flash memory products require silicon supply for the memory and controller components. Substantially all of our flash memory is currently supplied by Flash Ventures and to a much lesser extent by
third-party
silicon suppliers. Any disruption or shortage in supply of flash memory from our captive or
non-captive
sources, including disruptions due to disasters, unplanned maintenance, work stoppages, supply chain interruptions and other factors, would harm our operating results.
The concentration of Flash Ventures in Yokkaichi, Japan, magnifies the risks of supply disruption. The Yokkaichi location and Japan in general are subject to earthquakes, typhoons and other natural disasters. Moreover, Toshiba’s employees who produce Flash Ventures’ products are covered by collective bargaining agreements and any strike or other job action by those employees could interrupt our wafer supply from Flash Ventures. A disruption in our captive wafer supply, including but not limited to disruptions from natural disasters, emergencies such as power outages, fires or chemical spills, or employee strikes or other job actions could cause us not to have sufficient supply to meet demand, resulting in lost sales and market share, as well as significant costs, including wafer loss. For example, the March 11, 2011 earthquake and tsunami in Japan caused a brief equipment shutdown at Flash Ventures, which resulted in some wafer loss as well as delayed or canceled deliveries of certain tools and materials from suppliers impacted by the earthquake. In addition, Flash Ventures has, from time to time, experienced power outages and power fluctuations, which have resulted in a loss of wafers and increased costs associated with bringing the facility back online.
Currently, wafers for our internally-designed controllers are manufactured by
third-party
foundries. In addition, we purchase controllers from
third-party
sources, and most of our products require other components and materials for which we do not have captive supply, such as the DRAM included in some of our SSDs and MCP storage solutions. A disruption in the manufacturing operations of our controller wafer vendors,
third-party
controller vendors or suppliers of other components, such as DRAM, could result in delivery delays, harm our ability to make timely shipments of our products and harm our operating results until we could qualify an alternate source of supply for these components, which could take several quarters to complete.
Our business depends significantly upon sales through retailers and distributors, and if our retailers and distributors are not successful, we could experience reduced sales, substantial product returns or increased price protection claims, any of which would harm our business, financial condition and operating results.
A significant portion of our sales is made through retailers (for our retail channel) and distributors (for both our retail and commercial channels), and we must rely on them to effectively sell our products. Except in limited circumstances, we do not have exclusive relationships with our retailers or distributors. In addition, sales through retailers and distributors typically include commercial terms such as the right to return unsold inventory and protection against price declines. As a result, we do not recognize revenue until after the product has been sold through to the end user, in the case of sales to retailers, or to our distributors’ customers, in the case of sales to distributors. If our retailers and distributors are not successful in selling our products, not only would our revenue decrease, but we could also experience lower gross margin due to substantial product returns or price protection claims. Furthermore, negative changes in the credit-worthiness or the ability to access credit, or the bankruptcy or shutdown of any of our significant retail or distribution partners would harm our revenue and our ability to collect outstanding receivable balances. We also provide inventory on a consigned basis to certain of our retailers, and a bankruptcy or shutdown of these customers could preclude us from taking possession of our consigned inventory, which could result in inventory charges.
We develop new products, technologies and standards, which may not be widely adopted by consumers or enterprises, or, if adopted, may reduce demand for our older products.
We devote significant resources to the development of new products, technologies and standards. New products may require significant upfront investment with no assurance of long-term commercial success or profitability. As we introduce new products, standards or technologies, it can take time for these new standards or technologies to be adopted, for consumers to accept and transition to these new standards or technologies and for significant sales to be generated, if at all. Failure of consumers or enterprises to adopt our new products, standards or technologies could harm our results of operations as we fail to reap the benefits of our investments. Competitors or other market participants could seek to develop new standards for flash memory products that, if accepted by device manufacturers or consumers, could reduce demand for our products, negatively impact our license and royalty revenue, or increase license and royalty expense. For example, in embedded solutions, certain competitors have recently introduced a mobile storage standard referred to as UFS. If UFS is widely adopted by our customers, we could experience a decline in demand for our embedded solutions. We would need to update our embedded solutions to be compatible with this new standard in order to remain competitive. In the datacenter market, certain competitors have recently introduced a non-volatile memory express, or NVMe, product that can be used as a substitute for our custom PCIe solutions. If NVMe is widely adopted and we are not able to develop our own NVMe solution, our revenue and results of operations could be harmed. If new standards are broadly accepted and we do not adopt these new standards in our products, our revenue and results of operations may be harmed.
We face competition from numerous manufacturers and marketers of products using flash memory and if we cannot compete effectively, our operating results and financial condition will suffer.
We face competition from NAND flash memory manufacturers and from companies that buy NAND flash memory and incorporate it into their end products. We face different competitive pressures in different markets, and we compete to varying degrees on the basis of, among other things, price, quality and timely delivery of products, product performance, availability and differentiation, and the development of industry standards and formats. The success of our competitors may harm our future revenue or margins and may result in the loss of our key customers.
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NAND Manufacturers and Embedded Solutions Providers.
We compete with NAND flash memory manufacturers, including SK hynix, or Hynix, Intel Corporation, or Intel, Micron Technology, Inc., or Micron, Samsung Electronics Co., Ltd., or Samsung, and Toshiba. These companies compete with us in selling a range of flash-based products and form factors, including embedded, SSDs, removable and other form factors. These competitors are large companies that may have greater and more advanced wafer manufacturing capacity, substantially greater financial, technical, marketing and other resources, better recognized brand names and more diversified and lower cost businesses than we do, which may allow them to produce flash memory chips in high volumes at low costs and to sell these flash memory chips themselves or to our competitors at a low cost. We are now receiving initial 3D NAND production output from New Fab 2, and we have also begun OEM qualification work on 3D NAND. Samsung announced the start of mass production of its 3D NAND flash technology, VNAND, in 2013, and other competitors have either announced the expected launch or shipments of products or samples incorporating 3D NAND technologies. The availability and specifications of competitors’ 3D NAND may make their products more competitive than our products. In addition, many of our competitors have more diversified semiconductor manufacturing capabilities and can internally produce integrated solutions or hybrid products that may include a combination of NAND flash, DRAM, custom application-specific integrated circuits, or ASICs, or other integrated products, while our captive manufacturing capability is solely dedicated to NAND flash. These diversified capabilities may also provide these competitors with a competitive advantage not only in product design and manufacturing due to the ability to leverage know-how in DRAM, custom ASICs or other technologies, but also in a greater ability to respond to industry fluctuations due to their ability to convert their DRAM and other semiconductor manufacturing capacity or equipment to NAND flash and vice-versa. Furthermore, some of these competitors manufacture and sell products that are complementary to flash memory products, and may be able to leverage their competencies and customer relationships to gain a competitive advantage. Current and future memory manufacturer competitors could produce alternative flash or other memory technologies that could compete against our NAND flash technology or our alternative technologies, or may transition to more advanced technologies sooner than us, each of which may reduce demand or accelerate price declines for our products. Furthermore, if our technology development results in less cost reduction than the technology of our competitors, our business and operating results would be harmed and our investments in captive fabrication facilities could be impaired.
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Removable Products Manufacturers and Resellers.
We compete with manufacturers and resellers of flash memory card and USB drives, which purchase or have a captive supply of flash memory components and assemble memory products. Price fluctuations, the timing of product availability and resources allocated to marketing programs can harm our branded market share and reduce our sales and profits. We also sell flash memory in the form of private label cards, wafers or components to certain OEMs who sell flash products that may ultimately compete with our branded products in the retail or commercial channels. The sales volumes and pricing to these OEMs can be highly variable and these OEMs may be more inclined to switch to an alternative supplier based on short-term price fluctuations or the timing of product availability, which could harm our sales and profits.
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Client Storage Solution Manufacturers.
In the market for client SSDs, we face competition from Intel, Micron, Samsung, Hynix and Toshiba, all of which are also NAND flash producers, as well as client SSD and hard drive providers such as Kingston Technology Company, Inc., or Kingston, Philips & Lite-On Digital Solutions Corporation, or Lite-On, Seagate Technology plc, or Seagate, and Western Digital. In this market, we compete with these industry players largely on the basis of performance capabilities, quality, price, product reliability and relationships with computer manufacturers. Many of the large NAND flash producers have long established relationships with computer manufacturers, or are computer manufacturers themselves, which gives them a competitive advantage in qualifying and integrating their client storage solutions in this market as well as the ability to leverage competencies that have been developed through these relationships in the past. Hard drive manufacturers such as Seagate and Western Digital may also have a competitive advantage in their ability to leverage their existing relationships and brand recognition with customers, as well as their ability to leverage existing technology in creating hybrid drive products. Our failure to compete effectively against these industry players could harm our business and results of operations.
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Enterprise Storage Solution Manufacturers
. In the market for enterprise data center storage solutions, we face competition from Intel, Micron, Samsung and Toshiba, all of which are also NAND flash producers, as well as from Lite-On, Seagate, Western Digital, including its Hitachi Global Storage Technologies subsidiaries, and emerging competitors. Many of these companies offer competing solutions in enterprise SSDs, systems and software. Our enterprise system solutions, such as the InfiniFlash™ System, combined with different proprietary and open-source software stacks, compete with solutions that offer similar functionality, ranging from HDD-based system solutions to hybrid solutions which combine flash and HDDs, to all flash arrays, from a variety of companies including NetApp, Inc., or NetApp, EMC Corporation, or EMC, and others, which have a longer history and more established infrastructure for serving enterprise customers. In addition, hyperscale companies, such as Amazon.com, Inc., Google, Inc., Microsoft Corporation and Facebook, Inc. may internally develop enterprise storage solutions that reduce the demand for our solutions. Our competitors in this market may be able to leverage existing resources and competencies or acquire or develop other strategic relationships with established or start-up companies before we are able to, which could give them a competitive advantage, and if we are unable to independently develop comparable capabilities, we may be unable to effectively compete.
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The Chinese government has announced plans to make significant investments over the next decade to promote its domestic semiconductor industry. Some semiconductor companies have formed alliances and joint ventures with Chinese companies, such as Qualcomm Inc. and China’s Semiconductor Manufacturing International Corporation; Intel and government-run mobile chip manufacturers; and NXP Semiconductors and Datang Telecom Technology & Industry Group. These competitors and independent Chinese manufacturers can leverage the substantial resources and incentives provided by the Chinese government, and if we are unable to effectively compete with any new manufacturers located in China or domestic competitors benefitting from alliances with Chinese companies in the markets where we compete, our operating results and financial condition will suffer.
Our ability to generate revenue or adequate margins for certain products may be limited by our ability to secure, at competitive prices or at all, components or materials required to produce those products.
Our products require certain components and materials for which we do not have captive supply. Our ability to generate revenue or adequate margins could be impacted by an inability to source those components or materials in a cost-effective manner, or at all. For example, some of our SSDs and the MCP storage solutions that we supply for use in mobile devices include both NAND flash memory and DRAM. Since we do not have a captive supply of DRAM, there could be periods in which we are unable to cost-effectively and timely source DRAM in the quantities that we require, which could result in our competitors with greater access to DRAM becoming preferred suppliers for these solutions, as well as discrete flash solutions. In addition, costs of DRAM have increased in the past and continued increases in the future would harm our gross margin for our products that include DRAM. Furthermore, as our product portfolio has evolved to include an increasing mix of complex products, we have become increasingly reliant on components and materials other than flash memory, and the proportion of our product costs attributable to these materials has increased. If we are unable to source these components or materials cost effectively, or at all, or if we are unable to reduce the cost of these materials and other costs, our revenue and margin may be harmed.
Our financial performance and the value of our investments depend significantly on worldwide economic conditions, which have deteriorated in many countries and regions, and may not recover in the foreseeable future.
Demand for our products is harmed by negative macroeconomic factors affecting consumer and enterprise spending. Slower projected growth in certain geographic regions including China, higher prevailing interest rates, low levels of consumer liquidity, risk of default on sovereign debt and significant volatility in credit and equity markets have weakened and may continue to weaken consumer confidence and have decreased consumer and enterprise spending in many regions around the world. These and other economic factors may reduce demand for our products and harm our business, financial condition and operating results. In addition, we maintain investments, including our cash, cash equivalents and marketable securities, of various holdings, types and maturities and, given the global nature of our business, our investment portfolio includes both domestic and international investments. Credit ratings and pricing of these investments can be negatively affected by liquidity, credit deterioration, financial results, economic risk, political risk, sovereign risk and other factors, and declines in the credit ratings or pricing of our investments could result in a decline in the value and liquidity of our investments, including our cash, cash equivalents and marketable securities, and result in a significant impairment of our assets.
We depend on our captive assembly and test manufacturing facilities in China and Malaysia and our business could be harmed if these facilities do not perform as planned.
Our reliance on our captive assembly and test manufacturing facilities in Shanghai, China and Penang, Malaysia have increased significantly and we now utilize these factories to satisfy a majority of our assembly and test requirements, to produce products with leading-edge technologies such as multi-stack die packages and to provide order fulfillment. In addition, our China facilities are responsible for packaging and shipping our retail products within the U.S., Asia, Europe, Canada and Latin America. Any delays in ramping capacity or adding new or replacement equipment, interruptions in production or the ability to ship product, or issues with manufacturing yields at our captive facilities could harm our operating results and financial condition. In addition, investment decisions in adding new assembly and test capacity require significant planning and lead-time, and a failure to accurately forecast demand for our products could cause us to over-invest or under-invest in the expansion of captive assembly and test capacity in our facilities, which would lead to excess capacity, under-utilization charges and impairments, in the event of over-investment, or insufficient assembly and test capacity resulting in a loss of sales and revenue opportunities, in the event of under-investment. Furthermore, if we were to experience labor unrest, or strikes, or if wages were to significantly increase, our ability to produce and ship products could be impaired and we could experience higher labor costs, which could harm our operating results and financial condition.
We rely on our suppliers, some of which are the sole source of supply for our non-memory components, and capacity limitations or cost increases from these suppliers expose our supply chain to unanticipated disruptions or potential additional costs.
We do not have long-term supply commitments from many of our suppliers, certain of which are sole sources of supply for our non-memory components. For example, the controllers for a majority of our SSD revenue are sourced from one third‑party controller vendor. From time-to-time, certain materials may become difficult or more expensive to obtain, including as a result of capacity constraints of these suppliers, or other cost increases sought by these suppliers, which could impact our ability to meet demand and could harm our profitability. Our business, financial condition and operating results could be significantly harmed by delays or reductions in shipments if we are unable to obtain sufficient quantities of these components or develop alternative sources of supply in a timely manner, on competitive terms, or at all.
We depend on our
third-party
subcontractors and our business could be harmed if our subcontractors do not perform as planned.
We rely on
third-party
subcontractors for a portion of our wafer testing, chip assembly, product assembly, product testing and order fulfillment. From time-to-time, our subcontractors have experienced difficulty meeting our requirements. If we are unable to increase the amount of capacity allocated to us from our current subcontractors or qualify and engage additional subcontractors, we may not be able to meet demand for our products. We do not have long-term contracts with some of our existing subcontractors, nor do we always have guaranteed manufacturing capacity with our subcontractors and, therefore, cannot guarantee that they will devote sufficient resources or capacity to manufacturing our products. We are not able to directly control product delivery schedules or quality assurance. Furthermore, we manufacture on a turnkey basis with some of our subcontractors. In these arrangements, we do not have visibility and control of their inventories of purchased parts necessary to build our products or of the progress of our products through their assembly line. Any significant problems that occur at our subcontractors, or their failure to perform at the level we expect, could lead to product shortages or quality assurance problems, either of which would harm our operating results and financial condition.
Our products may contain errors or defects or otherwise fail to meet customer or user requirements, which could result in the rejection of our products, product recalls, damage to our reputation, lost revenue, diverted development resources, increased service costs, warranty and indemnification claims and litigation.
Our products are complex, must meet stringent customer or user requirements and may contain errors or defects, and the majority of our products provide a warranty period. Errors or defects in our products may be caused by, among other things, errors or defects in the memory or controller components or firmware, including memory and components that we procure from
non-captive
sources, may occur as a result of the production process, may occur in the software contained in our high value solutions, or result in security vulnerability in our solutions. In addition, substantially all of our flash memory is supplied by Flash Ventures, and if the wafers from Flash Ventures contain errors or defects from design or manufacturing, our overall supply and costs could be negatively impacted. These factors could result in the rejection of our products, damage to our reputation, lost revenue, diverted development resources, increased customer service and support costs, indemnification of our customers’ product recall and other costs, warranty claims and litigation. Generally, our OEM customers have more stringent requirements than other customers and our concentration of revenue from OEMs, especially OEMs who purchase our enterprise solutions and client SSD products, could result in increased expenditures for product testing, or increase our service and support costs and potentially lead to increased warranty or indemnification claims. Furthermore, the costs of errors or defects in our embedded products may be greater than those of stand-alone, removable products due to the effect that such errors or defects may have on other components of the device in which they are embedded. In addition, we may be unable to provide timely, sufficient and cost-effective customer support and service, which could increase the risk of product rejections, reputational damage, revenue loss, warranty and indemnification claims and litigation. We record an allowance for warranty and similar costs in connection with sales of our products, but actual warranty and similar costs may be significantly higher than our recorded estimate and harm our operating results and financial condition. Our business liability insurance may be inadequate or future coverage may be unavailable on acceptable terms, which could adversely impact our operating results and financial condition.
Our new products have, from time-to-time, been introduced with design and production errors at a rate higher than the error rate in our established products. We must estimate warranty and similar costs for new products without historical information and actual costs may significantly exceed our recorded estimates. Underestimation of our warranty and similar costs would harm our operating results and financial condition.
Certain of our products contain encryption or security algorithms to protect third‑party content and user-generated data stored on our products. To the extent our products are hacked or the encryption schemes are compromised or breached, this could harm our business by hurting our reputation, requiring us to employ additional resources to fix the errors or defects and expose us to litigation and indemnification claims. This could potentially impact future collaboration with content providers or lead to product returns or claims against us due to actual or perceived vulnerabilities.
We are exposed to foreign currency exchange rate fluctuations that could harm our business, operating results and financial condition.
A significant portion of our business is conducted in currencies other than the U.S. dollar, which exposes us to adverse changes in foreign currency exchange rates. A stronger U.S. dollar could increase the real cost of our products to our customers in those markets outside the U.S. where we sell in U.S. dollars, and in those markets where we sell in foreign currencies, a stronger U.S. dollar would result in those sales translating into a lower U.S. dollar amount. A weakened U.S. dollar could increase our costs for foreign currency based operating expenses and product costs. These exposures may change over time as our business and business practices evolve, and they could harm our financial results and cash flows.
Our most significant exposure is related to our purchases of NAND flash memory from Flash Ventures, which are denominated in Japanese yen. Appreciation in the value of the Japanese yen relative to the U.S. dollar increases our cost of NAND flash wafers, negatively impacting our gross margin and operating results. In addition, our investments in Flash Ventures are denominated in Japanese yen and strengthening of the Japanese yen increases the cost to us of future funding and increase the value of our Japanese yen-denominated investments, increasing our exposure to asset impairments. The Japanese yen strengthened relative to the U.S. dollar in the first quarter of 2016, starting the quarter at approximately
120
yen to the dollar and ending the quarter at approximately
112
yen to the dollar. Macroeconomic weakness in the U.S. or other parts of the world could lead to strengthening of the Japanese yen, which would harm our gross margin, operating results, and the cost of future Flash Ventures funding, and increase the risk of asset impairment. We also have foreign currency exposures related to certain non-U.S. dollar-denominated revenue and operating expenses in Europe and Asia. Additionally, we have exposures to emerging market currencies, which can be extremely volatile. We also have significant monetary assets and liabilities that are denominated in non-functional currencies.
We generally enter into foreign exchange forward contracts to reduce the impact of foreign currency fluctuations on certain foreign currency assets, liabilities and net investments. In addition, from time-to-time, we hedge certain anticipated foreign currency cash flows with foreign exchange forward contracts, primarily for Japanese yen-denominated inventory purchases and R&D operating expenses.
Our decisions and hedging strategy with respect to currency risks may not be successful, which could harm our operating results. In addition, if we do not successfully manage our hedging program in accordance with accounting guidelines, we may be subject to adverse accounting treatment, which could harm our operating results. There can be no assurance that this hedging program will be economically beneficial to us for numerous reasons; for example, hedging may reduce volatility, but prevent us from benefiting from a favorable rate change. Further, the ability to enter into foreign exchange contracts with financial institutions is based upon our available credit from such institutions and compliance with covenants and other restrictions. Operating losses, third‑party downgrades of our credit rating or instability in the worldwide financial markets, including the downgrade of the credit rating of the U.S. government, could impact our ability to effectively manage our foreign currency exchange rate risk, which could harm our business, operating results and financial condition. Hedging also exposes us to the credit risk of our counterparty financial institutions.
Our global operations and operations at Flash Ventures and third
‑
party subcontractors are subject to risks for which we may not be adequately insured.
Our global operations are subject to many risks, including but not limited to errors and omissions, infrastructure disruptions, such as large-scale outages or interruptions of service from utilities or telecommunications providers, supply chain interruptions,
third-party
liabilities, theft and fires or natural disasters. No assurance can be given that we will not incur losses beyond the limits of, or outside the scope of, the coverage of our insurance policies. From time-to-time, various types of insurance have not been available on commercially acceptable terms or, in some cases, at all. There can be no assurance that in the future we will be able to maintain existing insurance coverage or that premiums will not increase substantially. Due to market availability, pricing or other reasons, we may elect not to purchase insurance coverage or to purchase only limited coverage. We maintain limited insurance coverage and, in some cases, no coverage at all, for natural disasters and environmental damages, as these types of insurance are sometimes not available or available only at a prohibitive cost. For example, our test and assembly facilities in Shanghai, China and Penang, Malaysia, on which we significantly rely, may not be adequately insured against all potential losses. Accordingly, we may be subject to uninsured or under-insured losses. We depend upon Toshiba to obtain and maintain sufficient property, business interruption and other insurance for Flash Ventures. If Toshiba fails to do so, we could suffer significant unreimbursable losses, and such failure could also cause Flash Ventures to breach various financing covenants. In addition, we insure against property loss and business interruption resulting from the risks incurred at our
third-party
subcontractors; however, we have limited control as to how those sub-contractors run their operations and manage their risks, and as a result, we may not be adequately insured.
If our security measures or security measures of our suppliers, vendors and partners are breached and unauthorized access to our or their information technology systems is obtained, we may lose proprietary data.
Our security measures and the security measures of our suppliers, vendors and partners may be breached and our or their information technology systems accessed as a result of
third-party
action, including computer hackers, employee error, malfeasance or otherwise, and result in unauthorized access to our customers’ or partners’ data or our data, including IP and other confidential business information. Attempts by others to gain unauthorized access to information technology systems are increasingly more sophisticated. These attempts, which might be related to state-sponsored intrusions or industrial or other espionage, include covertly introducing malware to computers and networks and impersonating authorized users, among others. We seek to detect and investigate all security incidents and to prevent their recurrence, but in some cases, we might be unaware of an incident or its magnitude and effects. Moreover, because the techniques used to obtain unauthorized access, or to sabotage systems, change frequently, we may be unable to anticipate these techniques or to implement adequate preventative measures. Furthermore, we have limited or no control over the implementation of preventative measures of our suppliers, vendors and partners. While we have identified several incidents of unauthorized access, to date none have caused material damage to our business. Security breaches could result in disclosure of our IP, trade secrets or confidential customer, supplier or employee data, which could result in legal liability, harm to our reputation or cause harm to our business. Security breaches or other cyber attacks involving disruptions to or failures in information technology, communication systems or other critical infrastructure could also result in delays to or malfunctions in company, supplier, vendor or partner operations or services. We have minimal insurance coverage for cybersecurity-related matters. We could also be negatively affected by existing and proposed laws and regulations, as well as government policies and practices, related to cybersecurity, privacy and data protection. In addition, we have agreed with certain customers and strategic partners, including our manufacturing partner, Toshiba, to undertake certain commitments to promote information security, and we may be liable to Toshiba or such other parties if we fail to meet our cybersecurity commitments. We expect to continue to devote resources to the security of our information technology systems.
We may need to raise additional financing, which could be difficult to obtain, and which, if not obtained in satisfactory amounts, may prevent us from funding Flash Ventures, increasing our wafer supply, developing or enhancing our products, taking advantage of future opportunities, engaging in acquisitions of or investments in companies, growing our business or responding to competitive pressures or unanticipated industry changes, any of which could harm our business.
We currently believe that we have sufficient cash resources to fund our operations as well as our anticipated investments in Flash Ventures for at least the next 12 months; however, we may decide to raise additional funds to maintain the strength of our balance sheet or fund our operations through equity, public or private debt, or lease financings. However, we cannot be certain that we will be able to obtain additional financing on favorable terms, or at all. If we issue additional equity securities, our stockholders will experience dilution and the new equity securities may have rights, preferences or privileges senior to those of existing holders of common stock. If we raise funds through debt or lease financing, we will have to pay interest and may be subject to restrictive covenants, which could harm our business. If we cannot raise funds on acceptable terms, if and when needed, our credit rating may be downgraded, and we may not be able to develop or enhance our technology or products, fulfill our obligations to Flash Ventures, increase our wafer supply, take advantage of future opportunities, engage in acquisitions of or investments in companies, grow our business or respond to competitive pressures or unanticipated industry changes, any of which could harm our business.
We may be unable to protect our IP rights, which would harm our business, financial condition and operating results.
We rely on a combination of patent, trademark, copyright and trade secret laws, confidentiality procedures and licensing arrangements to protect our IP rights. From time to time, we are involved in significant and expensive disputes regarding our IP rights and those of others, including claims that we may be infringing patents, trademarks and other IP rights of third parties.
There can be no assurance that:
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any of our existing patents will continue to be held valid, if challenged;
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patents will be issued for any of our pending applications;
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any claims allowed from existing or pending patents will have sufficient scope or strength to protect us;
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our patents will be issued in the primary countries where our products are sold in order to protect our rights and potential commercial advantage; or
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any of our products or technologies do not infringe on the patents of other companies.
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In addition, our competitors may be able to design their products around our patents and other proprietary rights. We also have patent cross-license agreements with several of our leading competitors. Under these agreements, we have enabled competitors to manufacture and sell products that incorporate technology covered by our patents. While we obtain license and royalty revenue or other consideration for these licenses, if we continue to license our patents to our competitors, competition may increase and may harm our business, financial condition and operating results.
There are flash memory producers, flash memory card manufacturers and other companies that utilize flash memory who we believe may infringe our IP. Enforcement of our rights often requires litigation. If we bring a patent infringement action and are not successful, our competitors would be able to use similar technology to compete with us. Moreover, the defendant in such an action may successfully countersue us for infringement of their patents or assert a counterclaim that our patents are invalid or unenforceable. If we do not prevail in the defense of patent infringement claims, we could be required to pay substantial damages and royalties, cease the manufacture, use and sale of infringing products in one or more geographic locations, expend significant resources to develop non-infringing technology, discontinue the use of specific processes or obtain licenses to the technology infringed. If we are enjoined from selling our products, or if we are required to develop new technologies or pay significant monetary damages or are required to make substantial royalty payments, our business and results of operations would be harmed.
We rely on trade secrets to protect some of our IP. Trade secrets are difficult to maintain and protect. We have taken measures to protect our trade secrets and proprietary information, such as the use of confidentiality agreements with employees and business partners, but there is no guarantee that these measures will be effective. These agreements may be unenforceable or difficult and costly to enforce, and our proprietary information may be stolen or misused, otherwise become known or be independently developed by competitors. Enforcement of claims that a third party has illegally obtained or used trade secrets is expensive, time consuming and uncertain. In addition, foreign courts are sometimes less willing than domestic courts to protect trade secrets. Our failure to obtain or maintain trade secret protection could adversely affect our competitive position and harm our business.
The success of our branded products depends in part on the positive image that consumers have of our brands. We believe the popularity of our brands makes them a target of counterfeiting or imitation, with third parties attempting to pass off counterfeit products as our products. Any occurrence of counterfeiting, imitation or confusion with our brands could adversely affect our reputation and impair the value of our brands, which in turn could negatively impact sales of our branded products, our market share and our gross margin, as well as increase our administrative costs related to brand protection and counterfeit detection and prosecution.
Litigation filed against SanDisk or Western Digital could prevent or delay the completion of the merger or result in the payment of damages following completion of the merger.
SanDisk and members of its board of directors may in the future be parties, among others, to various claims and litigation related to the pending merger, including putative stockholder class actions. Among other remedies, the plaintiffs in such matters are seeking to enjoin the merger. The results of complex legal proceedings are difficult to predict, and could delay or prevent the merger from becoming effective in a timely manner. Moreover, litigation could be time consuming and expensive, could divert management’s attention away from their regular business, and, if any such lawsuit is adversely resolved against any plaintiff, could have a material adverse effect on our financial condition.
One of the conditions to the closing of the merger is that no applicable governmental entity having jurisdiction over Western Digital, SanDisk or Merger Sub shall have issued an order, decree or ruling or taken any other material action enjoining or otherwise prohibiting the consummation of any of the merger substantially on the terms contemplated by the merger agreement that remains in effect, and that no law shall have been enacted or promulgated by any applicable governmental entity that makes the consummation of the merger illegal that remains in effect. Consequently, if any plaintiff secures injunctive or other relief prohibiting, delaying or otherwise adversely affecting Western Digital’s and/or SanDisk’s ability to complete the merger on the terms contemplated by the merger agreement, then such injunctive or other relief may prevent the merger from becoming effective in a timely manner, or at all.
We and certain of our officers are at times involved in litigation, including IP, antitrust and securities litigation, which may be costly, may divert the efforts of our key personnel and could result in adverse court rulings, which could materially harm our business.
We are often involved in litigation, including cases involving our IP rights and those of others, antitrust and commercial matters, putative securities class action suits and other actions. We are the plaintiff in some of these actions and the defendant in others. Some of the actions seek injunctive relief, including injunctions against the sale of our products and substantial monetary damages, which if granted or awarded, could materially harm our business, financial condition and operating results.
Litigation is subject to inherent risks and uncertainties that may cause actual results to differ materially from our expectations. Factors that could cause litigation results to differ include, but are not limited to, the discovery of previously unknown facts, changes in the law or in the interpretation of laws, and uncertainties associated with the judicial decision-making process. If we receive an adverse judgment in any litigation, we could be required to pay substantial damages and cease certain practices or activities, including the manufacture, use and sale of products. With or without merit, litigation can be complex, can extend for a protracted period of time, can be very expensive and the expense can be unpredictable. Litigation initiated by us could also result in counter-claims against us, which could increase the costs associated with the litigation and result in our payment of damages or other judgments against us. In addition, litigation, and any related publicity, may divert the efforts and attention of some of our key personnel. Litigation may also harm the market prices of our securities.
We may be obligated to indemnify our current or former directors or employees, or former directors or employees of companies that we have acquired, in connection with litigation or regulatory investigations. These liabilities could be substantial and may include, among other things: the costs of defending lawsuits against these individuals; the cost of defending stockholder derivative suits; the cost of governmental, law enforcement or regulatory investigations; civil or criminal fines and penalties; legal and other expenses; and expenses associated with the remedial measures, if any, which may be imposed.
Moreover, from time to time, we agree to indemnify certain of our suppliers and customers for alleged IP infringement. The scope of such indemnity varies but generally includes indemnification for direct and consequential damages and expenses, including attorneys’ fees. We may be engaged in litigation as a result of these indemnification obligations. Third-party claims for patent infringement are excluded from coverage under our insurance policies. A future obligation to indemnify our customers or suppliers may harm our business, financial condition and operating results. For additional information concerning legal proceedings, see
Part II
,
Item 1
, “
Legal Proceedings
” of this report.
We may be unable to license, or license at a reasonable cost, IP from third parties as needed, which could expose us to liability for damages, increase our costs or limit or prohibit us from selling products.
If we incorporate
third-party
technology into our products or if we are found to infringe the IP of others, we could be required to license IP from
third-parties
. We may also need to license some of our IP to others in order to enable us to obtain important cross-licenses to
third-party
patents. We cannot be certain that licenses will be offered when we need them, that the terms offered will be acceptable, or that these licenses will help our business. If we do obtain licenses from third parties, we may be required to pay license fees, royalty payments, or offset license revenue. In addition, if we are unable to obtain a license that is necessary to manufacture or sell our products, we could be required to redesign or stop shipping our products to one or more geographic locations, suspend the manufacture of products or stop our product suppliers from using processes that may infringe the rights of third parties. We may not be successful in redesigning our products, or the necessary licenses may not be available under reasonable terms, which would harm our business and financial results.
Conflict minerals regulations are causing us to incur additional expenses and could limit the supply and increase the cost of certain materials used in manufacturing our products.
In August 2012, the SEC adopted rules establishing additional disclosure and reporting requirements regarding the use of specified minerals, or conflict minerals, that are necessary to the functionality or production of products manufactured or contracted to be manufactured. These rules require us to determine, disclose and report whether or not such conflict minerals originate from the Democratic Republic of the Congo or any adjoining country. These rules could affect our ability to source certain materials used in our products at competitive prices and could impact the availability of certain minerals used in the manufacture of our products, including gold, tantalum, tin and tungsten. During the course of our diligence procedures, we could find that the minerals procured by one or more of our suppliers are not “conflict free” or discover violations of other rules, regulations or laws. As there may be only a limited number of suppliers of “conflict free” minerals, we cannot be sure that we will be able to obtain necessary conflict free minerals in sufficient quantities or at competitive prices. Some customers have notified us that they will require that our products be free of conflict minerals, and our revenue and margin may be harmed if we are unable to provide assurances to our customers that our products are “conflict free,” procure conflict free minerals at a reasonable price, or at all, or pass through any increased costs associated with meeting these demands. Additionally, we may face reputational challenges with our customers and other stakeholders if we are unable to sufficiently verify the origins of all minerals used in our products through our due diligence procedures. We may also face challenges with government regulators and our customers and suppliers if we are unable to sufficiently verify that the materials used in our products are conflict free. There are significant costs associated with complying with the ongoing diligence and disclosure requirements, such as costs related to determining the source of certain minerals used in our products, and we will incur additional costs of an independent private sector audit, to the extent required. We could also be subject to costs related to possible changes to products, processes, or sources of supply as a consequence of such verification and disclosure requirements.
We and our suppliers rely upon certain rare earth materials that are necessary for the manufacturing of our products, and our business could be harmed if we or our suppliers experience shortages or delays of these rare earth materials.
Rare earth materials are critical to the manufacture of some of our products. We and our suppliers acquire these materials from a number of countries, including the People’s Republic of China. We cannot predict whether the government of China or any other nation will impose regulations, quotas or embargoes upon the materials incorporated into our products that would restrict the worldwide supply of these materials or increase their cost. If China or any other major supplier were to restrict the supply available to us or our suppliers or increase the cost of the materials used in our products, we could experience a shortage in supply and an increase in production costs, which would harm our operating results and financial condition.
Changes in the seasonality of our business may result in our inability to accurately forecast our product purchase requirements.
Sales of our products in the consumer electronics market are subject to seasonality. Sales have typically increased significantly in the fourth quarter of each year, sometimes followed by significant declines in the first quarter of the following year. However, the global economic environment may impact typical seasonal trends, making it more difficult for us to forecast our business. Changes in the product or channel mix of our business can also impact seasonal patterns, adding to complexity in forecasting demand. If our forecasts are inaccurate, we may lose market share or procure excess inventory or inappropriately increase or decrease our operating expenses, any of which could harm our business, financial condition and operating results. Changes in seasonality may also lead to greater volatility in our stock price and the need for significant working capital investments in receivables and inventory, including the need to build inventory levels in advance of our projected high volume selling seasons.
Flash Ventures’ master equipment lease obligations contain covenants, which if breached, would harm our business, operating results, cash flows and liquidity.
Flash Ventures’ master lease agreements contain customary covenants for Japanese lease facilities. In addition to containing customary events of default related to Flash Ventures that could result in an acceleration of Flash Ventures’ obligations, the master lease agreements contain an acceleration clause for certain events of default related to each of the guarantors, including, among other things, our failure to maintain a minimum stockholders’ equity of at least
$1.51 billion
. As of
April 3, 2016
, our stockholders’ equity was in compliance with the related covenant under Flash Ventures’ master lease agreements.
If our stockholders’ equity were to fall below
$1.51 billion
, or other events of default occur, Flash Ventures would become non-compliant with certain covenants under its master lease agreements and would be required to negotiate a resolution to the non-compliance to avoid acceleration of our guarantee obligations under the master lease agreements. Such resolution could include, among other things, supplementary security to be supplied by us, as guarantor, or increased interest rates or waiver fees, should the lessors decide they need additional collateral or financial consideration. If an event of default occurs and if we fail to reach a resolution, we may be required to pay a portion or the entire outstanding lease obligations up to approximately
$984 million
based upon the exchange rate at
April 3, 2016
, covered by our guarantees under Flash Ventures’ master lease agreements, which would significantly reduce our cash position and may force us to seek additional financing, which may not be available on terms acceptable to us, if at all.
We are vulnerable to numerous risks related to our international operations, including political instability, and we must comply with numerous laws and regulations, many of which are complex.
Currently, a large portion of our revenue is derived from our international operations, and all of our products and many of our components are produced overseas in China, Japan, Malaysia and Taiwan. Our revenue and future growth is also significantly dependent on international markets, and we may face difficulties entering or maintaining sales in some international markets. We are, therefore, affected by the political, economic, labor, environmental, public health and military conditions in these countries. For example, China does not currently have a comprehensive and highly developed legal system, particularly with respect to the protection of IP rights, which results in the prevalence of counterfeit goods in China, among other things, as well as piracy and degradation of our IP protection. Our efforts to prevent counterfeit products from entering the market may not be successful, and the sale of counterfeit products could harm our operating results and financial condition. In addition, customs regulations in China are complex and subject to frequent changes and, in the event of a customs compliance issue, our ability to import to, and export from, our factory in Shanghai, China could be adversely affected, which could harm our operating results and financial condition.
Our international business activities could also be limited or disrupted by any of the following factors, among others:
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the need to comply with foreign government regulation;
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the need to comply with U.S. regulations on international business, including the Foreign Corrupt Practices Act, the United Kingdom Bribery Act 2010, the anti-bribery laws of other countries and rules regarding conflict minerals;
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changes in diplomatic and trade relationships or government intervention, which may impact our ability to sell to certain customers;
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reduced sales to our customers or interruption to our manufacturing processes in the Pacific Rim that may arise from regional issues in Asia, including natural disasters or labor strikes;
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imposition of regulatory requirements, tariffs, import and export restrictions and other barriers and restrictions;
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a higher degree of commodity pricing than in the U.S.;
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changes in, or the particular application of, government regulations;
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import or export restrictions that could affect some of our products, including those with encryption technology;
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duties or fees related to customs entries for our products, which are all manufactured offshore;
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longer payment cycles and greater difficulty in accounts receivable collection;
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adverse tax rules and regulations;
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weak protection of our IP rights;
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delays in product shipments due to local customs restrictions;
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disruptions in operations, research and development or other business functions that may arise from political or economic instability; and
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difficulties in managing international offices and maintaining appropriate internal controls, compliance programs, training and documentation.
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Our common stock and convertible notes prices have been, and may continue to be, volatile, which could result in investors losing all or part of their investments.
The market prices of our common stock and convertible notes have fluctuated significantly in the past and may continue to fluctuate in the future. We believe that such fluctuations will continue as a result of many factors, such as changes in investor and analyst expectations regarding our pending acquisition by Western Digital, fluctuations in the market prices of Western Digital’s common stock, our financial performance, financing plans, future announcements concerning us, our competitors or our principal customers regarding financial results or expectations, technological innovations, industry supply and demand dynamics, new product introductions, level of share repurchases, governmental regulations, the commencement or results of litigation, changes in recommendations and earnings estimates by analysts or our ability to meet the expectations of investors or analysts. In addition, in recent years the stock market has experienced significant price and volume fluctuations and the market prices of the securities of high-technology and semiconductor companies have been especially volatile, often for reasons outside the control of the particular companies. These fluctuations as well as general economic, political and market conditions may harm the market price of our common stock as well as the prices of our outstanding convertible notes.
Our success depends on our key personnel, including our senior management, and the loss of key personnel or the transition of key personnel could disrupt our business.
Our success greatly depends on the continued contributions of our senior management and other key research and development, sales, marketing and operations personnel. We do not have employment agreements with any of our executive officers and they are free to terminate their employment with us at any time. Our success will depend on our ability to recruit and retain additional highly-skilled personnel. We have relied on equity awards in the form of stock options and restricted stock units as one means for recruiting and retaining highly skilled talent and a reduction in our stock price may reduce the effectiveness of these equity awards in retaining employees. We also rely on cash incentive awards to motivate and retain employees. These cash incentive awards depend significantly on our financial and business performance, and variations in our financial and business performance from our expectations at the time we set the targets for such cash incentive awards could result in decreased or eliminated awards, reducing the effectiveness of these cash incentive awards in retaining employees. In addition, the pending acquisition by Western Digital could adversely affect our ability to retain and motivate current employees or attract and recruit prospective employees, each of whom may be uncertain about their future roles and relationships with us following the completion of the acquisition. Any loss of key personnel could adversely affect our business.
Terrorist attacks, war, threats of war and government responses may negatively impact our operations, revenue, costs and stock price.
Terrorist attacks, U.S. military responses to these attacks, war, threats of war and any corresponding decline in consumer confidence could have a negative impact on customer demand. Any of these events may disrupt our operations or those of our customers and suppliers and may affect the availability of materials needed to manufacture our products or the means to transport those materials to manufacturing facilities and finished products to customers. Any of these events could also increase volatility in the U.S. and world financial markets, which could harm our stock price and may limit the capital resources available to us and our customers or suppliers, or adversely affect consumer confidence. We have substantial operations in Israel, including a development center in Northern Israel, near the border with Lebanon, a research center in Omer, Israel, which is near the Gaza Strip, and offices near Tel Aviv, all areas that have experienced significant violence and political unrest. Conflict in the Gaza Strip and the surrounding areas, as well as turmoil and unrest in the Middle East or other regions, could cause delays in the development or production of our products and could harm our business and operating results.
Natural disasters or epidemics in the countries in which we or our suppliers or subcontractors operate could harm our operations.
Our supply chain operations, including those of our suppliers and subcontractors, are concentrated in the U.S., China, Japan, Malaysia, Singapore and Taiwan. In the past, certain of these areas have been affected by natural disasters such as earthquakes, tsunamis, floods and typhoons, and some areas have been affected by epidemics. In addition, our headquarters, which house a significant concentration of our research and development and engineering staff, are located in the San Francisco Bay Area, an area that is prone to earthquakes. If a natural disaster or epidemic were to occur in one or more of these areas, we could incur a significant work or production stoppage, or damage to inventory. The impact of these potential events is magnified by the fact that we do not have insurance for most natural disasters or epidemics, including earthquakes and tsunamis. The impact of a natural disaster or epidemic could harm our business and operating results.
Disruptions in global transportation could impair our ability to deliver or receive product on a timely basis, or at all, causing harm to our financial results.
Our raw materials, work-in-process and finished products are primarily distributed via air transport. If there are significant disruptions in air transport, we may not be able to deliver our products or receive raw materials. Any natural disaster or other event that affects air transport in Asia could disrupt our ability to receive raw materials in, or ship finished product from, our facilities in Shanghai, China and Penang, Malaysia or our Asia-based contract manufacturers. As a result, our business and operating results may be harmed.
We rely on information systems to run our business and any prolonged down time could harm our business operations and financial results.
We rely on an enterprise resource planning system, as well as multiple other systems, databases, and data centers to operate and manage our business. Any information system problems, programming errors or unanticipated system or data center interruptions could impact our continued ability to successfully operate our business and could harm our financial results or our ability to accurately report our financial results on a timely basis.
Anti-takeover provisions in our charter documents, stockholder rights plan and Delaware law could discourage or delay a change in control and negatively impact our stockholders.
We have taken a number of actions that could have the effect of discouraging a takeover attempt. For example, we have a stockholders’ rights plan that would cause substantial dilution to a stockholder, and substantially increase the cost paid by a stockholder, who attempts to acquire us on terms not approved by our Board of Directors. This could discourage an acquisition of us. In addition, our certificate of incorporation grants our Board of Directors the authority to fix the rights, preferences and privileges of and issue up to 4,000,000 shares of preferred stock without stockholder action (2,000,000 shares of preferred stock have already been reserved under our stockholder rights plan). Issuing preferred stock could have the effect of making it more difficult and less attractive for a third party to acquire a majority of our outstanding voting stock. Preferred stock may also have other rights, including economic rights senior to our common stock that could harm the market value of our common stock. In addition, we are subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law. This section provides that a corporation may not engage in any business combination with any interested stockholder, defined broadly as a beneficial owner of 15% or more of that corporation’s voting stock, during the three-year period following the time that a stockholder became an interested stockholder, without certain conditions being satisfied. This provision could delay or discourage a change of control of SanDisk.
Unanticipated changes in our tax provisions or exposure to additional income tax liabilities could affect our profitability.
We are subject to income and other taxes in the U.S. and numerous foreign jurisdictions. Our tax liabilities are affected by the amounts we charge for inventory, services, licenses, funding and other items in intercompany transactions. We are subject to ongoing tax audits in various jurisdictions. Tax authorities may disagree with our intercompany charges or other matters and assess additional taxes. While we regularly assess the likely outcomes of these audits in order to determine the appropriateness of our tax provision, tax audits are inherently uncertain and an unfavorable outcome could occur. An unanticipated unfavorable outcome in any specific period could harm our operating results for that period or future periods. The financial cost and management attention and time devoted to defending income tax positions may divert resources from our business operations, which could harm our business and profitability. U.S. Internal Revenue Service, or IRS, audits may also impact the timing and amount of any refund claims. In addition, our effective tax rate in the future could be adversely affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, changes in tax laws and the discovery of new information in the course of our tax return preparation process. In particular, the carrying value of deferred tax assets, which are predominantly in the U.S., is dependent on our ability to generate future taxable income in the U.S. Furthermore, recent developments in foreign jurisdictions, including the Irish government’s announced changes to the taxation of certain existing non-resident Irish companies beginning in January 2021 and the Organisation for Economic Co-operation and Development’s project on base erosion and profit shifting, could ultimately increase our tax liabilities to foreign jurisdictions and the treatment of our foreign earnings from a U.S. perspective, which could adversely impact our effective tax rate.
We may be subject to risks associated with laws, regulations and customer initiatives relating to the environment or other social responsibility issues.
We are subject to a wide range of environmental and other regulations in numerous jurisdictions in which we operate, including China, Japan, Malaysia and the U.S. In addition, climate change issues, energy usage and emissions controls may result in new and enhanced environmental legislation and regulations, at the international, federal or state level, that may make it more difficult or expensive for us, our suppliers and our customers to conduct business. Any of these regulations could cause us to incur additional direct costs, as well as increased indirect costs related to our relationships with our customers and suppliers, and otherwise harm our operations and financial condition. Any failure to comply with environmental regulations could adversely impact our reputation and our financial results.
Government regulators or our customers may require us to comply with product or manufacturing standards that are more restrictive than current laws and regulations related to environmental matters, conflict minerals or other social responsibility initiatives. The implementation of these standards could affect the sourcing, cost and availability of materials used in the manufacture of our products. Non-compliance with these standards could cause us to lose sales to these customers and compliance with these standards could increase our costs, which may harm our operating results.
In the event we are unable to satisfy regulatory requirements relating to internal controls, or if our internal control over financial reporting is not effective, our financial results and stock price could suffer.
In connection with our certification process under Section 404 of the Sarbanes-Oxley Act, we have identified in the past and may, from time to time in the future, identify deficiencies in our internal control over financial reporting. There can be no assurance that individually or in the aggregate these deficiencies would not be deemed to be a material weakness or significant deficiency. Any internal control or procedure, no matter how well designed and operated, can only provide reasonable assurance of achieving desired control objectives and cannot prevent human error, intentional misconduct or fraud; therefore, we cannot be certain that our internal controls measures will continue to provide adequate controls over our financial process and reporting. A material weakness or significant deficiency in internal control over financial reporting could have a materially adverse impact on our reported financial results, may require the restatement of our financial results, limit our access to capital markets, subject us to sanctions from regulatory agencies and The NASDAQ Global Select Market, cause our investors to lose confidence in our financial reporting and the market price of our stock could significantly decline. Additionally, adverse publicity related to the disclosure of a material weakness in internal controls could harm our reputation, business and stock price.
We have significant financial obligations related to Flash Ventures, as well as under our 1.5% Convertible Senior Notes due 2017 and our 0.5% Convertible Senior Notes due 2020, which could negatively impact our cash flows and financial position, and the
merger with Western Digital will allow holders of the convertible notes to convert their notes into a mixture of cash and stock at a temporarily increased conversion rate.
We have entered into agreements to guarantee or provide financial support with respect to lease and certain other obligations of Flash Ventures in which we have a 49.9% ownership interest. As of
April 3, 2016
, we had guarantee obligations for Flash Ventures’ master lease agreements denominated in Japanese yen of approximately
$984 million
based on the exchange rate at
April 3, 2016
. We also have significant commitments for the future fixed costs of Flash Ventures, and we expect to continue to incur significant obligations with respect to, as well as make continued investments in, Flash Ventures. In addition, as of
April 3, 2016
, the aggregate principal amount outstanding under our
1.5% Convertible Senior Notes due 2017
(the “
1.5% Notes due 2017
”) and our
0.5% Convertible Senior Notes due 2020
(the “
0.5% Notes due 2020
,” and together with the
1.5% Notes due 2017
, the “Notes”) was
$2.5 billion
. The Notes may be converted at the option of the holders during certain periods as a result of, among other things, fluctuations in our stock price or in connection with a merger event. For example, the
1.5% Notes due 2017
are convertible at the holders’ option beginning April 1, 2016 and ending June 30, 2016, as the last reported sales price of our common stock exceeded 130% of the conversion price for more than 20 days in the period of 30 consecutive trading days prior to March 31, 2016. Convertibility of the Notes based on the trading price of our common stock is assessed on a calendar-quarter basis. Upon any conversion of the Notes, we will be required to deliver cash up to the principal amount of the Notes that are converted and, with respect to any excess conversion value greater than the principal amount of the Notes, shares of our common stock (plus cash in lieu of any fractional shares of common stock), which would result in dilution to our stockholders. In connection with the issuance of the Notes, we sold warrants to acquire shares of our common stock, which, if exercised, will result in dilution to our stockholders.
Under the terms of the Notes, the pending acquisition by Western Digital
will constitute
a designated event and a fundamental change. As a result, holders of the Notes will be permitted to choose (i) to convert their Notes into a mixture of cash and stock at a temporarily increased conversion rate, (ii) to require us to repurchase their Notes for a price equal to their principal amount plus accrued but unpaid interest to but excluding the repurchase date, or (iii) to continue holding their Notes. If the merger closes, the holders of the Notes would be expected to exercise the right to convert their Notes in accordance with their terms at a temporarily increased conversion rate shortly following the closing of the merger (although the holders’ actual decisions will depend upon their judgments based on the then prevailing market conditions) in which case the Notes will be converted into cash for the principal amount and the merger consideration with respect to the excess thereof. The holders of the Notes may deliver conversion notices prior to the closing of the merger, and if they do so, we will be required to settle such conversions regardless of whether the merger closes; however, if the merger does not close, any converting holders will not be entitled to the temporarily increased conversion rate. As a result, if the merger does not close, we would still be required to pay in cash the principal amount of the Notes surrendered for conversion, and deliver our common stock with respect to the excess thereof. Such requirement might have a material adverse effect on our financial condition and liquidity. On March 1, 2016, we issued a notice of an anticipated designated event and fundamental change to holders of our Notes and as a result, the
0.5% Notes due 2020
became convertible as of March 8, 2016; the
1.5% Notes due 2017
were already convertible at that time, and are also convertible in the second calendar quarter of 2016, per the calendar-quarter stock price assessment described above. Notice was given, pursuant to the indentures governing the Notes, that the consummation of the merger would constitute a designated event and a fundamental change under each of the indentures.
We are subject to financial and other covenants in our guarantees under Flash Ventures’ master lease agreements and in the Notes. Our failure to meet these covenants may result in the acceleration of our obligations under these agreements. We may not have sufficient funds to make payments related to our Flash Ventures obligations or under the Notes when converted or due. Further, these obligations could negatively impact our cash flows and limit our ability to use our cash flow for our other liquidity needs, including working capital, capital expenditures, acquisitions, investments and other general corporate purposes.
Although the conversion consideration that we must deliver for qualifying conversions of the Notes will be increased as a result of a temporarily increased conversion rate due to the Western Digital merger, we will not receive any corresponding increase in payments or deliveries we receive under the related bond hedge transactions in connection with such conversions.
Concurrent with the issuance of the Notes, we entered into bond hedge transactions and warrant transactions with five counterparties (the “Hedge Banks”). The bond hedge transactions, which were intended to potentially offset the dilutive effect on our stockholders of the conversion of the Notes, consisted of the purchase by us of call options with respect to the Notes. The amounts payable by the Hedge Banks to us under the bond hedge transactions will not incorporate the temporary increase in the conversion rate of the Notes due to the Western Digital merger or otherwise factor in the option time value of the bond hedge transactions. As a result, we will receive less under the bond hedge transactions in connection with the pending merger than the amount above principal that we will owe under the Notes. In addition, the payments or deliveries from the Hedge Banks under the bond hedge transactions as the result of the consummation of the pending merger could be greater than, equal to, or less than the amount of the payments that would have been paid or the value of the shares that would have been delivered by the Hedge Banks upon exercise, expiration or termination of the bond hedge transactions in the ordinary course in the absence of the pending merger.
SanDisk will owe the Hedge Banks cash payments with respect to the warrant transactions that terminate in connection with the merger with Western Digital, some of which we will be required to pay even if the merger does not close.
The warrant transactions, which were intended to partially offset the cost to us of the bond hedge transactions, consisted of the sale by us to the Hedge Banks of call options on shares of our common stock with a strike price higher than the conversion price of the applicable Notes. Under the original terms of the warrant transactions, the Hedge Banks would be entitled to receive from us a cash payment equal to the value of the warrant transactions with such Hedge Banks upon closing of the pending acquisition of SanDisk by Western Digital. If not otherwise agreed by the parties, the amount payable under these terminated warrant transactions will be determined by the applicable Hedge Bank in good faith and in a commercially reasonable manner, and will vary depending on factors including the date the merger is consummated, the market price of the relevant common stock, and market conditions (including interest rates and volatility) at the time as of which the warrant transactions are terminated.
The payments to the Hedge Banks with respect to the warrant transactions that terminate in connection with the Western Digital merger agreement could be greater than, equal to, or less than the amount of the payments or the value of the shares that would have been received by the Hedge Banks upon exercise or expiration of the warrant transactions in the ordinary course in absence of the pending merger. The cash payments owed by us to the Hedge Banks as a result of the termination of the warrant transactions will be significant and are expected to exceed in the aggregate the amounts receivable by us under the bond hedge transactions.
Since we entered into the Western Digital merger agreement, we discussed with the Hedge Banks potential amendments to the warrant transactions, including as to the timing of the termination of the warrant transactions and the amount of the warrant transaction termination payments owed by us. During the first quarter of 2016, we have executed definitive agreements with all Hedge Banks. With respect to the warrant transactions in connection with the
1.5% Notes due 2017
(the “2017 warrant transactions”), during the first quarter of 2016, we have agreed on a final termination value of approximately
$418 million
. We will be required to pay such amount on the earlier of the closing date of the merger or August 1, 2017 (regardless of whether the merger closes by such time). With respect to the warrant transactions in connection with the
0.5% Notes due 2020
(the “2020 warrant transactions”), during the first quarter of 2016, we have amended agreements with all Hedge Banks to specify the methodologies to determine the amount that will be payable to the Hedge Banks upon the closing of the merger with Western Digital. Additionally, 80% of the 2020 warrant transactions were amended to contain a potential downward adjustment to the strike price to reflect the economic effect of a merger announcement in the event such merger is subsequently cancelled. If the merger with Western Digital does not close, all 2020 warrant transactions will remain outstanding. The payments to the Hedge Banks may have a material adverse effect on our financial condition and liquidity.
SanDisk stockholders will have a reduced ownership and voting interest in the combined company after completion of the pending merger, and will be subject to risks in Western Digital stock price after becoming stockholders of Western Digital.
Our stockholders presently have the right to vote on the election of our Board of Directors and on other matters affecting us. After the closing of the merger, current SanDisk stockholders will have significantly less influence on the management and policies of the combined company than they now have on the management and policies of SanDisk.
Upon closing of the merger, our stockholders will become stockholders of Western Digital upon receipt of shares of Western Digital common stock, which has different stockholder rights and privileges than SanDisk common stock. Our stockholders will be subject to risks in Western Digital stock price after becoming stockholders of Western Digital. The market prices of Western Digital common stock after the merger might be affected by factors different from, or in addition to, those currently affecting the market prices of SanDisk common stock. The market for Western Digital common stock may be adversely affected by the merger. Western Digital may fail to realize the benefits expected from the merger, which could adversely affect Western Digital’s stock price. The use of cash and incurrence of substantial indebtedness in connection with the financing of the merger may have an adverse impact on Western Digital’s liquidity, limit Western Digital’s flexibility in responding to other business opportunities and increase Western Digital’s vulnerability to adverse economic and industry conditions, each of which could adversely affect Western Digital’s stock price.
There can be no assurance that we will reinstate our cash dividend program if our pending acquisition by Western Digital fails to close.
Due to pending acquisition by Western Digital, we do not intend to declare any future cash dividends. If the pending acquisition is terminated, any reinstatement of quarterly dividends would be subject to capital availability and periodic determination by our Board of Directors that cash dividends are in the best interest of our stockholders. If the pending acquisition is terminated, a failure to reinstate dividend payments could have a negative effect on our stock price, which could have a material adverse impact on investor confidence and employee retention.
C
hanges in existing financial accounting standards or practices, or taxation rules or practices may adversely affect our results of operations.
Changes in existing accounting or taxation rules or practices, new accounting pronouncements or taxation rules, or varying interpretations of current accounting pronouncements or taxation practice could have an adverse effect on our results of operations and financial condition. For example, the Financial Accounting Standards Board, or FASB, is currently working together with the International Accounting Standards Board, or IASB, on several projects to further align accounting principles and facilitate more comparable financial reporting between companies who are required to follow U.S. Generally Accepted Accounting Principles, or GAAP, under SEC regulations and those who are required to follow International Financial Reporting Standards, or IFRS, outside of the U.S. These efforts by the FASB and IASB, in areas such as revenue and lease accounting, may result in different accounting principles under GAAP that may have an adverse impact on our results of operations and financial condition. Accounting changes that affect our results of operations or our liquidity ratios may have an impact on the availability and cost of borrowing. In addition, new accounting principles may require costly and time consuming changes to our systems.