10-Q 1 form10q.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 -------------------------------------------------------- FORM 10-Q -------------------------------------------------------- [x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended May 31, 2005 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission file number 0-7422 -------------------------------------------------------- STANDARD MICROSYSTEMS CORPORATION -------------------------------------------------------- (Exact name of registrant as specified in its charter) DELAWARE 11-2234952 -------------------------------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 80 Arkay Drive, Hauppauge, New York 11788 -------------------------------------------------------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: 631-435-6000 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes _X_ No ____ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes _X_ No ____ Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. As of May 31, 2005, there were 20,739,000 shares of the registrant's common stock outstanding. Standard Microsystems Corporation Form 10-Q For the Quarter Ended May 31, 2005 Table of Contents ----------------- Part I Financial Information Item 1 Financial Statements (unaudited): Condensed Consolidated Balance Sheets as of May 31, 2005 and February 28, 2005 Condensed Consolidated Statements of Operations for the Three-Month Periods Ended May 31, 2005 and 2004 Condensed Consolidated Statements of Cash Flows for the Three-Month Periods Ended May 31, 2005 and 2004 Notes to Condensed Consolidated Financial Statements Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations Item 3 Quantitative and Qualitative Disclosures About Market Risk Item 4 Controls and Procedures Part II Other Information Item 1 Legal Proceedings Item 2 Unregistered Sales of Equity Securities and Use of Proceeds Item 3 Defaults Upon Senior Securities Item 4 Submission of Matters to a Vote of Security Holders Item 5 Other Information Item 6 Exhibits Signature PART I - FINANCIAL INFORMATION ITEM 1. Financial Statements STANDARD MICROSYSTEMS CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited) (in thousands) May 31, February 28, 2005 2005 ------------ -------------- Assets Current assets: Cash and cash equivalents $ 19,674 $ 116,126 Short-term investments 101,279 56,519 Accounts receivable, net 29,881 23,788 Inventories 42,303 33,310 Deferred income taxes 16,252 17,701 Other current assets 5,753 4,295 ---------------------------------------------------------------------------- Total current assets 215,142 251,739 ---------------------------------------------------------------------------- Property, plant and equipment, net 25,959 22,630 Goodwill 78,912 29,435 Intangible assets, net 49,671 3,584 Deferred income taxes 7,728 7,163 Other assets 3,549 4,708 ---------------------------------------------------------------------------- $ 380,961 $ 319,259 ============================================================================ Liabilities and shareholders' equity Current liabilities: Accounts payable $ 21,097 $ 15,995 Deferred income on shipments to distributors 11,126 7,689 Accrued expenses, income taxes and other liabilities 17,772 13,400 ---------------------------------------------------------------------------- Total current liabilities 49,995 37,084 ---------------------------------------------------------------------------- Deferred income taxes 16,658 - Other liabilities 12,215 12,326 Shareholders' equity: Preferred stock - - Common stock 2,273 2,053 Additional paid-in capital 225,515 187,854 Retained earnings 103,639 100,612 Treasury stock, at cost (25,961) (23,799) Deferred stock-based compensation (3,642) (1,925) Accumulated other comprehensive income 269 5,054 ---------------------------------------------------------------------------- Total shareholders' equity 302,093 269,849 ---------------------------------------------------------------------------- $ 380,961 $ 319,259 ============================================================================ See Notes to Condensed Consolidated Financial Statements. STANDARD MICROSYSTEMS CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (In thousands, except per share amounts) Three Months Ended May 31, ------------------------------- 2005 2004 ------------ ------------ Revenues $ 68,807 $ 53,053 Costs and expenses: Cost of goods sold 36,492 26,385 Research and development 12,966 10,862 Selling, general and administrative 13,591 11,852 Amortization of intangible assets 1,153 317 In-process research and development 895 - -------------------------------------------------------------------------------- Income from operations 3,710 3,637 Interest income 723 466 Other expense, net (47) (32) -------------------------------------------------------------------------------- Income before provision for income taxes 4,386 4,071 Provision for income taxes 1,359 1,159 -------------------------------------------------------------------------------- Net income $ 3,027 $ 2,912 ================================================================================ Basic net income per share: $ 0.15 $ 0.16 ================================================================================ Diluted net income per share: $ 0.15 $ 0.15 ================================================================================ Weighted average common shares outstanding: Basic 20,066 18,246 Diluted 20,476 19,790 See Notes to Condensed Consolidated Financial Statements. STANDARD MICROSYSTEMS CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (In thousands) Three Months Ended May 31, ---------------------------------- 2005 2004 -------------- --------------- Cash flows from operating activities: Cash received from customers and licensees $ 73,735 $ 50,938 Cash paid to suppliers and employees (57,941) (52,240) Interest received 588 421 Interest paid (21) (39) Income taxes paid (1,181) (44) -------------------------------------------------------------------------------- Net cash provided by (used for) operating activities 15,180 (964) -------------------------------------------------------------------------------- Cash flows from investing activities: Capital expenditures (3,162) (2,902) Acquisition of Oasis SiliconSystems Holding AG, net of cash acquired (60,349) - Sales of long-term investments - 4,000 Purchases of short-term investments (179,886) (134,016) Sales of short-term investments 135,172 132,238 Other 21 5 -------------------------------------------------------------------------------- Net cash used for investing activities (108,204) (675) -------------------------------------------------------------------------------- Cash flows from financing activities: Proceeds from issuance of common stock 21 210 Purchases of treasury stock (2,162) - Repayments of obligations under capital leases and notes payable (659) (506) -------------------------------------------------------------------------------- Net cash used for financing activities (2,800) (296) -------------------------------------------------------------------------------- Effect of foreign exchange rate changes on cash and cash equivalents (628) (25) -------------------------------------------------------------------------------- Net decrease in cash and cash equivalents (96,452) (1,960) Cash and cash equivalents at beginning of period 116,126 14,050 -------------------------------------------------------------------------------- Cash and cash equivalents at end of period $ 19,674 $ 12,090 ================================================================================ Reconciliation of net income to net cash provided by (used for) operating activities: Net income $ 3,027 $ 2,912 Adjustments to reconcile net income to net cash provided by (used for) operating activities: Depreciation and amortization 3,893 2,756 In-process research and development charge 895 - Stock-based compensation 232 212 Other adjustments, net 9 44 Changes in operating assets and liabilities, net of business acquisition impact: Accounts receivable (732) (7,960) Inventories 3,221 (48) Accounts payable, deferred income, accrued expenses and other liabilities 4,336 425 Current and deferred income taxes 174 1,067 Other changes, net 125 (372) -------------------------------------------------------------------------------- Net cash provided by (used for) operating activities $ 15,180 $ (964) ================================================================================ See Notes to Condensed Consolidated Financial Statements. STANDARD MICROSYSTEMS CORPORATIONAND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. Basis of Presentation The accompanying unaudited condensed consolidated financial information of Standard Microsystems Corporation and subsidiaries, referred to herein as "SMSC" or "the Company," has been prepared in accordance with generally accepted accounting principles and the rules and regulations of the Securities and Exchange Commission (SEC), and reflects all adjustments, consisting only of normal recurring adjustments, which in management's opinion are necessary to state fairly the Company's financial position, results of operations and cash flows for all periods presented. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported amounts of sales and revenues and expenses during the reporting period. Actual results may differ from those estimates, and such differences may be material to the financial statements. These condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended February 28, 2005 included in the Company's annual report on Form 10-K, as filed on May 16, 2005 with the SEC. The results of operations for the three-month period ended May 31, 2005 are not necessarily indicative of the results to be expected for any future periods. 2. Stock-Based Compensation The Company has in effect several stock-based compensation plans under which incentive stock options, non-qualified stock options, restricted stock awards and stock appreciation rights are granted to employees and directors. All stock options are granted with exercise prices equal to the fair value of the underlying shares on the date of grant. The Company accounts for stock option grants in accordance with Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees" and accordingly recognizes no compensation expense for the stock option grants. Additional pro forma disclosures as required under Statement of Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation," as amended by SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure," are detailed below. For purposes of the pro forma disclosures required by SFAS No. 123, the estimated fair market value of the Company's options is amortized as an expense over the options' vesting periods. The fair value of each option grant, as defined by SFAS No. 123, is estimated on the date of grant using the Black-Scholes option-pricing model. The Black-Scholes model, as well as other currently accepted option valuation models, was developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, that significantly differ from the Company's stock option awards. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in the opinion of management, the existing models do not necessarily provide a reliable single measure of the fair value of employee stock options. Had compensation expense been recorded under the provisions of SFAS No. 123, the Company's net income and net income per share would have been the pro forma amounts indicated below (in thousands, except per share data): Three Months Ended May 31, ------------------------------ 2005 2004 ------------------------------------------------------------------------------ Net income - as reported $ 3,027 $ 2,912 Stock-based compensation expense included in net income, net of taxes - as reported 145 141 Stock-based compensation expense determined using the fair value method for all awards, net of taxes (2,315) (2,421) ------------------------------------------------------------------------------ Net income - pro forma $ 857 $ 632 ============================================================================== Basic net income per share - as reported $ 0.15 $ 0.16 ============================================================================== Diluted net income per share - as reported $ 0.15 $ 0.15 ============================================================================== Basic net income per share - pro forma $ 0.04 $ 0.03 ============================================================================== Diluted net income per share - pro forma $ 0.04 $ 0.03 ============================================================================== 3. Acquisition of OASIS SiliconSystems Holding AG On March 30, 2005, SMSC announced the completion that day of its acquisition of OASIS SiliconSystems Holding AG (OASIS). Based in Karlsruhe, Germany, OASIS is engaged in the development and marketing of integrated circuits that enable networking of multimedia devices for automotive infotainment applications. The transaction was accounted for as a purchase under accounting principles generally accepted in the United States of America, whereby the purchase price for OASIS has been allocated to the net tangible and intangible assets acquired, based upon their fair values as of March 30, 2005, and the results of OASIS' operations subsequent to March 30, 2005 have been included in the Company's consolidated results of operations. SMSC acquired all of OASIS' outstanding capital stock in exchange for aggregate consideration of $118.7 million, including approximately 2.1 million shares of SMSC common stock valued for accounting purposes at $35.8 million, $79.5 million of cash, and approximately $3.4 million of direct acquisition costs, including legal, banking, accounting and valuation fees. The tangible assets of OASIS at March 30, 2005 included approximately $22.4 million of cash and cash equivalents, resulting in a net cash outlay of approximately $60.5 million. SMSC's existing cash balances were the source of the cash used in the transaction. For accounting purposes, the value of the SMSC common stock was determined using the average of the stock's market value for two days before and after the date the terms of the acquisition were announced. Under the terms of the Share Purchase Agreement, approximately 1.2 million of the shares and $1.8 million of the cash issued to the former shareholders of OASIS is being held in an escrow account as security for certain indemnity obligations of OASIS' former shareholders. Up to $20.0 million of additional consideration, payable in cash and SMSC common stock, may be issued to OASIS' former shareholders during fiscal 2007 upon satisfaction of certain future performance goals. Any additional consideration earned and paid will be recorded as goodwill. The following table summarizes the components of the purchase price (in millions): Cash $ 79.5 SMSC common stock issued 35.8 Transaction costs 3.4 ----------------------------------------------------------- $ 118.7 =========================================================== The following table summarizes the allocation of the purchase price (in millions): Cash and cash equivalents $ 22.4 Accounts receivable 5.8 Inventory 12.9 Other current assets 0.5 Identifiable intangible assets: Purchased technology 32.4 Customer relationships 10.5 Trademark 5.4 Other 0.6 Property and equipment 2.7 Goodwill 51.9 Deferred income tax benefits 0.6 Accounts payable (1.7) Accrued expenses and income taxes (6.9) Deferred income tax liabilities (19.3) In-process research and development 0.9 ----------------------------------------------------------- $ 118.7 =========================================================== The majority of OASIS' net assets, including goodwill and identifiable intangible assets, is located in Europe, and the functional currency of OASIS' operations in Europe is the euro. Accordingly, these euro-denominated net assets are translated into U.S. dollars at period-end exchange rates and gains or losses arising from translation are included as a component of Accumulated other comprehensive income within Shareholders' equity. In accordance with the provisions of SFAS No. 141, OASIS' finished goods inventory has been valued at estimated selling prices less the costs of disposal and a reasonable profit allowance for the related selling effort; work-in-process inventory has been valued at estimated selling prices of the finished goods less costs to complete, costs of disposal, and a reasonable profit allowance for the completing and selling efforts; and raw materials have been valued at current replacement costs. These values initially exceed OASIS' historical inventory cost by approximately $1.7 million. This value was included within the $12.9 million of fair value assigned to OASIS' inventory at March 30, 2005, and is being recorded as a component of cost of goods sold as the underlying inventory is sold, $0.6 million of which was recognized during the quarter ended May 31, 2005. The estimated fair value attributed to purchased technology was determined based upon a discounted forecast of the estimated net future cash flows to be generated from the technologies, using a discount rate of 25%. The estimated fair value of purchased technology is being amortized over a period of 8 years on a straight-line basis, which approximates the pattern in which the economic benefits of the technology are expected to be realized. The estimated fair value attributed to customer relationships was determined based on a discounted forecast of the estimated net future cash flows to be generated from the relationships, discounted at a rate of 23%. The estimated fair value of the customer relationships is being amortized over a period of 8 years on a straight-line basis, which approximates the pattern in which the economic benefits of the customer relationships are expected to be realized. OASIS owns certain trademarks related to its automotive infotainment technology. The estimated fair value attributed to these trademarks was determined by calculating the present value of the royalty savings related to the trademarks using an assumed royalty rate of 1.5% and a discount rate of 23%. These trademarks have indefinite lives and are therefore not being amortized. They will be subject to an impairment test on an annual basis, or when an event or circumstance occurs indicating a possible impairment in value. Goodwill represents the excess of the purchase price over the fair values of the net tangible and intangible assets. This acquisition significantly expands SMSC's presence in the automotive infotainment market, and is also providing opportunities for expanded presence in other market segments, including consumer networking. It also added an assembled workforce of about 150 employees into SMSC's operations. These factors contributed to recognition of goodwill in the purchase price. In accordance with SFAS No. 142, goodwill is not amortized but will be tested for impairment at least annually. The $0.9 million allocated to in-process research and development represents the fair value of purchased in-process technology for research projects that, as of the March 30, 2005 closing date of the acquisition, had not reached technological feasibility and had no alternative future uses. This value was based upon discounted cash flows attributable to the projects using a discount rate of 28%, the estimated time to complete the projects and the levels of risks involved. These projects are primarily focused on deployment of certain technology into consumer applications. The $0.9 million estimated fair value of in-process research and development is reflected within Costs and expenses for the quarter ended May 31, 2005. The following unaudited pro forma financial information presents the combined operating results of SMSC and OASIS as if the acquisition had occurred as of the beginning of each period presented. Pro forma data is subject to various assumptions and estimates, and is presented for informational purposes only. This pro forma data does not purport to represent or be indicative of the consolidated operating results that would have been reported had the transaction been completed as described herein, and the data should not be taken as indicative of future consolidated operating results. Pro forma financial information for the three-month periods ended May 31, 2005 and 2004 is as follows (in millions, except per share data): Three Months Ended May 31, ----------------------------- 2005 2004 ---------------------------------------------------------------------- Revenues $ 73.0 $ 65.0 Net income $ 2.5 $ 1.8 Basic net income per share $ 0.13 $ 0.09 Diluted net income per share $ 0.12 $ 0.08 4. Short-Term Investments Short-term investments consist of investments in obligations with maturities of between three and twelve months, at acquisition, and investments in auction rate securities. All of these investments are classified as available-for-sale. The costs of these short-term investments approximate their market values as of February 28, 2005 and May 31, 2005. The Company invests excess cash in a variety of marketable securities, including auction rate securities. Auction rate securities have long-term underlying maturities, but have interest rates that are reset every 90 days or less, at which time the securities can typically be purchased or sold, which creates a highly liquid market for these securities. The Company's intent is not to hold these securities to maturity, but rather to use the interest rate reset feature to provide liquidity as necessary. The Company's investment in these securities provides higher yields than money market and other cash equivalent investments. For all periods through November 30, 2004, the Company classified auction rate securities as cash equivalents, reflecting their highly liquid nature. Effective at February 28, 2005, auction rate securities are being classified as short-term investments on the Company's consolidated balance sheet for all dates presented, reflecting recently converging interpretations of the accounting treatment for these securities. In addition, consistent with this change in classification, all purchases and sales of auction rate securities are reflected in the investing activities section of the Company's Consolidated Statements of Cash Flows for all periods presented. The Company does not consider this change in classification to be material to its financial condition or cash flows. In addition, it has no effect on the Company's total current assets, working capital, total assets, or operating cash flows, and the change in classification in no way revises or restates the Company's Consolidated Statements of Operations. For purposes of the Condensed Consolidated Statement of Cash Flows for the three months ended May 31, 2004, auction rate and other securities at May 31, 2004 were changed in classification as follows (in thousands): Cash and Cash Short-Term Equivalents Investments ----------------------------------------------------------------------------- As previously classified $ 130,855 $ 27,260 Change in classification - auction rate securities (118,505) 118,505 Change in classification - other securities (260) 260 ----------------------------------------------------------------------------- As currently classified $ 12,090 $ 146,025 ============================================================================= For the three-month period ended May 31, 2004, $2.3 million of net cash provided by investing activities, related to activity in auction rate securities, was previously included in the decrease in cash and cash equivalents in the Consolidated Statements of Cash Flows. 5. Balance Sheet Data Inventories are valued at the lower of first-in, first-out cost or market and consist of the following (in thousands): May 31, 2005 Feb. 28, 2005 ------------------------------------------------------------------------------- Raw materials $ 1,667 $ 1,143 Work in process 21,088 16,626 Finished goods 19,548 15,541 ------------------------------------------------------------------------------- $ 42,303 $ 33,310 =============================================================================== Property, plant and equipment consist of the following (in thousands): May 31, 2005 Feb. 28, 2005 ------------------------------------------------------------------------------- Land $ 578 $ 578 Buildings and improvements 12,236 12,064 Machinery and equipment 71,381 68,190 Construction in progress 4,232 1,601 ------------------------------------------------------------------------------- 88,427 82,433 Less: accumulated depreciation 62,468 59,803 ------------------------------------------------------------------------------- $ 25,959 $ 22,630 =============================================================================== 6. Net Income Per Share Basic net income per share is calculated using the weighted-average number of common shares outstanding during the period. Diluted net income per share is calculated using the weighted-average number of common shares outstanding during the period, plus the dilutive effect of unvested restricted stock awards and shares issuable through stock options. The shares used in calculating basic and diluted net income per share for the Condensed Consolidated Statements of Operations included within this report are reconciled as follows (in thousands): Three Months Ended May 31, 2005 2004 ------------------------- Average shares outstanding for basic net income per share 20,066 18,246 Dilutive effect of stock options and unvested restricted stock awards 410 1,544 ------------------------------------------------------------------------------ Average shares outstanding for diluted net income per share 20,476 19,790 ============================================================================== Options covering 3.1 million and 0.2 million shares for the three-month periods ended May 31, 2005 and 2004, respectively, were excluded from the computation of average shares outstanding for diluted net income per share because their effect was antidilutive. 7. Comprehensive Income The Company's other comprehensive income consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, and unrealized gains and losses on equity investments classified as available-for-sale. The components of the Company's comprehensive income for the three-month periods ended May 31, 2005 and 2004 were as follows (in thousands): Three Months Ended May 31, 2005 2004 --------------------------- Net income $ 3,027 $ 2,912 Other comprehensive income (loss): Change in foreign currency translation adjustments (4,819) (53) Change in unrealized gain (loss) on marketable equity securities, net of taxes 34 (4) -------------------------------------------------------------------------------- Total comprehensive income (loss) $ (1,758) $ 2,855 ================================================================================ 8. Business Restructuring In December 2001, the Company announced a restructuring plan for its exit from the PC chipset business. The Company's reserve related to this restructuring declined from $0.5 million at February 28, 2005 to $0.4 million at May 31, 2005, reflecting payments against previously reserved non-cancelable lease obligations, which will continue through their respective lease terms through August 2008. 9. Goodwill and Intangible Assets The Company's March 2005 acquisition of OASIS included the acquisition of $42.9 million of finite-lived intangible assets, an indefinite-lived trademark of $5.4 million, and goodwill of $51.9 million. The June 2002 acquisition of Tucson, Arizona-based Gain Technology Corporation included the acquisition of $7.1 million of finite-lived intangible assets and $29.4 million of goodwill, after adjustments. All finite-lived intangible assets are being amortized on a straight-line basis, which approximates the pattern in which the estimated economic benefits of the assets are realized, over their estimated useful lives. Existing technologies have been assigned estimated useful lives of between six and eight years, with a weighted-average useful life of approximately eight years. Customer relationships and contracts have been assigned useful lives of between one and ten years, with a weighted-average useful life of approximately eight years. Intangible assets that are denominated in a functional currency other than the U.S. dollar have been translated into U.S. dollars using the exchange rate in effect on the reporting date. As of May 31, 2005 and February 28, 2005, the Company's identifiable intangible assets consisted of the following (in thousands): May 31, 2005 February 28, 2005 -------------------------------------------------------------------------------- Accumulated Accumulated Cost Amortization Cost Amortization -------------------------------------------------------------------------------- Purchased technologies $ 37,759 $ 3,747 $ 6,179 $ 2,832 Customer relationships and contracts 10,330 306 326 89 -------------------------------------------------------------------------------- Total - finite-lived intangible assets 48,089 4,053 6,505 2,921 -------------------------------------------------------------------------------- Trademark and other 5,635 - - - -------------------------------------------------------------------------------- $ 53,724 $ 4,053 $ 6,505 $ 2,921 ================================================================================ Total amortization expense recorded for finite-lived intangible assets was $1.1 million and $0.3 million for the three-month periods ended May 31, 2005 and 2004, respectively. Estimated future finite-lived intangible asset amortization expense for the remainder of fiscal 2006 and thereafter is as follows (in thousands): Period Amount --------------------------------------------------- Remainder of fiscal 2006 $ 5,128 Fiscal 2007 6,261 Fiscal 2008 6,261 Fiscal 2009 5,488 Fiscal 2010 5,231 Fiscal 2011 and thereafter 15,667 =================================================== 10. Retirement Plans The Company maintains an unfunded Supplemental Executive Retirement Plan to provide senior management with retirement, disability and death benefits. The Company's subsidiary, SMSC Japan, also maintains an unfunded retirement plan, which provides its employees and directors with separation benefits, consistent with customary practices in Japan. Benefits under these defined benefit plans are based upon various service and compensation factors. The following table sets forth the components of the consolidated net periodic pension expense for the three-month periods ended May 31, 2005 and 2004, respectively (in thousands): Three Months Ended May 31, ------------------------- 2005 2004 ----------------------------------------------------------------------------- Service cost - benefits earned $ 86 $ 72 Interest cost on projected benefit obligations 98 106 Net amortization and deferral 67 72 ----------------------------------------------------------------------------- Net periodic pension expense $ 251 $ 250 ============================================================================= Additionally, the Company is the beneficiary of life insurance policies that have been purchased as a method of partially financing benefits under the Supplemental Executive Retirement Plan. 11. Common Stock Repurchase Program The Company maintains a common stock repurchase program, as approved by its Board of Directors, which authorizes the Company to repurchase up to three million shares of its common stock on the open market or in private transactions. Under this program, the Company repurchased approximately 150,000 shares of its common stock at a cost of $2.2 million during the first quarter of fiscal 2006. No shares were repurchased during the first quarter of fiscal 2005. The Company currently holds repurchased shares as treasury stock. As of May 31, 2005, the Company has repurchased a total of approximately 2.0 million shares of its common stock, at a cost of $26.0 million, under this program. 12. Industry Segment Information The Company's operating segments conform to aggregation criteria set forth in SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," and their operating results are therefore aggregated into one reportable operating segment - the design, development and marketing of semiconductor integrated circuits. 13. Recent Accounting Pronouncements In November 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 151, "Inventory Costs, An Amendment of ARB No. 43, Chapter 4." SFAS No. 151 clarifies that abnormal inventory costs such as costs of idle facilities, excess freight and handling costs, and wasted materials (spoilage) are required to be recognized as current period charges. The provisions of SFAS No. 151 are effective for fiscal years beginning after June 15, 2005. The Company is currently evaluating the provisions of SFAS No. 151 and does not expect that its adoption will have a material impact on its consolidated financial condition, results of operations and cash flows. In December 2004, the FASB issued SFAS No. 123R (Revised 2004), "Share-Based Payment." The scope of SFAS No. 123R includes a wide range of share-based compensation arrangements including stock options, restricted stock plans, performance-based awards, stock appreciation rights, and employee stock purchase plans. SFAS No. 123R replaces SFAS No. 123, "Accounting for Stock-Based Compensation," and supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS No. 123, as originally issued in 1995, established as preferable a fair-value-based method of accounting for share-based payment transactions with employees. However, that statement permitted the option of continuing to apply the guidance in APB Opinion 25, provided that the footnotes to the consolidated financial statements disclosed pro forma net income and net income per share, as if the preferable fair-value-based method had been applied. SFAS No. 123R requires that compensation costs relating to share-based payment transactions be recognized in the consolidated financial statements. Compensation costs will be measured based on the fair value of the equity or liability instruments issued. SFAS No. 123R is effective for the first annual reporting period that begins after June 15, 2005. The Company is currently evaluating the impact of SFAS No. 123R and believes that the adoption of this statement could have a material impact on its consolidated financial position and results of operations. In December 2004, the FASB issued SFAS No. 153, "Exchanges of Nonmonetary Assets," an amendment of APB Opinion No. 29. SFAS No. 153 addresses the measurement of exchanges of nonmonetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. SFAS No. 153 is effective for nonmonetary asset exchanges in fiscal periods beginning after June 15, 2005. The Company does not expect the adoption of SFAS No. 153 to have a material impact on its consolidated financial position, results of operations and cash flows. In December 2004, the FASB issued FASB Staff Position (FSP) No. 109-2, "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004." The American Jobs Creation Act introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to U.S. companies, provided certain criteria are met. FSP No. 109-2 provides accounting and disclosure guidance on the impact of the repatriation provision on a company's income tax expense and deferred tax liability. The Company is currently studying the impact of the one-time favorable foreign dividend provision and intends to complete the analysis by the end of fiscal 2006. Accordingly, the Company has not recorded any adjustments to its income tax expense or deferred income taxes to reflect the tax impact of any repatriation of non-U.S. earnings it may make. In March 2005, the FASB issued Interpretation No. 47, "Accounting for Conditional Asset Retirement Obligations." Interpretation No. 47 clarifies that an entity must record a liability for a "conditional" asset retirement obligation if the fair value of the obligation can be reasonably estimated. Interpretation No. 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. Interpretation No. 47 is effective no later than the end of the fiscal year ending after December 15, 2005. The Company does not expect the adoption of Interpretation No. 47 to have a material impact on its consolidated financial position, results of operations and cash flows. ITEM 2. Management's Discussion and Analysis of Financial Conditions and Results of Operations The following discussion should be read in conjunction with the Company's Consolidated Financial Statements and notes thereto contained in this report. Portions of this report may contain forward-looking statements about expected future events and financial and operating results that involve risks and uncertainties. Words such as "believe," "expect," "anticipate" and similar expressions identify forward-looking statements. Such statements are qualified in their entirety by the inherent risks and uncertainties surrounding future expectations and may not reflect the potential impact of any future acquisitions, mergers or divestitures. All forward-looking statements speak only as of the date hereof and are based upon the information available to SMSC at this time. Such information is subject to change, and the Company may not inform, or be required to inform, investors of such changes. SMSC competes in the semiconductor industry, which has historically been characterized by intense competition, rapid technological change, cyclical market patterns, price erosion and periods of mismatched supply and demand. These and other risks and uncertainties, including potential liability resulting from pending or future litigation, are detailed from time to time in the Company's reports filed with the SEC. Investors are advised to read the Company's Annual Report on Form 10-K and quarterly reports on Form 10-Q filed with the SEC, particularly those sections entitled "Other Factors That May Affect Future Operating Results," for a more complete discussion of these and other risks and uncertainties. Other cautionary statements and risks and uncertainties may also appear elsewhere in this report. Overview -------- Description of Business Many of the world's global technology companies rely upon SMSC as a go-to resource for semiconductor system solutions that span analog, digital and mixed-signal technologies. Leveraging intellectual property, integration expertise and a comprehensive global infrastructure, SMSC solves design challenges and delivers performance, space, cost and time-to-market advantages to its customers. SMSC's application focus targets key vertical markets including mobile and desktop PCs, consumer electronics, automotive infotainment and industrial applications. The Company has developed leadership positions in its select markets by providing application specific solutions such as mixed-signal PC system controllers, non-PCI Ethernet, ARCNET, MOST, Hi-Speed USB and other high-speed serial communications. SMSC is headquartered in Hauppauge, New York with operations in North America, Taiwan, Japan, Korea, China and Europe. Engineering design centers are located in Arizona, New York, Texas and Karlsruhe, Germany. Additional information is available at www.smsc.com. Key Indicators Management measures the condition and performance of the Company's business in numerous ways. Among the key quantitative indicators generally used in this regard are bookings, sales and revenues, gross profit and operating expenses relative to revenues. The Company also carefully monitors the progress of its product development efforts. Critical Accounting Policies and Estimates ------------------------------------------ This discussion and analysis of the Company's financial condition and results of operations is based upon the unaudited condensed consolidated financial statements included in this report, which have been prepared in accordance with accounting principles for interim financial statements generally accepted in the United States. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of sales and revenues and expenses during the reporting period. The Company believes that the critical accounting policies and estimates listed below are important to the portrayal of the Company's financial condition and operating results, and require critical management judgments and estimates about matters that are inherently uncertain. Although management believes that its judgments and estimates are appropriate and reasonable, actual future results may differ from these estimates, and to the extent that such differences are material, future reported operating results may be affected. o Revenue recognition o Inventory valuation o Determination of the allowance for doubtful accounts receivable o Valuation of long-lived assets o Accounting for deferred income taxes o Legal contingencies Further information regarding these policies appears within the "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in the Company's annual report on Form 10-K for the fiscal year ended February 28, 2005 filed with the SEC on May 16, 2005. During the three-month period ended May 31, 2005, there were no significant changes to any critical accounting policies or to the related estimates and judgments involved in applying these policies. Business Acquisition -------------------- On March 30, 2005, SMSC announced the completion that day of its acquisition of OASIS SiliconSystems Holding AG (OASIS). Based in Karlsruhe, Germany, OASIS is engaged in the development and marketing of integrated circuits that enable networking of multimedia devices for automotive infotainment applications. OASIS is a leading provider of Media Oriented Systems Transport (MOST(R)) technology, which enables the seamless transport of digital audio, video, and packet-based data, along with control information, within automobiles. SMSC acquired all of OASIS' outstanding capital stock in exchange for aggregate consideration of $118.7 million, including approximately 2.1 million shares of SMSC common stock valued for accounting purposes at $35.8 million, $79.5 million of cash, and approximately $3.4 million of direct acquisition costs, including legal, banking, accounting and valuation fees. The tangible assets of OASIS at March 30, 2005 included approximately $22.4 million of cash and cash equivalents, resulting in a net cash outlay of approximately $60.5 million. SMSC's existing cash balances were the source of the cash used in the transaction. The results of OASIS' operations subsequent to March 30, 2005 have been included in the Company's consolidated results of operations. Up to $20.0 million of additional consideration, payable in cash and SMSC common stock, may be issued to OASIS' former shareholders during fiscal 2007 upon satisfaction of certain future performance goals. Results of Operations --------------------- Revenues Effective in fiscal 2006, SMSC is tracking revenues shipped into three vertical markets. For the first quarter of fiscal 2006, total revenues included approximately 53%, or $36.4 million, from mobile and desktop PCs; 28%, or $19.2 million, from consumer electronics & infotainment; and 19%, or $13.2 million, from industrial and other sources. It was not practicable to develop revenue data for shipments into these three vertical markets for the three months ended May 31, 2004. Therefore, the following year-over-year comparisons are structured based on our historical discussion of PC I/O and non-PC I/O revenues. Revenues for the three months ended May 31, 2005 were $68.8 million, compared to revenues of $53.1 million for the year earlier period, an increase of approximately 30%. Included in the current quarter's revenues are $9.3 million of revenues associated with the acquisition of OASIS. These revenues reflect shipments subsequent to March 30, 2005, representing approximately two months of activity, in the current quarter. The Company achieved growth in revenues from both PC I/O and non-PC I/O products (exclusive of OASIS revenues) in the current-year quarter, compared to the prior-year quarter, with increases of approximately 11% and 16%, respectively. The increase in PC I/O revenues was driven by a 31% increase in revenues from mobile I/O products, reflecting strong market demand in mobile computing applications, partially offset by a 6% decline in revenues from desktop I/O products. The increase in non-PC I/O revenues was the result of growth in the Company's connectivity and environmental monitoring and control (EMC) product lines, both of which benefited from broader product offerings in the current-year quarter. Revenues from networking products remained level in the current-year quarter, compared to the prior-year quarter. The Company's revenues for the three-month periods ended May 31, 2005 and 2004 are summarized in the following table (in millions): Three Months Ended May 31, 2005 2004 ---------------------------------------------------------------------- PC I/O products $ 33.4 $ 30.2 Non-PC I/O products * 23.5 20.2 AIS products and services 9.3 - I.P revenues and other 2.6 2.7 ---------------------------------------------------------------------- $ 68.8 $ 53.1 ====================================================================== * Includes networking, connectivity, EMC products and other non-PC I/O products Revenues from customers outside of North America accounted for approximately 85% and 83% of the Company's consolidated revenues for the three-month periods ended May 31, 2005 and 2004, respectively. While the largest portion of the Company's revenues continues to be derived from the Asia region, the acquisition of OASIS has significantly increased the Company's revenues in Europe. The Company's revenues in Europe, including the impact of OASIS, were about $9.5 million in the current-year quarter, compared to just under $3 million in the prior-year quarter. The Company expects that international shipments, particularly to the Asia region, will continue to represent a significant portion of its revenues. Cost of Goods Sold Cost of goods sold for the quarter ended May 31, 2005 was $36.5 million, which resulted in a gross profit at 47.0% of revenues, compared to $26.4 million, and gross profit at 50.3% of revenues, for the three months ended May 31, 2004. For purposes of this discussion, gross profit is defined as revenues minus cost of goods sold, before amortization of intangibles. The decline in gross profit percentage in the current-year period, compared to the prior-year period, results from a combination of (1) a lower gross profit percentage realized on desktop I/O products, driven by higher unit costs and lower average selling prices on certain devices; (2) a $0.6 million charge associated with sales of inventory that was acquired from OASIS and valued in the acquisition above its historical cost; and (3) a higher proportion of intellectual property revenues in the prior-year quarter. The higher unit costs reflect the impact of higher wafer costs on inventory built in the latter part of fiscal 2005 and sold during the first quarter of fiscal 2006. Research and Development Expenses Research and development (R&D) expenses consist primarily of salaries and related costs of employees engaged in research, design and development activities, costs related to engineering design tools and computer hardware, subcontractor costs and device prototyping costs. The Company's R&D activities are performed by highly-skilled and experienced engineers and technicians, and are primarily directed towards the design of new integrated circuits and the development of new software drivers, firmware and design tools and blocks of logic, as well as ongoing cost reductions and performance improvements in existing products. The Company intends to continue its efforts to develop innovative new products and technologies and believes that an ongoing commitment to R&D is essential in order to maintain product leadership and compete effectively. Therefore, the Company expects to continue to make significant R&D investments in the future. R&D expenses were $13.0 million, or approximately 19% of revenues, for the three months ended May 31, 2005, compared to $10.9 million, or approximately 20% of revenues, for the three months ended May 31, 2004. The increase in the current year's three-month period, compared to the prior year's three-month period, is primarily due to the addition of R&D expenses associated with the operations of OASIS, which impacted two months of the current quarter's operating results. OASIS' staff includes approximately 90 engineers and technicians. The remainder of the increase resulted from higher depreciation expenses associated with investments in advanced semiconductor design tools and higher device prototype expenses. Selling, General and Administrative Expenses Selling, general and administrative expenses were $13.6 million, or approximately 20% of revenues, for the quarter ended May 31, 2005, compared to $11.9 million, or approximately 22% of revenues, for the quarter ended May 31, 2004. The increase in the current year's first quarter, compared to the prior year's first quarter, is primarily due to the addition of expenses associated with the operations of OASIS, with the remainder of the increase primarily reflecting higher direct selling expenses, including sales commissions associated with the higher current quarter revenues. Amortization of Intangible Assets For the three-month period ended May 31, 2005, the Company recorded $0.9 million of amortization expenses for finite-lived intangible assets acquired in the OASIS transaction, as well as $0.3 million of amortization for finite-lived intangible assets associated with the acquisition of Gain Technology Corporation (Gain) during fiscal 2003. Amortization expense of $0.3 million for the Gain intangible assets was recorded in the prior-year's first quarter. In-Process Research and Development The $0.9 million in-process research and development expense recorded in the first quarter of fiscal 2006 represents the fair value of in-process technology for OASIS research projects that, as of the March 30, 2005 closing date of the OASIS acquisition, had not reached technological feasibility and had no alternative future uses. These projects are primarily focused on deployment of certain technology into consumer applications. The estimated fair value of this in-process research and development was recorded as an expense in the quarter ended May 31, 2005. Other Income and Expense The increase in interest income, from $0.5 million in the three-month period ended May 31, 2004, to $0.7 million in the three-month period ended May 31, 2005, primarily reflects the impact of higher average interest rates, partially offset by a lower average level of investments, during the current-year period. Provision For Income Taxes The Company's effective income tax rate reflects statutory federal, state and foreign tax rates, the impact of certain permanent differences between the book and tax treatment of certain expenses, and the impact of tax-exempt income and various income tax credits. The Company's $1.4 million provision for income taxes for the three-month period ended May 31, 2005 reflects an expected fiscal 2006 effective tax rate of approximately 31%. The provision for income taxes for the first quarter of the prior fiscal year was $1.2 million, which resulted in an effective income tax rate of approximately 28%. The higher projected effective tax rate for fiscal 2006, compared to the effective tax rate for the first quarter of fiscal 2005, reflects the lower proportionate effective tax rate impact of income tax credits and tax-exempt interest income which results from a higher current-year pre-tax income expectation. Liquidity and Capital Resources ------------------------------- The Company currently finances its operations through a combination of existing resources and cash generated by operations. The Company's cash, cash equivalents and liquid investments were $121.0 million at May 31, 2005, compared to $172.6 million at February 28, 2005, a decrease of $51.6 million. Operating activities generated $15.2 million of cash during the first three months of fiscal 2006, compared to a consumption of $1.0 million during the first three months of fiscal 2005. Operating cash flows during the current-year period reflect a decrease in inventories (excluding the impact of the OASIS acquisition), and an increase in accrued liabilities, while the prior year's operating cash flows were burdened by an $8.0 million increase in accounts receivable. The current-year period's operating activities include $5.0 million of non-cash charges, including depreciation, amortization, in-process research and development and stock-based compensation, compared to $3.0 million in the prior-year period. Investing activities consumed $108.2 million of cash during the first quarter of fiscal 2006, due principally to $60.3 million used for the acquisition of OASIS, a net increase of $44.7 million in short-term investments, and $3.2 million of capital expenditures. The $60.3 million of cash used for the acquisition of OASIS includes $79.5 million of cash paid to the former OASIS shareholders as part of the transaction's consideration, $3.4 million of transaction costs ($0.2 million of which were paid prior to the current-year quarter), partially offset by $22.4 million of cash acquired from OASIS. Investing activities consumed $0.7 million of cash during the first quarter of fiscal 2005, due principally to $2.9 million of capital expenditures, partially offset by a net increase of $2.2 million in short-term and long-term investments. Net cash of $2.8 million used for financing activities during the first quarter of fiscal 2006 included $2.2 million of treasury stock purchases and $0.7 million of debt repayments. Financing activities consumed $0.3 million of cash during the first quarter of fiscal 2005, including $0.5 million of debt repayments, partially offset by $0.2 million of proceeds from exercises of stock options. The Company's inventories were $42.3 million at May 31, 2005, compared to $33.3 million at February 28, 2005. This increase includes $11.5 million of OASIS product inventories at May 31, 2005, partially offset by a net decline in PC I/O, networking and connectivity device inventories. Accounts receivable increased from $23.8 million at February 28, 2005 to $29.9 million at May 31, 2005, an increase of $6.1 million. Of this increase, $5.7 million reflects the accounts receivable of OASIS. Total current liabilities increased from $37.1 million at February 28, 2005 to $50.0 million at May 31, 2005, including $9.0 million of current liabilities associated with the operations of OASIS, as well as a $3.4 million increase in deferred income on shipments to distributors. The increase in deferred income reflects an increase in distributor inventories in advance of anticipated product demand during the Company's second quarter ending August 31, 2005. Capital expenditures for the three-month period ended May 31, 2005 were $3.2 million, and were predominantly for facility expansion, production test equipment, advanced semiconductor design tools and investments in intellectual property. Capital expenditures were $2.9 million for the three-month period ended May 31, 2004. The Company anticipates that capital expenditures in fiscal 2006 will exceed those incurred during fiscal 2005, due in part to the Company's in-progress construction of an addition to its primary facility in Hauppauge, New York, which will expand the facility from its current 80,000 square feet to approximately 200,000 square feet, and which will allow consolidation of the Company's Hauppauge operations into a single facility, currently expected to occur during fiscal 2007. The Company currently expects the cost of this building expansion to be approximately $20 million, of which $4.2 million has been expended, and is classified as construction in progress, at May 31, 2005. The majority of the expenditures for this project are expected to occur during fiscal 2006. There were no other material commitments for capital expenditures as of May 31, 2005. SMSC maintains a common stock repurchase program, as approved by its Board of Directors, which authorizes the Company to repurchase up to three million shares of its common stock on the open market or in private transactions. Under this program, the Company repurchased approximately 150,000 shares of its common stock at a cost of $2.2 million during the first quarter of fiscal 2006. No shares were repurchased during the first quarter of fiscal 2005. The Company currently holds repurchased shares as treasury stock. As of May 31, 2005, the Company has repurchased a total of approximately 2.0 million shares of its common stock, at a cost of $26.0 million, under this program. In connection with the March 2005 acquisition of OASIS, up to $20.0 million of additional consideration, payable in cash and SMSC common stock, may be issued to OASIS' former shareholders during fiscal 2007 upon satisfaction of certain future performance goals. The Company has considered in the past, and will continue to consider, various possible transactions to secure necessary foundry manufacturing capacity, including equity investments in, prepayments to, or deposits with foundries, in exchange for guaranteed capacity or other arrangements which address the Company's manufacturing requirements. The Company may also consider utilizing cash to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies. From time to time, in the ordinary course of business, the Company may evaluate potential acquisitions of or investments in such businesses, products or technologies owned by third parties. The Company expects that its cash, cash equivalents, short-term investments, cash flows from operations and its borrowing capacity will be sufficient to finance the Company's operating and capital requirements for at least the next twelve months and for the foreseeable future thereafter. Recent Accounting Pronouncements -------------------------------- In November 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 151, "Inventory Costs, An Amendment of ARB No. 43, Chapter 4." SFAS No. 151 clarifies that abnormal inventory costs such as costs of idle facilities, excess freight and handling costs, and wasted materials (spoilage) are required to be recognized as current period charges. The provisions of SFAS No. 151 are effective for fiscal years beginning after June 15, 2005. The Company is currently evaluating the provisions of SFAS No. 151 and does not expect that its adoption will have a material impact on its consolidated financial condition, results of operations and cash flows. In December 2004, the FASB issued SFAS No. 123R (Revised 2004), "Share-Based Payment." The scope of SFAS No. 123R includes a wide range of share-based compensation arrangements including stock options, restricted stock plans, performance-based awards, stock appreciation rights, and employee stock purchase plans. SFAS No. 123R replaces SFAS No. 123, "Accounting for Stock-Based Compensation," and supersedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS No. 123, as originally issued in 1995, established as preferable a fair-value-based method of accounting for share-based payment transactions with employees. However, that statement permitted the option of continuing to apply the guidance in APB Opinion 25, provided that the footnotes to the consolidated financial statements disclosed pro forma net income and net income per share, as if the preferable fair-value-based method had been applied. SFAS No. 123R requires that compensation costs relating to share-based payment transactions be recognized in the consolidated financial statements. Compensation costs will be measured based on the fair value of the equity or liability instruments issued. SFAS No. 123R is effective for the first annual reporting period that begins after June 15, 2005. The Company is currently evaluating the impact of SFAS No. 123R and believes that the adoption of this statement could have a material impact on its consolidated financial position and results of operations. In December 2004, the FASB issued Statement No. 153, "Exchanges of Nonmonetary Assets," an amendment of APB Opinion No. 29. SFAS No. 153 addresses the measurement of exchanges of nonmonetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. SFAS No. 153 is effective for nonmonetary asset exchanges in fiscal periods beginning after June 15, 2005. The Company does not expect the adoption of SFAS No. 153 to have a material impact on its consolidated financial position, results of operations and cash flows. In December 2004, the FASB issued FASB Staff Position (FSP) No. 109-2, "Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004." The American Jobs Creation Act introduces a special one-time dividends received deduction on the repatriation of certain foreign earnings to U.S. companies, provided certain criteria are met. FSP No. 109-2 provides accounting and disclosure guidance on the impact of the repatriation provision on a company's income tax expense and deferred tax liability. The Company is currently studying the impact of the one-time favorable foreign dividend provision and intends to complete the analysis by the end of fiscal 2006. Accordingly, the Company has not recorded any adjustments to its income tax expense or deferred income taxes to reflect the tax impact of any repatriation of non-U.S. earnings it may make. In March 2005, the Financial Accounting Standards Board issued Interpretation No. 47, "Accounting for Conditional Asset Retirement Obligations." Interpretation No. 47 clarifies that an entity must record a liability for a "conditional" asset retirement obligation if the fair value of the obligation can be reasonably estimated. Interpretation No. 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. Interpretation No. 47 is effective no later than the end of the fiscal year ending after December 15, 2005. The Company does not expect the adoption of Interpretation No. 47 to have a material impact on its consolidated financial position, results of operations and cash flows. ITEM 3. Quantitative and Qualitative Disclosures About Market Risk Interest Rate Risk The Company's exposure to interest rate risk relates primarily to its investment portfolio. The primary objective of SMSC's investment portfolio management is to invest available cash while preserving principal and meeting liquidity needs. In accordance with the Company's investment policy, investments are placed with high credit-quality issuers and the amount of credit exposure to any one issuer is limited. As of May 31, 2005, the Company's $101.3 million of short-term investments consisted primarily of investments in auction rate securities, and investments in corporate, government and municipal obligations with maturities of between three and twelve months at acquisition. Auction rate securities have long-term underlying maturities, but have interest rates that are reset every 90 days or less, at which time the securities can typically be purchased or sold. As with all fixed-income instruments, these securities are subject to interest rate risk and would likely decline in market value if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from levels at May 31, 2005, the Company estimates that the fair values of these investments would decline by an immaterial amount, due to the portfolio's relatively short-term overall maturity. Furthermore, the Company has the option to hold its fixed-income investments until maturity and, therefore, would not expect to realize any material adverse impact to its results from operations or cash flows from such a decline. Declines in market interest rates would, over time, reduce the Company's interest income. Equity Price Risk The Company has no material investments in equity securities of other companies on its Consolidated Balance Sheet as of May 31, 2005. Foreign Currency Risk The Company has international sales and expenditures and is, therefore, subject to certain foreign currency rate exposures. The Company conducts a significant amount of its business in Asia. In order to reduce the risk from fluctuation in foreign exchange rates, most of the Company's product sales and all of its arrangements with its foundry, test and assembly vendors are denominated in U.S. dollars. Most transactions in the Japanese market made by the Company's subsidiary, SMSC Japan, are denominated in Japanese yen. SMSC Japan purchases a significant amount of its products for resale from SMSC in U.S. dollars, and from time to time has entered into forward exchange contracts to hedge against currency fluctuations associated with these product purchases. No such contracts were executed during either fiscal 2005 or the first three months of fiscal 2006, and there are no obligations under any such contracts as of May 31, 2005. The Company has never received a cash dividend (repatriation of cash) from SMSC Japan. OASIS' operating activities in Europe include transactions conducted in both euros and U.S. dollars. The euro has been designated as OASIS' functional currency for its European operations. From time to time, OASIS has entered into foreign currency contracts to minimize the exposure of its U.S dollar denominated transactions, assets and liabilities to currency exchange rate risk. Gains or losses on these contracts are intended to offset the gains or losses recorded from the remeasurement of certain assets and liabilities from U.S. dollars into euros. As of May 31, 2005, OASIS has foreign currency contracts to convert an aggregate of $3.2 million into euros in varying monthly amounts through December 31, 2005. Gains and losses on these contracts, as well as gains and losses recorded from the remeasurement of U.S. dollar denominated assets and liabilities into euros, were not significant during the three months ended May 31, 2005. Other Factors That May Affect Future Operating Results ------------------------------------------------------ As a supplier of semiconductors, the Company competes in a challenging business environment, which is characterized by intense competition, rapid technological changes and cyclical business patterns. Except for the historical information contained herein, the matters discussed in this report are forward-looking statements. The Company faces a variety of risks and uncertainties in conducting its business, some of which are out of its control, and any of which, were they to occur, could impair the Company's operating performance. For a more detailed discussion of risk factors, please refer to the Company's annual report on Form 10-K for the fiscal year ended February 28, 2005 filed with the SEC on May 16, 2005. ITEM 4. Controls and Procedures The Company has carried out an evaluation under the supervision and with the participation of the Company's management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Based upon the Company's evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of May 31, 2005, the disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed in the reports the Company files under the Exchange Act is recorded, processed, summarized, and reported as and when required. There have been no changes in the Company's internal control over financial reporting during the Company's fiscal quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. SMSC completed the acquisition of OASIS on March 30, 2005, as more fully described in Note 3 to the Financial Statements in this Form 10Q. As part of its ongoing integration activities, SMSC is in the process of incorporating its controls and procedures into OASIS. PART II - OTHER INFORMATION ITEM 1. Legal Proceedings As of May 31, 2005, SMSC was not a party to any legal proceedings, claims, disputes or litigation that are expected to have a material adverse effect on the Company's results of operations or financial condition. ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds Unregistered Sales of Equity Securities The disclosures regarding unregistered sales of equity securities are hereby incorporated by reference to the information appearing within Item 3.02 included in the Company's report on Form 8-K filed on April 5, 2005. Purchases of Equity Securities by the Issuer In October 1998, the Company's Board of Directors approved a plan authorizing the repurchase up to one million shares of the Company's common stock in the open market or in private transactions. The Board of Directors increased the authorization from one million shares to two million shares in July 2000, and from two million shares to three million shares in July 2002. The plan has no specified expiration date. Shares of common stock purchased pursuant to the repurchase plan are held as treasury stock. Activity under this plan during the period covered by this report was as follows (shares in thousands): Total Number Average Total Number of Maximum Number of of Shares Price Shares Purchased Shares that May Yet Purchased Paid per as Part of Publicly Be Purchased Under Period Share Announced Plans the Plans or Programs -------------------------------------------------------------------------------- March 2005 - - - 1,158 April 2005 100 $ 14.32 100 1,058 May 2005 50 $ 14.53 50 1,008 --------------------------------------------------------- First Quarter, Fiscal 2006 150 $ 14.39 150 ========================================================= All purchases during this period were open market transactions. ITEM 3. Defaults Upon Senior Securities None. ITEM 4. Submission of Matters to a Vote of Security Holders None. ITEM 5. Other Information None. ITEM 6. Exhibits 31.1 - Certification of Chief Executive Officer pursuant to Rule 13a-14(a) (17 CFR 240.13a-14(a)), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 - Certification of Chief Financial Officer pursuant to Rule 13a-14(a) (17 CFR 240.13a-14(a)), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 - Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. STANDARD MICROSYSTEMS CORPORATION DATE: July 11, 2005 By: /s/ Andrew M. Caggia ------------------------- (Signature) Andrew M. Caggia Senior Vice President (duly authorized officer) and Chief Financial Officer (principal financial officer)