| MICROCHIP TECHNOLOGY INC Item 1A RISK FACTORS When evaluating Microchip and its business, you should give careful consideration to the factors listed below, in addition to the information provided elsewhere in this Form 10-K and in other documents that we file with the Securities and Exchange Commission |
| Our quarterly operating results may fluctuate due to factors that could reduce our net sales and profitability |
| Our quarterly operating results are affected by a wide variety of factors that could reduce our net sales and profitability, many of which are beyond our control |
| Some of the factors that may affect our quarterly operating results include: • changes in demand or market acceptance of our products and products of our customers • levels of inventories at our customers • the mix of inventory we hold and our ability to satisfy orders from our inventory 11 ______________________________________________________________________ • changes in utilization of our manufacturing capacity and fluctuations in manufacturing yields • our ability to secure sufficient assembly and testing capacity • availability of raw materials and equipment • competitive developments including pricing pressures • the level of orders that are received and can be shipped in a quarter • the level of sell-through of our products through distribution • changes or fluctuations in customer order patterns and seasonality • constrained availability from other electronic suppliers impacting our customers’ ability to ship their products, which in turn may adversely impact our sales to those customers • costs and outcomes of any tax audits or any litigation involving intellectual property, customers or other issues • disruptions in our business or our customers’ businesses due to terrorist activity, armed conflict, war, worldwide oil prices and supply, public health concerns or disruptions in the transportation system • property damage or other losses which are not covered by insurance • general economic, industry or political conditions in the United States or internationally We believe that period-to-period comparisons of our operating results are not necessarily meaningful and that you should not rely upon any such comparisons as indications of future performance |
| In future periods our operating results may fall below our public guidance or the expectations of public market analysts and investors, which would likely have a negative effect on the price of our common stock |
| Our operating results will suffer if we ineffectively utilize our manufacturing capacity or fail to maintain manufacturing yields |
| The manufacture and assembly of integrated circuits, particularly non-volatile, erasable CMOS memory and logic devices such as those that we produce, are complex processes |
| These processes are sensitive to a wide variety of factors, including the level of contaminants in the manufacturing environment, impurities in the materials used, the performance of our wafer fabrication personnel and equipment, and other quality issues |
| As is typical in the semiconductor industry, we have from time to time experienced lower than anticipated manufacturing yields |
| Our operating results will suffer if we are unable to maintain yields at approximately the current levels |
| This could include delays in the recognition of revenue, loss of revenue or future orders, and customer-imposed penalties for failure to meet contractual shipment deadlines |
| Our operating results are also adversely affected when we operate at less than optimal capacity |
| Lower capacity utilization results in certain costs being charged directly to expense and lower gross margins |
| We are dependent on orders that are received and shipped in the same quarter and therefore limited in our visibility of future product shipments |
| Our net sales in any given quarter depend upon a combination of shipments from backlog and orders received in that quarter for shipment in that quarter, which we refer to as turns orders |
| We measure turns orders at the beginning of a quarter based on the orders needed to meet the shipment targets that we set entering the quarter |
| Historically, we have proven our ability to respond quickly to customer orders as part of our competitive strategy, resulting in customers placing orders with relatively short delivery schedules |
| Shorter lead times generally mean that turns orders as a percentage of our business are relatively high in any particular quarter and reduces our backlog visibility on future product shipments |
| Turns orders correlate to overall semiconductor industry conditions and product lead times |
| Because turns orders are difficult to predict, varying levels of turns orders make our net sales more difficult to forecast |
| If we do not achieve a sufficient level of turns orders in a particular quarter relative to our revenue targets, our revenue and operating results may suffer |
| Intense competition in the markets we serve may lead to pricing pressures, reduced sales of our products or reduced market share |
| The semiconductor industry is intensely competitive and has been characterized by price erosion and rapid technological change |
| We compete with major domestic and international semiconductor companies, many of which have greater market recognition and substantially greater financial, technical, marketing, distribution and other resources than we do with which to pursue engineering, manufacturing, marketing and distribution of their products |
| Emerging companies are also increasing their participation in the market for embedded control applications |
| We may be unable to compete successfully in the future, which could harm our business |
| 12 ______________________________________________________________________ Our ability to compete successfully depends on a number of factors both within and outside our control, including, but not limited to: • the quality, performance, reliability, features, ease of use, pricing and diversity of our products • our success in designing and manufacturing new products including those implementing new technologies • the rate at which customers incorporate our products into their own applications • product introductions by our competitors • the number, nature and success of our competitors in a given market • our ability to obtain adequate supplies of raw materials and other supplies at acceptable prices • our ability to protect our products and processes by effective utilization of intellectual property rights • the quality of our customer service and our ability to address the needs of our customers, and • general market and economic conditions |
| Historically, average selling prices in the semiconductor industry decrease over the life of any particular product |
| The overall average selling prices of our microcontroller and proprietary analog and interface products have remained relatively constant, while average selling prices of our Serial EEPROM and non-proprietary analog and interface products have declined over time |
| We have experienced, and expect to continue to experience, modest pricing declines in certain of our more mature proprietary product lines, due primarily to competitive conditions |
| We have been able to moderate average selling price declines in many of our proprietary product lines by continuing to introduce new products with more features and higher prices |
| We have experienced in the past and expect to continue to experience in the future varying degrees of competitive pricing pressures in our Serial EEPROM products |
| We may be unable to maintain average selling prices for our products as a result of increased pricing pressure in the future, which could adversely impact our operating results |
| Our business is dependent on selling through distributors |
| Sales through distributors accounted for 65prca of our net sales in fiscal 2006, 65prca of our net sales in fiscal 2005 and 64prca of our net sales in fiscal 2004 |
| Our two largest distributors together accounted for approximately 25prca of our net sales in fiscal 2006, fiscal 2005 and fiscal 2004 |
| We do not have long-term agreements with our distributors and both we and our distributors may each terminate our relationship with little or no advanced notice |
| We believe that customers recognize Microchip for its products and brand name and use distributors as an effective supply channel |
| During fiscal 2006 we reduced the gross margin that certain of our distributors earn when they sell our products |
| We reduced these distributors’ gross margins because we believe these distributors did not have sufficient technical sales resources to properly address the marketplace for our products |
| We have added a significant number of technical sales employees throughout our worldwide sales organization to address the support requirements for both our OEM and distribution customers |
| We cannot predict the impact, if any, that our actions will have on our relationships with such distributors |
| The loss of, or a disruption in the operations of, one or more of our distributors could reduce our net sales in a given period and could result in an increase in inventory returns |
| Our success depends on our ability to introduce new products on a timely basis |
| Our future operating results will depend on our ability to develop and introduce new products on a timely basis that can compete effectively on the basis of price and performance and which address customer requirements |
| The success of our new product introductions depends on various factors, including, but not limited to: • proper new product selection • timely completion and introduction of new product designs • development of support tools and collateral literature that make complex new products easy for engineers to understand and use, and • market acceptance of our customers’ end products |
| Because our products are complex, we have experienced delays from time to time in completing development of new products |
| In addition, our new products may not receive or maintain substantial market acceptance |
| We may be unable to 13 ______________________________________________________________________ design, develop and introduce competitive products on a timely basis, which could adversely impact our future operating results |
| Our success also depends upon our ability to develop and implement new design and process technologies |
| Semiconductor design and process technologies are subject to rapid technological change and require significant R&D expenditures |
| We and other companies in the industry have, from time to time, experienced difficulties in effecting transitions to advanced process technologies and, consequently, have suffered reduced manufacturing yields or delays in product deliveries |
| Our future operating results could be adversely affected if any transition to future process technologies is substantially delayed or inefficiently implemented |
| We must attract and retain qualified personnel to be successful, and competition for qualified personnel is intense in our market |
| Our success depends upon the efforts and abilities of our senior management, engineering and other personnel |
| The competition for qualified engineering and management personnel is intense |
| We may be unsuccessful in retaining our existing key personnel or in attracting and retaining additional key personnel that we require |
| The loss of the services of one or more of our key personnel or the inability to add key personnel could harm our business |
| We have no employment agreements with any member of our senior management team |
| We are dependent on several contractors to perform key manufacturing functions for us |
| We use several contractors located in Asia for a portion of the assembly and testing of our products |
| We also rely on outside wafer foundries for a portion of our wafer fabrication |
| Although we own the majority of our manufacturing resources, the disruption or termination of any of our contractors could harm our business and operating results |
| Our use of third parties involves some reduction in our level of control over the portions of our business that we subcontract |
| Our future operating results could suffer if any contractor were to experience financial, operations or production difficulties or situations when demand exceeds capacity, or if they were unable to maintain manufacturing yields, assembly and test yields and costs at approximately their current levels, or if due to their locations in foreign countries they were to experience political upheaval or infrastructure disruption |
| Further, procurement from third parties is done by purchase order and contracts |
| If these third parties are unable or unwilling to timely deliver products or services conforming to our quality standards, we may not be able to qualify additional manufacturing sources for our products in a timely manner or at all, and such arrangements, if any, may not be on favorable terms to us |
| In such event, we could experience an interruption in production, an increase in manufacturing and production costs, decline in product reliability, and our business and operating results could be adversely affected |
| We may lose sales if our suppliers of raw materials and equipment fail to meet our needs |
| Our semiconductor manufacturing operations require raw materials and equipment that must meet exacting standards |
| We generally have more than one source for these supplies, but there are only a limited number of suppliers capable of delivering various raw materials and equipment that meet our standards |
| The raw materials and equipment necessary for our business could become more difficult to obtain as worldwide use of semiconductors in product applications increases |
| We have experienced supply shortages from time to time in the past, and on occasion our suppliers have told us they need more time than expected to fill our orders or that they will no longer support certain equipment with updates or spare and replacements parts |
| An interruption of any raw materials or equipment sources, or the lack of supplier support for a particular piece of equipment, could harm our business |
| Our operating results may be impacted by both seasonality and the wide fluctuations of supply and demand in the semiconductor industry |
| The semiconductor industry is characterized by seasonality and wide fluctuations of supply and demand |
| Since a significant portion of our revenue is from consumer markets and international sales, our business may be subject to seasonally lower revenues in the third and fourth quarters of our fiscal year |
| However, broad strength in our overall business in recent periods has had a more significant impact on our results than seasonality, and has made it difficult to assess the impact of seasonal factors on our business |
| The industry has also experienced significant economic downturns, characterized by diminished product demand and production over-capacity |
| We have sought to reduce our exposure to this industry cyclicality by selling proprietary products that cannot be easily or quickly replaced, to a geographically diverse base of customers across a broad range of market segments |
| However, we have experienced substantial period-to-period fluctuations 14 ______________________________________________________________________ in operating results and expect, in the future, to experience period-to-period fluctuations in operating results due to general industry or economic conditions |
| We are exposed to various risks related to legal proceedings or claims |
| We are currently, and in the future may be, involved in legal proceedings or claims regarding patent infringement, intellectual property rights, contracts and other matters |
| We were involved in patent infringement litigation with Philips Corporation which was settled in fiscal 2005 |
| As is typical in the semiconductor industry, we receive notifications from customers from time to time who believe that we owe them indemnification or other obligations related to infringement claims made against the customers by third parties |
| These legal proceedings and claims, whether with or without merit, could result in substantial cost to us and divert our resources |
| If we are not able to resolve a claim, negotiate a settlement of a matter, obtain necessary licenses on commercially reasonable terms, reengineer our products or processes to avoid infringement, and/or successfully prosecute or defend our position, we could incur uninsured liability in any of them, be required to take an appropriate charge to operations, be enjoined from selling a material portion of our product line or using certain processes, suffer a reduction or elimination in value of inventories, and our business, financial condition or results of operations could be harmed |
| It is also possible that from time to time we may be subject to warranty or product liability claims that could lead to significant expenses related to the defense of such claims, increased costs associated with the replacement of affected products, and a requirement to pay damages claims |
| Because the systems into which our products are integrated have a higher cost of goods than the products we sell, these expenses and damages may be significantly higher than the sales and profits the company received from the products involved |
| While we specifically exclude consequential damages in our standard terms and conditions, our ability to avoid such liabilities may be limited by applicable law |
| We do have product liability insurance, but there is no certainty that insurance will cover all claims or be of a sufficient amount to fully protect against such claims |
| Costs or payments we may make in connection with warranty or product liability claims may adversely affect the results of our operations |
| Further, we sell to customers in industries such as automotive, aerospace, and medical, where failure of their systems could cause damage to property or persons |
| We may be subject to product liability claims if our products cause the system failures |
| Based on our historical experience, we believe that the risk of exposure to product liability claims is currently low |
| However, we will face increased exposure to product liability claims if there are substantial increases in either the volume of our sales into these applications and the frequency of system failures caused by our devices |
| Failure to adequately protect our intellectual property could result in lost revenue or market opportunities |
| Our ability to obtain patents, licenses and other intellectual property rights covering our products and manufacturing processes is important for our success |
| To that end, we have acquired certain patents and patent licenses and intend to continue to seek patents on our inventions and manufacturing processes |
| The process of seeking patent protection can be long and expensive, and patents may not be issued from currently pending or future applications |
| In addition, our existing patents and any new patents that are issued may not be of sufficient scope or strength to provide meaningful protection or any commercial advantage to us |
| We may be subject to or may ourselves initiate interference proceedings in the US Patent and Trademark Office, which can require significant financial and management resources |
| In addition, the laws of certain foreign countries do not protect our intellectual property rights to the same extent as the laws of the United States |
| Infringement of our intellectual property rights by a third party could result in uncompensated lost market and revenue opportunities for us |
| We do not typically have long-term contracts with our customers |
| We do not typically enter into long-term contracts with our customers and we cannot be certain about future order levels from our customers |
| When we do enter into customer contracts, the contract is generally cancelable at the convenience of the customer |
| Even though we have over 50cmam000 end customers and our ten largest customers make up approximately 10prca of our total revenue, cancellation of long-term and short-term customer contracts could have an adverse financial impact on our revenue and profits |
| Further, as the practice has become more commonplace in the industry, we have entered into contracts with certain customers that differ from our standard terms of sale |
| Under these contracts we commit to supply quantities of products on scheduled delivery dates |
| If we become unable to supply the customer as required under the contract, the customer may incur additional production costs, lost revenues due to subsequent delays in their own manufacturing schedule, or quality related issues |
| While we try to limit such liabilities, if they should arise, there may be a material adverse impact on our results of operation and financial condition |
| 15 ______________________________________________________________________ Business interruptions could harm our business |
| Operations at any of our manufacturing facilities, or at any of our wafer fabrication or test and assembly subcontractors, may be disrupted for reasons beyond our control, including work stoppages, power loss, incidents of terrorism or security risk, political instability, public health issues, telecommunications, transportation or other infrastructure failure, fire, earthquake, floods, or other natural disasters |
| If operations at any of our facilities, or our subcontractors’ facilities are interrupted, we may not be able to shift production to other facilities on a timely basis |
| If this occurs, we would likely experience delays in shipments of products to our customers and alternate sources for production may be unavailable on acceptable terms |
| This could result in reduced revenues and profits and the cancellation of orders or loss of customers |
| In addition, business interruption insurance will likely not be enough to compensate us for any losses that may occur and any losses or damages incurred by us as a result of business interruptions could significantly harm our business |
| We are highly dependent on foreign sales and operations, which exposes us to foreign political and economic risks |
| During fiscal 2006, approximately 74prca of our net sales were made to foreign customers |
| During fiscal 2005, approximately 73prca of our net sales were made to foreign customers |
| During fiscal 2004, approximately 71prca of our net sales were made to foreign customers |
| We purchase a substantial portion of our raw materials and equipment from foreign suppliers |
| In addition, we own product assembly and testing facilities located near Bangkok, Thailand |
| We also use various foreign contractors for a portion of our assembly and testing and for a portion of our wafer fabrication requirements |
| Substantially all of our finished goods inventory is maintained in Thailand |
| Our reliance on foreign operations, foreign suppliers, maintenance of substantially all of our finished goods in inventory at foreign locations and significant foreign sales exposes us to foreign political and economic risks, including, but not limited to: • political, social and economic instability • public health conditions • trade restrictions and changes in tariffs • import and export license requirements and restrictions • difficulties in staffing and managing international operations • employment regulations • disruptions in international transport or delivery • fluctuations in currency exchange rates • difficulties in collecting receivables • economic slowdown in the worldwide markets served by us, and • potentially adverse tax consequences |
| If any of these risks materialize, our sales could decrease and our operating results could suffer |
| Interruptions in information technology systems could affect our business |
| We rely on the efficient and uninterrupted operation of complex information technology systems and networks to operate our business |
| Any significant system or network disruption, including but not limited to computer viruses, security breach, and energy blackouts could have a material adverse impact on our operations, sales and operating results |
| We have implemented measures to manage our risks related to such disruptions, but such disruptions could negatively impact our operations and financial results |
| In addition, we may incur additional costs to remedy the damages caused by these disruptions or security breaches |
| The occurrence of events for which we are self-insured, or which exceed our insurance limits may affect our profitability and liquidity |
| We have insurance contracts with independent insurance companies related to many different types of risk; however, we self-insure for some risks and obligations |
| In these circumstances, we have determined that it is more cost effective to self-insure certain risks than to pay the increased premium costs in place since the disruption in the insurance market after the events of September 11, 2001 |
| The risks and exposures that we self-insure include, but are not limited to, product defects, 16 ______________________________________________________________________ political risks, and patent infringement |
| Should there be a loss or adverse judgment or other decision in an area for which we are self-insured, then our financial condition, result of operations and liquidity may be adversely affected |
| We are subject to stringent environmental regulations, which may force us to incur significant expenses |
| We must comply with many different federal, state, local and foreign governmental regulations related to the use, storage, discharge and disposal of toxic, volatile or otherwise hazardous chemicals used in our manufacturing process |
| Although we believe that our activities conform to presently applicable environmental regulations, our failure to comply with present or future regulations could result in the imposition of fines, suspension of production or a cessation of operations |
| Any such environmental regulations could require us to acquire costly equipment or to incur other significant expenses to comply with such regulations |
| Any failure by us to control the use of or adequately restrict the discharge of hazardous substances could subject us to future liabilities |
| Environmental problems may occur that could subject us to future costs or liabilities |
| Further, certain of our customers shipping their products into European markets are also subject to governmental environmental regulations such as the Restriction of Hazardous Substances in Electrical and Electronic Equipment Directive (RoHS) which will be effective July 1, 2006 |
| These directives focus on limiting the amounts of certain elements, such as lead, in electrical devices |
| The inability of this sub-set of our customers to use Microchip products which contain lead after July 2006 may adversely affect our results of operations |
| Compliance with future changes to securities laws and related regulations could result in increased costs to us |
| Changes in the laws and regulations affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and rules enacted and proposed by the Securities and Exchange Commission (SEC), The NASDAQ Stock Market^® (NASDAQ) and the New York Stock Exchange (NYSE), resulted in significantly increased costs to us in fiscal 2005 as we responded to their requirements |
| In particular, complying with the internal control audit requirements of Sarbanes-Oxley Section 404 in fiscal 2005 resulted in increased internal efforts and significantly higher fees from our independent accounting firm |
| In fiscal 2006, our costs associated with these activities were at approximately the same levels as in fiscal 2005 |
| Further changes in applicable legal or accounting requirements could result in additional costs in future periods |
| This report on Form 10-K contains a report by our management on our internal control over financial reporting including an assessment of the effectiveness of our internal control over financial reporting as of March 31, 2006 |
| This Form 10-K also contains an attestation and report by our auditors with respect to our management’s assessment of the effectiveness of internal control over financial reporting under Section 404 |
| While these assessments and reports did not reveal any material weaknesses in our internal control over financial reporting, compliance with Section 404 is an ongoing process and will be required for each future fiscal year |
| We expect that the ongoing compliance with Section 404 will continue to be both very costly and very challenging and there can be no assurance that material weaknesses with not be identified in future periods |
| Any adverse results from such ongoing compliance efforts could result in a loss of investor confidence in our financial reports and have an adverse effect on our stock price |
| Recent regulations related to equity compensation will adversely affect our earnings and our ability to attract and retain key personnel |
| Since our inception, we have used stock options and other long-term equity incentives as a fundamental component of our employee compensation packages and have accounted for them using the intrinsic value method of APB Nodtta 25, “Accounting for Stock Issued to Employees |
| ” We believe that stock options and other long-term equity incentives directly motivate our employees to maximize long-term stockholder value and, through the use of vesting, encourage employees to remain with Microchip |
| In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) Nodtta 123 (revised 2004), “Share-Based Payments,” (“SFAS 123R”) which changed US Generally Accepted Accounting Principles in such a way to require us to record a charge to earnings for the fair value of employee stock option grants and other share based compensation beginning in the first quarter of fiscal 2007 |
| This regulation will negatively impact our earnings for those share based awards that vest beginning in fiscal 2007 |
| Furthermore, adoption of SFAS 123R will require us to make certain assumptions and judgments in the valuation of stock options that we may grant in the future |
| A change in any of those assumptions or judgments could change the compensation expense that is charged against our earnings and, consequently, adversely affect our results of operations |
| 17 ______________________________________________________________________ In addition, recent regulations implemented by NASDAQ requiring shareholder approval for all stock option plans as well as recent regulations implemented by NYSE prohibiting NYSE member organizations from giving a proxy to vote on equity-compensation plans unless the beneficial owner of the shares has given voting instructions could make it more difficult for us to grant equity-based awards to employees in the future |
| To the extent that these or other new regulations make it more difficult or expensive to grant options to employees, we may incur compensation costs, productivity losses, change our equity compensation strategy or find it difficult to attract, retain and motivate employees, each of which could materially and adversely affect our business |
| The future trading price of our common stock could be subject to wide fluctuations in response to a variety of factors |
| The market price of our common stock has fluctuated significantly in the past and is likely to fluctuate in the future |
| The future trading price of our common stock could be subject to wide fluctuations in response to a variety of factors, many of which are beyond our control, including, but not limited to: • quarterly variations in our operating results and the operating results of other technology companies • actual or anticipated announcements of technical innovations or new products by us or our competitors • changes in analysts’ estimates of our financial performance or buy/sell recommendations • changes in our financial guidance or our failure to meet such guidance • general conditions in the semiconductor industry, and • worldwide economic and financial conditions |
| In addition, the stock market has experienced significant price and volume fluctuations that have particularly affected the market prices for many high technology companies and that often have been unrelated to the operating performance of such companies |
| These broad market fluctuations and other factors may harm the market price of our common stock |
| The outcome of currently ongoing and future examinations of our income tax returns by the IRS could have an adverse effect on our results of operations |
| We are subject to continued examination of our income tax returns by the Internal Revenue Service and other tax authorities |
| We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes |
| There can be no assurance that the outcomes from these continuing examinations will not have an adverse effect on future operating results |
| In the event we make acquisitions, we may not be able to successfully integrate such acquisitions or attain the anticipated benefits |
| While acquisitions do not represent a major part of our growth strategy, from time to time we may consider financially attractive and strategic acquisitions if such opportunities arise |
| Any transactions that we complete may involve a number of risks, including: the diversion of our management’s attention from our existing business to integrate the operations and personnel of the acquired or combined business or joint venture, or possible adverse effects on our operating results during the integration process |
| In addition, we may not be able to successfully or profitably integrate, operate, maintain and manage our newly acquired operations or employees |
| We may not be able to maintain uniform standards, controls, procedures and policies, and this may lead to operational inefficiencies |