UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

 

Form 10-K

 

 

Commission file number: 0-7422

 

 

 

 

STANDARD MICROSYSTEMS CORPORATION

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code: (631) 435-6000

 

Securities registered pursuant to Section 12(b) of the Act: None

 

Securities registered pursuant to Section 12(g) of the Act:

 

(Title of Class)

Common Stock, $.10 par value

Preferred Stock Purchase Rights

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

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

 

 

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s Proxy Statement for the 2006 Annual Meeting of Shareholders are incorporated by reference into Part II and Part III of this report on Form 10-K.

 

 

TABLE OF CONTENTS

 

 

General Description of the Business

 

Standard Microsystems Corporation (the “Company” or “SMSC”), a Delaware corporation, founded in 1971 and headquartered in Hauppauge, New York, designs and sells a wide variety of silicon-based integrated circuits (“ICs”) that incorporate digital or analog signal processing technologies, or both (referred to as “mixed-signal”).

 

SMSC’s integrated circuits and systems provide a wide variety of signal processing attributes that are incorporated by its globally diverse customers into a wide variety of end products in the mobile and desktop personal computer (“PC”), consumer electronics and infotainment, and industrial and other markets.

 

SMSC’s semiconductor products generally provide connectivity, networking, or input/output control solutions for a variety of high-speed communication, computer and related peripheral, consumer electronic device, industrial control system, or auto infotainment applications. The market for these solutions is increasingly diverse, and the Company’s technologies are increasingly used in various combinations and in alternative applications.

 

SMSC has what is commonly referred to as a “fabless” business model, meaning that the Company does not own the manufacturing assets to make the silicon wafer based integrated circuits, but rather has these manufactured by other companies to its specifications and incorporating its designs.

 

SMSC’s business is based on substantial intangible intellectual property assets consisting of patented technology and designs as well as know-how, extensive experience in integrating designs into systems, the ability to work closely with customers to solve technology application challenges, to develop products that satisfy market needs and the ability to efficiently manage its global network of suppliers. These attributes provide technical performance, cost, and time-to-market advantages to its customers and have allowed SMSC to develop leadership positions in several technologies and markets.

 

SMSC is headquartered in Hauppauge, New York with operations in the United States, Taiwan, Japan, Korea, China, Singapore and Europe. Major engineering design centers are located in Arizona, New York, Texas and Karlsruhe, Germany. Refer to Part I — Item 1.A. — Risk Factors and Part II — Item 7.A. — Quantitative and Qualitative Disclosures About Market Risk for further discussion regarding risks associated with foreign operations. Additional information is available at www.smsc.com.

 

Available Information

 

SMSC’s Internet address is www.smsc.com. Through the Investor Relations section of our Internet website we make available, free of charge, our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934 (the “Exchange Act”), as well as any filings made pursuant to Section 16 of the Exchange Act, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the Commission. Our Internet website and the information contained therein or incorporated therein are not incorporated into this Annual Report on Form 10-K.

 

You may also read and copy materials that we have filed with the U.S. Securities and Exchange Commission (the “SEC”) at the SEC’s Public Reference Room located at 100 F Street, N.E., Room 1580, Washington, D.C. 20549. Please call the Commission at 1-800-SEC-0330 for further information on the Public Reference Room. In addition, the Commission maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically at www.sec.gov.

 

Principal Products of the Company

 

SMSC develops its products to serve applications in three principal vertical markets: Mobile and Desktop PCs; Consumer Electronics and Infotainment; and Industrial and Other. Each of the Company’s products or technologies are sold into multiple end markets, and its product technologies, intellectual property and proprietary processes are increasingly being re-used and re-combined into new solutions that can be sold into these markets. All products are

manufactured using industry standard processes and all are sold through a unified direct sales force that also manages relationships with independent, third party sales representatives and distributors.

 

The flexibility of SMSC’s products to address multiple end market applications and the convergence of technologies is creating new market opportunities. For example, computer makers are supplying devices that address entertainment needs and traditional manufacturers of consumer entertainment goods are addressing computing needs. This trend is sometimes referred to as the “battle for the living room”. As the result of substantial investment in research and development over the past three years, the functionality of SMSC’s products has been greatly enhanced, and the portfolio of products in connectivity and networking has broadened considerably, enabling increased presence in many other vertical markets using these technologies. This strategic thrust to link available technologies into new applications and invest in new technologies capable of serving different aspects of these converging markets is expected to result in further sales increases and increased business and product diversity.

 

Universal Serial Bus (“USB”) is a technology that enables the transfer of data between devices. This technology can be adopted on computer motherboards, expansion circuit boards, or in a large number of consumer, industrial and other applications. SMSC is regarded as an industry leader in providing semiconductors that incorporate the latest industry USB standard specification, referred to in the industry as USB2.0 or “Hi-Speed USB”. USB2.0’s high data transfer rate supports the high data bandwidth and speed requirements of emerging technologies, and because of its ease of use and broad and growing acceptance it has increasingly become the leading standard by which interoperability and connectivity is provided between diverse systems platforms such as consumer electronics, multimedia computing and mobile storage applications. Designers are attracted to USB2.0’s “plug-and-play” features as well as its strong software support and predictable software development requirements. The ubiquity of USB2.0 silicon and software makes it a cost-effective choice for designers to add a high-speed serial data pipe for transferring media content.

 

SMSC’s products are positioned in several areas within the USB connectivity market and include:

 

 

SMSC also has extensive expertise in Ethernet products. Ethernet has emerged as a ubiquitous, versatile networking technology found in home, business, and industrial environments. Unlike many of today’s Ethernet controllers, the Company’s Ethernet products can be designed into applications that do not have Peripheral Component Interconnect (“PCI”) interfaces. PCI is a high speed connection technology common in computers, but is not commonly found in embedded applications such as consumer electronics and industrial equipment. The bulk of SMSC’s networking growth is currently being derived from consumer electronics design wins, as digital televisions, set-top boxes and digital video recorders start to adopt Ethernet technology. These devices are increasingly adding networking capabilities to broaden their feature-sets and attractiveness to the end consumer. Also, in both business and industrial environments, such as office buildings, or factory floors, there continues to be a rapidly expanding demand for computers, machinery, appliances and other applications to be networked together.

 

SMSC also serves the embedded market with other networking technologies, such as ARCNET and CircLink^tm, an ARCNET derivative. By replacing traditionally slow, wire intensive, hard-to-use serial communications, these solutions allow designers to reduce wiring and microcontroller costs, and create a more flexible and modular systems architecture. These products target networking applications requiring a high level of predictable

behavior, throughput, and ease of implementation such as telecom equipment, robotics, digital copiers and printers, and transportation systems.

 

SMSC’s networking product line include:

 

 

SMSC is a leading global supplier of advanced Input/Output (“I/O”) products for PC-related computing applications supplied by major original equipment manufacturers (“OEMs”), original design manufacturers (“ODMs”), channel PC and motherboard manufacturers. The Company’s broad product portfolio provides a variety of integration choices for designers, with unique configurations of serial ports, parallel ports, keyboard controllers, hardware monitoring, infrared ports, real time clocks, general purpose I/O pins, logic integration and power management.

 

SMSC has leveraged its analog design expertise to develop a line of stand-alone Environmental Monitoring and Control (“EMC”) products, providing thermal management, hardware monitoring and voltage supervision, all of which help ensure the stability and reliability of computing systems and other industrial applications. The Company’s EMC sensor and fan control products are specifically designed for today’s high-heat, small form factor system designs.

 

The Company’s computing platform products also extend into the PC-based server market. Advanced I/O products for server applications build on SMSC’s broad I/O and system management expertise and include timers, flash memory interfaces, thermal management and other requirements of server configurations.

 

The Company’s computing product lines include:

 

 

SMSC is also a supplier of semiconductor products based on its market-leading Media Oriented Systems Transport (“MOST^®” or “MOST”) technology. MOST is a proprietary networking protocol which enables the transport of high bandwidth digital audio, video and packet-based data, along with control information. MOST-enabled integrated circuits are being designed into multimedia components such as radios, microphones and CD-players, enabling these applications to be networked. MOST has been adopted as a standard primarily within the European luxury automotive market, but SMSC believes it has the potential to proliferate into medium and low end automobiles, into other geographic areas and into non-automotive markets. The Company also sells related system design and diagnostic tool products to customers who need to build or maintain MOST compliant systems. These products were added as a result of the acquisition of OASIS SiliconSystems Holding AG (“OASIS”) on March 30, 2005, as further discussed below.

 

Seasonality

 

The Company’s business historically has been subject to repeated seasonality, with the first and last quarters of each fiscal year tending to be weaker than the second and third. See Part I Item 1.A. — Risk Factors — Seasonality of the Business, for further discussion.

Competition

 

The Company competes in the semiconductor industry, servicing and providing solutions for various applications. Many of the Company’s larger customers conduct business in the PC and related peripheral devices markets. Intense competition, rapid technological change, cyclical market patterns, price erosion and periods of mismatched supply and demand have historically characterized these industries. See Part I Item 1.A. — Risk Factors, for a more detailed discussion of these market characteristics and associated risks.

 

The Company faces competition from several large semiconductor manufacturers, some of which have greater size and financial resources than the Company. The Company’s principal competitors in the advanced I/O controller market include eNe, Integrated Technology Express, Inc. (“ITE”), Renesas and Winbond Electronics Corporation. Principal competitors in SMSC’s other markets include Cypress Semiconductor, Davicom Semiconductor Inc., Genesys Logic, Inc. and NEC Corporation. As SMSC continues to broaden its product offerings, it will likely face new competitors. Many of the Company’s potential competitors have greater financial resources and the ability to invest larger dollar amounts into research and development. Some have their own manufacturing facilities, which may give them a cost advantage on large volume products and increased certainty of supply.

 

The principal methods that the Company uses to compete include introducing innovative new products, providing industry-leading product quality and customer service, adding new features to its products, improving product performance and reducing manufacturing costs. SMSC also cultivates strategic relationships with certain key customers who are technology leaders in its target markets, and who provide insight into market trends and opportunities for the Company to better support those customers’ current and future needs.

 

The Company believes that it currently competes effectively in the areas discussed above to the extent they are within its control. However, given the pace at which change occurs in the semiconductor, personal computer, automotive and other high-technology industries, SMSC’s current competitive capabilities are not a guarantee of future success. In addition, reductions in the growth rates of these industries, or other competitive developments, could adversely affect its future financial position, results of operations and cash flows.

 

Research and Development

 

The semiconductor industry and the individual markets that the Company currently serves are highly competitive, and the Company believes that continued investment in research and development (“R&D”) is essential to maintaining and improving its competitive position. In the fiscal years 2006, 2005, and 2004 the Company spent approximately $58.2 million, $43.0 million and $38.8 million, respectively, on R&D. SMSC has strategic relationships with many of its customers and tailors its solutions to these specific customers’ needs. Serving a wide array of world class OEMs and ODMs, the Company’s continued success will be based, among other things, on its ability to meet the individual needs of these customers and to help them speed their own products to market.

 

SMSC’s R&D activities are performed by highly-skilled engineers and technicians, and are primarily directed towards the design of integrated circuits in both mainstream and emerging technologies, the development of software drivers, firmware and design tools and intellectual property (“IP”), as well as ongoing cost reductions and performance improvements in existing products.

 

Over the past several years, SMSC has evolved from an organization having strength solely in digital design, to one with broad engineering and design expertise in digital, analog and mixed-signal solutions. Electronic signals fall into one of two categories — analog or digital. Digital signals are used to represent the “ones” and “zeros” of binary arithmetic, and are either on or off. Analog, or linear, signals represent real-world phenomena, such as temperature, pressure, sound, speed and motion. These signals can be detected and measured using analog sensors, which represent real-world phenomena by generating varying voltages and currents. Mixed-signal products combine digital and analog circuitry into a single device. Mixed-signal solutions can significantly reduce board space by integrating system interfaces, reducing external component requirements and lowering power consumption, all of which reduce system costs. During fiscal 2006, mixed-signal products contributed nearly 80% of SMSC’s unit sales.

SMSC employs engineers with a wide range of experience in digital, mixed-signal and analog circuit design, from experienced industry veterans to new engineers recently graduated from universities. Their activities are supported by state-of-the-art hardware, software and other product design tools procured from leading global suppliers. The Company’s major engineering design centers are strategically located in New York, Texas, Arizona and Germany to take full advantage of the technological expertise found in each region, and to closely cater to its global customer base.

 

Manufacturing

 

SMSC provides semiconductor products using a “fabless” manufacturing model, which is increasingly common in the semiconductor industry. Third party contract foundries and package assemblers are engaged to fabricate the Company’s products onto silicon wafers, cut these wafers into die and assemble the die into finished packages. This strategy allows the Company to focus its resources on product design and development, marketing, test and quality assurance. It also reduces fixed costs and capital requirements and provides the Company access to the most advanced manufacturing capabilities. See Part I Item I.A. — Risk Factors — Reliance upon Subcontract Manufacturing, for further discussion. The Company also faces certain risks as a result of doing business in Asia. See Part I Item I.A. — Risk Factors — Business Concentration in Asia, for further discussion.

 

The Company’s primary wafer suppliers, and their headquarters locations, are Chartered Semiconductor Manufacturing, Ltd. in Singapore, Taiwan Semiconductor Manufacturing Company, Ltd. (“TSMC”) in Taiwan, DongbuAnam Semiconductor in Korea and STMicroelectronics N.V. in Switzerland. The Company may negotiate additional foundry supply contracts and establish other sources of wafer supply for its products as such arrangements become useful or necessary, either economically or technologically.

 

Processed silicon wafers are shipped to various third party assembly suppliers, most of which are located in Asia, where they are separated into individual chips that are then encapsulated into plastic packages. SMSC also uses a number of independent suppliers for assembly purposes. This enables the Company to take advantage of these subcontractors’ high volume manufacturing-related cost savings, speed and supply flexibility. It also provides SMSC with timely access to cost-effective advanced process and package technologies. The Company purchases most of its assembly services from Advanced Semiconductor Engineering, Inc., STATSChipPac, Ltd., Orient Semiconductor Electronics, Ltd., and Amkor Technology, Inc. See Part I Item 1.A. — Risk Factors — Reliance upon Subcontract Manufacturing and Business Concentration in Asia for further discussion.

 

Following assembly, each of the packaged units receives final testing, marking and inspection prior to shipment to customers. Final testing for a portion of the Company’s products is performed at SMSC’s own testing operation in Hauppauge, New York. Final testing services of independent test suppliers, most of which occurs in Asia, are also utilized to a growing extent and afford the Company increasing flexibility to adjust to near-term fluctuations in product demand and corresponding production requirements.

 

Customers demand semiconductors of the highest quality and reliability for incorporation into their products. SMSC focuses on product reliability from the initial stages of the design cycle through each specific design process, including production test design. In addition, to further validate product performance across process variation and to ensure acceptable design margins, designs are typically subject to in-depth circuit simulation at temperature, voltage and processing extremes before initiating the manufacturing process. The Company prequalifies each of its assembly, test and wafer foundry subcontractors using a series of industry standard environmental product stress tests, as well as an audit and analysis of the subcontractor’s quality system and manufacturing capability. Wafer foundry production and assembly services are monitored to ensure consistent overall quality, reliability and yield levels.

 

Sales, Marketing and Customer Service

 

The Company’s primary sales and marketing strategy is to achieve design wins with technology leaders and channel customers in targeted markets through superior products, field applications and engineering support. Sales managers are dedicated to key OEM and ODM customers to ensure the high levels of customer service and to promote close collaboration and communication. Supporting the success of its customers through technological excellence, innovation and overall product quality are centerpieces of SMSC’s corporate strategy.

The Company also serves its customers with a worldwide network of field application engineers. These engineers assist customers in the selection and proper use of its products and are available to answer customer questions and resolve technical issues. The field application engineers are supported by factory application engineers, who work with both the customer’s and the Company’s factory design and product engineers to develop the requisite support tools and facilitate the introduction of new products.

 

The Company strives to make the “design-in” of its products as easy as possible for its customers. To facilitate this, SMSC offers a wide variety of support tools, including evaluation boards, sample firmware diagnostics programs, sample schematics and printed circuit board layout files, driver programs, data sheets, industry standard specifications and other documentation. These tools are readily available from the Company’s sales offices and sales representatives. SMSC’s home page on the World Wide Web (www.smsc.com) provides customers with immediate access to its latest product information. In addition, the Company maintains an electronic bulletin board so that registered customers can download software updates as needed. Customers are also provided with reference platform designs for many of the Company’s products, which enable easier and faster transitions from initial prototype designs through final production releases.

 

SMSC strategically markets and sells all of its products globally through a centrally-managed sales network using various channels in multiple geographic regions. SMSC conducts sales activities in the United States via a direct sales force, electronics distributors and manufacturers’ representatives. Two independent distributors are currently engaged to serve the majority of the North American market. Internationally, products are marketed and sold through regional sales offices located in Germany, Taiwan, China, Korea and Singapore as well as through a network of independent distributors and representatives. The Company serves the Japanese marketplace primarily through its Tokyo, Japan-based subsidiary, SMSC Japan.

 

Consistent with industry practice, most distributors have certain rights of return and price protection privileges on unsold products. Distributor contracts may be terminated by written notice by either party. The contracts specify the terms for the return of inventories. Shipments made by SMSC Japan to distributors in Japan are made under agreements that permit limited or no stock return or price protection privileges.

 

The Company generates a significant portion of its sales and revenues from international customers. While the demand for the Company’s products is primarily driven by the worldwide demand for personal computers, consumer electronics and infotainment, and industrial and other applications sold by U.S.-based suppliers, a significant portion of the Company’s products are sold to manufacturing subcontractors of those U.S.-based suppliers, and to distributors who serve to feed the high technology manufacturing pipeline, located in Asia. The Company expects that international shipments, particularly to Asian-based customers, will continue to represent a significant portion of its sales and revenues. See Part I Item 1.A. — Risk Factors — Business Concentration in Asia, for further discussion.

 

Markets & Strategy

 

The Company designs products that address specific applications for end products sold in three primary “vertical” markets:

 

 

SMSC serves industry leading PC customers in the Mobile and Desktop PC market with advanced I/O controllers, system controller devices, integrated microcontrollers, embedded I/O devices, PC-based server devices, USB2.0 hubs and environmental monitoring and control solutions. These products either facilitate transfer of content between system-level functions and PC peripherals or regulate temperature and power inside the system. Applications include laptop and desktop computers, media center PCs and docking stations.

 

Designs that serve the Consumer Electronics and Infotainment market provide connectivity or networking functions that allow data transfer or content sharing in consumer or automotive products. For instance, the Company provides USB2.0 hub, flash card reader and mass storage devices that may be embedded in LCD monitors, printers,

set-top boxes, digital televisions or gaming products to transfer content at high speeds. SMSC’s Ethernet networking products address system resource limitations and other challenges typical of embedded consumer electronics systems for applications such as digital televisions, DVD and hard disk drive based video recorders and digital media servers and adapters. Lastly, SMSC’s MOST technology enables the networking of infotainment systems in automobiles, such as a CD changer, radio, global positioning system, mobile telephone or a DVD player, by providing the means to distribute multimedia entertainment functions among various control devices in the car.

 

Customers in the Industrial and Other markets are primarily supported by the Company’s products that serve long life cycle embedded systems and those that require highly accurate signal transfer or industrial-level temperature monitoring functionality. SMSC provides Ethernet, ARCNET, CircLink^tm and Embedded I/O technology to address applications that include POS terminals, building and factory automation, security systems, industrial PCs, ATM machines and interactive kiosks.

 

The Company uses a highly integrated approach in developing its products, and discrete technologies developed by the Company are frequently integrated across many of its products and customer-specific applications. Further, the Company continuously explores and seeks opportunities to introduce new or existing products, either individually or in combination within systems and end products, for broader application within or across these “vertical” markets. Strategically, the Company believes that the integration of products and convergence of applications will be a continuing trend. The Company’s ability to anticipate and capitalize on these trends will be essential to its long-term success, and hence will continue to be a prime consideration in resource allocation decisions and the internal evaluation of the Company’s competitive and financial performance.

 

In executing this strategic approach, the Company is managed in a highly-integrated manner, and internal resources are allocated and corresponding investments are made in a manner which the Company believes will maximize total returns from product sales both individually (with respect to individual products or product families) and in the aggregate (a “portfolio” approach). Such returns are measured at the “project” level. The concept of “returns” as used by the Company encompasses both “turns” (i.e. pay-back multiple) and net present value metrics, as well as strategic considerations. Projects consist of either a single product offering (as would be the case for a new product launch) or a product family, consisting of multiple product variants stemming from an original design. Such variants can consist of relatively simple modifications to an original design, introduction of “next generation” capabilities and features and/or strategic integration(s) of new technologies into existing products.

 

Projected results for each project are evaluated independently for the impact on returns to SMSC as a whole, and the allocation of resources (particularly engineering and R&D investment) are based on the individual project economics. While the Company’s internal resources may be augmented or tempered depending on the business environment, product pipeline and other factors, such decisions are predicated on expected overall project returns and the corresponding impact on consolidated financial performance.

 

Given the proliferation of customer demand for products based on convergent technologies, especially among the Company’s current product offerings and core competencies, the opportunities to improve overall project/product returns with incremental investments are expected to increase. In addition, we believe that the continuous focus on such products and opportunities are strategic and key to the future success of the Company.

 

Acquisition of OASIS

 

On March 30, 2005, SMSC announced the acquisition of Karlsruhe, Germany-based OASIS, a leading provider of MOST technology, serving a top tier customer base of leading automakers and automotive suppliers. OASIS’ infotainment networking technology has been widely adopted by many European luxury and mid-market car brands, including Audi, BMW, DaimlerChrysler, Land Rover, Porsche, Saab and Volvo.

 

The initial cost of the acquisition at March 30, 2005 was approximately $118.6 million, including approximately $79.5 million of cash, 2.1 million shares of SMSC common stock, valued at $35.8 million, and an estimated $3.3 million of direct acquisition costs, including legal, banking, accounting and valuation fees. Included with the net assets acquired from OASIS was approximately $22 million of cash and cash equivalents; therefore SMSC’s initial net cash outlay for the transaction, including transaction costs, was approximately $60.5 million.

The terms of the agreement also provided the former OASIS shareholders the opportunity to earn up to $20 million of additional consideration, based upon achieving certain fiscal 2006 performance goals, the amount earned of which, if any, was indeterminable until February 28, 2006. Based upon fiscal 2006 performance, the Company has estimated that the former OASIS shareholders have earned an additional $17.8 million of consideration, consisting of approximately 0.2 million shares of SMSC common stock valued for accounting purposes as of February 28, 2006 at $5.4 million, and $12.4 million of cash, all of which was paid during the first quarter of fiscal 2007. SMSC’s existing cash balances were used as the source of the cash portion of the additional consideration. The aggregate, estimated value of this additional consideration was recorded as additional Goodwill and is also reflected within current liabilities on the Company’s consolidated balance sheet at February 28, 2006, and results in an aggregate purchase price for OASIS of $136.4 million as measured at February 28, 2006. See Part IV Item 15(a)(i) — Financial Statements — Note 4 and Note 20 for further discussion.

 

Geographic Information

 

The information below summarizes sales and revenues to unaffiliated customers for fiscal 2006, 2005 and 2004 by geographic region:

 

 

It is expected that in future periods sales and revenues will increase at a more rapid rate in geographic regions outside of the United States.

 

The Company’s long-lived assets include net property and equipment, goodwill and other intangible assets, deferred income taxes and various long-lived financial instruments. Net property, plant and equipment by geographic area consists of the following:

 

 

Intellectual Property

 

The Company believes that intellectual property is a valuable asset that has been, and will continue to be, important to the Company’s success. The Company has received numerous United States and foreign patents, or cross licenses to patents which relate to its technologies and additional patent applications are pending. The Company also has obtained certain domestic and international trademark registrations for its products and maintains certain details about its processes, products and strategies as trade secrets. It is the Company’s policy to protect these assets through reasonable means. To protect these assets, the Company relies upon nondisclosure agreements, contractual provisions, and patent, trademark, trade secret and copyright laws.

 

SMSC has patent cross-licensing agreements with more than thirty companies, including such semiconductor manufacturers as Intel Corporation, Micron Technology, Samsung Electronics Co., National Semiconductor Corporation and Toshiba Corporation, providing access to approximately 45,000 U.S. patents. Almost all of the Company’s cross-licensing agreements give SMSC the right to use patented intellectual property of the other companies royalty-free. SMSC also receives related payments from Intel. See Part IV Item 15(a) — Financial

Statements — Note 9, for further discussion on the Company’s agreement with Intel. In situations where the Company needs to acquire strategic intellectual property not covered by cross-licenses, the Company at times will seek to, and has entered into agreements to purchase or license the required intellectual property.

 

Backlog and Customers

 

The Company’s business is characterized by short-term order and shipment schedules, rather than long-term volume purchase contracts. The Company schedules production, the cycle for which is typically several months long, based generally upon a forecast of demand for its products, recognizing that subcontract manufacturers require long lead times to manufacture and deliver the Company’s final products. The Company modifies and rebalances its production schedules to actual demand as required. Sales are made primarily pursuant to purchase orders generally requiring delivery within one month, and at times, several months. Typical of industry practice, orders placed with the Company may be canceled or rescheduled by the customer on short notice without significant penalty. In addition, incoming orders and resulting backlog can fluctuate considerably during periods of perceived or actual semiconductor supply shortages or overages. As a result, the Company’s backlog may not be a reliable indicator of future sales and can fluctuate considerably.

 

From period to period, several key customers can account for a significant portion of the Company’s sales and revenues. Sales and revenues from significant customers for fiscal 2006, 2005 and 2004, stated as percentages of total sales and revenues, are summarized as follows:

 

 

 

 

The Company expects that a small number of larger customers will continue to account for a significant portion of its sales and revenues in fiscal 2007 and for the foreseeable future. The Company does not believe that the change in identity of the customers from 2005-2006 represents a fundamental change in its business, rather the change in top customers, in part, is due to certain end user customers changing the distributor from whom they purchase the Company’s products.

 

Employees

 

At February 28, 2006, the Company employed 767 individuals, including 165 in sales, marketing and customer support, 159 in manufacturing and manufacturing support, 320 in research and product development and 123 in administrative support and facility maintenance activities.

 

The Company’s future success depends in large part on the continued service of key technical and management personnel and on its ability to continue to attract and retain qualified employees, particularly highly skilled design, product and test engineers involved in manufacturing existing products and the development of new products. The competition for such personnel is intense.

 

The Company has never had a work stoppage. None of SMSC’s employees are represented by labor organizations, and the Company considers its employee relations to be positive.

 

Readers of this Annual Report on Form 10-K (“Report”) should carefully consider the risks described below, in addition to the other information contained in this Report and in the Company’s other reports filed or furnished with the SEC, including the Company’s prior and subsequent reports on Forms 10-Q and 8-K, in connection with any evaluation of the Company’s financial position, results of operations and cash flows.

 

The risks and uncertainties described below are not the only ones facing the Company. Additional risks and uncertainties not presently known or those that are currently deemed immaterial may also affect the Company’s operations. Any of the risks, uncertainties, events or circumstances described below could cause the Company’s financial condition or results of operations to be adversely affected.

 

THE COMPANY COMPETES IN COMPETITIVE INDUSTRIES AND HAS EXPERIENCED SIGNIFICANT VOLATILITY IN ITS STOCK PRICE

 

The Semiconductor Industry — The Company competes in the semiconductor industry, which has historically been characterized by intense competition, rapid technological change, cyclical market patterns, price erosion, periods of mismatched supply and demand and high volatility of results. The semiconductor industry has experienced significant economic downturns at various times in the past, characterized by diminished product demand and accelerated erosion of selling prices. In addition, many of the Company’s competitors in the semiconductor industry are larger and have significantly greater financial and other resources than the Company. General conditions in the semiconductor industry, and actions of specific competitors, could adversely affect the Company’s results.

 

The Personal Computer (“PC”) Industry — Demand for many of the Company’s products depends largely on sales of personal computers and peripheral devices. Reductions in the rate of growth of the PC market could adversely affect the Company’s operating results. In addition, as a component supplier to PC manufacturers, the Company may experience greater demand fluctuation than its customers themselves experience.

 

The PC industry is characterized by ongoing product changes and improvements, much of which is driven by several large companies whose own business strategies play significant roles in determining PC architectures. Future shifts in PC architectures may not always be anticipated or be consistent with the Company’s product design “roadmaps”.

 

The Company has a business strategy which involves targeting sales to market leading companies. These large companies also possess significant leverage in negotiating the terms and conditions of supply as a result of their market power. The Company may be forced in certain circumstances to accept potential liability exceeding the purchase price of the products sold by the Company, or various forms of potential consequential damages to avoid losing business to competitors. Such terms and conditions could adversely impact the revenues and margins earned by the Company.

 

Volatility of Stock Price — The volatility of the semiconductor industry has also been reflected historically in the market price of the Company’s common stock. The market price of the Company’s common stock can fluctuate significantly on the basis of such factors as the Company’s or its competitors’ introductions of new products, quarterly fluctuations in the Company’s financial results, announcements by the Company or its competitors of significant technical innovations, acquisitions, strategic partnerships, joint ventures or capital commitments; introduction of technologies or product enhancements that reduce the need for the Company’s products; the loss of, or decrease in sales to, one or more key customers; a large sale of stock by a significant shareholder; dilution from the issuance of the Company’s stock in connection with acquisitions; the addition or removal of our stock to or from a stock index fund; departures of key personnel; the required expensing of stock options or Stock Appreciation Rights (“SARs”); quarterly fluctuations in the Company’s guidance or in the financial results of other semiconductor companies; changes in the expectations of market analysts or investors, or general conditions in the semiconductor industry or in the financial markets. In addition, stock markets in general have experienced extreme price and volume volatility in recent years. This volatility has often had a significant impact on the stock prices of high technology companies, at times for reasons that appear unrelated to business performance.

The volatility of the stock price itself can impact the Company’s earnings because volatility is one measurement that is used in calculating the value of stock based compensation to employees. The value of such stock based compensation will be expensed for SMSC under the provisions of FAS 123(R) beginning in fiscal 2007. The impact of the adoption of FAS 123(R) is undetermined but is likely to have a material adverse impact on our results of operations. The impact of stock volatility on the new FAS 123(R) expense calculation is undetermined but generally higher volatility is expected to cause higher expenses.

 

THE COMPANY HAS LARGE CONCENTRATED CUSTOMERS AND MUST SATISFY DEMANDING PRICE, TECHNOLOGY AND QUALITY REQUIREMENTS

 

Product Development, Quality and Technological Change — The Company’s growth is highly dependent upon the successful development and timely introduction of new products at competitive prices and performance levels, with acceptable margins. The success of new products depends on various factors, including timely completion of product development programs, the availability of third party intellectual property on reasonable terms and conditions, market acceptance of the Company’s and its customers’ new products, achieving acceptable yields, securing sufficient capacity at a reasonable cost for the Company’s products and the Company’s ability to offer these new products at competitive prices.

 

The Company’s products are generally designed into its customers’ products through a competitive process that evaluates the Company’s product features, price, and many other considerations. In order to succeed in having the Company’s products incorporated into new products being designed by its customers, the Company seeks to anticipate market trends and meet performance, quality and functionality requirements of such customers and seeks to successfully develop and manufacture products that adhere to these requirements. In addition, the Company is expected to meet the timing and price requirements of its customers and must make such products available in sufficient quantities. There can be no assurance that the Company will be able to identify market trends or new product opportunities, develop and market new products, achieve design wins or respond effectively to new technological changes or product announcements by others.

 

Although the Company has significant processes and procedures in place in an attempt to guarantee the quality of its products, there can also be no assurance that the Company will not suffer unexpected yield or quality issues that could materially affect its operating results. The Company’s products are complex and may contain errors, particularly when first introduced or as new versions are released. The Company relies primarily on its in-house testing and quality personnel to design test operations and procedures to detect any errors prior to delivery of its products to its customers. Should problems occur in the operation or performance of the Company’s ICs, it may experience delays in meeting key introduction dates or scheduled delivery dates to its customers. These errors also could cause the Company to incur significant re-engineering costs, divert the attention of its engineering personnel from its product development efforts and cause significant customer relations and business reputation problems. Furthermore, a supply interruption or quality issue could result in claims by customers for recalls or rework of finished goods containing components supplied by the Company. Such claims can far exceed the revenues received by the Company for the sale of such products. Although the Company attempts to mitigate such risks via insurance, contractual terms, and maintaining buffer stocks of inventory, there can be no assurance that the Company will not receive such claims in the future, or that the Company will be able to maintain its customers if it refuses to be responsible for some portion of these claims.

 

As part of its product development cycle, the Company often is required to make significant investments well before it can expect to receive revenue from those investments. For example, investments to produce semiconductors for automotive companies, even if successful, may not result in a product appearing in an automobile and associated revenue until several years later. The long lead time between investment and revenue increases the risk associated with such investments. The Company’s operating results may be adversely affected if the product development cycle is delayed, or if the Company chooses the wrong products to invest in, or if product development costs exceed budgets.

 

The Company’s future growth will depend, among other things, upon its ability to continue to expand its product lines and products into new markets. To the extent that the Company attempts to compete in new markets, it may face competition from suppliers that have well-established market positions and products that have already

been proven to be technologically and economically competitive. There can be no assurance that the Company will be successful in displacing these suppliers in the targeted applications.

 

Price Erosion — The semiconductor industry is characterized by intense competition. Historically, average selling prices in the semiconductor industry generally, and for the Company’s products in particular, have declined significantly over the life of each product. While the Company expects to reduce the average prices of its products over time as it achieves manufacturing cost reductions, competitive and other pressures may require the reduction of selling prices more quickly than such cost reductions can be achieved. If not offset by reductions in manufacturing costs or by a shift in the mix of products sold toward higher-margin products, declines in the average selling prices could reduce profit margins.

 

Strategic Relationships with Customers — The Company’s future success depends in significant part on strategic relationships with certain of its customers. If these relationships are not maintained, or if these customers develop their own solutions, adopt a competitor’s solution, or choose to discontinue their relationships with SMSC, the Company’s operating results could be adversely affected.

 

In the past, the Company has relied on its strategic relationships with certain customers who are technology leaders in its target markets. The Company intends to pursue and continue to form these strategic relationships in the future. These relationships often require the Company to develop new products that typically involve significant technological challenges. The customers frequently place considerable pressure on the Company to meet their tight development schedules. Accordingly, the Company may have to devote a substantial portion of its resources to these strategic relationships, which could detract from or delay completion of other important development projects.

 

Customer Concentration and Shipments to Distributors — A limited number of customers account for a significant portion of the Company’s sales and revenues. The Company’s sales and revenues from any one customer can fluctuate from period to period depending upon market demand for that customer’s products, the customer’s inventory management of the Company’s products and the overall financial condition of the customer. Loss of an important customer could adversely impact the Company’s operating results.

 

A significant portion of the Company’s product sales are made through distributors. The Company’s distributors generally offer products of several different suppliers, including products that may be competitive with the Company’s products. Accordingly, there is risk that these distributors may give higher priority to products of other suppliers, thus reducing their efforts to sell the Company’s products. In addition, the Company’s agreements with its distributors are generally terminable at the distributor’s option. No assurance can be given that future sales by distributors will continue at current levels or that the Company will be able to retain its current distributors on acceptable terms. A reduction in sales efforts by one or more of the Company’s current distributors or a termination of any distributor’s relationship with the Company could have an adverse effect on the Company’s operating results.

 

Customers may decide to significantly alter their purchasing patterns, because we do not have material long-term purchase contracts with our customers and substantially all of our sales are being made on a purchase order basis, which permits our customers to cancel, change or delay product purchase commitments with little or no notice to us and without penalty. Also, we do not generally obtain letters of credit or other security for payment from customers or distributors. Accordingly, we are not protected against accounts receivable default or bankruptcy by these entities. Our ten largest customers or distributors represent a substantial majority of our accounts receivable. If any such customer or distributor were to become insolvent or otherwise not satisfy their obligations to us, we could be materially harmed.

 

Shipments to Original Design Manufacturers (“ODMs”) — As part of its strategy, the Company is attempting to sell more products directly to certain significant ODMs . Some of these ODMs previously purchased the Company’s products through distributors. The Company is making this change because it believes it can better service its customers, and more efficiently manage its business, as a result. The Company’s sales and margins may be adversely affected if the Company does not properly execute the transition from indirect to direct sales for the designated ODMs. It is also possible that the Company’s sales via its distributors may suffer as a result of this strategy.

Seasonality of the Business — The Company’s business historically has been subject to repeated seasonality, with the first and last quarters of each fiscal year tending to be weaker than the second and third quarters. The seasonality of the Company’s business may adversely impact the Company’s stock price and result in additional volatility in the business. Because the Company expects a certain degree of seasonality in its results, it may fail to recognize an actual downturn in its business, and continue to make investments or other business decisions that adversely affect its business in the future.

 

Credit Issues — The Company attempts to mitigate its credit risk by doing business only with creditworthy entities, and by managing the amount of credit extended to its customers. However, the Company may choose to extend credit to certain entities because it is necessary to support the requirements of an important customer or for other reasons. In the past the Company has had to take certain charges against earnings as a result of the inability of certain of its customers to pay for goods received. There can be no assurance that the Company will not incur similar charges in the future.

 

THE COMPANY’S ’FABLESS’ BUSINESS MODEL IS HEAVILY CONCENTRATED IN ASIA, DEPENDENT ON A SMALL NUMBER OF WAFER AND ASSEMBLY COMPANIES WITH SIGNIFICANT LEVERAGE, AND REQUIRES THE COMPANY TO COMMIT TO CERTAIN QUANTITIES TO SECURE CAPACITY

 

Business Concentration in Asia — A significant number of the Company’s foundries and subcontractors are located in Asia. Many of the Company’s customers also manufacture in Asia or subcontract to Asian companies. A significant portion of the world’s personal computer component and circuit board manufacturing, as well as personal computer assembly, occurs in Asia, and many of the Company’s suppliers and customers are based in, or do significant business in, Taiwan. In addition, many companies are expanding their operations in Asia in an attempt to reduce their costs, and the Company is also exploring relationships with companies in Asia as part of its ongoing efforts to make its supply chain more efficient. This concentration of manufacturing and selling activity in Asia, and in Taiwan in particular poses risks that could affect the supply and cost of the Company’s products, including currency exchange rate fluctuations, economic and trade policies and the political environment in Taiwan, China and other Asian communities. For example, legislation in the United States restricting or adding tariffs to imported goods could adversely affect the Company’s operating results.

 

The risk of earthquakes in Taiwan and the Pacific Rim region is significant due to the proximity of major earthquake fault lines in the area. We are not currently covered by insurance against business disruption caused by earthquakes as such insurance is not currently available on terms that we believe are commercially reasonable. Earthquakes, fire, flooding, lack of water or other natural disasters in Taiwan or the Pacific Rim region, or an epidemic, political unrest, war, labor strike or work stoppage in countries where our semiconductor manufacturers, assemblers and test subcontractors are located, likely would result in the disruption of our foundry, assembly or test capacity. There can be no assurance that such alternate capacity could be obtained on commercially reasonable terms, if at all.

 

Reliance upon Subcontract Manufacturing — The vast majority of the Company’s products are manufactured and assembled by independent foundries and subcontract manufacturers under a “fabless” model. This reliance upon foundries and subcontractors involves certain risks, including potential lack of manufacturing availability, reduced control over delivery schedules, the availability of advanced process technologies, changes in manufacturing yields and potential cost fluctuations. During downturns in the semiconductor economic cycle, reduction in overall demand for semiconductor products could financially stress certain of the Company’s subcontractors, and assemblers in particular experienced financial stress during the Company’s last fiscal year. If the financial resources of such independent subcontractors are stressed, the Company may experience future product shortages, quality assurance problems, increased manufacturing costs or other supply chain disruptions.

 

During upturns in the semiconductor cycle, it is not always possible to adequately respond to unexpected increases in customer demand due to capacity constraints. The Company may be unable to obtain adequate foundry, assembly or test capacity from third-party subcontractors to meet customers’ delivery requirements even if the Company adequately forecasts customer demand. The Company typically does not have supply contracts with its third-party vendors which obligate the vendor to perform services and supply products for a specific period, in specific quantities, and at specific prices. The Company’s third-party foundry, assembly and test subcontractors typically do not guarantee that adequate capacity will be available within the time required to meet customer

demand for products. In the event that these vendors fail to meet required demand for whatever reason, the Company expects that it would take up to twelve months to transition performance of these services to new providers. Such a transition may also require qualification of the new providers by the Company’s customers or their end customers.

 

Over the past year the Company received several unexpected price increases from several entities that assemble or package products. In the past there have been periods of shortage of capacity among companies that supply assembly services. Although the Company resists attempts by suppliers to increase prices, there can be no assurance that the Company’s margins will not be impacted in fiscal year 2007 or other future periods as a result of a shortage of capacity or price increases in assembly or other services. Because at various times the capacity of either wafer producers or assemblers can been limited, the Company may be unable to satisfy the demand of its customers, or may have to accept price increases or other compensation arrangements that increase its operating expenses and erode its margins.

 

Forecasts of Product Demand — The Company generally must order inventory to be built by its foundries and subcontract manufacturers well in advance of product shipments. Production is often based upon either internal or customer-supplied forecasts of demand, which can be highly unpredictable and subject to substantial fluctuations. Because of the volatility in the Company’s markets, there is risk that the Company may forecast incorrectly and produce excess or insufficient inventories. This inventory risk is increased by the trend for customers to place orders with shorter lead times and the customers’ ability to cancel or reschedule existing orders. In addition, the Company is sometimes the only supplier of a particular part to a customer. The value of the product line using the Company’s product may far exceed the value of the particular product sold by the Company to its customer. The Company may be forced to carry additional inventory of certain products to insure that its customers avoid production interruptions and to avoid claims being made by its customers for supply shortages.

 

Prior to purchasing the Company’s products, customers require that products undergo an extensive qualification process, which involves testing of the products in the customer’s system as well as rigorous reliability testing. This qualification process may continue for six months or longer. However, qualification of a product by a customer does not ensure any sales of the product to that customer. Even after successful qualification and sales of a product to a customer, a subsequent revision to the integrated circuit or software, changes in the integrated circuit’s manufacturing process or the selection of a new supplier by us may require a new qualification process, which may result in delays and in us holding excess or obsolete inventory. After products are qualified, it can take an additional six months or more before the customer commences volume production of components or devices that incorporate these products. Despite these uncertainties, the Company devotes substantial resources, including design, engineering, sales, marketing and management efforts, toward qualifying its products with customers in anticipation of sales. If the Company is unsuccessful or delayed in qualifying any products with a customer, such failure or delay would preclude or delay sales of such product to the customer, which may impede the Company’s growth and cause its business to suffer.

 

THE COMPANY’S SUCCESS DEPENDS ON THE EFFECTIVENESS OF ITS ACQUISITIONS, RETAINING AND INTEGRATING KEY PERSONNEL, AND MANAGING INTELLECTUAL PROPERTY RISKS

 

Strategic Business Acquisitions — The Company has made strategic acquisitions of complementary businesses, products and technologies in the past, including the OASIS acquisition in 2005, and may continue to pursue such acquisitions in the future as business conditions warrant. Business acquisitions can involve numerous risks, including: unanticipated costs and expenses; risks associated with entering new markets in which the Company has little or no prior experience; diversion of management’s attention from its existing businesses; potential loss of key employees, particularly those of the acquired business; differences between the culture of the acquired company and the Company, difficulties in integrating the new business into the Company’s existing businesses, potential dilution of future earnings; and future impairment and write-offs of purchased goodwill, other intangible assets, and fixed assets due to unforeseen events and circumstances. Although the Company believes it has managed the OASIS acquisition well to date, there is no guarantee that the OASIS or other acquisitions in the future will produce the benefits intended. Future acquisitions also could cause the Company to incur debt or contingent liabilities or cause the Company to issue equity securities that could negatively impact the ownership percentages of existing shareholders.

Protection of Intellectual Property — The Company has historically devoted significant resources to research and development activities and believes that the intellectual property derived from such research and development is a valuable asset that has been, and will continue to be, important to the Company’s success. The Company relies upon nondisclosure agreements, contractual provisions and patent and copyright laws to protect its proprietary rights. No assurance can be given that the steps taken by the Company will adequately protect its proprietary rights. During its history, the Company has executed patent cross-licensing agreements with many of the world’s largest semiconductor suppliers, under which the Company receives and conveys various intellectual property rights. Many of these agreements are still effective. The Company could be adversely affected should circumstances arise that results in the early termination of these agreements. In addition, the Company also frequently licenses intellectual property from third parties to meet specific needs as it develops its product portfolio. The Company’s competitive position and its results could be adversely affected if it is unable to license desired intellectual property at all, or on commercially reasonable terms.

 

Infringement and Other Claims — Companies in the semiconductor industry often aggressively protect and pursue their intellectual property rights. From time to time, the Company has received, and expects to continue to receive notices claiming that the Company has infringed upon or misused other parties’ proprietary rights. The Company has also in the past received, and may again in the future receive, notices of claims related to business transactions conducted with third parties, including asset sales and other divestitures.

 

If it is determined that the Company’s products or processes were to infringe on other parties’ intellectual property rights, a court might enjoin the Company from further manufacture and/or sale of the affected products. The Company would then need to obtain a license from the holders of the rights and/or reengineer its products or processes in such a way as to avoid the alleged infringement. There can be no assurance that the Company would be able to obtain any necessary license on commercially reasonable terms acceptable to the Company or that the Company would be able to reengineer its products or processes to avoid infringement. An adverse result in litigation arising from such a claim could involve the assessment of a substantial monetary award for damages related to past product sales that could have a material adverse effect on the Company’s result of operations and financial condition. In addition, even if claims against the Company are not valid or successfully asserted, defense against the claims could result in significant costs and a diversion of management and resources. The Company might also be forced to settle such a claim even if not valid as a result of pressure from its customers, because of the expense of defense, or because the risk of contesting such a claim is simply too great. Such settlements could adversely affect the Company’s profitability.

 

Dependence on Key Personnel — The success of the Company is dependent in large part on the continued service of its key management, engineering, marketing, sales and support employees. Competition for qualified personnel is intense in the semiconductor industry, and the loss of current key employees, or the inability of the Company to attract other qualified personnel, including the inability to offer competitive stock-based and other compensation, could hinder the Company’s product development and ability to manufacture, market and sell its products. We believe that our future success will be dependent on retaining the services of our key personnel, developing their successors and certain internal processes to reduce our reliance on specific individuals, and on properly managing the transition of key roles when they occur.

 

THE COMPANY’S RESULTS COULD BE ADVERSELY AFFECTED FROM FAILURE TO COMPLY WITH LEGAL AND REGULATORY REQUIREMENTS

 

Internal Controls Over Financial Reporting — Section 404 of the Sarbanes-Oxley Act of 2002 requires the Company to evaluate the effectiveness of its system of internal controls over financial reporting as of the end of each fiscal year, beginning with fiscal 2005, and to include a report by management assessing the effectiveness of its system of internal controls over financial reporting within its annual report. Section 404 also requires the Company’s independent registered public accounting firm to attest to, and report on, management’s assessment of the Company’s system of internal controls over financial reporting.

 

The Company’s management does not expect that its system of internal controls over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must recognize that there are resource constraints, and the benefits of controls must be considered relative to

their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, involving the Company have been, or will be, detected. These inherent limitations include faulty judgments in decision-making and breakdowns that may occur because of simple error or mistake. Controls can also be circumvented by individual acts, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and the Company cannot provide assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. In addition, because of the Company’s revenue recognition policies, the accuracy of the Company’s financial statements is dependent on data received from third party distributors (refer to Part I Item 7. — Management’s Discussion and Analysis of Financial Condition and Results of Operations, for further discussion). Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected. In addition, as described in greater detail in Part II Item 9.A. — Controls and Procedures, management has excluded from its assessment of internal controls certain elements of the internal control over financial reporting for those parts of its business that were acquired via the purchase of OASIS.

 

Although the Company’s management has concluded that its system of internal controls over financial reporting was effective as of February 28, 2006, there can be no assurance that the Company or its independent registered public accounting firm will not identify a material weakness in the system of internal controls over financial reporting in the future. A material weakness in the Company’s system of internal controls over financial reporting would require management and the Company’s independent registered public accounting firm to evaluate the Company’s system of internal controls as ineffective. This in turn could lead to a loss of public confidence, which could adversely affect the Company’s business and the price of its common stock.

 

Corporate Governance — In recent years, the Nasdaq National Market, on which the Company’s common stock is listed, has adopted comprehensive rules and regulations relating to corporate governance. These laws, rules and regulations have increased, and may continue to increase, the scope, complexity and cost of the Company’s corporate governance, reporting and disclosure practices. Failure to comply with these rules and regulations could adversely affect the Company, and in a worst case, result in the delisting of its stock. As a result of these rules, the Company’s board members, Chief Executive Officer, Chief Financial Officer and other corporate officers could also face increased risks of personal liability in connection with the performance of their duties. As a result, the Company may have difficulty attracting and retaining qualified board members and officers, which would adversely affect its business. Further, these developments could affect the Company’s ability to secure desired levels of directors’ and officers’ liability insurance, requiring the Company to accept reduced insurance coverage or to incur substantially higher costs to obtain coverage.

 

Changes in Accounting for Equity Compensation — The Company has historically used stock options as a key component of employee compensation in order to align employees’ interests with the interests of its stockholders, encourage employee retention, and provide competitive compensation packages. The Financial Accounting Standards Board (“FASB”) has recently adopted changes to generally accepted accounting principles known as Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-Based Payment (revised 2004) (“SFAS 123(R)”) that will require a charge to earnings for employee stock option grants and other equity incentives beginning in the first quarter of fiscal 2007. To the extent that this or other new regulations make it more difficult or expensive to grant options to employees, the Company may incur increased compensation costs. The Company may also consider changes to its equity compensation strategy and find it more difficult to attract, retain and motivate employees. Any of these results could materially and adversely affect the Company’s business.

 

Environmental Regulation — Environmental regulations and standards are established worldwide to control discharges, emissions, and solid wastes from manufacturing processes. Within the United States, federal, state and local agencies establish these regulations. Outside of the United States, individual countries and local governments establish their own individual standards. The Company believes that its activities conform to present environmental regulations and historically the effects of this compliance have not had a material effect on the Company’s capital expenditures, operating results, or competitive position. Future environmental compliance requirements, as well as amendments to or the adoption of new environmental regulations or the occurrence of an unforeseen circumstance

could subject the Company to fines or require the Company to acquire expensive remediation equipment or to incur other expenses to comply with environmental regulations.

 

The Company has received no written comments from the SEC staff regarding its periodic or current reports as filed under the Securities Exchange Act of 1934, nor on any filings made pursuant to the Securities Act of 1933, that remain unaddressed or unresolved as of the filing date of this Report.

 

SMSC’s headquarters facility is located in Hauppauge, New York, where it owns a 200,000 square foot building and conducts research, development, product testing, warehousing, shipping, marketing, selling and administrative activities.

 

During the first quarter of fiscal 2007, the Company will complete the expansion of its owned Hauppauge, New York facility that will increase the utilization of the building, previously occupying 80,000 square feet, to approximately 200,000 square feet (the entirety of that facility). During fiscal 2006, the Company leased a separate 50,000 square foot facility located in Hauppauge New York while it progressed toward the completion of this expansion project. The Company currently estimates that the final cost of this expansion will be approximately $24 million, of which $19.3 million had been expended through February 28, 2006.

 

In addition, the Company maintains offices in leased facilities as follows:

 

The Company believes that all of its facilities are in good condition, adequate for intended use and sufficient for its immediate needs. The Company will not renew its Hauppauge, New York facility lease, but does expect to renew the lease on its Munich, Germany and Tokyo, Japan offices. It is not certain whether the Company will negotiate new leases on its other facilities as existing leases expire. Such determinations will be made as existing leases approach expiration and will be based on an assessment of requirements and market conditions at that time. Further, management believes that additional space can be obtained, if necessary, based on prior experience and current and expected real estate market conditions.

 

From time to time as a normal consequence of doing business, various claims and litigation may be asserted or commenced against the Company. In particular, the Company in the ordinary course of business may receive claims that its products infringe the intellectual property of third parties, or that customers have suffered damage as a result of defective products allegedly supplied by the Company. Due to uncertainties inherent in litigation and other claims, the Company can give no assurance that it will prevail in any such matters, which could subject the Company to significant liability for damages and/or invalidate its proprietary rights. Any lawsuits, regardless of their success, would likely be time-consuming and expensive to resolve and would divert management’s time and attention, and an adverse outcome of any significant matter could have a material adverse effect on the Company’s consolidated results of operations or cash flows in the quarter or annual period in which one or more of these matters are resolved. The Company believes that at this time there is no pending or threatened litigation that is likely to have a material adverse effect on the Company.

 

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended February 28, 2006.

 

Market Information and Holders

 

The Company’s common stock is traded in the over-the-counter market under the NASDAQ symbol SMSC. Trading is reported in the NASDAQ National Market. There were approximately 942 holders of record of the Company’s common stock at February 28, 2006.

 

The following table sets forth the high and low trading prices, for the periods indicated, for SMSC’s common stock as reported by the NASDAQ National Market System:

 

 

Dividend Policy

 

The present policy of the Company is to retain earnings to provide funds for the operation and expansion of its business. The Company has never paid a cash dividend, and does not currently expect to pay cash dividends in the foreseeable future.

Securities Authorized for Issuance Under Equity Compensation Plans

 

The information under the caption “Equity Compensation Plan Information,” appearing in the 2006 Proxy Statement related to the 2006 Annual Meeting of Stockholders (the 2006 Proxy Statement), is hereby incorporated by reference. For additional information on the Company’s stock-based compensation plans, refer to Part IV Item 15(a) — Financial Statements — Note 15.

 

Common Stock Repurchase Program

 

In October 1998, the Company’s Board of Directors approved a common stock repurchase program, allowing the Company to repurchase up to one million shares of its common stock on the open market or in private transactions. In July 2000, the authorization was expanded from one million shares to two million shares and in July 2002 the authorization was expanded from two million shares to three million shares. As of February 28, 2006, the Company has repurchased approximately 2.0 million shares of its common stock at a cost of $26.0 million under this program, including 150,000 shares repurchased at a cost of $2.2 million in fiscal 2006 (none in the fourth quarter), and 21,800 shares repurchased at a cost of $0.3 million in fiscal 2005. No shares were repurchased during fiscal 2004. The Company currently holds repurchased shares as treasury stock, reported at cost.

 

Standard Microsystems Corporation and Subsidiaries
SELECTED FINANCIAL DATA

 

This selected financial data should be read in conjunction with the financial statements as set forth in Part IV Item 15(a) — Financial Statements and Part II. Item 7. — Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

The operating results presented above reflect:

 

 

GENERAL

 

The following discussion should be read in conjunction with the Company’s consolidated financial statements and accompanying notes, included in Part IV Item 15(a) — Financial Statements, of this Report.

 

Forward-Looking Statements

 

Portions of this Report may contain forward-looking statements, within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, that are based on management’s beliefs and assumptions, current expectations, estimates and projections. Such statements, including statements relating to the Company’s expectations for future financial performance, are not considered historical facts and are considered forward-looking statements under the federal securities laws. Words such as “believe,” “expect,” “anticipate” and similar expressions identify forward-looking statements. These risks and related uncertainties may cause the Company’s actual future results to be materially different from those discussed in forward-looking statements. The Company’s risks and uncertainties include the timely development and market acceptance of new products; the impact of competitive products and pricing; the Company’s ability to procure capacity from suppliers and the timely performance of their obligations, the effects of changing economic conditions domestically and internationally and on its customers; changes in customer order patterns, relationships with and dependence on customers and growth rates in the personal computer, consumer electronics and embedded and automotive markets and within the Company’s sales channel; changes in customer order patterns, including order cancellations or reduced bookings; the effects of tariff, import and currency regulation; potential or actual litigation; and excess or obsolete inventory and variations in inventory valuation, among others. In addition, SMSC competes in the semiconductor industry, which has historically been characterized by intense competition, rapid technological change, cyclical market patterns, price erosion and periods of mismatched supply and demand.

 

The Company’s forward looking statements are qualified in their entirety by the inherent risks and uncertainties surrounding future expectations and may not reflect the potential impact of any future acquisitions, mergers or divestitures. All forward-looking statements speak only as of the date hereof and are based upon the information available to SMSC at this time. Such statements are subject to change, and the Company does not undertake to update such statements, except to the extent required under applicable law and regulation. These and other risks and uncertainties, including potential liability resulting from pending or future litigation, are detailed from time to time in the Company’s periodic and current reports as filed with the SEC. Readers are advised to review other sections of this Report, including Part I Item 1.A. — Risk Factors, for a more complete discussion of these and other risks and uncertainties. Other cautionary statements and risks and uncertainties may also appear elsewhere in this Report.

 

Description of Business

 

Standard Microsystems Corporation (the “Company” or “SMSC”) designs and sells a wide variety of silicon-based integrated circuits that incorporate digital or analog signal processing technologies, or both (referred to as “mixed-signal”).

 

The Company’s integrated circuits and systems provide a wide variety of signal processing attributes that are incorporated by its globally diverse customers into a wide variety of end products in the mobile and desktop personal computer (“PC”), consumer electronics and infotainment, and industrial and other markets. These semiconductor products generally provide connectivity, networking, or input/output control solutions for a variety of high-speed communication, computer and related peripheral, consumer electronic device, industrial control system, or auto infotainment applications. The market for these solutions is increasingly diverse, and the Company’s various technologies are increasingly used in various combinations and in alternative applications.

 

CRITICAL ACCOUNTING POLICIES & ESTIMATES

 

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and

disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of sales and revenues and expenses during the reporting period.

 

SMSC believes the following critical accounting policies and estimates are important to the portrayal of the Company’s financial condition, results of operations and cash flows, and require critical management judgments and estimates about matters that are inherently uncertain. Although management believes that its judgments and estimates are appropriate and reasonable, actual future results may differ from these estimates, and to the extent that such differences are material, future reported operating results may be affected.

 

Revenue Recognition

 

Sales and revenues and associated gross profit from shipments to the Company’s distributors, other than to distributors in Japan, are deferred until the distributors resell the products. Shipments to distributors, other than to distributors in Japan, are made under agreements allowing price protection and limited rights to return unsold merchandise. In addition, SMSC’s shipments to its distributors may be subject from time to time to short-term fluctuations as distributors manage their inventories to current levels of end-user demand. Therefore, SMSC considers the policy of deferring revenue on shipments to distributors to be a more meaningful presentation of the Company’s operating results, as it allows investors to better understand end-user demand for the products that SMSC sells through distribution channels, and it better focuses the Company on end-user demand. This policy is a common practice within the semiconductor industry. The Company’s revenue recognition is therefore highly dependent upon receiving pertinent, accurate and timely data from its distributors. Distributors routinely provide the Company with product, price, quantity and end customer data when products are resold, as well as report the quantities of the Company’s products that are still in their inventories. In determining the appropriate amount of revenue to recognize, the Company uses this data and applies judgment in reconciling any differences between the distributors’ reported inventories and shipment activities. Although this information is reviewed and verified for accuracy, any errors or omissions made by the Company’s distributors and not detected by the Company, if material, could affect reported operating results.

 

Shipments made by the Company’s Japanese subsidiary to distributors in Japan are made under agreements that permit limited or no stock return or price protection privileges. SMSC recognizes revenue from product sales to distributors in Japan, and to original equipment manufacturers (OEMs), at the time of shipment, net of appropriate reserves for product returns and allowances. For these revenues, the Company must make assumptions and estimates of future product returns and sales allowances, and any differences between those estimates and actual results, if material, could affect reported operating results.

 

Inventories

 

The Company’s inventories are comprised of complex, high technology products that may be subject to rapid technological obsolescence and which are sold in a highly competitive industry. Inventories are valued at the lower of first-in, first-out cost or market, and are reviewed for product obsolescence and impairment in value, based upon assumptions of future demand and market conditions. The Company often receives orders from customers and distributors requesting delivery of product on relatively short notice and with lead times that are shorter than the manufacturing cycle time. In order to provide competitive delivery times to its customers, the Company builds and stocks a certain amount of inventory in anticipation of customer demand that may or may not materialize. Historically, forecasts of customer demand, particularly at a part-number level, are challenging and can vary significantly from actual future demand. In addition, as is common in the semiconductor industry, customers may be allowed to cancel orders with minimal advance notice. These dynamics create risks that the Company may forecast incorrectly and consequently produce excess or insufficient inventories.

 

When it is determined that specific inventory is stated at a higher value than that which can be recovered, the Company writes this inventory down to its estimated realizable value with a charge to costs of goods sold. While the Company endeavors to appropriately forecast customer demand and stock commensurate levels of inventory, unanticipated inventory write-downs may be required in future periods relating to inventory on hand as of any reported balance sheet.

Allowance for Doubtful Accounts

 

The Company maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. These estimated losses are based upon historical bad debts, specific customer creditworthiness and current economic trends. The Company regularly performs credit evaluations consisting primarily of reviews of its customers’ financial condition, using information provided by the customers as well as publicly available information, if any. If the financial condition of an individual customer or group of customers deteriorates, resulting in such customers’ inability to make payments within approved credit terms, additional allowances may be required.

 

Valuation of Long-Lived Assets

 

Long-lived assets, including property, plant and equipment, and intangible assets, are monitored and reviewed for impairment in value whenever events or changes in circumstances indicate that the carrying amount of any such asset may not be recoverable. The determination of recoverability is based on an estimate of undiscounted cash flows expected to result from the use of the related asset and its eventual disposition. The estimated cash flows are based upon, among other things, certain assumptions about expected future operating performance, growth rates and other factors. Estimates of undiscounted cash flows may differ from actual cash flows due to factors such as technological changes, economic conditions, and changes in the Company’s business model or operating performance. If at the time of such evaluation the sum of expected undiscounted cash flows (excluding interest) is below the carrying value, an impairment loss is recognized, which is measured as the amount by which the carrying value exceeds the fair value of the asset.

 

Goodwill is tested for impairment in value annually, as well as when an event or circumstance occurs indicating a possible impairment in value. The Company completed its most recent annual goodwill impairment review during the fourth quarter of fiscal 2006, during which no impairment in value was identified. Unless an indicator of impairment is identified earlier, the next goodwill impairment review will be performed in the fourth quarter of fiscal 2007.

 

Marketable and non-marketable long-term equity investments are also monitored for indications of impairment in value. The Company records an impairment charge against these investments when the investment is judged to have experienced a decline in value that is other than temporary. Judgments regarding the value of non-marketable equity investments are subjective and dependent upon management’s assessment of the performance of the investee and its prospects for future success. During the third quarter of fiscal 2003, impairment charges totaling $16.3 million were recorded against two such investments, both of which were subsequently sold during fiscal 2004. As of February 28, 2006, the Company had no significant long-term equity investments.

 

Income Taxes

 

Accounting for income tax obligations requires the recognition of deferred tax assets and liabilities, using enacted tax rates, for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. Deferred tax assets resulting from these differences must be reduced by a valuation allowance if it is more likely than not that some or all of the deferred tax assets will not be realized.

 

The Company regularly evaluates the realizability of its deferred tax assets by assessing its forecasts of future taxable income and reviewing available tax planning strategies that could be implemented to realize the deferred tax assets. At February 28, 2006, the Company had $25.8 million of deferred tax assets (considered fully realizable) and $9.8 million of deferred tax liabilities. Factors that may affect the Company’s ability to achieve sufficient future taxable income for purposes of realizing its deferred tax assets include declines in sales and revenues or gross profit, increased competition and loss of market share, delays in product availability, and technological obsolescence.

 

Legal Contingencies

 

From time to time, the Company is subject to legal proceedings and claims, including claims of alleged infringement of patents and other intellectual property rights and other claims arising in the ordinary course of business. These contingencies require management to assess the likelihood and possible cost of adverse judgments

or outcomes. Liabilities for legal contingencies are accrued when it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated. There can be no assurance that any third-party assertions against the Company will be resolved without costly litigation, in a manner that is not adverse to its financial position, results of operations or cash flows. In addition, the resolution of any future intellectual property litigation may subject the Company to royalty obligations, product redesigns or discontinuance of products, any of which could adversely impact future profitability.

 

Recent Accounting Pronouncements

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Accounting for Share-Based Payments (“SFAS 123(R)”). The scope of SFAS 123(R) includes a wide range of share-based compensation arrangements including stock options, restricted stock plans, performance-based awards, stock appreciation rights, and employee stock purchase plans. SFAS 123(R) replaces SFAS 123, Accounting for Stock-Based Compensation, (“SFAS 123”) and supersedes Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”). SFAS 123, as originally issued in 1995, established as preferable a fair-value-based method of accounting for share-based payment transactions with employees. However, that statement permitted the option of continuing to apply the guidance in APB 25, provided that the footnotes to the consolidated financial statements disclosed pro forma net income and net income per share, as if the preferable fair-value-based method had been applied. SFAS 123(R) requires that compensation costs relating to share-based payment transactions be recognized in the consolidated financial statements. Compensation costs will be measured based on the fair value of the equity or liability instruments issued. SFAS 123(R) is effective for the first annual reporting period that begins after June 15, 2005 (SMSC’s fiscal year ending February 28, 2007). The Company is currently evaluating the impact of SFAS 123(R), but believes that the adoption of this statement will likely have a material adverse impact on its consolidated financial position, results of operations and cash flows.

 

In November 2005, the FASB issued FASB Staff Position (“FSP”) Nos. FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which provides guidance on determining when investments in certain debt and equity securities are considered impaired, whether that impairment is other-than-temporary, and the measurement of an impairment loss. This FSP also includes accounting considerations subsequent to the recognition of an other-than temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The FSP is required to be applied to reporting periods beginning after December 15, 2005 (SMSC’s fiscal quarter ending May 31, 2006). The Company does not expect the adoption of this FSP in the first quarter of fiscal 2007 to have a material impact on its consolidated financial statements.

 

In June 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections (“SFAS 154”), which changes the requirements for the accounting for and reporting of voluntary changes in accounting principles. SFAS 154 requires retrospective application to prior periods’ consolidated financial statements of changes in accounting principles, unless impracticable. SFAS 154 supersedes APB Opinion No. 20, Accounting Changes (“APB 20”), which previously required that most voluntary changes in accounting principles be recognized by including in the current period’s net income the cumulative effect of changing to the new accounting principle. SFAS 154 also makes a distinction between retrospective application of an accounting principle and the restatement of consolidated financial statements to reflect the correction of an error. SFAS 154 carries forward without changing the guidance contained in APB 20 for reporting the correction of an error in previously issued consolidated financial statements and a change in accounting estimate. SFAS 154 applies to voluntary changes in accounting principles that are made in fiscal years beginning after December  15, 2005 (SMSC’s fiscal year ending February 28, 2007). The Company does not expect the adoption of SFAS 154 in the first quarter of fiscal 2007 to have a material impact on its consolidated financial statements.

 

BUSINESS ACQUISITION

 

On March 30, 2005, SMSC announced the acquisition of Karlsruhe, Germany-based OASIS SiliconSystems Holding AG (“OASIS”), a leading provider of Media Oriented Systems Transport (“MOST^®” or “MOST”) technology, serving a top tier customer base of leading automakers and automotive suppliers. OASIS’ infotainment

networking technology has been widely adopted by many European luxury and mid-market car brands, including Audi, BMW, DaimlerChrysler, Land Rover, Porsche, Saab and Volvo.

 

The initial cost of the acquisition at March 30, 2005 was approximately $118.6 million, including approximately $79.5 million of cash, 2.1 million shares of SMSC common stock, valued at $35.8 million, and an estimated $3.3 million of direct acquisition costs, including legal, banking, accounting and valuation fees. Included with the net assets acquired from OASIS was approximately $22 million of cash and cash equivalents; therefore SMSC’s initial net cash outlay for the transaction, including transaction costs, was approximately $60.5 million.

 

The terms of the agreement also provided the former OASIS shareholders the opportunity to earn up to $20 million of additional consideration, based upon achieving certain fiscal 2006 performance goals, the amount earned of which, if any, was indeterminable until February 28, 2006. Based upon fiscal 2006 performance, the Company determined that the former OASIS shareholders earned an additional $17.8 million of consideration, consisting of approximately 0.2 million shares of SMSC common stock valued for accounting purposes as of February 28, 2006 at $5.4 million, and $12.4 million of cash, all of which was paid during the first quarter of fiscal 2007. SMSC’s existing cash balances were used to fund the cash portion of the additional consideration. This additional consideration was recorded as additional Goodwill and a corresponding liability was reflected within current liabilities on the Company’s consolidated balance sheet at February 28, 2006, resulting in an aggregate purchase price for OASIS of $136.4 million. Refer to Part IV Item 15(a) — Financial Statements — Note 20, for additional information on the final computation and settlement of this obligation.

 

RESULTS OF OPERATIONS

 

Fiscal Year Ended February 28, 2006 Compared to Fiscal Year Ended February 28, 2005

 

Sales and Revenues

 

SMSC’s sales and revenues are comprised of sales of products across three strategically targeted “vertical” end-markets, as well as intellectual property revenues (consisting of royalties and similar contractual payments), as presented in the following table for fiscal 2006 and 2005 (dollars in millions):

 

 

The Company’s sales and revenues for fiscal 2006 were $319.1 million, consisting of $308.3 million of product sales and $10.8 million of intellectual property revenues, compared to fiscal 2005 sales and revenues of $208.8 million, consisting of $197.8 million of product sales and $11.0 million of intellectual property revenues. Product sales in fiscal 2006 include $52.8 million of sales from shipments of OASIS products subsequent to the March 30, 2005 acquisition date.

 

Sales of Mobile and Desktop PC products increased by approximately $41.3 million or 36.1% in fiscal 2006, driven primarily by an increase in sales of Mobile PC products reflecting strong market demand in mobile computing applications, as well as increased sales of Environmental Monitoring and Control (“EMC”) products, as the Company broadened its EMC product offerings in fiscal 2006. Sales of Mobile PC products in fiscal 2006 also included $1.1 million of sales associated with a prior accounts receivable collectibility issue, as more fully described below. SMSC’s sales of Desktop PC products were up modestly in fiscal 2006, despite softer market demand for desktop PCs.

 

Sales from Mobile PC product shipments were adversely impacted in fiscal 2005 by an accounts receivable collectibility issue with one of the Company’s Taiwan-based component distributors. In the third quarter of fiscal

2005, the Company determined that this long-time customer, whose credit and payment history with the Company had consistently been satisfactory, was experiencing financial distress and a lack of liquidity. As collectibility was not reasonably assured, the Company deferred recognition of approximately $5.4 million of product sales and corresponding trade receivables for shipments made to this distributor during the second half of fiscal 2005. The related inventory for these product sales, at a cost of approximately $2.7 million, had already been shipped to and resold by the distributor prior to identification of the collectibility issue and was fully charged to costs of goods sold in fiscal 2005. As the financial condition of this customer is still uncertain, the Company has ceased conducting business with this distributor. Future recovery of the remaining unpaid obligation to SMSC is as yet uncertain. The Company successfully arranged alternate channels for delivery of these products to its end customers, and no disruption occurred in the supply of the Company’s products.

 

Sales of Consumer Electronics and Infotainment products increased by approximately $70.9 million or 198.0%, primarily as a result of the March 2005 acquisition of OASIS (approximately $52.7 million of the noted increase), as well as stronger sales of connectivity and networking products for consumer electronics applications. Expanded product offerings of connectivity and networking products in fiscal 2006 accounted for most of the organic sales growth in this end-market this fiscal year.

 

Industrial and Other sales primarily represent sales from products used within industrial information networking and server applications in various business, service, factory, transportation and telecommunications environments. Sales of Industrial and Other products declined $1.7 million, or 3.6%, to $45.9 million, as a decrease in market demand for SMSC’s embedded computing designs was experienced and only partially offset by increased demand for embedded networking technology. The Company expects that overall industrial market adoption rates of embedded technology and market penetration due to enhanced product offerings will increase in the future.

 

Intellectual property revenues include $10.3 million and $10.0 million in fiscal 2006 and 2005, respectively, received from Intel Corporation pursuant to the terms of a September 2003 business agreement. Intellectual property revenues for fiscal 2006 include payments under this agreement of $2.5 million in the first, second and third quarters and $2.8 million in the fourth quarter. Fiscal 2005 results include the payments of $2.5 million in each of the fiscal year’s quarterly periods.

 

Sales and revenues by geographic region for fiscal years 2006 and 2005 were as follows:

 

 

Intellectual property revenues received from Intel are included within the United States. The increase in Germany is primarily due to the OASIS acquisition.

 

Product sales to electronic component distributors were reflected in the table above based on the geographic location of their respective operations; the geographic locations of the end customers may differ.

 

The Company expects international shipments, particularly to Asia, to continue to represent a significant portion of its sales and revenues for the foreseeable future. A significant portion of the world’s high technology manufacturing and assembly activity occurs in Asia, where many of the Company’s significant customers conduct business.

 

Costs of Goods Sold

 

Costs of goods sold include: the purchase cost of finished silicon wafers manufactured by independent foundries (including mask and tooling costs); costs of assembly, packaging, and mechanical and electrical testing; manufacturing overhead; quality assurance and other support overhead (including costs of personnel and equipment

associated with manufacturing support); royalties paid to developers of intellectual property incorporated into the Company’s products; and adjustments for excess, slow-moving or obsolete inventories.

 

Costs of goods sold for fiscal 2006 were $172.3 million, or 54.0% of sales and revenues, compared to $114.1 million, or 54.6% of sales and revenues, in fiscal 2005. Excluding intellectual property revenues, costs of goods sold were 55.9% of product sales in fiscal 2006, as compared to 57.7% in fiscal 2005.

 

The decrease in costs of goods sold as a percentage of revenues in fiscal 2006, compared to fiscal 2005, resulted from a combination of (i) the lower costs of goods sold as a percentage of sales associated with OASIS products and (ii) $1.1 million of revenue recognized during the current year period without any associated costs of goods sold, in connection with the previously discussed prior accounts receivable collectibility issue (see “Sales and Revenues” discussion above). Partially offsetting these favorable factors were (i) declines in average selling prices on certain desktop I/O product margins, as declines in average selling prices outpaced reductions in unit costs, and (ii) $0.8 million of higher provisions for compensation expense related to stock appreciation rights (“SARs”).

 

Research and Development Expenses

 

Research and development (“R&D”) expenses consist primarily of salaries and related costs of employees engaged in research, design and development activities, costs related to engineering design tools and computer hardware, subcontractor costs and device prototyping costs. The Company’s R&D activities are performed by highly-skilled and experienced engineers and technicians, and are primarily directed towards the design of new integrated circuits; the development of new software drivers, firmware and design tools and blocks of logic; and investment in new product offerings based on converging technology trends, as well as ongoing cost reductions and performance improvements in existing products.

 

The Company intends to continue its efforts to develop innovative new products and technologies, and believes that an ongoing commitment to R&D is essential in order to maintain product leadership and compete effectively. Therefore, the Company expects to continue to make significant R&D investments in the future.

 

R&D expenses for fiscal 2006 were $58.3 million, or approximately 18% of sales and revenues, compared to $43.0 million, or approximately 21% of sales and revenues, for fiscal 2005. The spending increase was primarily due to the addition of approximately $9.0 million of R&D expenses associated with the operations of OASIS, the acquisition of which added approximately 90 engineers and technicians to the Company’s engineering team; $3.1 million for compensation expense from SARs; and $2.4 million of higher compensation and benefit costs driven by engineering staff additions.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses were $68.5 million, or approximately 21% of sales and revenues, for fiscal 2006, compared to $48.8 million, or approximately 23% of sales and revenues, for fiscal 2005.

 

The increase in fiscal 2006 spending, compared to fiscal 2005, includes $8.1 million of expenses associated with the operations of OASIS; $9.1 million of higher compensation expense from SARs; $2.9 million of higher general compensation and benefit cost (exclusive of impact of OASIS); and $1.3 million of higher employee recruitment and relocation cost which were partially offset by $3.0 million of lower legal, accounting and other professional fees, due in part to lower cost associated with litigation. Fiscal 2006 expenses also include approximately $0.2 million of office lease expenses relating to prior periods.

 

Amortization of Intangible Assets

 

Amortization expense was $5.8 million and $1.1 million in fiscal 2006 and 2005, respectively, and represents the amortization of finite-lived intangible assets associated with the Company’s March 2005 acquisition of OASIS and June 2002 acquisition of Gain.

 

In-Process Research and Development

 

The $0.9 million in-process research and development expense recorded in fiscal 2006 represents the fair value of in-process technology for OASIS research projects that, as of the March 30, 2005 closing date of the OASIS

acquisition, had not reached technological feasibility and had no alternative future uses. These projects primarily focused on deployment of certain technology into consumer electronics applications. The estimated fair value of this in-process research and development was recorded as an expense as of the OASIS acquisition date, in the fiscal quarter ended May 31, 2005.

 

Gains on Real Estate Transactions

 

During the third quarter of fiscal 2005, the Company sold its remaining parcel of idle real estate in Hauppauge, New York, for net proceeds of $1.7 million, after transaction costs. This property had a carrying value of approximately $0.4 million. The contract of sale required the Company to complete the remediation of certain soil contamination of uncertain origin identified at this property, at its expense. In recognition of both the uncertain cost and uncertain completion date of the soil remediation obligation at that time, the Company did not reflect the impact of this transaction within its statement of operations for the third quarter of fiscal 2005. The Company subsequently completed the project during the fourth quarter of fiscal 2005, and received final regulatory approval thereafter. Accordingly, the Company then recognized a gain of $1.0 million on this transaction, net of related remediation project costs, in the fourth quarter of fiscal 2005.

 

Settlement Charge

 

In June 2003, SMSC was named as a defendant in a patent infringement lawsuit filed by Analog Devices, Inc. (“ADI”), which alleged that some of the Company’s products infringed one or more of three of ADI’s patents, and sought injunctive relief and unspecified damages. In September 2003, the Company filed an answer in the lawsuit, denying ADI’s allegations and raising affirmative defenses and counterclaims. During the fourth quarter of fiscal 2005, the Company and ADI reached a settlement of this dispute, under which both parties agreed to dismiss all claims against each other. As part of the agreement, the Company made a one-time payment of $6.0 million to ADI, which is reported as a settlement charge on the Company’s consolidated statement of operations for fiscal 2005. As part of the settlement, ADI also granted the Company a royalty-bearing license to the patents in question. The Company does not expect royalties incurred under the license to have a material impact on future results of operations.

 

Interest and Other Income (Expense)

 

The increase in interest income, from $2.5 million in fiscal 2005 to $3.3 million in fiscal 2006, primarily reflects the impact of higher average interest rates during fiscal 2006, partially offset by lower average cash, cash equivalent and liquid investment balances. Other income (expense), net was nominal in both fiscal 2006 and 2005.

 

Provision for Income Taxes

 

The Company’s effective income tax rate reflects statutory federal, state and foreign tax rates, the impact of certain permanent differences between the book and tax treatment of certain expenses, and the impact of tax-exempt income and various income tax credits.

 

The provision for income taxes for fiscal 2006 was $4.5 million, or an effective income tax rate of 27.3% against $16.5 million of income before income taxes. This provision included the impact of $1.7 million of income tax credits, $0.9 million of tax exempt income and a $1.0 million provision for differences between foreign and U.S. income tax rates.

 

The Company recorded an income tax benefit of $2.3 million for fiscal 2005, which reflected the impact of $1.1 million of income tax credits, and $0.6 million and $0.7 million of tax benefits associated with export sales and tax-exempt income, respectively.

 

The provisions for, or benefits from, income taxes from continuing operations have not been reduced for approximately $5.7 million and $0.9 million of tax benefits in fiscal 2006 and 2005, respectively, derived from activity in stock-based compensation plans. These tax benefits have been credited to additional paid-in capital.

Fiscal Year Ended February 28, 2005 Compared to Fiscal Year Ended February 28, 2004

 

Sales and Revenues

 

The Company’s sales from advanced Input/Output products for PC-related computing applications (“PC I/O”) and advanced Input/Output products for non-PC related computing applications (“Non-PC I/O”), together with intellectual property revenues, are presented in the following table for fiscal 2005 and 2004 (dollars in millions):

 

 

The Company’s sales and revenues for fiscal 2005 were $208.8 million, consisting of $197.8 million of product sales and $11.0 million of intellectual property revenues. Fiscal 2004 sales and revenues of $215.9 million consisted of $192.0 million of product sales and $23.9 million of intellectual property revenues.

 

The Company experienced strong demand in its non-PC I/O product lines, which was attributed to the impact of new design-wins, broader product offerings in these product lines, and the Company’s ongoing focus on aggressively identifying and pursuing market opportunities in its non-PC I/O product lines, consistent with the Company’s diversification goals. Non-PC I/O products contributed 41% of total product sales in fiscal 2005, compared to 33% in fiscal 2004. Despite an increase of more than 10% in unit PC I/O shipments during fiscal 2005, product sales from PC I/O products declined in fiscal 2005, compared to fiscal 2004, largely reflecting the impact of selling price attrition. The Company’s PC I/O business is concentrated in top-tier, mainstream PC suppliers who are able to exert significant pressure on selling prices.

 

The Company’s PC I/O product sales were also adversely impacted in fiscal 2005 by an accounts receivable collectibility issue with one of its Taiwan-based component distributors. In the third quarter, the Company determined that this long-time customer, whose credit and payment history with the Company had consistently been excellent, was experiencing financial distress and a lack of liquidity. As collectibility was not reasonably assured, the Company deferred recognition of approximately $5.4 million of product sales and corresponding trade receivables for shipments made to this distributor during the second half of fiscal 2005. The related inventory for these product sales, at a cost of approximately $2.7 million, had already been shipped to and resold by the distributor prior to identification of the collectibility issue and was fully charged to costs of goods sold in fiscal 2005.

 

Intellectual property revenues include $10.0 million and $22.5 million in fiscal 2005 and 2004, respectively, received from Intel Corporation pursuant to the terms of a September 2003 business agreement (see Part IV Item 15(a) — Financial Statements — Note 9, for further details). Intellectual property revenues for fiscal 2005 include payments under this agreement of $2.5 million in each of the fiscal year’s four quarterly periods, and in the prior fiscal year include the agreement’s initial payment of $20 million in the third quarter and a payment of $2.5 million in the fourth quarter.

Sales and revenues by geographic region for these two fiscal years were as follows:

 

 

Intellectual property revenues received from Intel are included in the United States amount. Although intellectual property revenues from Intel declined in fiscal 2005, pursuant to the terms of the underlying agreement, overall United States sales and revenues increased in fiscal 2005, reflecting increased shipments to a certain U.S.-based customer.

 

Costs of Goods Sold

 

Costs of goods sold for fiscal 2005 were $114.1 million, or 54.6% of sales and revenues, compared to $106.3 million, or 49.2% of sales and revenues, in fiscal 2004. Excluding the impact of intellectual property revenues, costs of goods sold were 57.7% of product sales in fiscal 2005, compared to 55.3% in fiscal 2004.

 

During fiscal 2005, the Company continued to experience a change in its product mix, with more of its product sales being derived from non-PC I/O products. While in the past, non-PC I/O products traditionally produced higher margins than PC I/O products, the Company introduced certain new products during fiscal 2005 into a very competitive market that supported lower margins than other non-PC I/O products. Accordingly, in fiscal 2005, the Company did not currently realize the overall decreased cost of goods sold percentage at the level that would otherwise be expected from a higher product sales mix of non-PC I/O products. The Company also recorded higher charges for slow-moving and obsolete inventory in fiscal 2005, compared to fiscal 2004, reflecting several customer product transitions occurring more rapidly than anticipated.

 

Research and Development Expenses

 

R&D expenses for fiscal 2005 were $43.0 million, or approximately 21% of sales and revenues, compared to $38.8 million, or approximately 18% of sales and revenues, for fiscal 2004. This increase reflects $1.8 million of higher compensation and benefit costs driven by engineering staff additions, $0.9 million of higher depreciation expense associated with investments in advanced semiconductor design tools and $0.9 million of higher device prototype costs. A portion of the increase in R&D expenses as a percentage of sales and revenues was due to the significant initial intellectual property revenues from Intel in fiscal 2004.

 

Selling, General and Administrative Expenses

 

Selling, general and administrative expenses were $48.8 million, or approximately 23% of sales and revenues, for fiscal 2005, compared to $42.2 million, or approximately 20% of sales and revenues, for fiscal 2004.

 

The increase in fiscal 2005, compared to fiscal 2004, includes $2.9 million of higher legal fees, primarily associated with litigation, $1.9 million of higher expenses associated with expanded worldwide resources in sales and marketing and $1.2 million of higher consulting and professional fees, primarily associated with projects to achieve compliance with provisions of the Sarbanes-Oxley Act of 2002.

 

Amortization of Intangible Assets

 

Amortization expense was $1.1 million and $1.3 million in fiscal 2005 and 2004, respectively, and represents the amortization of finite-lived intangible assets associated with the Company’s June 2002 acquisition of Gain.

Gains on Real Estate Transactions

 

During the third quarter of fiscal 2005, the Company sold its remaining parcel of idle real estate in Hauppauge, New York, for net proceeds of $1.7 million, after transaction costs. This property had a carrying value of approximately $0.4 million. The contract of sale required the Company to complete the remediation of certain soil contamination of uncertain origin identified at this property, at its expense. In recognition of both the uncertain cost and uncertain completion date of the soil remediation obligation at that time, the Company did not reflect the impact of this transaction within its statement of operations for the third quarter of fiscal 2005. The Company subsequently completed the project during the fourth quarter of fiscal 2005, and received final regulatory approval thereafter. Accordingly, the Company then recognized a gain of $1.0 million on this transaction, net of related remediation project costs, in the fourth quarter of fiscal 2005.

 

Settlement Charge

 

In June 2003, SMSC was named as a defendant in a patent infringement lawsuit filed by ADI, which alleged that some of the Company’s products infringed one or more of three of ADI’s patents, and sought injunctive relief and unspecified damages. During the fourth quarter of fiscal 2005, the Company and ADI reached a settlement of this dispute, under which both parties agreed to dismiss all claims against each other. As part of the agreement, the Company made a one-time payment of $6.0 million to ADI, which is reported as a settlement charge on the Company’s consolidated statement of operations for fiscal 2005.

 

Interest and Other Income (Expense)

 

The increase in interest income, from $1.9 million in fiscal 2004 to $2.5 million in fiscal 2005, primarily reflects the impact of higher average interest rates during fiscal 2005.

 

During fiscal 2004, the Company sold its remaining equity investment in Chartered Semiconductor Manufacturing, Ltd. (Chartered), realizing losses of $0.7 million, which are included within other income (expense).

 

Provision for Income Taxes

 

The Company recorded an income tax benefit of $2.3 million for fiscal 2005, which reflects the impact of $1.1 million of income tax credits, and $0.6 million and $0.7 million of tax benefits associated with export sales and tax-exempt income, respectively.

 

The provision for income taxes for fiscal 2004 was $8.1 million, or an effective income tax rate of 27% against $29.8 million of income before income taxes. This provision included $0.5 million of income tax credits, $0.8 million of tax benefits associated with export sales and a benefit of $0.8 million associated with better than anticipated settlements of previously open tax audits.

 

The provisions for, or benefits from, income taxes from continuing operations have not been reduced for approximately $0.9 million and $7.8 million of tax benefits in fiscal 2005 and 2004, respectively, derived from activity in stock-based compensation plans. These tax benefits have been credited to additional paid-in capital.

 

Discontinued Operations

 

The Company had been involved in an arbitration proceeding with Accton Technology Corporation (“Accton”) and SMC Networks, Inc. (“Networks”), relating to claims associated with the October 1997 purchase of a majority interest in Networks by Accton from SMSC. The divestiture was accounted for as a discontinued operation, and accordingly, costs associated with this action, net of income taxes, were reported within loss from discontinued operations on the consolidated statements of operations. In fiscal 2004, these costs totaled $0.3 million, before applicable income tax benefits. In September 2003, the arbitration panel issued its decision in this action, which directed the release of an escrow account to SMSC and awarded certain other payments among the parties. In December 2003, the parties reached a final settlement of the award, resulting in SMSC receiving $2.7 million in cash, including the escrow account, and realizing a pre-tax gain of $0.3 million, which is included within loss from discontinued operations for fiscal 2004.

LIQUIDITY & CAPITAL RESOURCES

 

The Company currently finances its operations through a combination of existing working capital resources and cash generated by operations. The Company had no bank debt during fiscal 2006, 2005 or 2004.

 

The Company’s cash, cash equivalents and liquid investments (including investments in marketable securities with maturities in excess of one year, if any) were $155.0 million at February 28, 2006, compared to $172.6 million at February 28, 2005.

 

Operating activities generated $53.4 million of cash during fiscal 2006, compared to $3.5 million of cash generated in fiscal 2005. This increase in operating cash flow during fiscal 2006 reflects a substantial increase in product sales as compared to a relatively lower rate of growth in operating expenses, the fact that inventories required to support the sales increase declined as a percentage of total sales and the fact that a greater proportion of the required increase in accounts receivable and inventories was financed by increases in accounts payable. Cash received in 2006 of $315.7 million increased 51.9% from $207.9 million the prior year, and cash payments grew 22.9%, from $213.3 million to $262.2 million. Fiscal 2004 operating activities generated $46.4 million of cash.

 

Investing activities consumed $138.5 million of cash during fiscal 2006, reflecting a $54.5 million increase of short-term and long-term investments, the $60.5 million investment in the OASIS acquisition, and a $23.8 million investment in capital expenditures. Capital expenditures were significantly higher than the prior two years due to the investment of approximately $19.3 million to date in the expansion of the Company’s primary facility in Hauppauge, New York. Investing activities provided $96.5 million of cash during fiscal 2005, due principally to a net decrease of $103.3 million in short-term and long-term investments and a $1.7 million real estate sale, partially offset by $8.4 million of capital expenditures. Investing activities consumed $68.1 million of cash during fiscal 2004.

 

Net cash provided by financing activities of $14.0 million during fiscal 2006 included $18.1 million of proceeds from exercises of stock options, partially offset by $2.2 million of treasury stock purchases and $2.0 million of payments of capital lease obligations and notes payable. Financing activities provided $1.7 million of cash during fiscal 2005, including $4.2 million of proceeds from exercises of stock options, partially offset by $0.3 million of stock repurchases and $2.1 million for payments of capital lease obligations and notes payable. Financing activities generated $17.3 million of cash during fiscal 2004.

 

The Company’s inventories were $41.9 million at February 28, 2006, compared to $33.3 million at February 28, 2005. This increase resulted primarily from the need to support substantially higher levels of sales. Accounts receivable increased from $23.5 million at February 28, 2005 to $39.8 million at February 28, 2006 for the same reason.

 

Total current liabilities increased from $37.1 million at February 28, 2005 to $87.1 million at February 28, 2006, reflecting a $11.2 million increase in accounts payable associated with a higher level of inventory to support increased sales, the inclusion of a $17.8 million accrued liability in connection with additional consideration payable in connection with the OASIS acquisition as discussed above, and higher accrued liabilities, primarily for foreign taxes payable, bonuses and accruals for compensation expenses associated with stock appreciation rights.

 

Capital expenditures for fiscal 2006 were $23.8 million, of which approximately $17.7 related to the expansion of the Company’s primary facility in Hauppauge, New York, construction on which began during the fourth quarter of fiscal 2005. This project expanded the space configured for permanent occupancy in this facility from its current 80,000 square feet to approximately 200,000 square feet (the entirety of the facility), allowing consolidation of the Company’s Hauppauge operations into a single building. At February 28, 2006 the new building expansion was still under construction and the space under construction was unoccupied and as of that date, total capital expenditures for this building expansion amounted to $19.3 million (consisting primarily of building improvements and related contractor costs).

 

The current year’s capital investments also include expenditures of $0.7 million for advanced design tools. The Company acquired $0.9 million and $3.9 million of advanced design tools during fiscal 2005 and 2004, respectively, under similar agreements, for which the vendors also provided extended payments. Payments under these agreements are reported within cash flows from financing activities on the consolidated statements of cash flows.

Capital expenditures in fiscal 2005 and 2004 were predominantly for production test equipment, advanced semiconductor design tools and investments in intellectual property. Capital expenditures were $8.4 million and $10.4 million for fiscal 2005 and 2004, respectively, including the aforementioned vendor-financed design tools.

 

Other than an estimated $4.6 million remaining in connection with the building expansion, there are no other material commitments for future capital expenditures as of February 28, 2006.

 

During fiscal 2006 the Company made cash payments for Federal and State income taxes of $2.9 million. During fiscal 2005, the Company filed claims for $7.3 million of Federal income tax refunds, which resulted from the carry back of several capital losses realized during fiscal 2004 against capital gains reported in previous fiscal years. Refunds of $6.9 million were received against these claims during fiscal 2005, and receipt of the remaining $0.4 million refund is dependent upon completion of the related I.R.S. audit. For federal income tax purposes, the Company had approximately $22.2 million and $5.8 million of federal net operating loss carryforwards as of the fiscal year end 2005 and 2006, respectively.

 

In October 1998, the Company’s Board of Directors approved a common stock repurchase program, allowing the Company to repurchase up to one million shares of its common stock on the open market or in private transactions. In July 2000, the authorization was expanded from one million shares to two million shares and in July 2002 the authorization was expanded from two million shares to three million shares. As of February 28, 2006, the Company had repurchased approximately 2.0 million shares of common stock at a cost of $26.0 million under this program, including 150,000 shares repurchased at a cost of $2.2 million in fiscal 2006. During fiscal 2005, 21,800 shares were repurchased under this program at a cost of $0.3 million. No shares were repurchased under this program during fiscal 2004.

 

In March 2005, the Company announced the acquisition of 100% of the outstanding common stock of OASIS. The cost of the acquisition was approximately $118.5 million, including approximately $79.5 million of cash, 2.1 million shares of SMSC common stock, valued at $35.8 million, and an estimated $3.2 million of direct acquisition costs, including legal, banking, accounting and valuation fees. Included with the net assets acquired from OASIS was approximately $22 million of cash and cash equivalents, so SMSC’s net cash outlay for the transaction, including transaction costs, was approximately $60 million.

 

Up to $20.0 million of additional consideration, payable in cash and SMSC common stock, may be issued to OASIS’ former shareholders during fiscal 2007 upon satisfaction of certain future performance goals. See Part IV Item 15.(a). — Financial Statements — Note 20 for further discussion.

 

The Company’s contractual payment obligations and purchase commitments as of February 28, 2006 were as follows:

 

 

Inventory and other purchase obligations include purchase commitments for processed silicon wafers and assembly and test services. The Company depends entirely upon subcontractors to manufacture its silicon wafers and provide assembly services, as well as for certain of its test services. Due to the length of subcontractor lead times, the Company orders these materials and services well in advance, and generally expects to receive and pay for these materials and services within the next six months.

 

For purposes of the preceding table, obligations for the purchase of goods or services are defined as agreements that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the

transaction. The Company cannot cancel these obligations without incurring cost. Non-cancelable purchase orders for manufacturing requirements are typically fulfilled by vendors within short time horizons, generally three months or less. The Company has additional purchase orders, not included within the table, that represent authorizations to purchase rather than binding agreements.

 

The Company has considered in the past, and will continue to consider, various possible transactions to secure necessary foundry manufacturing capacity, including equity investments in, prepayments to, or deposits with foundries, in exchange for guaranteed capacity or other arrangements which address the Company’s manufacturing requirements. The Company may also consider utilizing cash to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies. From time to time, in the ordinary course of business, the Company may evaluate potential acquisitions of or investments in such businesses, products or technologies owned by third parties.

 

The Company expects that its cash, cash equivalents, liquid investments, cash flows from operations and its borrowing capacity will be sufficient to finance the Company’s operating and capital requirements through the end of fiscal 2006.

 

Interest Rate Risk — The Company’s exposure to interest rate risk relates primarily to its investment portfolio. The primary objective of SMSC’s investment portfolio management is to invest available cash while preserving principal and meeting liquidity needs. In accordance with the Company’s investment policy, investments are placed with high credit-quality issuers and the amount of credit exposure to any one issuer is limited.

 

As of February 28, 2006, the Company’s $111.1 million of short-term investments consisted primarily of investments in corporate, government and municipal obligations with maturities of between three and twelve months at acquisition. If market interest rates were to increase immediately and uniformly by 10% from levels at February 28, 2006, the Company estimates that the fair values of these short-term investments would decline by an immaterial amount. The Company generally expects to hold these investments until maturity and, therefore, would not expect operating results or cash flows to be affected to any significant degree by the effect of a sudden change in market interest rates.

 

Equity Price Risk — The Company is not exposed to any equity price risks at February 28, 2006.

 

Foreign Currency Risk — The Company has international sales and expenditures and is, therefore, subject to certain foreign currency rate exposures. The Company conducts a significant amount of its business in Asia. In order to reduce the risk from fluctuation in foreign exchange rates, most of the Company’s product sales and all of its arrangements with its foundry, test and assembly vendors are denominated in U.S. dollars. Most transactions in the Japanese market made by the Company’s subsidiary, SMSC Japan, are denominated in Japanese yen. SMSC Japan purchases a significant amount of its products for resale from SMSC in U.S. dollars, and from time to time has entered into forward exchange contracts to hedge against currency fluctuations associated with these product purchases. No such contracts were executed during either fiscal 2006 or 2005, and there are no obligations under any such contracts as of February 28, 2006.

 

The Company has never received a cash dividend (repatriation of cash) from SMSC Japan.

 

OASIS’ operating activities in Europe include transactions conducted in both euros and U.S. dollars. The euro has been designated as OASIS’ functional currency for its European operations. From time to time, OASIS has entered into foreign currency contracts to minimize the exposure of its U.S dollar denominated transactions, assets and liabilities to currency exchange rate risk. Gains or losses on these contracts are intended to offset the gains or losses recorded from the remeasurement of certain assets and liabilities from U.S. dollars into euros. As of February 28, 2006, OASIS had no foreign currency contracts. Gains and losses on these contracts, as well as gains and losses recorded from the remeasurement of U.S. dollar denominated assets and liabilities into euros, were not material during fiscal 2006.

 

 

The financial statements and supplementary data required by this item are set forth in Part IV Item 15(a)  — Financial Statements, of this Report.

 

None.

 

 

Disclosure Controls and Procedures

 

Under the supervision and with the participation of the Company’s management, including its Chief Executive Officer and Chief Financial Officer, the Company conducted an evaluation of the effectiveness of its disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of February 28, 2006. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Disclosure controls and procedures include controls and procedures designed to reasonably assure that information required to be disclosed in the Company’s reports filed under the Exchange Act, such as this Form 10-K, are recorded, processed, summarized and reported within the time periods specified in the U.S. Securities and Exchange Commission’s (SEC’s) rules and forms. Disclosure controls and procedures are also designed to reasonably assure that such information is accumulated and communicated to the Company’s management, including the Chief Executive Officer and the Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

 

Based upon this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of February 28, 2006, the Company’s disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed in the Company’s Exchange Act reports is recorded, processed, summarized and reported within the time periods specified by the SEC, and that material information relating to SMSC and its consolidated subsidiaries is accumulated and communicated to the Company’s management, including the Chief Executive Officer and the Chief Financial Officer, to allow timely decisions regarding required disclosures.

 

Management’s Report on Internal Control Over Financial Reporting

 

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:

 

(1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company;

 

(2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and

 

(3) Provide reasonable assurances regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Management has excluded from its assessment of the effectiveness of the Company’s internal control over financial reporting as of February 28, 2006 certain elements of the internal control over financial reporting of OASIS. OASIS was acquired by the Company in a material purchase business combination in March 2005.

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Shareholders of Standard Microsystems Corporation:

 

We have completed an integrated audit of Standard Microsystems Corporation’s February 28, 2006 and 2005 consolidated financial statements and of its internal control over financial reporting as of February 28, 2006 and an audit of its February 29, 2004 consolidated financial statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.

 

Consolidated financial statements and financial statement schedule

 

In our opinion, the accompanying consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Standard Microsystems Corporation and its subsidiaries at February  28, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended February 28, 2006 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule listed in the index appearing under Item 15(a)(2) presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

Internal control over financial reporting

 

Also, in our opinion, management’s assessment, included in Management’s Report on Internal Control over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of February 28, 2006 based on the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of February 28, 2006, based on criteria established in Internal Control — Integrated Framework issued by the COSO. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management’s assessment and on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable

assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

As described in Management’s Report on Internal Control Over Financial Reporting, management has excluded OASIS SiliconSystems Holding AG from its assessment of internal control over financial reporting as of February 28, 2006 because it was acquired by the Company in a purchase business combination during the year then ended. We have also excluded OASIS SiliconSystems Holding AG from our audit of internal control over financial reporting. OASIS SiliconSystems Holding AG is a wholly-owned subsidiary whose total assets and total revenues represent 33.6% and 16.5%, respectively, of the related consolidated financial statement amounts as of and for the year ended February 28, 2006.

 

/s/  PricewaterhouseCoopers LLP

 

New York, New York

May 15, 2006

STANDARD MICROSYSTEMS CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED BALANCE SHEETS

 

 

The accompanying notes are an integral part of these consolidated financial statements.

STANDARD MICROSYSTEMS CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

 

The accompanying notes are an integral part of these consolidated financial statements.

STANDARD MICROSYSTEMS CORPORATION AND SUBSIDIARIES

 

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY