The Daily Magic Formula Stock for 03/14/2008 is Silicon Image Inc. According to the Magic Formula Investing Web Site, the ebit yield is 33% and the EBIT ROIC is >100 %.
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Silicon Image, Inc. is a technology innovator and a global leader developing high-bandwidth semiconductor and intellectual property (IP) solutions based on our innovative, digital interconnect technology. Our vision is digital content everywhere. Our mission is to be the leader in the innovation, design, development and implementation of semiconductors and IP solutions for the secure storage, distribution and presentation of high-definition content in the home and mobile environments. We are dedicated to the development and promotion of technologies, standards and products that facilitate the movement of digital content between and among digital devices across the consumer electronics (CE), personal computer (PC) and storage markets. We believe our track record of innovation around our core competencies, establishing industry standards and building strategic relationships, positions us to continue to drive change in the emerging world for high quality digital media storage, distribution and presentation.
We provide integrated and discrete semiconductor products as well as IP licensing to consumer electronics, computing, display, storage and networking equipment manufacturers. Our product and IP portfolio includes solutions for high-definition television (HDTV), high-definition set-top boxes (STBs), high-definition digital video disc (DVD) players, digital and personal video recorders (DVRs and PVRs), high-definition game systems, consumer and enterprise storage products and PC display products.
We have worked with industry leaders to create industry standards such as the High-Definition Multimedia Interface (HDMI tm ) and Digital Visual Interface (DVI tm ) specifications for digital content delivery. We capitalize on our leadership position through first-to-market, standards-based semiconductor and IP solutions. Our portfolio of IP solutions that we license to third parties for consumer electronics, PCs, multimedia, communications, networking and storage devices further leverages our expertise in these markets. We view these IP arrangements as selling another version of our semiconductor products i.e. â€śvirtual productsâ€ť. Moreover, through Simplay Labs, LLC, our wholly owned subsidiary, we offer one of the most robust and comprehensive test suites and testing technology platforms in the consumer electronics industry. We utilize independent foundries and third-party subcontractors to manufacture, assemble and test all of our semiconductor products.
Our customers are equipment manufacturers in each of our target markets â€” Consumer Electronics, Personal Computer and Storage. Because we leverage our technologies across different markets, certain of our products may be incorporated into equipment used in multiple markets. We sell our products to original equipment manufacturers (OEMs) throughout the world using a direct sales force and through a network of distributors and manufacturerâ€™s representatives. Our net revenue is generated principally by sales of our semiconductor products, with other revenues derived from IP core licensing and licensing and royalty fees from our standards activities. We maintain relationships with the eco-system of companies that provide the products that drive digital content creation and consumption, including the major Hollywood studios, consumer electronics companies, retailers and service providers. To that end, we have developed relationships with Hollywood studios such as Universal, Warner Brothers, Disney and Fox and with major consumer electronics companies such as Sony, Hitachi, Toshiba, Matsushita, Phillips and Thomson. Through these and other relationships, we have formed a strong understanding of the requirements for storing, distributing and viewing high quality digital video and audio in the home and mobile environments, especially in the area of High Definition (HD) content. We have also developed a substantial intellectual property base for building the standards and products necessary to promote opportunities for our products.
Historically, we have grown our business by introducing and promoting the adoption of new standards and entering new markets. We collaborated with several companies and jointly developed the DVI and HDMI standards. Our first products addressed the PC market. Subsequently, we introduced products for a variety of CE market segments, including DVD, STB, game console and digital television (DTV) markets. More recently, we have expanded our research and development activities and are developing products based on our innovative digital interconnect core technology for the mobile device market, including digital still cameras, HD camcorders, portable media players and smart phones. We are also developing a personal networking technology solution that will enable a consumer to access and display digital content from and to the various devices in the consumerâ€™s personal domain.
We are headquartered in Sunnyvale, California. Our Internet website address is www.SiliconImage.com. We are not including the information contained on our web site as a part of, or incorporating it by reference into, the Annual Report on Form 10-K. We make available through our Internet website free of charge, our Annual Report on Form 10-K quarterly reports on Form 10-Q current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable, after we electronically file such material with, or furnish it to, the Securities and Exchange Commission.
Our goal is to enable the access and presentation of high-definition digital content anytime, anywhere, on any device. Our business strategy is to grow the available market for our products and IP solutions through the development, introduction and promotion of industry standards such as HDMI, DVI and Serial Advanced Technology Attachment (SATA). In 2006, Gartner/Dataquest ranked Silicon Image as the sixth largest semiconductor IP licensing vendor in the world, based on revenue. We are active in existing industry standards bodies; however, we believe that it is our formation of and participation in, new industry standards organizations that have had and will continue to have, the greatest impact on our business.
We are directly involved in the following standards efforts:
High-Definition Multimedia Interface (HDMI)
In 2002, we entered into a Founderâ€™s Agreement with Sony, Matsushita Electric Industrial Co. (Panasonic), Philips, Thomson, Hitachi and Toshiba, under which we formed a working group to develop the HDMI specification, a next-generation digital interface for consumer electronics. The HDMI specification is based on our market-proven Transition Minimized Differential Signaling (TMDS) technology, the same technology underlying the HDMI specificationâ€™s predecessor specification, DVI, which we also developed. As an HDMI founder, we have actively participated in the evolution of the HDMI specification and we anticipate that our involvement in this and in other digital interface connectivity standards will continue.
Our leadership in the market for HDMI-enabled products has been based on our ability to introduce first-to-market semiconductor and IP solutions to manufacturers. We introduced the industryâ€™s first products for each new version of the HDMI standard, providing a time-to-market advantage to our customers. For consumers, HDMI has provided a simpler way to connect and use devices and enjoy the higher-quality entertainment experience available with digital content. More than 750 manufacturers around the world have become HDMI adopters. For CE manufacturers, HDMI is a low-cost, standardized means of interconnecting CE devices, which enables these manufacturers to build feature-rich products that deliver a true home theater entertainment experience. For PC and monitor manufacturers, HDMI enables a PC connection to digital TVs and monitors at HD quality levels. The market acceptance and adoption of HDMI enabled products have been significant factors in our growth over the last several years, driving both our product and licensing revenues. According to the market research firm In-Stat, an estimated over 143 million HDMI-enabled products were expected to ship worldwide in 2007.
High-bandwidth Digital Content Protection (HDCP)
In 2000, the HDCP specification HDCP 1.0 was published by Intel, with contributions from Silicon Image acknowledged in the specification. The specification was developed to add content protection to DVI in order to prevent unauthorized copying of content when transmitted between source and display over a DVI link. In 2003, the HDCP specification was updated to revision level 1.1 and made available for use with HDMI. This technology has been widely adopted in consumer electronics products, initially in combination with DVI and more recently and more prevalently in combination with HDMI. In 2007, the HDCP specification was again revised in VI.3.b.1. The HDCP Compliance Test Specification VI.1 was released in 2006.
Digital Visual Interface (DVI)
In 1998, together with Intel, Compaq, IBM, Hewlett-Packard, NEC and Fujitsu, we announced the formation of the Digital Display Working Group (DDWG) and in 1999, published the DVI 1.0 specification. The DVI 1.0 standard defines a high-speed serial data communication link between computers and digital displays. According to In-Stat, over 112 million DVI-enabled products were expected to ship in 2007. Today, in many applications, DVI is being replaced by the more feature-rich HDMI.
Serial Advanced Technology Attachment (SATA)
We have been a contributor to the SATA standard and a leading supplier of discrete SATA solutions including controllers, storage processors, port multipliers and bridges. Based on serial signaling technology, the SATA standard specifies a computer bus technology for connecting hard disk drives and other devices and was formed by Intel, Dell, Maxtor, Seagate and Vitesse in 1999. We sell SATA semiconductors primarily to merchant motherboard suppliers, computer OEMs and external drive manufacturers.
Recent Strategic Transactions
We completed two important transactions in 2007 intended to enhance our ability to offer higher levels of integration and greater price/performance value to our customers. In February 2007, we entered into a cross-license agreement with Sunplus Technology Company, Ltd. granting us the right to use certain advanced IP in DTV semiconductor products, which we believe will offer us greater opportunities to develop semiconductor solutions for the home and mobile device environment. The license agreement provided for the payment of an aggregate of $40.0 million to Sunplus by Silicon Image, $35.0 million of which was payable in consideration for the licensed technology and related deliverables and $5.0 million of which was payable in consideration for Sunplus support and maintenance obligations. In addition, our acquisition in January 2007 of sci-worx GmbH (sci-worx), now Silicon Image, GmbH provides us a combination of additional advanced IP and a highly skilled pool of engineers who we believe will help leverage our research and development efforts into new products. We acquired sci-worx GmbH for a net cash consideration of $13.8 million. We believe that the intellectual property licensed from Sunplus, along with the engineering talent and intellectual property acquired in the sci-worx transaction, will enhance our ability to develop a broader array of product offerings.
Products and Services
We sell products and services primarily into three markets: consumer electronics, personal computers and storage.
Our HDMI products have been selected by many of the worldâ€™s CE companies. Our products have driven the transition to industry-leading HDMI products with features including Deep Color tm and lossless HD audio. During the past year, we have seen a rapid penetration of HDMI 1.3 into the home theater and DTV markets. Beyond the outstanding video and sound quality enabled by HDMI technology, our latest products also include HDMI Consumer Electronics Control (CEC) functionality, which allows a single remote controller to operate all CEC enabled devices connected to the HDTV.
In 2007, we focused our activities on a new DTV architecture that, we believe, provides OEMs with best-in-class performance relating to DTV inputs and allows these manufacturers to bring their products to market more quickly. In 2007, we launched the SiI915x family of input processors, which are highly integrated HDTV processing solutions that include HDMI 1.3 with Deep Color and x.v.Color extended color gamut coupled with high-definition legacy analog video support. Our SiI915x family of input processors expands the number of HDMI ports available to consumers and augments the HDMI functionality with high-quality, high-definition analog video support. These new HDTV input processor solutions allow consumers to enjoy the highest quality content currently available on their HDTVs, including the new, lossless compressed digital audio formats available in HDMI 1.3: Dolby Â® TrueHD and DTS-HD Master Audio tm , as well as high-bandwidth uncompressed digital audio and compressed formats such as Dolby Digital, DTS and Super Audio CD (SACD). Complemented by advanced and thorough testing performed for us by Simplay Labs, these new products offer rapid time-to-market solutions and allow OEMs to significantly reduce cross-platform compatibility issues.
We also introduced our first-generation HDMI 1.3 switch products (SiI9181 and SiI9185) with integrated HDMI CEC functionality. These HDMI switches enable multiple HDMI source devices to connect to HDTVs with frequency of operation up to 225 megahertz (MHz), allowing consumers to enjoy Deep Color content.
Additionally, in 2007 we released several new integrated receivers that deliver advanced HDMI 1.3 HDTV features including 1080p Deep Color and x.v.Color expanded color gamut. Our two-port receiver (SiI9125), designed for use in HDTVs, is an advanced dual-input receiver that fits directly into the HDTV unit, offering manufacturers a low cost, easily implemented upgrade to add HDMI 1.3 capabilities to their full range of HDTVs. Our new four-port receiver (SiI9135), designed for use in audio/video receivers, is the first HDMI 1.3 receiver chip to support advanced HD features such as compressed lossless audio. HDMI 1.3 products represented 39.0% of CE product sales.
Our new Mobile High-Definition Link tm (MHL) technology is a low-pin-count link for low-power mobile devices with a direct HDMI connector for mobile phones, digital cameras and camcorders media players and other mobile devices enabling consumers to watch and listen to content from these devices on their HDTVs with pristine digital quality. In 2007, we introduced the industryâ€™s first three products that enable MHL: two transmitters (SiI9220 and SiI9222) which are the first MHL transmitters for mobile devices and the first MHL-to-HDMI bridge chip (SiI9290) for the docking station. We also introduced what we believe to be the lowest power consuming HDMI transmitters in the mobile device market. Our next generation of HDMI transmitters for mobile devices (SiI9022 and SiI9024) delivers reduced power consumption, improving reliability and battery life in mobile devices.
Our HDMI products are branded under the VastLane tm product family and have been selected by many of the worldâ€™s CE companies.
VastLane HDMI Transmitters. Our VastLane HDMI transmitter products reside in CE and PC products, such as DVD players, DVD recorders, game consoles, STBs, digital camcorders, A/V receivers and digital video recorders (DVRs). VastLane HDMI transmitters convert digital video and audio into a multi-gigabit per second (Gbps) encrypted serialized stream and transmit the secure content to an HDMI receiver that is built into televisions and A/V receivers.
VastLane HDMI Receivers. Our VastLane HDMI receiver products reside in display systems, such as HDTVs, plasma TVs, LCD TVs, rear-projection TVs, front projectors, PC monitors as well as A/V receivers. VastLane HDMI receivers convert an incoming encrypted serialized stream to digital video and audio, which is then processed by a television or PC monitor for display.
While the PC market has become an increasingly smaller portion of our business over time, a trend that we anticipate will continue, the growth of digital TVs with HDMI inputs provides a source of demand for our PC products as consumers increasingly seek to connect their PCs to their DTVs to play games, watch high-definition DVDs and view photos. Because HDMI is backward compatible with the DVI standard, HDMI-enabled PCs can also connect directly to the enormous installed base of PC monitors with DVI inputs.
Our DVI products are marketed under our VastLane product family. Market researcher In-Stat estimated that 92 million DVI-enabled PC devices were shipped by industry participants in 2006. Although DVI is being replaced by the more feature-rich HDMI in many applications, In-Stat projects that approximately 112 million DVI-enabled devices were expected to ship in 2007.
We believe the consumer trend of increasingly purchasing and downloading content (e.g. music, TV programs and movies) from the internet will create a growing awareness and need for low-cost, simple, secure and reliable storage. In 2007, we released our second-generation storage processors (SiI5733) compatible with SATA, external SATA (eSATA) and Universal Serial Bus (USB) hosts. Storage processors provide an extremely cost-effective storage solution that is both fast and reliable. Our SATA controllers, built on the new Unified Extensible Firmware Interface (UEFI) model, give manufacturers of DVRs, STBs and PC motherboards an easy way to add SATA connectivity.
In the storage market, we continue our leadership role in SATA, a standard that has replaced PATA in desktop storage. Through several SATA generations, we have introduced higher levels of SATA integration, driving higher SATA performance and functionality and delivering a family of SATA system-on-a-chip (SoC) solutions for the consumer electronics environment. SATA offers a number of benefits over PATA interfaces, including higher bandwidth, scalability, lower voltage and narrower cabling. As a result, SATA is quickly becoming the standard drive interface for desktop and notebook PCs and is establishing a significant presence in CE applications through e-SATA connections. eSATA extends the SATA connection outside the device enclosure providing a storage interface that is six times faster than Universal Serial Bus (USB) 2.0 and three times faster than IEEE 1394. The latest generation of digital video recorders (DVRs) from Scientific Atlanta, Motorola and TiVo, as well as PCs & motherboards from HP, Dell, ASUS, MSI, ECS, Foxconn, ASRock and iWill are equipped with eSATA ports.
We introduced our SteelVine architecture in 2004. SteelVine integrates the capabilities of a complex redundant array of independent disks (RAID) controller into a single-chip architecture. Our storage products fall into three categories: controllers, bridges and storage processors, each of which is branded under the SteelVine tm product family.
SteelVine Storage Controllers â€” We provide a full line of SATA controllers used in PC, DVR and network attached storage (NAS) applications. The current generation of SteelVine controllers provides the latest SATA Gen II features including eSATA signal levels, 3.0 Gb/s, native command queuing (NCQ), hot-plug and port multiplier support.
SteelVine Bridges â€” Our bridge products such as the SiI3811 provide PC OEMs with a solution that connects legacy PATA optical drives to the current generation of motherboard chip sets and are used primarily in desktop and laptop PC applications.
SteelVine Storage Processors â€” Our SteelVine storage processors represent a completely new product category that enables a new class of storage solutions for the PC, CE and external storage markets. SteelVine storage processors deliver enterprise-class features such as virtualization, RAID, hot-plug and hot spare, in a single very low cost SoC. These unique SoCs allow system builders to produce appliance-like solutions that are simple, reliable, affordable and scalable without the need for host software. Storage processors are currently shipping in PC motherboards as well as external storage solutions.
We believe that our multi-layer approach to providing robust, cost-effective, multi-gigabit semiconductor solutions on a single chip for high-bandwidth applications, lends itself well to SATA storage market applications.
Simplay Labs, LLC
We believe Simplay Labs LLC, our wholly owned subsidiary, has further enhanced our reputation for quality, reliable products and leadership in the HDMI market. The Simplay HD Testing Program offers one of the most robust and comprehensive testing platforms in the consumer electronics industry as device interoperability is a significant issue to retailers and consumers in the HD market. Devices that pass the Simplay HD test are certified to meet the HDMI and HDCP specifications and have demonstrated interoperability through empirical testing against over 80 â€śpeerâ€ť devices maintained by the labs. We have service centers operating in the US, China, we opened two new Simplay Labs European HD service centers in 2007 in the UK and Germany, providing global compatibility and performance testing centers. By December 31, 2007, more than 160 product lines had been Simplay HD-verified and 75 manufacturers, installers and retailers had become members of the Simplay HD Testing Program, enabling a higher level of consumer trust that their products are fully interoperable with other HDMI products.
In 2007, Simplay introduced the Simplay Pre-test System (SPS), designed to identify interoperability, usability and performance issues before products are submitted to a Simplay Labs service center. The first test tool of its kind for CE manufacturers, the SPS sets a higher performance standard for the CE industry and enables manufacturers to bring products to market faster. We also launched a new Simplay HD Consumer Support Service for end-to-end Simplay HD verified products, which provides consumers with complimentary installation assistance and troubleshooting services in the set-up, operation and performance of their new HD home theater products.
HDMI Licensing, LLC
The HDMI specification is experiencing rapid growth in the consumer electronics, mobile device and PC markets, as manufacturers meet consumer demand for multimedia convergence. The market acceptance and adoption of the HDMI specification has been a significant factor the growth of both our product and licensing revenues over the past several years.
As of December 31, 2007, more than 750 manufacturing companies had licensed HDMI from HDMI Licensing, LLC, our wholly-owned subsidiary and the agent responsible for the licensing of HDMI. We believe the adoption by additional manufacturers during 2007, further strengthens the specificationâ€™s position as the worldwide standard for high-definition digital connectivity. According to market researcher In-Stat, the HDMI specification has become widely adopted and has moved from an emerging standard to a prevalent connectivity standard used in many consumer applications. In-Stat reports that 143 million HDMI enabled devices incorporating HDMI were expected to be shipped in 2007, with over 229 million devices expected to ship in 2008 and an installed base of nearly 1.2 billion HDMI-enabled devices projected by 2010. Our licensing activity is complementary to our product sales and it helps us to monetize our intellectual property and accelerate market adoption curves associated with our technology. Most of the intellectual property we license includes a field of use restriction that prevents the licensee from building a chip in direct competition with those market segments we have chosen to pursue.
Markets and Customers
We focus our sales and marketing efforts on achieving design wins with OEMs of CE, PC and storage products. Historically, a relatively small number of customers and distributors have generated a significant portion of our revenue. Our top five customers, including distributors, generated 57.7%, 57.3% and 53.5%, of our revenue in 2007, 2006 and 2005, respectively. For the year ended December 31, 2007, shipments to Innotech Corporation, generated 15.6% of our revenue, shipments to Microtek Corporation, generated 14.2% of our revenue and shipments to World Peace Industrial, generated 13.6% of our revenue. The percentage of revenue generated through distributors tends to be significant, since many OEMs rely upon third-party manufacturers or distributors to provide purchasing and inventory management functions. Our revenue generated through distributors was 49.5%, 50.2% and 51.7% of our total revenue in 2007, 2006 and 2005, respectively.
A substantial portion of our business is conducted outside the United States; therefore, we are subject to foreign business, political and economic risks. Nearly all of our products are manufactured offshore, primarily in Asia and for the years ended December 31, 2007, 2006 and 2005, approximately 79.8%, 78.6% and 74.3%, of our revenue respectively, was generated from customers and distributors located outside the United States, primarily in Asia. Please refer to the section of this report titled â€śRisk Factorsâ€ť for a discussion of risks associated with the sell-through arrangement with our distributors.
Research and Development
Our research and development efforts continue to focus on innovative technologies and standards, higher-bandwidth, lower-power links, efficient algorithms, architectures and feature-rich implementations for higher-level SoCs, for CE (including DTV), PC, mobile and storage applications. By utilizing our patented technologies and optimized architectures, we believe our products can scale with advances in semiconductor manufacturing process technology, simplify system design and provide innovative solutions for our customers. As of December 31, 2007, we had been issued more than 100 United States patents and had in excess of 85 United States patent applications pending. Our U.S. issued patents expire in 2015 or later, subject to our payment of periodic maintenance fees. A discussion of risks related to our intellectual property is set forth in the section of this report titled â€śRisk Factorsâ€ť.
We have assembled a team of engineers and technologists with extensive experience in the areas of high-speed interconnect architecture, circuit design, digital audio-visual (A/V) processor architecture, storage architecture, logic design/verification, firmware/software, flat panel displays, digital video/audio systems and storage systems. We have invested and expect that we will continue to invest, significant funds for research and development activities. Our research and development expenses were approximately $78.0 million, $63.6 million and $44.9 million, in 2007, 2006 and 2005, respectively, including stock-based compensation expense (benefit) of $8.4 million, $11.1 million and ($3.9) million for 2007, 2006 and 2005, respectively.
Sales and Marketing
We sell our products using a direct sales force with field offices located in North America, Europe, Turkey, Taiwan, China, Japan and Korea and through a network of distributors located throughout North America, Asia and Europe. Our sales strategy for all products is to achieve design wins with key industry companies in order to grow the markets in which we participate and to promote and accelerate the adoption of industry standards that we support or are developing.
Our semiconductor products are designed using standard, complementary metal â€“ oxide â€“ semiconductor (CMOS) processes, which permit us to use independent wafer foundries to fabricate them. By outsourcing the manufacture of our semiconductor products, we are able to avoid the high-cost of owning and operating a semiconductor wafer fabrication facility and to take advantage of our contract manufacturersâ€™ high-volume economies of scale. Outsourcing our manufacturing also gives us direct and timely access to various process technologies. This allows us to focus our resources on the innovation, design and quality of our products.
Our semiconductor products are currently fabricated using 0.35, 0.25, 0.18 and 0.13 micron processes. We continuously evaluate the benefits, primarily the improved performance, costs and feasibility, of migrating our products to smaller geometry process technologies. We have conducted certain development projects for some of our customers, involving smaller and more cost effective geometries, namely 90 nm and 65 nm designs. We rely almost entirely on Taiwan Semiconductor Manufacturing Company (TSMC) to produce all of our semiconductor products. Because of the cyclical nature of the semiconductor industry, capacity availability can change quickly and significantly. We attempt to optimize wafer availability by continuing to use less advanced wafer geometries, such as 0.35, 0.25, 0.18 and 0.13 micron, for which foundries generally have more available capacity.
Assembly and Test
Our semiconductor products are designed to use low-cost standard packages and to be tested with widely available semiconductor test equipment. We outsource all of our packaging and the majority of our test requirements. This enables us to take advantage of high-volume economies of scale and supply flexibility and gives us direct and timely access to advanced packaging and test technologies. We test a small portion of our products in-house. Since the fabrication yields of our products have historically been high and the costs of our packaging have historically been low, we test our products after they are assembled. This testing method has not caused us to experience unacceptable failures or yields. Our operations personnel closely review the process and control and monitor information provided to us by our foundries. To ensure quality, we have established firm guidelines for rejecting wafers that we consider unacceptable. However, lack of testing prior to assembly could have adverse effects if there are significant problems with wafer processing. Additionally, for newer products and products for which yield rates have not stabilized, we may conduct bench testing using our personnel and equipment, which is more expensive than fully automated testing.
During 2007, we purchased and installed additional pieces of equipment at third-party testing facilities to ensure we receive priority on such equipment and to obtain lower test prices from these facilities. In the fourth quarter of 2007, in an effort to improve control, increase operational flexibility and lower costs, we began internally managing the relationships with our other third party subcontractors who handle our wafer assembly and test process and terminated our reliance on third-party management of this process.
We focus on product quality through all stages of the design and manufacturing process. Our designs are subjected to in depth circuit simulation at temperature, voltage and processing extremes before being fabricated. We pre-qualify each of our subcontractors through an audit and analysis of the subcontractorâ€™s quality system and manufacturing capability. We also participate in quality and reliability monitoring through each stage of the production cycle by reviewing data from our wafer foundries and assembly subcontractors. We closely monitor wafer foundry production to ensure consistent overall quality, reliability and yields. Our independent foundries and our assembly and test subcontractors have achieved International Standards Organization (ISO) 9001 certification.
The markets in which we participate are intensely competitive and are characterized by rapid technological change, evolving standards, short product life cycles and decreasing prices. We believe that some of the key factors affecting competition in our markets are levels of product integration, compliance with industry standards, time-to-market, cost, product capabilities, system design costs, intellectual property, customer support, quality and reputation.
Masood Jabbar has served as a director of Silicon Image since May 2005. Mr. Jabbar is a private investor. From November 2004 to September 2006, Mr. Jabbar served as the Chief Executive Officer of XDS Inc., a privately held services company. In September 2003, Mr. Jabbar retired from Sun Microsystems, Inc. after sixteen years, where he held a variety of senior positions, including Executive Vice President and Advisor to the Chief Executive Officer from July 2002 through September 2003, Executive Vice President of Global Sales Operations from July 2000 to June 2002, President of the Computer Systems Division from February 1998 to June 2002 and, prior to that, Vice President, Chief Financial Officer and Chief of Staff of Sun Microsystems Computer Corporation from May 1994 to January 1998. Prior to joining Sun Microsystems, Inc., Mr. Jabbar worked for ten years at Xerox Corporation and prior to Xerox, two years at IBM Corporation. Mr. Jabbar serves on the Board of Directors of JDS Uniphase Corporation and Openwave Systems, Inc., each a publicly traded company, and Picsel Technologies. Mr. Jabbar holds a MA in International Management from the American Graduate School of International Management, a Master of Business Administration degree from West Texas A&M University and a Bachelor of Arts degree in Economics & Statistics from the University of the Punjab, Pakistan.
John Hodge has served as a director of Silicon Image since February 2006. Since June 2006, Mr. Hodge has served as Senior Advisor to Blackstone Group, a private equity firm. Since December 2006, Mr. Hodge has served on the Board of Directors of Freescale Semiconductor, Inc. Mr. Hodge was a consultant from February 2006 to June 2006. From February 2005 to February 2006, Mr. Hodge served as Senior Advisor and Managing Director of the Technology Group of Credit Suisse First Boston. From 1998 to February 2005, Mr. Hodge was Managing Director and Global Head of Corporate Finance of the Technology Group of Credit Suisse First Boston. From 1996 to 1998, Mr. Hodge was Managing Director and Head of West Coast Corporate Finance of the Technology Group of Deutsche Bank. He also previously held positions at Morgan Stanley and Robertson Stephens. Mr. Hodge holds a Bachelor of Science degree in Biology from Stanford University.
Peter Hanelt has served as a director of Silicon Image since May 2005, including as Chairman of the Board since July 2005. Mr. Hanelt has been a self-employed business consultant since November 2003. He served as Chief Restructuring Officer and Chief Operating Officer of the Good Guys, a regional consumer electronics retailer, from December 2001 through July 2003 and through October 2003 as a consultant. From October 1998 to June 2001, Mr. Hanelt served as Chief Executive Officer and director of Natural Wonders, Inc., a national specialty retailer of nature and science merchandise. Mr. Hanelt is also a director of Shoe Pavilion, Inc., a publicly traded retailer, Patelco Credit Union and Catholic Healthcare West, both not for profit companies, and InterHealth Nutraceuticals, Inc., Bidz.com, and Trader Vicâ€™s Restaurants, all private companies.
William George has served as a director of Silicon Image since October 2005. Dr. George has served as Executive Vice President of Operations for ON Semiconductor Corporation and SCI, LLC since August 1999. He served as Corporate Vice President and Director of Manufacturing of Motorolaâ€™s Semiconductor Components Group from June 1997 until he assumed his current position. Prior to that time, Dr. George held several executive and management positions at Motorola, including Corporate Vice President and Director of Manufacturing of Motorolaâ€™s Semiconductor Products Sector. From 1991 to 1994, he served as Executive Vice President and Chief Operations Officer of Sematech, a consortium of leading semiconductor companies. He joined Motorola in 1968. From October 2003 until December 2004, Dr. George served as a director of the Supervisory Board of Metron Technology N.V., a global provider of marketing, sales, manufacturing, service and support solutions to semiconductor materials and equipment suppliers and semiconductor manufacturers in Europe, Asia and the United States. Since August 2005, Dr. George has also served as a director of Ramtron International Corporation, a semiconductor supplier located in Colorado Springs, Colorado. Mr. George received his Bachelorâ€™s degree in Metallurgical Engineering in 1964 from the University of Oklahoma and earned a Ph.D. in Materials Science from Purdue University in 1968.
Steve Tirado has served as a director and President and Chief Executive Officer of Silicon Image since January 2005. Mr. Tirado previously served as Division President of the Storage Group from April 2004 to January 2005, President from January 2003 to March 2004, Chief Operating Officer from November 2000 to March 2004, and Executive Vice President of Marketing and Business Development from August 1999 to November 2000. From April 1986 to July 1999, Mr. Tirado held various marketing and management positions at Sun Microsystems, Inc., a computer networking company, serving most recently as Vice President of Marketing and Business Development for the NC Systems Group. From 1985 to 1986, Mr. Tirado was President of Tirado, Sorrentino Associates, a consulting firm. From 1984 to 1985, Mr. Tirado held the position of Marketing Administration Manager at Qualogy, a mass storage disk drive and controller company. From 1976 to 1984, Mr. Tirado was a public program administrator and policy analyst within various government agencies. Mr. Tirado holds a Bachelorâ€™s degree in Psychology from the University of California at Santa Barbara, a Masters of Social Work degree in Community Organization, Management and Planning from Boston University and a Masters of Business Administration degree from the University of California at Berkeley.
William Raduchel has served as a director of Silicon Image since December 2005. Dr. Raduchel served as non-executive vice chairman of Silicon Imageâ€™s wholly-owned subsidiary Simplay Labs, LLC (formerly known as PanelLink Cinema LLC) from January 2005 until his election as a director of Silicon Image. From April 2003 until his election as a director, Dr. Raduchel served as a consultant to Silicon Image. Dr. Raduchel is an outside director, an active individual investor and a strategic advisor. From March 2004 until June 2006, he was the chairman of the board, and from May 2004 to January 2006, chief executive officer, of Ruckus Network, Inc., a digital entertainment network for students at colleges and universities over the university network. He is a director of Blackboard, Inc., Chordiant Software, Inc., Opera Software ASA, all public companies, and Aha Media, Datran Media, ePals (formerly known as In2Books), moka5, and Stoneacre Partners LLC, all private companies. From time to time, he has served as an advisor to Myriad International Holdings, a cable television and internet services company. From September 1999 through January 2001, he was chief technology officer of AOL, becoming chief technology officer of AOL Time Warner (now known as Time Warner Inc.) at that time, a position he held through 2002. After leaving AOL Time Warner, he served as a part-time strategic advisor to America Online, Inc. (a subsidiary of Time Warner Inc.) from March 2003 through February 2004. After attending Michigan Technological University, which gave him an honorary doctorate in 2002, Dr. Raduchel received his undergraduate degree in Economics from Michigan State University, and earned his A.M. and Ph.D. degrees in Economics at Harvard University.
(1) Based upon a Schedule 13G filed with the Securities and Exchange Commission on January 23, 2007 which indicates that Barclays Global Investors, NA has sole voting power over 3,367,705 of these shares and sole investment power over 3,651,747 of these shares and Barclayâ€™s Global Fund Advisors has sole voting power over 1,288,417 of these shares and sole investment power over 1,288,417 of these shares. The address of Barclays Global Investors is 45 Fremont Street, San Francisco, CA 94105.
(2) Based upon a Schedule 13G filed with the Securities and Exchange Commission on February 14, 2007 which indicates that The Vanguard Group, Inc. has sole voting power over 68,790 of these shares and sole investment power over 4,320,888 of these shares. The address of The Vanguard Group is 100 Vanguard Blvd., Malvern, PA19355.
(3) Includes 900 shares held by the Tirado Family Trust, of which Mr. Tirado is a trustee. Includes 822,531 shares subject to options held by Mr. Tirado that are exercisable within 60 days after February 28, 2007.
(4) Includes 402,396 shares subject to options held by Dr. Northcutt that are exercisable within 60 days after February 28, 2007.
(5) Includes 260,313 shares subject to options held by Mr. Shin that are exercisable within 60 days after February 28, 2007.
(6) Includes 274,418 shares subject to options held by Mr. Valiton that are exercisable within 60 days after February 28, 2007.
(7) Includes 106,600 shares held by the Hodges Family Trust 5/16/90, of which Dr. Hodges and Susan S. Hodges are trustees. Includes 98,959 shares subject to options held by Dr. Hodges that are exercisable within 60 days after February 28, 2007.
(8) Represents 183,333 shares subject to options held by Dr. Raduchel that are exercisable within 60 days after February 28, 2007.
(9) Represents 88,542 shares subject to options held by Mr. Freeman that are exercisable within 60 days after February 28, 2007.
(10) Includes 2,000 shares held by the Peter G. Hanelt and Mary Ann Hanelt Trust, of which Mr. Hanelt is the trustee. Includes 500 shares held by Mr. Haneltâ€™s spouse. Includes 30,626 shares subject to options held by Mr. Hanelt that are exercisable within 60 days after February 28, 2007.
(11) Represents 30,626 shares subject to options held by Mr. Jabbar that are exercisable within 60 days after February 28, 2007.
(12) Represents 15,000 shares subject to options held by Dr. George that are exercisable within 60 days after February 28, 2007.
(13) Represents 11,667 shares subject to options held by Mr. Hodge that are exercisable within 60 days after February 28, 2007.
(14) Mr. Reutens, who most recently served as Chief Legal Officer, resigned from Silicon Image in September 2006.
(15) Includes 2,031,015 shares subject to options that are exercisable within 60 days after February 28, 2007.
(16) Does not include shares or shares subject to options held by Mr. Reutens or Mr. Shin as of February 28, 2007, as neither Mr. Reutens nor Mr. Shin were executive officers at that date.
Base Salary. Base compensation is intended to provide a competitive cash package for employees based on their job scope, level and experience. It is intended to recognize and reward the day-to-day performance of oneâ€™s duties. Our target is to keep executive base compensation in the third quartile of our peer group. This survey provides us with overall market compensation for the semiconductor segment as well as specific compensation data for a targeted group of companies with whom we compete for talent.
We review base salary levels annually to assess whether we have met our target positioning relative to the market in which we compete for employees. We also review individual executive performance to assess whether a merit increase is warranted based on individual and company-wide performance. During 2006, we awarded increases in base pay to our executives, as described below under â€śSummary Compensation Table â€” Compensation of Named Executive Officers in 2006.â€ť
Incentive Bonus â€” Linking Pay with Performance. Silicon Imageâ€™s short term incentive program is referred to as the Silicon Image Incentive Bonus Program, and is designed to align executive performance with the annual goals and objectives of the company. Our objective is to have an incentive program that is competitive with the market, aligns focus, ties to results and rewards performance. It is funded based on overall company performance against predetermined revenue and net income objectives. The target incentives we provide for executives are intended to be in the third quartile of our peer group. We believe that our actual payout of incentive compensation in 2006 was at the high end of this range (based on an assessment by Compensia) and reflected our strong financial performance in 2006.
Performance Metrics. In 2006, our bonus plan provided two cash bonus pools, one for executive participants and one for non-executive participants. The amounts of the bonus pools were designed to be a function of the extent to which our revenue exceeded at least 95% of our planned revenue for the year, and our adjusted net income for 2006 exceeded at least 95% of our planned adjusted net income for the year. Adjusted net income for this purpose was defined as our GAAP net income, excluding (1) certain charges related to acquisitions, including expenses for amortization of intangible assets, (2) stock-based compensation expense, and (3) gains or losses on strategic investments. This generally correlates to the pro forma net income amounts that we publicly disclose when reporting our quarterly earnings. We believe that revenue and adjusted net income align employees and stockholdersâ€™ interests, and provide clear, definable and readily understood measures of overall company performance and stockholder interests. Half of the bonus plan funding was based on the revenue target, and half on the adjusted net income target. In 2007, our bonus plan will have a similar structure, except that we expect that the income-related component will be based upon an earnings before interest, taxes, depreciation and amortization (EBITDA) calculation (excluding stock based compensation expense), rather than adjusted net income. In addition, we anticipate that our 2007 bonus plan will require achievement of a minimum EBITDA level before any bonuses would be funded.
At the 95% of revenue and adjusted net income levels, our 2006 bonus plan would have provided for funding of the bonus pool at 80% of target, escalating to 100% funding at 100% performance against plan. In addition, the plan included accelerators that would provide higher than target funding levels at company performance levels that exceeded 100% of plan, so that if revenue or adjusted net income performance was at or above 125% of plan, the bonus pool would be funded at 300% of the applicable target. The plan provided for funding on a prorata basis between these levels of revenue and adjusted net income. In 2006, we achieved over 113.3% of our revenue target and 115.3% of our adjusted net income target, and accordingly funded a $2,378,411 pool for bonuses for executive participants. A significant portion of our performance in excess of our adjusted net income and revenue targets is attributable to royalty revenue that we recognized in 2006 in connection with our settlement with Genesis Microchip. Although a portion of the royalty revenue recognized in connection with the Genesis settlement related to years prior to 2006, we believed it was appropriate to take such royalty revenue into account in calculating the bonus pool for 2006 because our executives and other employees had not received credit for that revenue in their bonus pool in those prior years.
Individual Bonus Payout. Our Compensation Committee set the 2006 target bonus levels for executive participants in our bonus program in February 2006. Bonus targets for each executive position were: Chief Executive Officer â€” 70% of base compensation; Chief Technology Officer, Chief Financial Officer and Chief Legal Officer â€” 45% of base compensation; and all other VPs or equivalent â€” 40% of base compensation. The amount of individual bonus payments are proposed to our Compensation Committee by the CEO (with the exception of the CEOâ€™s own bonus) and are based on a subjective assessment of a number of factors and inputs, including peer assessments, a self-assessment, the CEOâ€™s ranking of performance against quantitative and qualitative goals and objectives established early in the year or shortly after the time of hire, and other factors. The percentage targets described above represent the amount of bonuses that would be paid if the company achieves 100% of its revenue and adjusted net income targets and the executive achieves his performance goals. The maximum possible payout under our executive bonus program would be three times the bonus target. For 2006, we determined that each of our executive officers achieved their individual performance objectives, and accordingly each executive officer as of the end of the year received a bonus based on their target amount, as adjusted to reflect the increased funding of our bonus plan due to our revenue and adjusted net income levels, as described above.
Incentive Compensation for our VP of Worldwide Sales. Our VP of Worldwide Sales does not participate in our Incentive Bonus Program. Instead, he receives incentive compensation based on our percent achievement of our revenue target for the fiscal year.
Total Cash Compensation Target. Our overall total cash compensation goal for our executive officers is to provide cash compensation at the third quartile of our peer group on average, reflecting the market positioning that we believe is necessary for Silicon Image to attract the executive talent necessary to remain competitive. We believe that our 2006 executive cash compensation was within this range, based on an assessment by Compensia.
Long-Term Equity Incentive Program. The goal of the companyâ€™s long term incentive program is to align management and employee performance with the longer-term interests of investors through stock options. At the executive level, we continue to believe that equity in the form of stock options is both a motivator as well as a recruiting and retention tool. We also believe that it is the best instrument in our compensation portfolio to align executive performance with the longer term goals of the company. Those goals in turn align with the longer term stockholder interests.
As with our bonus program, our equity incentive program is structured to provide a target level of participation based on the level of the position. Our target level of options for our executive officers is to provide equity compensation (in numbers of shares granted) in the third quartile of our peer group, based on an assessment by Compensia. Our current goal is to limit the number of shares subject to options granted in any one year so that they do not materially exceed four percent of our total shares outstanding.
At the executive officer level, there is more variability from person to person in option grant levels than at lower levels, as assessed by Compensia, due to market competitive pressures and individually negotiated offer packages.
Our stock option grant policies have been affected by the implementation of SFAS No. 123R, which we adopted in the first quarter of fiscal year 2006 using the modified prospective method as permitted by the pronouncement. Under this transition method, we are required to value all stock-based compensation awards granted prior to but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, as adjusted for estimated forfeitures.
Different Forms of Long-Term Incentives. The company has the ability in its plans to grant other forms of equity including performance based options and restricted shares. All of our long-term equity incentives have been in the form of stock options. Generally, our options provide for vesting over time, typically a four-year period. We have on occasion also granted performance based options, with vesting tied to specific measurable achievements. In 2006, we granted performance based options to our VP, Worldwide Sales.
Standardization of Grant Dates. Beginning in August 2006, all option grants to executive and non-executive employees have a vesting commencement and pricing on the first 15th of the month following approval, except as otherwise approved by our compensation committee. The standardization of grant dates on the first 15th of the month following approval is designed to avoid the timing of granting options in conjunction with the release of information that might have a favorable or unfavorable impact on the companyâ€™s stock price.
Other Equity, Retirement and Benefits Programs
Employee Stock Purchase Plan (ESPP). The company provides an Employee Stock Purchase Program (ESPP) that enables all employees, including executives, to purchase stock at a discount. The stock is offered for purchase at 85% of the market value at the beginning and end of specified purchase periods. In December 2006, we amended the ESPP to reduce the length of offering periods from two years to six months, among other things. We anticipate that this amendment will help reduce the compensation expense impact and dilution effect of the plan.
401K Defined Contribution Plan. The company does not offer a defined benefit retirement plan. However, it does have a defined contribution plan in the form of a 401K plan for its employees. At the current time, the company does not provide for a company match.
Other Benefits. The company offers a full range of benefits including life, medical, dental, vision and disability programs. The company also has a paid time off (PTO) program that allows employees time for vacation or personal matters. The goal of the plans is to provide an attractive and competitive set of benefits while also managing costs.
Other Benefits or Perquisites. The company does not generally offer other cash or non-cash incentives to executives that are not available to other employees. However, there are times when a specific situation requires additional compensation. Relocation or temporary living arrangements for executives who either work remotely but spend significant time in another Silicon Image work location or have not yet moved is an example. Some specifics include:
We pay rent on apartments for two executives (neither of whom are Named Executive Officers) who work full time in the headquarters offices but live in a different location for family reasons. We also pay for travel back and forth from their home locations to their work location, and are reimbursing these two executives for taxes payable on these arrangements. We anticipate that both situations will be temporary arrangements.
MANAGEMENT DISCUSSION FROM LATEST 10K
Headquartered in Sunnyvale, California., we are a leader in semiconductors for the secure storage, distribution and presentation of high-definition content. We are dedicated to the promotion of technologies, standards and products that facilitate the movement of digital content between and among digital devices across the consumer electronics (CE), personal computer (PC) and storage spaces. We have shipped more than 140 million HDMI compliant chips to date. We are the leading provider of semiconductor intellectual property solutions for high-definition multimedia and data storage applications.
Silicon Imageâ€™s HDMI products have been selected by many of the worldâ€™s leading CE companies. Our products have driven the transition to industry-leading HDMI products with features including Deep Color tm and lossless HD audio.
In the PC market, we continue to be a leader in the DVI market. The growth of digital TVs with HDMI inputs provides a source of demand for our PC products as consumers increasingly seek to connect their PCs to their DTVs to play games, watch high-definition DVDs and view photos. Because HDMI is backwards compatible with the DVI standard, HDMI-enabled PCs can also connect directly to the enormous installed base of PC monitors with DVI inputs.
We believe the consumer trend of increasingly purchasing and downloading content (e.g. music, TV programs and movies) from the internet will create a growing awareness and need for low-cost, simple, secure and reliable storage. In 2007, we released our second-generation storage processors compatible with SATA, external SATA (eSATA) and Universal Serial Bus (USB) hosts.
In addition, we offer one of the most robust and comprehensively tested technology platforms in the consumer electronics industry through our Simplay Labsâ€™ Simplay HD tm Testing Program. Simplay Labs, LLC, a wholly-owned subsidiary of Silicon Image, is a leading provider of testing technologies, tools and services for high- definition consumer electronics devices such as HDTVs, set-top boxes, A/V receivers and DVD players, helping manufacturers to achieve compatibility and deliver the highest- quality HDTV experience to consumers.
We completed two important transactions in 2007 that enhance our ability to offer higher levels of integration and greater price/performance value to our customers. We entered into a cross-license agreement with Sunplus Technology Company, Ltd. for advanced IP to use in DTV semiconductor products, which we believe will offer us greater opportunities to develop semiconductor solutions for the home and mobile device environment. The license agreement provides for the payment of an aggregate of $40.0 million to Sunplus by Silicon Image, $35.0 million of which is payable in consideration for the licensed technology and related deliverables and $5.0 million of which is payable in consideration for Sunplus support and maintenance obligations. As of December 31, 2007, we had paid approximately $18.8 million towards the $40.0 million obligation. In addition, while we are still validating the technology received from Sunplus, we began to integrate a portion of this technology into a new product development project. As a result, we began to amortize the $39.6 million in the fourth quarter of 2007. In addition, our acquisition of sci-worx GmbH (sci-worx), now Silicon Image, Germany provides us a combination of additional advanced IP and a highly skilled pool of engineers who will help leverage our research and development efforts into new products. We acquired sci-worx GmbH for a net cash consideration of $13.8 million. During 2007, the Company completed the integration of the sci-worx engineers and began utilizing this resource to drive development of existing and newly created product development projects. We believe that the intellectual property licensed from Sunplus, along with the engineering talent and intellectual property acquired in the sci-worx transaction, will enhance our ability to continue to develop a broader array of product offerings.
Critical Accounting Policies
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect amounts reported in our consolidated financial statements and accompanying notes. We base our estimates on historical experience and all known facts and circumstances that we believe are relevant. Actual results may differ materially from our estimates. We believe the accounting policies discussed in our notes to be most critical to an understanding of our financial condition and results of operations because they require us to make estimates, assumptions and judgments about matters that are inherently uncertain.
The Companyâ€™s revenue recognition policy complies with Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition (SAB No. 104). We recognize revenue when persuasive evidence of an arrangement exists, delivery or performance has occurred, the sales price is fixed or determinable and collectability is reasonably assured.
Revenue from products sold directly to end-users, or to distributors that do not receive price concessions and rights of return, is generally recognized when title and risk of loss has passed to the buyer which typically occurs upon shipment. Reserves for sales returns are estimated based primarily on historical experience and are provided at the time of shipment.
For products sold to distributors with agreements allowing for price concessions and product returns, we recognize revenue based on our best estimate of when the distributor sold the product to its end customer. Our estimate of such distributor sell-through is based on point of sales reports received from our distributors. Revenue is not recognized upon shipment since, due to various forms of price concessions, the sales price is not substantially fixed or determinable at that time. Price concessions are recorded when incurred, which is generally at the time the distributor sells the product to an end-user. Additionally, these distributors have contractual rights to return products, up to a specified amount for a given period of time. Revenue is earned when the distributor sells the product to an end-user, at which time our sales price to the distributor becomes fixed. Pursuant to our distributor agreements, older or end-of-life products are sold with no right of return and are not eligible for price concessions. For these products, revenue is recognized upon shipment and title transfer assuming all other revenue recognition criteria are met. Revenue for 2007 includes approximately $6.7 million of product revenue and cost of revenue includes approximately $2.6 million related to distributor sales for the month of December 2007. Historically, the Company had deferred the recognition of sell-through revenue from distributor sales for the third month of a quarter until the following quarter due to the unavailability of reliable sell-through information in a timely manner. As a result of improved business processes, the Company was able to eliminate this delay beginning with the fourth quarter of 2007, resulting in fiscal year 2007 revenue including an additional month of product revenue from distributor sales in December 2007. This one-time effect of the inclusion of an additional month of revenue for fiscal year 2007 is an increase to net income by approximately $2.6 million and an increase to net income per share, basic and diluted, by approximately $0.03
At the time of shipment to distributors, we record a trade receivable for the selling price since there is a legally enforceable right to payment, relieve inventory for the carrying value of goods shipped since legal title has passed to the distributor and record the gross margin in â€śdeferred margin on sale to distributorsâ€ť, a component of current liabilities in our consolidated balance sheet. Deferred margin on the sale to distributor effectively represents the gross margin on the sale to the distributor. However, the amount of gross margin we recognize in future periods will be less than the originally recorded deferred margin on sale to distributor as a result of negotiated price concessions. We sell each item in our product price book to all of our distributors worldwide at a relatively uniform list price. However, distributors resell our products to end customers at a very broad range of individually negotiated price points based on customer, product, quantity, geography, competitive pricing and other factors. The majority of our distributorsâ€™ resale are priced at a discount from list price. Often, under these circumstances, we remit back to the distributor a portion of their original purchase price after the resale transaction is completed. Thus, a portion of the â€śdeferred margin on the sale to distributorâ€ť balance represents a portion of distributorsâ€™ original purchase price that will be remitted back to the distributor in the future. The wide range and variability of negotiated price concessions granted to distributors does not allow us to accurately estimate the portion of the balance in the Deferred margin on the sale to distributor that will be remitted back to the distributors. We reduce deferred margin by anticipated or determinable future price concessions.
We derive revenue from license of our internally developed intellectual property (IP). We enter into IP licensing agreements that generally provide licensees the right to incorporate our IP components in their products with terms and conditions that vary by licensee. Revenue earned under contracts with our licensees is classified as development, licensing and royalties. Our license fee arrangements generally include multiple deliverables and for multiple deliverable arrangements we follow the guidance in EITF 00-21, Revenue Arrangements with Multiple Deliverables , to determine whether there is more than one unit of accounting. To the extent that the deliverables are separable into multiple units of accounting, we allocate the total fee on such arrangements to the individual units of accounting using the residual method, if objective and reliable evidence of fair value does not exist for delivered elements. We then recognize revenue for each unit of accounting depending on the nature of the deliverable(s) comprising the unit of accounting in accordance with the provisions of SAB No. 104.
The IP licensing agreements generally include a nonexclusive license for the underlying IP. Fees under these agreements generally include (a) license fees relating to our IP (b) maintenance and support, typically for one year; and (c) royalties payable following the sale by our licensees of products incorporating the licensed technology. The license for our IP has standalone value and can be used by the licensee without maintenance and support. Further, objective and reliable evidence of fair value exists for maintenance and support. Accordingly, license fees and maintenance and support fees are each treated as separate units of accounting.
Certain licensing agreements provide for royalty payments based on agreed upon royalty rates. Such rates can be fixed or variable depending on the terms of the agreement. The amount of revenue we recognize is determined based on a time period or on the agreed-upon royalty rate, extended by the number of units shipped by the customer. To determine the number of units shipped, we rely upon actual royalty reports from our customers when available and rely upon estimates in lieu of actual royalty reports when we have a sufficient history of receiving royalties from a specific customer for us to make an estimate based on available information from the licensee such as quantities held, manufactured and other information. These estimates for royalties necessarily involve the application of management judgment. As a result of our use of estimates, period-to-period numbers are â€śtrued-upâ€ť in the following period to reflect actual units shipped. To date, such â€śtrue-upâ€ť adjustments have not been significant. In cases where royalty reports and other information are not available to allow us to estimate royalty revenue, we recognize revenue only when royalty reports are received.
For contracts related to licenses of our technology that involve significant modification, customization or engineering services we recognize revenue in accordance the provisions of SOP 81-1 â€śAccounting for Performance of Construction-Type and Certain Production-Type Contractsâ€ť . Revenues derived from such license contracts are accounted for using the percentage-of-completion method. We determine progress to completion based on input measures using labor-hours incurred by our engineers. The amount of revenue recognized is based on the total contract fees and the percentage of completion achieved. Estimates of total project requirements are based on prior experience of customization, delivery and acceptance of the same or similar technology and are reviewed and updated regularly by management. If there is significant uncertainty about customer acceptance, or the time to complete the development or the deliverables by either party, we consider applying completed contract method. If application of the percentage-of-completion method results in recognizable revenue prior to an invoicing event under a customer contract, we recognize the revenue and record an unbilled receivable assuming collectability is reasonably assured. Amounts invoiced to our customers in excess of recognizable revenues are recorded as deferred revenues.
Prior to 2006, our stock-based employee compensation plans were accounted for under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees and related interpretations. Our Employee Stock Purchase Plan (ESPP) qualified as a non-compensatory plan under APB 25. Therefore, no compensation cost was recorded in relation to the discount offered to employees for purchases made under the ESPP.
Effective January 1, 2006, we adopted the fair value recognition provisions of SFAS No. 123R, Share-Based Payment , (SFAS No. 123R), requiring us to recognize expense related to the fair value of our stock-based compensation awards. We elected to use the modified prospective transition method as permitted by SFAS No. 123R and therefore have not restated our financial results for prior periods. Under this transition method, stock-based compensation expense for the year ended December 31, 2006 includes compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of December 31, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123, as adjusted for estimated forfeitures. Stock- based compensation expense for all stock-based compensation awards granted subsequent to December 31, 2005 was based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R. Under SFAS No. 123R, our ESPP is considered a compensatory plan and we are required to recognize compensation cost for grants made under the ESPP. We recognize stock-based compensation expense on a straight-line basis for all share-based payment awards over the respective requisite service period of the awards. For purposes of calculating the pool of excess tax benefits available to absorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123(R), we followed the alternative transition method discussed in FASB Staff Position No. 123(R)-3 â€śTransition Election to Accounting for the Tax Effects of Share-Based Payment Awards.â€ť
Cash Equivalents and Short-Term Investments
We account for our investments in debt and equity securities under Statement of Financial Accounting Standards, or SFAS, No. 115, Accounting for Certain Investments in Debt and Equity Securities and FASB Staff Position, or FSP, SFAS No. 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. Management determines the appropriate classification of such securities at the time of purchase and reevaluates such classification as of each balance sheet date. The investments are adjusted for amortization of premiums and discounts to maturity and such amortization is included in interest income. We follow the guidance provided by EITF No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments , to assess whether our investments with unrealized loss positions are other than temporarily impaired. Realized gains and losses and declines in value judged to be other than temporary are determined based on the specific identification method and are reported in the statements of income. Factors considered in determining whether a loss is temporary include the length of time and extent to which fair value has been less than the cost basis, the financial condition and near-term prospects of the investee, and our intent and ability to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. We place our investments in instruments that meet high credit quality standards, as specified in our investment policy guidelines. These guidelines also limit the amount of credit exposure to any one issue, issuer or type of instrument.
The longer the duration of our investment securities, the more susceptible they are to changes in market interest rates and bond yields. As yields increase, those securities purchased with a lower yield-at-cost show a mark-to-market unrealized loss. All unrealized losses are due to changes in interest rates and bond yields. We expect to realize the full value of all these investments upon maturity or sale.
The classification of our investments into cash equivalents and short term investments is in accordance with Statement of Financial Accounting Standard No. 95 (SFAS No. 95) Statement of Cash Flows. Cash equivalents consist of short-term, highly liquid financial instruments with insignificant interest rate risk that are readily convertible to cash and have maturities of three months or less from the date of purchase. Short-term investments consist of taxable commercial paper, United States government agency obligations, corporate/municipal notes and bonds with high-credit quality and money market preferred stock. These securities have maturities greater than three months from the date of purchase.
We believe all of the financial instrumentsâ€™ recorded values approximate current fair values because of their nature and respective durations. The fair value of marketable securities is determined using quoted market prices for those securities or similar financial instruments.
Allowance for Doubtful Accounts
We review collectability of accounts receivable on an on-going basis and provide an allowance for amounts we estimate will not be collectible. During our review, we consider our historical experience, the age of the receivable balance, the credit-worthiness of the customer and the reason for the delinquency. Delinquent account balances are written-off after management has determined that the likelihood of collection is remote. Write-offs to date have not been material. Increase in the allowance in 2007 as compared to 2006 is primarily due to the inclusion of allowance on receivables due to the purchase accounting of sci-worx, now Silicon Image GmbH. While we endeavor to accurately estimate the allowance, we may record unanticipated write-offs in the future.
We record inventories at the lower of actual cost, determined on a first-in first-out (FIFO) basis, or market. Actual cost approximates standard cost, adjusted for variances between standard and actual. Standard costs are determined based on our estimate of material costs, manufacturing yields, costs to assemble, test and package our products and allocable indirect costs. We record differences between standard costs and actual costs as variances. These variances are analyzed and are either included on the consolidated balance sheet or the consolidated statement of income in order to state the inventories at actual costs on a FIFO basis. Standard costs are evaluated at least annually.
Provisions are recorded for excess and obsolete inventory and are estimated based on a comparison of the quantity and cost of inventory on hand to managementâ€™s forecast of customer demand. Customer demand is dependent on many factors and requires us to use significant judgment in our forecasting process. We must also make assumptions regarding the rate at which new products will be accepted in the marketplace and at which customers will transition from older products to newer products. Generally, inventories in excess of six months demand are written down to zero and the related provision is recorded as a cost of revenue. Once a provision is established, it is maintained until the product to which it relates is sold or otherwise disposed of, even if in subsequent periods we forecast demand for the product.
Consideration paid in connection with acquisitions is required to be allocated to the assets, including identifiable intangible assets and liabilities acquired. Acquired assets and liabilities are recorded based on our estimate of fair value, which requires significant judgment with respect to future cash flows and discount rates.
For certain long-lived assets, primarily fixed assets and identifiable intangible assets, we are required to estimate the useful life of the asset and recognize its cost as an expense over the useful life. We use the straight-line method to depreciate long-lived assets. We evaluate the recoverability of our long-lived assets in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. Whenever events or circumstances indicate that the carrying amount of long-lived assets may not be recoverable, we compare the carrying amount of long-lived assets to our projection of future undiscounted cash flows, attributable to such assets. In the event that the carrying amount exceeds the future undiscounted cash flows, we record an impairment charge against income equal to the excess of the carrying amount over the assetâ€™s fair value. Predicting future cash flows attributable to a particular asset is difficult and requires the use of significant judgment.
We assign the following useful lives to our fixed assets â€” three years for computers and software, one to five years for equipment and five to seven years for furniture and fixtures. Leasehold improvements and assets held under capital leases are amortized on a straight-line basis over the shorter of the lease term or the estimated useful life, which ranges from two to five years. Depreciation expense was $9.5 million, $7.1 million and $6.1 million, for the years ended December 31, 2007, 2006 and 2005.
Goodwill and intangible assets
The Company periodically reviews the carrying value of intangible assets not subject to amortization, including goodwill, to determine whether impairment may exist. Statement of Financial Accounting Standards No. 142 (SFAS 142), Goodwill and Other Intangible Assets, requires that goodwill and certain intangible assets be assessed annually for impairment using fair value measurement techniques. Specifically, goodwill impairment is determined using a two-step process. The first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of a reporting unit with its carrying amount, including goodwill. The Company has determined based on the criteria of SFAS 142 that we have one reporting unit for this purpose. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test compares the implied fair value of the reporting unitâ€™s goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unitâ€™s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The implied fair value of goodwill is determined by comparing our market capitalization as of the date of the impairment testing to the carry amount of equity. The impairment test for other intangible assets not subject to amortization consists of a comparison of the fair value of the intangible asset with its carrying value. If the carrying value of the intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. Furthermore, SFAS 142 requires purchased other intangible assets to be amortized over their useful lives unless these lives are determined to be indefinite. Significant assumptions are inherent and highly subjective in this process. However, there can be no assurance that we will not incur impairment losses for goodwill and other intangible assets in the future, which could adversely affect our earnings.
Advertising and Research and Development
Advertising and research and development costs are expensed as incurred. Advertising expenses were insignificant in 2007, 2006 and 2005. It is the companyâ€™s policy to record a reduction to research and development expense for funding received from outside parties for research and development projects. During the year ended December 31, 2007, such funding was immaterial. During the year ended December 31, 2006, the Company recorded a reduction to research and development expense totaling approximately $1.0 million related to funding received from outside parties for one engineering project. During the year ended December 31, 2005, the Company recorded a reduction to research and development expense totaling approximately $1.8 million related to funding received from outside parties for three engineering projects. Such funding was provided irrespective of the results of the projects.
We must make certain estimates and judgments in determining income tax expense for financial statement purposes. These estimates and judgments occur in the calculation of tax credits, tax benefits and deductions and in the calculation of certain tax assets and liabilities, which arise from differences in the timing of recognition of revenue and expense for tax and financial statement purposes. Significant changes to these estimates may result in an increase or decrease to our tax provision in a subsequent period.
Deferred tax assets
We account for deferred tax assets in accordance with the Statement of Financial Accounting Standard No. 109 (SFAS No. 109), Accounting for Income Taxes. In the first quarter of 2007, we adopted the Financial Accounting Standards Board (FASB) FIN No. 48, Accounting for Uncertainty in Income Taxes â€” an Interpretation of FASB Statement No. 109 . FIN No. 48 requires that management determine whether a tax position is more likely than not to be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. For income taxes we use an asset and liability approach, which requires recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements, but have not been reflected in our taxable income. In general, a valuation allowance is established to reduce deferred tax assets to their estimated realizable value, if based on the weight of available evidence, it is more likely than not that some portion, or all, of the deferred tax asset will not be realized. We evaluate the realizability of the deferred tax assets quarterly and will continue to assess the need for valuation allowances.
At December 31, 2007, we had gross deferred tax assets, related primarily to stock-based compensation, accruals and reserves that are not currently deductible and tax credit carry forwards of $24.0 million. At December 31, 2006 our gross deferred tax assets of $23.4 million consisted primarily of tax credit carryforwards and stock-based compensation not currently deductible for tax purposes. Prior to 2006, we had provided a valuation allowance against 100% of our net deferred tax assets. In 2006, we determined that our net deferred tax assets as of December 31, 2006 were more likely than not to be realized. Therefore, in 2006, we released the remaining valuation allowance of approximately $52.3 million that had reduced the carrying value of our deferred tax assets as of December 31, 2005. Approximately $14.3 million of the valuation allowance release related to prior years windfall tax benefits on employee stock transactions that were included in the deferred tax asset for net operating loss carryforwards as of December 31, 2005. This portion of the valuation allowance release was recorded as a direct increase to additional paid-in capital instead of a reduction to the tax provision.
Annual Results of Operations
Total revenue for 2007 was $320.5 million and represented a sequential growth of 8.7% over 2006 and 50.9% over 2005. Revenue for 2007 includes approximately $6.7 million of product revenue and cost of revenue includes approximately $2.6 million related to distributor sales for the month of December 2007. Historically, the Company had deferred the recognition of sell-through revenue from distributor sales for the third month of a quarter until the following quarter due to the unavailability of reliable sell-through information in a timely manner. As a result of improved business processes, the Company was able to eliminate this delay beginning with the fourth quarter of 2007, resulting in fiscal year 2007 revenue including an additional month of product revenue from distributor sales in December 2007. The increase in product revenue in 2007 as compared to 2006 and 2005 was primarily driven by increased unit shipments, recognition of distributor revenue for December 2007, partially offset by declines in average selling prices (ASP) across all product categories. We currently expect average selling prices to continue to decline for all of our product categories in the first quarter of 2008. Additionally, we expect 2008 to be a product transition year. As part of this transition we currently expect to sample and subsequently announce a number of design wins throughout 2008. We expect volume shipments for the new products to start occurring in the first half of 2009. Accordingly, we expect our total revenue to decline in 2008.
Total revenue for 2006 was $295.0 million and represented a sequential growth of 38.9% over 2005 driven by increased sales, of our CE products. The increase in the CE product revenue relative to 2005 was due primarily to strong sales volumes of HDMI receivers and transmitters. The increase in PC product revenue was driven primarily by PC transmitters that incorporate our DVI technology and our intelligent panel controllers, which are key components in LCD displays, partially offset by modest erosion in the average selling prices of products. Revenue from our DVI products are expected to decline in the future as DVI technology is replaced by HDMI and DisplayPort. The decrease in storage product revenue was due to the trend of declining sales of our legacy storage systems products, which are being phased out of customer applications, partially offset by contributions from our new SATA and SteelVine products. We have experienced erosion of average selling prices for all of our product categories.
Our licensing activity is complementary to our product sales and it helps us to monetize our intellectual property and accelerate market adoption curves associated with our technology. Most of the intellectual property we license includes a field of use restriction that prevents the licensee from building a chip in direct competition with those market segments we have chosen to pursue. Revenue from development for licensees, licensing and royalties accounted for 15.9%, 15.1% and 8.7% of our revenues for the years ended December 31, 2007, 2006 and 2005, respectively. The increase in licensing revenues in 2007 as compared to 2006 is primarily due to recognition of $4.9 million of revenue for the delivery of the IP technology sold, which represented the $5.0 million license amount less $0.1 million for the fair value of support and maintenance which we are required to provide to Sunplus for one year. We completed the delivery of IP technology sold to Sunplus under the license agreement and received final acceptance. The increase in 2006 was primarily due to recognition of $11.8 million of royalty revenues related to the settlement agreement with Genesis Microchip in the fourth quarter of 2006 and the recognition of revenue for certain development projects that were previously deferred. Licensing contracts are complex and the recognition of related revenue depends upon many factors that require significant judgments including completion of milestones, allocation of values to delivered items and customer acceptances.
Revenues from products sold into the CE market have been increasing as a percentage of our total revenues and generated 63.7%, 56.9% and 51.2% of our total revenues for the years ended December 31, 2007, 2006 and 2005, respectively. If we include licensing revenues, these percentages would be 75.2%, 66.0% and 55.8% for the years ended December 31, 2007, 2006 and 2005, respectively. The increase in the CE product revenue in 2007 was due primarily to strong sales volumes of HDMI 1.3 receivers and transmitters partially offset by decrease in ASPs. Our HDMI 1.3 chips are targeted towards the DTV, AV receiver, Blu Ray recorders, HD DVD, DVD, game console and mobile markets. We believe that as the market acceptance of the HDMI 1.3 standard continues to grow and with our anticipated new product offerings in 2008 are introduced sales of our CE products will contribute a significant percentage of our CE revenues.
Product revenues from the PC market have declined in 2007 as compared to 2006 and 2005 and generated 12.6% of our revenue in 2007, 16.7% of our revenue in 2006 and 23.2% of our revenues in 2005. If we include licensing revenues, these percentages would be 14.6%, 19.9% and 23.8% for the years ended December 31, 2007, 2006 and 2005, respectively. The decrease in PC revenues as compared to 2006 and 2005 is primarily due to lower shipments coupled with declines in ASPs of our HDMI and DVI products. The decrease in ASP in the PC business is due to the competitive nature of the PC business. We expect the PC revenues in absolute dollars to decline in 2008 as compared to 2007.
The slight increase in PC revenue for 2006 as compared to 2005 is primarily as a result of DVI sales increasing in 2006 due to the peaking of the adoption of the standard. While 2006 revenues grew in absolute dollars, our 2006 PC product revenues were negatively affected by battery recalls by major computer manufacturers as well as the late launch of Windows Vista operating system. Licensing revenues included in our revenues from the PC market increased substantially in 2006 due to the recognition of royalty revenues related to the settlement agreement with Genesis Microchip.
Products sold into the storage market, as a percentage of our total revenues, generated 7.9%, 11.2% and 16.9% of our revenue for the years ended December 31, 2007, 2006 and 2005, respectively. If we include storage related licensing revenues, these percentages were 10.1%, 14.1% and 20.4%, for the years ended December 31, 2007, 2006 and 2005, respectively. The decrease in storage revenues is due primarily to the integration of SATA into PC chipsets obviating the need for our SATA controllers in all but the highest value PC motherboards. The decline in storage revenue from 2006 to 2007 is primarily due to declining sales in SATA controllers partially offset by an increase in storage processor products. Demand for our storage products is dependent upon market acceptance of our SteelVine architecture and the extent to which SATA is integrated into chipsets and controllers offered by other companies, which would make our discrete devices unnecessary.
Cost of revenue consists primarily of costs incurred to manufacture, assemble and test our products, as well as related overhead costs. Gross margin (revenue minus cost of revenue), as a percentage of revenue was 56.2%, 58.9% and 60.9% for 2007, 2006 and 2005, respectively. The increase in cost of revenue in 2007 as compared to 2006 and 2005 is primarily due to increased unit volume associated with increased sales partially offset by manufacturing cost reductions and cost of sales associated with licensing revenue that has not increased proportionately to licensing sales. Cost of revenue for 2007 includes approximately $2.6 million related to $6.7 million of product revenue recognized from distributor sales for the month of December. Historically, we have deferred the recognition of sell-through revenue and the related costs from distributor sales for the third month of a quarter until the following quarter due to the unavailability of reliable sell-through information in a timely manner. As a result of improved business processes, we have been able to eliminate this delay beginning with the fourth quarter of 2007, resulting in the fourth quarter and the fiscal year 2007 cost of revenues to increase. This increase in cost of revenue was partially offset by reduced manufacturing costs by lower negotiated vendor expenses as well as increased use of company owned testers.
Decrease in gross margins in 2007 as compared to 2006 and 2005 is primarily due to increased competition in all business lines reflected in decline in ASPs erosion partially offset by increase in units sold. In 2008, we expect continued competitive pressures which may continue to reduce our ASPs. However, we plan to mitigate this ASP erosion through manufacturing cost reductions and anticipated new product launches with expected higher margins.
The decrease in gross margin from 2005 to 2006 was primarily due to the recognition of stock-based compensation expense of $2.4 million under FAS 123R â€śShare-Based Paymentâ€ť as compared to the stock compensation benefit of $1.4 million recorded in 2005 under APB 25 â€śAccounting for Stock Issued to Employeesâ€ť , erosion in the average selling prices of our products as a result of increased competition and to a lesser extent by higher overhead expenses as a result of increase in headcount and related compensation.
Research and development (R&D). R&D expense consists primarily of employee compensation and benefits, fees for independent contractors, the cost of software tools used for designing and testing our products and costs associated with prototype materials. R&D expense, including stock-based compensation expense, was $78.0 million, or 24.3% of revenue for 2007 compared to $63.6 million, or 21.6% of revenue for 2006 and $44.9 million, or 21.1% of revenue for 2005. The increase in R&D expenses in 2007 was primarily due to the expansion of our R&D operations through the sci-worx acquisition and the establishment of a new China R&D facility in the third quarter of 2006. This expansion resulted in an increase in salaries, software and equipment and tape out costs. The increase in R&D costs was partially offset by decrease in stock-based compensation expense from 2006. We expect R&D expenses in absolute dollars (excluding stock-based compensation) to be relatively flat in 2008.
The increase in R&D expenses in 2006 as compared to 2005 was primarily due to an increased headcount, performance bonus incentives and implementation of FAS 123R â€śShare-Based Paymentâ€ť resulting in a recognition of stock-based compensation expense of $11.1 million as compared to the net stock compensation benefit of $3.9 million recorded in 2005 under APB 25 â€śAccounting for Stock Issued to Employeesâ€ť . In addition, the increase also reflected increased use of consultants and the number of R&D projects and lower credit to expense from engineering projects funded by outside parties.
Selling, general and administrative(SG&A). SG&A expense consists primarily of employee compensation and benefits, sales commissions and marketing and promotional expenses including stock-based compensation expense. SG&A expense was $70.3 million or 21.9% of revenue in 2007 as compared to $67.6 million, or 22.9% of revenue for 2006 and $31.4 million, or 14.8% of revenue for 2005. The increase is primarily due to higher compensation expense, lower allocation of general and administrative costs to other functional lines, increase in consulting fees as a result of our global strategy, increase in litigation and patent related expenses and increase in facilities related expenses. These increases were partially offset by a decrease in the stock-based compensation expense in 2007. We expect SG&A expenses in absolute dollars (excluding stock-based compensation) to be relatively flat in 2008.
The increase in SG&A expense in 2006 as compared to 2005, was primarily due to the recognition of stock-based compensation expense of $13.7 million under FAS 123R â€ś Share-Based Payment â€ť as compared to the stock compensation benefit of $3.3 million recorded in 2005 under APB 25 â€śAccounting for Stock Issued to Employeesâ€ť and to a lesser extent by an increase in headcount and performance incentives in the form of bonuses to employees.
Amortization of intangible assets. Increase in amortization of intangible assets for 2007 as compared to 2006 and 2005 is primarily due to the increase in amortization as a result of capitalization of intangibles acquired from Sunplus and intangibles from our sci-worx acquisition during 2007. The amortization of intangibles for fiscal 2006
Provision for Income Taxes. For the year ended December 31, 2007, we recorded income tax expense of $20.6 million, compared to $14.0 million in 2006 and $6.7 million in 2005. Our effective income tax rate was 52% in 2007. In 2007, the difference between the provision for income taxes and the income tax determined by applying the statutory federal income tax rate of 35% was due primarily to the following three items: (1) $3.1 million of tax benefits related to tax credits generated during 2007, (2) $2.8 million of additional tax charges associated with the certain foreign income and withholding taxes and (3) $5.1 million of additional tax charges related to foreign unbenefited losses associated with the implementation of our global business structure. The tax charges related to unbenefited foreign losses represent expenses for sharing in the costs of our ongoing research and development efforts as well as licensing commercial rights to exploit pre-existing intangibles to better align with customers outside the Americas. The new global strategy is designed to better align asset ownership and business functions with our expectations related to the sources, timing and amounts of future revenues and profits.
For the year ended December 31, 2006, we recorded income tax expense of $14.0 million, compared to $6.7 million in 2005. Our effective income tax rate was 25% in 2006. In 2006, the difference between the provision for income taxes and the income tax determined by applying the statutory federal income tax rate of 35% was due primarily to the following three items: (1) $18.5 million of federal loss carryforwards utilized, inclusive of $14.3 million related to excess stock option tax benefits for which the reduction of the related valuation allowance was recorded to additional paid-in capital, (2) $24.8 million associated with the impact of the release of our remaining valuation allowance inclusive of certain current year changes in the deferred tax asset to which the valuation allowance relates and (3) $22.8 million of tax charges related to unbenefited foreign losses in connection with the ongoing implementation of a new global strategy. The tax charges related to unbenefited foreign losses represent expenses for sharing in the costs of our ongoing research and development efforts as well as licensing commercial rights to exploit pre-existing intangibles to better align with customers outside the Americas. The fiscal year 2005 tax expense of $6.7 million was due primarily to a $5.4 million non-cash charge associated with stock option exercises, while the remaining $1.3 million was primarily for taxes in certain foreign jurisdictions and U.S. alternative minimum tax.
Our principal source of liquidity is cash provided by operations and exercise of stock options. At December 31, 2007, we had $223.7 million of working capital and $249.7 million of cash, cash equivalents and short-term investments. In February 2008, we entered into an accelerated stock repurchase program to repurchase common stock for an aggregate of approximately $62.0 million as part of a previously announced $100 million stock repurchase program authorized in February 2007. Additionally, our Board of Directors has authorized a new stock repurchase program for the repurchase, in the open market from time to time as business conditions warrant, of up to $100 million of the companyâ€™s common stock over a three-year period commencing upon the completion of the aforementioned accelerated stock repurchase program. We believe that our current cash, cash equivalents and short-term investment balances together with income derived from sales of our products and licensing will be sufficient to meet our liquidity requirements in the foreseeable future.
Operating activities provided $67.1 million of cash during 2007 primarily due to cash generated by operations. The cash generated from working capital consisted primarily of strong cash collections on our accounts receivables, cash generated by inventory management and accounts payable partially offset by cash used in prepaid accounts, accrued expenses and deferred revenue.
Net accounts receivable decreased to $21.3 million in 2007 from $40.0 million in 2006 reflecting the timing of invoicing and strong cash collections during the fourth quarter of 2007. We do not expect the decline in accounts receivable to continue in 2008. Inventories decreased to $20.2 million at December 31, 2007 from $28.3 million at December 31, 2006. This decrease is attributable primarily to increased sales and better inventory management including allowing our distributors to use up the existing inventory that was built up in 2006. Our inventory turns increased to 7.1 at December 31, 2007 from 4.7 at December 31, 2006. Inventory turns are computed on an annualized basis, using the most recent quarter results and are a measure of the number of times inventory is replenished during the year. Deferred revenue, which includes deferred intellectual property license revenue that is being recognized on a percentage of completion basis, decreased $1.4 million in 2007 as compared to 2006. This decrease is primarily related to the invoicing under the terms of the agreement and the recognition of revenue for which contracts exist. Deferred margin on sales to distributors increased $8.7 million in 2007 as compared to 2006, primarily due to the improved business processes which resulted in the company being able to eliminate the previously existing delay in recognition of sell-through revenue from distributor sales for the third month of a quarter until the following quarter. Other current liabilities including accounts payable and accrued liabilities, increased to $54.9 million from $52.0 million attributable primarily with the volume of our business, the timing of vendor payments, the payments on accruals for inventory related items and miscellaneous other items.
Operating activities provided $46.0 million in 2006. Net accounts receivable increased to $39.9 million or 32.5% in 2006 reflecting increased revenue and the timing of sales. Inventories increased to $28.3 million at December 31, 2006 from $17.1 million at December 31, 2005. The increase is attributable primarily to increased sales, to a buildup of inventories of certain new products in advance of sales and to production levels of certain products that exceeded sales levels in late 2006. Our inventory turns decreased to 4.7 at December 31, 2006 from 6.0 at December 31, 2005. Deferred revenue decreased $3.0 million or 36.4% in 2006, which is primarily related to the timing and recognition of revenue for which contracts exist. Deferred margin on sales to distributors increased to $17.7 million or 28.6% in 2006 as a result of overall increased shipments to distributors. Other current liabilities including accounts payable and accrued liabilities, increased to $51.5 million or 88.5% attributable primarily with the volume of our business, the timing of vendor payments, the accrual for income taxes of $12.7 million and the accrual for inventory related items and other items of $6.1 million.
Operating activities provided $55.6 million of cash during 2005. Increases in accounts receivable, inventories, accounts payable, accrued liabilities, deferred license revenue and deferred margin on sales to distributors and decreases in prepaid assets and other current assets used $2.4 million in cash.
Net cash provided by investing activities during 2007 consisted primarily of sale of investments of $137.1 million which was used to fund the purchase of sci-worx for $13.8 million, net of cash acquired, the acquisition of Sunplus IP for $40.0 million of which $18.8 million was paid in 2007 and purchases of property, plant and equipment of $13.4 million. Cash used in investing activities in 2006 and 2005 consisted primarily of purchases of short-term investments (net of proceeds from sales and maturities of investments) of $94.0 million and $8.2 million, respectively and purchases of property and equipment of $13.5 million and $6.2 million, respectively. Our investments are in U.S. government notes and bonds, corporate notes and bonds, commercial paper and asset backed securities. We are not a capital-intensive business. Our purchases of property and equipment in 2007, 2006 and 2005 related mainly to testing equipment, leasehold improvements and information technology infrastructure.
Net cash used in financing activities in 2007 consisted primarily of repurchases of common stock of $38.1 million partially offset by proceeds from stock options exercises and purchases under our employee stock purchase program (ESPP) of $12.9 million. Net cash flows provided by financing activities in 2006 and 2005 consisted primarily of proceeds from stock options exercises and ESPP purchases of $35.1 million and $11.4 million, respectively.
Cash requirements and commitments
In addition to our normal operating cash requirements, our principal future cash requirements will be to fund capital expenditures, share repurchases and any strategic acquisitions.
Specifically, we expect our cash requirements in 2008 to include the following:
â€˘ Commitments â€” We have approximately $43.2 million in commitments for fiscal years including and beyond 2008 as disclosed in the contractual obligations table below.
â€˘ We paid approximately $62.0 million in February 2008, to repurchase common stock, under an accelerated stock repurchase program, as part of a previously announced $100 million stock repurchase program authorized in February 2007. Additionally, our Board of Directors has authorized a new stock repurchase program for the repurchase, in the open market from time to time as business conditions warrant, of up to $100 million of the companyâ€™s common stock over a three-year period commencing upon the completion of the aforementioned accelerated stock repurchase program.
Debt and Lease Obligations
In December 2002, we entered into a non-cancelable operating lease renewal for our principal operating facility. In June 2004, the lease terms were amended and we leased approximately 28,000 square feet of additional space (for a total leased area of approximately 109,803 square feet). In May 2006, we entered into an amendment to the operating lease agreement. The amendment expanded the leased premises to include approximately 34,000 square feet of space in an adjacent building. The lease expiration was extended to July 2011 and the monthly rental payments are $146,237 with annual increases of 3% thereafter.
In June 2001, in connection with our acquisition of CMD, we acquired the lease of an operating facility in Irvine, California. Effective December 2005, the original lease was terminated and we entered into a new non-cancelable operating lease agreement through November 2008. Under the terms of the new agreement, base monthly rental lease payments of $42,000 are required and increases annually 3% thereafter.
We also lease office space in China, Germany, Japan, Korea, Taiwan, Turkey and United Kingdom.
Rent expense totaled $3.8 million, $2.6 million and $1.7 million in 2007, 2006 and 2005, respectively. Future minimum lease payments under operating leases have not been reduced by expected sublease rental income or by the amount of our restructuring accrual that relates to leased facilities.
The amounts above exclude liabilities under FASB Interpretation No. 48 â€śAccounting for Uncertainty in Income Taxesâ€ť , as we are unable to reasonably estimate the ultimate amount or timing of settlement. See Note 3, â€śIncome Taxes,â€ť in the Notes to Consolidated Financial Statements for further discussion.
Based on our estimated cash flows, we believe our existing cash and short-term investments are sufficient to meet our capital and operating requirements for at least the next twelve months. We expect to continue to invest in property and equipment in the ordinary course of business. Our future operating and capital requirements depend on many factors, including the levels at which we generate product revenue and related margins, the extent to which we generate cash through stock option exercises and proceeds from sales of shares under our employee stock purchase plan, the timing and extent of development, licensing and royalty revenue, investments in inventory, property, plant and equipment and accounts receivable, the cost of securing access to adequate manufacturing capacity, our operating expenses, including legal and patent assertion costs and general economic conditions. In addition, cash may be required for future acquisitions should we choose to pursue any. While, we believe that our current cash, cash equivalents and short-term investment balances together with income derived from sales of our products and licensing will be sufficient to meet our liquidity requirements in the foreseeable future, to the extent existing resources and cash from operations are insufficient to support our activities, we may need to raise additional funds through public or private equity or debt financing. These funds may not be available when we need them, or if available, we may not be able to obtain them on terms favorable to us.
MANAGEMENT DISCUSSION FOR LATEST QUARTER
Results of Operations
Total revenues for the three and nine months ended September 30, 2007 were $86.3 million and $235.2 million, respectively, representing an increase of 10.2% and 13.1% over the comparable periods in 2006. The increase in revenues in 2007 compared to comparable periods in 2006, is primarily due to increase in revenues from our Consumer Electronics (â€śCEâ€ť) and development, licensing and royalty revenue offset in part by declines in revenues from our personal computers and storage products. The increase in CE revenues compared to comparable periods in 2006 is primarily due to increased shipments of a majority of our CE parts particularly new products such as our input processors and HDMI 1.3 chips. Our HDMI 1.3 chips generally have higher average selling prices (â€śASPâ€ť) as compared to HDMI 1.2 and other legacy HDMI chips. CE revenues also increased due to the CE revenues from our acquisition of sci-worx (now Silicon Image Germany). This increase in CE revenues was partially offset by overall decreases in ASPs across CE products. Our HDMI 1.3 chips are targeted towards the DTV, AV receiver, Blu Ray recorders, HD DVD, game console and mobile markets. We believe that as the market acceptance of the HDMI 1.3 standard continues to grow, sales of our HDMI 1.3 products will contribute a significant percentage of our CE revenues; however, this increase in HDMI 1.3 products sales will be affected by expected declines in the ASPs for these chips. The decrease in Personal Computer (â€śPCâ€ť) and Storage revenues over comparable periods in 2006 is primarily due to lower shipments coupled with ASP declines in the respective lines of businesses. The decrease in ASP in the PC business is due to the competitive nature of the PC business coupled with lower sales of our new HDMI 1.3 PC products. We expect the PC revenues to increase in the fourth quarter as compared to the third quarter. The decrease in the ASP in the storage business is due to a slower than desired transition from our legacy non-core storage semiconductor products to our SteelVine storage processor products. Development, licensing and royalty revenues increased due to increased licensing activity attributable to HDMI and SATA licenses as well as the timing of recognition of revenue from development and licensing arrangements.
COST OF REVENUE AND GROSS PROFIT
Cost of revenue consists primarily of costs incurred to manufacture, assemble and test our products, license development costs, as well as other related overhead costs relating to the aforementioned costs including stock-based compensation expense. Total cost of revenue was $37.5 million and $105.2 million for the three and nine months ended September 30, 2007 compared to $32.7 million and $87.9 million for the comparable periods in 2006. The $4.8 million and $17.3 million increases in cost of revenue for three and nine months ended September 30, 2007, respectively, over the comparable periods in 2006 were primarily due to increased volumes of activity and manufacturing costs per unit, increase in inventory reserves for certain slow moving parts, integration expenses associated with the sci-worx acquisition and higher depreciation expense from additional testing equipment. These increases were partially offset by a decrease in stock-based compensation expense primarily as a result of changes in our Black-Scholes fair value assumptions as described in Note 3 to the Condensed Consolidated Financial Statement under Item 1.
Total gross profit was $48.8 million and $130.0 million for the three and nine months ended September 30, 2007 an increase of 7.0% and 8.2%, respectively from $45.6 million and $120.2 million for the comparable periods of 2006. Our gross profit margin of 56.5% and 55.3% for the three and nine months ended September 30, 2007, respectively, decreased from 58.2% and 57.8% for the same periods of 2006. Gross profit margins in absolute dollars increased for the three and nine months of 2007 as compared to the same periods in 2006 as a result of overall increase in sales, primarily in CE including the increase in development and licensing activities. The gross margin percentages decreased over the same periods as a result of product ASP erosion, changes in product mix and increased manufacturing costs per unit. We expect product gross margins in the fourth quarter of 2007 to be flat as compared to the third quarter of 2007.
R&D expense consists primarily of employee compensation, including stock-based compensation expense, and other related costs, fees for independent contractors, the cost of software tools used for designing and testing our products, masks costs and costs associated with prototype materials.
R&D expense was $20.5 million and $56.7 million for the three and nine months ended September 30, 2007, respectively, as compared to $16.9 million and $47.6 million for the same periods in 2006. R&D expenses increased primarily due to the integration of sci-worx engineers and the expansion of the research and development activities in China resulting in increased headcount. The increased R&D expenses were offset in part by a decrease in lower consulting costs and stock-based compensation expense primarily as a result of changes in our Black-Scholes fair value assumptions as described in Note 3 to the Condensed Consolidated Financial Statement under Item 1. We expect the R&D expenses to increase in the fourth quarter of 2007 due to the commencement of amortization of the intangibles paid to and licensed from Sunplus as described in Note 11 to the Condensed Consolidated Financial Statement under Item I.
SG&A expense consists primarily of employee compensation, including stock-based compensation expense, sales commissions, professional fees, marketing and promotional expenses. SG&A expense was $16.8 million and $51.1 million for the three and nine months ended September 30, 2007, respectively, as compared to $17.5 million and $49.5 million for the same periods. For the three months ended September 30, 2007, the decrease in SG&A expense is primarily due to a decrease in marketing, promotional and consulting expenses. The increase in SG&A expense for the nine months ended September 30, 2007, is primarily due to the integration of sci-worx, increased compensation expense as a result of higher headcount, increased consulting expenses for the implementation of our global strategy, increased legal expenses for various patent filings and litigation activities partially offset by a decrease in bonus and commission accruals as a result of lower achievement relative to plan and a decrease in stock-based compensation expense primarily as a result of changes in our Black-Scholes fair value assumptions as described in Note 3 to the Condensed Consolidated Financial Statement under Item 1.
Cash, Cash Equivalents and Short-Term Investments
Cash, cash equivalents and short-term investments were $225.7 million at September 30, 2007, a decrease of $10.1 million from $235.8 million at September 30, 2006 primarily as a result of usage of cash for $38.1 million in stock repurchases, $13.8 million (net) on purchase of sci-worx, $15.0 million on purchase of intangibles from Sunplus and $29.0 million in tax payments partially offset by increased sales activities, $12.3 million proceeds in connection with funds received on the exercise of stock options and for purchases of stock by employees under the employee stock purchase plan (ESPP).
We generated $37.0 million in cash from operating activities in the nine months ended September 30, 2007 as compared to $51.8 million in the same period of 2006. The decrease in cash from operating activities was primarily due to increase in accounts receivable, decrease in accrued liabilities and accrued expenses and deferred license revenue partially offset by increases in accounts payable and deferred margin on sale to distributors and decreases in inventory and prepaid expenses and others assets during the nine months of the year ended September 30, 2007.
Investing and Financing Activities
We generated $35.3 million in cash in our investing activities in the nine month period ended September 30, 2007 as compared to $120.2 million used in the same period of 2006. The increase in cash provided by investing activities is mainly due to sale of securities (net of purchases) of approximately $74.1 million partially offset by purchase of sci-worx for $13.8 million, purchase of intangibles related to Sunplus transaction $15.0 million and purchases of testing equipment, testing boards, other R&D equipment and miscellaneous other assets for $10.1 million. The sale of securities was intended to fund the program of stock repurchases and business acquisition as described in Notes 13 and 10 to the Condensed Consolidated Financial Statements, respectively. We used $23.4 million in our financing activities in the nine months ended September 30, 2007 as compared to $30.8 million provided by financing activities for the same period in 2006. The use of the cash from financing activities for the nine months ended September 30, 2007 is primarily due to $38.1 million of stock repurchases partially offset by the $12.3 million in proceeds from the exercise of stock options and sales of shares under the ESPP.