SanDisk 2004 Annual Report Download - page 23

Table of Contents
than the gross margin on our captive supply. However, our captive supply requires us to invest in capital assets, research and
development and start−up and other production costs. We expect to continue sourcing non−captive flash memory.
Licensing and Royalties. The timing and amount of royalty revenues and the recognition of license fees can vary substantially
from quarter to quarter depending on the terms of our license agreements and the timing and volume of sales of products by our
licensees. Gross margins and operating income fluctuate more with changes in license and royalty revenues than with changes in
product revenues since license and royalty revenues have no variable costs of sale.
Retail Sales. Our arrangements with retailers often involve complex terms. These terms include providing the retailer with a right
to return unsold product, market development funds, cooperative advertising funds, price protection, promotions, and volume
incentive rebates. In some cases, we consign inventory to our customers. These consignment activities reduce our working capital and
involve administrative costs to track and account for our inventory. We defer recognition of revenue on sales to retailers and
distributors until they sell the product they have purchased from us to their customers. We also have agreements with some of our
customers in which we agree to protect their inventory balances against changes in our suggested retail price. Our retail business is
seasonal, with the fourth quarter being the strongest due to holiday sales in North America.
Memory Market Dynamics. Semiconductor memory markets have generally been characterized by cycles of undersupply leading
to the building of additional capacity, which in turn has led to oversupply which reduces prevailing prices per megabyte in the market.
In an oversupply environment, the value of our inventory decreases resulting in charges against earnings. In 2001 for example, we
recorded approximately $85.0 million of charges related to inventory revaluation. We may be forced to reduce the carrying value of
our inventory if market demand for our products deteriorates and our inventory levels exceed customer orders. In addition, we may
record additional lower of cost or market price adjustments to our inventories if pricing pressure results in a net realizable value that is
lower than our cost.
Our business is characterized by constant focus on cost reduction. NAND flash memory cost reduction is achieved by transitioning
to new generations of technology, larger wafer sizes or improving yields. Manufacturing yields are lower at the start of manufacturing
each successive product generation. During the start−up phase, the fabrication equipment and operating expenses are applied to a
relatively small output of production wafers, making this output very expensive. In the next two to three years, we expect to make
substantial new investments in additional fabrication capacity in the ventures with Toshiba.
Critical Accounting Policies & Estimates
Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial
statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The
preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent liabilities. On an on−going basis, we evaluate our estimates,
including, among others, those related to customer programs and incentives, product returns, bad debts, inventories, investments,
income taxes, warranty obligations, contingencies and litigation. We base our estimates on historical experience and on other
assumptions that we believe are reasonable under the circumstances, the results of which form the basis for our judgments about the
carrying values of assets and liabilities when those values are not readily apparent from other sources. Estimates have historically
approximated actual results. However, future results will differ from these estimates under different assumptions and conditions.
Revenue Recognition, Sales Returns and Allowances and Sales Incentive Programs. We recognize net revenues when the earnings
process is complete, as evidenced by an agreement with the customer, transfer of title and acceptance, if applicable, fixed pricing and
reasonable assurance of realization. Sales made to distributors and retailers are generally under agreements allowing price protection
and/or right of return and, therefore, the sales and related costs of these transactions are deferred until the retailers or distributors sell
the merchandise to their end customer, or the rights of return expire. At January 2, 2005
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